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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Conference on Bank Structure and Competition, sponsored by the Federal Reserve Bank of Chicago, Chicago, Illinois, (via satellite), 6 May 2004.
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Alan Greenspan: Globalisation and innovation Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Conference on Bank Structure and Competition, sponsored by the Federal Reserve Bank of Chicago, Chicago, Illinois, (via satellite), 6 May 2004. * * * The United States economy appears to have been pressing a number of historic limits in recent years without experiencing the types of financial disruption that almost surely would have arisen in decades past. This observation raises some key questions about the longer-term stability of the U.S. and global economies that bear significantly on future economic developments, including the future competitive shape of banking. Among the limits we have been pressing against are those in our external and budget balances. We in the United States have been incurring ever larger trade deficits, with the broader current account measure having reached 5 percent of our gross domestic product (GDP). Yet the dollar’s real exchange value, despite its recent decline, remains close to its average of the past two decades. Meanwhile, we have lurched from a budget surplus in 2000 to a deficit that is projected by the Congressional Budget Office to be 4-1/4 percent of GDP this year. In addition, we have legislated commitments to our senior citizens that, given the inevitable retirement of our huge baby-boom generation, will create significant fiscal challenges in the years ahead. Yet the yield on Treasury notes maturing a decade from now remain at low levels. Nor are we experiencing inordinate household financial pressures as a consequence of record high household debt as a percent of income. *** Has something fundamental happened to the U.S. economy and, by extension, U.S. banking, that enables us to disregard all the time-tested criteria of imbalance and economic danger? Regrettably, the answer is no. The free lunch has still to be invented. We do, however, seem to be undergoing what is likely, in the end, to be a one-time shift in the degree of globalization and innovation that has temporarily altered the specific calibrations of those criteria. Recent evidence is consistent with such a hypothesis of a transitional economic paradigm, a paradigm somewhat different from that which fit much of our earlier post-World War II experience. *** Globalization has altered the economic frameworks of both advanced and developing nations in ways that are difficult to fully comprehend. Nonetheless, the largely unregulated global markets, with some notable exceptions, appear to move effortlessly from one state of equilibrium to another. Adam Smith’s “invisible hand” remains at work on a global scale. Because of a lowering of trade barriers, deregulation, and increased innovation, cross-border trade in recent decades has been expanding at a far faster pace than GDP. As a result, domestic economies are increasingly exposed to the rigors of international competition and comparative advantage. In the process, lower prices for some goods and services produced by our trading partners have competitively suppressed domestic price pressures. Production of traded goods has expanded rapidly in economies with large, low-wage labor forces. Most prominent are China and India, which over the past decade have partly opened up to market capitalism, and the economies of central and eastern Europe that were freed from central planning by the fall of the Soviet empire. The consequent significant additions to world production and trade have clearly put downward pressure on domestic prices, though somewhat less so over the past year. Moreover, the pronounced fall in inflation, virtually worldwide, over the past two decades has doubtless been a key factor in the notable decline in world economic volatility. In tandem with increasing globalization, monetary policy, to most observers, has become increasingly effective in achieving the objective of price stability. But because we have not experienced a sufficient number of economic turning points to judge the causal linkages among increased globalization, improved monetary policy, significant disinflation, and greater economic stability, the structure of the transitional paradigm is necessarily sketchy. Nonetheless, a paradigm encompassing globalization and innovation, far more than in earlier decades, appears to explain the events of the past ten years better than other conceptual constructs. If this is indeed the case, because there are limits to how far globalization and the speed of innovation can proceed, the current apparent rapid pace of structural shift cannot continue indefinitely. A couple of weeks ago, I indicated in testimony to the Congress that the outlook for the next year or two has materially brightened. But the outlook for the latter part of this decade remains opaque because it is uncertain whether this transitional paradigm, if that is what it is, is already far advanced and about to slow, or whether it remains in an early, still vibrant stage of evolution. *** Globalization - the extension of the division of labor and specialization beyond national borders - is patently a key to understanding much of our recent economic history. With a deepening of specialization and a growing population free to take risks over a widening area, production has become increasingly international.1 The pronounced structural shift over the past decade to a far more vigorous competitive world economy than that which existed in earlier postwar decades apparently has been adding significant stimulus to world economic activity. That stimulus, like that which resulted from similar structural changes in the past, is likely a function of the rate of increase of globalization and not its level. If so, such impetus would tend to peter out, as we approach the practical limits of globalization. Full globalization, in which trade and finance are driven solely by risk-adjusted rates of return and risk is indifferent to distance and national borders, will likely never be achieved. The inherent risk aversion of people, and the home bias implied by that aversion, will limit how far globalization can proceed. But because so much of our recent experience has little precedent, as I noted earlier, we cannot fully determine how long the current globalization dynamic will take to play out. *** The increasing globalization of the post-war world was fostered at its beginnings by the judgment that burgeoning prewar protectionism was among the primary causes of the depth of the Great Depression of the 1930s. As a consequence, trade barriers began to fall after the war. Globalization was enhanced further when the inflation-ridden 1970s provoked a rethinking of the philosophy of economic policy, the roots of which were still planted in the Depression era. In the United States, that rethinking led to a wave of bipartisan deregulation of transportation, energy, and finance. At the same time, there was a growing recognition that inflation impaired economic performance. Indeed, Group of Seven world leaders at their 1977 Economic Summit identified inflation as a cause of unemployment. Moreover, monetary policy tightening, and not increased regulation, came to be seen by the end of that decade as the only viable solution to taming inflation.2 Of course, the startling recovery of war-ravaged West Germany following Ludwig Erhard’s postwar reforms, and Japan’s embrace of global trade, were early examples of the policy reevaluation process. It has taken several decades of experience with markets and competition to foster an unwinding of regulatory rigidities. Today, privatization and deregulation have become almost synonymous with “reform.” *** By any number of measures, globalization has expanded markedly in recent decades. Not only has the ratio of international trade in goods and services to world GDP risen inexorably over the past half-century, but a related measure - the extent to which savers reach beyond their national borders to invest in foreign assets - has also risen. Through much of the post-World War II years, domestic saving for each country was invested predominantly in its domestic capital assets, irrespective of the potential for superior risk-adjusted returns to be available from abroad. Because a country’s domestic saving less its domestic investment Much of what is assembled in final salable form in the United States, for example, may consist of components from many continents. Companies seek out the lowest costs of inputs to effectively compete for their customers’ dollars. This international competition left unfettered, history suggests, would tend to direct output to the most efficient producers of specific products or services and, hence, maximize standards of living of all participants in trade. Given the skills and education of its workforce and a number of institutional factors, such as its legal structure, each economy will achieve its maximum possible average living standard. This had not always been the case. For example, wage and price controls were imposed in the United States in 1971 as a substitute for a tighter monetary policy and higher interest rates to address rising inflation. is equal to its current account balance, such balances, positive or negative, with the exception of the mid-1980s, were therefore generally modest. But in the early 1990s, “home bias” began to diminish appreciably,3 and, hence, the dispersion of current account balances among countries has increased markedly. The widening current account deficit in the United States has come to dominate the tail of that distribution of external balances across countries. Thus, the decline in home bias, or its equivalent, expanding globalization, has apparently enabled the United States to finance and, hence, incur so large a current account deficit. As a result of these capital flows, the ratio of foreign net claims against U.S. residents to our annual GDP has risen to approximately one-fourth. While some other countries are far more in debt to foreigners, at least relative to their GDPs, they do not face the scale of international financing that we require. A U.S. current account deficit of 5 percent or more of GDP would probably not have been readily fundable a half-century ago or perhaps even a couple of decades ago.4 The ability to move that much of world saving to the United States in response to relative rates of return almost surely would have been hindered by the far-lesser degree of both globalization and international financial flexibility that existed at the time. Such large transfers would presumably have induced changes in the prices of assets that would have proved inhibiting. Nonetheless, we have little evidence that the economic forces that are fostering international specialization, and hence cross-border trade and increasing dispersion of current account balances, are as yet diminishing. At some point, however, international investors, private and official, faced with a concentration of dollar assets in their portfolios, will seek diversification, irrespective of the competitive returns on dollar assets. That shift, over time, would likely induce contractions in both the U.S. current account deficit and the corresponding current account surpluses of other nations. Can market forces incrementally defuse a buildup in a nation’s current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of market flexibility. In a world economy that is sufficiently flexible, as debt projections rise, product and equity prices, interest rates, and exchange rates presumably would change to reestablish global balance.5 We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis.6 Should globalization continue unfettered and thereby create an ever more flexible international financial system, history suggests that current account imbalances will be defused with modest risk of The correlation coefficient between paired domestic saving and domestic investment, a conventional measure of the propensity to invest at home for OECD countries constituting four-fifths of world GDP, fell from 0.96 in 1992 to less than 0.8 in 2002. With rare exceptions, a decline in the correlation of countries’ paired domestic investment to domestic saving implies an increased dispersion of current account balances. It is true that estimates of the ratios of the current account to GDP for many countries in the nineteenth century are estimated to have been as large as, or larger, than we have experienced in recent years. However, the substantial net flows of capital financing for those earlier deficits were likely motivated in large part by specific major development projects (for example, railroads) bearing high expected rates of return. By contrast, diversification appears to be a more salient motivation for today’s large net capital flows. Moreover, gross capital flows are believed to be considerably greater relative to GDP in recent years than in the nineteenth century. (See Alan M. Taylor, “A Century of Current Account Dynamics,” Journal of International Money and Finance, 2002, pp. 725-48, and Maurice Obstfeld and Alan M. Taylor, “Globalization and Capital Markets,” NBER Working Paper 8846, March 2002.) The experience over the past two centuries of trade and finance among the individual states that make up the United States comes close to that paradigm of flexibility, even though exchange rates among the states have been fixed. Although we have scant data on cross-border transactions among the separate states, anecdotal evidence suggests that over the decades significant apparent imbalances have been resolved without precipitating interstate balance-of-payments crises. The dispersion of unemployment rates among the states, one measure of imbalances, spikes during periods of economic stress but rapidly returns to modest levels, a pattern reflecting a high degree of adjustment flexibility. That flexibility is even more apparent in regional money markets, where interest rates that presumably reflect differential imbalances in states’ current accounts and hence cross-border borrowing requirements have, in recent years, exhibited very little interstate dispersion. This observation suggests either negligible cross-state-border imbalances, an unlikely occurrence given the pattern of state unemployment dispersion, or more likely very rapid financial adjustments. Although increased flexibility apparently promotes resolution of current account imbalances without significant disruption, it may also allow larger deficits to emerge before markets are required to address them. Moreover, the apparent ability of the U.S. economy to withstand the stock market plunge of 2000, the terrorist attacks of 9/11, corporate governance scandals, and wars in Afghanistan and Iraq indicates a greater degree of economic flexibility than was apparent in the 1970s and earlier. disruption. A Federal Reserve study of large current account adjustments in developed countries,7 the results of which are presumably applicable to the United States, suggests that market forces are likely to restore a more long-term sustainable current account balance here without measurable disruption. Indeed, this was the case in the second half of the 1980s. I say this with one major caveat. Protectionism, some signs of which have recently emerged, could significantly erode global flexibility and, hence, undermine the global adjustment process. We are already experiencing pressure to slow down the expansion of trade. The current Doha Round of trade negotiations is in some difficulty owing largely to the fact that the low-hanging fruit of trade negotiation has already been picked in the trade liberalizations that have occurred since the Kennedy Round. *** Augmenting the dramatic effect of increased globalization on economic growth, and perhaps at some times, fostering it, have been the remarkable technological advances of recent decades. In particular, information and communication technologies have propelled the processing and transmission of data and ideas to a level far beyond our capabilities of a decade or two ago. The advent of real-time information systems has enabled managers to organize a workforce without the redundancy required in earlier decades to ensure against the type of human error that technology has now made far less prevalent. Real-time information, by eliminating much human intervention, has markedly reduced scrappage rates on production lines, lead times on purchases, and errors in all forms of recordkeeping. Much data transfer is now electronic and far more accurate than possible in earlier times. The long-term path of technology and growth is difficult to discern. Indeed, innovation, by definition, is not forecastable. Nonetheless, the overall pace of productivity growth that has recently been near 5 percent at an annual rate is highly likely to slow because we have rarely exceeded 3 percent for any protracted period. In the United States, we have always employed technologies at, or close to, the cutting edge, and we have created much of our innovative technologies ourselves. The opportunities of many developing economies to borrow innovation is not readily available to us. Thus, even though the longer-term prospects for innovation and respectable productivity growth are encouraging, some near-term slowing in the pace of advance to a rate closer to productivity’s long-term average seems likely. *** We have, I believe, a reasonably good understanding of why Americans have been able to reach farther into global markets, incur significant increases in debt, and yet fail to produce the disruptions so often observed as a consequence. However, a widely held alternative view of the past decade cannot readily be dismissed. That view holds that the postwar paradigm is still largely in place, and key financial ratios, rather than suggesting a moving structure, reflect extreme values of a fixed structure that must eventually adjust, perhaps abruptly. To be sure, even with the increased flexibility implied in a paradigm of expanding globalization and innovation, the combination of exceptionally low saving rates and historically high ratios of household debt to income can be a concern if incomes unexpectedly fall. Indeed, there is little doubt that virtually any debt burden becomes oppressive if incomes fall significantly. But rising debt-to-income ratios can be somewhat misleading as an indicator of stress. Indeed the ratio of household debt to income has been rising sporadically for more than a half-century, a trend that partly reflects the increased capacity of ever-wealthier households to service debt. Moreover, a significant part of the recent rise in the debt-to-income ratio also reflects the remarkable gain in homeownership. Over the past decade, for example, the share of households that owns homes has risen from 6 percent to 69 percent. During the decade a significant number of renters bought homes, thus increasing the asset side of their balance sheets as well as increasing their debt. It can scarcely be argued that the substitutions of debt service for rent materially impaired the financial state of the new homeowner. Yet the process over the past decade added more than 10 percent to outstanding Caroline Freund, “Current Account Adjustment in Industrialized Countries,” Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December 2000. mortgage debt and accounted for more than one-seventh of the increase in total household debt over that period.8 Thus, short of a period of overall economic weakness, households, with the exception of some highly leveraged subprime borrowers, do not appear to be faced with significant financial strain. With interest rates low, debt service costs for households are average, or only marginally higher than average. Adding other fixed charges such as rent, utilities, and auto-leasing costs does not materially alter the change in the degree of burden. Even should interest rates rise materially further, the effect on household expenses will be stretched out because four-fifths of debt is fixed rate of varying maturities, and it will take time for debt to mature and reflect the higher rates. Despite the almost two percentage point rise in mortgage rates on new originations from mid-1999 to mid-2000, the average interest rate on outstanding mortgage debt rose only slightly, as did debt service. In a related concern, a number of analysts have conjectured that the extended period of low interest rates is spawning a bubble in housing prices in the United States that will, at some point, implode. Their concern is that, if this were to occur, highly leveraged homeowners will be forced to sharply curtail their spending. To be sure, indexes of house prices based on repeat sales of existing homes have outstripped increases in rents, suggesting at least the possibility of price misalignment in some housing markets. A softening in housing markets would likely be one of many adjustments that would occur in the wake of an increase in interest rates. But a destabilizing contraction in nationwide house prices does not seem the most probable outcome. Indeed, nominal house prices in the aggregate have rarely fallen and certainly not by very much. Still, house prices, like those of many other assets, are difficult to predict, and movements in those prices can be of macroeconomic significance. Moreover, because these transactions often involve considerable leverage, they need to be monitored by those responsible for fostering financial stability. There appears, at the moment, to be little concern about corporate financial imbalances. Debt-to-equity ratios are well within historical ranges, and the recent prolonged period of low long-term interest rates has enabled corporations to fund short-term liabilities and stretch out bond maturities. Even the relatively narrow spreads on below-investment-grade corporate debt appear to reflect low expected losses rather than an especially small aversion to risk. The resolution of our current account deficit and household debt burdens does not strike me as overly worrisome, but that is certainly not the case for our yawning fiscal deficit. Our fiscal prospects are, in my judgment, a significant obstacle to long-term stability because the budget deficit is not readily subject to correction by market forces that stabilize other imbalances. One issue that concerns most analysts, especially in the context of a widening structural federal deficit, is inadequate national saving. Fortunately, our meager domestic savings, and those attracted from abroad, are being very effectively invested in domestic capital assets. The efficiency of our capital stock thus has been an important offset to what, by any standard, has been an exceptionally low domestic saving rate in the United States. Although saving is a necessary condition for financing the capital investment required to engender productivity, it is not a sufficient condition. The very high saving rates of the Soviet Union, of China, and of India in earlier decades, often did not foster significant productivity growth in those countries. Saving squandered in financing inefficient technologies does not advance living standards. It is thus difficult to judge how significant a problem our relatively low gross domestic saving rate is to the future growth of an efficient capital stock. The high productivity growth rate of the past decade does not suggest a problem. But our success in attracting savings from abroad may be masking the full effect of deficient domestic saving. *** Our day-by-day experiences with the effectiveness of flexible markets as they adjust to, and correct, imbalances can readily lead us to the conclusion that once markets are purged of rigidities, macroeconomic disturbances will become a historical relic. However, the penchant of humans for quirky, often irrational, behavior gets in the way of this conclusion. A discontinuity in valuation For statistical methodology see Karen Dynan, Kathleen Johnson, and Karen Pence, “Recent Changes to a Measure of U.S. Household Debt Service,” Federal Reserve Bulletin, vol. 89 (October 2003), pp. 417-26. judgments, often the cause or consequence of a building and bursting of a bubble, can occasionally destabilize even the most liquid and flexible of markets. I do not have much to add on this issue except to reiterate our need to better understand it. *** The last three decades have witnessed a significant coalescing of economic policy philosophies. Central planning has been judged as ineffective and is now generally avoided. Market flexibility has become the focus, albeit often hesitant focus, of reform in most countries. All policymakers are struggling to understand global and technological changes that appear to have profoundly altered world economic developments. For most economic participants, these changes appear to have had positive effects on their economic well-being. But a significant minority, trapped on the adverse side of creative destruction, are suffering. This is an issue that needs to be addressed if globalization is to sustain the necessary public support. *** The competitive state of banking, the subject of this conference, will be significantly affected by the path of global financial and technological innovations. In my judgment, this will be among the most significant developments affecting banking in the next decades.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, to the Financial Services Institute 2004, Washington, DC, 6 May 2004.
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Susan Schmidt Bies: Financial innovation and effective risk management Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, to the Financial Services Institute 2004, Washington, DC, 6 May 2004. * * * Introduction Thank you for inviting me to speak at this very timely seminar on the evolution of the financial services industry. The industry has indeed evolved over the four-and-one-half years since passage of the Gramm-Leach-Bliley Act - and perhaps in many respects, it has evolved in directions different than some envisioned when the act was under consideration in the Congress. Today I would like to discuss the evolution of the industry and the development of innovative products, services, and activities, especially in the areas of complex structured finance transactions and credit risk transfer. I will then discuss the role of counsel in ensuring the effective risk management of these innovations through a robust enterprise-wide risk-management framework. Industry evolution and innovation The Gramm-Leach-Bliley Act recognized the market reality that the limitations imposed by the Glass-Steagall Act in the 1930s and other statutory restrictions had been rendered nearly irrelevant by financial innovation, much of it outside the banking industry. Gramm-Leach-Bliley realigned the law to reflect the existing realities of the marketplace and to permit banks to do more efficiently what they were already doing in costly ways. The statute relaxed long-standing restrictions on affiliations among commercial banks, securities firms, and insurance companies; authorized the Federal Reserve Board and the Treasury to designate additional financial holding company activities as “financial in nature” or “incidental to a financial activity;” and authorized the Federal Reserve Board to determine whether activities are “complementary to a financial activity.” To avoid extending to these new activities the subsidy implicit in deposit insurance and in access to the Federal Reserve’s discount window and payment system guarantees, the act requires that many of these activities be conducted through a legally separate bank holding company affiliate, provided also that the holding company meets the “well-managed” and “well-capitalized” criteria for designation as a financial holding company. When Gramm-Leach-Bliley became law in 1999, many predicted the rise of the financial conglomerate - an entity that would provide a full range of banking, securities, and insurance products and services to institutional and retail customers. However, this prediction has not been realized, and the pace of change has been relatively slow since 1999. The slow pace is, no doubt, partly a result of the economic slowdown and stock market decline from 2000 to last year. But I suspect that these factors do not explain fully why we have not seen the rise of the financial conglomerate. Indeed, I suggest that the benefits that might result from running a financial conglomerate are in fact much more difficult to realize than many may have thought. True, there are now in excess of 600 domestic financial holding companies. But most of these are relatively small. Roughly three-quarters of financial holding companies have assets of less than $10 billion. Fewer than one-third of all financial holding companies have reported engaging in newly authorized activities, and most of these have opted to engage in relatively well-understood and less-risky insurance agency activities. Thus, the activities of most banking organizations have not changed significantly since Gramm-Leach-Bliley. However, innovation in financial products and services has continued since Gramm-Leach-Bliley. Many of these innovations cross sector boundaries and involve banking, securities, and insurance firms. Today, I will talk about two of these innovations: complex structured finance transactions and credit risk transfer. Complex structured finance transactions Innovation has occurred in the development of complex structured finance transactions, which have received quite a bit of negative press of late. While we are all too aware that recent events have unfortunately highlighted the ways in which complex structured transactions can be used for improper or even fraudulent purposes, these transactions, when designed and used appropriately, can play an important role in financing businesses and mitigating various forms of financial risks. Although deal structures vary, complex structured finance transactions generally have four common characteristics. First, they typically result in a final product that is nonstandard and is structured to meet a customer’s specific financial objectives. Second, they often involve professionals from multiple disciplines and may involve significant fees. Third, they may be associated with the creation or use of one or more special-purpose entities designed to address the customer’s economic, legal, tax, or accounting objectives or the use of a combination of cash and derivatives products. Fourth, and perhaps most important, they may expose the financial institution to elevated levels of market, credit, operations, legal, or reputational risk. Financial institutions may assume substantial risks when they engage in a complex structured finance transaction unless they have a full understanding of the economic substance and business purpose of the transaction. These risks are often difficult to quantify, but the result can be severe damage to the reputations of both the companies engaging in the transactions and their financial advisers - and, in turn, impaired public confidence in those institutions. These potential risks and the resulting damage are particularly severe when markets react through adverse changes in pricing for similarly structured transactions that are designed appropriately. Assessments of the appropriateness of a transaction for a client traditionally have required financial firms and advisers to determine if the transaction is consistent with the market sophistication, financial condition, and investment policies of the customer. Given recent events, it is appropriate to raise the bar for appropriateness assessments by taking into account the business purpose and economic substance of the transaction. When banking organizations provide advice on, arrange, or actively participate in complex structured finance transactions, they may assume legal and reputational risks if the end user enters into the transaction for improper purposes. Legal counsel to financial firms can help manage legal and reputational risk by taking an active role in the review of the customer’s governance process for approving the transaction, of financial disclosures relating to the transaction, and of the customer’s objectives for entering into the transaction. On the regulatory side, the Federal Reserve has been working with the other federal banking agencies and the Securities and Exchange Commission to develop interagency guidance on complex structured finance transactions. We believe it is important for all participants in complex structured finance transactions to understand the agencies’ concerns and supervisory direction. Our goal is to highlight the “lessons learned” from recent events as well as what we believe on the basis of supervisory reviews and experience, to be sound practices in this area. As in other operational areas, strong internal controls and risk-management procedures can help institutions effectively manage the risks associated with complex structured finance transactions. Here are some of the steps that financial institutions, with the assistance of counsel and other advisers, should take to establish such controls and procedures: • Ensure that the institution’s board of directors establishes the institution’s overall appetite for risk (especially reputational and legal) and effectively communicates the board’s risk tolerances throughout the organization. • Implement firm-wide policies and procedures that provide for the consistent identification, evaluation, documentation, and management of all risks associated with complex structured finance transactions - in particular, the credit, reputational, and legal risks. • Implement firm-wide policies and procedures that ensure that the financial institution obtains a thorough understanding of the business purposes and economic substance of those transactions identified as involving heightened legal or reputational risk and that those transactions are approved by appropriate senior management. • Clearly define the framework for the approval of individual complex structured finance transactions as well as new complex structured finance product lines within the context of the firm’s new-product approval process. The new-product policies for complex structured finance transactions should address the roles and responsibilities of all relevant parties and should require the approval of all relevant control areas that are independent of the profit center before the transaction is offered to customers. • Finally, implement monitoring, risk-reporting, and compliance processes for creating, analyzing, offering, and marketing complex structured finance products. Subsequent to new-product approval, the firm should monitor new complex structured finance products to ensure that they are effectively incorporated into the firm’s risk-control systems. Of course, these internal controls and risk-management processses need to be supported and enforced by a strong “tone at the top” and a firm-wide culture of compliance. We expect that banks, as a result of recent public and supervisory attention to complex structured finance transactions, will be asking more questions, requesting additional documentation, and scrutinizing financial statements more carefully to guard against reputational and legal risk. In fact, our supervisory reviews indicate that many financial institutions have already taken steps to enhance their internal controls and new-product approval processes in order to filter out transactions that pose unacceptable levels of reputational and legal risk. As a result, some financial institutions have turned down deals with unfavorable risk characteristics - deals that they might have accepted in the past. While we applaud these developments, we hope that the guidance we are developing will help further increase awareness, among both banking organizations and their advisers, of sound practices in this area. I would like to note that the guidance the agencies issue should be considered the first step in the evolution of sound practices for complex structured finance transactions. As these transactions take on new characteristics or different or heightened levels of risk over time, the sound practices for managing them also will need to evolve. Credit risk transfer Some of the complex structured finance transactions we have recently seen reflect and incorporate innovations in credit risk transfer mechanisms - credit default swaps and synthetic collateralized debt obligations in particular. As most of you know, credit default swaps involve the sale or transfer of credit risk associated with a specific reference entity for a fixed term in exchange for a fee from the buyer of the protection. Synthetic collateralized debt obligations entail similar arrangements but are based on portfolios of exposures and are tranched in a manner typically seen in securitizations. Credit default swaps and collateralized debt obligations provide flexibility in tailoring and marketing financial transactions to match the risk appetites of investors. One aspect that we, as bank supervisors, find encouraging about the growth of credit risk transfer activity is the diversification benefit it provides and its potential for greater economic efficiency. By their design, derivative instruments segment risks for distribution to those parties most willing to accept them. A key point, however, is that these parties should be able to successfully absorb and diffuse any subsequent loss. The ability to handle any losses on these instruments requires a recognition and understanding of the underlying risks. It is important to recognize that the market for these instruments is dominated by large institutions and private investors that have specialized expertise in credit analysis and significant historical performance records. As bank supervisors, we are also encouraged by the progress made by the legal profession to resolve legal issues relating to credit risk transfer. The standardization of documentation for credit derivatives transactions and the issuance of legal opinions regarding the enforceability of these contracts have provided increased certainty to the market. In general, the contracts have performed as expected. By way of note, the Federal Reserve is participating in work commissioned last year by the Financial Stability Forum to gain a broader understanding of issues related to credit risk transfer. I look forward to the conclusions and assessments of this group. Little evidence, to date, suggests that the institutions and investors that engage in most of the credit risk transfer activities fail to understand the risks of these transactions. That said, I would offer one critical caveat regarding the use of any model for risk-management purposes, including the pricing and risk management of increasingly complex credit risk transfer instruments. Models use historic data and rely heavily on supporting assumptions, including correlations between different reference entities. It is worth reminding ourselves that correlations may behave very differently during times of stress than under normal circumstances. Further, these are relatively young products, and the markets in which they trade often do not have deep liquidity. Thus, pricing information can be very volatile. Given the heavy reliance on models in this arena, it is important that any risk-management framework include an independent model review program. A review should be conducted by qualified independent staff prior to actual reliance on a model, and periodically thereafter. Tests should include validation of results, data integrity, and internal controls over changes in model specifications. Models should be appropriate for the specific products and the nature of the risks at an institution. Enterprise-wide risk-management framework The recent innovations in credit risk transfer and complex structured finance transactions offer opportunities for the development of new markets, improved pricing, and better risk-transfer mechanisms that can improve the efficiency of U.S. and world financial markets. However, innovation also presents risk-management challenges. I believe that these challenges are addressed most effectively through an enterprise-wide risk-management framework that provides a structure for dealing with uncertainty and its associated risks and opportunities. As you may know, the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, has published an exposure draft that sets forth an enterprise-wide risk-management framework, including the definition and components of risk management and the roles and responsibilities of various parties. Enterprise-wide risk management is a process that involves people at every level of the firm in setting strategy and making operational decisions based on an analysis of events that may impact the firm. Through an enterprise-wide risk-management framework, an entity can better limit exposures within its risk appetite and provide its management and board of directors with reasonable assurances regarding the achievement of the organization’s objectives. Recent operational breakdowns at financial institutions underscore the need for enterprise-wide risk management. As organizations expand into more lines of business, inherent conflicts of interest become more likely. Conflicts can arise when a firm offers research on fixed-income securities to investors and underwrites the public offerings of the same securities. And problems may occur if an organization offers compensation designed to encourage officers to increase deal volume without regard for reputational, credit, or legal risks. Thus, the traditional approach of managing risks only within individual business lines or functions may no longer be effective. Viewing risks across the enterprise can help management and the board of directors not only articulate more clearly the “most likely” outcome of a strategy, change in process, or transaction but, more important, focus on a range of possible results to facilitate a discussion of risks and effectiveness of processes to lay off or mitigate those risks. Internal controls are an integral part of enterprise-wide risk management. Under COSO’s Internal Control Framework, directors have responsibility for overseeing internal control processes so that they can reasonably expect that their directives will be followed. Directors should also keep up with innovations in corporate governance, and this is one key area in which the legal advisers of financial companies can assist their clients. Indeed, legal counsel can help lead the way to developing sound practices in corporate governance. While we are discussing the importance of effective internal controls, let me point out that the Public Company Accounting Oversight Board (PCAOB) has recently approved Auditing Standard No. 2, An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements.1 The new standard highlights the benefits of strong internal controls over financial reporting and furthers the objectives of the Sarbanes-Oxley Act. The standard requires external auditors of public companies to evaluate the process that management uses to prepare the company’s financial statements. External auditors must gather evidence regarding the design and operational effectiveness of the company’s internal controls and determine whether evidence supports management’s assessment of the effectiveness of the company’s internal controls. While the new standard allows external auditors to use the work of others, including that performed by internal auditors, it emphasizes that external auditors must perform enough of the testing themselves so that their own work provides the principal evidence for making a determination regarding the company’s controls. On the basis of the work performed, the external auditor must render an opinion as to whether the company’s internal control process is effective - a requirement that constitutes a relatively high standard. In addition, as part of its overall assessment of internal controls, the external auditor is expected to evaluate the effectiveness of the audit committee. If the audit committee is deemed to be ineffective, the external auditor is required to report that assessment to the company’s board of directors. While some skeptics may wonder if a public accountant will criticize its client, the goals are to strengthen professional standards and to remind accounting firms that acceptance of an engagement at a firm at which internal control weaknesses are not promptly addressed may be a risk exposure they should A copy of the auditing standard can be obtained at the PCAOB web site at http://www.pcaobus.org/pcaob_standards.asp. seriously reconsider. I would encourage the attorneys here today to adopt the best practices in risk management that the accounting and financial firms are implementing to improve their organizations’ governance. Conclusion In conclusion, the financial services industry has evolved considerably over the past several years, in large part because of innovation in products, services, and activities, particularly in the areas of complex structured finance transactions, credit risk transfer, and risk management. These innovations have the potential, I believe, to substantially improve the efficiency of the financial markets. However, these new products, services, and activities present challenges. Legal counsel can play an important role in helping financial institution clients understand and address these challenges through the development of a sound enterprise-wide risk-management framework.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Chicago's Money Smart Conference, Chicago, Illinois (via videoconference), 13 May 2004.
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Alan Greenspan: Financial literacy Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Chicago’s Money Smart Conference, Chicago, Illinois (via videoconference), 13 May 2004. * * * This morning I should like to broaden the focus of financial literacy to the education you are going to need more generally in the years ahead. Within the next several years the vast majority of you will have completed your formal schooling and begun careers in private business, government, or the nonprofit sector. I suspect most of you have not as yet figured out what career you would like to pursue. But as with all the generations of teenagers that have gone before you, something will grab your interest and engage you. With me it was music. I was entranced with sound and visualized myself playing with the likes of the Glenn Miller orchestra or becoming another Benny Goodman. I practiced clarinet and saxophone three to five hours a day and, following graduation from high school, toured the country for a couple of years with a dance band. I was a good amateur but only an average professional. I soon realized that there was a limit to how far I could rise in the music business, so I left the band and enrolled at New York University. During my dance band years I spent the twenty-minute breaks from playing in reading. I became intrigued by books on finance, and, hence, at NYU I majored first in finance and, as my interest broadened, in economics and in what was then called mathematical statistics and now econometrics. In retrospect, that choice probably was not surprising since math was my most engaging course in high school. I graduated and joined an economic research organization. But my education did not stop. I earned a masters degree and went on to further studies at night at Columbia University. At the age of twenty-seven I joined a very small Wall Street firm as a partner and was essentially in charge of making it grow. It did, and I eventually became the senior partner. But twelve hours a day at work left little time for school, and my aspirations to earn a Ph.D. faded, at least for a time. However, the pursuit of my profession as an economist and the head of a consulting firm required that I broaden my knowledge, and I proceeded to read books, not only on economics and mathematics but also on philosophy, history, physics, and astronomy. I was getting a liberal education far beyond the required curriculum of college. Eventually I returned to NYU, took additional courses at night, and completed my doctorate. Over the past six decades I followed a type of career path that many of you will follow, but with a twenty-first-century cast. I had two careers and four jobs - one as a musician, one as a private consultant, and two in government. But the world has changed since I was your age, and the pace of change has quickened. Today it is rare that one will finish school and then engage in the same job until retirement, which was the general experience of generations past. Many of you will switch professions once, possibly many times. Almost all of you will have several jobs, some many jobs. To succeed, you will soon learn, as I did, the importance of a solid foundation in the basics of education - literacy, both verbal and numerical, and communication skills. But beyond that you will need to acquire the on-the-job skills that you will need as you move from one job to another. At some point, almost all of you will lose a job and will want to be reemployed as quickly and as productively as possible. That means you will need the capability of learning a wholly new activity. The current workforce is increasingly turning to community colleges to prepare for new professions and new jobs. Today, almost a third of those enrolled in community colleges are thirty years old and older. So-called adult education was a rarity in my youth; today it is widespread. Most of you probably will be engaged in some form of learning through most of your working lives. Already numerous corporations have regularly scheduled classes in basic and advanced subjects directly and indirectly related to job requirements. Such corporate universities, as they are called, are growing rapidly, and I suspect that, as you join the workforce, you will have the sensation that you never left school. That is why it is so critical that you productively employ your current learning experiences to create the base capabilities necessary for continuing your education into your mature years. Learning, of course, need not be formal. You can engage in it on your own. In generations past, much learning occurred outside a classroom. I am fascinated by the eloquent and literate letters written by some Civil War enlisted personnel, who I doubt had formal schooling beyond the age of ten. Many of these soldiers obviously learned to read and discovered a whole new world of ideas in books. Today’s high-school graduates will be confronted with a breadth of ideas never contemplated by an eighteen year old in the 1860s. The world into which you graduate will require far greater conceptual skills than was required of your parents and grandparents. Productive and satisfying manual labor that engaged previous generations will become increasingly less available as technology substitutes for so many of those earlier skills. Your future incomes will depend on your conceptual abilities. Just as important, because the complexity of our economic system continues to increase, the skill level that you reach in your twenties will surely be inadequate for the needs of our economy when you reach forty. So education must be ongoing. But education alone will not guarantee a successful life. In this regard, let me leave you with some challenges I left with a graduating class at Harvard a few years ago. Decades from now, as you begin to contemplate retirement, you will want to be able to say that whatever success you achieved was the result of honest and productive work and that you dealt with people the way you would want them to deal with you. It is decidedly not true that “nice guys finish last,” as that highly original American baseball philosopher, Leo Durocher, was alleged to have said. I do not deny that many appear to have succeeded in a material way by cutting corners and by manipulating associates, both in their professional and in their personal lives. But material success is possible in this world and far more satisfying when it comes without exploiting others. The true measure of a career is to be able to be content, even proud, that you succeeded through your own endeavors without leaving a trail of casualties in your wake. I cannot speak for others whose psyches I may not be able to comprehend. But in my working life, I have found no greater satisfaction than achieving success through honest dealing and strict adherence to the view that, for you to gain, those you deal with should gain as well. Human relations be they personal or professional - are not, and should not be treated as, zero-sum games.
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Testimony of Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, before the Committee on Financial Services, US House of Representatives, Washington, DC, 13 May 2004.
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Susan Schmidt Bies: US - EU regulatory dialogue Testimony of Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, before the Committee on Financial Services, US House of Representatives, Washington, DC, 13 May 2004. * * * Thank you, Mr. Chairman, for the opportunity to speak today on matters relating to the informal U.S.-EU Financial Markets Regulatory Dialogue. I would like to focus my remarks on the Dialogue’s role in helping us to monitor European-wide regulatory developments in financial services and understand the effects on U.S. banking organizations operating in the European Union. Background to the dialogue As has been noted, the Dialogue was initiated by the Treasury Department in 2002, at a time of significant regulatory developments in both the European Union and in the United States. At that time, the European Union was continuing its efforts, begun in 1999, to establish a single market in financial services by implementing the “Financial Services Action Plan” (FSAP). The FSAP consists of a number of regulatory and legislative measures designed to achieve, among other things, a single wholesale European market; open and secure retail markets; and state-of-the-art prudential rules and supervision. On our side of the Atlantic, U.S. regulators were continuing to implement provisions of the Gramm-Leach-Bliley Act and Congress was considering reforms that led to the adoption of the Sarbanes-Oxley Act. These developments, which affected European financial services firms with U.S. operations, naturally were of interest to staff of the European Commission. From the outset, the Dialogue’s purpose has been to foster a better mutual understanding of U.S. and EU regulatory approaches and to identify potential substantive conflicts in approach as early in the regulatory process as possible. The Dialogue consists of an informal discussion or explanation of regulatory approaches, developments, and timetables, conducted at an experts level. This format has served us well during the past two years. Although the Federal Reserve has regular contact with staff of the European Commission in other groups on a range of issues, the Dialogue is the only venue dedicated specifically to U.S.-EU regulatory issues. Federal Reserve’s interest in monitoring foreign regulatory developments As the umbrella supervisor of U.S. bank holding companies and financial holding companies, the Federal Reserve has a strong interest in the regulatory environments in which these firms operate outside the United States. We have an established program of working with foreign supervisors at both bilateral and multilateral levels. Through regular contact, we track changes to foreign bank regulatory and supervisory systems and seek to understand how these systems affect the banking institutions we supervise. This is especially important in the European Union, where U.S. banking organizations have substantial operations. As of September 30, 2003, thirty-four U.S. banking organizations operated in the European Union with aggregate EU assets of more than $747 billion. As of December 31, 2003, sixty-eight EU banking organizations maintained active banking operations in the United States, with total third-party banking assets in their U.S. offices of $937 billion. As these figures suggest, institutions from the United States and the EU are major participants in each other’s markets. The dialogue as an additional forum for monitoring EU regulatory developments As the EU seeks increasingly to harmonize financial services rules across its internal market, the regulatory role of the European Commission has grown correspondingly. In this environment, the Dialogue complements the Federal Reserve’s ongoing relationships and discussions with EU national regulators. The Dialogue, moreover, fills a role not presently served by any one of those ongoing relationships and discussions. As the market for financial services becomes increasingly integrated, the interests of banking, securities, and insurance regulators correspondingly are becoming more common and intertwined. The Dialogue provides a forum for discussion of issues in each of these areas. The regulatory discussions benefit from this sharing of different substantive perspectives. For this reason, too, the Dialogue is an efficient forum for information exchange, which has great utility for supervisors of large complex financial services organizations. Global companies operate across many countries and must adapt their business and strategy to local regulatory and supervisory requirements. It is now generally accepted in the U.S. and internationally that a foreign firm that conducts business in a local market should receive national treatment, that is, the foreign firm should be treated no less favorably than a domestic firm operating in like circumstances. The United States adopted a specific policy of national treatment for foreign banks operating in this country with the enactment of the International Banking Act of 1978. As we have previously testified, implementing a policy of national treatment can be challenging. Although large financial services companies operate in a globalized world, each is based in a specific country whose economic regulation or supervisory approach will differ from those in other countries. The challenge of providing national treatment arises as we seek to adapt our own regulatory system to a foreign banking organization that operates under a different legal and regulatory structure. We believe the Federal Reserve has successfully met the challenge in its treatment of foreign banking organizations operating in this country. Part of that success can be attributed to our work with foreign regulators and supervisors in seeking to understand the operating environment of the foreign banks we regulate. The Dialogue contributes to that knowledge. We are equally concerned that U.S. banking organizations receive national treatment in their foreign operations. The Dialogue provides us the best opportunity to understand EU directives that affect those operations and provides us with the ability to raise concerns directly with the staff that has responsibility for the preparation and presentation of such directives. The Dialogue provides a useful forum for information exchange between U.S. regulators and the European Union over Europe-wide matters that have the potential to affect the application of national treatment in particular situations. In implementing the FSAP in the European Union, the European Union has an obligation to ensure that the rules adopted are consistent with the principle of national treatment. It is our expectation that the European Commission and the member states will continue to seek to do so. Select issues discussed during the dialogue The Dialogue has touched on a variety of issues in the past two years. Of particular interest to the Federal Reserve and to U.S. banking organizations operating in the EU is the issue of the application of the EU’s Financial Conglomerates Directive to U.S. financial firms. This Directive, and others that have been amended in connection with its adoption, establishes various supervisory requirements for EU firms. Among other matters, it requires that the consolidated group be subject to supervision and minimum capital standards by a member state authority. For firms that are headquartered outside the EU, such as U.S. banking organizations, the directives require that the foreign financial firm operating in EU markets must be subject to supervision at the holding company level by a competent home country authority, which supervision is equivalent to that provided for by the provisions of the Directive. The EU’s national supervisors will be responsible for making equivalency determinations on a groupby-group basis, in accordance with guidance issued by the European Commission. In the absence of an equivalence determination, U.S. financial firms with EU operations could be subject to higher capital and risk control requirements or be required to create an EU sub-holding company. The European Commission is preparing guidance on what might constitute equivalent supervision by third countries. In preparing this guidance, committees working under the auspices of the Commission convened a technical group comprised of member state supervisors to provide input on issues to be taken into account in verifying equivalence. The group sent questionnaires to home country supervisors of financial organizations having operations in the EU, inquiring about the measures those supervisors take to ensure that the entities they supervise are subject to consolidated supervision at the top-tier level. The Federal Reserve and the Office of the Comptroller of the Currency prepared a joint response on supervision of U.S. banking organizations with EU operations. We understand that the EC’s guidance is expected to be issued in the summer. Member state lead regulators are expected to rely on the European Commission’s guidance in verifying equivalent supervision with respect to individual institutions. We anticipate that the European Commission will keep us informed of member states’ progress in this regard during the Dialogue and also will alert us to the existence of and procedures for addressing any disparities in member states’ approaches. We fully expect that U.S. banking organizations will be found to meet the supervision standard of the directive. Another topic of discussion relating to banks has been the status of work on revisions to the Basel Capital Accord (Basel II). The discussions within the Dialogue have not focused on technical issues that have been under consideration within the Basel Committee on Banking Supervision (Basel Committee), but rather have addressed the scope of application and implementation and timing concerns. Specifically, the Dialogue has served as a useful venue for both the EU representatives and the Federal Reserve participants to gain a better understanding of the implementation procedures that are anticipated to be applicable in each jurisdiction. Staff has been able to ask questions about the EU legislative process, and to explain in detail how the U.S. regulatory process functions. Understanding the requirements and limitations of each others’ legislative and regulatory processes has helped both sides achieve, in my view, a better sense of the implementation challenges we all face and of the commitment to see the process through. With regard to the scope of application of the proposed new Accord, the Federal Reserve representatives were able to provide information for the EU participants about the reasons the U.S. banking agencies proposed to require only a core set of banks to apply the advanced approaches for both credit risk and operational risk. As you know, one of the primary drivers behind this decision was the U.S. banking agencies’ collective view that complex, sophisticated organizations should be using the most advanced risk measurement and management practices available and those techniques and practices are recognized in the Basel II advanced approaches. The U.S. agencies also proposed permitting other institutions to move voluntarily to the advanced approaches subject to the same rigorous risk measurement and management requirements as core banks. Through the Dialogue, the participants were able to discuss the U.S. approach and to compare it with the EU proposal to apply Basel II to all of its banks and investment companies. These different implementation strategies will raise some issues, and that is why the Basel Committee has created the Accord Implementation Group to coordinate implementation across jurisdictions and work through home-host issues. As noted, issues are not resolved during Dialogue discussions; that is not the purpose of the Dialogue. But open communication that fosters understanding can feed back into the decision-making discussions when they are held in other appropriate forums. With respect to Basel II implementation and the Dialogue, in my view, the current structure will continue to serve a useful purpose - as implementation issues are identified, the Dialogue can be a venue for candid, informal communication. Participants can take back to their constituents the results of those discussions and the subject matter experts can determine how best to address issues that are raised or respond to particular questions or concerns. The Dialogue has been useful in diffusing tensions over matters that have a direct impact on global firms. This has been especially true with respect to issues under the Sarbanes-Oxley Act, a discussion of which I shall leave to my SEC colleague. The Dialogue has also been helpful on less high profile matters. Through discussions at Dialogue meetings, we were able to keep EC staff apprised of developments relating to asset pledge requirements applicable to foreign banking organizations having U.S. offices. For more than forty years, federal and state bank licensing authorities have imposed an asset pledge or capital equivalency deposit requirement on U.S. branches and agencies of international banks, primarily for safety and soundness reasons. This requirement obligated such institutions to hold certain negotiable securities at American custodian banks. In recent years, foreign banks were of the view that such requirements were more onerous than necessary and sought a reduction in the level of assets to be pledged. The matter was brought to the attention of European Commission staff who raised it at the Dialogue. We were able to inform Commission staff of progress being made on this front by state authorities in New York and elsewhere over a two-year period. New York changed its asset pledge requirement in 2003, generally satisfying the concerns of foreign banks. The Dialogue was a useful forum to keep Commission staff apprised of developments during this period. International accounting The FSAP also contemplates mandating adherence to international accounting standards. Currently, banking organizations in the European Union may prepare their annual financial statements in accordance with the accounting standards of the International Accounting Standards Board (IASB), U.S. generally accepted accounting principles (U.S. GAAP), and/or national standards. The use of U.S. GAAP is usually limited to those banking organizations or other companies whose securities are publicly traded on U.S. stock exchanges and are registered with the Securities and Exchange Commission. In many cases, these companies will also provide separate financial statements based on their national accounting standards and disclosure rules. The European Union will require all EU companies listed on EU exchanges that are currently following national standards to follow IASB standards by 2005 and will require those EU companies that currently follow U.S. GAAP to adopt IASB standards by 2007. The EU is also working to adopt international auditing standards for external audits of EU companies, including banks. The IASB is now independent of the international accounting profession and independently funded. It has adopted many of the structural elements of the FASB in the United States, which are intended to promote an independent, objective standards-setting environment. Many senior American accounting experts serve on the IASB and its staff. IASB GAAP has many similarities with U.S. GAAP and the IASB issued extensive enhancements to its standards last year and this year, with additional improvements also issued as a proposal this year. For example, in recent months the IASB issued major revisions to its standards for financial instruments, which are similar to U.S. GAAP and cover many areas of banking activities. One aspect of these revisions by the IASB significantly improved the guidance on loan loss allowances in ways that could lead to better bank reserving practices around the world. The Federal Reserve has long supported sound accounting policies and meaningful public disclosure by banking and financial organizations with the objective of improving market discipline and fostering stable financial markets. The concept of market discipline is assuming greater importance among international banking supervisors as well. Basel II seeks to strengthen the market’s ability to aid bank supervisors in evaluating banking organizations’ risks and assessing capital adequacy. It consists of three pillars, or tools: a minimum risk-based capital requirement (pillar I), risk-based supervision (pillar II), and disclosure of risks and capital adequacy to enhance market discipline (pillar III). This approach to capital regulation, with its market-discipline component, signals that sound accounting and disclosure will continue to be important aspects of our supervisory approach. The Federal Reserve and the other U.S. banking agencies are also actively involved in the efforts of the Basel Committee to promote sound international accounting, auditing, and disclosure standards and practices for global banking organizations and other companies. For example, an official of the Federal Reserve Board is a member of the Standards Advisory Council that advises the IASB and its trustees on IASB projects, proposals and standards. The U.S. banking agencies have been active in supporting the Basel Committee in its work with the IASB’s technical advisory groups to enhance the IASB’s standards for financial instruments and bank disclosures. The Federal Reserve Board has also been active in supporting the Basel Committee’s projects with the International Federation of Accountants (IFAC) and other international regulatory organizations, such as International Organization of Securities Commissions (IOSCO), to promote substantial enhancements to global standards and practices for audits of banks and other companies. Although the Federal Reserve Board has been actively involved in addressing international accounting and auditing issues primarily through our involvement in the Basel Committee’s projects, the Securities and Exchange Commission has had the primary role in discussing these matters with the EU representatives as part of the Dialogue. Cooperation on anti-money laundering and counter-terrorist financing issues While not historically part of the U.S.-EU Dialogue, recent anti-money laundering and counter-terrorist financing regulatory initiatives on both sides of the Atlantic have had a significant impact on banking organizations, many of which operate globally. Because of the potential consequences of differences in regulatory approaches in this area, governments have been in frequent contact. In the end, the anti-money laundering provisions set forth in the USA PATRIOT Act and those contained in the EU Anti-Money Laundering Directive are generally in harmony. Part of this can be attributed to the Federal Reserve’s and other U.S. and EU regulatory authorities’ mutual involvement in multilateral policy efforts to improve regulatory systems so to prevent these crimes, such as the Financial Action Task Force and the Basel Committee’s cross-border banking group. On a practical level, supervisory dialogue and cooperation on anti-money laundering and counter-terrorist financing also has been necessary due to the role the Federal Reserve frequently shares with its EU counterparts as “home/host” supervisors of global banking organizations. However, this cooperation is typically focused on providing assistance in order to fulfill supervisory mandates, not to conduct money laundering or terrorist financing investigations, the authority for which typically falls with law enforcement authorities. While Bank Secrecy Act requirements, including the provisions added by the USA PATRIOT Act, generally do not extend to foreign operations of U.S. banking organizations, the Federal Reserve is interested in understanding the global operations of the banking organizations under Federal Reserve supervision as a matter of safety and soundness. In this regard, the Federal Reserve relies upon communication with supervisors from foreign jurisdictions, including EU member states, in which banking organizations subject to Federal Reserve supervision have material operations. Critical information obtained in the course of an examination, which may impact a banking organization’s operations in the foreign jurisdiction, is typically exchanged among relevant supervisors. For example, when a Federal Reserve Bank conducts an on-site examination of a foreign banking organization in the United States, and significant problems are identified with regard to its anti-money laundering program, the Federal Reserve contacts the home country supervisor to discuss the findings and to develop corrective action plans. Moreover, the Federal Reserve may provide information to European Union member bank supervisors when administrative penalties have been imposed or any other formal enforcement action has been taken against a U.S. banking organization (whether or not it is related to anti-money laundering requirements) if the Federal Reserve believes such information will be important to the host country supervisor. The Federal Reserve expects the same from its counterparts. Future of the dialogue As is evident from the tenor of my remarks, the Federal Reserve has found the Dialogue to be a useful vehicle for monitoring the rapid regulatory developments in the European Union and exchanging information. We are committed to continuing discussions with the Commission on matters of mutual interest, both bilaterally and as part of the financial markets regulatory discussions led by the Treasury Department. The regulatory landscape in the European Union is certain to continue to develop rapidly in the coming years, particularly with expansion of the European Union, member states’ implementation of the numerous FSAP measures needed to create a single market for financial services, and the growing integration of our capital markets. We at the Federal Reserve have an obligation to keep apprised of these developments on a timely basis in order to fulfill our supervisory function and to ensure a level playing field for U.S. banking organizations operating in the European Union. We are confident that continuing the Dialogue in its present form would facilitate these objectives. We are equally confident that other existing multilateral and bilateral exchange mechanisms are appropriate venues for discussing policies and attempting to resolve disputes. In our view, formalizing the Dialogue - for example, by elevating it to the principals level or expanding its mandate to include policy-setting or dispute resolution functions - would be unnecessary and may impair the Dialogue’s utility. The Federal Reserve believes that U.S. banks are second to none in their ability to compete when they are given the opportunity of operating on a level playing field. Providing strong supervision at home and participating in international regulatory and supervisory groups such as the Dialogue helps assure that our banking organizations will continue to have such opportunities.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the National Bank of Belgium Conference on Efficiency and Stability in an Evolving Financial System, Brussels, 17 May 2004.
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Roger W Ferguson, Jr: The role of central banks in fostering efficiency and stability in the global financial system Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the National Bank of Belgium Conference on Efficiency and Stability in an Evolving Financial System, Brussels, 17 May 2004. * * * It is a great pleasure for me to open this conference. Our agenda is filled with addresses by distinguished speakers and research papers of uniformly high quality on topics of keen interest to central bankers. Indeed, few subjects are more important for central bankers than the efficiency and stability of the financial system. Many of the papers to be presented and discussed over the next two days focus on the behavior of private institutions operating in financial markets. I thought I could complement these presentations by discussing the efforts of an important class of public institutions--central banks--to foster efficiency and stability in the financial system. Before proceeding, I should note that my remarks today represent my own views, which are not necessarily shared by my colleagues on the Federal Reserve Board or on the Federal Open Market Committee. In previous discussions, I have found it useful to offer a working definition of financial instability that seems most relevant from a public-policy perspective. Although difficult to define precisely, financial instability, in my view, connotes the presence of market imperfections or externalities in the financial system that are substantial enough to create significant risks for real aggregate economic performance. Over the past few decades, economic research has identified a variety of imperfections inherent in markets, such as moral hazard, asymmetric information, and externalities. On occasion, these imperfections can become so widespread and significant as to result in outcomes that threaten the functioning of the financial system and adversely affect real economic variables. History suggests that these imperfections reach this advanced and disruptive stage when they are exacerbated by large external shocks. Such outcomes include panics, bank runs, severe market illiquidity, and excessive risk aversion. These outcomes are highly undesirable for society because they can be accompanied by a variety of economic distortions: Financial prices can diverge sharply and for prolonged periods from fundamentals, and their correction is likely to impose great cost on society; the availability and pricing of credit may be too lax at times and at other times too restrictive relative to underlying macroeconomic conditions. As a result of these distortions, spending and real activity may undergo much wider swings than would otherwise be the case. I would hasten to add, however, that this definition of financial instability does not encompass failures of financial firms due to poor management or poor luck; nor does it include fluctuations in asset prices or credit conditions as a consequence of the normal evolution of economic circumstances, nor occasional substantial losses of individual counterparties. Indeed, such failures and losses, as well as accompanying market volatility, are the unavoidable and even necessary features of dynamic market economies. In my view, market volatility and institutional stresses need to be addressed by publicpolicy action only when they are symptomatic of, and interact with, more-fundamental market failures that have a high likelihood of impairing real macroeconomic performance. Indeed, public policies that rely too heavily on regulation of financial institutions, instruments, and markets with the aim of avoiding any period of financial stress almost surely entail a significant cost measured in terms of increased moral hazard, lower economic growth, and financial markets that do not always allocate resources to their most productive use. In my experience, central bankers as a rule have an almost instinctive aversion to financial instability as I have defined it. Those instincts are no doubt rooted, at least partly, in the historical efforts of many nations to overcome structural defects in financial markets that left their economies prone to boomand-bust cycles. In some cases, central banks were seen as part of the solution in addressing the results of such market imperfections. The Federal Reserve, for example, owes its existence in large measure to the financial panics in the late nineteenth and early twentieth centuries in the United States that increased public recognition of the need for a lender of last resort, for more-effective bank supervision, and for greater efficiency in the payment system. In the modern era, central banks’ association with matters relating to financial stability has become broader and more formalized. To be sure, many central bank charters give primacy to broad macroeconomic objectives such as price stability and full employment. And, indeed, I concur with those who argue that conducting monetary policy over time so as to achieve stable prices and sustainable economic growth is the single most important contribution that central banks can make in promoting financial stability. However, many central bank charters also recognize financial stability as an important and distinct objective, and these statutory objectives have been prominently discussed in the time since I joined the ranks of central bankers in 1997. Over that relatively brief span, the global financial system has weathered many storms--the market turmoil in the fall of 1998, the preparations for Y2K, devastating terrorist attacks in 2001 and a recognition of the threat of future attacks, and major accounting scandals in 2002. As I will discuss in more detail shortly, these developments have been important in shaping the international central banking policy agenda. Key financial trends Before exploring some of these issues in a bit more depth, it seems useful to consider some of the longer-run trends that have set the backdrop for much of the work of central banks in international forums dealing with financial efficiency and stability. One clear trend in many countries is an increase in market concentration in the banking sector and in other sectors of the financial services industry. In the United States, for example, the share of assets held by the top ten commercial banks has risen from about 30 percent in 1995 to about 45 percent today. Outside the commercial banking sector, consolidation has resulted in a small number of financial firms doing much of the equity and bond underwriting throughout the world. A second trend is the steadily increasing share of total credit provided directly through markets rather than through intermediaries like banks. For example, in the United States, the share of bank loans in the total outstanding debt of domestic nonfinancial corporations has declined from about 21 percent at the end of 1990 to 12 percent at the end of last year. The growing importance of market-based finance has not, however, signaled a decline in the commercial banking industry. U.S. banks, for example, have enjoyed record profits that stem, in part, from their activities in securities markets and in the development of new instruments. Indeed, banks’ development of sophisticated risk-management techniques helped to fuel the growth of new financial instruments. More generally, by providing lines of credit and assuming other off-balance-sheet exposures, banks support the advancement and ongoing operation of financial markets and lower the costs of market-based finance for many market participants. Another important trend has been the expanding scope and availability of financial instruments. The global financial system is still well short of the theoretical ideal of complete financial markets, but clearly it is moving in that direction. Market participants now use an array of financial instruments that, twenty years ago, were not actively traded and, in many cases, did not even exist. The growth of derivatives is a useful example of this trend. According to the December 2003 survey of derivatives conducted by the Bank for International Settlements (BIS), the notional and market values of all overthe-counter foreign exchange and interest rate derivatives contracts - rough measures of market activity - have nearly doubled in just the past two years. The credit derivatives market is still in its infancy, but data gathered by the International Swap Dealers Association suggest that this market has registered even more spectacular growth in the past two years. All of these new instruments allow more-effective management and pricing of risks, so the growth of these markets has surely been positive, on net, for market participants. But the increasing complexity of these instruments also raises a host of policy questions regarding, to name just a few items, accounting treatment, disclosure policy, netting provisions, capital charges, and the enforceability of netting and collateral arrangements in bankruptcy proceedings. A final trend worth singling out is the steady increase in global financial integration. Borrowers today raise funds in multiple financial centers and in multiple currencies; commercial lenders and retail investors regularly take on international exposures; and arbitrageurs establish leveraged risk positions across currencies and markets. Data collected by the BIS, for example, suggest that the volume of debt outstanding that was issued in international credit markets has more than doubled worldwide in the past four years. Likewise, the international positions of banks worldwide have increased almost as markedly over the same interval. For the most part, these developments suggest that global financial markets are becoming more efficient and more integrated. But increased global financial integration carries with it some new risks. As we learned all too well following the Russian debt default in August 1998, financial difficulties in one corner of the world can now spread in unpredictable and potentially disruptive ways to every major financial center. In the remainder of my remarks this morning, I will draw out some of the implications of these long-run trends for the core responsibilities of many central banks, which include the conduct of monetary policy, bank supervision and regulation, and crisis management and liquidity assistance. Monetary policy The steadily increasing importance of markets and nonbank instruments as the primary vehicles for borrowing and lending has several important implications for monetary policy transmission and strategy. It seems plausible, for example, that a financial system dominated by market-based finance has likely reinforced the status of the market for financial assets as the most important channel of monetary policy transmission. This simple observation has some rather profound implications for the conduct of monetary policy. Typically, central banks directly control a short-term interest rate, but the forward-looking nature of financial markets implies that long-term interest rates and other asset prices are determined importantly by expectations about future policy. These expectations, in turn, are informed (one hopes) by a clear understanding of the objectives of the central bank and how it will choose to set policy in the future in response to economic developments. Central banks have long recognized the effect their words and actions can have on interest rates and asset prices and, as a result, have increasingly moved toward greater transparency in the policy process. The sharpened focus on transparency has been motivated in part by a desire to avoid short-run misperceptions about policymakers’ intentions that can distort financial asset prices and ultimately prove detrimental to the real economy. But central bankers have also discovered that transparency, broadly writ, can lead to improved economic performance. Market expectations are more likely to remain anchored in the face of various shocks when investors understand that central bankers are committed to key long-run objectives such as price stability and sustainable economic growth. Moreover, by operating in a predictable way in response to economic developments, central bankers can foster an “automatic stabilizer” of sorts in financial markets. For example, recognizing that the central bank will seek to counter adverse demand shocks, investors will anticipate an easing in monetary policy if they observe aggregate demand weakening; in turn, that anticipation would soon be reflected in lower long-term interest rates that would cushion the drop in demand even before a change in policy is made. This market dynamic suggests that gauging the overall effect of monetary policy requires an assessment of broad financial conditions, including policy rates, long-term interest rates and foreign exchange rates. Although central bankers can use predictable policy actions and the forward-looking nature of financial prices to their advantage, they must also be mindful of the potential market reactions to policy actions that are not fully anticipated or that may be misinterpreted. This, too, is an aspect of monetary policy that may have become more prominent given the evolution of financial markets in recent years. Monetary policymakers evaluate the probabilities as well as the costs and benefits of the full range of potential economic and financial outcomes in arriving at a policy decision. One such risk to be evaluated is the potential, particularly during times of stress, for outsized and unintended changes in interest rates and asset prices after an unexpected policy action. Of course, the response of central banks to this risk should not be to avoid taking policy actions that are necessary to achieve macroeconomic objectives. But central banks can mitigate the potential for unintended market reactions by communicating their goals and economic outlook as clearly as possible to inform market expectations and thereby avoid possible misperceptions about the future path for policy. The record shows that on occasion monetary policy has been used to counter financial instability. These incidents arise when financial instability is so great that the financial markets themselves seem to become incapable of intermediating effectively and, partially as a result of these market weaknesses, the economic outlook has been revised down sharply and the downside risks to that outlook have become quite large. Naturally, at those moments, asset prices as well as market functioning become a focus for policymakers. However, this does not mean that policymakers have particular targets for those asset prices--that they seek to place a floor under such prices, as some have inferred. Rather, in those situations asset prices are evaluated in the context of all the factors bearing on the economic outlook, just as when markets are orderly, though financial market conditions in all their aspects play a particularly prominent role in such an evaluation when markets are stressed. Bank supervision The concentration in banking structures that I referred to earlier, coupled with the growing scope of permissible bank activities paralleling the evolving nature of the world’s financial markets, has had some profound effects on bank supervision. For one thing, supervisors worldwide have increasingly shifted the emphasis of their concern toward large banks’ internal risk-management policies and systems and relatively away from individual bank positions and transactions. Much of this shift in emphasis has reflected changes in banks’ own internal policies, as increases in the scale and scope of operations have required different control and management systems to maximize risk-adjusted profits. In addition, the change has reflected the need to alter supervisory strategy to address the reality that earlier techniques are inadequate for large, complex entities, especially given supervisors’ limited resources. The same motivations have induced U.S. and other supervisors to emphasize transparency and disclosure by the largest banks in order to exploit the potential market discipline as a supervisory supplement. Market discipline, in turn, requires not only disclosure, but also the expectation that bank counterparties face a risk of loss. Government guarantees in the name of stability may actually pose a greater risk of bank difficulties by reducing market discipline, or, alternatively, could require more intrusive supervision, reducing the innovative market dynamics I mentioned earlier. If you see in these developments the seeds of Basel II - in their requirements for better risk-management systems and greater disclosure - you understand the objectives and approach of the Basel Committee on Banking Supervision. The same factors are driving the proposal of the U.S. authorities to require the supervisory application of Basel II only to the largest, most complex banks, in which scale and scope imply that the necessity of continued investment in improved risk-management techniques and greater emphasis on disclosure are particularly appropriate. These factors are, I believe, also behind the suggestion of my colleague Chairman Powell, of the Federal Deposit Insurance Corporation, that perhaps the United States ought to consider a different supervisory policy for smaller banks than for the complex entities. I cannot leave the subject of supervision without a brief comment on the trend to remove supervision from the responsibility of central banks and to create an overarching single supervisory authority for all financial institutions and markets. Such a structure may well be appropriate for the jurisdictions that have adopted such regulatory frameworks, given their history and institutional development. I certainly respect the decision of countries that have adopted the Financial Supervisory Authority model, and have thus excluded their central banks from the direct supervision and regulation of their banks. However, I believe that such a decision has the potential to undermine a central bank’s ability to manage financial crises. At the outset of my remarks, I emphasized that financial market stability and efficiency do not require an absence of volatility and loss and indeed may require some degree of financial stress. But, my experience also suggests that at certain times - genuine crises, particularly those with a global dimension - the central bank must act to avert disaster. The history of the Federal Reserve in the last couple of decades suggests that central bank effectiveness requires that it have a deep and practical understanding of how banking works and, what is more, genuine credibility with bankers. This kind of understanding and credibility can only be gained by direct interactions with banks and bankers. In turn, such interactions, which develop the knowledge of institutions and markets that is needed for crisis management, can in my view be gained only by hands-on supervision of banking organizations. Indirect knowledge is simply not a substitute. In the United States, the Congress has recognized the relationship between supervision and crisismanagement capability. In its most recent review of the banking law - the Gramm-Leach-Bliley Act the Congress gave the Federal Reserve umbrella supervisory authority for the new financial holding companies as well as preserving its authority for bank holding companies and for member banks chartered by the states. To continue to fulfill its central bank role as crisis manager, I believe the Federal Reserve must continue to have a deep, meaningful, and, most important, practical, understanding of the largest, most systemically important, banks operating in the United States, as well as an understanding of the markets in which they operate. I believe that it can do so, in its role as umbrella supervisor of banking organizations and direct supervisor of state chartered member banks, while respecting the prerogatives of the primary supervisors of banks and other holding company subsidiaries that are not under its direct supervisory authority. And, an important point given the U.S. institutional structure, such an approach continues to be consistent with a healthy dual banking system--in which banks chartered by the federal government and by the respective states exist and compete side-by-side. The value of the dual banking system has withstood the test of time. Crisis management and liquidity assistance The global trends toward market finance, consolidation, and global integration has expanded the range of liquidity and other crisis scenarios that central banks may need to confront. The market turmoil in the autumn of 1998 and the extreme risk-aversion that pervaded credit markets in 2002 amid accounting scandals in the United States may suggest that major market disruptions are probably more likely today to originate from shocks to financial markets that are outside the banking sector. Of course, if such shocks and the attendant market stress appear to pose risks to a central bank’s macroeconomic objectives, policymakers can make appropriate adjustments to the stance of monetary policy. In addition, if policymakers are particularly concerned about improbable but highly costly events, they might well wish to consider market stress in their monetary policy deliberations even when the modal forecasts for macroeconomic variables such as inflation and economic growth have not changed much. Central banks can also be a calming influence on markets in a crisis simply by standing ready, as I noted earlier, to provide liquidity assistance if necessary. Although shocks may originate in global debt and equity markets, they may well reverberate in the banking sector. For example, in 1998, banks were faced with a surge in loan demand from borrowers with reduced access to their usual market funding sources. Assistance from the central bank may involve expanding the liquidity of the entire financial system through open market operations, or it could entail direct loans through the discount window to meet the liquidity demands of specific institutions. On the latter point, I would note that the Federal Reserve has recently restructured its lending programs so that credit can be routinely provided to borrowers in sound condition at an above-market rate but with few other administrative criteria. These changes should help to make the discount window even more effective in a crisis. The trends toward consolidation and worldwide operations in the financial sector also raise some important practical questions of coordination among central banks in providing liquidity assistance should there be a situation that requires it. For example, there are basic questions regarding arrangements among central banks on matters of collateral - the types of collateral that are acceptable, details of cross-border pledging arrangements and so on. These seemingly simple questions are not always easy to answer in international settings, but central banks should be actively working to resolve these and other such issues that bear on their ability and preparedness to meet cross-border liquidity needs. Conclusion Central banks have a long history of working to foster efficiency and stability in the global financial system. That traditional role has become more complex over time as the institutional and market realities of the financial system have evolved. Fortunately, central banks are aware of these changes and have made great progress in appropriately adapting their approaches to the execution of monetary policy, supervision, and crisis management. In our evolving financial system, however, much remains to be done. I can assure you that, as public servants, central bankers will continue to pursue these matters vigorously.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, on the occasion of his acceptance of the Eisenhower Medal for Leadership and Service, Eisenhower Fellowship, Philadelphia, 20 May 2004.
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Alan Greenspan: The resilience of free societies and the impact of free markets Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, on the occasion of his acceptance of the Eisenhower Medal for Leadership and Service, Eisenhower Fellowship, Philadelphia, 20 May 2004. * * * I am honored to accept the Eisenhower medal, which symbolizes a program for advancing leadership around the world. Such a program and the civil values of understanding and peace that it espouses stand in stark contrast to the rising level of violence so evident today. Nonetheless, civil values continue to prevail. The resilience of free societies and economies to threats has been most notable in recent years. In the aftermath of the terrorism of September 2001, fears were widespread that international commerce would contract and the ever-widening globalization of most of the previous half-century would come to a halt. And for a short while it did. Global trade faltered. Travel contracted. New projects were postponed. But the freeing of markets over the previous quarter-century had imparted a flexibility and, hence, a resilience that enabled cross-border commerce to quickly stabilize and, by early 2002, to resume its expansion. Despite the worrisome pockets of strife and destruction, commerce and wealth building continue apace. On average, world standards of living are rising, in large part owing to the increasing embrace of free markets, especially by populous and growing China and India. Since the autumn of 2001, global gross domestic product per capita has grown some 5 percent. Growth in developing Asia, where so many of the world’s poor reside, has been considerably faster. Free markets are the antithesis of violence. They rest not only on voluntary exchange but also on a necessary condition of voluntary exchange: trust in the word of those with whom we do business. To be sure, all market economies require a rule of law to function - laws of contracts, protection of property rights, and a general protection of citizens from arbitrary actions of the state. Yet, if even a small fraction of legally binding transactions required adjudication, our court systems would be swamped into immobility. In practice, in virtually all our transactions, whether with customers or with colleagues, we rely on the word of those with whom we do business. If we could not do so, goods and services could not be exchanged efficiently. The trillions of dollars of assets that are priced and traded daily in our financial markets before legal confirmation illustrate the critical role of trust. Even when followed to the letter, laws guide only a few of the day-to-day decisions required of business and financial managers. The rest are governed by whatever personal code of values that market participants bring to the table. Commerce is inhibited if we cannot trust the reliability of counterparties’ information and commitments. Indeed, the willingness to rely on the word of a stranger is integral to any sophisticated economy. This necessary condition for commerce was particularly evident in freewheeling nineteenth-century America, where reputation and trust became valued assets. Throughout much of that century, laissezfaire reigned in the United States as elsewhere, and caveat emptor was the prevailing prescription for guarding against wide-open trading practices. A reputation for honest dealing was thus particularly valued. Even those inclined to be less than scrupulous in their private dealings had to adhere to a more ethical standard in their market transactions, or they risked being driven out of business. To be sure, the history of world business is strewn with Fisks, Goulds, and numerous others treading on, or over, the edge of legality. But they were a distinct minority. If the situation had been otherwise, nineteenth-century market economies would never have achieved so high a standard of living. Over the past half-century, societies have embraced the protections of the myriad initiatives that have partially substituted government financial guarantees and implied certifications of integrity for business reputation. As a consequence, the value of trust so prominent in the nineteenth century seemed by the 1990s to be less necessary. Most analysts believe that the world is better off as a consequence of these governmental protections. But recent corporate scandals in the United States and elsewhere have clearly shown that the plethora of laws of the past century have not eliminated the less-savory side of human behavior. We should not be surprised then to see a re-emergence in recent years of the value placed by markets on trust and personal reputation in business practice. After the revelations of corporate malfeasance, the market punished the stock prices of those corporations whose behaviors had cast doubt on the reliability of their reputations. There is no better antidote for business and financial transgression. Corporate scandals and evidence of fraud and malfeasance notwithstanding, the history of ever-rising standards of living in a world fearful of violence is extraordinary testimony to the resilience of free peoples engaged in commerce. As President Eisenhower opined during the height of the Cold War, stating a view that remains applicable today, “[W]e now stand in the vestibule of a vast new technological age - one that, despite its capacity for human destruction, has an equal capacity to make poverty and human misery obsolete.”
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at an economics luncheon co-sponsored by the Federal Reserve Bank of San Francisco (Seattle Branch) and the University of Washington, Seattle, 20 May 2004.
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Ben S Bernanke: Gradualism Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at an economics luncheon co-sponsored by the Federal Reserve Bank of San Francisco (Seattle Branch) and the University of Washington, Seattle, 20 May 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * As a general rule, the Federal Reserve tends to adjust interest rates incrementally, in a series of small or moderate steps in the same direction. Between January 2001 and June 2003, for example, the Fed reduced its policy rate, the federal funds rate, a total of 550 basis points in thirteen separate actions. Four of the actions were reductions of 25 basis points in the policy rate, and nine were reductions of 50 basis points. Moreover, the easing cycle that began in 2001 probably represented a more rapid adjustment than normal for the Fed - for good reason, I think, as I will discuss later. The easing that spanned the 1990-91 recession and subsequent recovery is a better example of how drawn out the process of adjusting rates can be. That episode lasted for more than three years, from June 1989 to September 1992, and involved twenty-four policy actions that cumulated to a total reduction of 675 basis points in the funds rate. Of these twenty-four actions, twenty-one were rate cuts of 25 basis points, and three were cuts of 50 basis points. Gradual adjustment tends to characterize periods of rate increases as well as periods of decreases. Even the policy tightening that occurred during 1994-95, though distinctly more rapid than most episodes of rate adjustment, involved seven steps over a period of twelve months, with an ultimate increase in the policy rate of 300 basis points. Of these increases in the policy rate, three were of 25 basis points, three were of 50 basis points, and one was an unusually large 75 basis points. More recently, the eleven-month tightening cycle that began in June 1999 involved five increases of 25 basis points and one of 50 basis points. Researchers have documented that the Federal Reserve is not unique in its tendency to adjust the policy rate in a long sequence of steps in one direction: Central banks in most other industrial countries generally behave in a similar manner (Lowe and Ellis, 1998; Goodhart, 1999; Srour, 2001). This relatively slow adjustment of the policy rate has been referred to variously as interest-rate smoothing, partial adjustment, and monetary policy inertia. In today’s talk I will use the term gradualism. An alternative to gradual policy adjustment is what an engineer might call a bang-bang solution, or what I will refer to today as the “cold turkey” approach. Under a cold turkey strategy, at each policy meeting the Federal Open Market Committee (FOMC) would make its best guess about where it ultimately wants the funds rate to be and would move to that rate in a single step. In the abstract, the cold turkey approach is not without appeal: If you think you know where you want to end up (or are at least are willing to make your best guess), why not just go there directly in one step rather than drawing out the process? As I have already suggested, however, in practice the FOMC seems to take a gradualist approach. Why should this be the case? Are there times when other approaches, such as cold turkey, might be more appropriate? In my remarks I will briefly address these questions. As always, I emphasize that my colleagues in the Federal Reserve System do not necessarily share the views I will express today.1 Gradualism and policymaker uncertainty Several arguments have been made for the desirability of a gradualist approach to monetary policy. Today I will focus on three of these: (1) Policymakers’ uncertainty about the economy should lead to more gradual adjustment of the policy rate; (2) gradualism in adjusting the policy rate affords policymakers greater influence over the long-term interest rates that most affect the economy; and (3) gradualism reduces risks to financial stability. I will begin by discussing the implications of uncertainty for policy choices and then consider the other two arguments for gradualism. I will I thank members of the Board staff for useful comments and assistance. conclude by briefly revisiting the empirical case for gradualism and then discussing some implications for current policy. Many central bankers and researchers have pointed to the pervasive uncertainty associated with analyzing and forecasting the economy as a reason for central bank caution in adjusting policy. Because policymakers cannot be sure about the underlying structure of the economy or the effects that their actions will have on economic outcomes, and because new information about the economic situation arrives continually, the case for policymakers to move slowly and cautiously when changing rates seems intuitive. In a classic article published in 1967, William Brainard of Yale University showed in the context of a simple economic model why this intuition might make sense. Specifically, Brainard showed that when policymakers are unsure of the impact that their policy actions will have on the economy, it may be appropriate for them to adjust policy more cautiously and in smaller steps than they would if they had precise knowledge of the effects of their actions. An analogy may help to clarify the logic behind Brainard’s argument. Imagine that you are playing in a miniature golf tournament and are leading on the final hole. You expect to win the tournament so long as you can finish the hole in a moderate number of strokes. However, for reasons I won’t try to explain, you find yourself playing with an unfamiliar putter and hence are uncertain about how far a stroke of given force will send the ball. How should you play to maximize your chances of winning the tournament? Some reflection should convince you that the best strategy in this situation is to be conservative. In particular, your uncertainty about the response of the ball to your putter implies that you should strike the ball less firmly than you would if you knew precisely how the ball would react to the unfamiliar putter. This conservative approach may well lead your first shot to lie short of the hole. However, this cost is offset by the important benefit of guarding against the risk that the putter is livelier than you expect, so lively that your normal stroke could send the ball well past the cup. Since you expect to win the tournament if you avoid a disastrously bad shot, you approach the hole in a series of short putts (what golf aficionados tell me are called lagged putts). Gradualism in action! In a policy context, the analogous situation is one in which policymakers hope to guide the economy in a particular direction but fear overshooting, either to the inflationary upside or the recessionary downside. Overshooting the objective of stable, non-inflationary growth is perceived as costly by policymakers because overshooting creates unnecessary volatility in the economy and delays the achievement of macroeconomic stability. Like the golfer with the unfamiliar putter, monetary policymakers are far from certain about the impact that a policy change of a given size will have on the economy, as already noted. Given this uncertainty, the Brainard argument suggests a gradual approach to policy adjustment. In contrast, by applying the stronger policy impetus that may be called for by the cold turkey approach, policymakers might inadvertently drive the economy away from its desired path, increasing economic volatility. Brainard’s argument relies on a specific form of uncertainty, namely, policymakers’ uncertainty about the effects of their actions on the economy, but other types of uncertainty may also provide a rationale for policy gradualism. For example, because economic data can be quite noisy, policymakers must inevitably operate with imperfect knowledge about the current state of the economy. Generally, all else being equal, the noisier the economic data, the less aggressive policymakers should be in responding to newly arriving information (Orphanides, 2003). A cold-turkey approach, by contrast, carries the risk that policymakers will take strong action in response to information that may later be revealed to have been seriously inaccurate. Another potential advantage of gradualism is that, by taking small steps, policymakers give themselves the opportunity to assess the effects of their actions and perhaps to refine their views on how large a policy change will ultimately be needed (Sack, 1998). In terms of the golf analogy, by taking a few strokes of moderate firmness one may learn more about the elasticity of the unfamiliar putter and thereby improve the accuracy of subsequent shots. A related benefit of the strategy of taking a small step and then reassessing the situation is that it allows policymakers to avoid excessive reliance on unobservable constructs, such as potential output or the neutral federal funds rate (Orphanides, Porter, Reifschneider, Tetlow, and Finan, 2000; Orphanides and Williams, 2002). In contrast, because they need to determine the optimal policy setting before each action, policymakers following the cold turkey approach may need to rely heavily on estimates of such concepts. Although the idea that uncertainty should induce policy caution seems plausible, research since Brainard’s original contribution has shown that this conclusion is not a general principle but depends instead on the type of uncertainty facing policymakers. A simple variant of the miniature golf analogy can illustrate one important case in which the Brainard intuition fails. Suppose that the hole lies on an elevated plateau, so that your putt must be strong enough to make it up the hill and onto the flat area that holds the cup. If the ball does not make it up the hill, it will roll backward and out of bounds. In this case, if you are using an unfamiliar putter, your best strategy is to hit the ball harder than otherwise, not more softly. Because you don’t know how far the putter will send the ball, you want to be sure that you do not inadvertently putt too softly and end up out of bounds. Compared with our initial example, the key difference in this case is that undershooting the objective imposes an especially high cost. Likewise, in an economic context, a high cost of undershooting the objective leads the optimal policy to be more aggressive and less gradualist, all else being equal. The interaction of uncertainty and concerns about undershooting may well have affected Fed policy during the easing cycle that began in 2001. During that cycle, the FOMC faced a worrisome trend of disinflation, a trend that if left unchecked might have brought the economy close to the zone of falling prices, or deflation. The FOMC had two options during that episode: gradual easing, which some observers advocated as a way of saving the remaining “interest rate ammunition”; or a more preemptive approach, to try to nip in the bud any further decline of inflation toward the deflation boundary. In this particular episode, the risk of doing too little appeared to exceed the risk of doing too much, and the FOMC undertook a relatively aggressive strategy of rate cuts, as I mentioned in the introduction. Similar considerations presumably played a role during the 1994-95 tightening cycle, when concerns that inflation might rise significantly induced a relatively more rapid tightening. Indeed, interesting research by Ulf Söderström (2002) has shown that uncertainty about the persistence of inflation should induce more aggressive policies. For example, if policymakers are worried that inflation may be difficult to control once it is “out of the bottle,” so to speak, a more preemptive approach to controlling inflation may be justified. Although we can draw no general conclusions about the effects of policymakers’ uncertainty on the pace of policy adjustment, empirical studies and simulations of realistic economic models suggest that, normally, relatively gradual policy adjustment produces better results in an uncertain economic environment (Sack, 1998, 2000; Rudebusch, 2001; Söderström, 2002; Orphanides, 2003). In practice, then, a desire on the part of policymakers to be conservative in the face of many different forms of uncertainty is probably an important reason for gradualism in monetary policy. Gradualism and the determination of long-term interest rates A rather different, but nevertheless complementary, argument for gradualism builds on the observation that private-sector expectations play a crucial role in the determination of long-term interest rates and other asset prices and yields. Specifically, by leading market participants to anticipate that changes in the policy rate will be followed by further changes in the same direction, policy gradualism may increase the ability of the Fed to affect long-term rates and thus influence economic behavior. Informal discussions of monetary policy sometimes refer to the Fed as “setting interest rates.” In fact, the FOMC does not set interest rates in general; rather, the Committee “sets” one specific interest rate, the federal funds rate.2 The federal funds rate, the interest rate at which commercial banks borrow and lend to each other on a short-term basis (usually overnight) is not important in itself. Only a tiny fraction of aggregate borrowing and lending is done at that rate. From a macroeconomic perspective, longer-term interest rates - such as home mortgage rates, corporate bond rates, and the rates on Treasury notes and bonds - are far more significant than the funds rate, because those rates are the most relevant to the spending and investment decisions made by households and businesses. These longer-term rates are determined not by the Fed but by participants in deep and sophisticated global financial markets. Although the FOMC cannot directly determine long-term interest rates, it can exert significant influence over those rates through its control of current and future values of the federal funds rate. The crucial link between the federal funds rate and longer-term interest rates is the formation of private-sector Even this statement is not quite accurate. The Fed does not set the federal funds rate in an administrative sense but only controls it indirectly by varying the supply of bank reserves. expectations about future monetary policy actions. Loosely speaking, long-term interest rates embody the expectations of financial-market participants about the likely future path of short-term rates, which in turn are closely tied to expectations about the federal funds rate. Thus, to influence long-term interest rates, such as thirty-year mortgage rates or the yields on corporate bonds, the FOMC must influence private-sector expectations about future values of the federal funds rate. The Committee can do this by its communication policies, by establishing certain patterns of behavior, or both. I will focus here on the effect on expectations of the FOMC’s patterns of behavior, of which gradualism is an example. Suppose the FOMC decided at a given meeting to raise the federal funds rate 25 basis points. What effect would that action likely have on mortgage rates and other longer-term interest rates that the Committee would like to influence? This question can be answered only if we know the effect of the action on market expectations about the future course of short-term rates. To take an extreme and unrealistic example, if the FOMC had established a reputation for reversing any changes made in the funds rate at the subsequent meeting, an increase in the funds rate today would not affect market expectations of future values of the rate (beyond one meeting). In this example, the FOMC’s action would have essentially no effect on long-term interest rates. How can the FOMC ensure that its policy actions feed into longer-term rates and thus influence the economy? An interesting result, noted in an early paper by Marvin Goodfriend (1991) of the Federal Reserve Bank of Richmond and developed more formally by my Princeton colleague Michael Woodford (2000, 2003), is that gradualist policies may allow the Fed to gain greater influence over long-term interest rates.3 The reason is the effect of past episodes of gradualist behavior on market expectations. In a gradualist regime, an increase in the federal funds rate not only raises current shortterm rates but also signals to the market that rates are likely to continue to rise for some time. Because they reflect the whole path of expected future short-term rates, under a gradualist regime long-term rates such as mortgage rates tend to be relatively sensitive to changes in the federal funds rate. Thus, gradualism helps to ensure that the FOMC will have an effective lever over economic activity and inflation. Of course, gradualism is not the only approach that might be used to try to increase the FOMC’s influence on long-term rates. Cold turkey policies would also likely lead to a strong response of longterm rates to changes in the funds rate, because under this approach changes in the funds rate could be presumed to be long lasting. However, theoretical analyses have tended to show that, in models in which financial-market participants are assumed to be forward-looking, optimal monetary policies generally involve some degree of gradualism (Woodford, 2000, 2003). One advantage of the gradualist approach in this context is that it can provide a powerful lever on long-term rates with relatively modest volatility in short-term rates. Less variable short-term rates reduce the risk that the policy rate will hit the zero lower bound on interest rates; they may also reduce stress in the financial system, as I will discuss shortly. More subtly, Woodford (2000) has also shown in theoretical models that purely forward-looking policies such as the cold turkey approach may not be consistent with the existence of a rational expectations equilibrium in the economy. In practical terms, Woodford’s result suggests that such policies may lead to excessive volatility in expectations and hence in financial markets. The fact that market expectations are key in determining long-term yields has an important implication, which is that the current level of the federal funds rate provides only partial information about overall monetary and financial conditions. In particular, a given setting of the funds rate may be consistent with a range of monetary conditions, depending on the direction and pace of future expected changes in the policy rate. For example, monetary conditions in the United States have recently tightened noticeably, even though the funds rate has remained unchanged for some time at 1 percent - a consequence of the expectations about future rates engendered in the financial markets. I will return to this point in my concluding remarks. See Amato and Laubach (1999) for further discussion. These authors use simulations of a small macroeconomic model to show that gradualism can improve the Fed’s ability to affect long-term rates and thus stabilize the economy. Gradualism and financial stability A third explanation of gradualism is that a slower adjustment of policy rates enhances financial stability. For example, some researchers have argued that gradual adjustment of short-term rates gives commercial banks more time to adjust to changes in the costs of short-term funding and thereby increases the stability of bank profits (Cukierman, 1991). Slow adjustment of short-term rates may reduce financial stress for other economic actors as well - for example, households with adjustablerate mortgages and businesses with heavy needs for short-term financing. A variant of the financial stability argument is that the Fed chooses to move interest rates gradually to minimize the risk of “shocking” the bond market. According to this argument, sharp changes in the policy rate risk creating large capital gains and losses for bondholders, which increase market volatility and pose risks for banks and other financial institutions that hold bonds. Because the Fed has a broad responsibility to maintain orderly and well-functioning financial markets, the argument goes, the central bank will avoid policies that create unnecessary financial stress, all else being equal. I suspect that this second variant of the financial-stability argument has some merit, but the case is not as straightforward as it may seem at first. A problem with the argument is that policy gradualism does not necessarily insulate bondholders from capital gains and losses. Indeed, we have just seen that, under a gradualist approach, a small change in the policy rate may have a relatively large effect on longer-term rates, because of its implications for private-sector expectations about the future path of short-term rates. Large movements in long-term rates translate, of course, into wide swings in bond prices and thus potentially large capital gains and losses. To the extent that the FOMC is concerned about stabilizing the bond market, the key is not necessarily keeping changes in the policy rate small but in making policy changes as easy to forecast as possible. Of course, complete predictability of policy cannot be achieved because the FOMC must react to incoming information in order to achieve its macroeconomic objectives. However, the FOMC can attempt to minimize bond-market stress in at least two ways: first, through transparency, that is, by providing as much information as possible about the economic outlook and the factors that the FOMC is likely to take into account in its decisions; and second, by adopting regular and easily understood policy strategies. In the latter respect, gradualism may be helpful to some degree, because it establishes a relatively forecastable pattern of adjustment by the central bank. By varying the pace of policy adjustment, the FOMC may also be able to provide additional signals to bond markets about its views and intentions. Is the Fed really gradualist? In my remarks today I have taken as self-evident that the FOMC conducts monetary policy by gradualist principles and have focused on reasons that gradualist policies may help to promote the Federal Reserve’s objectives. Although theory and empirical analysis generally suggest that the Fed should be gradualist, not everyone agrees, as an empirical matter, that the Fed actually has been gradualist in its policies. The alternative view, most closely associated with Glenn Rudebusch of the Federal Reserve Bank of San Francisco, is that slow adjustment is not an intrinsic feature of Fed behavior (Rudebusch, 2001, 2002; Lansing, 2002). Rather, Rudebusch has argued, in practice the FOMC responds relatively promptly to changes in the economy. The reason that monetary policy appears to adjust gradually, according to Rudebusch, is that the economy itself evolves slowly, which in turn leads policy to change slowly as well. To illustrate, suppose that the FOMC did not adjust policy gradually but set the federal funds rate at each meeting precisely as needed to offset the effects of shocks to the economy. Suppose also that shocks to the economy tend to die away slowly or that the economy’s adjustment mechanisms lead it to respond only gradually to disturbances. In this scenario, observed interest rates would appear to be adjusting slowly, but in reality the apparent gradualism would reflect only the slow adjustment of the underlying economy that the Fed is trying to influence. To support his view, Rudebusch has presented evidence that longer-term rates respond to changes in the funds rate less than they would if the FOMC were intent on pursuing a gradualist approach. Distinguishing “true” gradualist policies from policies that respond to gradual changes in the economic environment is difficult, as the two hypotheses imply similar behavior by policymakers. However, recent studies that have taken up Rudebusch’s challenge have generally found that both an intrinsically gradualist approach to policy and gradual changes in the underlying economic environment are needed to explain the historical patterns of U.S. monetary policy (English, Nelson, and Sack, 2003; Gerlach-Kristen, 2004). If correct, these more-recent studies confirm that gradualism is an accurate description of actual Fed behavior as well as a normative prescription of economic theory. Clearly, though, the extent to which the Fed has pursued gradualism over its history remains an interesting question for further research. Conclusion In my talk I discussed three sets of reasons for gradualist policies: policymaker uncertainty, improved control of long-term interest rates, and the reduction of financial stress. The debate about the sources of gradualism is ongoing and I cannot hope to render a definitive verdict today on the relative merits of these rationales. My sense, though, is that policymakers’ caution in the face of many forms of uncertainty and their desire to make policy as predictable as possible both contribute to the gradualist behavior we seem to observe in practice. I will close by briefly discussing some implications of the gradualist approach for current monetary policy. Before doing so, I remind you once again that the views I express are my responsibility alone. As you know, in reaction to gathering economic momentum and an apparent stabilization in inflation, the FOMC at its May 4 meeting characterized the risks to both sustainable growth and inflation as being roughly in balance. The Committee’s statement ended with the following sentence: “At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.” As a number of FOMC members have noted in public forums, the federal funds rate’s current setting of 1 percent (which implies a negative real funds rate) cannot be sustained in a growing economy and eventually will have to be normalized. The Committee’s statement suggests that, based on current information, it appears likely that this normalization can proceed gradually. As I have discussed today, given the highly uncertain environment in which policy operates, a gradual adjustment of rates has the advantage of allowing the FOMC to monitor the evolution of the economy and the effects of its policy actions, making adjustments along the way as needed. On the margin, a more gradual process may also help ease the transition to higher rates for participants in money markets and bond markets, as well as for households, banks, and firms. In my own view, economic developments over the next year are reasonably likely to be consistent with a gradual adjustment of policy. It is true that the inflation rate rose in the first quarter, a point to which I will return in a moment. However, policy involves lags and thus must of necessity be based on forecasts. As we look ahead, core inflation appears likely to remain in the zone of price stability during the remainder of 2004 and into 2005. Although slack utilization of resources, which moderates wage and price pressures, is an important reason that inflation is likely to remain subdued, my forecast of controlled inflation is based on more than output gap arguments. Other factors likely to keep inflation at modest levels include continuing rapid gains in productivity, which have kept growth of unit labor costs at a very low level; unusually high price-cost margins in industry, which provide scope for firms to absorb future cost increases without raising prices; globalization and intensified competition in product markets; and the recent strengthening of the dollar. There are also indications that commodity prices, with the important exception of energy prices, may be peaking. Long-term inflation expectations also appear well contained, although inflation expectations over shorter horizons have risen, perhaps partly in reaction to the rise in energy costs. Not everyone agrees with my relatively sanguine inflation forecast; indeed, some observers have questioned whether the current low level of the federal funds rate is not already excessively stimulative in light of the gathering recovery and the recent inflation data. I would like to make two observations. First, I do agree that the flare-up in inflation in the first quarter is a matter for concern, and that the inflation data bear close watching. Should the rise in inflation show signs of persisting, I am confident that the Federal Open Market Committee will adjust policy as necessary to preserve price stability. As the qualified and probabilistic language of the FOMC’s statement makes clear, the likelihood that the pace of rate normalization will be “measured” represents a forecast about the future evolution of policy, not an unconditional commitment on the part of the Committee. Although I expect policy to follow the usual gradualist pattern, the pace of tightening will of necessity respond to evolving economic conditions, particularly the strength of the ongoing recovery in the labor market and developments on the inflation front. Second, however, concerns that that monetary policy is “behind the curve” may not fully take into account a point I made earlier, that the level of the federal funds rate by itself does not fully describe broad monetary conditions. A given level of the funds rate can be consistent with easing or tightening monetary conditions, depending on market expectations about future short-term rates. In part because of the FOMC’s communication strategy, which has linked future rate changes to the levels of inflation and resource utilization, and in part because of the gradualist policies that the FOMC has pursued in the past, markets have responded to recent data on payrolls, spending, and inflation by bringing forward a considerable amount of future policy tightening into current financial conditions. Notably, in the past few months, long-term interest rates have risen 100 basis points or more, equity markets have been subdued despite robust earnings reports, and the dollar has strengthened. These developments - the sort of “front-loading” of monetary tightening predicted by our analysis of gradualism - will reduce the financial impetus being provided to the economy and thus provide some check to nascent inflationary pressures. In short, the low level of the federal funds rate not withstanding, broad monetary conditions have already begun to normalize, a development that should tend to limit future inflation risks. Of course, at some point the FOMC will have to validate the general expectation of rising short-term rates; expectations management is not an independent tool of monetary policy. The good news is that, because of the impact of private-sector expectations about policy on current long-term rates, a significant portion of the financial adjustment associated with the tightening cycle may already be behind us.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, before the Annual Convention of the Arkansas Bankers Association, Hot Springs, Arkansas, 17 May 2004.
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Susan Schmidt Bies: Corporate governance and community banks Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, before the Annual Convention of the Arkansas Bankers Association, Hot Springs, Arkansas, 17 May 2004. * * * Thank you for the invitation to participate in the 2004 Annual Convention of the Arkansas Bankers Association. Over the past two years, a considerable amount of time and energy has been expended in our country addressing corporate governance issues. If you read the headlines in the financial press, you might think that every financial institution in the United States discovered corporate governance two years ago when the Sarbanes-Oxley act was enacted. Well, as we all know, corporate governance is not new to U.S. financial institutions. Senior management and boards of directors of banks, both publicly traded and privately held, have a tradition of taking their responsibilities for ensuring effective governance seriously. In my comments today, I would like to address the state of corporate governance at community banks. I’ll discuss the assessments some of the consultants and public accountants are giving the banking industry and I’ll contrast that to what we are observing through the examination process. I’ll also touch on some of the developing “best practices” in corporate governance, internal controls and operational risk management. Many of these best practices seem to be resulting from community bankers like you modifying the Sarbanes-Oxley corporate governance requirements to make them relevant for your individual business and corporate structure. At the Federal Reserve, we tend to favor best-practice approaches for corporate governance at community banks rather than a one-size-fits-all approach. Corporate governance perspective of consultants I’ll start with a report card on the state of corporate governance at community banks issued by the major consulting and accounting firms. Recently, several have reported on the governance practices at financial services firms, including community banks. These studies begin by recognizing the progress financial services firms have made in the areas of director independence, audit committee oversight, and overall board awareness of governance issues within their organizations. These studies cite a growing sensitivity to governance issues among employees and a heightened awareness among senior management and the board. They cite improvements in “governance type” disclosures to shareholders/stakeholders and increased vigilance on the part of the regulatory agencies. However, a number of these studies conclude by saying that banks and other financial services firms have a long road ahead of them if they are to achieve the goal of effective corporate governance. Based on these studies, it sounds like the firms believe that bank corporate governance practices should receive the equivalent of a C grade with a needs improvement notation. Why is this? According to a global survey of financial institutions conducted by PricewaterhouseCoopers, part of the reason why financial institutions are not making the grade is that they equate effective governance with meeting the demands of regulators and legislators.1 That is, they tend to look at this as another compliance exercise. The study goes on to state that the compliance mentality is limiting the ability of these institutions to achieve strategic advantages through governance. I would agree that any institution who views corporate governance as merely a compliance exercise is missing the mark. We all are aware of companies in various industries who have successfully presented their strategic vision to investors, but who later stumble because the execution of that strategy did not meet expectations. While the reasons for shortfalls can occur for many reasons, one of the more common shortcomings is that the strategy itself was focused too much on market and financial results without adequate attention to the infrastructure necessary to support and sustain the strategy. PricewaterhouseCoopers and the Economist Intelligence Unit, “Governance: From Compliance to Strategic Advantage” (April 2004). Corporate strategies often focus on the most likely future scenario and the benefits of a strategic initiative. A sound governance, risk management, and internal control environment starts by being part of the strategic planning exercise. That is, while the strategy is being considered, managers and board members should be asking: What are the major risks of this plan? How much risk exposure are we willing to accept? What mitigating controls need to be in place to effectively limit these risks? How will we know if these controls are working effectively? In other words, by considering risks as part of the planning process, controls can be built into the design, the costs of errors and reworking in the initial rollout can be reduced, and the ongoing initiative can be more successful because monitoring can reveal when activities and results are missing their intended goals, so that corrective actions can be initiated more promptly. Many of these studies note that it is very difficult for outsiders to determine the effectiveness of governance. Unfortunately, it takes significant breaks in internal controls for the public to be aware of weaknesses in the process. The disclosure of deficient business and governance practices can then lead to lower share prices, the likelihood of potential shareholder lawsuits and enforcement actions, the loss of credibility and damage to a bank’s reputation, and the payment of higher spreads to access capital markets. The size of potential detrimental impacts due to a serious breach in governance can place the costs of improved governance in perspective. Several studies highlight that institutions are spending more on corporate governance today than in the past. According to Grant Thornton’s 2003 Eleventh Annual Survey of Community Bank Executives,2 it isn’t just large organizations that are feeling the cost impact of corporate governance. Community banks not subject to the Sarbanes-Oxley and Federal Deposit Insurance Corporation Improvement (FDICIA) acts experienced or are expected to incur increases in costs for a number of services and functions related to corporate governance. Seventy-three percent of these banks expected to incur increases in general audit fees; sixty-two percent expected to incur increases in director and officer liability insurance premiums; thirty-two percent expected to incur increases in financial education costs for directors; and twelve percent expected to incur increases in costs associated with attracting and retaining board members. In response to this study, a logical question is whether the benefits outweigh the costs. Many of you are reflecting on the first quarter 2004 discussion of your annual operating results, budget estimates, and income projections that were presented at recent board and staff meetings. True, these costs reduced some of your current profitability goals. But corporate managers have demonstrated over the years that focusing on better process management can enhance financial returns and customer satisfaction. They have learned that correcting errors, downtime in critical systems, lack of training for staff to promptly handle their changing tasks, all create higher costs and lost revenue opportunities. I would challenge you to consider the appropriate corporate governance structure suitable to your bank’s unique business strategy and scale as an important investment, and consider returns on that investment in terms of the avoidance of the costs of poor internal controls. Corporate governance perspective of regulators Now I would like to discuss the grade the regulatory community has given the community banks on their corporate governance practices. Regulators typically measure effectiveness by some sort of examination assessment. Using the current CAMELS type of assessment, a review of recent Federal Reserve examination results would indicate that most community banks have effective corporate governance. Eighty-four percent of all community banks reviewed were rated highly with respect to risk management practices, including corporate governance. This is not to say that we don’t see the need for improvement in certain areas. Examination findings routinely cite ways in which risk management, including corporate governance, could be improved. However, it is apparent that the senior management, boards, and audit committees in these highly rated organizations are setting annual agendas that focus attention on the high-risk and emerging risk areas within their banks while continuing to provide appropriate oversight to the low-risk areas. Internal auditors, or equivalent functions at these banks, are testing to determine whether the risk management program is effective and are communicating the results to the board and audit committee. Grant Thornton, LLP, Eleventh Annual Survey of Community Bank Executives (January 2004). So, the examination results appear to indicate that the majority of banks are getting the message on the basics of sound governance. I would almost like to stop my speech here and conclude by saying, “All is well in the banking industry.” However, we also performed a review of the corporate governance at the subset of banks with weak or unsatisfactory ratings. Not surprisingly, the review identified the major challenges facing these banks to be poor asset quality and corporate governance issues, such as policies, planning, management, audits, controls, and systems. Eighty-nine percent of the community banks in this group experienced serious asset quality problems, which was the most significant factor resulting in their low rating. Sixty percent of the community banks in this group experienced significant deficiencies in corporate governance. The corporate governance deficiencies could broadly be described as internal control weaknesses, weak or inadequate internal audit coverage, significant violations of law, accounting system weaknesses, and information technology issues. Obviously, poor asset quality and ineffective corporate governance are not mutually exclusive. When we find significant asset quality problems, we usually find corporate governance problems - particularly inadequate internal controls. Similarly, when we find significant control deficiencies, significant asset quality or financial reporting problems are generally present. So, what is the message we should take away from these statistics? On the one hand, we could pat ourselves on the back and say that things are generally going very well for most of the industry and we can finally tone down all of the corporate governance rhetoric. Or, we could say those negative statistics only apply to the boards and senior managers at a small group of poorly rated institutions who now have to pay the price. Or, yet again, we could say that effective corporate governance is a continuous process that requires ongoing vigilance on the part of the board, audit committee, senior management, and others within your bank. I hope you are thinking along the lines of this last sentiment. As you know, once an organization gets lax in its approach to corporate governance, problems tend to follow. Many of you can recall the time and attention management devoted to Section 112 of FDICIA, which first required management reports and auditor attestations in the early 1990s. Then the process became routine, delegated to lower levels of management, and stale to the changes in the way the business was being run. That is when the breaks in internal controls occur. Unfortunately, trying to change the culture again is taking an exceptional amount of senior management and directors’ time time taken away from building the business. The challenge, therefore, is to ensure that the corporate governance at community banks keeps pace with the changing risks that you will face in the coming years. Another consequence of so much public attention on the breakdowns in controls at a few organizations is difficulty in finding good directors. One common theme we have heard during our examinations is the challenge facing banks of all sizes to retain, or attract, board members with the appropriate depth of understanding and commitment to sound corporate governance practices. Many potential directors who have the experience needed are cautious about the potential liability they face. They also would rather join a board on which they are able to balance their time among all of the areas of oversight - strategy, marketing, financial performance, human resource development, community involvement, and so on - and not just governance, compliance, audits, and internal controls. This is another result of inconsistent attention over time to good governance practices. Operational risk The Federal Reserve System is also conducting selected reviews for operational risk at community banks. By operational risk, I mean “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events,” which is the definition used by the Basel Committee on Banking Supervision. At the Federal Reserve, we are placing an increasing focus on operational risk. In part, this is due to the significant improvements we have seen in the last two decades in interest rate and credit risk management. Thus, weaknesses in governance and internal controls and operational risks become more apparent. For example, at one of our Reserve Banks we are conducting a pilot program specifically geared toward the operational risk activities of smaller community banks, those with less than $500 million in assets. One of the objectives of the program is to identify and test the key internal controls used by banks to mitigate operational risk exposures. The reviews focus on specific business processes with high operational risk - for example, the wire transfer and loan administration areas. Based on the results of these reviews, the bankers involved have responded very favorably to the program and indicated they have received measurable benefits. Moreover, the program has identified some common operational control weaknesses to which we believe community banks should pay particular attention. Let’s use wire transfers and loan administration as examples. With wires and similar transactions, the bank could suffer a significant financial loss from unauthorized transfers, as well as incur considerable damage to its reputation if operational risk factors are not properly mitigated. A few recurring recommendations from our reviews, are to: (1) establish reasonable approval and authorization requirements for these transactions to ensure that an appropriate level of management is aware of the transaction and establish better accountability; (2) establish call-back procedures, passwords, funds transfer agreements, and other authentication controls related to customer wire transfer requests; and (3) pay increased attention to authentication controls, since this area may also be particularly susceptible to external fraud. Loan administration is an area where a bank could suffer a significant financial loss from the lack of appropriate segregation of duties or dual controls, as well as incur considerable damage to its reputation if operational risk factors are not properly mitigated. A few recurring recommendations from our reviews, are to: (1) ensure that loan officers do not have the ability to book and maintain their own loans, (2) limit employee access to loan system computer applications that are inconsistent with their responsibilities, and (3) provide consistent guidance - policies and procedures - to line staff on how to identify and handle unusual transactions. We have several other recommendations that resulted from these reviews and have a number of operational risk initiatives underway currently. We expect to summarize these findings and provide further updates and guidance to the industry as we move forward. But given the examples of best practice I just mentioned, these are not revolutionary insights. Well-run organizations have these or similar controls in place. We hope these studies serve as reminders that can be used to help bank managers keep the focus on continuous improvements in internal controls as part of the normal business process. Observations on best practices Finally, I would like to focus on some best practices for corporate governance at community banks. Rather than talk broadly about best practices, I’ll focus on certain aspects of internal controls and operational risk management. Best practice 1: Adopt a recognized internal control framework that works for the bank. All banks have some framework for internal control. What I’m suggesting as a best practice is to adopt a version of the Committee of Sponsoring Organizations (COSO) of the Treadway Commission’s Internal Control - Integrated Framework.3 Don’t be put off by the titles of these frameworks. These frameworks are flexible enough to work effectively at a $25 million bank or a multi-billion dollar financial institution. The COSO framework describes how each internal control element can be tailored to smaller and less complex organizations. For example, if COSO is used as a best practice, you should modify the five following elements of internal control to meet your organization’s needs. Control environment - Board members and senior managers should identify the bank’s key business strategies, objectives, and goals and tailor COSO to influence the bank’s management philosophy, culture, and ethics to establish and maintain an appropriate control environment. Risk assessment - Managers should look at the risks inherent in the businesses and processes they manage, and determine the bank’s risk appetite and establish risk measurement practices that are appropriate for their organization. Control activities - Managers should establish and maintain controls and monitoring processes that ensure they will be effective in achieving the organization’s profit and other objectives based on a designated level of risk. Managers should monitor the organization’s business plan to assess how risk exposures are changing and determine whether new controls, or changes in existing controls, are needed to manage that level of risk. Committee of Sponsoring Organizations of the Treadway Commission, Internal Control - Intergrated Framework. Information and communication - Information required to successfully achieve the organization’s control objectives should typically be accumulated in a management information system and should be communicated through reliable channels to all responsible parties - from tellers to board members. Normal bank communication channels should normally be adequate for this purpose. However, new channels may be necessary if the type of information is too sensitive to communicate over existing channels, or if that information may be risky to the individual making the communication (in other words, the knowledge of an incident of identified fraud for a whistle blower). Monitoring - Monitoring should typically be the role of internal audit. A number of community banks do not have a permanent internal audit department. Recognizing this, each community bank must develop a review (audit) function that is appropriate to its size and the nature and scope of its activities. As you may know, COSO is just about to release a revised framework that will incorporate enterprise risk management (ERM). When this is issued, the best practices in these five elements will need to be re-evaluated to address ERM. Best practice 2: Adopt a program for independently assessing the effectiveness of internal controls on at least an annual basis. Boards of directors and audit committees are responsible for ensuring that their organizations have effective internal controls that are adequate for the nature and scope of their businesses and are subject to an effective audit process. Effective internal control is the responsibility of line management. Line managers must determine the acceptable level of risk in their line of business and must assure themselves that they are getting an appropriate return for this risk and adequate capital is being maintained. Supporting functions such as accounting, internal audit, risk management, credit review, compliance, and legal should independently monitor and test the control processes to ensure that they are effective. Implementing management reports on internal controls comparable to those required under SarbanesOxley and FDICIA 112 can also assist community bank boards of directors and audit committees in obtaining a better understanding of the controllable risks within the bank and the quality of the controls in place over those risks. Sarbanes-Oxley and FDCIA 112 require an annual management assessment of internal control effectiveness and an attestation of management’s assessment and the effectiveness of controls by the bank’s external auditor. Community bank management could perform periodic assessments of internal control effectiveness. Another group of employees within the bank could perform an independent evaluation of management’s report. By independent, I do not necessarily mean an external auditor should be engaged to issue a report. In this sense, independent may mean that internal audit is brought in to perform something similar to an external auditor’s attestation. The details of such an approach need to be worked out. The important point is that the audit committee should have some reasonably independent assessment of management’s report. Audit committee members could use these reports to set the audit plan for the next year, to track how risks have changed and are changing within the organization, and to facilitate discussion of which controls should be added. Best practice 3: Adopt a framework for assessing operational risk Over the past few years, the discussion of operational risk management has increased significantly in banking circles. In 2003, the Basel Committee released a paper, “Sound Practices for the Management and Supervision of Operational Risk.”4 This paper sets forth a set of broad principles that should govern the management of operational risk at banks of all sizes. Although operational risk is nothing new to community banks, the prospect of addressing this risk in a structured framework with measurable results is something new. The broad variety of products and services that banks provide, the evolution of business processes, and changes in the ethical environment in which we live have all contributed to more observable exposures to this type of risk. Managers and boards are beginning to gather the information necessary Basel Committee on Banking Supervision, “Sound Practices for the Management and Supervision of Operational Risk” (February 2003). to monitor and understand the growing risks inherent in their operations. Supervisors are developing approaches for measuring and evaluating operating risk. At the Federal Reserve, we are studying different approaches and have a project underway to develop guidance on how to address this risk. In the near future, we plan to compare our observations on best practices on internal controls and operational risk management practices with yours to develop some useful resource materials for good corporate governance at community banks. Conclusion In conclusion, community banks are further improving their traditional focus on strong corporate governance. Those banks leading the way recognize that the culture of governance, ethics, and controls cannot readily be switched on and off. They build a culture of accountability and ethics to make governance a part of every strategic plan and daily operation. Banks are also beginning to focus more attention on operational risk issues which are an essential part of the overall risk management plan of the organization. The Federal Reserve has a number of initiatives underway, and we plan to work with community bankers to continue to identify emerging best practices.
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the second meeting of the Financial Literacy and Education Commission, Washington, DC, 20 May 2004.
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Edward M Gramlich: Workplace financial education Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the second meeting of the Financial Literacy and Education Commission, Washington, DC, 20 May 2004. * * * The Federal Reserve System has a long history as a promoter and provider of consumer education. An increasingly complex global financial system requires consumers to have a strong working knowledge of financial concepts. To highlight the importance of financial education and to make people aware of the multitude of financial education resources that are available to them, the Federal Reserve System launched a national public campaign that began in May 2003. But before we launched a public campaign, we began putting together a serious program of workplace education for our own Board employees. In November 2002, we sponsored a roundtable with fifteen to twenty employers that we identified as having active workplace education programs. Attendees, representing Reserve Banks, private corporations, and government agencies, discussed goals, plans, and how to get started. This group suggested some key features that we built into our own program. One was to make financial education a lifetime responsibility, for us and our employees. Another was to keep information current, relevant, and responsive to changing conditions. A third was to provide information through a range of vehicles. From this session we gathered information on best practices and formed an internal task force to plan, coordinate, and evaluate these efforts. The task force developed ongoing objectives for the program that include • increasing employees’ understanding of how Board-sponsored benefit programs can contribute to short- and long-term financial well-being, • improving employees’ knowledge of basic financial concepts and improving their capability to make personal finance decisions, • encouraging employees to adopt financial management behaviors that will help them increase their short- and long-term savings and better manage or eliminate debt, and • evaluating the impact of workplace financial education on participation in Board benefit programs and financial behavior through appropriate metrics. To carry out our objectives, we use a variety of methods. We host lunch-time seminars, offer morning or afternoon programs, and place articles and educational materials on our internal electronic newsletter. We are also developing an internal web site designed to improve employees’ knowledge of finance, benefits, health, and career development issues. Our programs and educational materials cover a variety of topics. “Making Sense of Your Credit Report” provides information on the factors that can positively or negatively affect a credit report. “College Savings: Making Education Your Financial Goal” discusses education as a financial goal and presents information on Coverdell Education Savings Accounts, U.S. Savings Bonds, and Qualified Tuition Programs as types of savings vehicles for achieving that goal. Programs on estate planning and retirement are offered, as well as seminars on financial planning and advanced investment. Many of these programs are geared to those employees who have been in the workforce for many years. However, understanding that many of our young people don’t receive formal course work in financial matters, we designed a program that is more meaningful to new professionals. This program, which is designed for those young people just entering the workforce, discusses the importance of starting to save at a young age, homeownership, advanced education, and avoiding debt. Workplace education benefits both the employer and employee. For the employee, more knowledge, one hopes, will result in better financial decisions and overall financial well-being. Employees who are taking maximum advantage of the benefits available to them will more likely have greater job satisfaction, which may result in lower turnover. For the employer, research studies have shown that employees who are financially healthy are more productive. They are absent less often, spend less time at the workplace dealing with financial crises, and earn higher job performance ratings. We commend the Commission for recognizing workplace education as an integral component in formulating a national financial education strategy.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, on the occasion of his acceptance of the 2004 Distinguished Alumni Award, Sidwell Friends School, Washington, DC, 22 May 2004.
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Roger W Ferguson, Jr: Economics and ethical behaviors Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, on the occasion of his acceptance of the 2004 Distinguished Alumni Award, Sidwell Friends School, Washington, DC, 22 May 2004. * * * I am pleased to be here today and honored to accept the Sidwell Friends School Distinguished Alumni Award for 2004. It is awe-inspiring to be included in the company of so many accomplished graduates, including Walter Gilbert, Hanna Holborn Gray, Antonio Casas, Helen Colson, and Bill Nye. All of you, as Sidwell Friends graduates and friends, clearly understand the value of a good education. Indeed, economists have long noted an “education premium” in compensation, with college-educated workers earning approximately fifty percent more than workers with no more than a high school education.1 However, you also know that a good education is more than just the classroom-based learning of facts, or even the skill of critical thinking. A truly outstanding education also encourages moral behaviors and appropriate decisions. Sidwell Friends, with its grounding in Quaker traditions, certainly values the moral and ethical development of its students. Fortunately, many schools teach the importance of choosing the “hard right over the easy wrong.” That is where I will focus my brief remarks. From my perspective as a policymaker, I want to commend the emphasis on a complete education, with technical, critical thinking, and ethical components, and encourage you and other schools to, if anything, redouble your efforts to instill moral values and ethical behaviors. Obviously, we as Sidwell graduates hope to exemplify those values as much as possible in our personal and professional dealings. Similarly, I encourage the current generation of students to take advantage of the moral and ethical training available at these schools. Do not forsake a solid grounding in those topics that will help you to do “good” while you are learning the skills required to do “well.” Some of you may have noticed that I encouraged this focus on teaching and practicing ethical and cooperative behaviors as an economic policy maker. In that role, shouldn’t I encourage you to be only a coolly self-centered, utility-maximizing, homo economicus? The answer is no. Economic outcomes are improved when market participants “play by the rules.” This fact has a strong grounding in economic theory and empirical research. In fact, you may be surprised to know that the economics profession, even with its hard-headed assumption of rational actors pursuing their own self interest, has for the last few decades also focused on the role of moral and cooperative behaviors in leading to better economic outcomes. As one major example, a recent Nobel Prize in economics was shared by George Akerloff, who in a classic paper in 1970 showed that a failure of markets arises when the seller does not share honest and complete information about the quality of a product, in his paper, used cars, with would-be buyers.2 Akerloff went on to show that such asymmetry in information and opportunistic behavior will ultimately drive honest dealings out of the market unless it is overcome by new institutional structures. Some of those structures arise from the private sector. As a policymaker, I see many of those structures arise in the form of regulation. In those markets in which there is a strong likelihood that self-policing behavior will not emerge, and opportunistic behavior is a real risk, the government must create regulation to protect the weaker or less-well-informed party from the stronger, better-informed one. These regulations are well intended and often have the desired outcome; however, in spite of the regulators’ best efforts, they can be burdensome, and compliance with them may well consume resources that might go to providing more or better goods and services. This is not an argument against regulation; sound regulation is needed. It is an example of the cost imposed on society by the unscrupulous behaviors of a few. Not only have economists identified theoretical failures that come from unethical and opportunistic behaviors, social scientists have also demonstrated real world benefits from cooperative behaviors. For example, a study of engineers found that individual workers who are more generous with their time Card, David and John E. DiNardo, Skill Biased Technological Change and Rising Wage Inequality: Some Problems and Puzzles, Journal of Labor Economics, Vol. 20, No. 4 (2002), pp. 733-783. Akerloff, George A., The Market for Lemons: Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, Vol. 84, No. 3 (Aug., 1970), pp. 488-500. with other workers, and in turn frequently benefit from the help of others, are more productive and have higher social standing.3 More recently of course, the entire economy, that is to say all of us, have experienced the costs of unethical behaviors in a matter of great macroeconomic consequence. The recent accounting and governance scandals were sufficiently numerous and serious to generate widespread concern among investors about the reliability of financial reporting in general. These scandals were a notable factor behind the U.S. stock market slide in the spring and summer of 2002, amidst the cascade of scandals culminating with WorldCom’s revelations in June that year. And concerns about corporate governance probably contributed, at least in some measure, to the heightened business caution and sharp fall-off in business investment during this period. Thus, although other, more important factors were also working to restrain real activity during this period, it seems likely that the scandals exacerbated an already weak economic situation. Just as opportunistic behavior by individuals calls forth regulations as a counterweight, so too these corporate governance scandals have called forth new laws and regulations, which were probably the proper response and required to restore confidence, but which have almost surely added to the cost of doing business. The negative effect from lapses in corporate governance at the macroeconomic level in the United States is a very visible example of the national costs of poor corporate governance. Social scientists have also found that at the level of the individual company poor corporate governance costs and good corporate governance pays, quite literally. Some researchers have found that investments in firms which engage in unethical behavior earn abnormally negative returns for prolonged periods (Long and Rao, 1995).4 Others find that firms that have better corporate governance also have higher stock market valuations, higher profitability and faster sales, and there is evidence that buying shares of firms that score high in corporate governance and selling shares in firms that do not yields abnormally positive returns (Gompers, Ishii and Metrick, 2003).5 All of this is true not just in the United States, but globally as well. At the macroeconomic level, the World Bank has identified corruption as the single greatest obstacle to economic and social development. The Bank states that “corruption undermines development by distorting the rule of law and weakening the institutional foundation on which economic growth depends.”6 Fortunately, there is some evidence from studies of emerging markets that firm-level corporate governance matters more in countries with weak legal systems, and one can infer from this work that firms can partially compensate for ineffective legal systems by practicing ethical behavior.7 Let me close by saying that the economy of the United States depends greatly on an educated workforce. My own research demonstrates that our productivity boom of the last nine years requires a talented and flexible work force.8 Education, however, must be broadly defined to include moral and ethical behaviors and good decisionmaking. There is plenty of evidence that such behaviors pay an ample reward to the individuals who make them and, unfortunately, the absence of such behaviors extracts a cost, potentially from all of us. I am pleased to have attended a school that continues to value such an education, encourage all schools to emphasize such training, and am truly honored to accept this award from my fellow alumni. Flynn, Francis J., How Much Should I Give and How Often? The Effects of Generosity and Frequency of Favor Exchange on Social Status and Productivity, Academy of Management Journal, Vol. 48, No. 5 (2003), pp. 539-553. Long, D. Michael and Spuma Rao, The Wealth Effects of Unethical Business Behavior, Journal of Economics and Finance, Vol. 19, No. 2 (Summer 1995), pp. 65-73. Gompers, Paul, Joy Ishii, Andrew Metrick, Corporate Governance and Equity Prices, The Quarterly Journal of Economics, Vol. 118, No. 1 (Feb., 2003), pp. 107-155. The World Bank Group, The New Anticorruption Home Page. Klapper, Leora F. and Inessa Love, Corporate Governance, Investor Protection and Performance in Emerging Markets, Journal of Corporate Finance (forthcoming). Ferguson, Jr., Roger W. and William L. Wascher, Distinguished Lecture on Economics in Government: Lessons from Past Productivity Booms, Journal of Economic Perspectives (forthcoming).
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Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the National Economists Club luncheon meeting, Washington DC, 4 June 2004.
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Donald L Kohn: The outlook for inflation Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the National Economists Club luncheon meeting, Washington DC, 4 June 2004. * * * Inflation has picked up this year, and by enough to raise questions in the minds of some about whether it might be on a rising trend that poses a risk to price stability. Total consumer price inflation as measured by the chain price index for personal consumption expenditures (PCE) has risen from 1.4 percent over the twelve months of last year to an annual rate of 3.0 percent over the first four months of 2004. Of course, a portion of this acceleration is due to the faster increase in energy prices this year. But the strengthening in price increases has not been confined to energy markets. PCE prices excluding food and energy have risen at an annual rate of 1.7 percent this year, up from 0.8 percent last year. The consumer price index has shown a similar pattern of acceleration. The recent shift up in inflation can be seen not just in the price indexes but also in attitudes, anecdotes, and expectations. Businesses report that the prices of many inputs to the production process are increasing, and they also sense a return of “pricing power” that has allowed them to pass on at least some of these cost increases to their customers; my impression is that of late a greater number of stories in general-circulation newspapers have focused on rising prices and their effect on households; and expectations by economists and households of near-term inflation have moved higher. The commitment of the Federal Reserve to maintaining price stability remains strong and unaltered. Price stability is our responsibility, and the record of the past thirty-five years demonstrates how important it is that we meet it. Allowing businesses and households to plan and operate without worrying about increases in the general price level over the long run is how we contribute best to fostering economic efficiency and rising standards of living. A number of members of the Federal Open Market Committee (FOMC), myself included, have been quite explicit in noting that the current level of the federal funds rate will not be consistent, over time, with the objective of preserving price stability. The question is what path of tightening is likely to be necessary to accomplish that objective, and the answer to that question will depend critically on the behavior of inflation. Although inflation is ultimately a monetary phenomenon, the stance of policy - measured either by interest rates or liquidity provision - is not connected in a direct and simple way to the rate of inflation. Individual prices are determined by supply and demand in the markets for goods and services, and the average of those prices by relationships of aggregate supply and demand. Monetary policy acts on inflation indirectly by altering the balance among the multiplicity of factors that affect supply and demand. To make well-informed policy decisions, we need to analyze the elements behind the recent increase in inflation and form some judgment about its likely future course. Like many economists, I believe the inflation process is influenced by a number of factors, chief among which are: the degree to which the productive capacity in the economy is being utilized; one-time shifts in product prices resulting from shocks to important supply and demand curves; changes in productivity growth; and inflation expectations. This basic model is a rough approximation of a complex and constantly evolving mechanism of price determination, and its track record can hardly be considered flawless.1 But it does offer a useful framework for the analysis of inflation, and I am going to use it for that purpose here. I want to emphasize that I am speaking for myself today. The analysis and views are my own, and not necessarily those of my colleagues on the FOMC.2 In simulations of the FRB/US model, which uses such a framework, the 70 percent confidence interval around the four-quarter forecast of core PCE inflation is 1-1/4 percentage points wide. David Wilcox, John Roberts, Jeremy Rudd, and Peter Tulip of the Federal Reserve Board’s staff provided valuable assistance. The data Before beginning to examine the determinants of inflation, we need to remind ourselves of the inherently noisy nature of the price data. They are highly variable month-to-month and quarter-to-quarter, and they are imperfect proxies for the true change in general prices. As a consequence, discerning the underlying trend of inflation is no easy task. Had I been speaking to you just a year ago, you would have expected me to address the possibility of deflation and what the Federal Reserve might do either to head it off or to deal with it once interest rates had reached zero. In newspapers and in market reports, you would have read that the integration of China and India into the global trading system meant persistent excess supply of labor and products that would place downward pressure on wages and prices in the developed world for years to come. Now the concern has shifted to whether inflation is rising, and those earlier stories are frequently being turned on their heads. It is increasingly common to hear that strong demand for energy and other basic materials, importantly including demand from Asia, has been boosting inflation here. To be sure, the underlying economic situation has changed over the past year - most particularly, growth has picked up in the United States and elsewhere around the world. But actual circumstances probably have not shifted as dramatically as the commentary, which serves as a warning about how important it is to try to gauge the fundamental forces bearing on inflation so as to reduce the chances of being misled by noisy data. In that regard, although a weak economy, associated slack in resource utilization, and rapid increases in productivity were undoubtedly reducing inflation last year, core inflation - especially as measured by the core CPI - seems to have fallen by more, and to a lower level, in 2003 than these fundamentals can explain. Typically, such departures from historically normal behavior do not persist, and inflation tends to return to a level more in line with its fundamental determinants. Indeed, the step-up in inflation this year from last year’s pace may partly reflect such a return. Within the CPI, the component called owners’ equivalent rent, which accounts for nearly a quarter of the overall index, seems to have been an important factor in the surprising decline in inflation last year. That series uses movements in home rents as a proxy for changes in the cost of home ownership. Owners’ equivalent rent rose only 2 percent in 2003, down from 3-1/4 percent in 2002. Some deceleration in rents is to be expected when low interest rates hold down the user cost of owning a home, favoring home ownership over renting. However, owners’ equivalent rent softened more than one would have predicted from historical relationships between rents and interest rates. So far this year, owners’ equivalent rent has risen at an annual rate of 3 percent, returning to a more typical relationship with interest rates and contributing to the pickup in core inflation. Of course, even if some of the rebound in core consumer price inflation represents simply a reversal of some of the factors that kept inflation unusually low last year, other influences might be at work that would cause inflation to continue to rise. To get a sense of whether we are on the cusp of worsening inflation, we must examine what might be affecting the supply and demand for goods and services. Determinants of inflation Economic slack. Judgments about the source of the recent increase in inflation and the likely course of prices over the next year or so rest in part on an assessment of how close the economy is to producing at its long-run potential. History indicates that when capital and labor are not fully employed, competition for market share and for jobs tends to push down the rate of inflation.3 Using measures of potential output and economic slack in real-time forecasting and policymaking presents daunting challenges. That is because potential output is not something that can ever be observed and directly verified; we infer it from the behavior of other variables, including prices themselves, that we do observe. Estimating potential output and slack also is complicated by changes over time in labor and product markets that alter the degree of resource utilization that is consistent with stable inflation. We need to be careful not to overstate the importance of slack for determining the future course of inflation, however. In most econometric models, measures of slack account for only about one-fourth or less of the year-ahead fluctuations in core consumer price inflation. That said, most indicators we have suggest that the economy continues to operate with an appreciable - albeit diminishing - margin of slack. For about the past six months, the unemployment rate has averaged a little less than 5-3/4 percent. This rate is down from its peak of about 6-1/4 percent in the middle of last year, but it is still somewhat above a level that, on the basis of the experience of the last decade or so, appears to be consistent with stable inflation. Capacity utilization in manufacturing has recovered to a little more than 75 percent in recent months. But that level remains well below its long-run average of 80 percent. A number of observers have argued lately that a pickup in the pace of technological change and a more rapid evolution in the character of global competition have increased the speed at which capital equipment is becoming obsolete and at which workers’ skills are becoming poorly matched with job requirements. If these effects are important, current consensus estimates of the natural rate of unemployment as well as of the “natural rate of capacity utilization” could overstate the degree of effective slack. I am skeptical of these arguments for a couple of reasons. In the labor market, the behavior of compensation in recent years has been consistent with standard models of wage dynamics incorporating a natural rate still somewhat below the current unemployment rate. Moreover, one of the surprising developments of the current cycle has been the extent of the decline in labor-force participation. Many analysts have adopted the working hypothesis that this decline reflects a type of “discouraged worker” effect, albeit one that is not captured in the standard statistical series attempting to measure that phenomenon. Presumably, many of the people who exited the workforce in the face of poor employment prospects now stand ready to resume competing for jobs as the market improves. If that is correct, then the current level of the unemployment rate relative to estimates of the natural rate, may, if anything, understate the availability of labor resources. In addition, I do not believe that the relationship of the Federal Reserve’s measure of capacity utilization to available slack in the manufacturing sector has changed materially of late. This measure is, for the most part, benchmarked to utilization rates from a large survey of individual plant managers who would be aware of, and take into account, the technological obsolescence of the equipment in their own factories. These survey data, as well as data on capacity from various trade sources, should fully reflect permanent plant closings within, at most, a year or so.4 Most measures of resource utilization have not changed very much from a year and more ago, when inflation was falling. The unemployment rate hovered near 5-3/4 percent through much of 2002 and the first quarter of 2003; capacity utilization has recovered only a fraction from its lowest level since the very deep recession of the early 1980s. The structure and functioning of markets and the pace of obsolescence simply do not change enough over a year to alter materially the implications of a given reading on these particular indicators. The net decline in core measures of inflation over the past few years - even after taking account of possible understatement of inflation last year - is consistent with a noticeable gap in resource utilization still existing today. Going forward, I anticipate continued strong growth in demand but, given persistent solid gains in productivity and potential output, only a gradual closing of the output gap. Under these circumstances, ongoing competitive pressures in labor and product markets should help to contain cost and price increases. The downward pressure will probably diminish over time, but at least for a while, economic slack should continue to operate as a restraining force on the overall trend in inflation. Of course, I may be wrong in this assessment of slack in the economy. As central bankers, we need to be cognizant of the uncertainties associated with our estimates of potential output and adjust policies if events prove us wrong. But for now, I believe the balance of the evidence points to the conclusion that the recent rise in inflation probably does not signal that the economy has been producing beyond its In the view of some observers, the argument that the Federal Reserve’s capacity measures overstate available slack has been lent some credibility recently by the much higher capacity utilization numbers published by the Institute of Supply Management (ISM). The differences between the ISM and Federal Reserve’s estimates of operating rates likely lie in the definitions of capacity. The Federal Reserve’s measure assumes the availability of additional labor, if needed. The ISM measures the capacity of plants to produce with their current labor force. In the wake of a significant cyclical contraction in manufacturing employment, such as we have experienced in recent years, a definition of capacity that relies on workers in place will indicate much less slack than a definition that does not include current labor as a limiting factor. Since labor can be added relatively quickly, the Federal Reserve’s definition of capacity utilization seems more relevant for assessing effective slack in the manufacturing sector. sustainable potential, but rather that other causes have been at work. I now turn to these other causes. Price shocks. Quite a few prices have been pushed higher in recent quarters by special influences on the supply and demand for the specific products involved. Such increases are probably contributing to the broad pickup in inflation that we have seen this year, but most likely they are not going to be a source of continuing upward pressure on prices. It is not surprising that the substantial strengthening of aggregate demand here and abroad has boosted prices for inputs into the production process, with the most noticeable effects on products for which the short-run supply is relatively price-inelastic. Increases in commodity prices are typical as an expansion gathers momentum, but they have been unusually large in the current episode because of the synchronous strengthening here and overseas, especially in Asia. Petroleum prices have been under particular pressure, reflecting not only stronger demand but also risks that supplies could be constrained by terrorism or political disruption. The decline in the foreign exchange value of the dollar over the past year or so has contributed to the rise in the price of imports in the United States. The prices of core non-energy imports began to increase more rapidly than the general level of core consumer prices in 2003, and the difference widened in the first quarter of this year, adding to general price increases. In addition, the dollar’s decline has reduced the intensity of foreign competition felt by U.S. producers, which may be one source of the sense among domestic producers that their pricing power has returned. Commodities and imports are only a small part of what we consume, and changes in their prices as well as in the price of energy usually do not affect measured core consumer inflation very much. But the recent situation has been notable for the size and number of price shocks going in the same direction, so that even with limited pass-though of individual price movements, the total effect probably has been significant. Judging from the results of statistical models incorporating the factors we have been examining, increases in commodity, energy and import prices together might have boosted core consumer inflation on the order of roughly 1/4 to 1/2 percentage point over the past four quarters. But we are already seeing evidence of the limited nature of these types of price-level adjustments. The prices of many non-energy commodities have come down from their peaks lately, perhaps reflecting an actual or expected moderation of growth in Asia and ongoing demand and supply responses to higher prices. In addition, the dollar has stabilized as optimism has increased about the strength and durability of the expansion in the United States. Energy prices have continued to climb, but futures markets see some moderation of these prices getting under way before long. If these circumstances prevail, shocks to commodity, energy, and import prices should no longer be adding as much to inflation. Of course, over the longer haul, whether or not these one-off shifts in the price level lead to ongoing price inflation will be determined by their effects on inflation expectations and the response of monetary policy, an issue I will refer to shortly. Productivity. The rate of increase in productivity also can have important effects on inflation pressures. In the past few years, for example, the juxtaposition of very rapid productivity growth and weak aggregate demand has resulted in the slack in resource utilization I talked about earlier, which contributed to the decrease in inflation. But productivity growth also influences inflation through its effects on labor compensation and profit margins. Over the long run, real labor compensation tends to track labor productivity. This implies that when productivity accelerates, compensation eventually will as well. The record of the post-World War II period suggests, however, that changes in compensation tend to lag well behind changes in productivity trends. Thus, when underlying productivity growth picks up, firms tend to enjoy a wider profit margin for a time because unit labor costs tend initially to decelerate. The economy can enjoy the fruits of more rapid productivity growth for a while in the form of unusually high levels of production without added inflation or in the form of lower inflation. We realized some of each in the last half of the 1990s after productivity growth picked up. Over time, as compensation catches up to productivity, profit margins tend to come back toward more normal levels, and output must return to its long-run potential if inflation is to be avoided. Productivity increased especially rapidly through the recent downturn and the initial stages of the subsequent expansion. We will not know for some time with any degree of confidence whether this increase marked a further pickup in structural productivity growth - that is, over and above the already rapid rate of increase of the late 1990s. We can be reasonably certain that a portion of the extraordinary increase in productivity over the past few years was a response to the particular circumstances that were prevailing. These included the pressures on the profits and finances of firms when the economy was sluggish and the availability of efficiency gains as businesses continued to find better ways to utilize the large amounts of new technology and capital that became available in the 1990s. The extraordinary increase in productivity in recent years reduced unit labor costs and elevated profit margins to near record levels, even as inflation continued to decline. I think we can anticipate that productivity growth will remain strong on a sustained basis, even if it is unlikely to match the outsized gains of the past few years. Meanwhile, compensation growth should strengthen as labor markets tighten and businesses bid harder for labor to take advantage of profit opportunities. Nonetheless, the high level of business profit margins suggests that, even if unit labor costs begin to rise more quickly than prices, the effect on inflation could be muted for a time because firms would have room to absorb some of the cost increases in the form of reduced profit margins. Such was the experience in the late 1990s. The initial surge in productivity showed up mostly in higher profit margins in 1996 and 1997. From 1998 through 2000, as compensation caught up to productivity, unit labor costs rose more rapidly than prices without placing inflation under significant upward pressure. To be sure, margins cannot shrink forever - just as they cannot grow to the sky. But elevated margins provide some cushion against cost pressures being passed through to prices - so long as the central bank does not allow excess demand to develop in product markets. Inflation expectations. Inflation expectations play a key role in price determination. Among other effects, a rise in inflation expectations tends to become self-fulfilling as people seek to protect themselves in the process of setting wages and prices. Expectations of price increases over the near-term - specifically, over the next year - have, in fact, risen noticeably on the heels of the actual increase in inflation. But, as I have discussed, some of the price shocks giving rise to the increase in inflation in the past few months look as though they are unlikely to be repeated and may already be in the process of partially reversing, and expectations should subside with actual inflation. Moreover, available surveys suggest that the recent uptick in total and core inflation has not materially affected expectations of inflation over the longer term. This stability of long-term inflation expectations is evident in the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, and in the median expectations of households responding to the University of Michigan survey. However, the pattern of inflation compensation in Treasury securities markets has been less reassuring. A widening of the spread between the ten-year nominal and ten-year indexed securities is not itself surprising; part of that widening is accounted for by the increase in short-term inflation expectations. But part could be read also as signaling investor concerns about inflation over a more distant horizon. The spread of the forward rates embedded in the nominal yield curve from five to ten years out over the forward rates derived from the indexed yield curve has widened more than 50 basis points since late March. Changes in this spread can be a misleading indicator of inflation expectations. It is affected by idiosyncratic movements in either nominal or indexed yields, and it reflects changing liquidity in these markets and compensation for inflation risk as well as for inflation itself. But it could be a warning sign. Long-term inflation expectations firmly anchored at price stability make the task of keeping inflation low much easier. The Federal Reserve has made plain its commitment to preserving price stability, and I am confident that we would act decisively to counter any deterioration in longer-run inflation expectations that threatened that objective. Summary and policy implications The evidence and analysis I have just reviewed suggest that the recent pickup in price increases probably does not represent the leading edge of steadily worsening inflation. Much of the acceleration in the early months of this year likely reflects a rebound from unexplainably low inflation last year and the feed-through of increases in commodity, energy, and import prices. The best indications are that some economic slack persists and that long-term inflation expectations are stable, which bolsters the inference that the economy has not entered a situation of steadily rising inflation. Most economic forecasts point to a gradual approach toward full utilization of the productive capacity of the economy. Commodity, energy, and import prices are unlikely to continue moving up at the speed of recent quarters. Productivity growth is still strong. And elevated profit margins are available to absorb increases in unit labor costs for a while. As a result, inflation is most likely to remain at levels consistent with a continuation of effective price stability. That said, the federal funds rate cannot be held at its current level indefinitely if price stability is to be preserved. The very accommodative stance of policy - including both the low level of the funds rate and the FOMC’s indications that it was intending to hold it at that level for a while - was put in place to counter unusually weak demand and declining inflation. Circumstances have changed and policy will respond. The challenge we face is to remove the accommodation in such a way as to foster both the return to full employment and the maintenance of price stability. Because I believe that the rise in inflation will be limited and because I agree that growth of output is likely to only moderately exceed the growth of the economy’s potential, I supported the FOMC’s assessment at its last meeting that accommodation likely can be removed at a pace that is likely to be measured. But experience counsels caution. There is much about the inflation process that we do not understand, and I have been surprised at the extent of the pickup in core inflation this year. Moreover, measures of inflation expectations will require careful scrutiny as we move forward. An examination of the variables believed to proxy for aggregate demand and potential supply can help to explain inflation and to forecast future price developments, and the concepts are integral to making monetary policy. But given our limited understanding of price determination, we must also keep a close watch on actual inflation outcomes. It took about twenty years to undo the effects on economic behavior of the inflationary episode of the 1970s. We must preserve those gains if we are to meet our responsibilities for fostering economic growth and stability.
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Testimony by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington DC, 3 June 2004.
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Susan Schmidt Bies: Bank Secrecy Act enforcement Testimony by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington DC, 3 June 2004. * * * Mr. Chairman, thank you for the opportunity to appear before the Senate Committee on Banking, Housing, and Urban Affairs to discuss the Federal Reserve’s participation in efforts to combat money laundering and terrorist financing. The Federal Reserve and the other federal financial institutions supervisory agencies play a critical role in these efforts, and the Federal Reserve is actively engaged in a number of initiatives to refine and strengthen examination protocols in this area and to effectively deploy resources to prevent, identify, and address problems at the banking organizations supervised by the Federal Reserve. In my remarks today, I will describe for you some of the important steps we are taking to fulfill our supervisory mission, to guide the institutions we supervise, and, in cooperation with the other banking and financial services regulators and the Treasury Department, to make every effort to use our supervisory tools to enhance the banking industry’s role in preventing and detecting money laundering and terrorist financing. The Federal Reserve’s anti-money laundering program is multifaceted. It involves work in bank supervision, applications, enforcement, investigations, training, coordination with the law enforcement and intelligence communities, and rule writing. This morning, I will touch on some of these aspects of the Federal Reserve’s anti-money laundering program, but will concentrate on bank supervision efforts and enforcement matters. I would like to begin with a few words about the Federal Reserve’s supervisory philosophy in this area. The Federal Reserve has long shared Congress’s view that financial institutions and their employees are on the frontline of the effort to combat illicit financial activity. The Federal Reserve believes that the banking organizations it supervises must take every reasonable step to identify, minimize, and manage any risks that illicit financial activity may pose to individual financial institutions and the banking industry. Accordingly, the Federal Reserve has required the financial institutions it supervises to put in place appropriate controls and risk management mechanisms, and has also devoted extensive resources to issuing guidance on legislative and regulatory requirements and sound banking practices, as well as to coordinating supervisory efforts with other agencies. In addition, the Federal Reserve uses its enforcement authority, where necessary, in the event that serious problems or risks cannot be satisfactorily addressed in the supervisory process. Supervisory strategy and procedures for anti-money laundering and counter terrorist financing It has been our longstanding policy that Federal Reserve supervisors incorporate a Bank Secrecy Act compliance and anti-money laundering program component into every safety and soundness examination conducted by a Reserve Bank. This means that on a regular examination cycle, examiners seek to determine if a banking organization’s Bank Secrecy Act (BSA) and anti-money laundering (AML) compliance programs are satisfactory and are commensurate with the organization’s business activities and risk profiles. Examinations are conducted at the state member banks, bank holding companies, Edge Act corporations, and U.S. branches and agencies of foreign banks supervised by the Federal Reserve. Every Reserve Bank has BSA/AML specialists and coordinators on its staff, and, since the late 1980s, the Board has had an anti-money laundering program in its supervision division overseen by a senior official. Simply put, Bank Secrecy Act and anti-money laundering compliance has for years been an integral part of the bank supervision process at the Federal Reserve. Furthermore, the Federal Reserve’s enforcement program has a strong history of addressing both anti-money laundering and safety and soundness problems in formal actions, where necessary. While the number of actions may fluctuate somewhat from year to year, the Federal Reserve’s exercise of its enforcement authority has been consistently strong and timely. The Federal Reserve supervision process includes both on-site examinations and off-site surveillance and monitoring. The Federal Reserve generally conducts an on-site examination of each bank it supervises once every twelve to eighteen months, and at each examination staff reviews the institution’s anti-money laundering procedures and its compliance with the Bank Secrecy Act, as amended by the USA Patriot Act and new Treasury regulations. For large, complex banking organizations, the safety and soundness examination process is continuous, and anti-money laundering and BSA compliance is incorporated into examinations conducted throughout the year. The Federal Reserve always includes BSA/AML examinations in the supervisory strategy for every banking organization we supervise. A key component of anti-money laundering examinations is the institution’s compliance with the BSA compliance program requirement. The Federal Reserve and the other federal banking agencies have compliance program requirements for institutions they supervise. In general, the rules require a bank to establish, maintain, and document a program that includes: • a system of internal controls to ensure ongoing compliance with the BSA, • independent testing of the bank’s compliance with the BSA, • training of appropriate bank personnel, and • the designation of an individual responsible for coordinating and monitoring day-to-day compliance with the BSA. The Federal Reserve works to ensure that the banking organizations we supervise understand the importance of having in place an effective anti-money laundering program. When a Reserve Bank conducts a BSA/anti-money laundering examination of a banking organization under its supervision, the four components of the program establish the framework for the examination. To properly evaluate the effectiveness of a banking organization’s anti-money laundering program, the Federal Reserve has developed comprehensive examination procedures and manuals, and regularly provides training for its examiners. The BSA/AML examination procedures are currently under revision to reflect newly issued regulations under the USA Patriot Act. The Federal Reserve’s BSA examinations are risk-focused. While a “core” BSA examination is required of all banking organizations, risk-focused procedures allow examiners to apply the appropriate level of scrutiny to higher-risk business lines, where necessary, and alleviate burden where high-risk products or customers are not present. In other words, a small state member bank with a low-risk customer base receives a considerably different and less burdensome BSA/AML examination than a large, complex banking organization with international operations. The examination process During every safety and soundness examination of banking organizations under Federal Reserve supervision, bank examiners specially trained in BSA requirements review the institution’s previous and current compliance with the BSA. Examiners first determine whether the institution has included BSA/AML procedures in all of its operational areas, including retail operations, credit, private banking, and trust, and has adequate internal control procedures to detect, deter and report money laundering activities, as well as other potential financial crimes. As part of such an examination, bank examiners also review an institution’s fraud detection and prevention capabilities, and its policies and procedures for cooperating with law enforcement (whether through responding to subpoenas, acting on information requests under section 314 of the USA Patriot Act, or otherwise). Our supervision policy guidance in this area requires that examiners also conduct a review of the databases of Suspicious Activity Reports (SARs) and Currency Transaction Reports (CTRs) to determine if the banking organization that is about to be examined has filed such reports and that they appear complete and timely. Examiners are not doing this to count the number of SARs and CTRs, to compare their findings against other institutions, or to base any criticisms solely on a numerical count, but rather to make sure, for example, that the bank or U.S. branch of a foreign bank understands its obligations in this critical area and has taken steps to fulfill its responsibilities by filing timely and accurate reports with law enforcement and bank regulators. The on-site examination begins as a review of the institution’s written compliance program and documentation of self-testing and training, as well as a review of the institution’s system for capturing and reporting certain transactions pursuant to the Bank Secrecy Act, including any suspicious or unusual transactions possibly associated with money laundering or other financial crimes. Transaction testing is generally conducted to verify these systems. In those instances where there are deficiencies in the BSA/AML program, including failures to adequately document self-testing or training, obvious breakdowns in operating systems, or failures to implement adequate internal controls, the Federal Reserve’s examination procedures require examiners to conduct a more intensified second-stage examination that would include the review of source documents and expanded transaction testing, among other steps. There is an important correlation between the areas covered by a BSA/AML examination and an institution’s overall risk management and internal controls. Thus, bank examiners take into account an organization’s enterprise-wide corporate governance mechanisms and how they are applied. The Federal Reserve’s bank examiners are able to apply a broad perspective and depth of organizational knowledge to the area of BSA/AML and to coordinate with examination and analytic staff to ensure that the safety and soundness and BSA/AML examinations are integrated and comprehensive. The Federal Reserve has found that there is an important synergy gained by integrating the safety and soundness and BSA/AML supervisory processes. Enforcement actions The Federal Reserve focuses significant resources on the prevention and early resolution of deficiencies within the supervisory framework. When problems are identified at a banking organization, they are typically communicated to the management and directors in a written report. The management and directors are requested to address identified problems voluntarily and to take measures to ensure that the problems are corrected and will not recur. Most problems are resolved promptly after they are brought to the attention of a banking organization’s management and directors. In some instances, however, examiners identify problems relating to anti-money laundering measures that are pervasive, repeated, unresolved by management, or otherwise of such serious concern that use of the Federal Reserve’s enforcement authority is warranted. If the problem does not require a formal action, the Reserve Banks have the authority to take informal, non-public supervisory action, such as requiring the adoption of an appropriate resolution by an institution’s board of directors or the execution of a memorandum of understanding between an institution and the Reserve Bank. When informal action will not suffice, the Federal Reserve has authority to take formal, public enforcement action to compel the management and directors of a banking organization to address anti-money laundering and BSA compliance problems. These actions include written agreements, cease and desist orders, and civil money penalties, and are legally enforceable in court. These actions are not delegated to the Reserve Banks, and are undertaken only with the concurrence of the Board’s General Counsel and the Board’s Director of the Division of Banking Supervision and Regulation. Because these actions are public, they can have a significant impact on a banking organization, particularly one that is a public company. In determining whether formal action is appropriate, Federal Reserve staff considers all relevant factors, including the nature, severity, and duration of the problem, the anticipated resources and actions necessary to resolve the problem, and the responsiveness of the directors and management. In cases where examiners have identified a violation of the compliance program requirement, the federal banking agencies are bound by law to take formal enforcement action. The same law requiring the banking agencies to promulgate rules requiring the four-part compliance program that I discussed earlier provides that if an institution fails to establish and maintain the required procedures, or if it has failed to correct any previously identified problem with the procedures, then the agency must issue a formal action requiring the institution to correct the problem. The Federal Reserve takes this responsibility very seriously and has issued a number of public actions against banking organizations in fulfillment of this statutory mandate. Federal Reserve staff exerts every effort to ensure that this statute is implemented consistently, and Board staff acts as a central coordinator for the examination and enforcement staff at the different Reserve Banks. Over the past three years, for example, the Federal Reserve has taken approximately twenty-five formal, public enforcement actions addressing BSA/AML-related matters. Actions have been taken against large banking organizations as well as smaller ones - the one constant is that the examination process identified regulatory violations in the organizations’ compliance programs that, under the law, mandated the supervisory actions. In addition to taking action itself, the Federal Reserve may refer a BSA-related matter to Treasury’s Financial Crimes Enforcement Network (FinCEN) for consideration of an enforcement action based solely on BSA violations, rather than a program failure or issues relating to safety and soundness. Treasury has delegated to the federal financial banking agencies the authority to examine for BSA compliance those institutions they normally examine for safety and soundness; however, Treasury has not delegated the authority to take an enforcement action, such as the assessment of a fine, for violations of the Bank Secrecy Act. Federal Reserve staff coordinates enforcement actions with other regulators or agencies, including in the area of anti-money laundering. If a banking organization’s problems involve entities supervised by different regulators, resolution of enterprise-wide problems may involve multiple enforcement actions. For example, the Office of the Comptroller of the Currency (OCC), FinCEN, and the Federal Reserve coordinated their recent enforcement actions against Riggs National Corporation; Riggs Bank, N.A.; and Riggs International Banking Corporation, the bank’s Edge Act subsidiary, to ensure consistency and concurrent resolution of open issues. The Federal Reserve coordinates enforcement actions with state banking supervisors on a regular basis, and enforcement actions involving operations of foreign banking organizations may be resolved in cooperation with supervisors abroad. In several recent matters, there was close coordination with the U.S. Department of Justice as well. The applications process Before I describe some more aspects of the Federal Reserve’s supervisory process, let me touch on a very important component of the Federal Reserve’s anti-money laundering process - the processing of applications and notices filed with the Board. The Federal Reserve has had a longstanding practice of considering an applicant’s compliance with anti-money laundering laws in evaluating various applications, including bank mergers and acquisitions of insured depositories by bank holding companies as well as applications filed by foreign banks to establish U.S. banking offices under the Foreign Bank Supervisory Enhancement Act. The USA Patriot Act included a provision memorializing our practice in the application area and required the Board to take into account the effectiveness of an applicant’s BSA compliance program when it considers applications under various laws. Under our longstanding protocols as well as the new law, every application matter considered by the Federal Reserve includes a BSA/AML compliance-related component whereby staff has to make specific judgments regarding an applicant’s compliance with the law in this important area. While I cannot, of course, comment on specific cases, I can report to you that Board staff has on some recent occasions advised banking organizations considering expansion or other activities requiring the filing of applications with the Federal Reserve to concentrate instead on their BSA/AML programs. While not the full equivalent of an enforcement action, I am sure that you can appreciate the fact that every banking organization that is seeking or planning on seeking Federal Reserve approval of an application makes every effort possible to ensure that its anti-money laundering program is considered to be fully satisfactory by examiners and that any deficiencies that may be identified are addressed as expeditiously as possible. The applications process gives the Board a strong tool in the BSA/AML area. Guidance to banking organizations Turning back to the Federal Reserve’s normal supervision process, Board and Reserve Bank supervisors seek to provide guidance to banking organizations to assist them to fully understand applicable regulatory requirements and what is expected by the regulators. While financial institutions are, of course, fully responsible for their own compliance, the supervisors play an important role in ensuring that regulatory requirements are correctly understood and uniformly applied. This is particularly true in areas such as compliance with new regulations promulgated since the USA Patriot Act. The Federal Reserve views its supervisory role as including initiatives to enhance awareness and understanding by examiners throughout the Federal Reserve System, by banking organizations under Federal Reserve supervision, and by the financial industry at large. To promote a full understanding of anti-money laundering requirements, the Federal Reserve issues Supervision and Regulation letters, which are used to advise Reserve Bank supervisory staff, supervised institutions, and the banking industry about policy matters; provides on-going training to examiners; speaks regularly before the financial industry; and issues guidance in conjunction with other regulators and Treasury. These initiatives are meant to respond to or anticipate questions that arise regarding anti-money laundering requirements. The Federal Reserve is keenly aware of the resources that anti-money laundering and counter-terrorist financing requirements demand of financial institutions and believes that it is our duty to assist them in meeting their obligations. Federal Reserve resource commitment The Federal Reserve’s BSA/AML function ranges from supervising and regularly examining banking organizations subject to Federal Reserve supervision for compliance with the BSA and relevant regulations, to requiring corrective action for detected weaknesses in BSA/AML programs, to enhancing money laundering investigations by providing expertise to the U.S. law enforcement community, and to providing training to U.S. law enforcement authorities and various foreign central banks and government agencies. Over the past three years, for example, Federal Reserve experts in BSA/AML-related matters have participated in special reviews of funds transfers for federal law enforcement and intelligence authorities, taught classes at FBI and Department of Homeland Security training academies, held seminars for central bank and foreign supervisory authorities in over ten countries, including Botswana, Mexico, Russia and the United Arab Emirates, and engaged in discussions on AML-related matters at international fora such as the Basel Cross-border Group and the Financial Action Task Force on Money Laundering (FATF). Over the course of the past ten plus years, the Federal Reserve’s anti-money laundering program has grown dramatically. From a senior official at the outset assigned to coordinate the Federal Reserve’s BSA activities in the late 1980s, to the creation and staffing in early 2004 of a new section within the Board’s Division of Banking Supervision and Regulation dedicated solely to anti-money laundering efforts (the Anti-Money Laundering Policy and Compliance Section), the Federal Reserve continues to commit a growing number of its resources to BSA/AML compliance. In 1993, the Federal Reserve System began the practice of designating a senior examiner at each of the twelve Reserve Banks to serve as a Bank Secrecy Act coordinator for the BSA examiners at that Reserve Bank. The number of senior BSA examiners throughout the System has grown tremendously, particularly since the enactment of the USA Patriot Act and the increasing complexity of BSA examinations. The web of BSA examiners throughout the Federal Reserve System is brought together through a direct communication channel with the Board’s AML Policy and Compliance Section. This communication is an important tool for gathering examination experiences and providing consistent guidance throughout the Federal Reserve System. By any standard, the Federal Reserve has taken a leadership role in the U.S. government’s and international banking and regulatory community’s anti-money laundering efforts. Supervisory coordination Due to the complexity of financial institutions today, it is imperative that the Federal Reserve coordinate with a long list of agencies on issues tied to the Bank Secrecy Act. First, the Federal Reserve views the Department of the Treasury and FinCEN as important partners due to their leadership role in administering the Bank Secrecy Act. In addition, for a number of complex financial institutions, the Federal Reserve shares supervisory and regulatory responsibilities with the OCC, Federal Deposit Insurance Corporation, and the Office of Thrift Supervision at the federal level, with the banking agencies of the various states, and with foreign banking authorities for the international operations of U.S. banks and the operations of foreign banks in the United States. This network of partners requires a high degree of coordination. The regulatory authorities communicate constantly regarding BSA-related matters. For example, among bank regulators, there are a number of electronic systems in place that allow secure access to examination information. This allows regulators to monitor the status of organizations under their direct or indirect purview. It is also the Federal Reserve’s practice to notify relevant functional regulators when a supervisory action may have impact on an institution subject to their supervision. In addition, bank regulators collaborate in the development of consistent examination procedures and examiner training. The USA Patriot Act required a surge of rulemaking activity, and the Federal Reserve and its regulatory colleagues continue to advise Treasury as it completes this important work. Law enforcement coordination The Federal Reserve routinely coordinates with federal and state law enforcement agencies with regard to potential criminal matters, including anti-money laundering and financial crime activities. This coordination may occur when the Federal Reserve takes action to address matters that are also addressed in a criminal proceeding, when the financial condition of a bank is affected by a criminal matter, or when law enforcement draws on Federal Reserve staff expertise in its investigative work. The Federal Reserve maintains open channels of communication with law enforcement, whether through interagency working groups or informal staff level contacts. Conclusion The Federal Reserve believes that banking organizations should take reasonable and prudent steps to combat illicit financial activities such as money laundering and terrorist financing, and to minimize their vulnerability to risks associated with such activity. For this reason, the Federal Reserve’s commitment to ensuring compliance with the Bank Secrecy Act continues to be a high supervisory priority. The Federal Reserve has an important role in ensuring that criminal activity does not pose a systemic threat, and, as important, in improving the ability of individual banking organizations in the United States and abroad to protect themselves from illicit activities. Thank you again for inviting me today to explain the Federal Reserve’s work in this important area.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the International Monetary Conference, London (via satellite), 8 June 2004.
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Alan Greenspan: Central Bank panel discussion - economic developments Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the International Monetary Conference, London (via satellite), 8 June 2004. * * * One of the defining characteristics of the recent business expansion in the United States has been the evident reluctance of corporate managers to expand spending and hiring aggressively in response to and in anticipation of continued cyclical growth. A substantial rebound in business spending had been a hallmark of most past economic expansions. Judging by the pickup in capital spending in recent quarters, businesses are becoming more confident in the strength and durability of the cyclical upturn. Still, over the four quarters ending in March, corporate investment in capital and inventories likely fell short of rapidly rising cash flow for the first time, over a comparable period, since the mid-1970s. Corporate debt expansion has accordingly been tepid. Indeed, corporate net bond issuance was negative in May. The exceptional reluctance to expand payrolls also appears to have waned this year, and businesses are once again hiring with some vigor. But for nearly three years prior, managers sought every avenue to forestall new hiring despite rising business sales. Their ability to boost output without adding appreciably to their workforces, appears to have reflected a backlog of unexploited capabilities to enhance productivity with minimal capital investment, a delayed effect of the capital goods boom of the 1990s. Even now, the proportion of increases in temporary workers relative to total employment gains has been unusually large, suggesting that business caution remains a feature of the economic landscape. This hesitancy on the part of businesses to expand risk-taking, as I have noted in the past, is an apparent consequence of scandals surrounding corporate accounting and governance, an aftermath of the stock market surge. Although there is no compelling evidence that corporate governance risk has fully subsided, with time, it should. An increased willingness to borrow, and ample liquid assets, should provide a further lift to capital investment and, with it, economic activity. *** With concerns of deflation now presumably safely behind us, developments ahead are likely to be dominated by the paths of productivity growth and profit margins - assuming, of course, the always latent danger of terrorism in the United States remains in check. Profits of nonfinancial corporations as a share of sector output, after falling to 7 percent in the third quarter of 2001, rebounded to 12 percent in the first quarter of 2004, a pace of advance not experienced since 1983. This sharp recovery in profits reflects, at least in part, the dramatic swing over the past couple of years from relatively heavy business price discounting to the restoration of a significant degree of pricing power. The most visible manifestation of the return to pricing power can be seen in the recent acceleration of core consumer prices. The twelve-month percent change in the core PCE price index, which stood at just above 0.8 percent in December of last year, was at 1.4 percent in May. To better understand recent developments, it is helpful to view prices from the perspective of consolidated costs and profit margins. From the first quarter of 2003 to the first quarter of 2004, consolidated unit costs for the nonfinancial corporate business sector declined. Hence, at least from an accounting perspective, all of the 1.1 percent increase in the prices of final goods and services produced in that sector during that period was the consequence of a rise in profit margins. The 6.4 percent increase in nonfinancial corporate business productivity over those four quarters accounts for much of the decline in unit costs. The remainder of the decline is accounted for by the effects of accelerating output in reducing nonlabor fixed costs per unit of output. Productivity in the nonfinancial corporate sector evidently decelerated somewhat this year. Moreover, as best we can judge, the growth of compensation per hour has stepped up in recent months. With gains in hourly compensation now apparently outstripping advances in productivity, unit labor costs have moved up. Moreover, the increase in overall operating expenses over the last couple of months has also reflected higher energy costs and rising prices of imported non-oil inputs. It seems unlikely, however, that a further rise in profit margins will contribute to significantly higher prices of final goods and services. In an endeavor to exploit current high margins, businesses are being driven to expand their use of capital and labor resources. If history is any guide, this will tend to increase both real wages and interest rates. Fears of losing market share should dissuade businesses from passing these high costs fully through to prices. Accordingly, the forces of competition should cap the rise in profit margins and ultimately return them to more normal levels. To date, the aforementioned cost pressures have been relatively subdued. Nonetheless, the persistence of the rise in energy prices is a worrisome element in the cost picture. Fears for the long-term security of oil production in the Middle East, along with increased concerns about prospects in other oil-producing countries, are doubtless key factors behind the nearly $9 per barrel rise in distant crude oil futures since 2000. This run-up presumably reflects a broadening of demand for claims on oil inventories beyond traditional commercial buyers and sellers of crude oil and petroleum products. The marked rise in the net long positions of non-commercial investors in oil futures and options since May 2003 has increased net claims on an already diminished global level of commercial crude and product inventories. Oil prices accordingly have surged. At some point, however, investors will have achieved the level of claims on oil that they seek. When that occurs, their demand will presumably stop rising, thus removing some of the current upward pressure on prices. Nonetheless, the increased value of oil imports has been a net drain on purchasing power, spending, and production in the United States. Moreover, higher oil prices, if they persist, are likely to boost core consumer prices, as well as the total price level, in this country. The recent modest declines in oil and natural gas prices may or may not signal a trend but are nonetheless welcome. *** The end of deflationary fears and the onset of modest upward pressure on costs, coupled with a strengthening economic outlook in the United States, have driven long-term interest rates higher, which has spurred a marked shift in credit flows and has prompted many firms to focus on the possibility of further interest rate increases in developing their hedging strategies. The rise in rates, for example, has induced a dramatic fall in mortgage refinancing and, hence, has produced a pronounced rise in the duration of mortgage-backed securities (MBS). Owing to the volume of the earlier wave of mortgage refinancing, there is now a paucity of existing mortgages at rates appreciably above current levels, implying that the extent of further duration hedging is likely to be quite modest. As a consequence of record levels of refinancing in the second half of 2002 and the first half of 2003 which, by our estimates, encompassed roughly 45 percent of the total value of home mortgages outstanding - MBS duration fell to exceptionally low levels. As mortgage and other long-term rates rebounded last summer, a consequence of rapidly improving economic conditions and the fading of deflationary concerns, refinancing fell sharply, removing most downward pressure on duration. Holders of MBS endeavoring to hedge developing interest rate gaps rapidly shed receive-fixed swaps and Treasuries, and these actions markedly aggravated last summer’s long-term interest rate upturn. In recent months, mortgage rates have risen further, suppressing much of what is left of incentives to refinance, thereby increasing mortgage duration to its current elevated level. This suggests that the vast secondary market for home mortgages has largely adjusted to the recent increases in mortgage rates. Moreover, the expectation of Federal Reserve tightening has apparently already induced other significant balance sheet adjustments as well. An unwinding of carry trades is notably under way at least judging from the shift in the trading portfolios of primary dealers. In addition, a swing toward a net short position on ten-year Treasury note futures among investors has been the largest since the inception of the contract in the 1980s. *** Economic developments going forward will determine the level and term structure of interest rates. Federal funds futures prices already reflect expectations of a substantial firming of policy by the Federal Open Market Committee (FOMC). Unlike 1994, there has been an appreciable increase of market rates in anticipation of policy tightening, though history cautions that investors’ anticipations of the cumulative magnitude of policy actions and their timing under such circumstances are far from perfect. Lastly, let me emphasize that recent financial indicators, including rapid growth of the money supply, underscore that the FOMC has provided ample liquidity to the financial system that will become increasingly unnecessary over time. The Committee is of the view, as you know, that monetary policy accommodation can be removed at a pace that is likely to be measured. That conclusion is based on our current best judgment of how economic and financial forces will evolve in the months and quarters ahead. Should that judgment prove misplaced, however, the FOMC is prepared to do what is required to fulfill our obligations to achieve the maintenance of price stability so as to ensure maximum sustainable economic growth.
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Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Bank Insurance and Securities Association Legislative, Regulatory and Compliance Seminar, Washington DC, 10 June 2004.
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Mark W Olson: Regulatory update - banking industry, insurance and securities activities Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Bank Insurance and Securities Association Legislative, Regulatory and Compliance Seminar, Washington DC, 10 June 2004. * * * Introduction Many thanks to the Bank Insurance and Securities Association (BISA) for inviting me to speak to you this afternoon. Financial modernization, characterized by the ever-increasing ability of financial services firms to offer banking, securities, and insurance products, introduces new challenges as well as new opportunities. From the perspective of the Federal Reserve Board, I’d like to discuss compliance and riskmanagement issues for banking organizations that are beginning new, or expanding existing, insurance sales activities. I’d also like to offer a few observations on the “push-out” provisions being drafted by the Securities and Exchange Commission to require certain securities-related activities previously conducted by banks to be removed from the banks and “pushed out” to an entity that is a licensed, SEC-regulated securities broker-dealer. My comments today are my own and do not necessarily represent the views of my fellow Federal Reserve Board members or the Federal Reserve System. Background Following enactment of the McCarran-Ferguson Act in 1945, supervision of insurance was almost exclusively the domain of the states. Therefore, for most of the past century, we - that is, the Federal Reserve and state insurance supervisors - have traveled in different circles. The Federal Reserve has had very little to do with insurance issues because banks and bank holding companies have generally been involved only in credit-related insurance sales and underwriting activities. In fact, the federal legislation that charges the Federal Reserve with supervising bank holding companies - the Bank Holding Company Act of 1956 - was enacted in large part to prevent the affiliation of one of the largest banks in this country with a large insurance underwriter. Congress went on to strengthen the separation of banking and insurance in 1982 with an amendment to that act generally prohibiting bank holding companies from engaging in insurance agency activities. The historic statutory separation of banking and insurance was ended in November 1999 by the Gramm-Leach-Bliley Act (GLB Act), which allows well-managed and well-capitalized banking organizations to affiliate with any kind of insurance underwriter and insurance sales and brokerage firms not just those that offer credit-related financial services, such as insurance to pay off a loan in the event of a borrower’s death or disability, or mortgage guaranty insurance. To engage in the broader range of insurance activities, a bank holding company must qualify to become a financial holding company by certifying that its subsidiary banks are well capitalized and well managed, among other criteria. As of year-end 2003, about 630 bank holding companies and foreign banks have chosen to become financial holding companies. Only 12 percent of U.S. bank holding companies have become financial holding companies; however, these financial holding companies control about 80 percent of the domestic banking industry’s assets. Since enactment of the GLB Act, surprisingly few banking organizations have taken advantage of their expanded insurance powers. About 25 percent of financial holding companies have used their new insurance powers, largely through acquisitions of insurance agency or brokerage firms or, in a few instances, of insurance underwriters. Only a few financial holding companies have expanded their insurance activities in any significant way. Anecdotal evidence suggests that many more financial holding companies are considering commencing or further expanding their existing insurance sales and, to a lesser extent, insurance underwriting. The sale of insurance by banking organizations makes sense. Insurance is a financial product that many customers need. Entering the insurance market as an agent fits naturally with the nature of banking. Banking organizations have developed networks and systems for delivering financial products to consumers - a business model that does not always require manufacture of the product. Insurance is increasingly viewed not just as a product that stands on its own, but as an important item on a menu of financial products that helps consumers create a portfolio of financial assets, manage their financial risks, and plan for their financial security and well-being. Many consumers find it convenient to purchase financial planning products at a single location that offers a full range of financial services. Thus, banking organizations are a natural alternative sales channel for insurance underwriters looking to expand their customer base. Compliance and risk management issues With these developments have come new challenges. While some types of risks are common to banking organizations and insurance companies, the products, business practices, and regulatory framework of the insurance industry are outside the experience of many banking organizations. Changes in the banking and financial services industry have highlighted the importance of incorporating an assessment of compliance risk into the evaluation of a banking organization’s overall risk profile and into its enterprisewide risk-management program. In December 2003, to further augment the Federal Reserve’s risk-focused supervision program, we adopted a policy to emphasize the importance of compliance with consumer protection regulations in the context of overall bank safety and soundness evaluations. Examiners will assess consumer compliance risk across the broad range of a banking organization’s activities to determine the level and trend of consumer compliance risk. Supervision and consumer compliance examiners will work together more closely to evaluate how consumer compliance risk affects the organization’s reputational, legal, and operational risk profiles. Supervisory plans, particularly for large complex banking organizations, now will more fully integrate the consumer compliance reviews into the overall risk-focused safety and soundness supervisory program. Key issues for bank and bank holding company compliance and risk managers to address in designing and updating their insurance and annuity sales programs are • Preventing conflicts of interest - ensuring that sales are suitable in light of customer needs and that appropriate alternative products are adequately considered; • Monitoring consumer complaints regarding sales practices, and identifying and addressing trends and issues that may expose the banking organization to potential loss; • Implementing the Consumer Protection in Sales of Insurance Regulation, upon which I will elaborate in a moment; • Ensuring that the parent bank or bank holding company have in place appropriate controls over accounting and other systems, including disaster recovery programs related to the insurance sales line of business; • Ensuring that the bank or bank holding company has controls to protect the privacy of customer information, consistent with relevant state or other regulations; • Monitoring claims and potential exposures from mistakes - “errors and omissions” - related to insurance sales and brokerage activities, and identifying and reporting to banking organization management adverse trends and potential significant legal exposures; • Formal reporting to the board and management regarding the risks associated with insurance sales activities and the internal controls used by the organization to minimize potential loss from those risks. Many of these issues are covered in more detail in Federal Reserve supervisory guidance. While I’ll discuss just one of these issues, I urge you, when updating your compliance and risk management programs, to review and consider all of the issues as described in the Federal Reserve’s recently updated supervisory guidance entitled “Insurance Sales Activities and Consumer Protection in Sales of Insurance,” which is contained in the Commercial Bank Examination Manual and the Bank Holding Company Inspection Manual. The issue in the compliance area that I’d like to discuss with you today is conformity with federal consumer protection rules required by the GLB Act for bank sales of insurance and annuities. The Consumer Protection in Sales of Insurance Regulation, as the rule is referred to, was issued on an interagency basis by the federal banking and thrift regulators, effective in October 2001. The federal banking and thrift agencies have responsibility for enforcing these relatively new regulations. The regulations require insurance and credit disclosures to consumers regarding insurance sold or solicited at or on behalf of a bank. The insurance disclosures, among other things, are intended to ensure that consumers understand that insurance products and annuities sold by banks are not insured by the Federal Deposit Insurance Corporation - disclosures that are similar to those required for bank sales of non-deposit investment products. The credit disclosures seek to ensure that consumers understand that banks cannot “tie” loans to the purchase of an insurance product or annuity from the bank or an affiliate. The federal regulation also generally prohibits certain deceptive sales practices. In addition, the regulation limits the fees that may be paid to a bank employee for insurance and annuity referrals to a one-time, nominal fee that is not based on whether the referral results in the sale of insurance or an annuity product. While banking organizations, generally, are attuned to these new regulations and are implementing appropriate controls, some banking organizations have been slow to train staff appropriately, to update internal procedures, and to provide adequate controls to ensure compliance with the regulations. Such deficiencies may expose the institution to reputational and legal risk. Sales incentive programs that award points toward nonmonetary prizes of significant value, such as vacation packages, based on the number of insurance and securities product referrals also may raise compliance issues. Compliance staff should closely review these programs to ensure that they do not give bank employees, or those acting on behalf of the bank, rewards for insurance or non-deposit investment product referrals, that have a value exceeding a nominal one-time fee. While most banking organizations provide appropriate oversight over their insurance activities, it is important that banks have in place a formal mechanism for reporting to the board and senior management, at regular intervals, regarding the identification and assessment of risks arising from that business activity and the status of issue resolution. The insurance sales and annuity line of business should not be run on autopilot, even though this may be convenient simply because the business line is new and likely unfamiliar to bank management and the board, is managed by the “business line experts,” and is already being reviewed by the insurance underwriter and the functional regulator. As required in the GLB Act, the Federal Reserve generally does not examine insurance underwriters or insurance agencies owned by a bank holding company. Instead, we defer to the appropriate state insurance authorities. However, we do review, at the bank or holding company level, the appropriateness of risk management and internal controls over a banking organization’s insurance and annuity sales activities, and assess the level of risk arising from such activities. To improve our own understanding of the issues developing in the insurance industry, we also have established resource centers at the Board and at the Federal Reserve Bank of Boston to monitor developments in the insurance industry. Observations regarding the proposed “push-out” provisions Before concluding, I’d like to touch on the securities side of the business. The GLB Act removed the blanket exemption from the definition of broker and dealer under the federal securities laws for so many years enjoyed by banks. In that exemption’s place, the GLB Act provides specific exemptions that permit banks to continue to conduct securities activities that are part of providing traditional banking products and services, including trust and fiduciary, custody and safekeeping and other specified traditional banking products and services. The SEC recently decided to invite public comment on rules that implement these exemptions. I believe that it is instructive to remember the context in which Congress adopted this change. Importantly, the replacement of the general exemption for banks with more-targeted exemptions was not in response to problems at banks providing trust and fiduciary or other traditional banking products and services. In fact, Congress recognized that banks have provided these services, and I quote, “without any problems for years.” Moreover, Congress recognized that banks have the expertise and customer relationships that make them uniquely qualified to provide these products and services. In particular, Congress expressed its expectation that the GLB Act would not disturb traditional bank trust activities. Congress concluded that the trust and fiduciary laws and oversight by federal and state banking agencies provide sufficient consumer protection. The Federal Reserve Board concurs with the judgment of Congress. We have expressed concern in the past that the rules proposed by the SEC would significantly disrupt - and might force discontinuation of - major lines of business for banks as well as longstanding relationships with bank customers. I believe that such consequences would be wholly unwarranted given the long-standing customer protections provided under federal and state banking and fiduciary laws. The members of the SEC have indicated their interest in engaging in a dialogue with the banking agencies and the banking industry about the effects of their recently proposed rules. We will carefully review this latest proposal and have already expressed our willingness to work with the SEC to ensure that the bank exceptions adopted by Congress in the GLB Act are implemented in a manner consistent with the purposes of those exceptions and, thus, enable banks to continue engaging in activities that Congress intended without incurring unnecessary burden and expense. Conclusion To be sure, the U.S. system of risk-focused bank supervision relies heavily on cooperation among multiple state and federal supervisors, and it is not perfect. But it is working - and, we think, working effectively. Certainly, we could not have postponed interstate banking until we had devised the perfect system for supervising it. The marketplace is constantly moving, and we have to adjust our role. To conclude, I offer one final thought on financial services convergence. It is simply that, even with the changes we have seen, further change is inevitable. The future offers the promise of better, more efficient, and more convenient financial services. Your role as compliance officers and risk managers is of utmost importance in ensuring that this potential is achieved. I encourage you to continue your efforts, and I am confident that your efforts will make an important difference.
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Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington DC, 15 June 2004.
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Alan Greenspan: Nomination hearing Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington DC, 15 June 2004. * * * I want to express my gratitude to President Bush for his confidence in me and to you, Mr. Chairman and members of the committee, for expeditiously holding this hearing on my renomination for a fifth term as Chairman of the Board of Governors of the Federal Reserve System. The Federal Reserve has had a close and productive relationship with this committee over the years. If you and your Senate colleagues afford me the opportunity, I look forward to working with you in advancing our shared goal of strengthening the firm foundation upon which the American people have built a prosperous economy and a sound and efficient financial system. The performance of the U.S. economy has been most impressive in recent years in the face of staggering shocks that in years past would almost surely have been destabilizing. Economic policies directed at increasing market flexibility have played a major role in that solid performance. Those policies, aided by major technological advances, fostered a globalization, which unleashed powerful new forces of competition, and an acceleration of productivity, which at least for a time has held down cost pressures. We at the Federal Reserve gradually came to recognize these structural changes and accordingly altered our understanding of the key parameters of the economic system and our policy stance. But while we lived through them, there was much uncertainty about the evolving structure of the economy and about the influence of monetary policy. The Federal Reserve’s experiences over the past two decades make it clear that such uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. As a consequence, the conduct of monetary policy in the United States has come to involve, at its core, crucial elements of risk management. This conceptual framework emphasizes understanding the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks. This framework entails devising, in light of those risks, a strategy for policy directed at maximizing the probabilities of achieving over time our goals of price stability and the maximum sustainable economic growth that we associate with it. In designing strategies to meet our policy objectives, we have drawn on the work of analysts, both inside and outside the Fed, who over the past half century have devoted much effort to improving our understanding of the economy and its monetary transmission mechanism. A critical result has been the identification of key relationships that, taken together, provide a useful approximation of our economy's dynamics. Such an approximation underlies the statistical models that we at the Federal Reserve employ to assess the likely influence of our policy decisions. However, despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and, in all likelihood, will always remain so. Every economic model, no matter how detailed or how well designed, conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis. Policymakers have needed to reach beyond models to broader - though less mathematically precise - hypotheses about how the world works. A central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes around that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy. As the transcripts of Federal Open Market Committee meetings attest, faced with these abundant challenges, we find the making of monetary policy to be an especially humbling activity. In hindsight, the paths of inflation, real output, employment, productivity, stock prices, and exchange rates may seem to have been preordained, but no such insight existed as we experienced these developments at the time. Yet, during the past quarter-century, policymakers managed to defuse dangerous inflationary forces and to deal with the consequences of a stock market crash, a large asset price bubble, and a series of liquidity crises. These developments did not divert us from the pursuit and eventual achievement of price stability and the greater economic stability that goes with it. Going forward, we must remain prepared to deal with a wide range of events. Particularly notable in this regard is the fortunately low, but still deeply disturbing, possibility of another significant terrorist attack in the United States. Our economy was able to absorb the shock of the attacks of September 11 and to recover, though remnants of the effects remain. We at the Federal Reserve learned a good deal from that tragic episode with respect to the impact of policy and, of no less importance, the functioning under stress of the sophisticated payments system that supports our economy. Our efforts to further bolster the operational effectiveness of the Federal Reserve and the strength of the financial infrastructure continue today. Each generation of policymakers has had to grapple with a changing portfolio of problems. So while we importantly draw on the experiences of our predecessors, we can be sure that we will confront different problems in the future. The Federal Reserve has been fortunate to have worked in a particularly favorable structural and political environment over the past quarter-century. But we trust that monetary policy has contributed meaningfully to the impressive performance of our economy in those years. I have been extraordinarily privileged to serve my country at the Federal Reserve during most of these years and would be honored if the Senate saw fit to enable me to continue this service.
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Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the annual meeting of the Charlotte Regional Partnership, Charlotte, North Carolina, 15 June 2004.
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Mark W Olson: Economic outlook Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the annual meeting of the Charlotte Regional Partnership, Charlotte, North Carolina, 15 June 2004. * * * I am very pleased to have the opportunity to share with you my thoughts about what is required to maintain an economic environment that businesses like yours will find conducive to investment and job creation. I should note that these views are my own; I do not speak for my colleagues on the Federal Open Market Committee. Over the second half of last year, the U.S. economy gathered strength, and its performance so far this year suggests that it has made the transition to a sustained, broad-based expansion. Household spending and new homebuilding have continued to move up, and businesses now appear to have shed a good deal of the uncertainty and caution that for some time weighed on their decisions to upgrade their capital and to hire workers. Real business spending on new equipment and software in the first quarter of this year was 12-1/2 percent above its level a year earlier, and more-recent data indicate that manufacturers are continuing to book new orders for capital goods at a solid pace. The upturn in hiring has been particularly encouraging; between January and May, private nonfarm establishments added almost 1.2 million jobs. We have not seen a string of monthly increases like that in more than four years. To be sure, monetary and fiscal policies played key roles in the strengthening in aggregate demand over the past year. Accommodative monetary policy raised the prices of household assets and lowered the costs of financing new homes and durable goods while reductions in personal taxes boosted disposable income. Businesses, too, benefited from the more-accommodative financial environment. Low interest rates have not only reduced short-term borrowing costs but they have combined with more narrow risk spreads to keep longer-term corporate borrowing costs attractive. The extended period of low interest rates has allowed firms to refinance high-cost debt and to substitute long-term debt for short-maturity debt to improve their balance sheet liquidity. On the fiscal front, firms have been able to take advantage of the temporary partial-expensing tax provision. At the same time, the impressive efforts that businesses have been making to control costs and to increase productivity have paid off in a strong rebound in profitability and cash flow. The combination of balance sheet restructuring and strong profitability has allowed corporate America to achieve the highest level of liquidity in more than a decade. As I noted a moment ago, I find the recent recovery in hiring to be a particularly welcome indication that businesses have become confident about the durability of the expansion. Last year, as economic activity began to pick up, the recovery remained even more “jobless” than the recovery of the early 1990s. A good deal of monetary and fiscal stimulus was in place, which we expected over time to show through to a pickup in real economic activity. But firms were unusually reluctant to make commitments to take on new workers in an atmosphere clouded by risks and uncertainties associated with the war in Iraq and with the fallout from lapses in corporate governance. My sense, from both my informal contacts in the business and banking communities and the available surveys of business attitudes, is that confidence has recovered noticeably this year. Other explanations for the sluggish recovery in employment during 2002 and 2003 focused on developments that may have more lasting effects on the labor market. First, the recovery seemed to be marked to an unusual degree by an ability of businesses to achieve labor-saving efficiency gains. Recall that we began to detect an improvement in productivity in the second half of the 1990s. The rate of increase in output per hour in the nonfarm business sector moved up from just 1-1/2 percent per year between 1973 and 1995 to 2-1/2 percent per year between 1996 and 2000. That acceleration appears to have been largely the result of brisk business investment. Since then, even with the slump in capital spending from 2001 to early 2003, productivity has risen at a stunning annual rate of 4 percent. One of the striking features of the recent acceleration is that the gains in efficiency seem to be the result of organizational changes and innovations in the use of existing resources -perhaps in part the result of learning better how to apply the new technologies that they acquired at a rapid pace in the late 1990s. During the early part of the expansion, when aggregate demand remained weak, the especially rapid gains in efficiency allowed businesses to meet their sales and production goals without having to add workers. But as the pace of the expansion has stepped up over the past several quarters, we have begun to see both sustained advances in output per hour and gains in jobs. I suspect that productivity will eventually slow from the extraordinary pace of the past couple of years - indeed, the recent figures offer some evidence that some slowing has already occurred. Nonetheless, I am optimistic that part of the step-up in productivity growth will be sustained and that it will be reinforced by the renewed upturn in capital spending. Continued solid gains in productivity will be an important plus for our economy over the longer run because faster increases in productivity lead over time to higher profits, wages, and standards of living. The jobless recovery also led economists to debate the extent to which the lack of hiring overall and the continued decline in manufacturing jobs specifically represented structural changes, that is, changes that were not likely to be reversed as the recovery strengthened. Specifically, a great deal of attention focused on the loss of international competitiveness, foreign outsourcing, and the relocation of jobs to overseas subsidiaries. Although these changes are, indeed, a natural consequence of globalization, we have considerable evidence that they are only a small part of the larger story. The ongoing turnover in jobs in our dynamic economy is considerable. The estimates that our staff assembled for a speech earlier this year at Duke University by my Federal Reserve Board colleague Ben Bernanke indicated that, over the past decade, gross private-sector job losses in the U.S. economy have likely amounted to 15 million per year, not including seasonal and short-term layoffs.1 Estimates of jobs lost to imports account for only slightly more than 2 percent of the total. More important, of course, is that the job creation side of the churning process has been even larger roughly 17 million jobs per year. Given the total number of private-sector jobs of 108 million, an average year of job gains and losses represents about 30 percent of the total. Certainly, the Charlotte region is very familiar with this dynamic process of job creation and destruction. In 1990, the Charlotte-Gastonia-Rock Hill metropolitan area was relatively dependent on the fortunes of its manufacturing sector. The area had almost 150,000 manufacturing jobs, which represented almost one-fourth of the area’s employment; by contrast, jobs in professional and business services accounted for just 10 percent of the area’s employment, or roughly 60,000 jobs. Ten years later, the picture was dramatically different: Largely because of cutbacks at textile mills, the Charlotte metropolitan area had lost almost 20,000 factory jobs. But, at the same time, employment in professional and business services had more than doubled to roughly equal the number of manufacturing jobs that existed here in 2000. Employment in education, health, and leisure had also expanded rapidly. Certainly, the broader distribution of employment in recent years has helped the area weather the recession generally and, more specifically, the continued loss of textile jobs to import competition. You have also witnessed first-hand that globalization works two ways. As you know from your experience in attracting foreign-owned companies to this region, U.S. workers also benefit from a good deal of “insourcing.” Nationwide, the employment of U.S. workers by affiliates of foreign firms was more than 5.5 million during the 2000-2002 period - up 1.7 million from ten years earlier. Although globalization clearly has resulted in very real hardships for workers in certain industries, it remains more generally an essential component of economic growth by encouraging innovation and promoting efficiency and higher standards of living. Placing restrictions on international trade would, over the long run, be counterproductive; consumers would likely end up paying higher prices for consumer goods, and businesses might lose the opportunities to be more productive that arise in an environment of open trade. The appropriate policy approaches are those that promote maximum job creation while easing the transition for workers caught up in the painful but inevitable shifts in the mix of job opportunities. An important feature of the ongoing structural change in our economy is the increasing demand for skilled workers, which has arisen both from shifts in the industrial composition of jobs and from the upgrading of skills required within specific industries. Ensuring that the supply of workers with the necessary skills matches the demand is a critical element in adjusting effectively to ongoing structural change. As recently as 1980, many young persons depended on a high school education to launch a career; only half of all high school graduates enrolled in college. Today, the expectations of our high Governor Ben S. Bernanke, “Trade and Jobs”,Distinguished Speaker Series, Fuqua School of Business, Duke University, Durham, N.C., March 30, 2004. school students have changed dramatically as the rising demand for skilled workers has resulted in a sharp increase in the premium paid in the labor market for a college education. In recent years, roughly 60 percent of high school graduates have enrolled in college. And surveys of high school sophomores indicate that many of them believe that simply earning a bachelor’s degree is not enough. In addition to the 40 percent of tenth graders in 2002 who expected that they would complete a bachelor’s degree as their highest degree, another 40 percent expected to finish a graduate or professional degree.2 This appetite for education is good news because the knowledge and skill of a country’s workforce is an important factor in economic growth. Because the demand for skills and the churning of jobs is a never-ending process, workers have also come to realize that their education is not complete once they have a formal degree. In 2002-2003, 40 percent of adults participated in work-related training to retool, upgrade, or acquire skills.3 Many benefited from programs conducted on-site by their employers, but courses at colleges and technical schools were also an important source of training. I am sure that you all realize that your area’s universities, colleges, community colleges, and technical schools are a valuable asset in developing and maintaining a flexible and ever more productive workforce. I urge you also to engage in a civic dialogue with educators at all levels - including those at the elementary and secondary levels - about the importance not only of developing skills but also of adopting the view that education is a life-long process with important economic payoffs. As I indicated earlier, monetary policy has played an important role in providing support for the economy in recent years. But our work is not done. Now that the expansion seems to have taken hold, we face the challenge of making the transition to a policy stance more appropriate for sustained economic expansion. Our goal is to do so in way that maximizes economic growth while sustaining the significant progress that we have made in achieving price stability. I only have to compare my experience as a banker in the 1970s and early 1980s with the environment today to see the value of price stability. In that earlier period, my colleagues and I doubted that we would ever see single-digit mortgage rates again. And, many of us despaired as we listened to borrowers who were convinced that it was wise to “buy now” before prices inevitably rose further. Certainly, today’s environment of low inflation and stable inflation expectations allows for much more rational business decisions concerning capital investment than we experienced in that earlier period. Although inflation has picked up so far this year, it remains moderate. In this morning’s report, the core CPI was up 1.7 percent from a year earlier; in December, the year-over-year change was 1.1 percent. Keeping inflation low and stable will contribute importantly to sustaining financial conditions conducive for further gains in business investment. Over the short run, low inflation and well-anchored inflation expectations are critical to maintaining economic stability and, over the long run, price stability promotes growth and efficiency. As Chairman Greenspan indicated last week, economic developments will determine the level and term structure of interest rates. Of course, we cannot predict exactly how economic events will unfold over the coming year. But, at this point, I still concur with the Federal Open Market Committee’s characterization that monetary policy accommodation will become increasingly less necessary over time and can be removed at a pace that is likely to be measured. National Center for Education Statistics, The Condition of Education 2004, “Student Attitudes and Aspirations: Postsecondary Expectations of 10th-Graders,” U.S. Department of Education, June 2004. National Center for Education Statistics, The Condition of Education 2004, “Adult Learning: Adult Participation in WorkRelated Learning,” U.S. Department of Education, June 2004.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the New York Association for Business Economics Meeting, New York, 7 July 2004.
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Roger W Ferguson, Jr: Productivity - past, present, and future Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the New York Association for Business Economics Meeting, New York, 7 July 2004. * * * Thank you for the invitation to speak here today. In assessing the economic outlook, economists cannot avoid confronting the question of how fast the economy can expand without creating upward pressure on inflation. A fundamental determinant of the economy’s potential growth is the sustainable rate of productivity expansion. Critical though this issue is, it does not by itself capture the importance of productivity. Besides influencing the near-term course of important economic variables, such as gross domestic product growth, inflation, and profits, productivity largely determines our society’s long-term economic welfare. Productivity growth forms the foundation for improvements in living standards. And our ability to deal with budgetary challenges - such as funding the large future obligations of our Social Security and Medicare systems and, more generally, managing the nation’s debt - depends critically on the future direction of productivity. Thus, knowing where productivity growth is headed is, in many respects, equivalent to foreseeing our economic destinies. In thinking about productivity in the future, it is useful to first consider how it has behaved in the distant past and more recently. The past offers lessons about the kinds of economic and political environments that have proven most effective in fostering high rates of productivity growth. And a better understanding of the forces shaping recent developments in productivity - in particular, the causes of the pickup in labor productivity growth that began in the mid-1990s and the sources of the additional post-2000 surge - can help us put sensible bounds on possible future movements in productivity. In my discussion today, I will not attempt to predict these future movements, but with the knowledge gained from studying the past and the present, I will lay out some of the conditions - both favorable and unfavorable - that are likely to influence them. As usual, my remarks represent my own views, which are not necessarily shared by other members of the Board of Governors or of the Federal Open Market Committee. The past1 Over the past century and a half, three episodes stand out as especially relevant for assessing the sustainability of the current productivity boom: the late 1800s from roughly the end of the Civil War to around 1890; the decade or so between the end of World War I and the onset of the Great Depression; and the period from about 1950 to the early 1970s. In these boom periods, average labor productivity growth ranged from 2-1/2 to 3-3/4 percent, about double the average of growth rates during other periods. The striking similarities of these three episodes provide clues about the types of economic policies and other factors that have been important in promoting sustained productivity gains. Perhaps not surprisingly, all three periods were influenced heavily by the introduction of new technologies. But they were also characterized by important changes in the organization of production, in the means of financing new enterprises, and in investment in human capital that facilitated the complex process of applying these new technologies to the creation of new goods and more-efficient production processes. The productivity boom after the Civil War resulted from a variety of technological advances, including the expansion of and improvements in the use of steam power, railroad transportation, and communication by telegraph. By lowering the cost of transportation, railroad expansion allowed firms to take advantage of economies of scale in production and distribution. The telegraph’s lowering of communication costs enabled firms to better coordinate movements in rail traffic and made possible more-informed and better decisions in many other industries. In the productivity boom that followed World War I, a chief technological innovation was the spread of electrification to the factory floor. By allowing each machine to be driven by its own power source, electric motors spurred the development This discussion is based on Roger W. Ferguson, Jr., and William L. Wascher, "Lessons from the Past Productivity Booms (139 KB PDF)," Journal of Economic Perspectives, vol. 18, (Spring 2004). of complex and more-productive configurations of machinery, such as the assembly line. Finally, the productivity gains of the 1950s and 1960s had their roots in a wide range of technological innovations made during the 1930s as well as in research sponsored by the military during World War II. For example, research advances in polymer chemistry, the development of new diesel and jet engine technologies, and the invention of the transistor and the integrated circuit facilitated productivity improvements in a wide range of industries and the creation of an array of highly useful consumer products. In each episode, businesses found that changes to their organizational structures allowed them to take greater advantage of the new possibilities opened up by these technological innovations. In the productivity boom of the late nineteenth century, for example, the potential for economies of scale made possible by the new technologies led to dramatic increases in firm size in many industries. Their larger size, in turn, prompted firms to implement hierarchical management systems to coordinate their greater numbers of workers and machinery and to speed the flow of information between management and the factory floor. Shorter delivery times, reduced inventory holdings, and a better match between production and orders were the beneficial results. Similarly, to take advantage of the continuousprocessing technologies of the early 1900s, firms increased the scope of their operations, integrating forward into distribution and retailing and backward into materials processing. This vertical integration reduced transaction costs but required the development of new units within the firm that were not directly tied to production, such as advertising, accounting, and research departments. In the third productivity boom, large multinational and multiproduct firms arose to take further advantage of economies of size and scope. In this episode, firms created multi-divisional organizations, with each product or geographic division having its own manufacturing and marketing departments. Such a structure was well suited to a firm with diverse activities as it allowed managers to respond to changes in preferences and technologies relevant to specific areas or products. Because the implementation of new technologies often requires new capital, the productivity gains during these boom eras were also dependent on the development of efficient mechanisms to transfer capital to the entrepreneurs and firms best able to transform the potential of the new technologies into new goods and new production processes. In the productivity boom after the Civil War, for example, the increased use of secured debt and preferred stock reduced the transaction costs associated with borrowers having better information than lenders about the risks of bankruptcy and provided firms with the external funds needed to support a rapid buildup in the capital stock. In the second productivity boom, the introduction of regular audited financial statements, rating agencies, and newsletters covering firm and industry developments further reduced investors’ costs of acquiring information about firms’ finances, which led to a sharp expansion in equity markets and the opening of a new channel of capital flows to that period’s large-sized innovators. Similarly, the growth in pension funds, mutual funds, and brokerage houses during the productivity boom of the 1950s and 1960s reduced the costs of portfolio diversification and further increased the participation of individual investors and the flow of capital available to innovators. A fourth ingredient contributing to the productivity booms of the past was the availability of a workforce capable of realizing the possibilities offered by technological innovations. In the late 1800s, new technologies increased the demand for unskilled production workers and skilled white-collar workers. Employers generally were able to satisfy these demands through existing domestic sources of such labor, augmented by substantial rates of immigration. In contrast, the complex continuous-processing technologies of the early 1900s increased the demand for skilled blue collar and white collar workers well above the available supply. But the new job opportunities and the wage premiums attached to them led to a significant increase in high-school graduation rates, which helped the supply of skills to catch up to the new demand. In much the same way, the new technologies and organizational structures of the post-World War II boom sharply increased the demand for workers in professional and technical occupations, which was quickly met by a corresponding increase in the percentage of young adults obtaining a college education. The similarities of these previous productivity booms seem to offer some valuable lessons. The first concerns the importance of “general purpose technologies,” or GPTs, in promoting long-run economic growth. Many of the technological innovations associated with past productivity booms - railroads and electric power, among others - were GPTs with widespread applicability. Because such GPTs raise efficiency not only in production but also in distribution and business practices, they offer the possibility of broad-based and long-lasting improvements in productivity. Second, the new capital investment and the organizational and financial innovations that helped to turn new technological possibilities into better and cheaper goods and services generally derived from the actions of individual economic agents and not from the directives of central planners. Of course, that doesn’t mean that government has no role to play in fostering economic growth. Indeed, maintaining an economic, legal, and financial environment that provides individuals with the proper incentives to invest in new technologies is an important and often challenging responsibility of government policymakers. Also, government actions can help broaden opportunities for education and support the basic research that contributes to new technological breakthroughs. Recent developments As I noted at the beginning of my remarks, it is also important to understand the forces shaping more recent developments in productivity. From 1995 through 2003, average annual productivity growth was 3 percent, double the 1-1/2 percent rate of growth that prevailed between 1973 and 1995. Although some observers initially questioned whether the pickup in productivity growth after 1995 represented a real increase in the underlying trend of productivity growth, the passage of time and the changes in cyclical conditions occasioned by the most recent recession have produced a general consensus that the trend growth rate did indeed increase. From the fourth-quarter of 2001 through the fourth-quarter of 2003, the gains in productivity were particularly strong, at an annual average rate of growth of more than 4 percent; indeed, last year the rise in productivity was close to 5-1/2 percent. The increases in productivity experienced during this period have been an important factor, perhaps the dominant factor, in the elevated profit margins that businesses have enjoyed in the past few years. Moreover, the strong performance of productivity relative to the more modest gains in labor compensation has helped to keep inflation low. Thus, a key question is whether this elevated pace of productivity growth can be sustained. I see several reasons to believe that the additional pickup in productivity growth during the last couple of years is due primarily to cyclical factors and thus not likely to be sustained. First, the 2001 recession, by dramatically reducing profits, focused firms’ attention on restructuring and cost-cutting rather than on business expansion and likely induced some one-time gains in efficiency. That firms could realize such large advances in productivity was perhaps due to their substantial, but underexploited, investments in high-tech equipment in the late 1990s; but at some point additional efficiencies from these earlier investments will be more difficult to achieve. Second, the threat of terrorist attacks, geopolitical risks, and corporate governance scandals led many employers to question the durability of the current recovery and thus made them hesitant to incur the costs of bringing on new employees. As firms chose instead to meet increases in their orders by using their existing workforces more intensively, measured productivity rose. The recovery in the labor market during the second half of 2003 and the first half of this year appears to be a sign that employers are now more confident about the economic outlook and are attempting to return workloads to a more-sustainable level. Thus, I would not be surprised if measured productivity growth over the next few years falls below the rates of the fourth-quarter 2001 through fourth-quarter 2003 period or even, for a time, below the average growth rate from 1995 through 2003. Indeed, such a drop would be an expected consequence of the pickup in hiring that now seems to be under way. The average monthly increase in private payrolls of slightly more than 200,000 during the past six months appears to have coincided with an easing in labor productivity growth. Spending and hours data for the first half of this year point to a stepdown in productivity growth from last year’s pace. A second important question is whether trend productivity growth will slow as well. A pronounced deceleration in structural productivity could result in more rapidly accelerating labor costs and lower profit margins, which, in turn, could lead to a deteriorating outlook for inflation. Moreover, a deterioration in trend productivity growth would have adverse consequences for our ability to meet long-term economic challenges. The future In my view, there are a number of reasons to expect that the stepped-up pace of underlying productivity growth that we have experienced since the mid-1990s can persist for a while longer. In particular, conditions similar to those that fostered previous productivity booms seem, on balance, to be in place today. General purpose technologies such as the personal computer, fiber optics, wireless communications, and the Internet - to give just a few examples - continue to present new avenues for raising productivity. Past deregulation should enable businesses to adapt their organizational structures in response to these new opportunities. Ongoing financial-market innovations have allowed financial intermediaries to expand the range of financing alternatives to businesses seeking external funds. And in response to the rising demand for skilled labor able to use new technologies, four-year colleges and community colleges are providing both experienced and inexperienced workers with opportunities to obtain new market-relevant skills. Nevertheless, each of the previous productivity booms eventually ended, and thus one can reasonably ask whether any developments threaten the longevity of the current boom. One hypothesis along these lines is that periods of strong productivity growth come to an end when the productivity-increasing opportunities associated with new technologies are exhausted. I think that, at this point, such concerns are premature. Sharp declines in the prices of high-tech capital equipment, spawned by the rapid rate of innovation in high-tech industries, were an important part of the productivity acceleration that began in the mid-1990s. As prices fell, firms used more high-tech capital to increase efficiencies in the production of other goods. Though productivity pessimists sometimes cite the absence of a “killer application” as an indication that the ability of high-tech capital to raise productivity in other industries is declining, the limited evidence available suggests that both the breadth and the depth of demand for new technologies remain substantial. With respect to breadth, research by Kevin Stiroh shows that the acceleration in productivity owing to investments in high-tech capital has been spread widely across industries.2 Regarding depth, research coauthored by Jason Cummins of the Board’s staff found that, despite the high investment rates of the late 1990s, a wide gap between the technology embodied in state-of-the-art capital equipment and the technology embodied in the existing stock of equipment remains across a broad set of industries. That gap implies continued incentives for capital investment.3 Although the exhaustion of technological possibilities seems unlikely to slow trend productivity growth, adverse changes in the economic, legal, and financial environment could threaten the longevity of the current productivity boom. For example, economists have long noted that free trade - and the specialization and economies of scale that it affords - fosters productivity increases. That our most recent productivity boom occurred against a backdrop of freer trade and increased globalization is likely no coincidence. However, the momentum for the liberalization of global trade now appears to be facing strong resistance. A halt in the movement toward freer trade or outright backsliding, such as the erection of new barriers to the trade of goods or services, would endanger the sustainability of the current productivity boom. Some observers believe that security-enhancing limitations on the international flow of capital, labor, and goods in response to an increased terrorist threat could have similar effects. In addition, a failure to continue to vigorously address the corporate governance issues of the past few years could also threaten the current boom. As I noted earlier, the efficient channeling of capital to innovators has been a critical component of past productivity booms. Fraud or dishonesty in corporate accounts increases investors’ risk, raising the cost of capital and reducing incentives for investment. Large government borrowing to fund current consumption could also raise the cost of capital and crowd out the investment on which the current boom depends. The magnitude of future government obligations to fund Social Security payments for the retiring baby-boom generation and the growing costs of providing medical care to the elderly add to the urgency to put government debt on a sustainable long-term path. Doing so sooner rather than later would make the necessary adjustments easier and diminish the likelihood of significant future economic disruptions. Some observers have also stressed the importance of large economic shocks, such as the oil price shock of the early 1970s, in bringing periods of rapid productivity growth to an end. It seems possible that the recent run-ups in energy prices, and the fact that markets expect much of them to be permanent, could reduce productivity growth by rendering energy-intensive technologies and capital obsolete. Without dismissing such concerns, one needs to keep in mind that the recent shock to date has been significantly smaller than the oil shocks of the 1970s and that the economy today is far less energy intensive than it was then. Additionally, one can take some comfort from the economy’s generally strong performance in the face of the numerous economic and geopolitical shocks that See Kevin J. Stiroh, "Information Technology and the U.S. Productivity Revival: What Do the Industry Data Say?" American Economic Review, vol. 92 (December 2002), pp. 1559-76. See Jason Cummins and Giovanni Violante, "Investment-Specific Technical Change in the United States (1947-2000): Measurement and Macroeconomic Consequences," Review of Economic Dynamics, vol. 5 (April 2002), pp. 243-84. buffeted it over the past several years. Despite these shocks, the most recent recession, in terms of output decline, was one of the mildest on record. Our economy’s ability to weather these shocks reflects well on the institutions we have established and on the hard work and determination of the American people. Nonetheless, developments in energy markets, and their potential effects on the U.S. economy, merit close and ongoing attention. Finally, many observers have noted a positive relationship between macroeconomic stability and productivity growth. So let me here reaffirm the Federal Reserve’s commitment to maintaining price stability, to promoting sustainable growth in output, and to safeguarding the stability of our financial system. I believe that by meeting these objectives, we can do our part to promote an economic environment that encourages the investment and innovation upon which all productivity booms have depended. Conclusion In conclusion, productivity growth - buoyed both by favorable cyclical and by structural factors - has greatly contributed to the recent benign coincidence of rising output, expanding profit margins, subdued unit labor costs, and low inflation. But because the future does not simply replicate the present, uncertainty surrounds the path that productivity will take from here. My sense is that cyclical factors likely contributed to the most recent advances and thus a slowing in productivity growth is likely. Such a cyclical slowing is not a concern in itself, but a simultaneous drop-off in the underlying trend rate of productivity growth could significantly impair our economic prospects. Certain circumstances argue against such an occurrence. History contains several precedents of sustained periods of elevated productivity growth, and, in general, the conditions prevailing during those periods appear to exist today. In addition, the technological underpinnings of the current boom appear secure. However, other forces bear close watching. Stagnation or regression in the movement toward free trade, continued large fiscal deficits, a failure to continue addressing problems in corporate governance, and elevated oil prices could all lessen the weight of conditions that have up to now tilted so favorably toward strong productivity advances.
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Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 22 June 2004.
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Donald L Kohn: Regulatory reform proposals Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 22 June 2004. * * * Chairman Shelby, Senator Sarbanes, and members of the Committee, thank you for the opportunity to testify on issues related to regulatory relief. The Federal Reserve strongly supports this and other efforts to review the federal banking laws periodically to determine whether they may be streamlined without jeopardizing the safety and soundness of this nation’s insured depository institutions or undermining consumer protection or other important policy principles that Congress has established to guide the development of our financial system. Earlier this spring, Chairman Shelby and Senator Crapo asked the Federal Reserve Board to identify its top two or three legislative priorities for regulatory relief. In his letter of April 23, Chairman Greenspan highlighted three proposals that the Board has supported for many years: authorization for the Federal Reserve to pay interest on balances held by depository institutions in their accounts at Federal Reserve Banks, repeal of the prohibition against the payment of interest on demand deposits by depository institutions, and increased flexibility for the Federal Reserve in setting reserve requirements. As we have previously testified, unnecessary legal restrictions on the payment of interest on demand deposits at depository institutions and on balances held at Reserve Banks distort market prices and lead to economically wasteful efforts by depository institutions to circumvent these artificial limits. In addition, authorization of interest on all types of balances held at Reserve Banks would enhance the toolkit available for the continued efficient conduct of monetary policy. And the ability to pay interest on a variety of balances, together with increased authority to lower or even eliminate reserve requirements, could allow the Federal Reserve to reduce the regulatory and reporting burden on depository institutions of reserve requirements. Let me explore each of these topics at greater length. Interest on reserves and reserve requirement flexibility For the purpose of implementing monetary policy, the Federal Reserve is obliged by law to establish reserve requirements on certain deposits held at depository institutions. Banks, thrifts, and credit unions may satisfy their reserve requirements either by holding cash in their vaults and ATM machines, which they need in any case for normal business activities, or by holding balances at Reserve Banks. Because no interest is paid on the balances held at Reserve Banks to meet reserve requirements, depositories have an incentive to reduce their reserve requirements to a minimum. To do so, they engage in a variety of reserve avoidance activities, including sweep arrangements that move funds from deposits that are subject to reserve requirements to those that are not and to money market investments. These sweep programs and similar activities absorb real resources and therefore diminish the efficiency of our banking institutions. The payment of interest on required reserve balances would remove a substantial portion of the incentive for depositories to engage in such reserve avoidance measures, and the resulting improvements in efficiency should eventually be passed through to bank borrowers and depositors. Although paying interest on reserves would yield significant benefits, even greater efficiencies and regulatory burden reduction might be realized by substantially reducing, or even eliminating, reserve requirements. To understand how elimination of reserve requirements could be consistent with effective monetary policy and the other legislative changes that would be necessary to realize this greater reduction in regulatory burden, I need to review with you the role of reserve requirements in the implementation of monetary policy and alternatives that might be possible. The Federal Reserve’s Federal Open Market Committee (FOMC) conducts monetary policy by setting a target for the overnight federal funds rate - the interest rate on loans between depository institutions of balances held at Reserve Banks. While the federal funds rate is a market interest rate, the Federal Reserve can strongly influence its level by adjusting the aggregate supply of balances held at Reserve Banks. It does so through open market operations - the purchase or sale of securities that causes increases or decreases in such balances. However, in deciding on the appropriate level of balances to supply in order to achieve the targeted funds rate, the Federal Reserve’s Open Market Desk must estimate the aggregate demand for such balances. At present, a depository institution may hold three types of balances in its account at a Federal Reserve Bank - required reserve balances, contractual clearing balances, and excess reserve balances. As noted above, required reserve balances are the balances that a depository institution must hold to meet reserve requirements. A depository institution holds contractual clearing balances when it needs a higher level of balances than its required reserve balances in order to pay checks or make wire transfers out of its account at the Federal Reserve without incurring overnight overdrafts. Currently, such clearing balances do not earn explicit interest, but they do earn implicit interest for depository institutions in the form of credits that may be used to pay for Federal Reserve services, such as check clearing. Finally, excess reserve balances, which earn no interest, are funds held by depository institutions in their accounts at Reserve Banks in excess of their required reserve and contractual clearing balances. To conduct policy effectively, it is important that the combined demand for these balances be predictable, so that the Open Market Desk knows the volume of reserves to supply to achieve the FOMC’s target federal funds rate. Required reserve and contractual clearing balances are predictable in that depository institutions must maintain these balances over a two-week maintenance period, and the required amounts of both types of balances are known in advance. It is also helpful for policy implementation that, when the level of balances unexpectedly deviates from the desk’s intention, banks engage in arbitrage activities that help to keep the funds rate near its target. Depository institutions have an incentive to engage in this arbitrage activity because required reserve and contractual clearing balances must be maintained, not day-by-day, but only on an average basis over a two-week period. Thus, for example, if the funds rate were higher than usual on a particular day, some depository institutions could choose to hold lower balances on that day, and their reduced demand would help to alleviate the upward pressure on the funds rate. Later in the period, when the funds rate might be lower, those institutions could choose to hold extra balances to make up the shortfall in their average holdings of reserve balances. The averaging feature is only effective in stabilizing markets, however, if the sum of required reserve and contractual clearing balances is sufficiently high that banks hold balances, on the margin, as a means of hitting their two-week average requirements. If the sum of required reserve and contractual clearing balances declined to a very low level so that depositories held balances at Reserve Banks on the margin only to meet possible payments out of their accounts late in the day, the demand for balances would be more variable from day to day and more difficult to predict. While overnight interest rates have exhibited little volatility in recent years, even when the sum of required and contractual balances was considerably smaller than at present, volatility nevertheless could potentially become a problem at some future time if such balances fell to very low levels. Such a development might be possible if interest rates were to rise to high levels, which would reduce the demand for required and contractual balances and provide extra incentives for reserve avoidance. Paying interest on such balances is one way to ensure that they do not drop too low. If increased flexibility in setting reserve requirements were authorized, the Federal Reserve nonetheless could consider substantial reductions in reserve requirements, or even their eventual removal, as long as balances held at Reserve Banks other than required reserve balances could serve the purpose of ensuring the effective implementation of monetary policy. To enable the alternative types of balances to play a more important policy implementation role, it would be essential for the Federal Reserve to be authorized to pay explicit interest on them. In particular, in the absence of reserve requirements, the Federal Reserve would need to be able to pay explicit interest on contractual clearing balances or a similar type of voluntary instrument maintained over a two-week average period. This could potentially provide a demand for Federal Reserve balances that would be high and stable enough for monetary policy to be implemented effectively through existing procedures for open market operations, even with lower or zero required reserve balances. A number of other countries, including Canada, Switzerland, Sweden, Australia, and New Zealand, have found that they are able to implement monetary policy satisfactorily without the aid of reserve requirements. One method central banks in some of these countries employ to mitigate potential volatility in overnight interest rates is to attempt to establish a ceiling and floor for such rates through the central bank’s own lending and deposit rates. If a central bank lends freely at a penalty interest rate, that rate tends to act as a ceiling on overnight market interest rates. Last year, the Federal Reserve changed its discount window operations to institute a lending facility of this type that should help to mitigate large upward spikes in overnight interest rates. If the Federal Reserve had the authority to pay interest on excess reserve balances, and did so, that interest rate would act as a minimum for overnight interest rates, because banks would not generally lend to other banks at a lower rate than they could earn by keeping their excess funds at the Federal Reserve. However, our depository institutions are much more heterogeneous than those in other countries and it is not entirely clear how well a ceiling and floor arrangement would work in the United States. Although the Federal Reserve sees no need to pay interest on excess reserves in the near future, the ability to do so nevertheless would be a potentially useful addition to the monetary toolkit of the Federal Reserve. Interest on demand deposits The efficiency of our financial sector also would be improved by repealing the prohibition of interest on demand deposits. This prohibition was enacted during the Great Depression, due to concerns that large money center banks might have earlier bid deposits away from country banks to make loans to stock market speculators, depriving rural areas of financing. It is doubtful that the rationale for this prohibition was ever valid, and it is certainly no longer applicable. Today, funds flow freely around the country, and among banks of all sizes, to find the most profitable lending opportunities, using a wide variety of market mechanisms, including the federal funds market. Moreover, Congress authorized interest payments on household checking accounts with the approval of nationwide NOW accounts in the early 1980s. The absence of interest on demand deposits, which are held predominantly by businesses, is no bar to the movement of funds from depositories with surplus funds - whatever their size or location - to the markets where the funding can be profitably employed. Moreover, in rural areas, small firms with extra cash are able to bypass their local banks and invest in money market mutual funds with check-writing and other transaction capabilities. Indeed, smaller banks have complained that they are unable to compete for the deposits of businesses precisely because of their inability to offer interest on demand deposits. The prohibition of interest on demand deposits distorts the pricing of transaction deposits and associated bank services. In order to compete for the liquid assets of businesses, banks have been compelled to set up complicated procedures to pay implicit interest on compensating balance accounts. Banks also spend resources - and charge fees - for sweeping the excess demand deposits of businesses into money market investments on a nightly basis. To be sure, the progress of computer technology has reduced the cost of such systems over time. However, the expenses are not trivial, particularly when substantial efforts are needed to upgrade such automation systems or to integrate the diverse systems of merging banks. From the standpoint of the overall economy, such expenses are a waste of resources and would be unnecessary if interest were allowed to be paid on both demand deposits and the reserve balances that must be held against them. The prohibition of interest on demand deposits also distorts the pricing of other bank products. Many demand deposits are not compensating balances, and because banks cannot pay explicit interest, they often try to attract these deposits by pricing other bank services below their actual cost. When services are offered below cost, they tend to be overused to the extent that the benefits of consuming them are less than the costs to society of producing them. Interest on demand deposits would clearly benefit small businesses, which currently earn no interest on their checking accounts. But larger firms would also benefit as direct interest payments replaced more costly sweep and compensating balance arrangements. For banks, paying interest on demand deposits likely would increase costs, at least in the short run. However, to the extent that banks were underpricing some services to attract these “free” deposits, those prices would adjust to reflect costs. Moreover, combining interest on demand deposits with interest on required reserve balances and possibly a lower burden associated with reduced or eliminated reserve requirements would help to offset the rise in costs for some banks. Many banks will benefit from the elimination of unnecessary costs associated with sweep programs and other reserve-avoidance procedures. Over time, these measures should help the banking sector attract liquid funds in competition with nonbank institutions and direct market investments by businesses. Small banks in particular should be able to bid for business demand deposits on a more level playing field vis-a-vis both nonbank competition and large banks that currently use sweep programs for such deposits. The payment of interest on demand deposits would have no direct effect on federal revenues, as interest payments would be deductible for banks but taxable for the firms that received them. However, the payment of interest on required reserve balances, or reductions in reserve requirements, would lower the revenues received by the Treasury from the Federal Reserve. The extent of the potential revenue loss, however, has fallen over the last decade as banks have increasingly implemented reserve-avoidance techniques. Paying interest on contractual clearing balances would primarily involve a switch to explicit interest from the implicit interest currently paid in the form of credits, and therefore would have essentially no net cost to the Treasury. Industrial loan companies Although the Federal Reserve Board strongly supports repealing the prohibition of interest payments on demand deposits, the Board opposes any amendment - such as the one contained in H.R. 1375 that would permit industrial loan companies (ILCs) to offer NOW accounts to businesses. ILCs are state-chartered FDIC-insured banks that were first established early in the twentieth century to make small loans to industrial workers, but over time have been granted by the states many of the powers of commercial banks and in some cases now hold billions of dollars of assets. Under a special exemption in current law, ILCs that are chartered in certain states are excluded from the definition of “bank,” and their parent companies are not considered “bank holding companies” for purposes of the Bank Holding Company Act. This special exemption allows any type of company - including a commercial or retail company - to own an FDIC-insured bank without complying with either the limitations on activities or the consolidated supervision requirements that apply to bank holding companies under the Bank Holding Company Act. An amendment that would allow ILCs to offer NOW accounts to businesses would permit ILCs to become the functional equivalent of full-service insured banks. These expanded powers are inconsistent with both the historical functions of ILCs and the terms of their special exemption in current law. Granting these powers to ILCs would provide their owners a competitive advantage over the owners of other insured banks. Moreover, such an amendment would raise significant questions for the Congress concerning the nation’s policy of maintaining the separation of banking and commerce and the desirability of permitting large, diversified companies to control insured depository institutions without consolidated supervision. H.R. 1375 also included ILCs in a provision removing limitations on de novo interstate branching by banks. The Federal Reserve supports expanding the de novo branching authority of depository institutions. Current limitations on de novo branching are anti-competitive obstacles to interstate entry for banks and also create an unlevel playing field between banks and federal savings associations, which have long been allowed to open new branches in other states. But we also believe that Congress should not grant this new branching authority to ILCs unless the corporate owners of these institutions are subject to the same type of consolidated supervision and activities restrictions as the owners of other insured banks. With de novo branching, a large retail company could potentially open a branch of an ILC in each of the company’s retail stores nationwide. As mentioned above, allowing a commercial or financial firm to operate an insured nationwide bank outside the supervisory framework established by Congress for the other owners of insured banks raises significant safety and soundness concerns, creates an unlevel competitive playing field, and undermines the policy of separating banking and commerce that Congress reaffirmed in the Gramm-Leach-Bliley Act of 1999. These important questions should be addressed in a more comprehensive and equitable manner than would be possible in the consideration of minor amendments to legislation on demand deposits or de novo branching. Conclusion In conclusion, the Federal Reserve Board strongly supports, as its key priorities for regulatory relief, legislative proposals that would authorize the payment of interest on demand deposits and on balances held by depository institutions at Reserve Banks, as well as increased flexibility in the setting of reserve requirements. We believe these steps would improve the efficiency of our financial sector, make a wider variety of interest-bearing accounts available to more bank customers, and better ensure the efficient conduct of monetary policy in the future.
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Concord Coalition Budget and Fiscal Policy Conference, Washington, DC, 24 June 2004.
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Edward M Gramlich: Reducing budget deficits Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Concord Coalition Budget and Fiscal Policy Conference, Washington, DC, 24 June 2004. * * * Thank you for inviting me to speak today. Three years ago, at just about this time of year, I gave a talk about the supposed large and growing federal budget surpluses that were then being projected. It then appeared that the national debt could be paid off within the decade, and my remarks addressed the economic and political implications of this declining national debt. Unfortunately, much has changed for the worse since that time. Rather than expecting the stream of surpluses projected just three years ago, budget analysts now expect sizable deficits for at least the remainder of the decade. The national debt as a share of gross domestic product (GDP), which reached almost 50 percent in 1993 and declined to 33 percent by 2001, is now rising again. Today, I am here to talk about how to deal with our current worsening fiscal outlook. Fiscal policy can have important long-run effects on the health of the economy, particularly through its impact on national saving and the growth of productivity. National savings can be generated privately, by households and business, or publicly, by government. Although fiscal policy can, in theory, help boost private saving, this has proven difficult, in practice. Instead, the most important effect of fiscal policy on national saving has been through the direct government budget. When the government runs deficits, it siphons off private savings (reducing national saving), leaving less available for capital investment. With less capital investment, less new equipment is provided to workers, and, all else being equal, future productivity growth rates and levels are lower. Productivity growth is the principal source of improvement in economic well-being. The faster productivity increases over time, the more rapidly living standards increase. Maintaining a rapid rate of trend productivity growth is particularly important in light of the coming budgetary pressures associated with the retirement of the baby boom generation. A more productive economy will ease the financing of Social Security and Medicare benefits for tomorrow’s retirees without placing an undue burden on tomorrow’s workers. In contrast, if we allow debt to build now and in coming years, we will have both lower output to meet future obligations as well as the added burden of financing a growing amount of debt. Indeed, under numerous scenarios, our current debt path is unsustainable: without changes to taxes or spending, we may reach a point where ever-larger amounts of debt must be issued to pay ever-larger interest charges. To be sure, budget deficits are not always inappropriate, and to a certain extent, the recent fiscal deficits have helped limit the recent economic slowdown. But now that the recovery is well under way, it is important to concentrate on longer-run fiscal policy. Specifically, it is time to bring the budget deficits under control. Doing so will, of course, require action in the political arena. But the manner in which the process of deficit reduction is framed can strongly influence the likelihood of success. There are various ways to restore fiscal discipline. Today I will discuss some of these approaches, focusing on their past performance and future potential. Better information One approach is to provide the Congress with better information about the fiscal situation and the costs of legislation. The first milestone in that effort was the Congressional Budget and Impoundment Control Act of 1974. This act established the Congressional Budget Office (CBO) to provide baseline projections of current and future revenues and outlays and to estimate the budgetary effect of spending proposals. The act named the Joint Committee on Taxation (JCT) as the official “scorekeeper” for revenue legislation. The CBO and the JCT provide credible estimates of taxes, spending, and deficits based on a common set of assumptions. By establishing a sensible context in which the inevitable political struggles associated with setting budgetary priorities can take place, this information significantly affects the budget process and, ultimately, budget outcomes. Many analysts have worried about deficiencies in the concepts underlying the official budget estimates. Apart from a few exceptions, budget estimates are based on cash accounting. Thus, they do not take into account the accrual of future obligations or revenues and do not offer an accurate picture of the entire fiscal situation. For example, by today’s cash-based yardstick, the federal budget posted surpluses from 1998 to 2001; yet, if the budget definitions had included the costs of future Medicare and Social Security benefits accrued over this period, the budget likely would have shown substantial deficits. Similarly, if our measure of national debt had included the present value of our already accrued future liabilities for Medicare and Social Security, the debt would never have been close to being paid off. In short, although cash deficits have economic relevance, they can provide a misleading picture of the nation’s long-term budgetary situation. Should the Congress try to target a better measure of the fiscal situation than the deficit as it is currently defined? Would providing the Congress with this better measure affect budget outcomes and help improve the fiscal outlook? Some have suggested moving to an accrual-based accounting system, where the deficit would better account for future obligations and revenues. Others suggest adopting the generational accounts framework. Rather than focusing on a particular year’s imbalance between revenues and spending, this framework recognizes that, ultimately, we must pay for all government spending, and instead calculates the net burden of government taxes and spending on each generation. Calculating generational accounts and other long-term budget measures requires many assumptions that are not as critical under today’s rules. For example, to calculate generational accounts, one must specify the future path of numerous economic and demographic variables like wages, capital income, immigration, longevity, health costs, and inflation.1 One must also specify a discount rate in order to calculate present values - a choice that would likely be controversial and that could greatly affect the results. Finally, one must assume something about future policy variables. Typically, generational accounts assume the continuation of current policy. Thus, they measure the fiscal burden under the assumption that current tax policy is continued, Social Security benefits are not curtailed, and Medicare spending continues to rise with health costs.2 The information provided by generational accounts and other similar methods would definitely be valuable, but their computational methods seem too complicated and rely too much on assumptions about future variables to make them a viable alternative to the current deficit as the main benchmark of fiscal policy. Moreover, much useful information about the future implications of current policy is already provided by the Office of Management and Budget and the CBO, both in their official five- and ten-year budget projections and in their longer-run projections. Targeting longer-term measures like generational accounts is further complicated by the fact that the estimates would be affected by promises to raise taxes or cut spending far off in the future. These very long-term calculations may be subject to a great deal of budgetary sleight of hand. Indeed, even the five- and ten-year targets currently used in the budget process have already been subject to considerable budget sleight of hand. Most important, I am skeptical of the view that more information, as desirable as it is, would alone lead to greater budget discipline. The major differences between the various measures of the current fiscal situation stem from differences in their accounting for Medicare and Social Security. It is no secret to the public or to members of the Congress that these programs face long-term imbalances. This information has been widely known and studied in depth for many years. And yet, despite that fact, we still find ourselves on a fiscal trajectory that is probably unsustainable. Better information alone does not seem to be the answer to our fiscal difficulties. Typically, these are the types of assumptions used to provide long-term projections of the budget deficit or to calculate the long-term solvency of the Social Security system. To illustrate the uncertainty inherent in long-term projections, the CBOs most recent long-term outlook report focused on six possible scenarios based on different assumptions about future revenues and spending. Determining future policy for tax rates is not clear-cut either. Under current law, tax revenues as a share of GDP will reach levels well above historical norms as real bracket creep pushes more and more income into the highest tax brackets. Yet, most calculations of generational accounts assume that the tax law will be adjusted so that average tax rates remain constant over time. Overall deficit targets A second approach to controlling budget deficits is for the Congress to establish budget targets. This approach was the centerpiece of the Balanced Budget and Emergency Deficit Control Act of 1985 commonly known as the Gramm-Rudman-Hollings (GRH) Act. That act aimed to wipe out the deficit in five years. It did so by establishing annual targets - declining to zero - for the budget deficit. The process worked as follows: if projected deficits in the next fiscal year exceeded the targets by $10 billion or more, the legislation mandated that unprotected programs be cut, across-the-board, and by enough to reach the legislated targets. This process of across-the-board cuts was known as “sequestration”. The law did not specify how the targets were to be reached; instead, the assumption was that the existence of those targets and the threat of sequestration would be enough to get the Congress and the Administration to agree on a package of spending cuts and tax increases. GRH did not allow changes in external circumstances to affect the budget deficit targets. Spending cuts were to be enforced regardless of whether the deficit picture had deteriorated because of worsening economic circumstances or because of congressional action. The result of this legislation was quite different than originally envisioned. A sequestration was enforced only once, in the first year. In other years, the Congress used various gimmicks to avoid sequestration, or it simply raised the targets. The actual deficit did not meet the target in any of the years GRH was law, in part because, during this period, external events, such as the savings and loan crisis, tended to overtake the policies that the Congress had enacted to try to close the budget gaps. Other countries have also used budget targets as a means of enforcing fiscal discipline. For example, the Stability and Growth Pact of the European Monetary Union specifies that the budget deficits of member countries are not to exceed 3 percent of GDP except under some special circumstances. If they do, sanctions are to be imposed. But the Stability and Growth Pact has been as ineffective as GRH has, and for the same reasons: countries have resorted to budgetary gimmicks to meet the criteria, and the sanctions have not been imposed on countries that have not met their targets. Another example of deficit targets comes from the balanced-budget requirements of the states, which can be viewed as deficit targets with the target set at zero. Most states have some form of balancedbudget requirement, although the form and stringency of the requirement varies considerably across states. In the most stringent cases, states are required to pass balanced budgets, and no borrowing is allowed to finance the operating budget. The states can use rainy day funds built up from previous years’ surpluses to finance current operations. The states keep capital budgets separate, and states are permitted to finance capital expenditures with borrowing. The available academic literature suggests that these balanced-budget requirements do work, at least in part. Although states have a wide array of budgetary tricks they can and do employ to hit their deficit targets, research evidence suggests that the balanced-budget requirements do limit borrowing and that, as a result, states with more stringent requirements face somewhat lower borrowing costs. Furthermore, there seems to be a deeply held consensus that state budgets should be balanced, and this consensus undoubtedly helps legislators make the difficult choices sometimes necessary to balance state budgets.3 Hence, it may seem attractive just to limit overall deficits, but such limits have had only mixed success. They have typically worked, at least to a small degree, for U.S. states. For national governments, however, they typically generated more budgetary gimmicks than real cutbacks because the limits have not adjusted to the sources of fiscal shock. In a political setting, inflexible deficit limits are likely to lead more to avoidance than to real changes. Controls on legislative action A third approach involves tighter controls on legislative action. Even though GRH did not produce the budget balance it sought, the determination to improve the fiscal outlook remained. In response to the perceived failures of GRH, the Congress passed the Budget Enforcement Act (BEA) of 1990. This There is a real question about the cyclical sensitivity of tax revenues. The states’ balanced-budget rules typically do not make adjustments for such sensitivity, but they effectively accommodate fiscal stabilizers because states, as mentioned, can build up rainy day funds in good years and run them down in bad years. A federal balanced-budget amendment would need to confront similar issues. legislation replaced the system of deficit targets with two types of restraints on legislative actions. First, a cap was imposed on discretionary spending - spending that the Congress appropriates each year and was to be enforced with a sequestration process. The cap declined slightly over time, in real terms. Second, for revenues and entitlement programs, the BEA established a system called PAYGO (pay as you go) that required all revenue and mandatory spending legislation to be deficit-neutral over a five-year period. For example, an expansion in a program like Medicare would be allowed only if it were accompanied by a reduction in other entitlement spending or an increase in revenues. In other words, the PAYGO restraint didn’t require the Congress to climb out of the deficit hole by any particular date, but it did prohibit the Congress from digging the hole any deeper. The largest difference between the BEA and GRH was that the BEA attempted to restrain legislative action alone. Changes in the deficit resulting from changes in economic conditions, health prices, demographics, and other technical or economic factors were allowed to show through to the deficit without sanction. Only those parts of the budget that the Congress could control directly - discretionary spending and programmatic changes to entitlement and revenue programs - were subject to the new requirements. The BEA’s budget rules - which were extended twice before they were allowed to expire in 2002 appear to have been more successful than previous attempts at budget control. Budget deficits declined sharply from 1992 to 1997 and then turned to surpluses from 1998 through 2001. To a significant extent, of course, the decline in the deficit and the emergence of surpluses were attributable to circumstances external to the budget process, including the stellar performance of the economy; the increase in equity prices, which raised tax revenues to historic highs; and the end of the Cold War, which allowed for a decrease in defense spending. But without a broad consensus to reduce the deficit, and without a mechanism to enforce that consensus, the Congress might have responded to these positive developments by increasing spending or cutting taxes. Instead, the federal deficit was allowed to decline. As a result, national saving increased, providing further impetus to economic growth. Most economists view these rates of national saving as an important factor in the strong economic performance of the late 1990s. It is difficult to know exactly what the deficit path would have been in the absence of the BEA. But budget experts generally believe that the BEA did help to reduce deficits. How? A likely possibility is that the rules helped solve the prisoner’s dilemma problem inherent in the legislative process. When representatives choose between seeking funding for local projects and exercising fiscal discipline (by not requesting funding for local projects), they will naturally consider the payoff of each choice. Without a set of credible budget rules, the narrow local interest is usually the more attractive option for two reasons. First, any individual representative knows that bringing home the pork is not likely to have much of an effect on the deficit. Therefore, there really is no measurable payoff in greater national fiscal virtue from an individual representative curtailing efforts to win special benefits for the home district. Second, in the absence of a credible set of budget rules, representatives have no assurance that others in the Congress will not be doing everything in their power to work the system to their benefit, and an individual representative would not want to appear to be relatively lax in his or her pork-procuring efforts. Budget rules help alleviate this problem. Under discretionary caps and PAYGO, individual representatives could choose to forgo their special projects, secure in the knowledge that others would not gain an advantage as a result. As already noted, an advantage of the budget rules was that they aimed at constraining the things that the Congress could control directly rather than targeting the overall level of the deficit. But these rules also had a fatal flaw, which was that they had no sensible stopping point. Over the course of the 1990s, the economic news got better and better. The federal budget was borne along on the tide, and eventually moved into surplus, even excluding the Social Security cash surplus. At that point, a welldesigned set of rules probably would have said “enough”. But unfortunately, even when surpluses emerged, the PAYGO rules continued to require deficit neutrality in mandatory spending and revenue programs and adherence to the discretionary caps. Unfortunately, because such strict fiscal discipline was no longer viewed as necessary, the budget rules ceased to be effective: Congress enacted measures that reduced or eliminated their bite until they were finally allowed to expire in 2002. As a consequence of this aftertaste, it may be harder to bring back PAYGO rules now, when they are really needed. A sensible strategy for the future The main lesson to be learned from this examination of past budget rules is that, within limits, budget institutions do matter. A good budget process can help the Congress enforce fiscal discipline if the political consensus to do so exists. In order to be effective, the process must be based on reliable information about current and future baseline budget deficits and about the effects of legislation on the budget. It must produce results that are reasonable and valued by the Congress and the public. The process must be flexible enough to adjust in a reasonable way to changing economic and technical factors that affect the budget. Of course, no single set of rules can be flexible enough to address all possible circumstances, and over time, any set of budget rules likely will have to be revised. Although the budget rules of the BEA did not prove flexible enough to endure in the face of budget surpluses, that is no longer an important problem. Reinstating both the discretionary caps as well as the PAYGO rules for revenue and mandatory spending programs - perhaps with some adjustments would be useful initial steps in restoring fiscal discipline. Once some success has been achieved with these measures, it may be easier to tackle the more ambitious step of instituting overall deficit limits. Two further issues are worth considering. First, what is the appropriate time horizon for budget rules? We have seen problems in the past with periods that were too short - for example, under GRH, the annual budget targets could be met by simply pushing costs into the next year. But there are also problems with periods that are too long - for example, when budget rules are satisfied by specifying painful measures that occur ten years in the future. The current focus on five years may be a reasonable compromise, or it might be worth considering some more-complicated rules that might limit annual deficits as well as five- or ten-year totals. A second question concerns the ultimate target of budget rules. Should we, as a nation, aim to build up surpluses to fully fund all of our future Medicare and Social Security liabilities as they would exist under current law? Would that commit the government to maintain those programs as they are under current law rather than allowing the government to adapt them to future circumstances? Can the government reasonably accumulate the large stock of assets that full funding would require? These are all difficult questions on which there is no political consensus. In the past, a reasonable goal might have been to maintain a zero deficit in our on-budget accounts - those accounts that exclude the Social Security and Medicare surplus - and to begin a serious discussion of reforms to Social Security and Medicare to bring them closer into actuarial balance. In the future, as the cash surplus for these retirement programs winds down, a proximate budget goal might be just a balanced overall budget (including the retirement programs), though we will still need to confront Social Security and Medicare issues. As I have stressed, rules alone cannot create fiscal discipline where none exists. So, in conclusion, let me reiterate the most important point: restoring fiscal discipline should be one of our nation’s most important priorities. While the current deficits may not be terribly harmful in the short run, a failure to confront them now will steadily detract from the growth of the economy and will require even more wrenching changes in the future.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Financial Executives International Chicago Chapter Dinner, Chicago, 15 July 2004.
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Susan Schmidt Bies: Business financial conditions and relationships with bankers Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Financial Executives International Chicago Chapter Dinner, Chicago, 15 July 2004. * * * I am very pleased to join you for this meeting of the Chicago chapter of Financial Executives International. As many of you know, before my appointment to the Board of Governors, I was quite active in this organization, particularly on the Committee on Corporate Reporting. I also served on the Financial Accounting Standards Board’s Emerging Issues Task Force. Now, as a member of the Federal Reserve Board and chair of the Board’s Committee on Supervisory and Regulatory Affairs, I find myself looking at the growth and evolution of the financial system from a slightly different perspective than when I was a chief financial officer. Today I want to focus on the financial health of households and businesses, and on changes in the relationships between businesses and their bankers. First, I would like to briefly share with you my assessment of the economic outlook and discuss in more detail how the evolution of household and business balance sheets in recent years is affecting economic activity. Second, I want to discuss an issue concerning the relationship between corporations and their bankers that has been receiving attention - anti-tying restrictions. I also need to add that I am expressing my own opinions, which are not necessarily those of my colleagues on the Board of Governors or on the Federal Open Market Committee. The economic outlook As you know, the economic expansion has gained more-solid footing. Real gross domestic product grew at an annual rate of nearly 4 percent in the first quarter, building on an even larger increase in the second half of 2003, and it appears to have posted another sizable gain in the second quarter of this year. Although consumer spending has slowed this spring, housing demand has stayed very strong, and business outlays for capital equipment have continued to rebound from their weakness of the past several years. In addition, businesses have stepped up their hiring lately - although the monthly increases have been uneven. Moreover, surveys of corporate executives as well as my business contacts indicate that businesses expect to increase the size of their payrolls in coming months. And with financial conditions still accommodative, I expect that economic activity will continue to expand at a solid pace in the second half of the year. At the same time, inflation has picked up more rapidly this year than I had expected. The price index for personal consumption expenditures excluding food and energy rose 1-1/2 percent over the twelve months ending in May, compared with 3/4 percent over the twelve months ending last December. The step-up in inflation in recent months reflects the ability of more companies to effectively raise prices, but it also has been exacerbated by transitory factors, such as the pass-through of large increases in energy prices and by large apparently one-time adjustments in such items as lodging away from home. The Federal Reserve will need to be alert to signs of higher inflation, and be ready to respond in order to fulfill its commitment to maintain price stability as a necessary condition for maximum sustainable economic growth. Household financial conditions Before I turn to the business sector, let me spend a few minutes on the financial condition of the household sector. Some commentators have expressed concern about the rapid growth in household debt in recent years. They fear that households have become overextended and will need to rein in their spending to keep their debt burdens under control. My view is considerably more sanguine. Although there are pockets of financial stress among households, the sector as a whole appears to be in good shape. It is true that households have taken on quite a bit of debt over the past several years. According to the latest available data, total household debt grew at an annual rate of 10 percent between the end of 1999 and the first quarter of 2004; in comparison, after-tax household income increased at a rate of about 5 percent. But looking below the aggregate data, we must understand that the rapid growth in household debt reflects largely a surge in mortgage borrowing, which has been fueled by historically low mortgage interest rates and strong growth in house prices. Indeed, many homeowners have taken advantage of low interest rates to refinance their mortgages, some having done so several times over the past couple of years. Survey data suggest that homeowners took out cash in more than one-half of these “refis”, often to pay down loans having higher interest rates. On net, the resulting drop in the average interest rate on household borrowings, combined with the lengthening maturity of their total debt, has damped the monthly payments made by homeowners on their growing stock of outstanding debt. The Federal Reserve publishes two data series that quantify the burden of household obligations. The first series, the debt-service ratio, measures the required payments on mortgage and consumer debt as a share of after-tax personal income. The second series, the financial-obligations ratio, is a broader version of the debt-service ratio that includes required household payments on rent, auto leases, homeowners insurance, and property taxes. Both ratios rose during the 1990s, and both reached a peak in late 2001. Since then, however, they have receded slightly on net, an indication that households, in the aggregate, have been keeping an eye on repayment burdens. Because the debt-service ratio and the financial-obligations ratio are calculated from aggregate data, they do not necessarily indicate whether the typical household is experiencing financial stress. Nonetheless, we have found that changes in either ratio help predict future changes in consumer loan delinquencies. Accordingly, the fact that these ratios have come off their recent peaks is a hopeful sign about household loan performance. Indeed, delinquency rates for a wide range of household loans turned down over the second half of 2003 and edged down again in the first quarter of this year. Another often-cited indicator of household financial conditions is the personal bankruptcy rate. Movements in the bankruptcy rate, to be sure, partly reflect changes in the incidence of financial stress. But the rate has been trending up for more than two decades for a variety of other reasons. The Bankruptcy Reform Act of 1978 made bankruptcy a more attractive option for most households by increasing the amount of wealth that households could retain after bankruptcy. Other factors that have likely contributed to the upward trend are a lessening of the social stigma of filing for bankruptcy and growing access to credit in the United States. As lenders have become more sophisticated in their ability to assess the riskiness of borrowers, they have extended loans to households that were previously denied credit. These households are more likely to default on their obligations than the typical borrower, but the increased risk is priced into loan terms. Although the bankruptcy rate remains elevated, it has edged down on balance in recent months, likely because of the pickup in economic growth in the United States since mid-2003. To be sure, mortgage rates and other consumer loan rates have come off the lows reached early this year, and concerns have been heightened about interest payment burdens for households. Although some households will be pressured by the higher rates, I believe the concerns can be overstated. First, most household debt - mortgage and consumer debt combined - carries a fixed interest rate, which slows the adjustment of interest costs to rising rates. Second, although interest rates on some variable-rate loans will rise quickly, the adjustment for a large number of variable-rate loans could be a good deal slower. For example, many adjustable-rate mortgages start off with a fixed rate for several years, providing households with some protection from rising rates. This relatively upbeat assessment of household credit quality seems to be shared by lenders and by investors in securities backed by consumer debt. According to the Federal Reserve’s survey of senior loan officers, the number of banks tightening their standards on consumer loans has fallen over the past year. This behavior certainly does not point to much concern about household loan performance. Moreover, one gets an even more positive message from the credit spreads on securities backed by auto loans and credit card receivables. In recent months, the spreads between the yields on these securities and the swap rates of comparable maturities have narrowed across the credit spectrum. Thus far, I have focused on the liability side of the household balance sheet. There have been favorable developments on the asset side as well. Equity prices rallied strongly last year and have held their ground this year, reversing a good portion of the losses sustained over the previous three years. In addition, home prices appreciated sharply during each year from 1997 through 2003. Our most recent reading for the first quarter of this year indicates that home prices continued to rise, but at a more moderate pace. All told, the ratio of household net worth to disposable income - a useful summary of the sector’s financial position - recovered last year and currently stands at a level about equal to its average over the past decade. Financial conditions of businesses The change in the economy that caught my attention in the second half of 2003 was that business fixed investment had finally begun to strengthen. Capital spending by businesses posted a solid increase in the second half of last year and appears to have advanced again at a robust pace in the first half of this year. Moreover, orders for nondefense capital goods - a key indicator of equipment spending - point to further sizable gains. I view this pickup, along with the improving jobs picture thus far this year, as an indication that business caution about the strength and sustainability of this expansion has waned. Also of special importance is the improvement in the financial health and profitability of the business sector. Indeed, starting last year, many firms found themselves in the unusual position of being able to finance a pickup in spending entirely out of rapidly rising cash flow, and those that needed to turn to external markets generally found the financing environment to be quite accommodative. Four factors have contributed to this improvement in financial conditions: low interest rates, a widespread restructuring of corporate liabilities during the past few years, significant cost-cutting and productivity gains, and a substantial narrowing in market-risk premiums. Even with interest rates expected to rise and profit growth expected to moderate, the financial condition of the business sector should remain strong and able to support continued expansion. I will discuss each factor in turn. First, firms are continuing to benefit from the accommodative stance of monetary policy. Even after the FOMC raised the target funds rate to 1.25 percent a few weeks ago, short-term borrowing costs remain very low. For longer-term debt, the combination of low yields on benchmark Treasury securities and reduced risk spreads has kept borrowing costs quite attractive. Currently, yields on investmentgrade corporate debt generally are at the low end of levels of the past several decades, despite having risen on balance by about ¾ to one percentage point since late spring of last year. For speculativegrade firms, yields have fallen almost one percentage point as spreads contracted sharply. Second, in response to low long-term rates and to investors’ concerns arising from some high-profile, unanticipated meltdowns, firms have greatly strengthened their balance sheets. Many firms have refinanced high-cost debt, a move that has reduced the average interest rate on the debt of nonfinancial corporations by more than 1 percentage point since the end of 2000. Businesses have also substituted long-term debt for short-maturity debt to improve their balance sheet liquidity and to reduce the risk of rolling over funds. In addition, many firms - especially in the most troubled industries - have retired debt through equity offerings and asset sales, while others have used their mounting profits to retire debt. As a result, the growth of nonfinancial corporate debt in the past two-and-a-half years was limited to its slowest pace since the early 1990s. These repairs to balance sheets have also reduced the exposure of many firms to rising interest rates, especially in the near term. In particular, the replacement of short-term debt by long-term bonds means that less debt will have to be rolled over in the near term at higher rates. In addition, because much of the long-term debt has a fixed rate, interest payments typically are unaffected over the life of the bond. Moreover, research by Board staff suggests that firms that rely on floating-rate debt, and for that reason might be more vulnerable to rising rates, have tended to use derivatives in recent years to hedge their exposure to interest rate risk. Thus, for many firms, the effect of rising interest rates will be mitigated and stretched out over time. A third factor contributing to the improvement in financial conditions among businesses is significant belt-tightening by many firms. Over the past few years, the drive to cut costs and boost efficiency has generated rapid productivity gains. Fuller utilization of the capabilities of capital already in place, ongoing improvements in inventory management, and streamlined production processes requiring fewer workers, to name but a few examples of efficiency enhancements, have boosted corporate profitability even when revenue growth was tepid. In the second half of last year, revenue growth picked up, and companies were able to leverage those productivity gains and produce a dramatic recovery in overall corporate profitability. The profits of nonfinancial corporations as a share of sector output surged to reach 12 percent in the first quarter of this year. This share lies above the long-run average of about 10 percent over the past few decades, and well above the cyclical trough of 7 percent in 2001. To be sure, the profit share likely will slip a bit from its high level as the expansion gains steam and businesses are less able to keep a lid on their labor costs. Moreover, because cyclical factors likely contributed to the recent dramatic advances in productivity, we should expect productivity gains to moderate. But these developments and the decline in profit share are to be expected and will not, in my view, lead to a meaningful impairment of the financial health of companies. And finally, risk premiums fell substantially last year as corporate governance scandals receded and investor sentiment turned markedly more positive. The recovery in stock prices reflects this brighter view. Spreads on corporate bonds narrowed appreciably - especially for the riskiest firms - and they now are quite thin, relative to those in several years. Spreads on commercial and industrial loans at commercial banks have diminished over the past year or so, at a time when banks also report that their underwriting standards have moved from restraint to ease. The narrowing of spreads was helped by the balance-sheet improvements that I mentioned a moment ago. Indicators of corporate financial stress, such as delinquency rates on commercial and industrial loans and corporate bonds, have declined markedly, with the latter reaching lows that prevailed in the mid-1990s. Bond-rating downgrades have subsided, and upgrades have picked up to levels normally associated with economic expansion. The narrowing of spreads also reflects the outlook of investors for sustained strength in sales and profit growth. The continuation of efforts to address the accounting and corporate governance scandals of the past few years also serves to increase investors’ comfort with providing capital to firms with reasonable premiums for risk. These four factors all suggest that financial conditions are capable of supporting sustained, solid growth of the U.S. economy. The much-improved profitability can help finance expansion directly out of internal funds or indirectly by supporting firms’ borrowing capacity. Furthermore, firms will be able to draw on the liquid assets that they have accumulated over the past couple of years. Of course, profit margins are likely to recede from their current high levels as labor and other costs pick up and productivity growth moderates. Even so, given the successful efforts to pare costs, firms are set to benefit from new investment in plant and equipment. Anti-tying restrictions on banks Finally, I want to discuss the nature of anti-tying regulations for financial institutions, an issue that can be very confusing to nonbankers. As innovations create new financial instruments, services, and markets, and as banks expand the scope of the financial services they offer, the process of making business decisions for banks is similar to the process many of you apply in your own business. Financial institutions are trying to build customer loyalty by offering a broader menu of financial services to corporate customers. The concern addressed by anti-tying restrictions is that banks may force customers to take unwanted products to obtain needed services. As a brief background, the special anti-tying statute that applies to banks generally prohibits a bank from conditioning the availability or price of one product on a requirement that the customer also obtain another product that is not a traditional bank product from the bank or an affiliate of the bank. For example, a bank may not inform a customer that the bank will provide the customer a loan only if the customer engages the bank’s securities affiliate for an underwriting or obtains some other product or service that is not a traditional bank product from the bank or an affiliate. The words “that is not a traditional bank product” are important. Not all tying arrangements are illegal ties. The statute and the Board’s regulations expressly permit a bank to condition the availability or price of a product or service on a requirement that the customer also obtain one or more traditional bank products from the bank or an affiliate. A traditional bank product generally is defined as any “loan, discount, deposit, or trust service”, and the Board’s proposed interpretation provides guidance on what types of products fall within the scope of these terms. In light of these complexities, the Board has published and sought public comment on an interpretation of the anti-tying statute and related supervisory guidance. The proposed interpretation was published to help banking organizations and corporate customers clarify permissible practices under this complex statute in today’s financial services environment. Importantly, the interpretation proposes guidelines that could be followed when a bank seeks to engage in traditional “relationship banking”, that is, serving customers on the basis of the profitability of the overall customer relationship. The guidance includes the establishment of some regulatory “safe harbors”. The proposed guidance communicates our expectations as to the types of policies, procedures, internal controls, and training programs that should help banks comply with the anti-tying restrictions. It also emphasizes the importance of the compliance and internal audit functions in ensuring compliance with the law and regulations. The Federal Reserve Board and the other federal banking agencies have long required that banking organizations establish and maintain policies and procedures to ensure compliance with the anti-tying restrictions, and the agencies monitor these policies and procedures through the supervisory process. Admittedly, at times it can be difficult to determine whether a violation of the anti-tying statute has occurred. As I mentioned, some forms of tying by banks are expressly permitted, and the statute does not apply to tying arrangements imposed by the nonbank affiliates of a bank. Moreover, divining whether a bank imposed a prohibited tie often requires a close review of the facts and circumstances associated with the particular transaction. A prohibited tie, for example, may be conveyed orally and not memorialized in transaction documentation. Our supervisory reviews indicate that banks generally understand and have implemented systems to ensure compliance with the anti-tying provisions to which they are subject. In addition, although we have encouraged customers that believe they have been the subject of an illegal tie to come forward, we have received few complaints from bank customers. Moreover, few customers have sought to challenge their banks directly, although they are granted a private right of action under the statute and may obtain treble damages if successful. A 2003 General Accounting Office report on bank tying practices found that the available evidence did not substantiate claims of illegal tying by banks, but it did note that borrowers were reluctant to file formal complaints. The GAO recommended that the Board consider taking additional steps to enforce compliance with the anti-tying provisions. Our proposed interpretation and guidance is intended to help banks understand this rather complex compliance area. I should mention that we also received a comment letter on the proposed interpretation from the Department of Justice. This letter, which is available on the department web site, expresses concern that the bank anti-tying statute itself may suppress competition and harm consumers, especially as it is applied to large customers. The department has recommended that the Board interpret the bank antitying statute in a manner similar to the federal antitrust laws. Unlike the general antitrust laws, the courts historically have found that the anti-tying statute applicable to banks generally does not require a showing of market power to support a violation. Alternatively, the department has recommended that the Board exercise its statutory authority to exempt large, corporate customers from the reach of the bank anti-tying statute. These are all issues the Board will have to carefully consider as we move toward finalizing the interpretation and guidance in this area. Conclusion In conclusion, the economic expansion is now broad based, and the financial strength of businesses should help provide the foundation for continued growth in the months ahead. The Financial Executives International has contributed to the financial strength of businesses today by providing corporate financial officers with information on evolutions in best business practices and processes and by serving as an effective forum for dialogue on emerging issues in finance and governance. I encourage you, as senior officers of your firms, to keep this discussion alive within your firms. When businesses have a strong focus on corporate ethics, a robust internal control culture, and transparent disclosure, financial markets can provide capital efficiently.
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Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, on the occasion of the Federal Reserve Board¿s semiannual monetary policy report to Congress, before the Committee on Banking, Housing, and Urban Affairs, US Senate, 20 July 2004.
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Alan Greenspan: Semiannual monetary policy report to the US Congress Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, on the occasion of the Federal Reserve Board’s semiannual monetary policy report to Congress, before the Committee on Banking, Housing, and Urban Affairs, US Senate, 20 July 2004. Mr Greenspan presented identical testimony before the Committee on Financial Services, US House of Representatives, on 21 July 2004. * * * Mr Chairman and members of the Committee, I am pleased to be here today to present the Federal Reserve’s Monetary Policy Report to the Congress. Economic developments in the United States have generally been quite favorable in 2004, lending increasing support to the view that the expansion is self-sustaining. Not only has economic activity quickened, but the expansion has become more broad-based and has produced notable gains in employment. The evident strengthening in demand that underlies this improved performance doubtless has been a factor contributing to the rise in inflation this year. But inflation also seems to have been boosted by transitory factors such as the surge in energy prices. Those higher prices, by eroding households’ disposable income, have accounted for at least some of the observed softness in consumer spending of late, a softness which should prove short-lived. When I testified before this Committee in February, many of the signs of the step-up in economic activity were already evident. Capital spending had increased markedly in the second half of last year, no doubt spurred by significantly improving profits, a low cost of capital, and the investment tax incentives enacted in 2002 and enhanced in 2003. The renewed strength in capital spending carried over into the first half of 2004. Orders and shipments of nondefense capital goods have been on the rise, and backlogs of unfilled orders for new equipment continue to build. A key element of the expansion that was still lacking in February, however, was evidence that businesses were willing to ramp up hiring to meet the stepped-up pace of sales and production. Businesses’ ability to boost output without adding appreciably to their workforces likely resulted from a backlog of unexploited capabilities for enhancing productivity with minimal capital investment, which was an apparent outgrowth of the capital goods boom of the 1990s. Indeed, over much of the previous three years, managers had seemed to pursue every avenue to avoid new hiring despite rising business sales. Their hesitancy to assume risks and expand employment was accentuated and extended by the corporate accounting and governance scandals that surfaced in the aftermath of the decline in stock prices and also, of course, by the environment of heightened geopolitical tensions. Even now, following the pattern of recent quarters, corporate investment in fixed capital and inventories apparently continues to fall short of cash flow. The protracted nature of this shortfall is unprecedented over the past three decades. Moreover, the proportion of temporary hires relative to total employment continues to rise, underscoring that business caution remains a feature of the economic landscape. That said, there have been much clearer indications over recent months that conditions in the labor market are improving. Most notably, gains in private nonfarm payroll employment have averaged about 200,000 per month over the past six months, up sharply from the pace of roughly 60,000 per month registered over the fourth quarter of 2003. The improvement in labor market conditions will doubtless have important follow-on effects for household spending. Expanding employment should provide a lift to personal disposable income, adding to the support stemming from cuts in personal income taxes over the past year. In addition, the low interest rates of recent years have allowed many households to lower the burdens of their financial obligations. Although mortgage rates are up from recent lows, they remain quite attractive from a longer-run perspective and are providing solid support to home sales. Despite the softness of recent retail sales, the combination of higher current and anticipated future income, strengthened balance sheets, and still-low interest rates bodes well for consumer spending. Consumer prices excluding food and energy - so-called core prices - have been rising more rapidly this year than in 2003. For example, the twelve-month change in the core personal consumption expenditures price index stood at 0.8 percent in December of last year and climbed to 1.6 percent by May of this year. Core inflation, of course, has been elevated by the indirect effects of higher energy prices on business costs and by increases in non-oil import prices that reflect past dollar depreciation and the surge in global prices for primary commodities. But the acceleration of core prices has been augmented by a marked rise in profit margins, even excluding domestic energy corporations. This surge in profits reflects, at least in part, the recent recovery of demand after a couple of years during which weak demand led to relatively heavy price discounting by businesses. Profits of nonfinancial corporations as a share of sector output, after falling to 7 percent in the third quarter of 2001, rebounded to 12 percent in the first quarter of 2004, a pace of advance not experienced since 1983. Half of this rise in the profit share occurred between the first quarter of 2003 and the first quarter of 2004, a period during which business costs were unusually subdued. In fact, consolidated unit costs for the nonfinancial corporate business sector actually declined during this period. The increase in output per hour in the nonfinancial corporate business sector of more than 6 percent accounted for much of the net decline in unit costs. The remainder was due to the effects of rising output in reducing nonlabor fixed costs per unit of output. Hence, at least from an accounting perspective, between the first quarter of 2003 and the first quarter of 2004, all of the 1.1 percent increase in the prices of final goods and services produced in the nonfinancial corporate sector can be attributed to a rise in profit margins rather than rising cost pressures. However, businesses are limited in the degree to which they can raise margins by raising prices. An increase in margins should affect mainly the level of prices associated with any given level of unit costs but, by itself, should not prompt a sustained pickup in the rate of inflation going forward. In a market economy, any tendency for profit margins to continue to rise is countered largely by the entry of new competitors willing to undercut prices and by increased labor costs as more firms attempt to exploit the opportunity for outsized profits by expanding employment and output. That increase in competitive pressure, as history has amply demonstrated, with time, returns markups to more normal levels. Over the past three decades, the share of the profits of nonfinancial corporations in the total nominal income of that sector has fluctuated around a longer-run average of roughly 10-1/2 percent. The profit share in the first quarter of this year, at about 12 percent, was well above that level. The gap suggested that the growth of unit profits would eventually slow relative to increases in unit costs. This outlook had accorded with analysts’ expectations for earnings growth over the next year, which are substantially below the realized growth of profits in recent quarters. Indeed, some leveling or downward pressure on profit margins may already be in train, owing to a pickup in unit labor costs. Although advances in productivity are continuing at a rate above the longterm average, they have slowed from the extraordinary pace of last summer and are now running below increases in hourly compensation. The available information suggests that hourly compensation has been increasing at an annual rate of about 4-1/2 percent in the first half of the year. To be sure, the increases in average hourly earnings of nonsupervisory workers have been subdued in recent months and barely budged in June. But other compensation has accelerated this year, reflecting continued sizable increases in health insurance costs, a sharp increase in business contributions to pension funds, and an apparently more robust rate of growth of hourly earnings of supervisory workers. The larger wage gains for supervisory workers together with anecdotal reports of growing skill shortages are consistent with earlier evidence of rising wage premiums for skilled workers relative to less-skilled workers. For the moment, the modest upward path of unit labor costs does not appear to threaten longer-term price stability, especially if current exceptionally high profit margins begin to come under more intense competitive pressures at home and from abroad. Although some signs of protectionist sentiment have emerged, there is little evidence that the price-containing forces of ever-widening global competition have ebbed. In addition, the economy is not yet operating at its productive capacity, which should help to contain cost pressures. But we cannot be certain that this benign environment will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation. Accordingly, in assessing the appropriateness of the stance of policy, the Federal Reserve will pay close attention to incoming data, especially on costs and prices. What does seem clear is that the concerns about the remote possibility of deflation that had been critical in the deliberations of the Federal Open Market Committee (FOMC) last year can now be safely set aside. Those deflationary pressures were largely a consequence of the stock market slump, the capital goods contraction that commenced in 2000, and, as I noted earlier, the extreme business caution that followed from these events as well as from terrorist attacks, corporate scandals, and the lead-up to the war in Iraq. Both equity prices and capital goods spending have turned up over the past year, and the probability that economic activity might stagnate has receded. As always, considerable uncertainties remain about the pace of the expansion and the path of inflation. Some of those uncertainties, especially ones associated with potential terrorism both here and abroad, are difficult to quantify. Such possibilities have threatened the balance of world supply and demand in oil markets in recent months, especially as demand has risen with the pace of world economic growth. Yet aside from energy, markets exhibit little evidence of heightened perceptions of risk. Credit spreads remain low, and market-based indicators of inflation expectations, after rising earlier this year, have receded. With the growth of aggregate demand looking more sustainable and with employment expanding broadly, the considerable monetary accommodation put in place starting in 2001 is becoming increasingly unnecessary. In May, the FOMC believed that policy accommodation needed to be removed and that removal could be accomplished at a pace that is likely to be measured. At our meeting last month, the FOMC raised the target federal funds rate from 1 percent to 1-1/4 percent, and the discount rate was raised commensurately. Policymakers reiterated that, based on our current outlook, the removal of accommodation would likely proceed at a measured pace. But in light of the considerable uncertainty surrounding the anticipated evolution of price pressures, the FOMC emphasized that it will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability. If economic developments are such that monetary policy neutrality can be restored at a measured pace, a relatively smooth adjustment of businesses and households to a more typical level of interest rates seems likely. Even if economic developments dictate that the stance of policy must be adjusted in a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic adjustment of interest rates. Of course, considerably more uncertainty and hence risk surrounds the behavior of the economy with a more rapid tightening of monetary policy than is the case when tightening is more measured. In either scenario, individual instances of financial strain cannot be ruled out. The protracted period of low interest rates has facilitated a restructuring of household and business balance sheets. Businesses have been able to fund longer-term debt at highly favorable interest rates and, by extending the maturity of their liabilities, have rendered net earnings and capital values less exposed to destabilizing interest rate spikes. Households have made similar adjustments. Between mid-2002 and mid-2003, homeowners were able to refinance at lower interest rates almost half of total outstanding home mortgage debt and thereby to substantially reduce monthly debt service payments. Households also substituted mortgage debt for more-expensive consumer credit. Moreover, those households and businesses that held long-term investment-grade bonds in that year accumulated realized and unrealized capital gains as long-term rates declined. The FOMC judged this extended period of exceptionally low interest rates to have been helpful in assisting the economy in recovering from a string of adverse shocks. But in the process of returning the stance of policy to a more neutral setting, at least some of the capital gains on debt instruments registered in recent years will inevitably be reversed. Prices in financial markets have already adjusted in anticipation of a significant amount of policy tightening, engendering additional alteration of balance sheets in recent months. An unwinding of carry trades - that is, market positions premised on low short-term financing costs - seems to be under way, at least judging from a pronounced shift in the trading portfolios of primary dealers. In addition, investors classified as non-commercial have established net short positions in ten-year Treasury note futures in recent months. Indeed, the swing toward a net short position on ten-year Treasury note futures has been the largest since the inception of the contract in the 1980s, likely offsetting a significant portion of the interest rate exposure of previously established carry trade positions. Moreover, the recent increase in market interest rates has slowed the pace of mortgage refinancing and reportedly has precipitated some winding down of leveraged positions among major mortgage market participants. These circumstances are quite different from the situation prevailing at this time last summer. Then, record levels of refinancing in the second half of 2002 and the first half of 2003 had pushed the duration of mortgage-backed securities (a measure of the price sensitivity of fixed-income instruments to changes in interest rates) to exceptionally low levels. As mortgage and other long-term rates rebounded last summer, a consequence of rapidly improving economic conditions and the fading of deflationary concerns, refinancing fell sharply, removing most downward pressure on duration. Holders of mortgage-backed securities endeavoring to hedge the resulting shifts in interest rate gaps moved rapidly to shed Treasuries and receive-fixed interest-rate swaps, and these actions magnified last summer’s upturn in long-term interest rates. In the current environment, by contrast, it appears that the scope for such mortgage hedging effects to greatly amplify an increase in long-term rates is much diminished given the decline in the pace of refinancing and the associated increase in mortgage durations that have already occurred. Lastly, very large fractions of the total outstanding obligations of businesses and households are longterm, fixed-rate debt. As a result, rising market interest rates will not have much immediate direct effect on business and household debt service burdens. Indeed, from early 1999 through early 2000, a period when interest rates on new home mortgage originations rose more than 150 basis points, the average interest rate on the total of home mortgage debt outstanding barely moved. Nonetheless, despite the lock-in of low interest rate costs on a substantial share of household and business liabilities, recent higher market interest rates will, in time, show through into increased charges against household and business income. To be sure, financial intermediaries and other creditors that extended loans or purchased securities in recent years at relatively low long-term interest rates will sustain capital losses as rates rise. In general, however, financial intermediaries are profitable and well-capitalized and appear to be well positioned to manage in a rising rate environment. In short, financial markets along with households and businesses seem to be reasonably well prepared to cope with a transition to a more neutral stance of monetary policy. Some risks necessarily attend this transition, but they are outweighed in our judgment by those that would be associated with maintaining the existing degree of monetary policy accommodation in the current environment. Although many factors may affect inflation in the short-run, inflation in the long-run, it is important to remind ourselves, is a monetary phenomenon. As we attempt to assess and manage these risks, we need, as always, to be prepared for the unexpected and to respond promptly and flexibly as situations warrant. But although our actions need to be flexible, our objectives are not. For twenty-five years, the Federal Reserve has worked to reestablish price stability on a sustained basis. An environment of price stability allows households and businesses to make decisions that best promote the longer-term growth of our economy and with it our nation’s continuing prosperity.
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Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Exchequer Club of Washington luncheon, Washington, DC, 21 July 2004.
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Roger W Ferguson, Jr: A retrospective on business-cycle recoveries: are “jobless” recoveries the new norm? Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Exchequer Club of Washington luncheon, Washington, DC, 21 July 2004. * * * It is an honor for me to address the Exchequer Club of Washington, D.C. Your purpose of providing a frank and open exchange of information and opinion on national policy is indeed laudable. With business investment bouncing back and consumption continuing to grow, real gross domestic product seems to have been advancing at approximately a 4 percent annual pace over the first half of the year. In addition, both the labor market and the manufacturing sector, two areas that had been lagging through most of the recovery, appear to have finally started to advance. Private payroll employment has risen a little more than 200,000 per month, on average, since the end of last year, and although last month’s increase of 117,000 was disappointing, there is little indication that the labor market’s progress is stalling. The same may be said of the manufacturing sector, in which employment, before last month’s decline, had posted three consecutive months of solid gains, and production advanced strongly again in the second quarter. Of course, as some recent data remind us, there are always sizable uncertainties regarding both the likely rate of growth of economic activity and the trajectory of inflation. That said, the recovery from the 2001 recession appears to be firmly on track. Accordingly, this seems to be a good time to take stock of what we should learn from recent business-cycle experience. In particular, we have experienced two “jobless” recoveries. Are these the new norm? The question is of more than academic interest. A change in business-cycle dynamics might dictate important changes in the conduct of monetary policy. As usual, the remarks I make today represent my own views, which are not necessarily shared by other members of the Board of Governors or of the Federal Open Market Committee. Distinctive features of the current recovery A truism among students of business cycles is that no two cycles are ever exactly the same, and the current recovery has been unusual in several respects. For some time after the recovery began, businesses were reluctant to increase expenditures for fixed capital and to re-stock inventories. Business fixed investment usually jumps shortly after a business-cycle trough, as firms that held back during the recession rush to put new equipment in place to replace aging equipment and to meet the expected surge in demand. For example, in the year-and-a-half after each of the six troughs between 1958 and 1982, business fixed investment rose at an average annual rate of 7-1/2 percent. But in the year-and-a-half after the trough of the 2001 recession, firms actually decreased investment at an annual rate of ¾ percent; this decline occurred in addition to the sharp fall in capital spending (relative to GDP) that took place during the recession. Likewise, investment in business inventories, which had subtracted more than 1 percentage point from real GDP growth, on average, during the six quarters leading up to the trough, failed to snap back in its usual fashion. Instead, the inventory stock was little changed, on balance, in the first two years of the recovery. Some of this unusual behavior probably reflects the ability of modern firms to function with leaner inventories, but firms also appear to have been acting more cautiously. A second distinctive element of this recovery involved households. The household sector remained a relatively bright spot in the economy in 2001; increases in spending for consumption goods and housing prevented the downturn in investment from generating a deeper recession. Household spending has continued to rise at a solid pace during the recovery. However, because this recession included neither the typical sharp decline in purchases of durable goods nor the usual deceleration in outlays for other types of personal consumption, we have not seen the sharp increases in these areas that often follow a trough. Indeed, real consumer spending actually rose at a greater rate during the recession than it did over the first year of the recovery. Similarly, real residential investment continued to expand during the recession, and although the rate of growth was relatively subdued, it bore no resemblance to the sharp declines that characterized every previous recession in the post-World War II period; the acceleration since the upturn began has been relatively subdued as well. However, the most noted feature of the current recovery is that employment has been below par another so-called jobless recovery. Private payroll employment, and the workweek on net, continued to fall for two years from the trough of the recession in late 2001. Private employment last month remained well below its level when the recession began, and only in May had it climbed above its level when the recession ended. This situation contrasts sharply with the beginning of most postwar recoveries (although, as I will discuss later, not with the one in the early 1990s), when employment surged. Similarly, with employment growth until recently having been wanting, the unemployment rate peaked more than a year and a half after the recession ended and has not yet fallen below its level at the time designated by the National Bureau of Economic Research as the economic trough. And quite possibly the unemployment rate has been understating the amount of slack in the labor market because labor-force participation has been unusually weak, perhaps reflecting an assessment on the part of many households that job availability would be poor for those actually in the labor market. The output growth that largely defines the recovery resulted from impressive growth in labor productivity. During the two years of falling employment, productivity in the nonfarm business sector rose about 5 percent per year. Part of this spectacular performance is typical. One expects productivity to rise quickly during the early stages of a recovery; as utilization rates rise, companies find more for their workers to do. Part of the growth of labor productivity may have to do with unusual, and transitory, hesitation on the part of businesses to hire, a topic to which I will return. Happily, however, the recent increases appear to have an important structural component as well. Whereas most recessions since World War II had no productivity growth or had outright declines, productivity during this past recession rose at a rate of more than 2 percent. And this growth was a continuation of the rapid gains that characterized the latter half of the 1990s. The favorable performance of productivity likely is related to another unusual feature of this recovery: the behavior of prices. Productivity growth in the years leading up to the business-cycle peak in early 2001 was one factor that contributed to keeping inflation low. Core prices for personal consumption expenditures advanced at an average annual rate of less than 2 percent over the two years preceding the peak - despite unemployment rates down around 4 percent. Moreover, prices decelerated during the recovery. At this time last year we observed core PCE inflation in the vicinity of 1 percent. In fact, inflation was so low, especially once known biases in the price indexes are taken into account, that for several months the FOMC was concerned more about the possibility of “inflation becoming undesirably low” than about the risk of a rise in inflation. These low rates of inflation coming into the recession and continuing into the recovery were one reason why the Federal Reserve responded so aggressively to the downturn and why we maintained a historically low federal funds rate so long after the trough. Just how aggressive was this response, relative to history? In general, comparing monetary policy responses across cyclical episodes is difficult. The natural indicator to look at, the federal funds rate, is measured in nominal terms, so that large movements in the rate of inflation can mask the underlying stance of policy. Moreover, an easing of a certain size might be considered relatively more or less aggressive depending on the magnitude and nature of the shocks hitting the economy. Still, in the current cycle, the Fed began lowering the federal funds rate two months before the official cyclical peak (as identified by the National Bureau of Economic Research) and lowered rates 450 basis points over the first year of the easing and 100 basis points over the second year. Although this total decline of 550 basis points was not the largest on record, it was large and quite early. And given the relatively small decline in output in 2001, one can easily argue that this monetary policy response was unusually aggressive. Similarities with the recovery in the early 1990s In the period since World War II, several of the earlier recoveries had one or two of these features in common with the most recent period. For example, the rebound in residential investment fell short of the typical burst in 1961, the unemployment rate remained stubbornly high in 1971, and inventory investment remained low in 1975. But no previous recovery looked quite like this one. However, the recovery following the 1990 recession stands out as similar to the current episode in several important respects. First, employment rose at a glacial pace for a year and a half after the trough in early 1991, and the unemployment rate continued to rise. Second, the business sector continued for a full year to reduce spending on fixed investment and to refrain from accumulating significant amounts of inventories. Third, household spending did not accelerate rapidly after the 1990 recession. Instead, both consumption expenditures and residential investment posted among the most-subdued recoveries in the past fifty years. One should note, however, that household expenditures did fall markedly during the 1990 recession, unlike the most recent episode. Figuring out why these two recoveries were atypically hesitant and jobless is not an easy task. Let me consider several possible explanations. One explanation for the similarity of the two most recent recoveries may be that both of these lukewarm recoveries followed shallow recessions. The shallowness of the downturns is consistent with the general moderation of the volatility of U.S. economic activity in the past twenty years, which many observers have noted. The 2001 decline in total output - only ½ percent spread over the first three quarters of the year - was so small that the level of real GDP exceeded its pre-recession peak by the first quarter of 2002. Similarly, real GDP fell only 1-1/4 percent in the 1990 recession. One could argue that, because little ground was lost during the recessions, little ground was available to be regained in the recovery phase. However, the recession of 1969-70 was not any deeper, yet investment spending and payroll employment growth shot up immediately after the trough. Accordingly, a shallow recession does not appear to guarantee a shallow recovery. A second possibility is that the labor market has changed in a way that makes jobless recoveries the new norm. For example, perhaps the pace of structural change in the demand for labor has increased over time. One could point, say, to a smaller proportion of temporary layoffs among job losers during the past two episodes as an indication that re-employment is now more likely to require changing employers than it was in earlier times. And the common perception is that workers are now more likely to have to change industries or occupations to remain employed. From a firm’s perspective, hiring new workers for different jobs rather than recalling former workers to their previous jobs is likely to involve greater up-front costs in terms of recruitment and training, and the shifts in demand that created the need for new workers mean that hiring is associated with new capital as well. In this case, firms may require greater confidence in the durability of demand for their products to be willing to incur the costs involved in hiring. Many analysts argue, however, that the labor market has become more flexible since workers have become less attached to individual firms, jobs have become more project-oriented, wage setting has become less rigid, and the use of temporary help and other “contingent” work arrangements has become more prevalent. These developments reduce the up-front costs and commitments involved in hiring and should make firms more willing to hire as demand for their products revives. Therefore, the case for structural change in the labor market as the cause of the jobless recoveries is far from conclusive. It is tempting to interpret the two recent recoveries as reflecting a fundamental shift in the behavior of the economy or the labor market over the business cycle. Indeed, the two explanations for slow economic recoveries that I have discussed - shallower recessions and structural change in the labor market - likely contain some elements of the truth. However, the structure of the economy is always in flux to some extent, and I think it probable that experiencing two hesitant recoveries in a row was largely a matter of coincidence. In each case, idiosyncratic factors that were specific to each episode combined in a way that inhibited the economic expansion in important sectors when other fundamentals would have favored a more typical cyclical upturn. I will discuss these factors now. Idiosyncratic factors inhibiting recoveries The strength of a recovery may be related to the nature of the shocks that led the economy into recession. In contrast to earlier recessions, which were often sparked by tightening monetary policy, the 1990 recession was triggered by a pullback in aggregate demand not induced by monetary policy. In 1990, oil prices increased and consumer confidence dropped sharply; both occurrences were at least partly related to the Iraqi invasion of Kuwait. In response, consumer spending dropped sharply. Although the Federal Reserve had tightened policy in the late 1980s to restrain price pressures, it was loosening again by mid-1989. Similarly, before the 2001 downturn, the Federal Reserve was not aggressively tightening. Rather, the 2001 recession seems to have been kicked off by unreasonable expectations about the profitability of investment in technology related to the Internet. One manifestation of these overly optimistic expectations was that the nominal share of high-tech investment in overall equipment and software spending rose from about 35 percent in the mid-1990s to almost 45 percent by the end of 2000. By the time more-sober assessments of the profitability of the high-tech sector came to the fore, huge sums of money had been sunk into capital equipment and software and into new enterprises. A serious reconsideration of these expenditures contributed to a sharp retrenchment of business investment. Although the causes of these two most recent recessions were clearly different, they were similar along one important dimension: Both were related to changes in the subjective appraisals by persons and businesses of fundamental economic prospects, and to heightened uncertainty about those prospects. In real time, it is extraordinarily difficult to determine the likely severity and duration of these types of shocks. Using monetary policy to counter a shock of this nature is not as straightforward as reversing an earlier tightening. In retrospect, it is clear that during the two most recent recoveries these subjective views improved and uncertainty abated only slowly. Therefore, the first idiosyncratic reason why these recoveries were tepid was likely that the preceding recessions were caused by shocks that proved to have longer-lasting effects and that were more difficult to counteract than expected. In the wake of the two recent downturns, further idiosyncratic shocks hit the economy, exacerbating the sluggishness of the recoveries. In the early 1990s, the collapse of savings and loan institutions and the need to repair the capital structure of the banking industry led to a period in which the flow of credit to businesses was impaired - the so-called credit crunch. Facing limited access to credit, businesses - especially small businesses - curtailed hiring and capital expenditures. After the trough in 2001, the banking industry was much sounder. However, the economy was still adjusting to the excess capital spending from the late 1990s. Equipment takes years to depreciate; so when firms realized that they had purchased more than they needed, they did not feel compelled to raise their level of capital expenditures again for quite some time. Indeed, this “overhang” of capital has likely contributed to the impressive growth in productivity over the past few years, as businesses have made more and better use of the high-tech equipment they had previously installed but underexploited. Besides the boom-bust cycle in capital spending, the U.S. economy confronted the terrorist attacks of 2001, the corporate governance scandals of 2002, and the 2003 war in Iraq. Clearly, such an uncertain and risky environment, which led many firms to question the durability and strength of the recovery, encouraged neither the creation of new jobs nor the expansion of capacity. This discussion of the post-recession shocks that damped the pace of the most recent two recoveries does not imply that similar obstacles were absent in earlier recoveries. The early stages of previous recoveries also contained events that legitimately raised concerns about the vitality and viability of the upturns. Indeed, at the beginning of each recovery for at least the past fifty years, some observers expressed concern that various factors might result in a tepid recovery. In 1982, for instance, as the United States emerged from recession, growth in the rest of the world was moribund, and the international financial system was considered fragile. Other concerns were that the length of the recession would make consumers and businesses cautious and that changes in the economy would lead to prolonged structural unemployment. In 1975, concerns were that the recovery would be weak because businesses were still adjusting to higher oil prices and pollution regulations and because several large cities (most famously New York) were having serious financial troubles. In addition, the housing industry was threatened by a large inventory of unsold homes as well as difficulties obtaining financing after the collapse of the market for real estate investment trusts. Even after the relatively mild recession of 1969-70, a speculative crisis in foreign exchange markets and apprehensions on the part of businesses about just-enacted wage and price controls and environmental regulations fueled some pessimism about the prospects for a quick recovery. Geopolitical tensions, which may seem like a distinctive feature of the past two business cycles, also weighed on analysts’ minds following the cyclical troughs in 1961 and 1958. The 1961-62 recovery coincided with the building of the Berlin Wall, the resumption of nuclear weapons testing in the Soviet Union, and other incidents that heightened Cold War tensions in various parts of the world. The 1958-59 recovery coincided with a crisis in the Middle East that involved the entry of U.S. troops into Lebanon as well as a crisis in the market for Treasury securities that kept Fed observers, at least, on the edges of their seats. Thus, adverse conditions and events were certainly not confined to the two most recent recoveries. In the earlier cases I have just noted, however, these headwinds did not, in the event, result in sluggish recoveries. Given the disparate nature of the shocks across these episodes, one cannot say with certainty why the particular combinations of factors in the most recent cases led to a different outcome. The upshot for policy, unfortunately, is that clearly identifying both the possible obstacles to a recovery and the ramifications of those obstacles is extremely difficult, if not impossible. Conclusion In summary, delayed and sluggish improvements in the labor market, business equipment investment, and inventory accumulation mark the two most recent recoveries as different from other recoveries after World War II. Why these most recent two recoveries have been atypically hesitant and jobless is unclear. As I have discussed, the shallowness of the recessions and the possible structural changes in the labor market may have played some role. However, I think that important weight should be given to idiosyncratic features such as the causes of the preceding recessions and the occurrence of additional shocks after the recessions ended that exacerbated the economy’s problems. This view implies that monetary policymaking probably does not need to be altered in a systematic way to accommodate a new sort of business-cycle dynamics. On the contrary, the fact that the two most recent recoveries have involved slow job growth in their initial stages may best be attributed to chance rather than a new structure of the economy. Each recovery faces its own obstacles, and understanding the forces acting on the economy at any point requires continual monitoring of a wide range of indicators of economic activity, household and business attitudes, financial market developments, and price pressures. In all cases, however, the touchstone guiding policy should be the mandate given to the Federal Reserve: a foundation of stable prices underpinning maximum sustainable growth.
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Opening remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, 27 August 2004.
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Alan Greenspan: Economic implications of population aging Opening remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, 27 August 2004. * * * I am pleased to be here this morning to discuss the economic implications of population aging and to provide a general overview of some of the issues that will be covered in much greater detail over the next two days. The so-called elderly dependency ratio - the ratio of older adults to younger adults - has been rising in the industrialized world for at least 150 years. The pace of increase slowed greatly with the birth of the baby-boom generation after World War II. But elderly dependency will almost certainly rise more rapidly as that generation reaches retirement age. The changes projected for the United States are not as dramatic as those projected for other areas particularly Europe and Japan - but they nonetheless present substantial challenges. The growth rate of the working-age population in the United States is anticipated to slow from about 1 percent per year today to about 1/4 percent per year by 2035. At the same time, the percentage of the population that is over 65 is poised to rise markedly - from about 12 percent today to perhaps 20 percent by 2035. These anticipated changes in the age structure of the population and workforces of developed countries are largely a consequence of the decline in fertility that occurred after the birth of the baby-boom generation. The fertility rate in the United States, after peaking in 1957 at about 3-1/2 births over a woman’s lifetime, fell to less than 2 by the early 1970s and then rose to about 2.1 by 1990.1 Since then, the fertility rate has remained close to 2.1, the so-called replacement rate that is, the level of the fertility rate required to hold the population constant in the absence of immigration or changes in longevity. Fertility rates in Europe, on the whole, and in Japan have fallen far short of the replacement rate. The decrease in the number of children per family since the end of the baby boom, coupled with increases in life expectancy, has inevitably led to a projected increase in the ratio of elderly to working-age population throughout the developed world. The populations in most developing countries likewise are expected to have a rising median age but to remain significantly younger and doubtless will grow faster than the populations of the developed countries over the foreseeable future. Eventually, declines in fertility rates and increases in longevity may lead to similar issues with aging populations in what is currently the developing world but likely only well after the demographic transition in the United States and other developed nations. * * * The aging of the population in the United States will significantly affect our fiscal situation. Most observers expect Social Security, under existing law, to be in chronic deficit over the long haul; however, the program is largely defined benefit, and so the scale of the necessary adjustments is limited. The shortfalls in the Medicare program, however, will almost surely be much larger and much more difficult to eliminate. Medicare faces financial pressure not only from the changing composition of the population but also from continually increased per recipient demand for medical services. The combination of rapidly advancing medical technologies and our current system of subsidized third-party payments suggests continued rapid growth in demand, though future Medicare costs are admittedly very difficult to forecast. Although the sustainability of fiscal initiatives is generally evaluated for convenience in financial terms, sustainability rests, at root, on the level of real resources available to an economy. The resources available to fund the sum of future retirement benefits and the real incomes of the employed will The fertility rate used here is the total fertility rate. It is measured as the average number of children who would be born to a woman over her lifetime if she experienced the birth rates by age observed in any given year. depend, of course, on the growth rate of labor employed plus the growth rate of the productivity of that labor. The growth rate of the U.S. working-age population is expected to decline substantially over the next two decades and to remain low thereafter. But the fraction of that population that is employed will almost surely be affected by changes in the economic returns to working and, especially for older workers, improvements in health. Americans are not only living longer but also generally living healthier. Rates of disability for those over 65 years of age have been declining even as the average age of the above-65 population is increasing. This decline in disability rates reflects both improvements in health and changes in technology that accommodate the physical impairments associated with aging. In addition, work is becoming less physically strenuous but more demanding intellectually, continuing a century-long trend toward a more-conceptual and less-physical economic output. For example, in 1900, agricultural and manual laborers composed about three-quarters of the workforce. By 1950, those types of workers accounted for one-half of the workforce, and though still critical to a significant part of our economic value-added, today compose only about one-quarter of our workforce. To date, however, despite the improving feasibility of work at older ages, Americans have been retiring at younger ages. But rising pressures on retirement incomes and a growing scarcity of experienced labor could eventually reverse that trend. Of course, immigration, if we choose to expand it, could also lessen the decline of labor force growth in the United States. As the influx of foreign workers that occurred in response to the tight labor markets of the 1990s demonstrated, U.S. immigration does respond to evolving economic conditions. But to fully offset the effects of the decline in fertility, immigration would have to be much larger than almost all current projections assume. * * * It is thus heightened growth of output per worker that offers the greatest potential for boosting U.S. gross domestic product to a level that would enable future retirees to maintain their expected standard of living without unduly burdening future workers. Productivity gains in the United States have been exceptional in recent years. But, for a country already on the cutting edge of technology to maintain this pace for a protracted period into the future would be without modern precedent. One policy that could enhance the odds of sustaining high levels of productivity growth is to engage in a long overdue upgrading of primary and secondary school education in the United States. We obviously cannot attribute recent productivity trends to a high level of national saving. Rather, the effectiveness with which we have invested both domestic saving and funds attracted from abroad is the apparent source of our decade-long rise in productivity growth. As I have noted previously, the bipartisan policies of recent decades directed at deregulation and increasing globalization and the innovation that those policies have spurred have markedly improved our ability to channel saving to its most productive uses, and as a byproduct increased the flexibility and the resiliency of the U.S. economy. It is, of course, difficult to separate rates of return based on the innovations embedded in new equipment from the enhanced returns made available by productive ideas of how to rearrange existing facilities. From an accounting perspective, efficiency gains, broadly defined as multifactor productivity, have accounted for roughly half the growth in labor productivity in recent years. Capital deepening accounts for most of the remainder. All else being equal, domestic investment would raise future labor productivity and thereby help provide for our aging population. But the incremental benefit of additional investment may itself be affected by aging. With slowed labor force growth, the amount of new equipment that can be used productively could be more limited, and the return to capital investment could decline as a consequence. Yet it is possible that the return to certain types of capital - particularly those embodying new labor-saving technologies - could increase. Although domestic investment has accounted for only half our recent productivity gains, its contribution has historically been much larger. Should the pace of efficiency gains slow, it would fall to the level of investment to again become the major contributor to productivity gains. Investment, however, cannot occur without saving. But maintaining even a lower rate of capital investment growth will likely require an increased rate of domestic saving because it is difficult to imagine that we can continue indefinitely to borrow saving from abroad at a rate equivalent to 5 percent of U.S. gross domestic product. A key component of domestic saving in the United States in future decades will be the path of the personal saving rate. That rate will depend on a number of factors, especially the behavior of the members of the baby-boom cohort during their retirement years. Over the post-World War II period, the elderly in the United States, contrary to conventional wisdom, seem to have drawn down their accumulated wealth only modestly. Apparently retirees spend at a lesser rate and save more than is implicit in the notion that savings are built up during the working years to meet retirement needs. Perhaps, people mis-estimate longevity or desire a large cushion of precautionary savings. Moreover, often people bequeath a significant proportion of their savings to their children or others rather than spend it during retirement. If the baby-boom generation continues this pattern, achieving a higher private domestic saving rate is not out of reach. Even so, critical to national saving will be the level of government, specifically federal government, saving. * * * A doubling of the over-65 population by 2035 will substantially augment unified budget deficits and, accordingly, reduce federal saving unless actions are taken. But how these deficit trends are addressed can have profound economic effects. For example, aside from suppressing economic growth and the tax base, financing expected future shortfalls in entitlement trust funds solely through increased payroll taxes would likely exacerbate the problem of reductions in labor supply by diminishing the returns to work. By contrast, policies promoting longer working life could ameliorate some of the potential demographic stresses. Changes to the age for receiving full retirement benefits or initiatives to slow the growth of Medicare spending could affect retirement decisions, the size of the labor force, and saving behavior. In choosing among the various tax and spending options, policymakers will need to pay careful attention to the likely economic effects. * * * The relative aging of the population is bound to bring with it many changes to the economy of the United States - some foreseeable, many probably not. Inevitably it will again require making difficult policy choices to balance competing claims. The decade-long acceleration in productivity and economic growth has seemingly muted the necessity of making such choices. But, as I noted earlier, history discourages the notion that the pace of growth will continue to increase. Though the challenges of prospective increasingly stark choices for the United States seem great, the necessary adjustments will likely be smaller than those required in most other developed countries. But how and when we adjust will also matter. Early initiatives to address the economic effects of baby-boom retirements could smooth the transition to a new balance between workers and retirees. As a nation, we owe it to our retirees to promise only the benefits that can be delivered. If we have promised more than our economy has the ability to deliver to retirees without unduly diminishing real income gains of workers, as I fear we may have, we must recalibrate our public programs so that pending retirees have time to adjust through other channels. If we delay, the adjustments could be abrupt and painful. Because curbing benefits once bestowed has proved so difficult in the past, fiscal policymakers must be especially vigilant to create new benefits only when their sustainability under the most adverse projections is virtually ensured. * * * Responding to the pending dramatic rise in dependency ratios will be exceptionally challenging for the policymakers in developed countries. While I do not underestimate the difficulties that we face in the United States, I believe that, given the political will, we are better positioned than most others to make the necessary adjustments. Aside from the comparatively lesser depth of required adjustment, our open labor markets should respond more easily to the changing needs and abilities of our population; our capital markets should allow for the creation and rapid adoption of new labor-saving technologies, and our open society should be receptive to immigrants. These supports should help us adjust to the inexorabilities of an aging population. Nonetheless, tough policy choices lie ahead.
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Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on the Budget, US House of Representatives, Washington, 8 September 2004.
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Alan Greenspan: Economic outlook Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on the Budget, US House of Representatives, Washington, 8 September 2004. * * * Mr. Chairman and members of the committee, I am pleased to be here today to offer my views on the state of the U.S. economy and current fiscal issues. I speak for myself and not necessarily for the Federal Reserve. As you know, economic activity hit a soft patch in late spring after having grown briskly in the second half of 2003 and the first part of 2004. Consumer spending slowed materially, and employment gains moderated notably after the marked step-up in early spring. That softness in activity no doubt is related, in large measure, to this year’s steep increase in energy prices. The most recent data suggest that, on the whole, the expansion has regained some traction. Consumer spending and housing starts bounced back in July after weak performances in June, although early readings on retail sales in August have been mixed. In addition, business investment remains on a solid upward trend. In the manufacturing sector, output has continued to move up in recent months, though part of that rise likely reflected an increase in inventory investment. In the labor market, though job gains were smaller than those of last spring, nonfarm payroll employment growth picked back up in August. Despite the rise in oil prices through mid-August, inflation and inflation expectations have eased in recent months. To be sure, unit labor costs rose in the second quarter as productivity growth slowed from its extraordinary pace of the past two years and employee compensation per hour remained on an upward trend. But, as best we can judge, the growth in profit margins of non-energy, nonfinancial, corporations, which, at least from an accounting perspective, had contributed significantly to price pressures earlier, has recently slowed. Moreover, increases in non-oil import prices have lessened - a development that, coupled with the slowing of profit-margin growth, has helped to lower core consumer price inflation in recent months. *** Movements in energy prices have been a major influence on overall inflation this year. In the second quarter, gasoline prices rose rapidly as a marked pickup in gasoline demand strained refinery capacity and resulted in sharply higher profit margins. In May and June, refinery and marketing margins rose to levels that were 25 cents to 30 cents per gallon over typical spreads going into the summer driving season. As a consequence of the steep run-up in prices, demand for gasoline eased, and an accompanying increase in inventories helped to reverse the bulge that had occurred in refinery and marketing margins. That reduction in margins resulted in a decline in the price of regular gasoline of about 20 cents per gallon despite the concurrent sharp rise in the price of crude oil. With margins having returned to more-typical levels, prices of both gasoline and home heating oil are likely to reflect changes in crude oil prices more directly. *** Evaluating the impact of rising oil prices on economic activity in the United States has long been a subject of dispute among economists. Most macroeconomic models treat an increase in oil prices as a tax on U.S. residents that saps the purchasing power of households and raises costs for businesses. But economists disagree about the size of the effects, in part because of differences in the key assumptions employed in the statistical models that underlie the analyses. Moreover, the models are typically based on average historical experience, which is dominated by periods of only moderate fluctuations in oil prices and thus may not adequately capture the adverse effects on the economy of oil price spikes. In addition to the difficulties of measuring the impact of oil prices on economic growth, the oil price outlook itself is uncertain. Growing concerns about the long-term security of oil production in the Middle East, along with heightened worries about the reliability of supply from other oil-producing regions, led to a pronounced increase in the demand to hold inventory at a time when the level of world commercial oil stocks was rising only modestly. Some of that increased demand came from investors and speculators who took on larger net long positions in crude oil futures, especially in distantly dated contracts. Crude oil prices accordingly rose sharply, which, in turn, brought forth increased production from OPEC and induced some investors to take profits on long inventory positions. The resulting reduction in the speculative demand for inventories has, at least temporarily, reduced pressures in these markets, and crude prices have come off from their highs of mid-August. Nevertheless, the outlook for oil prices remains uncertain. Higher prices have damped the consumption of oil - for example, U.S. gasoline consumption, seasonally adjusted, fell about 200,000 barrels a day between April and July. But the growing concerns about long-term supply, along with large prospective increases in demand from the rapidly growing economies of China and India, both of which are expanding in ways that are relatively energy intensive, have propelled prices of distant futures to levels well above their ranges of recent years. Meanwhile, despite the paucity of new discoveries of major oil fields, improving technology has significantly increased the ultimate recovery of oil from already existing fields. During the past decade, despite more than 250 billion barrels of oil extracted worldwide, net proved reserves rose well in excess of 100 billion barrels. That is, gross additions to reserves have significantly exceeded the extraction of oil the reserves replaced. Indeed, in fields where, two decades ago, roughly one-third of the oil in place ultimately could be extracted, almost half appears to be recoverable today. Gains in proved reserves have been concentrated among OPEC members, though proved reserves in the United States, essentially offshore, rose 3-1/2 percent during the past five years. The uptrend in proved reserves is likely to continue at least for awhile. Oil service firms continue to report significant involvement in reservoir extension and enhancement. Nevertheless, future balances between supply and demand will remain precarious, and incentives for oil consumers in developed economies to decrease the oil intensity of their economies will doubtless continue. Presumably similar developments will emerge in the large oil-consuming developing economies. *** The remainder of my remarks will address the federal budget, for which the incoming data suggest that the unified deficit has recently leveled out. With the economy continuing to improve, the deficit is more likely to decline than to increase in the year ahead. Nonetheless, the prospects for the federal budget over the longer term remain troubling. As yet, concerns about the budget do not appear to have left a noticeable imprint on the financial markets. In recent years, even as fiscal discipline has eroded, implied one-year forward Treasury rates at long horizons, which history suggests are sensitive to changes in the fiscal outlook, have held fairly steady. Various measures of long-term real interest rates have also remained at moderate levels over this period. These developments, however, do not warrant complacency about the fiscal outlook. With the baby boomers starting to retire in a few years and health spending continuing to soar, our budget position will almost surely deteriorate substantially in coming years if current policies remain in place. The enormous improvement of the federal budget balance in the second half of the 1990s and early in the current decade was due importantly to the rapid growth in labor productivity during that period, which led, both directly and indirectly, to a vast but, in retrospect, temporary increase in revenues. The Budget Enforcement Act (BEA) of 1990, and the later modifications and extensions of the act, almost surely contributed to the better budget outcomes as well, before the brief emergence of surpluses eroded the will to adhere to its deficit-containment rules. The key provisions of the BEA expired in 2002, and no replacement has been adopted. Reinstatement of a structure like the BEA would signal a renewed commitment to fiscal restraint and would help restore discipline to the annual budgeting process. But it would be only a part of any meaningful endeavor to establish a framework for fiscal policy choices. The BEA was designed to constrain legislative actions on new initiatives. It contained no provisions for dealing with unanticipated budgetary outcomes over time. It was also not designed to be the centerpiece for longer-run budget policy; importantly, the BEA did not set a clear objective toward which fiscal policy should aim. Budget outcomes over the next decade will deviate, as they always have from projections - perhaps, significantly. Accordingly, it would be quite helpful to have mechanisms in place that assist the Congress in making mid-course corrections as needed. Four or five decades ago, such mechanisms were unnecessary, in part because much of the budget was determined on an annual basis. Indeed, in the 1960s, discretionary spending, which is subject to the annual appropriations process and thus comes under regular review by the Congress, accounted for about two-thirds of total outlays. That share dropped markedly in the 1970s and 1980s as spending on retirement, medical, and other entitlement programs rose sharply. In the early 1990s, it fell below 40 percent, where it has remained over the past decade. The rise in the share of expenditures that is not subject to annual review complicates the task of making fiscal policy by effectively necessitating an extension of the budget planning horizon. In the 1960s and early 1970s, the President’s budgets provided information mainly for the upcoming fiscal year. The 1974 legislation that established a new budget process and created the Congressional Budget Office required that CBO provide five-year budget projections. By the mid-1990s, CBO’s projection horizon had been pushed out to ten years. Given the changing composition of outlays, these longer planning horizons and the associated budget projections were essential steps toward allowing the Congress to balance budget priorities sensibly. Among other things, this change has made the budget process more reliant on forecasting. To be sure, forecasting has become more sophisticated as statistical techniques and economic models have evolved. But because of the increasing complexity of our markets, the inaccuracy of forecasts especially those that go beyond the near term - is a large problem. A well-designed set of measures for mid-course corrections would likely include regular assessments of existing programs to verify that they continue to meet their stated purposes and cost projections. Although the vast majority of existing programs would doubtless be extended routinely, some that face appreciable opposition and offer limited societal benefit might not clear hurdles set by the Congress unamended, if at all. More generally, mechanisms, such as triggers, to bring the budget back into line if it goes off track should be considered, particularly measures that force a mid-course correction when estimated future costs for a program or tax provision exceed a specified threshold. I do not mean to suggest that our budget problems will be solved simply by adopting a set of budget rules that restrain new legislation - even if those rules are augmented by effective mechanisms for making mid-course corrections. The fundamental challenge that we face is to come to grips with the adverse budgetary implications of an aging population and current health entitlements and with the limits on our ability to project the likely path of medical outlays. The rapid increase in revenues during the 1990s significantly muted the necessity of making choices between high-priority tax and spending initiatives. In the context of an unprecedented increase in retirees, the need to make stark choices among budget priorities will again become pressing. Federally funding access to advances in medical technology, for example, likely will have to be weighed against other spending programs as well as tax initiatives that foster increases in economic growth and the revenue base. Because the baby boomers have not yet started to retire in force and accordingly the ratio of retirees to workers remains relatively low, we are in a demographic lull. But short of an outsized acceleration of structural productivity or a major expansion of immigration, this state of relative tranquility will soon end. In 2008 - just four years from now - the leading edge of the baby-boom generation will reach 62, the earliest age at which Social Security retirement benefits may be claimed and the age at which about half of prospective beneficiaries have retired in recent years. In 2011, these individuals will reach 65 and will thus be eligible for Medicare. The pressures on the federal budget from these demographic changes will come on top of those stemming from the relentless upward trend in expenditures on medical care. Indeed, outlays for Medicare and Medicaid have grown much faster than has nominal GDP in recent years, and no significant slowing seems to be in the offing. In 2003, outlays for Social Security and Medicare amounted to about 7 percent of GDP; according to the programs’ trustees, by 2030 that ratio will nearly double. Moreover, such projections are subject to considerable uncertainty, especially those for Medicare. Unlike Social Security, where benefits are tied in a mechanical fashion to retirees’ wage histories and we have some useful tools for forecasting future benefits, the possible variance in medical spending rises dramatically as we move into the next decade and beyond. As with Social Security, forecasting the number of Medicare beneficiaries is reasonably straightforward. But we know very little about how rapidly medical technology will continue to advance and how those innovations will translate into future spending. Technological innovations can greatly improve the quality of medical care and can, in some instances, reduce the costs of existing treatments. But because technology expands the set of treatment possibilities, it also has the potential to add to overall spending - in some cases, by a great deal. Other sources of uncertainty - for example, about how longer life expectancies among the elderly will affect medical spending - may also turn out to be important. As a result, the range of future possible outlays per recipient is extremely wide. Developing ways to deal with these uncertainties will be a major part of an effective budget strategy for the longer run. Critical to that evaluation is the possibility that, as a nation, we may have already made promises to coming generations of retirees that we will be unable to fulfill. If, on further study, that possibility turns out to be the case, it is imperative that we make clear what real resources will be available so that our citizens can properly plan their retirements. This problem raises a more-general principle of public policy prudence. If, as history strongly suggests, entitlement benefits and tax credits, once bestowed, are difficult to repeal, consideration should be given to developing a framework that recognizes that potential asymmetry. *** Re-establishing an effective procedural framework for budgetary decisionmaking should be a high priority. But it is only a start. As we prepare for the retirement of the baby-boom generation and confront the implications of soaring expenditures for medical care, a major effort by policymakers to set priorities for tax and spending programs and to start making tradeoffs is long overdue. The significant improvement in the budget in the 1990s reflected persistent efforts on the part of this committee and others. If similar efforts are made now, they should assist in preparing our economy for the fiscal challenges that we will face in the years ahead.
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Testimony of Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, before the Committee on Financial Services, US House of Representatives, Washington, 8 September 2004.
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Mark W Olson: Protecting the financial infrastructure Testimony of Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, before the Committee on Financial Services, US House of Representatives, Washington, 8 September 2004. * * * Introduction Thank you Chairman Oxley and Ranking Member Frank, for inviting me to discuss a matter of significant importance to our country: protecting our financial infrastructure. As we approach September 11, I would like to take a moment to honor the memory of those who lost their lives and to honor those who supported one another on September 11, 2001. Although the financial sector has years of experience dealing with operational disruptions caused by weather, power, and other critical infrastructure outages, the September 11 attacks had a profound effect on how the industry thinks about physical and cyber security as well as business-continuity planning. After the crisis subsided, sector participants, including the Federal Reserve, reflected on lessons learned and how they should be incorporated into daily business processes and business-resumption planning. My remarks today will highlight the actions the Federal Reserve took on September 11 and immediately following to maintain confidence in and restore the operation of our financial system. I will also focus on numerous steps that we and the other financial regulators have taken since September 11 to improve the resilience of - and to protect - the financial infrastructure. Response to September 11 On Tuesday, September 11, terrorists destroyed a portion of the critical infrastructure that supports the U.S. financial markets, disrupted communications networks, and forced numerous market participants to move to contingency sites. These challenges, along with the tragic loss of employees of a few major financial firms, complicated trading, clearing, and settlement of a number of financial instruments. Operational disruptions caused uncertainties about payment flows, making it difficult for the reserve market to channel funds to where they were needed most. Depository institutions that held more reserve balances than they preferred had difficulty placing and delivering the excess in the market; on the other hand, depository institutions awaiting funds had to scramble to cover overdraft positions. As a result, market participants experienced significant liquidity dislocations, and the demand for reserves grew rapidly. The Federal Reserve accommodated the demand for reserves through a variety of means, the relative importance of which shifted through the week. On Tuesday morning, shortly after the attacks, the Federal Reserve issued a press release stating that “the discount window is available to meet liquidity needs,” thus reassuring financial markets that the Federal Reserve System was functioning normally. Borrowing by depository institutions surged to a record $45.5 billion by Wednesday. Federal Reserve discount loans to banks to meet liquidity needs dropped off sharply on Thursday and returned to lower levels by Friday. Separately, overnight overdrafts on Tuesday and Wednesday rose to several billion dollars, as a handful of depository and other institutions with accounts at the Federal Reserve were forced into overdraft positions on their reserve accounts. Overdrafts returned to negligible levels by the end of the week. Like their U.S. counterparts, foreign financial institutions operating in the United States faced elevated dollar liquidity needs. In some cases, however, these institutions encountered difficulties positioning the collateral at their U.S. branches to secure Federal Reserve discount window credit. To be in a position to help meet the enhanced need for funds, three foreign central banks established new or expanded arrangements with the Federal Reserve to receive U.S. dollars in exchange for their respective currencies. These swap lines, which lasted for thirty days, consisted of $50 billion for the European Central Bank, $30 billion for the Bank of England, and an increase of $8 billion (from $2 billion to $10 billion) for the Bank of Canada. The European Central Bank drew on its line that week to channel funds to institutions with a need for dollars. During that week, the disruption in air traffic caused the Federal Reserve to extend record levels of credit to depository institutions in the form of check float. Float increased dramatically because the Federal Reserve continued to credit the accounts of banks for the checks they deposited, even though the grounding of airplanes meant that checks normally shipped by air could not be presented to the checkwriters’ banks on the usual schedule. Float declined to normal levels the following week once air traffic was permitted to recommence. Finally, over the course of the week, as the market for reserves began to function more normally, the Federal Reserve resumed the use of open market operations to provide the bulk of reserves. The open market desk accommodated all propositions for funding through repurchase agreements down to the target federal funds rate, operating exclusively through overnight transactions for several days. The injection of reserves through open market operations peaked at $81 billion on Friday. The combined infusion of liquidity from the various sources caused the level of reserve balances at Federal Reserve Banks to rise to more than $100 billion on Wednesday, September 12 - about ten times the normal level. In addition to accommodating the heightened demand for reserves, the Federal Reserve took several steps to facilitate market functioning in the wake of the September 11 attacks. For example, the hours of the funds and securities transfer systems for U.S. government and agency securities operated by the Federal Reserve were significantly extended during the week after the attacks. From September 11 through the 21st, the Federal Reserve reduced or eliminated the penalty charged on overnight overdrafts, largely because those overdrafts were almost entirely the result of extraordinary developments beyond the control of the account holders. For four weeks after the attacks, the Federal Reserve Bank of New York liberalized the terms under which it would lend securities from the System portfolio, and the amount of securities lent rose to record levels in the second half of September. The Federal Reserve working with the National Communications System (NCS) also assisted market participants in restoring their telecommunications services. The markets and financial market authorities worked hard to restore operations, and market activity resumed relatively quickly after the attacks. By the week following September 11, the financial system had largely begun to function normally, although activities to address the aftermath of the attacks continued for some time. Steps taken since September 11 to protect the financial infrastructure Within weeks of September 11, we initiated a self-assessment of our contingency arrangements across the Federal Reserve and embarked on forty initiatives, which we classified under five broad headings: • Ensure continuity of Federal Reserve operations. • Ensure market liquidity during a crisis. • Ensure effective communications and coordination during a crisis. • Improve resilience of the private-sector financial system infrastructure. • Improve resilience of the telecommunications infrastructure supporting critical financial services. Some of the key steps the Federal Reserve has taken to improve our infrastructure and the delivery of critical central-bank and financial services include the following: • We have developed plans to ensure that critical central-bank activities, supervisory functions, and financial services operations have sufficient redundancy in facilities and staff. We have enhanced and tested business-continuity arrangements for critical functions and business lines. • Our facilities for providing critical financial services are backed up at fully operational, geographically diverse sites to ensure a speedy recovery even if the critical infrastructure is disrupted across multistate areas. • We have enhanced our resiliency for discount window lending and cash services provided by the Reserve Banks. • We have improved our tools and authority to provide liquidity in a crisis. In 2003, the Board established the primary credit program, as well as special arrangements for rapidly reducing the primary credit rate to the federal funds rate in an emergency. We also have improved the ability of the Board to approve the extension of emergency discount window credit. The federal financial agencies took immediate steps to work together to identify new vulnerabilities exposed by September 11. These efforts were coordinated under the umbrella of the President’s Working Group on Financial Markets, the Financial and Banking Infrastructure Information Committee (FBIIC), and, for depository institutions more specifically, the Federal Financial Institutions Examination Council (FFIEC). The agencies have implemented a duty officer program and developed communications protocols for dealing with their staffs, regulated financial institutions, and the public. We have also developed and tested facilities for secure communication among ourselves and with other agencies. The agencies that participate in FBIIC, including the Federal Reserve, and that have direct supervisory and regulatory responsibilities for the financial sector have assessed potential system vulnerabilities. We have shared that information with the Department of Homeland Security (DHS). Indeed, I would like to commend the DHS for their work to share information and coordinate with the financial sector including the FBIIC during the recent elevation of the threat level to orange for financial services firms in New York City, northern New Jersey, and Washington, D.C. The timely communications and sharing of information enabled financial-sector participants and law enforcement authorities to take steps to mitigate risks so that customers of financial services firms were able to conduct business in the usual fashion. Financial-sector participants, including the financial regulators, strengthened business-resumption plans with an overall goal of ensuring the smooth operation of the financial system. Previously, terrorist attacks were treated as low-probability/high-impact events affecting a single institution. As a result of September 11, industry participants are now planning for events that affect wide areas, last longer, and involve loss of life or widespread destruction of property and information assets. The process of strengthening the resilience of the financial system and, in particular, organizations that could have a systemic effect if they were disabled, is being accomplished through the existing regulatory framework. More than a year ago, in April 2003, the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Securities and Exchange Commission (SEC) issued an Interagency Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System. The paper formalizes a set of sound practices viewed as necessary by the agencies and the financial industry to ensure the rapid recovery of the U.S. financial system following a wide-scale disruption that may include loss or inaccessibility of staff. In particular, the paper articulates sound practices for resumption and recovery of critical clearing and settlement activities by core clearing and settlement organizations and financial institutions that play significant roles in critical markets by virtue of their market share (greater than five percent in one or more critical financial markets). The sound practices include establishing geographically dispersed backup facilities for clearing and settlement so that these organizations can meet recovery objectives within the business day if a wide-scale disruption takes place. Using their respective supervisory and regulatory processes, the agencies are conducting focused, ongoing dialogues with the organizations that are subject to the sound practices paper. Financial organizations are investing millions of dollars to implement the sound practices. Clearing and settlement organizations, which are the financial utilities for the U.S. financial system, have made substantial progress in improving their resilience and achieving out-of-region geographic dispersion between primary and backup operations facilities and data centers. Several have met or will meet the sound practices by year-end, with the remainder scheduled to complete implementation in the second half of 2005. Banks and broker-dealers that play significant roles in the critical markets defined in the paper indicate they will meet the paper’s 2006 implementation date. The sound practices are also relevant to other financial-sector participants. Many of the concepts in the paper amplify long-standing and well-recognized principles relating to safeguarding information and the ability to recover and resume essential financial services. Over the past few years, the FFIEC has revised and expanded guidance for banking organizations pertaining to operational risk. In December 2002, we issued revised guidance on information security. In April 2003, the FFIEC issued expanded guidance on business-continuity planning. The guidance addresses both the operationaland business-risk issues that depository institutions must incorporate into their business-continuity plans. The guidance specifically refers to the need to plan and test for recovery of critical business lines and functions - such as retail banking services - in the face of wide-scale disruption, as well as scenarios in which physical or information assets and personnel are lost. Recently, the FFIEC issued guidance on managing additional risks arising from information technology operations, network management, and wholesale and retail payments systems. Our examiners are assessing banks against these guidelines. Other financial market authorities are taking similar steps for the organizations that they regulate. Challenge of protection While the agencies and financial-sector participants are working to improve their operational resilience, some vulnerabilities continue to pose challenges. The strategy underlying the sound practices is to increase the likelihood that systemically critical institutions will be able to recover rapidly from a wide-scale disruption. However, the sound practices address only recovery, not the prevention of an attack. The agencies are addressing this concern by working to improve coordination and emergency planning efforts between federal, state, and local homeland security authorities; the various federal, state, and local protection agencies; and the systemically critical institutions. Efforts have focused on the locations where the systemically critical institutions have their primary operations - including New York City. The agencies also plan to work with local protection agencies in cities where critical institutions are locating backup sites. As part of these efforts, the Department of the Treasury has arranged for site surveys of key financial-services sector assets to determine whether physical security can be hardened. Protection plans have been developed and are being implemented. Importance of telecommunications to the financial services sector The resilience of the telecommunications infrastructure is, from our perspective, one of the most important national issues involving the nation’s critical infrastructure. The U.S. financial system depends on telecommunications to effect transactions and make payments. Following September 11, the Federal Reserve and the FBIIC agencies expanded and promoted the use of National Security/Emergency Preparedness (NS/EP) telecommunications programs sponsored by NCS. These programs worked well in helping to resume operations on September 11. The Federal Reserve is working with FBIIC agencies through outreach to expand NCS services to clearing and settlement organizations processing securities. Approximately 5,000 additional authorizations to ensure the priority of voice telecommunications have been issued in the financial sector. Moreover, about 4,100 critical circuits used to transmit financial data have been registered for priority restoration and provisioning of new lines; these include most circuits between the payment and settlement systems, the markets, and key market participants. The National Security/Emergency Preparedness telecommunications program operated by the NCS currently focuses on recovery and restoration. The FBIIC agencies believe that a third aspect protection - through establishment of a national program for maintaining physically diverse circuits and switches, should be incorporated into the program. Treasury has designated the Federal Reserve as the lead agency for telecommunications for the FBIIC interdependencies study. At the Federal Reserve’s request, the telecommunications sector through the National Security Telecommunications Advisory Committee (NSTAC) reviewed the resilience of the telecommunications infrastructure. In response to the NSTAC’s recommendations that were submitted to the President in April 2004, the Alliance for Telecommunications Industry Solutions (ATIS) is organizing a National Diversity Assurance Initiative. ATIS has asked the Federal Reserve to participate in a pilot program to develop and test the requirements for physical circuit diversity across multiple carriers that can be used by the financial system and potentially other critical sectors. The Federal Reserve is collaborating with telecommunications services providers through NSTAC and the Federal Communications Commission Network Reliability and Interoperability Council. As an example, the Federal Reserve is currently working with the NSTAC to plan how NS/EP telecommunications services can be applied to the next generation of telecommunications networks based on internet protocols. Summary In summary, Mr. Chairman, we believe that protecting the infrastructure that supports our financial system is a matter of national importance. As a result of careful planning and considerable investment by both the private and public sectors, the financial sector is one of the most resilient parts of our economy. The supervisory framework for the financial sector oversees compliance with security and business-resumption expectations, which are relatively high because of the importance of ensuring the smooth operation of our financial system. All financial institutions have been expected to incorporate lessons learned from September 11, recent power outages, and cyber attacks. Organizations that we believe could have a systemic effect on the financial system if their functions were disrupted are being asked to meet very high standards of business resumption. The Federal Reserve will continue to treat the protection and resilience of the sector as a key responsibility. Thank you Mr. Chairman and members of the Committee. I am happy to respond to any questions.
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Annual Economic Luncheon, Federal Reserve Bank of Kansas City, Kansas City, 16 September 2004.
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Edward M Gramlich: Oil shocks and monetary policy Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Annual Economic Luncheon, Federal Reserve Bank of Kansas City, Kansas City, 16 September 2004. * * * Oil shocks have confounded macroeconomists since they first arose on the scene in the 1970s. The oil price spikes of that time clearly had significant macroeconomic implications, representing one of the rare times that higher prices in an individual industry have importantly affected the overall macroeconomy. To account for these effects, structural-model builders had to disaggregate their systems into oil and non-oil, or energy and non-energy, sectors, dealing with effects on both the demand and the supply sides of the economy. The need to make such distinctions has greatly complicated the task of economic-model builders ever since. The challenges are even more pronounced for policymakers - fiscal or monetary. In a world where all shocks are on the demand side, policymaking boils down to finding the optimal balance between inflation and unemployment, or in modern parlance, finding the strategy that hits the optimal point on the frontier relating the variances of inflation and unemployment around their target values. Such an exercise can be quite complicated, building in all sorts of lags and expectation effects; but the basic analytical model has been around for a long time, and the reasoning is familiar. With oil shocks, policymakers are confronted with a new dilemma. Policy must then balance competing objectives in the presence of a shock that normally implies more inflation, more unemployment, or a combination thereof. In this environment, the choices become more difficult, and the public perceptions of how well stabilization policy is doing will inevitably decline. However, it is possible to distinguish between good and bad policy choices, even when no choice looks especially desirable. My remarks address these choices and how to make them. I will first review the evidence on the seriousness of oil shocks for the macroeconomy and then discuss how I think monetary policy should generally respond. I will follow this with a brief discussion of the current situation in the United States. How serious are oil shocks? Oil shocks have serious effects on the economy because they immediately raise prices for an important production input - oil - and important consumer goods - gasoline and heating oil. They are also likely to push up prices in other energy markets. These price increases are significant enough that they typically show up as temporary bursts in the overall rate of inflation. They may even get passed through to continuing rates of inflation if they become incorporated into price- and wage-setting behavior. Increases in oil prices also reduce consumer spending power, in much the same way as when a new excise tax is passed along by oil producers. To the extent that these producers are foreign, there should be a corresponding drop in domestic demand. Even if the oil producers are domestic, a drop in domestic demand could still occur if the producers do not spend as much of their new income as consumers would have or if they do not recycle their profits to shareholders. Estimating the impact of these oil shocks on the real economy can be done in at least two ways. One approach, often associated with James Hamilton, measures the reduced-form correlation between oil price movements and subsequent movements in unemployment, or output gaps.1 Such an analysis is shown in figure 1, which compares aggregate real oil prices with a measure of the overall output gap.2 The figure shows that since 1973 every upward spike in real oil prices has been followed by a jump in the output gap. However, some of these jumps seem much larger than can be accounted for by oil prices alone, and there appears not to be a symmetric macro response to downward oil price shocks. But this result is still impressive because most of these oil price shocks have been perceived as James D. Hamilton (1983), "Oil and the Macroeconomy since World War II," Journal of Political Economy, vol. 91, (April), pp. 228-48. Specifically, from a Hodrick-Prescott filter with a standard tuning parameter. temporary, as measured by the difference between the oil spot price and far futures price (discussed further below). Presumably, the macroeconomic impact would have been even more powerful for price shocks that were perceived as permanent. Hamilton and others have run a series of causality tests to these macro data and do find significant causal effects for oil prices. One can also analyze oil price shocks by using structural econometric models. These models would typically build in some sort of price-responsiveness behavior to measure pass-through effects. They would account for the effects of higher energy prices on the real disposable income and spending demands of the household sector. They would make similar calculations for business investment, working out the impact of oil prices on the cost of capital and business-cash flows, to the extent that these influence overall investment spending. When one does all this, as many economists are doing these days, one sees effects of about one-third of 1 percent on unemployment and slightly more for core inflation rates for a permanent shock in the price of oil of $10 a barrel.3 With appropriate transformations, these structural effects appear to be a good bit smaller than the implications of the reduced-form correlations. Why the difference? Many sources of discrepancy between the reduced form effects and the structural effects are possible. One involves consumers - perhaps a serious oil price shock could affect consumers’ confidence or spending plans in a way that would not be captured by working out the effect of normal income and price elasticities. Capital investment may also be affected if the oil price shock encourages producers to substitute less-energy-intensive capital for more-energy-intensive capital. Of course, such a substitution will not necessarily lower aggregate demand if it requires more investment demand for new energy-saving equipment. Oil is a pervasive commodity, and other types of non-model effects are possible, but these consumption and investment effects seem the most obvious. How should monetary policy respond to oil price shocks? Monetary policy makers in this country have a dual mandate, to stabilize prices and to maximize sustainable employment in the long run. Their response to oil price increases should focus on these two objectives. At one extreme, monetary policy makers might focus exclusively on the demand-reducing effect of oil shocks and try to stabilize unemployment rates. The risk from this approach is that prices would rise the full amount implied by the shock and would more likely be passed through into further wage and price increases. Continuing inflation rates could bump up the full amount of the initial boost in inflation. The continuing inflationary potential from the oil price shock would, in effect, be maximized. At the other extreme, monetary policy makers could focus exclusively on neutralizing the initial impact of the shock on inflation. Given the initial oil price shock, this approach would entail reducing demand enough to stabilize overall, or core, inflation rates. If prices were at all sluggish in their response to changes in unemployment, this approach could entail large increases in unemployment from the shock. Most observers would choose a policymaking approach somewhere between these two extremes. If, for example, monetary policy makers tried to keep overall nominal income on a steady path, the direct rise in nominal income from the oil price shock would be met by a fall in real income from somewhat higher unemployment. The result would be a temporary rise in both inflation and unemployment. Because the temporary rise in unemployment would damp price pressures, the chances that the initial oil price inflation would pass through into continuing inflation would be reduced. Most likely, the initial inflationary boost would prove temporary, permitting the rise in unemployment to be temporary as well. But nominal income targeting has its own deficiencies. First, since a large share of U.S. oil is imported, a significant difference could exist between the value-added price deflator comprising nominal income and more-appropriate measures of true consumer price inflation. Monetary policy makers would be better off focusing directly on these more-appropriate measures. Second, as before, if prices were highly sensitive to supply shocks but not sensitive to output movements, even nominal income targeting could imply substantial increases in unemployment. Core consumer price inflation is defined to exclude direct energy and food prices and hence more accurately measures the continuing effect of an oil price shock. A better approach would be to follow a policy rule based directly on target values of unemployment and some appropriate measure of inflation. One example is a Taylor rule, under which monetary policy makers would move the short-term target interest rate - the federal funds rate in the United States - up or down to respond to deviations in core inflation and unemployment from their target values.4 The results would be qualitatively similar to those of the nominal income targeting rule, with a temporary rise in both inflation and unemployment, though the increases would now be more keyed to underlying monetary policy objectives. Because of the offsetting policy reactions, the real federal funds rate would be likely to remain approximately constant during this chain of events. If it did, the nominal funds rate would first rise and then fall with the inflation rate itself. While not a perfect outcome, this targeted intermediate approach is probably about the best that can be done. Were policy to try to avoid any rise in unemployment, the initial oil price shock might get passed through to continuing inflation. Were policy to try to avoid any rise in inflation, the movement in unemployment would be substantial. The best approach is likely to be to accept some temporary rise in both inflation and unemployment, with the increases being based on underlying objectives. The rises would be temporary so long as inflation did not persistently deviate from its long-term price-stability target. But even in this preferred approach, the widely watched nominal federal funds rate would likely rise for a time. Current events With that backdrop, I will now turn to the current situation. As shown in figure 2, the spot price of oil (solid line) has recently spiked up, as it has several times since 1985.5 But in contrast to most other oil-price-spike episodes, this time the far futures price of oil - that is, the price for contracts seven years out - has also risen sharply. This correlation seems to indicate that the present oil price increase is not viewed as a purely temporary shock. At the same time, as shown in figure 3, which plots the difference between the spot price and the futures price, the current price is still greater than the far futures price, representing a phenomenon known as backwardation.6 Because of such backwardation, this oil price shock still seems to have an important temporary component. One question that arises immediately is whether the source of the shock matters. In the 1970s and 1980s, most oil shocks seemed clearly to be on the supply side in that international producers withheld production from the world market, either because of attempts to gain more oil revenue or because of other supply interruptions, such as the Iranian Revolution. Today, the high price of oil is much more likely to be due to demand growth in the United States, China, India, and other countries. Does the source matter when trying to determine how monetary policy should respond? If the demand growth that caused the oil price increases is domestic, it could mean that the price shock might be less permanent. The high oil prices would themselves cut into demand growth and tend to stabilize the system. If the demand growth is foreign, say from China and India, this feedback effect is still present but damped. Even foreign demand for oil might be influenced by reduced demand growth in the United States and its trading partners. It is certainly possible that oil shocks partially motivated by demand may be less permanent than true supply shocks, though that reasoning is contradicted by current-day oil futures prices. This whole issue, however, is new and imperfectly understood. It is not much of a silver lining, but the present price burst might provide some information on the qualitative difference between domestic and international demand and supply shocks. A second question is whether the present shock is large enough to cause macroeconomic ripples. As figure 1 shows, even the present high real price of oil is only about half the real price in 1980, and the importance of energy in the overall economy is also less than half what it was then. At the same time, figure 2 suggests that the permanent oil price rise is on the order of $15 a barrel. Since the United States now imports 4.5 billion barrels of oil per year, this price rise makes for an effective reduction in Named after John B. Taylor (1983), "Discretion versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 195-214. Astute chart-gazers will note that the commonly quoted price in figure 2, for a barrel of west Texas intermediate crude oil, is higher than the current price of oil in gross domestic product shown in figure 1. That is because, on average, the United States uses a lower quality of oil in its production of total output. A stock exchange term for a percentage paid by a seller of stock for the privilege of delaying its delivery until some agreed on future date. In effect, the futures price is less than the spot price. domestic income of $68 billion. To the extent that dollars going to domestic oil producers are not fully recycled, the effective demand reduction could be even greater. There could also be important parallel effects in natural gas and other markets. The rise in consumer prices from all these sources, as well as the reduction in aggregate demand, could be noticeable. All things considered, although the present oil shock may not be as significant as the shocks we remember from the 1970s and 1980s, it will definitely register. A final issue involves the initial position of the economy and monetary policy. In the usual exercise, one analyzes the economy in some sort of equilibrium position and posits an oil price shock, which normally results in the temporary increases in inflation and unemployment described earlier. When monetary policy begins with inordinately low nominal interest rates, the reasoning becomes more complicated. Now the response to the oil shock is, in effect, superimposed on any re-equilibration process built in for monetary policy. The ultimate response of the economy will blend the two responses, though not additively because of the complicated nonlinear structure of the economy. The net effect of these factors is difficult to perceive in any more than broad outline. Without the oil shock, policymakers beginning from a period of low interest rates would try to keep the economy on an even growth path as they gradually raised nominal interest rates. With the shocks, nominal rates would still likely follow an upward path, though the economic reactions would be bumpier, with temporary rises in both inflation and unemployment. Conclusion As a new economic event of the 1970s, oil price shocks forced monetary policy makers to rethink all their rules and added new chapters to macroeconomic textbooks. Today the question of how to respond to oil price spikes is better understood, but the outcomes are no more pleasant. It is virtually inevitable that shocks will result in some combination of higher inflation and higher unemployment for a time. But I must stress that the worst possible outcome is not these temporary increases in inflation and unemployment. The worst possible outcome is for monetary policy makers to let inflation come loose from its moorings.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Bond Market Association¿s Regional Bond Traders and Sales Managers Roundtable, Irving, Texas, 30 September 2004.
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Susan Schmidt Bies: Developments in financial markets and financial management Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Bond Market Association’s Regional Bond Traders and Sales Managers Roundtable, Irving, Texas, 30 September 2004. * * * I am very pleased to join you for this meeting of the Bond Market Association. Tonight, I would like to talk about my views on the economy, and then draw to your attention some emerging regulatory issues that affect your businesses. First, I would like to briefly share with you my assessment of the economic outlook and discuss in more detail how households and businesses appear poised for an expected rise in interest rates. Second, I want to discuss some issues related to the accounting and auditing of securities. I also need to add that in terms of the economic outlook, I am expressing my own opinions, which are not necessarily those of my colleagues on the Board of Governors or on the Federal Open Market Committee. The economic outlook As you know, real gross domestic product grew at an annual rate of 3.3 percent in the second quarter, building on larger increases since the middle of 2003. After having moderated a bit in late spring, partly in response to a substantial rise in energy prices, output growth appears to have regained some traction. Both consumer spending and housing starts jumped in July and held steady in August. Business outlays for capital equipment also appear to be on an upward trend, continuing to rebound from their weakness of the past several years. And with financial conditions still accommodative, I expect that economic activity will continue to expand at a solid pace for the remainder of the year. At the same time, it appears that inflation and inflation expectations have eased. The core consumer price index, which excludes food and energy, edged up only 0.1 percent in each of the past three months through August. This pace is substantially below the pace of earlier this year, when inflation was likely boosted by some transitory factors, such as the pass-through of large increases in energy and import prices, and some payback from the unusually modest increases in 2003. I expect underlying inflation to remain low, and, in my view, under these circumstances the Federal Reserve can remove its policy accommodation at a measured pace, consistent with its commitment to maintain price stability as a necessary condition for maximum sustainable economic growth. Household financial conditions Continued vigorous expansion depends importantly on consumer spending, so let me spend a few minutes on the financial condition of the household sector. Some commentators have expressed concern about the rapid growth in household debt in recent years. They fear that households have become overextended and will need to rein in their spending to keep their debt burdens under control. My view is considerably more sanguine. Although there are pockets of financial stress among households, the sector as a whole appears to be in good shape. It is true that households have taken on quite a bit of debt over the past several years. According to the latest available data, total household debt grew at an annual rate of about 10 percent between the end of 1999 and the second quarter of 2004; in comparison, after-tax household income increased at a rate of about 5 percent. But looking below the aggregate data, we must understand that the rapid growth in household debt reflects largely a surge in mortgage borrowing, which has been fueled by historically low mortgage interest rates and strong growth in house prices. Indeed, many homeowners have taken advantage of low interest rates to refinance their mortgages, some having done so several times over the past couple of years. Survey data suggest that homeowners took out cash in more than one-half of these “refis,” often to pay down loans having higher interest rates. On net, the resulting drop in the average interest rate on household borrowings, combined with the lengthening maturity of their total debt, has damped the monthly payments made by homeowners on their growing stock of outstanding debt. The Federal Reserve publishes two data series that quantify the burden of household obligations. The first series, the debt-service ratio, measures the required payments on mortgage and consumer debt as a share of after-tax personal income. The second series, the financial-obligations ratio, is a broader version of the debt-service ratio that includes required household payments on rent, auto leases, homeowners insurance, and property taxes. Both ratios rose during the 1990s, and both reached a peak in late 2001. Since then, however, they have receded slightly on net, an indication that households, in the aggregate, have been keeping an eye on repayment burdens. Moreover, delinquency rates for a wide range of household loans have continued to drift down this year and lie below recent highs in 2001. To be sure, mortgage rates and other consumer loan rates have come off the lows reached early this year, and concerns have been heightened about interest payment burdens for households. Although some households will be pressured by the higher rates, I believe the concerns can be overstated. First, most household debt - mortgage and consumer debt combined - carries a fixed interest rate, which slows the adjustment of interest costs to rising rates. Second, although interest rates on some variable-rate loans will rise quickly, the adjustment for a large number of variable-rate loans could be a good deal slower. For example, many adjustable-rate mortgages start off with a fixed rate for several years, providing households with some protection from rising rates. This relatively upbeat assessment of household credit quality seems to be shared by lenders and by investors in securities backed by consumer debt. According to the Federal Reserve's survey of senior loan officers, the number of banks tightening their standards on consumer loans has fallen over the past year. Moreover, credit spreads on securities backed by auto loans and credit card receivables have narrowed in recent months. These indicators do not point to much concern about household loan performance. Thus far, I have focused on the liability side of the household balance sheet. There have been favorable developments on the asset side as well. Equity prices rallied strongly last year and have held their ground this year, reversing a good portion of the losses sustained over the previous three years. In addition, home prices have appreciated sharply since 1997. All told, the ratio of household net worth to disposable income - a useful summary of the sector's financial position - has climbed in the past couple of years and currently stands at a high level relative to the past decade. Financial conditions of businesses Businesses are also in good financial shape, reflecting a dramatic improvement in recent years. Indeed, starting last year, many firms found themselves in the unusual position of being able to finance a pickup in spending entirely out of rapidly rising cash flow, and those that turned to external markets generally found the financing environment to be quite accommodative. This improvement in financial conditions reflects a number of factors, namely low interest rates, a widespread restructuring of corporate liabilities, and significant cost-cutting and productivity gains that boosted profitability. In my view, even with an expected rise in interest rates and some moderation in profit growth, the financial condition of the business sector should remain strong and able to support continued expansion. I will address each factor in turn. First, firms are continuing to benefit from the accommodative stance of monetary policy. Even with the increase by the FOMC last week in the target funds rate to 1.75 percent, short-term borrowing costs remain low. For longer-term debt, the combination of low yields on benchmark Treasury securities and sharply-reduced risk spreads from a couple of years ago has kept borrowing costs quite attractive. The reduced risk spreads reflect the improved financial positions and more positive investor sentiment, perhaps as accounting and corporate governance scandals have receded. Second, in response to low long-term rates and to investors' concerns arising from some high-profile, unanticipated meltdowns, firms have greatly strengthened their balance sheets. Many firms have refinanced high-cost debt, a move that has reduced the average interest rate on the debt of nonfinancial corporations by about 1 percentage point, on net, since the end of 2000. Businesses have also substituted long-term debt for short-maturity debt to improve their balance sheet liquidity and to reduce the risk of rolling over funds. In addition, many firms - especially in the most troubled industries - have retired debt through equity offerings and asset sales, while others have used their growing profits to retire debt. As a result, the growth of nonfinancial corporate debt in the past two-and-a-half years was limited to its slowest pace since the early 1990s. These repairs to balance sheets have also reduced the exposure of many firms to rising interest rates, especially in the near term. In particular, the replacement of short-term debt by long-term bonds means that less debt will have to be rolled over in the near term at higher rates. In addition, because much of the long-term debt has a fixed rate, interest payments typically are unaffected over the life of the bond. Moreover, research by Board staff suggests that firms which are more likely to rely on floating-rate debt, and for that reason might be more vulnerable to rising rates, have tended to use derivatives in recent years to hedge their exposure to interest rate risk.1 Thus, for many firms, the effect of rising interest rates will be mitigated and stretched out over time. In addition, a lesson we can take from the episode of policy tightening in 1994 is that rising interest rates have little detrimental effect on the financial health of the corporate sector when the rate increases occur in the context of an expanding economy. Specifically, corporate credit quality improved on balance after 1994 with the pickup in economic activity and corporate profits. Third, the improvement in financial conditions among businesses owes partly to some significant belttightening by many firms. Over the past few years, the drive to cut costs and boost efficiency has generated rapid productivity gains. Fuller utilization of the capabilities of capital already in place, ongoing improvements in inventory management, and streamlined production processes requiring fewer workers, to name but a few examples of efficiency enhancements, have boosted corporate profitability even when revenue growth was tepid. With the pick up in revenue growth in the second half of last year, companies were able to leverage the productivity gains and produce a dramatic recovery in overall corporate profitability. The profits of nonfinancial corporations as a share of sector output rose to almost 11 percent in the second quarter of this year. This share lies above its long-run average over the past few decades and well above the cyclical trough of 7 percent in 2001. To be sure, the profit share likely will slip a bit from its high level as the expansion gains steam and businesses are less able to keep a lid on their labor costs. Moreover, because cyclical factors likely contributed to the recent dramatic advances in productivity, we should expect productivity gains to moderate. But these developments and the decline in profit share are to be expected and will not, in my view, lead to a meaningful impairment of the financial health of companies. The improvements that businesses have made to their financial strength and profitability have been substantial and should help to support sustained, solid growth of the U.S. economy. Accounting for securities Let me now turn to some supervisory issues that are currently being considered. The first is the recent accounting guidance surrounding The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, or EITF 03-01. As many of you are aware, when the Emerging Issues Task Force came to its consensus earlier this year, it appeared to follow practices generally in use. But early in August, one public accounting firm interpreted the guidance very differently. Specifically, if a security was sold from the available-for-sale investment portfolio at a loss, this new interpretation called into question the facts and circumstances that should be used to determine if the remaining portfolio should be viewed as “other than temporarily impaired,” and thereby marked down to the lower of cost or market through earnings (LOCOM). At the Federal Reserve, we were concerned about this interpretation since most banks use their available-for-sale portfolio to manage their net interest margin on longer-term, fixed-rate deposits and funding. A LOCOM accounting model applied to such instruments is not consistent with this important management function. We have always expected banks to regularly review the fair values of all their securities. But the concept of “tainting” due to realized losses from the available-for-sale portfolio had not been widely applied in such a narrow way. Covitz, Daniel and Steven A. Sharpe, “Which Firms use Interest Rate Derivatives to Hedge? An Analysis of Debt Structure and Derivative Positions at Nonfinancial Corporations,” Working paper, July 2004. I commend the Financial Accounting Standards Board (FASB) for listening to questions raised by preparers, auditors, and bank regulators and agreeing to defer the effective date for the troublesome paragraph 16 from the third to the fourth quarter. It has also issued some implementation guidance, and has a comment period that runs until October 25. I would encourage you to read the new guidance, and to provide comments if you feel additional clarification is needed. Pay particular attention to the facts and circumstances that should be considered. Note that the guidance allows sales of available-for-sale securities at a loss for the same reasons that you can sell held-to-maturity securities without tainting the remaining portfolio, for example mergers and changes in regulatory capital. The guidance also permits sales for unexpected and significant changes in liquidity needs or increases in interest rates. In practice, EITF 03-01 should make all organizations with available-for-sale securities review their procedures for identifying impairment. Clearly, investors should continue their current practice of monitoring for credit downgrades and changes in prepayment speeds, especially for mortgage-backed securities booked at a premium and interest-only strips. But in addition, the trigger for recognizing impairment is no longer an intent to sell, but rather whether the investor no longer intends to hold the security until fair value recovers to its amortized cost. Also note that the disclosure aspects of EITF 03-01 do apply in third quarter financial statements. The major change is separate disclosure of securities whose fair value is below carrying cost. Organizations now must disclose separately the amount of securities that have been in a continuous unrealized loss position for more than one year, and in the narrative discuss why the loss has not yet been recognized. Fair value and regulatory capital issues As you know, the Basel II effort to revise bank risk-based capital standards is now in its final stages and moving toward implementation. Importantly, that effort has adopted an approach to credit risk on instruments held in the banking book that differs from the current capital rules applied to instruments held in the trading book under the 1998 Market Risk Amendment (MRA) to the Basel Accord. Clearly, the fair valuing or “marking to market” of trading portfolios and the implied holding period of such positions factor into such differences. At the same time, however, we must remember that the MRA approach was adopted at a time when bank trading portfolios looked very different from today. The significant growth in the credit derivative market is just one example. Also, there appears to be an increasing tendency for financial institutions to hold less-liquid instruments in trading accounts over longer time horizons than has been traditionally associated with the concept of a trading account. This suggests that the time may have arrived for supervisors to begin to review the implications that financial market innovation and the changing nature of trading accounts have for the current capital regime applied to these activities. In an initial effort to fully identify the types and characteristics of instruments that are held by banks in their trading accounts, and that are held at fair value by securities firms, a joint subgroup of International Organization of Securities Commissions and the Basel Committee on Banking Supervision is surveying the industry. This survey is also focused on gaining a better perspective on the range of techniques financial institutions are developing to more robustly measure the risk these instruments entail. The information acquired in this survey is to be fully incorporated in supervisors' review of the current adequacy of the MRA. It is important for me to note that this effort to review the MRA is still in its early stages. As yet, it is uncertain whether this effort will result in minor revisions to the current MRA or significant changes. Challenges in securities accounting and auditing Both of these issues relating to practices around securities accounting should also be viewed in light of broader issues that are challenging corporate management, independent accountants, and regulators. Fair value accounting for securities, whether in the income statement or in disclosures, relies on key assumptions, modeling techniques and judgment. For example, modeling techniques are commonly used in valuing mortgage-backed securities. The present value of the estimated future net cash flows attempts to anticipate consumer behavior to adjust for prepayments of mortgages due to forecasted interest rates. Changes in the assumptions used in the modeling approach for any instrument or product will affect the resulting values. For example, if property values are rising rather than falling, the buildup of equity in the home can affect the borrowers desire to refinance the loan or use the equity to purchase a more expensive home. Thus, auditing model-based fair values for accounting purposes requires a high level of specialized knowledge. The auditor must fully understand how modeling or other sophisticated techniques are used to determine fair value, and whether the assumptions used in the models are appropriate, and whether the data has integrity. Furthermore, “fair value” is not always clearly defined or easily determined for some products or instruments. The lack of observable market prices, differences in modeling assumptions, expectations of future events and market conditions, as well as customer behavior make the task of assigning appropriate valuations very difficult. Certainly, a non-complex instrument that is highly liquid with an observable market price is easier to value with more precision than a highly complex, illiquid instrument. In today's world, with the myriad of complex financial instruments that exist and are constantly being created, developing verifiable and auditable fair value estimates is a major concern. And because fair value models are forward looking, the auditor has an additional challenge of determining the line between normal variability in expectations that surrounds any forecast and earnings manipulation. To its credit, the FASB has recently issued an exposure draft on fair value measurement. The proposal was developed to provide a framework for fair value measurement objectives, and it is just the initial phase of a long-term fair value project. The initial phase is generally intended to apply to financial and nonfinancial assets and liabilities that are currently subject to fair value measurement and disclosure. It is not intended to expand the use of fair value measurements in financial statements at the present time. In my view, the proposal is a good first step in enhancing fair value measurement guidance, but I believe additional guidance is warranted. Reliability issues should be addressed more comprehensively in the proposal. Most important, the FASB should develop further guidance and conduct further research and testing to enhance the reliability of fair value measurements before the use of fair value is significantly expanded in the primary financial statements. Furthermore, the FASB should work with other organizations including the Public Company Accounting Oversight Board (PCAOB), American Institute of Certified Public Accountants (AICPA), and accounting firms to enable the development of robust guidance that ensures fair value estimates can be verified and audited. Conclusion In summary, I expect that economic activity will continue to expand at a solid pace for the remainder of the year. At the same time, it appears that inflation and inflation expectations have eased. I encourage you to not only focus on economic conditions that affect the bond market, but to also pay attention to emerging regulatory issues. The depth and diversity of bond markets will continue to support economic expansion as long as investors can rely on the integrity of information about issuers and characteristics of specific securities.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, to the Cincinnati Chapter of the Ohio Society of Certified Public Accountants, Cincinnati, Ohio, 28 September 2004.
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Susan Schmidt Bies: Challenges facing the accounting profession today Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, to the Cincinnati Chapter of the Ohio Society of Certified Public Accountants, Cincinnati, Ohio, 28 September 2004. * * * Introduction Good evening. Thank you for the invitation to speak to you during your annual CPA Recognition Night. Those of you who are new to the profession no doubt realize, just as your more experienced colleagues do, that you are entering into this noble area of service during a dynamic and crucial time in its existence. You are entering the profession just as new rules, greater responsibility and increased scrutiny are being imposed on accountants and auditors alike in response to the discovery of accounting and auditing improprieties in the recent past. In addition, as the world of commerce and business continues to change, it is vital that the accounting profession responds to meet the challenges of auditing new innovations. This evening, I will share some of my views on the challenges that the profession faces today, particularly with regard to accounting and auditing in service industries and model-based accounting. Accounting in a service based economy I think it is fair to say that nearly all of us, including those of you who are new to the profession, first learned about accounting from the “old economy” perspective of retail and manufacturing. Our accounting text books gave us examples and exercises that pertained to the XYZ Corporation that sold widgets. In this context, we learned that assets and liabilities were valued on a historical cost basis and that the earnings cycle was completed when sales occurred. Indeed, we learned the fundamental concept that revenue was recognized only when it was earned. Today, our economy is becoming more and more service-based. Unlike in manufacturing and retail trade, where the sale marks the end of the earnings process, in most services the sale of the service marks the beginning of the earnings process. In the case of services, once the sale has closed, revenues are earned over the ensuing period in which such services are rendered. If earnings are recorded at the time of the sale, that is at the beginning of the service process or before risks are transferred, the financial statements may not be reflecting the earnings process. You may recall that the practice of recognizing revenue “up front” was used by some high-tech firms a few years ago, sometimes in inappropriate circumstances. The Securities and Exchange Commission issued guidance at that time to clarify that revenue should be deferred until it is earned. One major industry affected by these concepts is the financial services industry. While a small amount of revenue is received for transactions, most is generated by sales that lead to future revenue streams, such as that when a checking account is opened. In the context of the financial services industry, the accounting practice used today is sometimes called the “mixed attribute” approach. This means that some assets and liabilities continue to be recorded on a historical cost basis, while others are reported at fair value or at lower-of-cost-or-market (LOCOM). In some instances in the mixed attribute approach, changes in fair value are reported in earnings, while in other cases they are excluded from earnings but affect the equity portion of the balance sheet. For example, assets that are included in the trading account are carried at fair value and changes in fair value are reported in earnings during the period. However, securities that are intended to be held until maturity are reported at amortized cost with no change in fair value recognized in earnings unless permanent impairment has occurred. Loans that are held-for-sale are separately reported on the balance sheet and recorded at LOCOM, while loans that a bank intends to hold for the long-term are reported at amortized cost. The mixed attribute accounting model is effective for financial services because it reflects differences in the earnings process. Thus, when profits are generated through the trading account, earnings are driven by the activity of buying and selling securities. Traders make decisions about what to buy, and the market timing of the purchases and sales rest on comparisons of relative returns on the alternative securities. The success of a trading account as a business reflects management's ability to identify unusual valuations in the market and quickly act upon them. In this case, a fair value framework is appropriate for accounting since it is similar to the information and decision process that management is using. An example of a different business model is a floating rate loan that is made and held on the balance sheet with the intent to service the loan until it is paid off. Here, the floating rate means that changes in market interest rates will not affect the fair value of the loan. Rather, credit quality and the cost to service the loan are the two major drivers of profitability. Management's ability to underwrite the credit initially, manage changes in credit risk over the life of the loan, and limit losses of principal and interest and collection costs should a default occur, are key drivers of credit costs. In addition, the costs to receive and post payments and service the loan over its life are important drivers of the operating costs of making the loan. In this case of loans made to be held in portfolio, amortized cost is appropriate accounting. The interest received over the life of the loan supports the operating costs to service the loan that are incurred while it is outstanding, as well as credit losses that occur, and the cost to acquire funding for the loan. To the user of financial statements, amortized yield, operating costs, funding costs, and credit quality each need to be visible to the user of financial statements, and be reflected in the period in which they are earned or incurred. Fair value accounting and auditing While historical cost accounting methods have well-developed auditing techniques, fair value accounting relies on key assumptions, modeling techniques and judgment. For example, modeling techniques are commonly used in valuing mortgage loan servicing assets. The present value of the estimated future net cash flows of servicing assets attempts to anticipate prepayments of mortgages due to changing interest rates, fees earned from late payments, cost to receive payments and remit funds to investors, costs to handle delinquent and charged-off loans and other factors. Changes in the assumptions used in the modeling approach for any instrument or product will change the resulting values. Further, the models used for financial statements look to what the market would expect these revenues and costs to be, rather than the firm's specific information. Since sales of servicing assets, especially for seasoned loans, is so irregular, it is often difficult to validate the model against actual values seen in the market. Thus, auditing model-based accounting requires a high level of specialized knowledge. The auditor must fully understand how modeling or other sophisticated techniques are used to determine fair value, and whether the assumptions used in the models are appropriate, and that the data has integrity. Furthermore, “fair value” is not always clearly defined or easily determined for some products or instruments. Certainly, a non-complex instrument that is highly liquid with an observable market price is easier to value with more precision than a highly complex, illiquid instrument. Accountants are being asked to know more than just the proper classification of assets and liabilities, but also the appropriate way to value assets and liabilities. Let me mention that the Federal Reserve supports a fair value-based measurement for assets and liabilities used in the business of short-term trading for profit, such as the trading account for banks. And we support enhanced disclosures of fair value-based information. However, we believe that the accounting industry should be very careful before moving toward a comprehensive fair value approach, where all assets and liabilities are recorded on the balance sheet at fair value and changes in fair value are recorded in earnings, whether or not realized. In today's world, with the myriad of complex financial instruments that exist and are constantly being created, developing verifiable and auditable fair value estimates is a major concern. The lack of observable market prices, differences in modeling assumptions, expectations of future events and market conditions, as well as customer behavior make the task of assigning appropriate valuations very difficult. And because fair value models are forward looking, the auditor has an additional challenge of determining the line between normal variability in expectations that surrounds any forecast and earnings manipulation. To its credit, the Financial Accounting Standards Board (FASB) has recently issued an exposure draft on fair value measurement. The proposal was developed to provide a framework for fair value measurement objectives, and it is just the initial phase of a long-term fair value project. The initial phase is generally intended to apply to financial and nonfinancial assets and liabilities that are currently subject to fair value measurement and disclosure. It is not intended to expand the use of fair value measurements in financial statements at the present time. In our view, the proposal is a good first step in enhancing fair value measurement guidance, but we believe additional guidance is warranted. Reliability issues should be addressed more comprehensively in the proposal. Most important, the FASB should develop further guidance and conduct further research and testing to enhance the reliability of fair value measurements before the use of fair value is significantly expanded in the primary financial statements. Furthermore, we believe that the FASB should work with other organizations including the Public Company Accounting Oversight Board (PCAOB), American Institute of Certified Public Accountants (AICPA), and accounting firms to enable the development of robust guidance that ensures fair value estimates can be verified and audited. Transparent disclosure These concerns, among others, also raise the importance of disclosures in the financial statements that assist readers in understanding how the financial statements reflect the business strategy, risk management, and operating effectiveness of the enterprise. As organizations have grown in size and scope, innovative financing techniques have made it more difficult for outside investors to understand a particular firm's risk profile and the performance of its various lines of business. Traditional accounting standards have not kept pace with the risk-management tools employed by sophisticated corporations. Thus, more meaningful disclosures of firms' risk-management positions and strategies are crucial for improving corporate transparency for market participants. The improvements in technology, the quick pace of financial innovation, and the evolving risk-management techniques enable businesses to use almost limitless configurations of products and services and sophisticated financial structures. Accordingly, outsiders will have ever more difficulty understanding the risk positions of many large, complex organizations. These developments represent significant challenges to standard setters and to accounting firms. For market discipline to be effective, accounting standards and disclosures must evolve to accurately capture these developments. Challenges for auditors Auditing firms are facing the growing challenge to build and pass along the knowledge possessed by their professionals who truly understand the audit and accounting issues around particular business lines. As companies broaden the range of products, services, and delivery channels they offer, clients require more specialized knowledge for each operation. As we are all aware, there are fewer large accounting firms competing in the marketplace today. I understand that many of the larger accounting firms are no longer accepting audit engagements of some smaller or medium-sized companies. This opens an opportunity for small to medium-sized auditing firms to become specialists - so-called “niche players.” In this way, smaller auditing firms can develop the expertise of their auditing staff around the accounting and business practices of the specialized industries or particular types of clients, as knowledge-sharing can be more successful when it is naturally more targeted. Perhaps a broader question facing the auditing industry today is how to maintain and instill the appropriate professional judgment required of auditors as accounting theory moves towards a more principles-based approach. One impact that the Sarbanes-Oxley Act is having on preparers and auditors of financial statements is the quest for more “bright line” rules so they can more readily know when an interpretation comes close to the acceptable limit. But the changing business world, especially around financial instruments, is making it impossible to write an accounting rule for each potential nuance of innovation, and so we are turning to more principles-based accounting. Thus, sound judgment is becoming a more valuable talent to businesses and their auditors. As CPAs, one of your most important missions is to reinvigorate the profession to successfully address these conflicting goals. Other challenges Let me also mention an area that places increased responsibility on auditors. I mentioned earlier the PCAOB. The PCAOB was created through the Sarbanes-Oxley Act to oversee the auditors of public companies. The PCAOB has recently approved Auditing Standard No. 2, An Audit of Internal Control over Financial Reporting Conducted in Conjunction with an Audit of Financial Statements. The new standard highlights the benefits of strong internal controls over financial reporting and furthers the objectives of Sarbanes-Oxley. This standard requires external auditors of public companies to evaluate the process that management uses to prepare the company's financial statements. External auditors must gather evidence regarding the design and operations effectiveness of the company's internal controls and determine whether the evidence supports management's assessment of the effectiveness of the company's internal controls. While the new standard allows external auditors to use the work of others, including work performed by internal auditors, it emphasizes that external auditors must perform enough of the testing themselves so that their own work provides the principal evidence for making a determination regarding the company's controls. Based on the work performed, the external auditor must render an opinion as to whether the company's internal control process is effective, which is a relatively high standard. In addition, as part of its overall assessment of internal controls, the external auditor is expected to evaluate the effectiveness of the audit committee. If the audit committee is deemed to be ineffective, the external auditor is required to report that assessment to the company's board of directors. This new standard will certainly put more demands on external auditors and public companies alike. But in the world of business and financial innovation and growing complexity of firms, these standards should encourage greater reliability of corporate financial statements and therefore, regain the confidence of the public and the trust of financial markets. Conclusion In conclusion, I hope my views will give you an opportunity to think about some of the challenges both accountants and auditors face in today's business environment. The accounting industry should be cautious and prudent as it debates the merits of fair value accounting. Accountants and auditors alike must be knowledgeable of the models and assumptions used in determining the fair value of products and services. A models-based approach to valuations must produce results that accountants, auditors, and market participants feel are objective. Standardsetters have the daunting task of balancing the need to provide accounting principles that keep pace with financial innovation with the need to promulgate standards that produce accurate, reliable and verifiable results.
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Institute of International Bankers¿ Annual Breakfast Dialogue, Washington DC, 4 October 2004.
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Ben S Bernanke: The implementation of Basel II - some issues for cross-border banking Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Institute of International Bankers’ Annual Breakfast Dialogue, Washington DC, 4 October 2004. * * * I am pleased to join this discussion of international banking regulation. Larry Uhlick asked me to focus my comments on international aspects of the evolving new capital accord, Basel II, and I am happy to comply. I should say at the beginning that the views I will express today are not necessarily those of my colleagues at the Board of Governors of the Federal Reserve System.1 The implementation of Basel II will raise many practical issues, of course, but I thought it might be most interesting for this audience if I focused on two areas important for internationally active banks: (1) home-host supervisory cooperation, and (2) the proposed bifurcated application of Basel II in the United States and the special issues it creates for cross-border banking. I hope to persuade you that the U.S. banking agencies are quite aware of these issues and are proactively attempting to address the potential problems that these facets of Basel II implementation may create for banks that operate both in the United States and abroad. Home-host: global banking, international consensus, and sovereign countries Banks with significant cross-border operations have understandable concerns about the prospect of each national supervisor asking different questions about Basel II implementation, demanding different data, applying the rules differently, or taking other actions that increase cost or are inconsistent with the principle of consolidated supervision. At the outset - and at the risk of feeding your worst fears - let me remind you of the broad context in which we are working. The Basel II capital accord is not a treaty; it is a consensus which the authorities in each national jurisdiction will inevitably apply in their own specific ways reflecting their preferred approaches to bank supervision and regulation. The large number of banks with cross-border operations will continue to fall under the consolidated supervision of their home-country supervisors. But at the same time, each host-country supervisor is charged by its own government with ensuring that, at least at the bank subsidiary level, legal entities operating within its jurisdiction are operating in a sound manner with adequate capital. Since 1975, the Concordat among national supervisors has recognized a division of labor that holds the home country responsible for consolidated supervision and the host country for supervision of the legal entities in its jurisdiction, whether domestic or foreign. The Concordat does not rule out differences in the concerns and objectives of supervisors in different countries. For example, it does not matter to a host supervisor that the consolidated entity has sufficient capital if, in a period of duress, that capital is not available to the legal-entity subsidiary in that host country. Put somewhat differently, the combination of global banking and sovereign states has, for some time, produced what we may delicately call “tensions”. Such tensions have existed for years under Basel I. Three aspects of Basel II may raise the level of tension experienced by internationally active banks still further: (1) Basel II is more complex, (2) it includes requirements for capital to cover operational risk, and (3) it has all the uncertainties of the new and untested. Host-country supervisors face the costs of adjusting to differences in the manners in which foreign banks will implement Basel II, while the banks and home-country supervisors worry about host-supervisor intrusions, questions, and special rules. These concerns are quite understandable. One might choose to be philosophical and accept that there are inevitable costs of doing business as a global bank, and of supervising global banks, in a world of sovereign states. Fortunately the situation - as Mark Twain said about Wagner’s music - is “better than it sounds”. A variety of efforts are underway to mitigate the potential problems of the new system. I owe thanks to Ed Ettin and his colleagues for invaluable assistance in the preparation of these remarks. As you may know, the Basel Supervisors’ Committee has established the Accord Implementation Group, or AIG, headed by the vice chairman of the Basel Committee, Canada’s superintendent of financial institutions, Nicholas Le Pan. The AIG consists of senior line supervisors from Basel member countries, who gather regularly to share best practices and develop ways to foster consistent application across national jurisdictions. Among its efforts is a series of case studies, in which home and host supervisors review how the banks under study plan to implement Basel II. To date, a dozen case studies have been launched, and more are planned. Of course, the usefulness of each case study depends on how far along the subject bank is in its own Basel II implementation plan. In the United States, for example, a case study focusing on Citigroup involves the United States and a panel of about ten host-country supervisors from jurisdictions in which Citigroup has important operations. The panel of supervisors is developing a common understanding of how Citigroup has established its risk management structure and risk measurement systems, and how the entity will use the various statistical inputs and methodologies for determining its minimum regulatory capital requirements under Basel II. The host-country participants are active in the process and, importantly, all involved are working collaboratively under the principles articulated by the Basel Supervisors’ Committee. As the home-country supervisor in the Citigroup exercise, we are organizing an outreach program to inform other host countries, not participating in the case study, of the efforts. In addition, U.S. supervisors are involved in many other case studies in which we are acting as the host supervisor for foreign banks’ U.S. operations. In short, efforts to ensure effective cross-border supervisory coordination are under way, and we are committed to making them successful. The objective of the home-host exercises is to understand what has to be done, what information has to be shared, and what understandings have to be developed to make host supervisors comfortable with the operations of foreign banks in their jurisdictions, as well as to reduce the need for host supervisors to duplicate the work of the home-country consolidated supervisor. Please note that the operative word is reduce, not eliminate, but our hope is that the reduction will be substantial. Just as under Basel I, host supervisors will still examine the legal entities in their country. We hope to keep the supervisors better informed about how operations outside their jurisdiction affect the entities they supervise, and to do this with a minimum of burden on the consolidated organization. The principles developed from these case studies are expected to be applied broadly. I expect that they will include mechanisms for coordination among home and host supervisors in the development of the work plan to be applied by the home country in its consolidated examination. Coordination would also include the sharing of examination results with host-country supervisors to the extent practicable. In addition, we will do our best to promote extensive home-host communication on a continuous basis, not just in times of stress. Overall, the AIG effort should help to reduce home-host coordination problems considerably, but, as with Basel I, there will inevitably be bugs to work out as implementation proceeds. During that shakeout period, some of your concerns may turn out to be real - although, I hope and expect that they will be less daunting or costly than you may fear. I have focused so far on credit-risk aspects of Basel II. On the operational-risk side, however, the home-host implementation challenges are knottier. In contrast to the treatment for credit risk, Basel II allows both the consolidated and the individual legal entities to benefit fully from the risk reduction associated with group-wide diversification. However, host countries charged with ensuring the strength of the legal entities operating in their jurisdictions will not be inclined to recognize an allocation of group-wide diversification benefits, given that capital among legal entities is simply not freely transferable, especially in times of stress. The Basel Supervisors’ Committee has thus proposed that “significant” subsidiaries will have to calculate stand-alone operational-risk capital requirements that may not incorporate group-wide diversification benefits. Other subsidiaries can use an allocated portion of the group-wide requirements, requirements that may be calculated with diversification offsets. Host-country supervisors, of course, have the right to demand more capital than may result from such allocations. Thus, both the proposal for significant subsidiaries and the possible hostsupervisor response for other subsidiaries may well result in the sum of the individual legal-entity capital requirements being greater than the consolidated-entity requirements. Home country supervisors of consolidated entities facing such capital demands are likely to be more tolerant of double leverage or gearing in reflection of this reality. In short, home-host issues under Basel II are quite real, and dealing with them effectively will require extensive cooperation and communication. But we must acknowledge that these issues cannot be fully avoided in a world of sovereign states; all we can do it try to minimize the resultant costs. Bifurcated application of Basel II in the United States Global banks have also voiced some concern about the implications of the planned application of Basel II in the United States. As you know, in contrast to the rest of the world, this country has proposed to offer only one option under Basel II: the Advanced Internal Ratings Based, or A-IRB, method for credit risk and the Advanced Management Approach, or AMA, for operational risk. For convenience, I will refer to them together as the “advanced approach”. All U.S. home-country banks and U.S. subsidiaries of foreign banks that meet certain size or foreign-exposure criteria will be expected to adopt the advanced approach. Others domiciled or operating here would have the option to adopt these versions of Basel II if they meet the infrastructure requirements. All other banks operating in the United States will remain under the current U.S. regime, based on Basel I. The global banks’ concerns about the bifurcated U.S. application depend in part on whether they are based here or abroad. For foreign banks the issue is the additional complexity and perceived inequity they will face if they have chosen to operate in the rest of the world under the foundation approach for credit risk, an approach which will not be permissible in the United States. (I am making the reasonable assumption that the foreign banks whose U.S. subsidiaries would be required to use the advanced approach, or who, for competitive or other reasons, choose the advanced approach in the United States, will be operating in their home country under the foundation approach at least.) For U.S.-based banks the fear is that foreign rivals may get a competitive edge for one year through lower regulatory capital requirements in some markets; the potential head start for foreign banks arises because the permissible start date for the foundation and standardized versions is the beginning of 2007, while the advanced approach, with its greater complexity for banks and supervisors, starts in all markets at the beginning of 2008. A foreign bank under the foundation approach at home but under the advanced approach in the United States would have to determine two variables in the United States for its corporate exposures that would not be required of its consolidated entity: loss given default (LGD) and exposure at default (EAD). For its consolidated entity at home it would need to calculate only the probability of default. The U.S. subsidiary might well find it a real challenge to gather the needed data and generate the LGD and EAD parameters required in the United States; doing so would certainly add cost, even for an entity using the full foundation approach at home. The U.S. authorities did not make their decision to require the advanced approach lightly. Given the structure and size of our markets, we believe it necessary that large entities operating here use sophisticated techniques for risk measurement and management that rely on bank estimates of all the risk variables required by the advanced approach. Nonetheless, we understand our global responsibilities for cooperation. Both bilaterally and through the AIG, we will continue to work with U.S. subsidiaries of foreign banks and their home supervisors on transition steps, where necessary, although we expect to continue to require full implementation within a reasonable period of time. These transition steps could involve, for example, relying on conservative estimates of the LGD and EAD parameters when the bank in question is not yet prepared to provide estimates derived from its own experience. For a limited period, we also may be willing to consider conservative methodologies for allocating consolidated operational risk capital charges to the U.S. subsidiary. Although we will do what we can to facilitate transition, let me be clear that, for both domestic and foreign banks, we expect that plans for full adoption will be complete within a relatively short period. Moreover, any shortfalls in systems will have to be disclosed under Pillar 3; and we reserve the right, under Pillar 2, to require additional capital during the transition to full implementation. It was a difficult decision for the Basel Supervisors’ Committee to delay by one year, to 2008, the start date for implementation of the advanced approach while retaining the 2007 target for the other approaches. The delay reflected the realities that many banks that will be applying the advanced approach needed more time and that the requirements in the United States for public comment and review made it impossible for final U.S. rules to be promulgated before 2006. Thus, the earlier start for the other approaches, along with the imposition of the 95 percent of Basel I capital floor for that first year, 2007, seemed to all concerned to be a reasonable compromise, more practical than trying to hold to the original schedule for all banks or delaying the start date for approaches not permitted in the United States. Under the circumstances, consistent with our agreement to have a single, worldwide start date for the advanced approach, the U.S. authorities do not see any opportunity for implementation of the advanced approach in the United States before 2008, regardless of any individual bank’s ability and readiness to do so.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, to the Conference on Reflections on Monetary Policy 25 Years after October 1979, Federal Reserve Bank of St Louis, St Louis, Missouri, (via videoconference), 7 October 2004.
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Alan Greenspan: Monetary policy twenty-five years after October 1979 Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, to the Conference on Reflections on Monetary Policy 25 Years after October 1979, Federal Reserve Bank of St Louis, St Louis, Missouri, (via videoconference), 7 October 2004. * * * A defining moment may shape the direction of an institution for decades to come. In the modern history of the Federal Reserve, the action it took on October 6, 1979, stands out as such a milestone and arguably as a turning point in our nation’s economic history. The policy change initiated under the leadership of Chairman Paul Volcker on that Saturday morning in Washington rescued our nation’s economy from a dangerous path of ever-escalating inflation and instability. As I noted in congressional testimony before the Joint Economic Committee on November 5 of that year: We are here … to evaluate the moves of Chairman Volcker and his colleagues last month, implying that some alternate policies were feasible at that time. However, given the state of the world financial markets, had the Fed not opted to initiate a sharp interest rate increase in this country, the market would have done it for us.1 In a democratic society such as ours, the central bank is entrusted by the Congress, and ultimately by the citizenry, with the tremendous responsibility of guarding the purchasing power of money. It is now generally recognized that price stability is a prerequisite for the efficient allocation of resources in our economy and, indeed, for fulfilling our ultimate mandate to promote maximum sustainable employment over time. But the importance of price stability has sometimes been insufficiently appreciated in our central bank’s history, and, as Allan Meltzer will soon point out, such episodes have had unfortunate consequences. Far from being a bulwark of stability in the 1970s, the Federal Reserve conducted policies that, in the judgment of many analysts, inadvertently contributed to an environment of macroeconomic instability. We should strive to retain in the collective memory of our institution the ensuing lessons of that period. It may be the most fruitful and proper way to commemorate the events of October a quarter-century ago. Tracing the roots of the 1970s inflation brings us to an earlier era. The Keynesian revolution of the 1930s and its subsequent empirical application led many economists to accept the view that through regulation, state intervention, and the macroeconomic management of aggregate demand, government policies, including those of our nation’s central bank, could improve on earlier efforts to achieve and maintain “full employment.” By the 1960s, policymakers seemed to concentrate their short-run objectives on maintaining a “high pressure” economy in the belief that such a recipe could virtually thwart economic contractions at little or no risk to long-run stability and growth. If this high-pressure management inadvertently carried the economy beyond its productive potential, some cost in terms of inflation could be expected, but such costs appeared tolerable in light of the employment gains that came with them. Furthermore, policymakers hoped that additional tools at their disposal - so-called incomes policies enforced by “jawboning,” guideposts, and price and wage controls - were ready to combat and control any resulting upcreep in inflation with minimal macroeconomic cost. By the turn of the 1970s, the ugly reality of stagflation forced an overhaul of this policy framework. The corrosive influence of inflation on our nation’s productive potential was beginning to take hold. Policymakers slowly came to recognize the adverse long-term consequences of compromising the purchasing power of our currency for economic well being. Indeed, by the late 1970s, a consensus gradually emerged that inflation destroyed jobs rather than facilitating their creation. Unfortunately, a legacy of failed attempts during the decade to restore stability with gradualist plans and with various incarnations of incomes policies took its toll on business and household attitudes toward inflation and toward the prospects of our nation. By the end of the decade, an inflationary psychology had become well entrenched and complicated efforts to restore a sense of stability in the national psyche. Alan Greenspan (1980), “Statement,” in Domestic and International Implications of the Federal Reserves New Policy Actions, Hearing before the Subcommittee on International Economics of the Joint Economic Committee, November 5, 1979, 96 Cong. 1 Sess. (Washington: Government Printing Office), p. 5. Little leeway for policy was left before the Federal Reserve took decisive action on October 6, 1979. In retrospect, the policy put in place on that day was the obvious and necessary solution to the nation’s troubles. As events unfolded, however, the Federal Reserve did not escape criticism, and for a time it was not entirely obvious that the System could maintain the necessary public support to see its disinflationary efforts come to fruition. Though widely anticipated even before the actions of October, the recession and retrenchment in employment that followed those actions resulted in pressures on the Federal Reserve to reverse course. The fiftieth anniversary of the beginning of the Great Depression - the crash of 1929 - was observed later during that same month, October 1979. I recall that this anniversary not only rekindled the question of whether such an event could recur but also inflamed sensitivities regarding the effects on unemployment that might stem from the new anti-inflationary action. Judging from the fate of earlier attempts during the 1970s to tame inflation in the face of a weakening economy, when short-run considerations appeared to trump policies oriented toward longer horizons, such fears of rising unemployment could have also derailed the reforms of October. In the event, they did not. We owe a tremendous debt of gratitude to Chairman Volcker and to the Federal Open Market Committee for their leadership and steadfastness on that important occasion and for restoring the public’s faith in our nation’s currency. By the time that I arrived at the Federal Reserve, in 1987, the task of the Federal Open Market Committee had become easier precisely because of the perseverance and success of our predecessors in the turbulent years following October 1979. Maintaining an environment of stability is simpler than restoring the public’s faith in the soundness of our currency. The task is easier still as we remind ourselves of the stark difference between the long-term prospects of our economy now, in our current environment of stability, and then, a quarter-century ago, before the reforms of that October. In closing, I applaud President Poole and his colleagues for organizing this event to reflect upon that critical episode in our nation’s economic history. An appreciation of our history is, after all, an invaluable guide to sound policies for a better future.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the American Bankers Association Annual Convention, New York, 5 October 2004.
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Alan Greenspan: Banking Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the American Bankers Association Annual Convention, New York, 5 October 2004. * * * It is a pleasure to join you once again at the annual convention of the American Bankers Association. By any measure, banking in the United States today is strong, vibrant, and profitable. However, a number of times in the past half-century, many informed observers questioned the longterm viability of commercial banking. U.S. commercial banks, which began the post-World War II period as the dominant financial institution, soon faced intense competition from thrifts, from new forms of mutual funds, from customer direct financing in the securities markets, from foreign banks, and from a wide range of nondepository lenders. As the competition intensified, banks found their ability to respond increasingly constrained by rules and regulations established in the far different environment of the Great Depression of the 1930s. And banking, just like other businesses, faced the implications of immense changes in technology and of the rapid growth in globalization, which created new risks as well as new opportunities. Under the circumstances, the present health of banking is a dramatic testament to both the management skills of bankers and the ability of regulators and legislators to adapt, albeit slowly, to change. This morning, I would like to review some of the major innovations and changes that have propelled banks to their present state and have allowed them successfully to navigate through a rapidly changing economic and technical environment. A further word of prologue, however, is necessary to understand today’s banking markets. What turned out to be bad credit judgments, especially in real estate, energy, and foreign credit markets, coupled with high interest rates and a deep recession, led to the assisted acquisitions of almost 120 banks and the actual demise of about 1,250 of them between 1985 and 1992. Many more had a neardeath experience, and survivors recapitalized by raising $176 billion of new long-term capital, including $13 billion of equity, from 1991 to 1995. The managers of these surviving organizations had deeply impressed upon them anew the need to manage risks, to control costs, to build capital and reserves, and generally to focus on the lessons of banking history. The passage of time no doubt has caused the experience to fade for those banks that looked into an abyss, but survived; nevertheless the systems and procedures that were put into place by many institutions remains one of the hallmarks of today’s banking industry. To fund or not to fund The first response to the changing environment after World War II occurred in the early 1960s, with banks’ decision to actively compete on a price basis to buy money to fund operations - the development of the negotiable certificate of deposit (CD). For years preceding the 1960s, banks had no reason to aggressively seek deposits. During the Great Depression, credit demands on banks, of course, were unusually low, and during and immediately after World War II banks were extremely liquid owing to heavy accumulations of U.S. government securities, an aftermath of war-time financing. The decision to compete on a price basis using instruments such as the negotiable CD seems quaint today, but in the early 1960s it represented a sea change in the way managers thought about the business of banking. And its implications turned out to be far reaching. It was a modest step forward to the whole range of nondeposit and price-sensitive borrowing, from the repurchase agreement to the subordinated debenture, not to mention the NOW account and the range of retail time deposits that banks routinely tap by adjusting offering rates when additional funding is needed. Many of these instruments, including the large-denomination, market-rate-based deposit, that was once thought to be only for large banks, are now used, with great success, by community banks when their core deposits fall short of their funding needs. Indeed, banks of all sizes will never again be the passive deposit takers that they were at the beginning of the 1960s. To be sure, the whole range of services and characteristics of bank claims are important, but banks now both can and do look at the cheapest source first and pay at the margin what is necessary to obtain the needed funding. When deposit rate ceilings - Regulation Q - first constrained the ability of banks to pay the market rate on CDs in the mid-1960s, banks shifted to a source that was then unconstrained, the Eurodollar market. This step not only underlined the increasing importance of globalization but also finally required legislators and regulators to consider the efficacy and policy implications of deposit rate ceilings. Only the inability of thrifts to sustain deposit inflows with the high rates of the mid-1960s and the late 1970s, an important cause of the later thrift crisis, kept the eroding deposit rate ceilings from being eliminated until the 1980s. But the principle slowly began to be established that regulations that are inconsistent with market realities cannot be sustained indefinitely, although vestiges may remain long beyond the regulations’ perceived usefulness. The pricing of liabilities was not the only response of banks to the new competition. Another was the securitization of consumer and residential mortgage loans - the conversion of a pool of credits into a security - that others not necessarily other banks, could hold. Securitization also allowed the creating bank to remove the underlying loans from its books. The bank, or an affiliate, might provide limited recourse or take an equity position in the pool to provide a credit enhancement, but the concept was clearly to eliminate the need for funding while profiting from fees or rate spread. The syndicated commercial loan soon followed the initial securitizations, with the managing bank acting more like the lead underwriter on behalf of a syndicate, a syndicate that, I might add, increasingly is composed of nonbank financial institutions. Some observers at the time, projecting these developments, concluded that the bank of the future would hold virtually no assets, would require virtually no funding, and would have no branches. The vision that the bank of the future would be essentially an underwriter of diverse credits has not come to pass, despite the continued growth of securitization and syndication, because taking credit risk, the historic core of banking, remains profitable for those that know how to manage it effectively. In addition, with better pricing, deposits have been restored as a more-resilient funding source. Moreover, the market test has clearly underlined the customer desire for branches at most types of banking organizations. Pricing and managing risk One of the more painful lessons learned in the 1970s and 1980s is that accepting narrow or nonexistent spreads in order to retain market share is a losing strategy. This lesson seems clear enough, but many banks were nevertheless reluctant to see traditional customers shift to other markets, let alone other banks, and matched loan rates despite the resultant lackluster returns on equity. Competition in the loan market can still be intense, as it is today. Nonetheless, even with narrowing margins most recently, loan pricing is now generally linked to careful assessment of economic returns that often includes an assessment of the profitability of the credit and the overall relationship. Loan officers, if left to their own devices, might be more interested in booking loans than in evaluating risk and pricing loans commensurately. But, pricing, credit decisions, and risk measurement and management at those banking organizations displaying best practices have increasingly been based on systems and procedures that impose a quantifiable discipline. That discipline, in turn, has given the credit-risk manager the ability to make the case for absolute and relative risk, enabling the bank to choose its risk profile rather than having it imposed by events. Quantification of risk has contributed to a changing balance of power between loan officers and credit-risk managers. We have already begun to see the benefits of this new balance. The tightening of lending standards by banks has historically occurred at, or most often after, cyclical peaks, accentuating the decline in economic activity. Before our most recent recession, however, banks began to be more selective lenders in response to the data indicating cumulating deterioration in borrower balance sheets. The volatility of interest rates in 1998 associated with the Asian crisis and the Russian default, as well as cautions from the regulatory community, also provided a useful early warning, and the memory of the painful losses of the late 1980s and early 1990s contributed importantly to the response of bank management. But, in my judgment, better risk measurement and risk management were noticeably important in moderating overall credit losses during the most recent recession and in establishing the higher credit standards that have been so important in the most recent years. The supervisory authorities are seeking, as you know, to build on these best practices of banks in developing the new capital rules, Basel II. The improving bank practices, coupled with the new rules, hold out the hope of a safer and stronger banking system contributing to a more stable economy. We anticipate that the best practices and procedures will spread beyond the largest banks, even to those entities that are not required to adopt the new capital rules. No discussion of better risk management would be complete without mentioning derivatives and the technologies that spawned them and so many other changes in banking and finance. Derivatives have permitted financial risks to be unbundled in ways that have facilitated both their measurement and their management. Because risks can be unbundled, individual financial instruments can now be analyzed in terms of their common underlying risk factors, and risks can be managed on a portfolio basis. Concentrations of risk are more readily identified, and when such concentrations exceed the risk appetites of intermediaries, derivatives and other credit and interest rate risk instruments can be employed to transfer the underlying risks to other entities. As a result, not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient. Derivatives have been used effectively by many banks to shift interest rate risks. In addition, while credit risks are transferred among financial intermediaries based on their ability and willingness to absorb such risk, increasingly credit risk has been transferred from highly leveraged financial institutions to those with much larger equity coverage. For example, not only has a significant part of the credit risks of an admittedly few large U.S. banks been shifted to other U.S. and foreign banks and to insurance and reinsurance firms here and abroad, but such risks also have been shifted to pension funds, to hedge funds, and to other organizations with diffuse long-term liabilities or no liabilities at all. Most of the credit-risk transfers were made early in the credit-granting process; but in the late 1990s and early in this decade, significant exposures to telecommunication firms were laid off through credit default swaps, collateralized debt obligations, and other financial instruments. Other risk transfers reflected later sales at discount prices as specific credits became riskier and banks rebalanced their portfolios. Some of these sales were at substantial concessions to entice buyers to accept substantial risk. Whether done as part of the original credit decision or in response to changing conditions, these transactions represent a new paradigm of active credit management and are a major part of the explanation of the banking system’s strength during the most recent period of stress. Even the largest corporate defaults in history (WorldCom and Enron) and the largest sovereign default in history (Argentina) have not significantly impaired the capital of any major U.S. financial intermediary. Technology Technology, as I have noted, has been among the most significant factors permitting banks to adjust to the new competitive environment in making credit decisions, in measuring and managing risk, and in creating and using new instruments. Technology of course, is a two-edged sword. The technology that banks use so profitably in risk measurement and management and in their dealing and underwriting activities is the same that their rivals and their customers used to deprive banks of the traditional lending business with their best customers. However, technology has also allowed banks to assess the credit and other risks of customers previously deemed too risky and, then, to extend credit profitably to such borrowers. Some investment in bank technology has been largely defensive, with the gains captured mainly by customers who would otherwise have shifted to competing institutions. Retail internet banking and, for some smaller banks, ATMs, are examples. But the use of even these defensive investments has often yielded benefits for banks from greater fees and from lower costs resulting from reduced check processing. I would be remiss not to note the more-direct contributions of technology to increased productivity in banking, the same kind of improvements that have occurred throughout our economy. Such gains are notoriously hard to measure in banking, but have visibly contributed to the improved profitability of banking. Not all such gains have been cost reducing: Some have increased cost, but have raised revenue even more by improving the variety and quality of banking services in ways for which customers are willing to pay. The increase in banks’ fee income is not unrelated to improvements in technology. Bank consolidation Technology has also facilitated consolidation in banking by making it more efficient at the margin - or perhaps less inefficient - for firms to become larger, more geographically dispersed, and better able to manage multiple business lines. Research at the Federal Reserve and elsewhere is consistent with other indications in the past decade or so of cost scale economies, or fewer diseconomies, and improved control by multibank holding companies over their bank subsidiaries. Improvement in the ability of these organizations to make small business loans over a wider geographical area is striking. Some of the consolidation of the past decade would not have been possible if the Congress, led by the states, had not removed prohibitions on interstate banking and branching. The combination of the resultant geographical diversification with the product line diversification facilitated by technology and the removal of out-dated legal prohibitions, has, in my view, greatly strengthened the stability of our financial system. Diversified banking organizations in most recent years have been able to absorb substantial losses in some lines or weak demand for some products without significant hits to capital or, in some cases, even to earnings. Banking history as recently as the 1980s and early 1990s would have been quite different had our banking structure then been more similar to that of today. The recent consolidation of the banking system has been dramatic. Excluding intra-bank holding company mergers, and including the approximate 100 announced but not yet completed mergers, about 2,400 banking organizations have been absorbed by other banking entities since 1995. If all the mergers that have been announced are completed, the ten largest banking organizations in the United States will account for about 51 percent of all domestic banking assets, almost double their share in 1995. Consolidation has not been a phenomenon involving only large banks. Roughly 45 percent of the mergers involved an acquirer and a target each of which had less than one billion dollars in assets. I must emphasize that, despite these merger trends, market and other pressures have kept measures of local market banking concentration virtually unchanged. An important factor has been the almost 1,400 new commercial bank formations since 1995. It would be a mistake to conclude from these comments that the only way to succeed in banking is through ever-greater size and diversity. Indeed, better risk management may be the only truly necessary element of success in banking. The variety in scale, strategy, and approach among quite profitable and well-capitalized banks in this country is striking. A handful of organizations operate diversified, multi-line, financial service businesses nationally or globally or both. Others deliver services throughout a multistate region. Some specialize in credit cards or mortgage finance. Some operate an alliance of smaller, independent organizations through multibank holding companies, seeking local investors and management. Some insurance, securities, or investment management firms have become affiliated with banks with the intention of broadening their product lines. Some banks have large branch systems whereas others have business plans with no branches, using mail and ATMs as alternatives. A very few are trying to operate without brick and mortar, only through the Internet. And, by number, our structure is still dominated, as it will continue to be, by the community banks that offer local services through local management, using specialized local information. The potential for new entrants, we should not forget, is always there and will keep the existing entities on this non-exhaustive list on their toes. Conclusion The factors that have contributed to the strength, resilience, and profitability of the U.S. banking system, which I have described, should continue to guide the industry in the years ahead. We have, in short, every reason to believe that banks of all sizes and types will continue to successfully compete in an ever-changing market environment. Nonetheless, as time passes, more and more bank managers will not have the first-hand memories of times of banking stress. That is why we must endeavor to build into bank and regulatory systems the product of the earlier experiences in order not only to retain and consolidate the gains made, but also to rapidly incorporate more widely the future advances that best-practice banks will continue to make.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the Conference on Reflections on Monetary Policy 25 Years after October 1979, Federal Reserve Bank of St Louis, St Louis, Missouri, 8 October 2004.
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Roger W Ferguson, Jr: Panel discussion - safeguarding good policy practice through maintaining flexibility Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the Conference on Reflections on Monetary Policy 25 Years after October 1979, Federal Reserve Bank of St Louis, St Louis, Missouri, 8 October 2004. * * * I am pleased to address this conference commemorating the twenty-fifth anniversary of the historic monetary policy changes implemented in October 1979. In my prepared remarks, I would like to focus on two issues with respect to safeguarding good monetary policy practice. First, I will discuss what constitutes good monetary policy practice and review the Federal Reserve’s record in satisfying its mandates in recent decades. Then, I will speculate on how good policy outcomes come about. In particular, I will discuss the role of policy transparency, central bank leadership, and alternative monetary policy regimes in preserving effective monetary policy. Of course, the usual caveat to my remarks applies: I will express my own views, and you should not interpret them as the position of the Federal Open Market Committee or of the Board of Governors. Assessing the Federal Reserve’s performance after 1979 When assessing what constitutes good monetary policy practice, I prefer to focus not on theory but on the reality of the Federal Reserve’s objectives. In contrast to many other central banks, the Federal Reserve has been assigned a “dual mandate” - to pursue policies that both maintain price stability and achieve maximum sustainable economic growth and employment. Good policy practice can be judged by the outcomes achieved. Therefore, I would like to briefly outline the Federal Reserve’s performance with respect to the level and the variability of inflation and growth. To be sure, the strong economic performance over the past two decades has several possible explanations, but the practice of monetary policy has likely contributed by helping to preserve macroeconomic stability. With respect to price stability, inflation in the United States over the past decade or so has clearly been lower and more stable than it was earlier in our history. In fact, annual inflation in the price index of personal consumption expenditures excluding food and energy - core PCE - averaged just over 2 percent from 1990 through the end of last year and consistently remained within a range - roughly 1 to 4 percent - that is relatively narrow compared with historical experience. This period contrasts sharply to the fourteen-year period from 1965 through the end of 1979, when annual core-PCE inflation averaged just over 5 percent and fluctuated between 3 and 10 percent. The recent experience of the United States with inflation has been similar in some respects and dissimilar in others to that of other countries. For example, based on the Organisation for Economic Co-operation and Development’s measures of overall consumer price inflation, prices rose at an annual average rate of about 3 percent in the United States from 1990 through 2003, compared with about 3 percent in the euro area and in the United Kingdom and roughly 1 percent in Japan.1 But, more important, the volatility of inflation was lower in the United States than in these other economies. An equally important indicator of the success of the Federal Reserve’s monetary policy is private expectations for future inflation. Measures of inflation expectations obtained from financial asset prices clearly indicate that market participants expect that the Federal Reserve will maintain low and stable inflation. For example, although the difference between the yields on nominal inflation-indexed and Treasury securities is an imperfect measure that includes complicating factors such as inflation risk and liquidity premiums, the five-year break-even inflation rate five years ahead has averaged about 2-1/2 percent over the past five years and has fluctuated in a narrow range of about 1-1/2 to 3-1/2 percent. Survey measures confirm that inflation expectations over this period have been subdued and well anchored. The University of Michigan’s survey of ten-year inflation expectations has averaged less than 3 percent and has stayed within a very narrow range over the past five years. Data are from the most recent OECD Economic Outlook (No. 75) (Excel spreadsheet). Assessing the outcomes with respect to the Federal Reserve’s goal of maximum sustainable output growth is inherently more difficult. Estimates of the relevant measures, such as the nonacceleratinginflation rate of unemployment (NAIRU), which in recent years has been decreasing according to some estimates, have very wide confidence intervals. But we can point to some evidence suggesting that the United States has enjoyed, besides subdued and stable inflation, some favorable developments with respect to output and employment. Certainly, we can document substantial gains in productivity in recent decades in the United States. According to the OECD, business sector labor productivity growth in the United States averaged about 2 percent from 1990 through the end of 2003, compared with about 1-1/2 percent in the euro area and in Japan over the same period. And since the mid-1990s, this gap has widened, with annual productivity growth averaging about 2-1/2 percent since 1995 in the United States, compared with about 1-1/2 percent in Japan and just less than 1 percent in the euro area over the same period.2 Another important measure of the success of monetary policy is how well the FOMC has responded to threats to our nation’s financial stability. This claim is surely hard to quantify. But everyone would agree that, compared especially with the deleterious effects of the Federal Reserve’s policy response during the Great Depression, the Fed has responded effectively to more-recent crises so as to help minimize the impact of such shocks on the greater economy. These episodes include the stock market crash of October 1987, the Asian financial crisis, and the collapse of Long-Term Capital Management in the late 1990s. Thanks in no small part to the flexibility of our policy framework, which I will discuss in greater detail in a few moments, the Federal Reserve appropriately discharged its responsibility as lender of last resort by providing ample liquidity and ensuring confidence during these and other troubling episodes, including the aftermath of the terrorist attacks of September 11, 2001. There is greater disagreement about how well the Federal Reserve responded to the bursting in recent years of the so-called bubble in technology stocks. This topic is broad, but I would like to note that, as many of my colleagues and I have previously argued, prospectively addressing perceived asset-price bubbles is a matter of such great uncertainty that, even with the benefit of hindsight, it is not clear that policy decisions in the late 1990s, for example, should have been any different. In any case, the recession that followed the sharp decline in stock prices was shallow by historical standards. How can we safeguard good policy outcomes? I would now like to turn to issues related to preserving, as best we can, a continuation of good policy practice in the future. Central bank transparency Consider first the important role of central bank transparency. Transparency of central bank decisionmaking is desirable, not only for economic reasons, but also because it is supportive of central bank independence within a democratic society. Because of the lagged effects of monetary policy on output and prices, the time horizon of central bankers is necessarily more distant than that of other policymakers. Thus, the central bank needs substantial insulation from political pressures to execute policy: An independent monetary authority is less tempted to make policy for the short term, such as boosting output or refinancing national budgets, at the expense of long-run objectives. Of course, the goals of monetary policy should be determined within the democratic process, but the central bank should have discretion to achieve those ends. In short, an appropriate arrangement within democratic societies is for central banks to have independence with respect to the instruments, but not the goals of monetary policy, and transparency is an appropriate condition for that independence. Besides its inherent virtues in a democratic society, transparency can enhance monetary policy’s economic effectiveness by more closely aligning financial market forces with central bankers’ intentions. Like other central banks, the Federal Reserve controls only a very short-term interest rate, the overnight federal funds rate. However, theory and empirical evidence suggest that longer-term interest rates and conditions in other financial markets, which reflect expectations for short-term rates, matter most for monetary policy transmission to the economy. If the monetary authority is transparent These data on productivity growth are also from the most recent OECD Economic Outlook (No. 75) (Excel spreadsheet). about the rationale and the stance of policy as well as its perception of the economic outlook, then investors can improve their expectations of future short rates.3 The path that monetary policy will follow in the future is uncertain even to policymakers because that trajectory will depend on incoming news about the economy and the implications of that news for the economic outlook. But announcing policy decisions in a timely manner and explaining those decisions fully allows market participants to better anticipate the response of policy to unexpected developments and to speed needed financial adjustments. Central bank leadership Next, I consider the role of the individuals entrusted with the responsibility for making policy decisions. Although monetary policy frameworks have a potentially great influence on macroeconomic outcomes, we should not forget that the individuals who serve in central banks themselves have a crucial role in preserving policy outcomes. Even with a monetary policy regime that follows best practices and shapes the decisionmaking process, ultimately individuals’ beliefs and perceptions still matter for the actual policy taken. An interesting recent study of the history of the Federal Reserve by Christina Romer and David Romer finds a very strong link between the skill and knowledge of the FOMC, particularly the Chairman, and macroeconomic outcomes.4 For example, with little reference to transformations in the disclosure policy and the independence of the Federal Reserve over the years, they ascribe the policy successes of two periods - the 1950s and the 1980s and 1990s - to a conviction of Federal Reserve Chairmen regarding the high costs of inflation and their tempered views about the sustainable levels of output and employment. In contrast, they attribute the deflationary and counterproductive policies of the 1930s to the erroneous belief that monetary policy can do little to stimulate output and that the economy can actually overheat at low levels of capacity utilization. But there is one aspect of the process that Romer and Romer do not emphasize enough - the ability of central bankers in general, and indeed members of the FOMC in particular, to withstand political pressures. In addition, central bankers should have a thorough and practical, rather than a purely academic, understanding of the economy and, given the Federal Reserve’s objective to preserve financial stability, of financial markets and institutions. The committee’s institutional memory may also matter in this context. Today, the FOMC is well versed in the monetary history of the 1970s and 1980s, for example, and recognizes the great efforts that previous members of the FOMC undertook to achieve price stability. I trust that future generations of policymakers will continue to share that understanding and thus help to preserve good policy outcomes. Will inflation targets preserve good policy practice? Finally, I would like to touch on a topic that is perhaps more controversial in the context of safeguarding good policy practice. Several academic and professional economists, including distinguished colleagues of mine at this conference, have eloquently advocated the adoption of explicit numerical goals for central bank objectives, most notably inflation targets. The adoption of numerical targets, it is argued, facilitates central bank accountability and better anchors private expectations about inflation and monetary policy and thereby yields better macroeconomic outcomes. Quantifying central bank objectives has some positive aspects and, certainly, vigorous advocates. Nonetheless, I harbor significant reservations about this approach regarding both its practical implementation, in the specific context of the Federal Reserve System, and its demonstrated See Joe Lange, Brian Sack, and William Whitesell (2003), “Anticipations of Monetary Policy in Financial Markets,” Journal of Money, Credit, and Banking, vol. 35 (December), pp. 889-909; William Poole, Robert H. Rasche, and Daniel L. Thornton (2002), “Market Anticipations of Monetary Policy Actions,” (253 KB PDF) Federal Reserve Bank of St Louis, Review, vol. 84 (July/August), pp. 65-93; and Ben S. Bernanke, Vincent R. Reinhart, and Brian P. Sack (2004), “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment,” Finance and Economics Discussion Series 2004-48 (Washington: Board of Governors of the Federal Reserve System, September), for evidence relating to the increased transparency of the FOMC over the past several years to the predictability of short-term interest rates. See Christina D. Romer and David H. Romer (2004), “Choosing the Federal Reserve Chair: Lessons from History,” Journal of Economic Perspectives, vol. 18 (Winter), pp. 129-62. effectiveness based on inferences from the recent experience of regimes that have specific numerical targets, particularly with respect to inflation, around the world. A basic, yet difficult, issue is the selection of a particular price index to guide policy, even in the case of a single goal such as inflation. Experience tells us that economies and the composition of productive enterprises change over time, and therefore the appropriate index and inflation value for the monetary authority would also need to change to reflect technological and other advances. In light of this inherent uncertainty associated with the construction of a price index, one might be concerned that choosing and rigidly adhering to an inappropriate index could have negative economic consequences that might outweigh prospective benefits. Also, we must consider the ramifications of quantified goals in the context of our democracy. That is, the quantification of objectives becomes even more problematic for central banks such as the Federal Reserve with multiple democratically based mandates, some of which are notably less disposed to quantification than others. For example, considering our dual mandate from the Congress, how do we measure maximum sustainable employment? Indeed, as I mentioned previously, estimates of the NAIRU and other possible related measures that address the full-employment objective such as the output gap have uncomfortably wide confidence intervals and are far more controversial than selecting a target for a specific price index. Of course, the central bank could in principle quantify only the inflation objective. However, I fear that quantifying one goal and not the other would present problems because the monetary authority might inadvertently place more emphasis on the quantified goal at the expense of the nonquantified objective. Doing so would seem inappropriate. The ease of quantification should not influence how the Federal Reserve pursues its dual mandate. In addition, I worry about the potential loss of flexibility from the implementation of an inflation target, as explicit numerical goals might inhibit the central bank’s focus on output variation or financial stability. I would argue that, besides the episodes of financial turmoil in the late 1990s mentioned earlier, supply shocks, such as large increases in oil prices that simultaneously increase the price level and decrease aggregate output, can be problematic for inflation-targeting regimes. Of course, some variants of the approach - so-called flexible inflation targeting for instance - can address the issues I just raised by stipulating wide target ranges, by maintaining escape clauses that allow inflation to diverge from the target, or by aiming at average inflation over the business cycle. But the credibility gains from inflation targeting seem to me to be inversely related to its flexibility. Simply, credibility is less likely to be gained and expectations are less likely to be anchored if the central bank frequently uses escape clauses, widens the target bands, or pushes out its time horizon. Ultimately, real credibility for achieving goals must come from performance, and predetermined frameworks do not seem to be a necessary or a sufficient condition to safeguard desirable policy outcomes. Observation of more-recent Federal Reserve actions reveals the apparent preferences of policymakers. In recent years, the Federal Reserve has apparently leaned against disinflation when core inflation threatens to fall much below 1 percent, and, similarly, against inflation when the core rate threatens to rise above 2 to 2-1/2 percent. The Federal Reserve has demonstrated this strategy without the formal adoption of a specific inflation target or range for the FOMC. Given the subdued and stable inflation witnessed over the past fourteen years, I have to ask: What would be gained from a formal goal for inflation? Can we draw compelling general inferences from the recent experience of inflation-targeting central banks? As a caveat regarding this evidence, economists have very limited data to work with, as the first recognizable inflation targeting regime appeared in New Zealand in 1990. But to date, I would argue that the case for inflation targeting has yet to be proved. Certainly, I would not deny that numerical inflation targets have proven useful for several countries in particular circumstances. One example is the United Kingdom, where, in the aftermath of “Black Wednesday” in October 1992, an inflation target helped provide a nominal anchor after sterling was removed from the European exchange rate mechanism. I should also add that the Bank of England has quite successfully helped to achieve low and stable inflation ever since. In addition, inflation targeting can have demonstrable benefits in lower-income countries that have experienced high and variable inflation rates in the recent past. In several cases, quantified inflation targeting has served as a means of achieving the central bank independence necessary to focus more effectively on controlling inflation. That is, the adoption of an inflation target is frequently part of a broader program to increase the autonomy and transparency of central bank practice. But inflation targeting is not the only means by which to achieve these ends. Again, the recent experience in the United States that I have noted is an object lesson in this regard. Unfortunately, the empirical evidence for industrial countries available to date generally appears insufficient to assess the success of the inflation-targeting approach with confidence. For example, it is unclear whether the announcement of quantitative inflation targets lessens the short-run tradeoff between employment and inflation, and whether it helps anchor inflation expectations. In addition, some research, controlling for other factors, fails to isolate the benefits of an inflation target with respect to the level of inflation or its volatility over time, and output does not seem to fluctuate more stably around its potential for countries that have adopted numerical targets.5 Future data may or may not produce compelling evidence, but I maintain that the case today for inflation targets in countries that already enjoy low and stable inflation rates has certainly not been proved. With respect to both its practical implementation, particularly in the United States, and the empirical evidence to date, I submit that the adoption of a numerical inflation target does not promise any obvious incremental benefits, at least in countries that have already achieved reasonable price stability. That said, a continuing commitment to price stability is certainly important, and the Federal Reserve has established a solid record of such commitment. Conclusion Based on this brief review, I conclude that, at least since the policy reform of October 1979, most observers would agree that the Federal Reserve has achieved generally good policy practice and outcomes. In my assessment, good policy practice cannot be safeguarded with certainty using a single rule or framework, such as inflation targeting. Good outcomes ultimately depend on flexible execution of an evolving strategy and policymakers with an unwavering commitment to low and stable inflation as the foundation for maximum sustainable growth. See for example, Laurence Ball and Niamh Sheridan (2003), “Does Inflation Targeting Matter?” NBER Working Papers Series, no. 9577 (March), and E. Castelnuovo, S. Nicoletti-Altimari, and D. Rodriguez-Palenzuela (2003), “Definition of Price Stability, Range and Point Inflation Targets: The Anchoring of Long-term Inflation Expectations,” (413 KB PDF) ECB Working Paper No. 273 (September).
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Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, to the National Bankers Association, Nashville, Tennessee, 6 October 2004.
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Roger W Ferguson, Jr: Questions and reflections on the personal saving rate Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, to the National Bankers Association, Nashville, Tennessee, 6 October 2004. * * * I am delighted to be here today to offer my thoughts on an issue that I believe is important to all of us: the long-standing decline in household saving. Since the early 1980s, the personal saving rate has fallen steadily; on average, a household today saves only about 1-1/2 percent of its disposable income, compared with about 11 percent in 1984. The fall in the personal saving rate could have important implications for the ability of the country to finance investment in plant and equipment, for future growth in productivity and real incomes, and for our growing economic dependence on other countries to finance our spending patterns. Although my remarks today concentrate on the behavior of household saving and overall national saving, I also want to spend some time on a related issue: What is the evidence on the saving of minority households? Much has been written about the adequacy of retirement saving for many American households and the wealth accumulation of different income cohorts. But what do we know about the saving of minority households, and does it differ from the saving of low-income households, where minorities are disproportionately concentrated? Let me turn first to the bigger picture. Personal saving, as measured by the Commerce Department’s Bureau of Economic Analysis, is essentially the amount of after-tax income left after household bills are paid. From the end of the Second World War until the early 1980s, the personal saving rate personal saving expressed as a percentage of disposable income - gradually trended up. To be sure, the saving rate showed considerable volatility from year to year, and in some periods, such as the second half of the 1970s, its upward drift stalled for a time. But overall, the picture was that of a fairly steady rise in the personal saving rate, from about 7-1/2 percent in the early 1950s to around 10-1/2 percent in the early 1980s. Since that time, however, the household saving rate has declined precipitously and, in the last couple of years, it has averaged only about 1-1/2 percent. As is often the case with statistics, the figures I’ve just given are not the only word on this subject because the government publishes additional measures of household saving. One such measure, produced by the Federal Reserve, uses different source data to estimate the same concept of savings. The Fed measure suggests that households have been putting away about 3 to 4 percent of their income in recent years, a little more than estimated by the Commerce Department. But, importantly, it also shows the same precipitous decline since the early 1980s in the personal saving rate. Interestingly, the Fed’s study of this issue shows that the decline in the saving rate of households at the top 20 percent of the income distribution accounts for virtually all of the decline in the aggregate personal saving rate since 1989, the first year for which estimates on saving by income quintile are available. That is, the saving rates of the bottom 80 percent of the income distribution have fluctuated in a relatively narrow range and importantly have shown no secular decline since 1989. Should we worry about the fall in the personal saving rate? Do we need to worry about the fall in the personal saving rate? Taking a big-picture point of view and asking whether the low rate signals that adjustments are needed for the future for the U.S. economy, the answer is a conditional “yes”; but the period over which those adjustments will occur is very unclear. In the aggregate, an economy needs to generate savings for two basic purposes - to invest in new plant and equipment with the aim of raising future consumption growth and to expand the residential housing stock, thereby boosting the flow of housing services over time. Thus, the act of saving is essentially about the allocation of an economy’s resources: Some sector of the economy must be willing to consume less than its current income to free resources for the purchase of capital. Intuitively, we often think of saving in financial terms: Rather than spending our entire paycheck, we put money aside into savings accounts or certificates of deposits, and the bank lends this money to business; or we lend directly to firms by buying corporate bonds or stocks. Similarly, corporations save by not paying out all their profits to their stockholders. But underlying all these financial transactions is the reallocation of resources away from the immediate consumption of goods and services and toward the purchase of capital goods - goods that are not consumed directly but are instead used to produce future goods and services for consumption. How much should an economy save and invest? The answer comes down to a decision about what combination of capital and labor inputs minimizes the cost of producing goods and services. The cost-minimizing mix will depend on the relative prices and relative productivity of capital and labor and on the rate of interest. If saving is inadequate to meet these investment needs, then interest rates rise, increasing the return to saving and perhaps boosting saving to some extent but also making it worthwhile for firms to reorganize their production methods to use less capital per worker. It is this consequence - operating at a lower ratio of capital to labor - that drives the concern about adequate savings in the economy. Over time, reducing the ratio of capital to labor in production reduces the productive capacity of the economy. And critically for the average worker, reducing the amount of capital per worker reduces a worker’s marginal productivity, his or her real wage rate, and of course, the sustainable amount of his or her consumption. To get some idea about the importance of saving and investment for future productivity growth, we can look to the past. Since the mid-1990s, productivity growth in the nonfarm business sector has averaged a bit more than 3 percent, roughly double its average from 1973 through 1995. Estimates produced by the Bureau of Labor Statistics, augmented by analysis carried out at the Federal Reserve and elsewhere, suggest that about one-third of the step-up in productivity growth is attributable directly to increases in the amount of capital per worker used in production.1 This so-called capital deepening has in turn come about because of the sharp decline in the relative price of capital: For example, the price of new high-tech capital equipment has fallen 70 percent relative to the price of business output since the end of 1995, so that increasing the capital intensity of production has become cost efficient. But this estimate may well understate the total contribution from investment to labor productivity growth because of synergies that are difficult to quantify but are significant nonetheless. For example, newer vintages of capital may embody more-advanced technology than older vintages and thus, even without any increase in capital intensity, productivity would rise as new capital replaces old capital in production. So if capital investment is a critical factor behind productivity growth, why have I hedged on the issue of whether the decline in the personal saving rate is something about which we should be concerned? The reason is that, in a country with a well-developed capital market, investment needs of one sector can be met by savings of another sector. In principle, the burden of saving need not fall exclusively or even primarily on the household sector, and indeed, the contribution of the various sectors to aggregate saving has varied considerably over the past fifty years. For the most part, government saving has been negative over this period; consolidating the savings of the federal, state, and local governments indicates that, since about 1960, except for a few years during the late 1990s, the government has spent more each year than it has collected in tax revenues. It is the federal government that accounts for nearly all of the negative saving; state and local governments have generally balanced their operating budgets because most of them face constitutional or statutory requirements to do so. Although the Treasury ran a surplus as recently as 2001, the prospects for its doing so again anytime soon are not high. Both Social Security and Medicare face running deficits in the near future because of factors such as the retirement of the baby-boom generation, rapidly increasing health costs, and a slowdown in the growth rate of the labor force. Tax cuts enacted over the past three years, although undoubtedly supporting the economy during its recent period of recession, have also added to the prospects for federal government deficits. In this regard, let me just say that I fully support the goal of fiscal prudence for the federal government: To the extent that the federal government is soaking up funds that might otherwise be used for private domestic investment, the United States is getting smaller productivity gains than we could be getting. Foreigners are another source of saving, and they have played an increasingly important role over the past twenty years in financing our domestic investment. Foreign saving is identified with our current account balance: When we import more than we export in dollar terms, we borrow from foreigners. Between 1950 and the early 1980s, our current account balance stayed close to zero - sometimes we borrowed from foreigners, and other times we lent, but for many years we remained a net global For estimates of productivity growth and the contribution of capital deepening through 2001, see the Bureau of Labor Statistics release Multifactor Productivity Trends. For more recent years, I use Federal Reserve estimates. creditor. Since then we have become increasingly reliant on the willingness of foreigners to fund our investment needs; the current account deficit now stands at almost 6 percent of gross domestic product, and foreigners today fund about 30 percent of our domestic investment. In some respects, this foreign borrowing is not problematic - the rest of the world supports investment in plant and machinery while we maintain our consumption. But two considerations weigh against foreign funding being a sustainable long-run solution. First, continued borrowing from abroad means that foreigners have an ever-growing claim on the nation’s capital assets. Thus, a growing share of the output produced by those assets is not ours to spend but instead goes to foreigners in the form of dividends and interest payments. So, if the goal of saving is to raise the capital stock in order to increase our own future production and consumption possibilities, sending increasingly larger amounts of additional income abroad lowers the gain from investment. Certainly, we are still better off than we would be had the investment not occurred: Labor productivity is increased regardless of who owns the capital stock, and as a result, both real wage growth and future consumption growth are greater than they would otherwise be. A second reason we should be vigilant about our growing foreign indebtedness is that, should global investors decide to rebalance their own portfolio so as to reduce the amount of their lending to the United States, the economy could face some significant adjustments in numerous economic variables, including interest rates, the composition of consumption, and the level of investment. Of course, dynamic economies are used to seeing such changes, and for the United States, these changes have historically been orderly. But there is always some risk, however remote, that future changes could be less orderly than has been our experience historically. So, if depending in the long run on government saving and foreign saving to finance private domestic investment raises serious concerns, where does that leave us? The answer is that the private domestic sector, households and businesses, ultimately must generate the bulk of saving. Business saving is, and has always been, greater than household saving because corporations set aside a large volume of income to replace aging equipment. Thus, the precipitous drop in the share of income that households save does not translate into a proportional drop in total private-sector savings. But, we have no evidence that business saving has moved over time to significantly offset the downward trend in household saving. Indeed, the ratio of gross business saving to GDP has risen only about 1 percentage point since the mid-1980s, whereas the decline in personal saving - again relative to GDP - has been about 7 percentage points. Realistically, the key to ensuring adequate saving in the future appears to rest on reversing or at least containing the decline in the personal saving rate. The prospects for doing so depend on why the personal saving rate has fallen. Why has the personal saving rate fallen? Economists, as you might expect, are not in complete agreement about the causes of the decline. Perhaps the most popular explanation is that large capital gains on equity holdings and residential real estate have sharply raised the net worth of many households, assuring them that they are well positioned to meet goals for precautionary or retirement savings even while they save less of their current income.2 This explanation suggests that for many households the operative concept of saving is not the portion of current income that they do not spend but rather the change in their net worth. The former measures only the acquisition cost of new household assets whereas the latter measures the change in the market value of assets, which is the acquisition cost of new assets plus the capital gain or loss on existing assets. The latter measure of saving does indeed paint a far more positive picture of household saving behavior: The ratio of the change in net worth to disposable income, although more volatile over the past decade than previously, has been essentially trendless over the past two decades.3 The so-called wealth effect has a long history in the economics profession. Among the earliest and most frequently cited references is the work of Albert Ando and Franco Modigliani (1963), “The ‘Life Cycle’ Hypothesis of Saving: Aggregate Implications and Test,” American Economic Review, vol. 53 (March), pp. 55-84. A review of the effect that of the late 1990s gains in equity prices had on consumption is available in James M. Poterba (2000), “Stock Market Wealth and Consumption,” Journal of Economic Perspectives, vol. 14 (Spring), pp. 99-118. This alternative concept of the personal saving rate has, in fact, shown a slight positive trend since the early 1950s. Whether or not we should take comfort from this alternative picture of the saving rate is a complicated issue, one that is inextricably tied to our confidence that the price of corporate equity accurately reflects the underlying productivity of corporate assets. One would expect that capital gains on financial or real capital assets reflect a positive reassessment of the productivity of some physical asset and, therefore, an increase in the potential for greater future consumption. To this extent, capital gains serve the same function as saving out of current income. But, it is hard to believe that all the movements in asset prices witnessed in recent years are well-rooted in changes to the underlying productivity of those assets. A telling reason for skepticism is the behavior of stock prices since the late 1990s. What information on productivity or productivity growth can account for, first, the near-tripling of share prices during the late 1990s and, then, the retrenchment of prices in 2000 and 2001? It would appear that a portion of past swings in net worth has reflected behavior based on something other than well-founded assessments of changes in the underlying productive potential of existing capital. Nevertheless, on the issue of why the personal saving rate has fallen, empirical evidence linking the stock of wealth to consumption spending supports the view that capital gains on corporate equities and residential real estate have been important factors. Another explanation for the decline in the personal saving rate relates to possible upward revisions to households’ expectations for their long-run or permanent income. Many studies of household consumption and saving behavior link current consumption to both current income and expected future income as households appear to smooth spending in response to fluctuations in income.4 One consequence of this behavior is that the ratio of consumption to current income will be higher - and hence the personal saving rate will be lower - the higher is the expected growth rate of future income. So to the extent that households have taken note of the step-up in productivity growth over the past decade and have assumed that it means more rapid increases in future income, their saving rate would fall. This belief in “better economic times ahead” increases the confidence of households about their future income prospects and encourages them to be less thrifty today. Another commonly referenced argument for the decline in the personal saving rate emphasizes the growing importance of Social Security, Medicare, and other government transfer payments in overall household income. These programs have the effect of shifting income toward those portions of the population that, at least in theory, have a relatively high propensity to spend. Moreover, by providing some insurance against future financial hazards, the very existence of the programs has probably reduced the incentive of even those currently not receiving such transfers to save for retirement and other emergencies.5 Many other theories have been put forth dissecting the fall in personal savings. One involves financial market innovation. Since the 1980s, households have had easier access to credit markets. Credit card usage has grown exponentially over the past two decades, and the ratio of consumer credit to income has increased 50 percent. Mortgage credit has also become less costly to obtain, and along with the tremendous run-up in real estate prices since the mid-1990s, it has encouraged frequent refinancings with many households tapping into their home equity for consumption needs. Another theory attributes the fall in the personal savings rate to the generally low level of real interest rates in recent years. This particular theory has both supporters and detractors in the economics profession. Whether raising the rate of return on savings raises or reduces savings propensities remains an open question. On the one hand, the higher return to saving should make saving more attractive; on the other hand, a higher return means that less saving is required to achieve any given level of wealth. The weight of empirical evidence favors a positive relationship between interest rates and the saving rate, although the confidence intervals around such estimates are quite large. The influence of permanent income on consumption also has a long history in the economics literature, and the work by Milton Friedman is among the best known of the early papers. See, for example, Milton Friedman (1957), A Theory of the Consumption Function, (Princeton: Princeton University Press. For another early and fundamental study, see Franco Modigliani and Richard Brumberg (1954), “Utility Analysis and the Consumption Function: An Interpretation of Cross-section Data,” in Kenneth K. Kurihara (ed.), Post-Keynesian Economics, (Rutgers, N.J.: Rutgers University Press), pp.338-436. For a more recent study on this issue, see John Y. Campbell (1987), “Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis,” Econometrica, vol. 55 (November), pp. 1249-73. The classic paper on the effect of government transfer payments on household spending is by Martin Feldstein (1974), “Social Security, Induced Retirement, and Aggregate Capital Accumulation,” Journal of Political Economy, vol. 82 (September/October), pp. 905-26. For a commonly cited paper on the relationship between precautionary saving and government entitlement programs, see Lawrence H. Summers and Christopher D. Carroll (1987), “Why is U.S. National Savings So Low?” Brookings Papers on Economic Activity, 2:1987, pp. 607-36. Will the personal saving rate rebound? Suffice it to say, theories on the decline in the personal saving rate are abundant. Empirical research suggests that multiple factors played into the decline in the rate, and the relative contributions of the factors have fluctuated over time. Taking all the factors into account, what are the odds of a rebound in the personal saving rate to the average level of the 1950s through the 1980s? First, current levels of personal saving are insufficient to maintain the current ratio of wealth to income, without significant capital gains in the future. A decline in the ratio of wealth to income would, by itself, tend to raise the future saving rate. To the extent that a decline in net worth relative to income turns out to be the precipitating factor for a future rebound in the personal saving rate, it is reasonable to expect that the saving rate of the top quintile of the income distribution will do the bulk of the rebounding. As I noted earlier, the saving rate of this quintile accounted for virtually all of the decline in the aggregate personal saving rate. Because households in this income quintile own about 65 percent of aggregate net worth, any revaluation of assets will be felt strongly in this group and consequently their saving behavior should most clearly reflect this influence. Second, productivity growth, or households’ perceptions of such growth, could fall back from rates experienced in the past few years, again raising personal saving rates. Once again, this might most noticeably affect the saving rate of the top quintile of the income distribution, at least in the short run. Why? While changes in trend productivity growth should ultimately feed through to changes in wage growth, the passthrough of productivity gains to wages generally is not instantaneous. Instead, changes to productivity growth are felt first in capital income - profits and rents and dividends - so any drop back in future productivity growth would likely be felt first in capital income. Capital income is of course more frequently found in the income of the top quintile than in the lower quintiles of the income distribution. A third factor that could influence the saving rate is that market-determined interest rates may rise from their low levels at present and thus may raise the incentive to save a bit. Such a rise in interest rates might also tend to slow the increase in the value of real estate and equities, eliminating some of the cushion that households currently might count on from past high rates of capital gains and reducing the impetus to consumption spending that mortgage refinancings have in recent years permitted. On the other hand, government transfer payments are unlikely to fall, and financial innovation is not going to reverse itself. Although it is difficult to predict with any precision the course of asset values, or productivity growth, or federal entitlement programs, or even interest rates, all told I would not expect the personal saving rate to return in the near term to the peaks seen twenty years ago, and I would be surprised even by a return anytime soon to the average rate that prevailed between the 1950s and the 1980s. At the same time, I want to note that we likely will not need quite so high a national saving rate in the future because, as the growth rate of the labor force slows with the retirement of the baby boom generation, less investment will be required to equip each worker with the same amount of capital. Thus the shortfall in national savings relative to private domestic investment might be a bit less than we would assess by looking only at national savings. But the problem of inadequate national savings is still there. Saving and minority households Let me now turn away from the issue of whether the country saves and invests enough and focus on the issue of what we know about the wealth accumulation of minority households. A fair number of studies exist on this subject, but two stand out.6 Both find that, after controlling for differences in income and in demographic factors, black families have lower wealth than white families. Thus, even if policies designed to reduce racial differences in income were completely successful, the bulk of the wealth differential would remain, and the ratio of net worth to income would be lower for black families. Francine D. Blau and John W. Graham (1990), “Black-White Differences in Wealth and Asset Composition,” Quarterly Journal of Economics, vol. 105, pp. 321-39. See also Joseph G. Altonji, Ulrich Doraszelski, and Lewis Segal, (2000), “Black/White Differences in Wealth,” Federal Reserve Bank of Chicago, Economic Perspectives, vol. 24 (1st quarter), pp.38-50. Three principle factors can account for this. First, black families may receive lower inheritances or other intergenerational transfers; second, black families may have lower propensities to save out of income; and third, black families may experience lower rates of return on their savings. The two studies that I cited disagree to some extent on which of these factors is most important. One study stresses the importance of intergenerational transfers, whereas the other stresses differences in savings behavior. But both argue that differential rates of return are important. Black families are less inclined at most income levels to invest in stocks, and black families are less likely to be owners of small business. Although it is difficult to draw precise inferences regarding the key factors that have limited minority wealth accumulation, one endeavor should pay off in terms of greater saving by and higher net worth of minority households: increased efforts in financial education. We at the Federal Reserve have embarked on a program to raise the level of financial literacy in our country, and I believe that similar programs offered by private financial institutions will also yield a high return. Thus, I encourage all of you to work to increase the knowledge of your depositors about financial issues. Conclusion Let me briefly conclude by restating my main points. Probably nothing is more critical to the long-run well-being of the U.S. economy than ensuring high rates of productivity growth. Productivity growth requires adequate levels of investment. While foreign saving is currently a feasible source of investable resources, it would be more economically advantageous in the longer run if we could raise the amount of household and government savings and close the gap between domestic investment and national savings. Within the household sector, the accumulated saving of minority households, relative to their income, appears to be lower than that of nonminority households. In this regard, increased efforts at financial literacy programs can have a positive payoff, especially since at least one source of the minority-nonminority differential is apparently due to lower rates of return earned by minority households.
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board of governors of the federal reserve system
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Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Conference on Trade and the Future of American Workers, Washington, DC, 7 October 2004.
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Roger W Ferguson, Jr: Free trade - what do economists really know? Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Conference on Trade and the Future of American Workers, Washington, DC, 7 October 2004. * * * The role of trade in the U.S. economy has moved well into the spotlight in recent years, and I am pleased to be here today to share my thoughts on this important topic with such distinguished and knowledgeable colleagues. Over the course of this day, you will be hearing from leading analysts, policymakers, and commentators about recent developments in the U.S. economy, past and prospective trends in job creation, the role of sourcing (both out- and in-), and the implications of trade for the coming elections. In my remarks this morning, I would like to put these issues into the broader context of the debate over free trade and its implications for the American economy. Though my focus will be on free trade, we must remember that prospects for the average American depend on many other factors as well, including technological progress, the education required to exploit this progress, a dynamic market-oriented economy, a framework of limited but effective regulation, healthy and well-governed financial institutions, and a stable macroeconomic environment. And free trade is not necessarily the most important item on this list. Even so, it has been a focus of interest and aspiration for economists dating back to Adam Smith and David Ricardo. As you know, finding overwhelming agreement on issues is difficult among economists, but free trade is an exception.1 The supporters of free trade have not been ignored. In the past half-century, global trade has become freer and has expanded rapidly. The ratio of trade (exports plus imports) to worldwide gross domestic product rose from only 16 percent in 1960 to 40 percent by 2001. In 1960, the United States, Germany, and Japan had average tariff rates of around 7 percent; these rates were more than halved by 1993. The number of members of the World Trade Organization (WTO), or its predecessor, the General Agreement on Tariffs and Trade, rose from 18 in 1948 to 146 in 2003, and the number of regional trade agreements in the world ballooned from only 1 in 1958 to 161 in 2003. Although most economists welcome these trends, the public at large has been much more ambivalent about international trade. Attitudes toward free trade in principle remain generally positive, but a substantial - and, perhaps, growing - minority of Americans hold more negative views. According to a poll completed around the beginning of this year, 41 percent of respondents viewed the process of increasing international trade through reduction of barriers as proceeding too quickly; this number was up from 30 percent in 1999. And 43 percent of respondents believed that the government should try to slow or reverse the expansion of international trade, up from 39 percent in 1999.2 What accounts for the apparent deterioration in public support for free trade over the past five years? The widening of the U.S. trade deficit may have exacerbated concerns about the country’s international competitiveness. More important, some have blamed overseas competition for the job losses associated with the economic slowdown earlier in this decade. Without solid public support for free trade, achieving continued progress in reducing protectionist barriers, both at home and abroad, may become more difficult. In the remainder of my remarks, I’d like to review the arguments for and against free trade, explore why it has been difficult to muster more widespread public support for this goal, and address some of the consequences of trade protection as it has been implemented in practice. Ninety-three percent of economists surveyed agreed, to a least a limited degree, with the statement that “tariffs and import quotas usually reduce general economic welfare.” Richard M. Alston, J.R. Kearl, and Michael B. Vaughan (1992), “Is There a Consensus Among Economists in the 1990s?” American Economic Review, vol. 82 (May, Papers and Proceedings, 1991), pp. 203-09. Steven Kull and others (2004), “Americans on Globalization, Trade, and Farm Subsidies,” The American Public on International Issues, the PIPA/Knowledge Networks Poll (Program on International Policy Attitudes, University of Maryland, January 22), www.pipa.org. Arguments for free trade International trade contributes to prosperity and growth through several channels. These channels are not especially subtle or esoteric, and I would argue that the public at large understands them reasonably well. At the same time, however, quantifying the contributions of trade to national welfare is by no means straightforward. First, and most obviously, trade increases the variety of goods available to consumers. Trade provides some products that otherwise would be beyond the reach of most American households, such as roses for Valentine’s Day, or peaches and nectarines during the winter. More generally, international trade allows us to choose from a wider array of goods than would otherwise be available: Japanese and German cars in addition to American, Chilean apples as well as Washington state, French and Australian wine as well as Californian. It is difficult to put a dollar figure on the value of this increased variety to the consumer, but estimates range as high as nearly 3 percent of GDP.3 A second benefit of international trade is its role in reducing the cost of goods and hence in raising our standard of living. To anyone who has walked into a large discount store and surveyed the range of low-priced items produced in any number of distant economies, this benefit is abundantly clear. However, actually measuring the extent to which trade holds down consumer costs is tricky. Between 1990 and 2003, for example, the overall consumer price index rose 41 percent, whereas prices declined for many highly traded goods, including toys (whose prices fell 26 percent), televisions (53 percent), and clocks and lamps (15 percent); in just the past five years, the price of telephones, calculators, and other such items has fallen 42 percent. Yet, we do not know how much of the decline in these prices can be attributed to trade, as most traded products are manufactures and are subject to greater productivity growth (and hence steeper declines in costs) than nontraded products such as services. A more fruitful approach may be to compare the prices of goods that are protected from international competition with what they would be in the absence of such barriers. A recent study by the U.S. International Trade Commission indicates that sectoral trade liberalization would lower the price of sugar for U.S. consumers by 8 percent, of apparel by 5 percent, and of footwear and leather products by 4 percent.4 Clearly, if international trade were curtailed for a much broader range of goods, the cost of living for American workers would be higher and the standard of living correspondingly lower. A third key benefit of free trade is that it allows economies to specialize in the activities they do best. This notion was at the core of the classical economists’ defense of free trade. By allowing England to specialize in cloth production and Portugal in wine, for example, international commerce leads to a higher income for both countries than if each tried to produce both goods for themselves. By the same token, no American today would object to trade between Massachusetts and Montana, or between Alaska and Alabama - the various U.S. states obviously have their own comparative advantages in producing a variety of different products, and trade among them makes such specialization possible. Extending the example of trade among states to trade among countries is not much of a stretch. Can we measure the extent to which the specialization associated with free trade may boost incomes and welfare? Such an estimate is obviously no simple thing to calculate. Economists frequently use so-called computable general equilibrium models, often consisting of hundreds of equations, to address this issue. A recent analysis of the effects of past trade liberalizations on the U.S. economy puts the gains to U.S. welfare at about 1/2 percent of GDP.5 A separate analysis of a hypothetical 33 percent reduction in trade barriers around the world suggests it would raise welfare by 1-1/2 percent of global GDP.6 Christian Broda and David E. Weinstein (2004), “Globalization and the Gains from Variety,” NBER Working Paper Series 10314 (Cambridge, Mass.: National Bureau of Economic Research, February). U.S. International Trade Commission (2004), The Economic Effects of Significant U.S. Import Restraints: Fourth Update, Investigation 332-325, Publication 3701 (Washington: ITC, June). U.S. International Trade Commission (2003), The Impact of Trade Agreements: Effect of the Tokyo Round, U.S.-Israel FTA, U.S.-Canada FTA, NAFTA, and the Uruguay Round on the U.S. Economy, Investigation TA-2111-1, Publication 3621 (Washington: ITC, August). Drusilla K. Brown, Alan V. Deardorff, and Robert M. Stern (2002), “Computational Analysis of Multilateral Trade Liberalization in the Uruguay Round and Doha Development Round,” Discussion Paper 489, Research Seminar in International Economics, Gerald R. Ford School of Public Policy (Ann Arbor: University of Michigan). In addition to promoting specialization, trade boosts productivity through a fourth channel of influence: opening the economy to heightened competition. This effect could occur either as firms are spurred by foreign competitors to become more efficient, or as the least productive firms are forced to close, thus raising the average level of productivity for the economy as a whole. Again, most Americans likely recognize the importance of competition in boosting performance - the ascendancy of Japanese automobiles, for example, has been cited as a factor that has spurred Detroit to greater innovation and better quality. By heightening competitive forces and thus incentives for productivity and innovation, international trade has likely accelerated the process of “creative destruction” by which outdated and less productive activities are replaced by new technologies and more dynamic enterprises. Academic research supports the view that import competition has led U.S. manufacturing firms to become more capital intensive;7 trade liberalization apparently has enhanced productivity in some import-competing firms in foreign countries as well.8 Producing for export markets may also yield dividends: Research suggests that exporters are more productive than non-exporters in the same industry and that they grow more rapidly as well.9 Finally, many studies suggest that countries that are more open to international trade have enjoyed higher rates of economic growth.10 Our sad experience after adoption of the Smoot-Hawley tariff of 1930, as well as the record of Latin America, India, and other regions that experimented with “import-substituting industrialization,” point to the deterioration in economic performance that occurs when countries erect barriers to trade.11 Arguments against free trade If the benefits conferred by international trade are reasonably straightforward, how can we explain the apparent ambivalence toward trade picked up by recent surveys? Clearly, many people view the benefits of free trade as being outweighed by its perceived costs. One concern about free trade may be that it has given rise to large trade and current account deficits, thereby adding to the nation’s debt and putting future prosperity at risk. Now at more than 5 percent of GDP, the current account deficit is in record territory, it is growing, and it cannot be sustained indefinitely. We cannot foresee when the deficit will stop growing and return to more-sustainable levels, through what mechanisms this adjustment will occur, or whether this adjustment will be smooth or disruptive for financial markets and the economy more generally. No matter how a correction of the external imbalance proceeds, however, it will involve a range of adjustments to investment, saving, and asset prices, both for the U.S. economy and for our trading partners. Research suggests that past corrections of large external imbalances in industrial countries generally have occurred without crisis.12 Whether or not this will remain the case, I am confident that protectionism is not the appropriate response to our growing current account deficit. The amount of current account adjustment that would be gained from a given tightening of import controls is questionable. Yet, it is certain that such actions would impose costs on the economy that would persist long after concerns about the deficit dissipated. Andrew B. Bernard, J. Bradford Jensen, and Peter K. Schott (2002), “Survival of the Best Fit: Competition from Low Wage Countries and the (Uneven) Growth of U.S. Manufacturing Plants,” NBER Working Paper Series 9170 (Cambridge, Mass.: National Bureau of Economic Research, September). Petia Topalova (2004), “Trade Liberalization and Firm Productivity: The Case of India,” IMF Working Paper WP/04/28 (Washington: International Monetary Fund, February); Nina Pavcnik (2002), “Trade Liberalization, Exit, and Productivity Improvements: Evidence from Chilean Plants,” Review of Economic Studies, vol. 69 (January), pp. 245-76. Andrew B. Bernard and J. Bradford Jensen (1995), “Exporters, Jobs, and Wages in U.S. Manufacturing, 1976-1987,” Brookings Papers on Economic Activity: Microeconomics, 1995, pp. 69-119. David Dollar and Aart Kraay (2001), “Trade, Growth, and Poverty,” unpublished paper, World Bank, June; Sebastian Edwards (1998), “Openness, Productivity and Growth: What Do We Really Know?” Economic Journal, vol. 108 (March), pp. 383-98. Alan M. Taylor (1994), “Three Phases of Argentine Economic Growth,” NBER Historical Paper 60 (Cambridge, Mass.: National Bureau of Economic Research, September); Jagdish Bhagwati (1993), India in Transition: Freeing the Economy (New York: Oxford University Press); Douglas A. Irwin (2002), Free Trade Under Fire (Princeton: Princeton University Press); Mario J. Crucini and James Kahn (1996), “Tariffs and Aggregate Economic Activity: Lessons from the Great Depression,” Journal of Monetary Economics, vol. 38 (December), pp. 427-67. Caroline Freund (2000), “Current Account Adjustment in Industrialized Countries,” International Finance Discussion Paper 2000-692 (Washington: Board of Governors of the Federal Reserve System, December). A second concern about free trade that is frequently voiced, and probably a more important one to many people, is that trade destroys American jobs and creates unemployment. The same survey I mentioned earlier, showing a deterioration in general attitudes toward trade, also indicated that 40 percent of respondents believed that trade barriers should be maintained because of the threat to U.S. jobs, up from 31 percent in 1999.13 It is worth distinguishing among several variants of the concern about trade and jobs. The first variant holds that the rise in imports lowers employment and raises the unemployment rate by shifting jobs overseas. This claim is strongly contradicted both by theory and by experience. Make no mistake: Import competition clearly has cost some American workers their jobs and has caused them considerable hardship as a result. However, economywide equilibrating forces, including monetary policy, ensure that over time such employment losses are offset by gains elsewhere in the economy, so that the nationwide unemployment rate averages around its equilibrium level. In fact, the inflow of foreign capital that finances our trade deficit provides the funding for investment projects that employ U.S. workers just as surely as does any other productive activity in the economy. Between 1960 and 2003, the trade balance moved from a slight surplus to a deficit of 4-1/2 percent of GDP, and nominal imports rose from about 4 percent of GDP to 14 percent - yet, the current unemployment rate of about 5-1/2 percent is little changed from its 1960 level, while nonfarm private employment has grown by more than 60 million jobs.14 It has also been suggested that import competition has caused a significant portion of the decline in employment since the recession of 2001. Yet, the ratio of the nominal trade deficit to GDP widened less than 1 percentage point between 2000 and 2003. Moreover, this deterioration came entirely from a decline in the ratio of exports to GDP, from 11.2 percent in 2000 to 9.5 percent in 2003; the ratio of imports to GDP actually declined about 1 percentage point over this period. A second variant of the concern over trade and jobs is certainly valid: Import competition can be highly disruptive and cause considerable pain for those who lose their jobs. One study of worker displacement indicates that only about two-thirds of displaced workers found another job within three years, and even when they were successful in finding full-time work, the earnings of these workers on average declined 8 percent.15 Another study found that job losers in industries facing heavy import competition were slightly less likely to be reemployed, and suffered greater earnings losses, than workers who lost their jobs in industries facing less import competition.16 We cannot and should not minimize the hardships of workers displaced by imports. However, we must also keep in mind that their numbers are relatively small compared with either the total labor force or even the total number of jobs lost in the United States. Estimates of the gross number of jobs lost to imports vary, but one representative estimate puts them at a bit more than 300,000 per year during the 1980s and 1990s.17 This number, while hardly negligible, is dwarfed by the roughly 15 million job losses estimated to occur each year in the United States. As our dynamic market economy evolves, it generates substantial churning in labor markets as jobs are gained in some sectors and lost in others; jobs gained and lost because of trade are only a small part of that process. It is understandable that concerns about job losses from import competition may extend far beyond their actual incidence in the labor market, given more general anxieties about employment security among American workers. However, to echo a point that has been made before, the proper response to the disruptions associated with trade is not to reduce trade, but rather to ameliorate the pain associated with those disruptions through enhanced assistance and retraining for displaced workers. A final concern about trade that I would like to discuss is that import competition, whether or not it affects the number of jobs, shifts the employment mix from high-quality jobs to low-quality jobs. For Kull and others (2004), “Americans on Globalization, Trade, and Farm Subsidies.” My colleague, Ben Bernanke, has discussed many of the issues linking trade and jobs in a speech earlier this year (“Trade and Jobs,” at the Fuqua School of Business, Duke University, March 30, 2004). Henry Farber (2003), “Job Loss in the United States, 1981-2001,” Industrial Relations Section Working Paper 471, (Princeton: Princeton University, January). This study covers workers displaced for any reason, including import competition. Lori G. Kletzer (2001), Job Loss from Imports: Measuring the Costs (Washington: Institute for International Economics). Kletzer, Job Loss from Imports, estimates that 6.4 million workers were displaced from import-competing industries from 1979 to 1999. example, critics have long held that international trade pushes workers out of manufacturing jobs and into less desirable service-sector jobs. However, no conclusive evidence has shown that, over the long haul, the service jobs being created pay less or are otherwise less desirable than manufactured jobs being displaced. Moreover, the declining share of manufacturing in U.S. employment most likely stems less from import competition than it does from the rapid pace of productivity growth in manufacturing; this growth outpaced the productivity growth of the overall economy by about 1-1/4 percentage points annually from 1973 to 1994 and by 1-1/2 percentage points from 1994 to 2000. The higher rate of productivity growth in manufacturing has restrained both price increases and employment in the sector, thus leading the services area of the economy to expand its share of spending and jobs. This phenomenon is hardly unique to the United States - the share of manufacturing has declined in most of our major foreign trading partners as well. More recently, the outsourcing of service jobs to developing countries has come under the spotlight. The increasing use of computer programming talent in India and other low-wage countries has, understandably, struck a chord of anxiety among American workers. For years, the response of pro-trade advocates to the loss of low-wage jobs in manufacturing has been that they are being made up by the creation of higher-paid, higher-skilled jobs in the service sector. The loss of highly paid programming jobs to lower-paid workers abroad now appears to suggest that there is no place where American workers can hold their own. Yet, as in the case of import competition more generally, we must not exaggerate the importance of outsourcing to the nation’s overall employment picture. There are no conclusive data, but a prominent study puts the number of jobs displaced through services outsourcing over the next decade or so at fewer than 300,000 annually, or less than 2 percent of the 15 million in total gross job losses I noted earlier.18 Moreover, only a fraction of those jobs represent high-skilled, high-wage jobs; these numbers are quite difficult to pin down, but one study puts the number of software jobs lost to India since 2000 at fewer than 50,000 annually.19 Finally, we should remember that the United States gains jobs through what is often referred to as “insourcing,” that is, performing service jobs for other countries. In fact, the United States has consistently run a surplus in those categories of the balance-of-payments associated with trade in business services. Turning from the sectoral job mix to the impact of import competition on wages, the evidence is particularly unclear. Some studies have suggested that import competition from low-wage countries has depressed wages for low-skilled workers relative to those for higher-skilled workers in recent decades. However, other studies have argued that the rise in skill premiums is attributable to technological developments that have raised relative demands for educated workers. Focusing on the past few years, we see no consensus on how the mix of low- and high-wage jobs in the economy has evolved; estimates are extremely sensitive to the definition of job classes, the source of data, the time period, and method of calculation. In any event, it is doubtful that changes in the pattern of wages in the U.S. economy can be explained by any single factor - trends in trade, in population and immigration, in unionization and labor market competition, in minimum wage policy, in the skill mix of the labor force, and in technology all play a role. Drawbacks of protectionism To sum up the discussion so far, the public likely has a reasonably good grasp of the benefits of free trade. It is the perceived drawbacks to international trade that probably account for the ambivalence indicated in opinion surveys. Some of these fears may be overstated - for example, the claim that imports lower aggregate employment. But other concerns cannot be dismissed out of hand - especially the claim that trade leads to disruptions for some workers. Balancing the pain for a few against the This is based on widely cited results from the technology research firm Forrester, which predicts that 3.4 million U.S. service jobs will have been moved offshore by 2015. Martin Neil Baily and Robert Z, Lawrence (2004), “What Happened to the Great U.S. Job Machine? The Role of Trade and Offshoring,” paper prepared for the Brookings Panel on Economic Activity, September 9-10. Their rough estimate of nearly 45,000 software jobs relocated annually to India is consistent with an estimate by Charles L. Shultze that “the number of workers employed in producing computer and related services relocated from the United States to India could have increased by roughly 185,000 over the past four years” (Charles L. Schultze, “Offshoring, Import Competition, and the Jobless Recovery,” Policy Brief 136, Washington: The Brookings Institution, August). lasting gains for the economy as a whole, economists generally view the latter as outweighing the former, but it is admittedly difficult for many individuals in American society to share this assessment. Rather than arguing the merits of international trade in the abstract, advocates of free trade might gain more traction by arguing against concrete examples of protectionism. Each year brings new actions by the U.S. government to protect individual sectors from imports. Antidumping duties are imposed when domestic industry is believed to be injured by the sale of imported goods at less than “fair value.” Countervailing duties are intended to counteract subsidies to foreign producers. Safeguard actions are intended to protect a domestic industry that has been seriously injured by a surge in imports.20 As of August 2004, 359 antidumping and countervailing duty orders were in place in the United States against imports from 51 countries.21 By discouraging unfair commercial practices, such actions, in principle, promote a more stable and competitive environment for international trade. In practice, identifying anticompetitive practices is a murky process. For example, in antidumping cases, determining the “fair value” of a good may involve a degree of discretion, thereby complicating the assessment of whether foreign goods are being sold below their appropriate price.22 Domestic producers have a strong incentive to lobby for trade actions regardless of whether such actions are merited. Because they inhibit free trade, protectionist actions have an array of adverse consequences that one would expect: They reduce variety and raise costs for consumers; they distort the allocation of resources in the economy by encouraging excessive resources to flow into protected sectors; and they foster inefficiency by reducing the extent of competition. Perhaps more important in the eyes of the public, however, may be several related and highly egregious consequences of protectionist actions. First, by raising the cost of goods that are inputs for other producers, import barriers may destroy more jobs in so-called “downstream” sectors than they save in protected sectors. According to one study, the 2002 steel safeguard program contributed to higher steel prices that eliminated about 200,000 jobs in steel-using industries, whereas only 187,500 workers were employed by U.S. steel-producers in December 2002.23 Second, trade protection may lead to very large payouts to a small number of producers and hence is often inequitable. Any time a product receives import protection, of course, a relatively small number of domestic producers receive benefits - through higher prices - at the cost of all domestic consumers in the economy. On top of this, a disproportionately small number of sectors, and often a disproportionately small number of firms within a sector, tend to enjoy the gains from protection. For example, more than one-half of the antidumping and countervailing duty orders in place as of August were on iron and steel-related products alone; by contrast, less than one-half of 1 percent of total private nonfarm employment is accounted for by iron and steel producers.24 As another example, according to a 1993 General Accounting Office study, 42 percent of the benefits to growers from sugar protection went to just 1 percent of growers.25 Although Americans favor policies designed to help the small farmer, much larger enterprises are also benefiting from agricultural trade protection. This disturbingly inequitable distribution of the benefits of protectionism is exacerbated under current law by provisions allowing antidumping and countervailing duties to be disbursed to the companies that petitioned for the duties. These provisions, which have been ruled illegal by the WTO, lead to protected producers being rewarded twice: Once through the higher prices stemming from the trade protection and again through the disbursal of the higher duties paid by importers. The distribution of See World Trade Organization, “Anti-dumping, Subsidies, Safeguards: Contingencies, etc.,”; U.S. International Trade Commission (1998), Summary of Statutory Provisions Related to Import Relief, Publication 3125 (Washington: ITC, August). U.S. International Trade Commission (2004), “Antidumping and Countervailing Duty Orders in Place as of August 9, 2004, by Product Group (111 KB PDF),” Five-Year (Sunset) Reviews, General Information, item 7: AD and CVD orders in place. Bruce A. Blonigen (2003), “Evolving Discretionary Practices of U.S. Antidumping Activity,” NBER Working Paper Series 9625 (Cambridge, Mass.: National Bureau of Economic Research, April). Joseph Francois and Laura M. Baughman (2003), “The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002,” CITAC Job Studies (Washington: Consuming Industries Trade Action Coalition). “U.S. International Trade Commission, Antidumping and Countervailing Duty Orders in Place as of August 9, 2004, by Product Group.” U.S. General Accounting Office (1993), “Sugar Program: Changing Domestic and International Conditions Require Program Changes,” GAO/RCED-93-84 (Washington: GAO, April). these payouts has been extremely skewed: For fiscal year 2003, a single firm received more than onefourth of the $190 million in countervailing and antidumping duties that were distributed to U.S. firms.26 Import quotas (as opposed to tariffs) raise a third concern about trade protection. By restricting the supply of certain types of imports within the United States, quotas may benefit those foreign producers who retain the right to sell to U.S. markets by raising the prices of their goods. For example, one study found that, of the $8.6 billion in net welfare costs induced by the Multi-Fiber Agreement, which restricts textile and apparel imports, about $6 billion accrued to those foreign producers who were allotted shares of the import quotas.27 Surely, many Americans would cease to support certain types of import protections if they knew that such actions were serving to prop up the profits of foreign producers. Finally, we must not forget that trade actions, while sometimes protecting some American workers in import-competing industries, often invite the threat of foreign retaliation that would hurt American workers in export industries. For example, after the imposition of steel safeguard duties in March 2002, eight of our trading partners initiated safeguard investigations of their own on steel imports. Given the importance of export markets to the most dynamic areas of U.S. manufacturing, we cannot afford to jeopardize them by inviting foreign barriers to our products. Conclusion In conclusion, I think it unlikely that we will see a marked global reversal of trade liberalization on the order of the restrictions enacted in the 1930s. Policymakers have generally learned the lessons of that destructive episode. Nevertheless, it is not inconceivable that progress in dismantling trade barriers could stall. Many of the easiest negotiations - such as on lowering tariffs - have already taken place. More ambitious and intrusive trade liberalizations, which often involve dismantling barriers to internal competition or cherished systems of domestic subsidies, may not have the necessary public support. It is also possible that a multiplicity of narrow, targeted trade actions - such as antidumping or safeguard actions - could lead to a de facto rollback in the overall degree of free trade even without a concerted shift in national policies. Thus, it is crucial to maintain public pressure for free trade. First, it is important to continue to educate the public and create a political environment supportive of free trade. In this respect, targeted criticisms of protectionist actions may be more effective than general paeans to free trade. In a recent speech, my colleague, William Poole, urged journalists describing trade restrictions to ask who gains, who loses, and what is the net gain or loss for the economy as a whole?28 I very much support that sentiment. Second, it is crucial to implement policies that foster stability and economic growth. Reducing unemployment and diminishing economic insecurity will likely be more effective against protectionism than a thousand speeches like this one. Toward that end, the Federal Reserve will do its part by working to promote stable financial conditions and sustainable, noninflationary growth. As of March 2004. U.S. Customs and Border Protection (2004), Continued Dumping and Subsidy Offset Act FY 2003 Annual Report (Washington: CBP). Gary Clyde Hufbauer and Kimberly Ann Elliot (1994), Measuring the Costs of Protection in the United States (Washington: Institute for International Economics). William Poole (2004), Free Trade: Why Are Economists and Noneconomists So Far Apart? Speech prepared for the Trade, Globalization, and Outsourcing Conference, Reuters America, Inc., New York, June 15.
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, to the Conference on Reflections on Monetary Policy 25 Years after October 1979, Federal Reserve Bank of St Louis, St Louis, Missouri, 8 October 2004.
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Ben S Bernanke: Panel discussion: what have we learned since October 1979? Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, to the Conference on Reflections on Monetary Policy 25 Years after October 1979, Federal Reserve Bank of St Louis, St Louis, Missouri, 8 October 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * The question asked of this panel is, “What have we learned since October 1979?” The evidence suggests that we have learned quite a bit. Most notably, monetary policy-makers, political leaders, and the public have been persuaded by two decades of experience that low and stable inflation has very substantial economic benefits. This consensus marks a considerable change from the views held by many economists at the time that Paul Volcker became Fed Chairman. In 1979, most economists would have agreed that, in principle, low inflation promotes economic growth and efficiency in the long run. However, many also believed that, in the range of inflation rates typically experienced by industrial countries, the benefits of low inflation are probably small - particularly when set against the short-run costs of a major disinflation, as the United States faced at that time. Indeed, some economists would have held that low-inflation policies would likely prove counterproductive even in the long run, if an increased focus on inflation inhibited monetary policy-makers from responding adequately to fluctuations in economic activity and employment. As it turned out, the low-inflation era of the past two decades has seen not only significant improvements in economic growth and productivity but also a marked reduction in economic volatility, both in the United States and abroad, a phenomenon that has been dubbed “the Great Moderation.” Recessions have become less frequent and milder, and quarter-to-quarter volatility in output and employment has declined significantly as well. The sources of the Great Moderation remain somewhat controversial, but as I have argued elsewhere, there is evidence for the view that improved control of inflation has contributed in important measure to this welcome change in the economy (Bernanke, 2004). Paul Volcker and his colleagues on the Federal Open Market Committee deserve enormous credit both for recognizing the crucial importance of achieving low and stable inflation and for the courage and perseverance with which they tackled America’s critical inflation problem. I could say much more about Volcker’s achievement and its lasting benefits, but I am sure that many other speakers will cover that ground. Instead, in my remaining time, I will focus on some lessons that economists have drawn from the Volcker regime regarding the importance of credibility in central banking and how that credibility can be obtained. As usual, the views I will express are my own and are not necessarily shared by my colleagues in the Federal Reserve System. Volcker could not have accomplished what he did, of course, had he not been appointed to the chairmanship by President Jimmy Carter. In retrospect, however, Carter’s appointment decision seems at least a bit incongruous. Why would the President appoint as head of the central bank an individual whose economic views and policy goals (not to mention personal style) seemed, at least on the surface, quite different from his own? However, not long into Volcker’s term, a staff economist at the Board of Governors produced a paper that explained why Carter’s decision may in fact have been quite sensible from the President’s, and indeed the society’s, point of view. Although the question seems a narrow one, the insights of the paper had far broader application; indeed, this research has substantially advanced our understanding of the links among central bank credibility, central bank structure, and the effectiveness of monetary policy. Insiders will have already guessed that the Board economist to whom I refer is Kenneth Rogoff, currently a professor of economics at Harvard, and that the paper in question is Ken’s 1985 article, “The Optimal Degree of Commitment to an Intermediate Monetary Target” (Rogoff, 1985).1 The insights of the Rogoff paper are well worth recalling today. Rather than considering the paper in isolation, however, I will place it in the context of two other classic papers on credibility and central bank design, an earlier work by Finn Kydland and Edward Prescott and a later piece by Carl Walsh. Rogoff’s paper was widely circulated in 1982, a sad commentary on publication lags in economics. As I proceed, I will note what I see to be the important lessons and the practical implications of this line of research.2 Central bankers have long recognized at some level that the credibility of their pronouncements matters. I think it is fair to say, however, that in the late 1960s and 1970s, as the U.S. inflation crisis was building, economists and policymakers did not fully understand or appreciate the determinants of credibility and its link to policy outcomes. In 1977, however, Finn Kydland and Edward Prescott published a classic paper, entitled “Rules Rather than Discretion: The Inconsistency of Optimal Plans” (Kydland and Prescott, 1977), that provided the first modern analysis of these issues.3 Specifically, Kydland and Prescott demonstrated why, in many situations, economic outcomes will be better if policymakers are able to make credible commitments, or promises, about certain aspects of the policies they will follow in the future. “Credible” in this context means that the public believes that the policymakers will keep their promises, even if they face incentives to renege. In particular, as one of Kydland and Prescott’s examples illustrates, monetary policy-makers will generally find it advantageous to commit publicly to following policies that will produce low inflation. If the policymakers’ statements are believed (that is, if they are credible), then the public will expect inflation to be low, and demands for wage and price increases should accordingly be moderate. In a virtuous circle, this cooperative behavior by the public makes the central bank’s commitment to low inflation easier to fulfill. In contrast, if the public is skeptical of the central bank’s commitment to low inflation (for example, if it believes that the central bank may give in to the temptation to overstimulate the economy for the sake of short-term employment gains), then the public’s inflation expectations will be higher than they otherwise would be. Expectations of high inflation lead to more-aggressive wage and price demands, which make achieving and maintaining low inflation more difficult and costly (in terms of lost output and employment) for the central bank. Providing a clear explanation of why credibility is important for effective policymaking, as Kydland and Prescott did, was an important step. However, these authors largely left open the critical issue of how a central bank is supposed to obtain credibility in the first place. Here is where Rogoff’s seminal article took up the thread.4 Motivated by the example of Carter and Volcker, Rogoff’s paper showed analytically why even a president who is not particularly averse to inflation, or at least no more so than the average member of the general public, might find it in his interest to appoint a well-known “inflation hawk” to head the central bank. The benefit of appointing a hawkish central banker is the increased inflation-fighting credibility that such an appointment brings. The public is certainly more likely to believe an inflation hawk when he promises to contain inflation because they understand that, as someone who is intrinsically averse to inflation, he is unlikely to renege on his commitment. As increased credibility allows the central bank to achieve low inflation at a smaller cost than a non-credible central bank can, the president may well find, somewhat paradoxically, that he prefers the economic outcomes achieved under the hawkish central banker to those that could have been obtained under a central banker with views closer to his own and those of the public. In focusing on three landmark papers I necessarily ignore what has become an enormous literature on credibility and monetary policy. Walsh (2003, chap. 8) provides an excellent overview. Rogoff (1987) was an important early survey of the “first generation” of models of credibility in the context of central banking. In another noteworthy paper, Calvo (1978) made a number of points similar to those developed by Kydland and Prescott. The extension of the Kydland-Prescott “inflation bias” by Barro and Gordon (1983a) has proved highly influential. Rogoff was my graduate school classmate at M.I.T., and I recently asked him for his recollections about the origins of the conservative central banker. Here (from a personal e-mail) is part of his response: [T]he paper was mainly written at the Board in 1982 . . . It came out as an IMF working paper in February 1983 (I was visiting there), and then the same version came out as an International Finance Discussion paper [at the Board of Governors] in September 1983 . . . The original version of the paper . . . featured inflation targeting. Much like the published paper, I suggested that having an independent central bank can be a solution to the time consistency [that is, credibility] problem if we give the bank an intermediate target and some (unspecified) incentive to hit the target . . . I had the conservative central banker idea in there as well, as one practical way to ensure the central bank placed a high weight on inflation. Larry Summers, my editor at the [Quarterly Journal of Economics], urged me to move that idea up to the front section and place inflation targeting second. This, of course, is how the paper ended up. [Regarding the Fed], Dale Henderson and Matt Canzoneri liked the paper very much . . . many other researchers gave me feedback on my paper (including Peter Tinsley, Ed Offenbacher, Bob Flood, Jo Anna Gray, and many others) . . . Last but perhaps most important, there is absolutely no doubt that the paper was inspired by my experience watching the Volcker Fed at close range. I never would have written it had I not . . . ended up as an economist at the Board. Appointing an inflation hawk to head the central bank may not be enough to ensure credibility for monetary policy, however. As Rogoff noted in his article, for this strategy to confer significant credibility benefits, the central bank must be perceived by the public as being sufficiently independent from the rest of the government to be immune to short-term political pressures. Thus Rogoff’s proposed strategy was really two-pronged: The appointment of inflation-averse central bankers must be combined with measures to ensure central bank independence. These ideas, supported by a great deal of empirical work, have proven highly influential.5 Indeed, the credibility benefits of central bank autonomy have been widely recognized in the past twenty years, not only in the academic literature but, far more consequentially, in the real-world design of central banking institutions. For example, in the United Kingdom, the euro area, Japan, and numerous other places, recent legislation or other government action has palpably strengthened the independence of the central banks.6 Rogoff’s proposed solution to the credibility problems of central banks does have some limitations, however, as Ken recognized both in his paper and in subsequent work. First, although an inflation-averse central banker enhances credibility and delivers lower inflation on average, he may not respond to shocks to the economy in the socially desirable way. For example, faced with an aggregate supply shock (such as a sharp rise in oil prices), an inflation-averse central banker will tend to react too aggressively (from society’s point of view) to contain the inflationary impact of the shock, with insufficient attention to the consequences of his policy for output and employment.7 Second, contrary to an assumption of Rogoff’s paper, in practice the policy preferences of a newly appointed central banker will not be precisely known by the public but must be inferred from policy actions. (Certainly the public’s perceptions of Chairman Volcker’s views and objectives evolved over time.) Knowing that the public must make such inferences might tempt a central banker to misrepresent the state of the economy (Canzoneri, 1985) or even to take suboptimal policy decisions; for example, the central banker may feel compelled to tighten policy more aggressively than is warranted in order to convince the public of his determination to fight inflation. The public’s need to infer the central banker’s policy preferences may even generate increased economic instability, as has been shown in a lively recent literature on the macroeconomic consequences of learning.8 The third pathbreaking paper I will mention today, a 1995 article by Carl Walsh entitled “Optimal Contracts for Central Bankers,” was an attempt to address both of these issues.9 To do so, Walsh conducted a thought experiment. He asked his readers to imagine that the government or society could offer the head of the central bank a performance contract, one that includes explicit monetary rewards or penalties that depend on the economic outcomes that occur under his watch. Remarkably, Walsh showed that, in principle, a relatively simple contract between the government and the central bank would lead to the implementation of monetary policies that would be both credible and fully optimal. Under this contract, the government provides the central banker with a base level of compensation but then applies a penalty that depends on the realized rate of inflation - the higher the observed inflation rate, the greater the penalty. If the public understands the nature of the contract, and if the penalty assessed for permitting inflation is large enough to affect central bank behavior, the existence of the contract would give credence to Walsh (2003, section 8.5) reviews empirical research on the correlations of central bank independence and economic outcomes. A consistent finding is that more-independent central banks produce lower inflation without any increase in output volatility. The benefits of central bank independence should not lead us to ignore its downside, which is that the very distance from the political process that increases the central bank’s policy credibility by necessity also risks isolating the central bank and making it less democratically accountable. For this reason, central bankers should make communication with the public and their elected representatives a high priority. Moreover, central bank independence does not imply that central banks should never coordinate with other parts of the government, under the appropriate circumstances. Lohmann (1992) shows that this problem can be ameliorated if the government limits the central bank’s independence, stepping in to override the central bank’s decisions when the supply shock becomes too large. However, to preserve the central bank’s independence in normal situations, this approach would involve stating clearly in advance the conditions under which the government would intercede, which may not be practicable. Evans and Honkopohja (2001) is the standard reference on learning in macroeconomics. Recent papers that apply models of learning to the analysis of U.S. monetary policy include Erceg and Levin (2001) and Orphanides and Williams (forthcoming). Persson and Tabellini (1993) provided an influential analysis of the contracting approach that extended and developed many of the points made by Walsh (1995). central bank promises to keep the inflation rate low (that is, the contract would provide credibility).10 Walsh’s contract has in common with Rogoff’s approach the idea that, in a world of imperfect credibility, giving the central banker an objective function that differs from the true objectives of society may be useful. However, Walsh also shows that the contracting approach ameliorates the two problems associated with Rogoff’s approach. First, under the Walsh contract, the central banker has incentives not only to achieve the target rate of inflation but also to respond in the socially optimal manner to supply shocks.11 Second, as the inflation objective and the central banker’s incentive scheme are made explicit by the contract, the public’s problem of inferring the central banker’s policy preferences is significantly reduced. There have been a few attempts in the real world to implement an incentive contract for central bankers - most famously a plan proposed to the New Zealand legislature, though never adopted, which provided for firing the governor of the central bank if the inflation rate deviated too far from the government’s inflation objective.12 But Walsh’s contracts are best treated as a metaphor rather than as a literal proposal for central bank reform. Although the pay of central bankers is unlikely ever to depend directly on the realized rate of inflation, central bankers, like most people, care about many other aspects of their jobs, including their professional reputations, the prestige of the institutions in which they serve, and the probability that they will be reappointed. Walsh’s analysis and many subsequent refinements by other authors suggest that central bank performance might be improved if the government set explicit performance standards for the central bank (perhaps as part of the institution’s charter or enabling legislation) and regularly compared objectives and outcomes. Alternatively, because central banks may possess the greater expertise in determining what economic outcomes are both feasible and most desirable, macroeconomic goals might be set through a joint exercise of the government and the central bank. Many countries have established targets for inflation, for example, and central bankers in those countries evidently make strong efforts to attain those targets. The Federal Reserve Act does not set quantitative goals for the U.S. central bank, but it does specify the objectives of price stability and maximum sustainable employment and requires the central bank to present semi-annual reports to the Congress on monetary policy and the state of the economy. Accountability to the public as well as to the legislature is also important; for this reason, the central bank should explain regularly what it is trying to achieve and why. In sum, Walsh’s paper can be read as providing theoretical support for an explicit, well-designed, and transparent framework for monetary policy, one which sets forth the objectives of policy and holds central bankers accountable for reaching those objectives (or, at least, for providing a detailed and plausible explanation of why the objectives were missed). In the simple model that Walsh analyzes, the optimal contract provides all the incentives needed to induce the best possible monetary policy, so that appointing a hawkish central banker is no longer beneficial. However, in practice - because Walsh’s optimal contracts can be roughly approximated at best, because both the incentives and the policy decisions faced by central bankers are far more complex than can be captured by simple models, and because the appointment of an inflation-averse central banker may provide additional assurance to the public that the government and the central bank will keep their promises - the Walsh approach and the Rogoff approach are almost certainly complementary.13 That is, a clear, well-articulated monetary policy framework; inflation-averse central bankers; and autonomy for central banks in the execution of policy are all likely to contribute to increased central bank credibility and hence better policy outcomes. Of course, other factors that I An objection to this conclusion is that, although the central bank’s incentives are made clear by the contract, the public might worry that the government might renege on its commitment to low inflation by changing the contract. Those who discount this concern argue that changing the contract in midstream would be costly for the government, because laws once enacted are difficult to modify and because changing an established framework for policy in an opportunistic way would be politically embarrassing. A key assumption underlying this result is that the central banker cares about the state of the economy as well as about the income provided by his incentive contract. In personal communication, Walsh reports to me that he was visiting a research institute in New Zealand at the time of these discussions. Walshs reflection on the New Zealand proposals helped to inspire his paper. Several authors have shown this point in models in which the inflation bias arising from non-credible policies differs across states of nature; see, for example, Herrendorf and Lockwood (1997) and Svensson (1997). could not cover in this short review, such as the central bank’s reputation for veracity as established over time, may also strengthen its credibility (Barro and Gordon, 1983b; Backus and Driffill, 1985).14 Let me end where I began, with reference to Paul Volcker and his contributions. I have discussed today how Volcker’s personality and performance inspired one seminal piece of research about the determinants of central bank credibility. In focusing on a few pieces of academic research, however, I have greatly understated the impact of the Volcker era on views about central banking. The Volcker disinflation (and analogous episodes in the United Kingdom, Canada, and elsewhere) was undoubtedly a major catalyst for an explosion of fresh thinking by economists and policymakers about central bank credibility, how it is obtained, and its benefits for monetary policy-making. Over the past two decades, this new thinking has contributed to a wave of changes in central banking, particularly with respect to the institutional design of central banks and the establishment of new frameworks for the making of monetary policy. Ironically, the applicability of the ideas stimulated by the Volcker chairmanship to the experience of the U.S. economy under his stewardship remains unclear. Though the appointment of Volcker undoubtedly increased the credibility of the Federal Reserve, the Volcker disinflation was far from a costless affair, being associated with a minor recession in 1980 and a deep recession in 1981-82.15 Evidently, Volcker’s personal credibility notwithstanding, Americans’ memories of the inflationary 1970s were too fresh for their inflation expectations to change quickly. It is difficult to know whether alternative tactics would have helped; for example, the announcement of explicit inflation objectives (which would certainly have been a radical idea at the time) might have helped guide inflation expectations downward more quickly, but they might also have created a political backlash that would have doomed the entire effort. Perhaps no policy approach or set of institutional arrangements could have eliminated the 1970s inflation at a lower cost than was actually incurred. If so, then the significance of Paul Volcker’s appointment was not its immediate effect on expectations or credibility but rather the fact that he was one of the rare individuals tough enough and with sufficient foresight to do what had to be done. By doing what was necessary to achieve price stability, the Volcker Fed laid the groundwork for two decades, so far, of strong economic performance. But see Rogoff (1987) for a critique of models of central bank reputation. Evidence on the behavior of inflation expectations after 1979 supports the view that the public came to appreciate only very gradually that Volcker’s policies represented a break from the immediate past (Erceg and Levin, 2001).
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Japan Society Corporate Luncheon, New York, 7 October 2004.
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Ben S Bernanke: Central bank talk and monetary policy Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Japan Society Corporate Luncheon, New York, 7 October 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * A few days before the last meeting of the Federal Open Market Committee (FOMC), I noticed a wire service story about the upcoming meeting with the following headline: “It’s Not What They Do, It’s What They Say.” The story alluded to the fact that, with a 25-basis-point increase in the federal funds rate target at the FOMC meeting being widely anticipated, financial-market participants planned to focus their attention instead on the statement that would accompany the announcement of the rate decision. In doing so, they hoped to garner information about the FOMC’s outlook and policy intentions that might prove useful in pricing fixed-income securities and other assets. Indeed, it has not been uncommon in the past few years for financial markets to react more strongly to changes in the wording of the Committee’s statement than to its decision about the target for the federal funds rate itself. The increased prominence of the FOMC’s post-meeting statement is best understood as the latest step in a journey toward greater transparency and openness on the part of the Committee. This increase in transparency is highly welcome, for many reasons. Perhaps most important, as public servants whose decisions affect the lives of every citizen, central bankers have a responsibility to provide the public as much explanation of those decisions as possible, so long as doing so does not compromise the decisionmaking process itself. A more open policymaking process is also likely to lead to better policy decisions, because engagement with an informed public provides central bankers with useful feedback in the form of outside views and analyses. Beyond the basic rationales of democratic accountability and engagement with the public, however, open and clear communication by the policy committee - which in practice includes speeches and congressional testimony by FOMC members, as well as official statements - makes monetary policy more effective in at least three distinct ways. First, in the very short run, clear communication helps to increase the near-term predictability of FOMC rate decisions, which reduces risk and volatility in financial markets and allows for smoother adjustment of the economy to rate changes. Indeed, the three recent rate hikes by the FOMC were so well anticipated that financial markets hardly responded when those actions were announced. Second, in the long run, communicating the central bank’s objectives and policy strategies can help to anchor the public’s long-term expectations - most importantly, its expectations of inflation. Public confidence that inflation will remain low in the long run has numerous benefits. Notably, if people feel sure that inflation will remain well controlled, they will be more restrained in their wage-setting and pricing behavior, which (in something of a virtuous circle) makes it easier for the Federal Reserve to confirm their expectations by keeping inflation low. At the same time, by reducing the risk that inflation will come loose from its moorings, well-anchored inflation expectations may afford the central bank more short-term flexibility to respond to economic disturbances that affect output and employment. The third way in which clear and open communication enhances the effectiveness of monetary policy the channel that will be the focus of my remarks today - is by helping to align financial-market participants’ expectations about the future course of monetary policy more closely with the policy committee’s own plans and projections. As I will discuss, to the extent that central bank talk provides useful guidance to markets about the likely future path of short-term interest rates, policymakers will exert greater influence over the longer-term interest rates that most matter for spending decisions. At the same time, expanding the information available to financial-market participants improves the efficiency and accuracy of asset pricing. Both of these factors enhance the effectiveness and precision of monetary policy. In the remainder of my remarks I will elaborate on the usefulness of central bank communication as a means of informing the policy expectations of financial-market participants and the public more generally. In doing so, I will discuss some new empirical evidence on the effects of central bank communication policies in both the United States and Japan, drawn from a recent paper I prepared with two Federal Reserve colleagues. Before proceeding, however, I should say that the views I express today are not necessarily those of my colleagues on the Federal Open Market Committee or in the Federal Reserve System more generally. Communication and the effectiveness of monetary policy Although people often speak of the Federal Reserve as controlling interest rates, in fact the Fed directly affects only one very short-term and (in the scheme of things) relatively unimportant interest rate, the federal funds rate. As you may know, the federal funds rate is the interest rate at which commercial banks lend each other reserves for short periods, usually overnight. Other than managers of bank reserves and some other traders in short-term funds, few people in the private sector have much interest in the funds rate per se. In particular, most private-sector borrowing and investment decisions depend not on the funds rate but on longer-term yields, such as mortgage rates and corporate bond rates, and on the prices of long-lived assets, such as housing and equities. Moreover, the link between these longer-term yields and asset prices and the current setting of the federal funds rate can be quite loose at times. It is striking, for example, that even as the FOMC has raised its target for the federal funds rate by 75 basis points in its three meetings since June, the yield on ten-year Treasury securities has fallen by almost the same amount during that period. This unusual recent movement in longer-term yields contrasts with most previous Fed tightening cycles, in which long-term yields typically rose, sometimes quite dramatically. Although the relation between the FOMC’s setting of the federal funds rate and the more economically relevant long-term yields is hardly direct or mechanical, a critical connection does exist. The connection operates less through the current value of the funds rate, however, than through the interest-rate actions that the FOMC is expected to take in the future. Specifically, financial theorists and market practitioners concur that, with risk and term premiums held constant, long-term yields move closely with the expectations that financial-market participants hold about the future evolution of the funds rate and other related short-term rates. For example, all else being equal, if short-term rates are expected to be high on average over the relevant period, then longer-term yields will tend to be high as well. Were that not the case, investors would profit by holding a sequence of short-term securities and declining to hold long-term bonds, an outcome inconsistent with the requirement that, in equilibrium, all securities must be willingly held. Likewise, if future short-term rates are expected to be low on average, then long-term bond yields will tend to be low as well. The fact that long-term yields depend at least as much on expected future values of the federal funds rate as on its current setting helps to explain the recent behavior of long-term bond yields to which I alluded a moment ago. This June, concerns about inflation, together with a general belief that economic growth would continue to be strong, led bond traders to anticipate that the Fed would tighten policy relatively quickly. Because the funds rate was expected to rise at a comparatively rapid pace, longer-term yields were well above short-term rates; in other words, the term structure of interest rates sloped steeply upward. Since June, however, inflation fears have receded, and some financial-market participants have become less optimistic about the economy’s near-term growth prospects. Because of these changes in their outlook, market participants now expect the FOMC to proceed more slowly in its tightening than they did in June.1 Moreover, with inflation now expected to remain low, market participants may anticipate a lower short-term interest rate to prevail in the long run. With expectations of future short-term rates revised downward, bond yields have declined, and the slope of the term structure is much less steep than it was a few months ago. I hope that this brief discussion is sufficient to convince you that the current setting of the federal funds rate provides at best only partial information about the overall tightness or ease of monetary conditions. To assess whether monetary policy is providing net stimulus or restraint to spending and the economy, one needs to know not only the current value of the funds rate but also the expected future path of the funds rate, as priced in financial markets. But how are private-sector expectations of the FOMC’s future policy actions formed in the first place? We come now to the nub of why central bank communications are so important. Without guidance By the way, my statements about what the markets expect are not guesses. As I discuss later, various futures markets, such as the federal funds futures market and the Eurodollar futures market, provide useful information about how market participants expect the federal funds rate to evolve over the next couple of years. from the central bank, market participants can do no better than form expectations based on the average past behavior of monetary policymakers, a strategy that may be adequate under some or even most circumstances but may be seriously misguided in others. In contrast, when the monetary policy committee regularly provides information about its objectives, economic outlook, and policy plans, two benefits result. First, with more complete information available, markets will price financial assets more efficiently. Second, the policymakers will usually find that they have achieved a closer alignment between market participants’ expectations about the course of future short-term rates and their own views. By guiding market expectations in this way, the policy committee attains increased influence over the most economically relevant long-term yields, reduced financial and economic uncertainty, and, in all probability, better economic outcomes. These potential benefits have not been lost on Federal Reserve policymakers. Certainly, the development of the FOMC’s post-meeting statement over the past decade suggests an increasing awareness of the practical advantages of increased transparency and communication. As hard as it may be to imagine, given the prominence afforded to FOMC statements today, before 1994 the FOMC issued no post-meeting statement, not even an announcement of its decision about the federal funds rate. Instead, in most instances, the Committee signaled its decision to financial markets only indirectly through the open-market operations used to affect the rate.2 In February 1994, the FOMC began to release statements to note changes in its target for the federal funds rate but continued to remain silent after meetings with no policy changes. Statements have been released after every meeting only since May 1999. The FOMC statements have evolved considerably. In their current form, they provide a brief description of the state of the economy and a somewhat formulaic description of the so-called balance of risks with respect to the outlook for output growth and inflation. The “balance-of-risks” part of the statement replaced an earlier formulation, known as the “policy tilt,” which loosely characterized the likely future direction of the federal funds rate. The balance-of-risks portion of the statement also provides information about the likely course of policy, but it does so more indirectly by describing the Committee’s assessment of the potential risks to its dual objectives of maximum sustainable employment and price stability rather than by commenting on the policy rate itself. Most recently, the Committee has introduced additional commentary on the outlook for policy into its statement. For example, the August 2003 statement of the FOMC indicated that “policy accommodation can be maintained for a considerable period,” a formulation replaced a few meetings later with the comment that the Committee could be “patient” in removing policy accommodation. These statements conveyed information to markets about the Committee’s economic outlook as well as its policy approach. In my view, this language served an important purpose, illustrating in the process the value of central bank communication. At the time that “considerable period” was introduced, the market was pricing in a significant degree of near-term policy tightening, presumably on the expectation that the sharp pickup in growth in the third quarter of 2003 would induce the FOMC to raise rates. However, this market reaction placed insufficient weight, I believe, on the fact that the expansion that began in mid-2003 was characterized by exceptional gains in labor productivity, which implied in turn that the rapid growth in output did not materially increase the pressure on resources. With inflation low and with continuing slack in resource utilization, the rapid tightening projected by the markets did not appear justified, the surge in output growth notwithstanding. The language of the statement in August 2003 and subsequent meetings persuaded the markets that an autumn tightening was not in the cards, and market expectations adjusted accordingly. Crucially, this change in expectations resulted in lower interest rates at all maturities, a development that helped support the expansion in the latter part of last year. When the policy tightening cycle finally began earlier this year, the FOMC indicated that, with underlying inflation still relatively low, it would proceed “at a pace that is likely to be measured.” As I discussed in a speech in May, the gradualist approach implied by this statement is often appropriate during a period of economic and financial uncertainty (Bernanke, 2004). At the same time that it provided information on its outlook and its expected policy path, however, the Committee properly insisted that its policies would be conditional on the arriving economic data. In particular, the Committee noted that it would respond as necessary to maintain price stability. Before 1994 the public did receive relatively immediate notice of monetary policy action if a change in the FOMC’s target for the federal funds rate was accompanied by a change in the discount rate, which was always announced in a press release. To be absolutely clear, in pointing out the benefits of clear communication I am not asserting that central bank talk represents an independent tool of policy. Indeed, if the central bank’s statements are not informative about the likely future course of the short-term interest rate, they will soon lose their ability to influence market expectations. Rather, the value of more-open communication is that it clarifies the central bank’s views and intentions, thereby increasing the likelihood that financial-market participants’ rate expectations will be similar to those of the policymakers themselves - or, if views differ, ensuring at least that the difference can not be attributed to the policymakers’ failure to communicate their outlook, objectives, and strategy to the public and the markets. Do FOMC statements affect policy expectations? Some evidence In my remarks thus far I have argued in general terms that FOMC communication can help inform the public’s expectations of the future course of short-term interest rates, providing the Committee with increased influence over longer-term rates and hence a greater ability to achieve its macroeconomic objectives. Casual observation confirms that market participants do pay close attention to FOMC statements and that these statements often move markets. But have FOMC statements had the effects that were intended? And how important have these effects been, relative to the impact of the rate-setting decision itself? With two Federal Reserve colleagues, Vincent Reinhart and Brian Sack, I recently developed new empirical evidence on these questions, some highlights of which I will briefly share with you today (Bernanke, Reinhart, and Sack, 2004).3 The effects of FOMC actions and statements are reflected most clearly and directly in financial markets; so to try to measure these effects my coauthors and I studied the responses to FOMC decisions of some key interest rates and asset prices. More specifically, we observed financial-market developments over the period beginning fifteen minutes before and ending forty-five minutes after each policy decision became known to the public.4 The advantage of restricting the analysis to a short period spanning the Committee’s decision is that the changes in yields or asset prices occurring within that narrow window are more likely to reflect the impact of the decision, as opposed to the arrival of other information about the economy. We included in our data set all FOMC policy decisions since July 1991 - both those taken at regular meetings and those made between meetings, a total of 116 decisions. Of these 116 policy decisions, 56 were accompanied by an official statement, and 60 did not involve a statement. Of greatest interest to us was determining how FOMC actions and statements affected the expectations of financial-market participants about the likely future course of the federal funds rate. A variety of financial instruments convey information about these expectations. In our work we focused on a particular futures contract (a Eurodollar futures contract), which provides a good measure of what the market expects the federal funds rate to be at a horizon of about one year.5 By observing the change in the price of that contract in the period around each FOMC decision, we were able to infer how that decision affected year-ahead policy expectations. Moreover, the fact that our data set included some decisions accompanied by statements and some without statements allowed us to separate the effects of rate actions and statements on policy expectations and, consequently, on longer-term yields. Our findings support the view that FOMC statements have proven a powerful tool for affecting market expectations about the future course of the federal funds rate.6 Certainly, the market’s expectations for year-ahead rates respond to unexpected changes in the FOMC’s target for the federal funds rate, as we would expect. However, as most rate actions are well anticipated by financial markets, changes in Sack has very recently left the Board. Our paper was commissioned by the Brookings Institution and was presented there on September 9, 2004. It will be published in the Brookings Papers on Economic Activity. Determining precisely when each decision was either announced or conveyed to the market by other means, such as the commencement of open-market operations to establish the new rate, was a tedious process. For details and a record of the timing of decisions, see Grkaynak, Sack, and Swanson (2004). The future rate implied by the contract embeds a risk premium that generally causes it to deviate from the federal funds rate expected by the typical market participant. However, changes in the contract rate that occur in a short period surrounding an FOMC decision are likely to be determined primarily by changes in the policy outlook rather than changes in the risk premium. Kohn and Sack (2003) and Grkaynak, Sack, and Swanson (2004), using methods similar to ours, also find evidence that FOMC statements have a strong impact on policy expectations and on financial markets generally. the federal funds rate alone account for only a small portion of the change in expectations around FOMC decisions.7 Over the short period around a policy decision, FOMC statements, not the rate-setting action itself, have the greater influence on year-ahead rate expectations, particularly when the content of the statement is not fully anticipated by market participants.8 For example, according to our estimates, a policy statement that surprises the market leads market participants to revise their year-ahead rate expectations about 14 basis points more than they would have in the absence of such a statement. We also confirmed that FOMC statements tend to move market beliefs in the direction one would have expected. In particular, statements that were unexpectedly “hawkish” in tone - that is, statements that seemed to indicate that future policies might involve higher rates than previously thought - resulted in increases in year-ahead policy expectations of between 12 and 16 basis points on average, whereas “dovish” statements led to similar decreases in rate expectations. The largest effects on policy expectations and yields were observed following FOMC statements that directly addressed the likely future evolution of policy, such as the August 2003 statement that invoked the “considerable period” and the January 2004 statement that introduced the phraseology that the Committee “can be patient.” There seems to be little doubt that FOMC statements can have a substantial influence on year-ahead policy expectations. We found that they influence expectations and rates beyond the one-year horizon, as well. For example, we calculated that the content of FOMC statements accounts for about 68 percent of the variability in the five-year Treasury yield in the hour around FOMC decisions. By contrast, the Committee’s decision about where to set the funds rate explains only 12 percent of the variance in the five-year yield, with the remaining 20 percent of the variance reflecting other influences. We investigated a number of other dimensions of FOMC statements and their effects. For example, some observers have argued that, by focusing attention on certain macroeconomic variables as possible triggers for policy action, recent statements have increased the responsiveness of yields and asset prices to news about those particular variables. A possible case in point is the monthly payroll employment number, whose importance to markets appears to have been elevated by references to employment and resource utilization in recent FOMC statements.9 If FOMC communication has served to highlight the monthly payroll statistics and their possible link to policy decisions, then financial markets should have become more sensitive to unexpected developments in payrolls. To check this hypothesis, we studied the behavior of the ten-year Treasury yield in the thirty-minute window around the monthly release of the payroll data. We broke the sample into the periods before and after the introduction of the “considerable period” language in August 2003. We found that, in the earlier period, an announcement that reported 100,000 jobs more than expected translated into a 4-basis-point increase in the ten-year yield during the thirty-minute window around the announcement. In contrast, since the August 2003 FOMC meeting, a positive surprise of 100,000 jobs has increased Treasury yields about 11 basis points. This economically and statistically important difference is consistent with the view that FOMC statements have increased the sensitivity of financial markets to the payroll data. It is interesting that, although central bank talk may have increased sensitivity to certain data releases, overall financial market volatility has declined recently. Federal Reserve communications policy has likely contributed to the fall in volatility by reducing the uncertainty surrounding the future course of policy. We concentrated on changes in the funds rate that were surprises to financial markets, on the grounds that changes in the funds rate that were fully anticipated would already be priced into markets in advance of the FOMC’s action. To determine which FOMC rate-setting actions were unexpected, as well as the magnitude of the policy surprises, we followed Kuttner (2001) and compared the rate actually set by the FOMC at each meeting to the market’s expectation of that rate, as inferred from the prices of federal funds futures contracts. Applying our methodology, we found that an unexpected 25-basis-point change in the Committees funds rate target has been associated with a change of about 13 basis points, in the same direction, in the expected funds rate one year ahead. As noted in the text, however, most changes in the funds rate are at least partially anticipated, implying that the unexpected component of most funds rate decisions is considerably less than 25 basis points. The effect on year-ahead rate expectations of a typical change in the funds rate is correspondingly reduced, to 5 basis points or less. To determine which statements surprised markets we used a number of sources, including staff commentaries prepared at the Board of Governors and the Federal Reserve Bank of New York, articles in the Wall Street Journal, pre-meeting commentary by a leading financial firm, and pre-meeting surveys of primary dealers and other market participants. Each FOMC statement that used the “considerable period” language also discussed labor market conditions, and the December 2003 statement tied the “considerable period” outlook for policy closely to “slack” in resource use. As I observed earlier, much of the potency of monetary policy lies not in the FOMC’s ability to affect today’s federal funds rate but rather in the Committee’s ability to influence market expectations about future policy and, consequently, the economically more relevant long-term rates. On this important metric, the statement has become an increasingly important tool of policy. Of course, as I have already emphasized, talk is of no value if market participants do not believe that the FOMC intends to follow through on its plans - adjusting as necessary, of course, to developments in the economy. In the long run, talk and action must complement and reinforce each other if policy is to be effective. Central bank talk when the policy rate is near the zero bound The research I have described was actually a part of a larger project in which my coauthors and I investigated alternative monetary policies that might be used when the short-term interest rate is close to zero. As the attending members of the Japan Society well know, Japan has been in that difficult situation for more than six years. Although effective communication by the central bank is always important, it becomes especially important when the rates are near zero. Indeed, when the proximity of the zero bound prevents further rate cuts to stimulate the economy, talking about future policy actions may be one of the few tools at the central bank’s disposal by which to influence conditions in financial markets. The Bank of Japan’s recent policies illustrate the centrality of communication policies. In April 1999, the Bank of Japan (BOJ) not only reduced its call rate to within a few basis points of zero, it also announced its attention to keep the call rate at zero “until deflationary concerns are dispelled.” This policy, known as the zero-interest-rate policy, or ZIRP, was interrupted by a 25-basis point rise in the call rate in August 2000 but then effectively re-introduced in March 2001 in conjunction with the BOJ’s new policy of quantitative easing.10 The BOJ’s goal in committing to the ZIRP was to persuade participants in the Japanese bond market that short-term rates would remain low for longer than they had thought - a commitment that, if credible, should result in longer-term rates being lower than they otherwise would be. Did the ZIRP influence longer-term rates as intended? I will spare you the details but report that our tentative answer is “yes.” Our most useful evidence involved a comparison of the actual Japanese term structure of interest rates with estimates of the term structure derived from an econometric model, one that links interest rates to macroeconomic conditions. We found that, relative to the predictions of our model, Japanese interest rates fell significantly after the introduction of the ZIRP in April 1999, rose after the policy was interrupted in August 2000, then declined again when the ZIRP was re-introduced (along with the new policy of quantitative easing) in March 2001. The effects of the ZIRP look particularly large for interest rates on securities with maturities between two to five years, a result consistent with other research on this episode (for example, Fujiki and Shiratsuka, 2002). Apparently, then, central bank talk has had benefits in Japan as well as in the United States. Conclusion The practice of monetary policy has changed significantly over the past fifteen years or so, both in the United States and abroad. We see today a worldwide trend toward greater clarity, transparency, and specificity in central bank communication with the public. These changes are important for reasons of governance and democratic accountability as well as for promoting the exchange of ideas between those inside and those outside central banks. Significantly, as I have emphasized today, monetary policy is more effective when the policy committee provides the public guidance on its outlook, objectives, and plans. Reasonable people differ on how the FOMC statement should evolve from its present form. My own view is that we are approaching the limits of purely qualitative communication and should consider the inclusion of quantitative information presented in a clearly specified framework (Bernanke, 2003). For example, like policymakers at many other central banks, the FOMC could specify its long-term inflation objective and include explicit economic forecasts, conditioned on alternative assumptions, in its Under its quantitative easing policy, the BOJ has committed to provide more reserves to the banking system than are needed to maintain the call rate at zero. The BOJ’s commitment to quantitative easing thereby commits it to the ZIRP as well. statements or in regular reports. That being said, one must recognize that the FOMC is not a “unitary actor,” as the political scientists term it, but a committee of nineteen highly independent people. With the best will in the world, achieving a Committee consensus on a detailed forecast (for example) will always be difficult in the short time available. Some ambiguity in the FOMC’s communications may therefore be unavoidable. That being said, the increases in the transparency of the FOMC and the Federal Reserve System during the past decade have really been quite impressive, to the credit of those who have served the institution during that period. Experience has shown that this greater transparency has had many palpable benefits, including more effective monetary policy and better macroeconomic outcomes.
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Cato Institute 22nd Annual Monetary Conference, Washington, DC, 14 October 2004.
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Ben S Bernanke: International monetary reform and capital freedom Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Cato Institute 22nd Annual Monetary Conference, Washington, DC, 14 October 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * The free movement of capital across borders has created, and will certainly continue to create, enormous economic benefits. Capital flows afford developing countries and other regions the means to exploit promising investment opportunities, while providing savers around the globe the means both to earn higher returns and to reduce risk through international portfolio diversification. Access to international capital markets also permits nations to accumulate foreign assets in good times and to deplete those assets or to borrow in bad times, mitigating the effects on living standards of shocks to domestic income and production. In recent years, global capital flows have attained record highs relative to global income, reflecting both the powerful tendency of capital to seek the highest return and a concerted international effort to dismantle political and regulatory barriers to capital mobility. The issue I would like to address today is the role of monetary policy, and in particular the choice of the exchange rate regime, in enabling economies to take the maximum advantage of the increasing openness and depth of international capital markets. I should begin by noting that the views I will express today are my responsibility and are not necessarily shared by my colleagues at the Federal Reserve.1 The discussion of monetary policy and capital flows almost inevitably begins with the well-known “trilemma,” the observation that a country can choose no more than two of the following three features of its policy regime: (1) free capital mobility across borders, (2) a fixed exchange rate, and (3) an independent monetary policy.2 Various combinations of these features have dominated world monetary arrangements in different eras. Under the classical gold standard of the nineteenth century, the major trading countries chose the benefits of free capital flows and the perceived stability of a fixed relation of their currency to gold; of necessity, then, they largely abjured independent monetary policies. Under the Bretton Woods system created at the end of World War II, many countries renounced capital mobility in an attempt to maintain both fixed exchange rates and monetary independence. Currently, among the major industrial regions at least, we have collectively chosen a regime that gives up fixed exchange rates in favor of the other two elements. Is the international monetary regime that is in place today the best one for the world? For the economically advanced nations that use the world’s three key currencies - the euro, the yen, and the dollar - I believe that the benefits of independent monetary policies and capital mobility greatly exceed whatever costs may result from a regime of floating exchange rates. My view is widely - though not universally - shared among economists and policymakers. In particular, what was once viewed as the principal objection to floating exchange rates, that their adoption would leave the system bereft of a nominal anchor, has proven to be unfounded. Most countries today, including many emerging-market and developing nations as well as the advanced industrial countries, have succeeded in establishing a commitment to keeping domestic inflation low and stable, a commitment that has served effectively as a nominal anchor. A newer critique of floating exchange rates contends that exchange rates are more volatile than can be explained by the macroeconomic fundamentals and, moreover, that this excess volatility has in some cases inhibited international trade (Flood and Rose, 1995; Rose, 2000; Klein and Shambaugh, 2004). Like other asset prices, floating exchange rates do indeed exhibit a great deal of volatility in the very short term, responding to many types of economic news and, sometimes it seems, to no news at all. Whether this very short-term volatility is excessive relative to fundamentals (which are inherently difficult to observe and measure) is debatable. In any case, this short-term volatility seems unlikely to I would like to thank Board staff members Joseph Gagnon and Steven Kamin for excellent assistance in the preparation of these remarks. Obstfeld, Shambaugh, and Taylor (2004) provide historical evidence that supports the empirical relevance of the trilemma. have substantial effects on trade or capital flows, as short-term fluctuations in exchange rates are easily hedged. Exchange rates also exhibit long-horizon volatility, of course; but, although the swings in the exchange value of the dollar over the past thirty years have been large, so have been the changes in the global macroeconomic environment. As key components of the international adjustment mechanism, fluctuations in exchange rates and the associated financial flows have often played an important stabilizing role. For example, the sharp rise in the dollar in the late 1990s reflected to an important degree a surge in U.S. productivity growth, which raised perceived rates of return and attracted significant inflows of capital. The capital inflows, the stronger dollar, and the associated rise in imports worked together to permit increased capital investment in the United States during that period, enabling production and incomes to grow without overheating the economy or requiring a sustained rise in interest rates. The value of floating exchange rates as shock absorbers might make their adoption worthwhile even if their volatility did have a chilling effect on trade. However, the sharp rise in trade volumes relative to world gross domestic product in recent decades suggests to me that, at least for the world as a whole, any such chilling effect has likely been minor. The presumption in favor of allowing the market to determine the exchange rates among the major currencies is strengthened by the fact that a consensus about the appropriate levels at which to peg these currencies would be difficult to obtain. A poor choice of the rates at which currencies would trade could condemn one or more regions to unwanted inflation and the other regions to economic stagnation for a transition period that could easily last several years. The United Kingdom suffered the consequences of a poor choice of peg when it returned to the gold standard after World War I, as an overvalued pound reduced British exports and significantly worsened the country’s unemployment problem. The United Kingdom faced analogous problems sixty-five years later, when it entered the European exchange rate mechanism (ERM) in 1990 at a parity that again disadvantaged British exports and contributed to Great Britain’s worst recession in the past twenty years. Nor were these macroeconomic costs compensated for by greater external stability; in both episodes, doubts about the sustainability of the peg generated speculative attacks that ultimately forced the pound off its fixed rate. Overall, the case for floating exchange rates among the United States, Japan, and the euro zone seems to me to be compelling. For smaller industrial countries, the case for floating rates may in some instances be less clear-cut, for example, when the bulk of a country’s trade is with a single, large trading partner. Generally, though, my sense is that the benefits of floating exchange rates exceed the costs for these countries as well. Much more controversial is the question of how developing and emerging-market countries should resolve the trilemma. Some might argue against these countries’ choosing to allow free capital mobility on the grounds that rapid reversals in international capital flows have induced balance of payments crises and difficult domestic adjustments for them in the past. But even those most concerned about potential instability in international capital flows would have to admit that comprehensive capital controls, if applied for any extended period, might solve one problem at the cost of creating a more serious one - namely, the inhibition of growth and development that occurs when nations lack access to international capital markets. At best, then, restrictions on capital mobility should be viewed as a temporary expedient, a second-best or third-best solution to the problems presented by flawed or immature institutions in a nation at early or intermediate stages of development. In the medium run, the better approach - admittedly, one not always so easy to implement - is to commit to making the nation’s legal, regulatory, and fiscal framework stronger and more transparent. If foreign investors are thus reassured that their capital will be employed efficiently and its returns repatriated smoothly, the risks of capital flow reversals under a regime of free capital mobility should be much reduced. If we agree that every country should set a goal of achieving at least some degree of capital mobility, then the trilemma for developing countries ultimately boils down to the choice between flexible exchange rates (and the associated independence of monetary policy) and fixed rates (which do not allow monetary independence). For the remainder of my remarks I will focus on that choice. I should acknowledge immediately that to state the choice as one of “fixed versus floating” is to oversimplify. Both types of regime are actually broad categories, each of which contains a number of variants. Fixed exchange rates are almost never irrevocably fixed, for example: Crawling pegs allow the rate to be adjusted in a controlled manner, while some putatively fixed rates are actually re-set at frequent intervals, either as an instrument of policy or under external pressure. So-called hard pegs, including currency boards and dollarization, may draw credibility from various institutional impediments to changing the rate; but even full dollarization can be reversed, as Liberia proved in 1982.3 Floating exchange rates cover an even wider range of policy behavior than fixed rates - from full reliance on the foreign exchange market for the determination of the exchange rate to a carefully managed float. So what should developing countries do about the exchange rate? Theory suggests that any group of countries whose economic structures and trade linkages satisfy the requirements of an optimum currency area, in the sense of Mundell (1961), would be well served by fixing the exchange rates among their currencies or, even better, by forming a currency union.4 However, in practice, empirical analyses have generally been unsuccessful at identifying multi-country regions of any size that meet the criteria for an optimum currency area. Indeed, some studies have concluded that even the United States and the European Union, the largest currency unions, are themselves not optimum currency areas.5 Plausibly, political rather than economic considerations - namely, the desire to form a more perfect union - underlay the decisions of each of these entities to adopt a common currency.6, 7 Besides countries well-suited for a currency union, a second group of countries that might conceivably be better off with a fixed exchange rate, at least for a time, are the very poorest and least developed countries, which may lack the institutional infrastructure to effectively operate an independent monetary policy. In these countries, a hard peg or even the adoption of the currency of a major trading partner - sometimes known as dollarization, although the term also refers to cases in which the currency adopted is one other than the dollar - may be policy options worth considering. (I want to be clear that I am speaking generally and am not advocating that other countries adopt the U.S. currency.) Although dollarization has the advantage of making monetary policy essentially automatic and should be an effective device for controlling inflation, one is struck by the fact that so few countries have chosen this approach. Costs of dollarization include the loss of revenue from money creation and the reduced ability of the central bank to serve as a lender of last resort. But perhaps the most important impediment to dollarization is that, in giving up their own currency, the country’s citizens may feel that they are losing an important symbol of the nation’s sovereignty and pride. For other developing and emerging-market countries, I would argue that the best course is generally to let the exchange rate float freely and to make low and stable inflation a principal focus of monetary policy. As I have already suggested, this approach makes the targeted inflation rate, and not the exchange rate or some other variable, the nominal anchor of the system. An important reason for making the inflation rate (more precisely, the price level) the nominal anchor is that the general price level is more directly linked to economic welfare than is the exchange rate. Domestic price stability improves the operation of markets, reduces the costs associated with economizing on money holdings and with changing prices, lessens distortions associated with imperfect indexing of the tax system and the accounting system, and aids long-term planning. As I have also already noted, concerns about the feasibility of this approach have been put to rest by the experience of the past decade or so. Central banks in many countries, with either an explicit or an implicit inflation target, have demonstrated the capacity to keep inflation low and stable. Indeed, recent research suggests that the combination of an inflation target, central bank independence, and a market-determined exchange rate tends to reduce variability in both inflation and output, even in small open economies such as Finland and When the parity is nominally fixed but can be varied, and if capital flows are less than perfectly free, monetary policy under a fixed exchange rate may have a degree of independence; thus, the resolution of the trilemma may not be a stark choice of two of the three elements but a partial adoption of each. An optimum currency area is a region in which labor and capital are internally mobile and sub-regions tend to be affected by similar shocks. As Mundell (1961) first argued, in this situation the shock-absorbing benefits of flexible exchange rates are outweighed by the reduction in transactions costs and in uncertainty provided by fixed exchange rates or a common currency. See, for example, Bayoumi and Eichengreen (1993) and Ghosh and Wolf (1994). European economic integration has been motivated to a significant degree by a desire to make a repeat of the destructive conflicts of the twentieth century impossible. In the fledgling United States, the desire to strengthen the central government was a principal reason behind Alexander Hamilton’s advocacy of a common currency and common national debt. On the other hand, recent research has pointed out the interesting possibility that the formation of a currency union, by promoting trade and economic integration among its members, may lead the criteria for an optimum currency area among the participating countries to be satisfied after the fact even if not before (Frankel and Rose, 2002). Of course, to justify a currency union on this basis requires the ability to forecast how linkages among the participants will evolve under the common currency, a difficult undertaking indeed. New Zealand (Truman, 2003). To be clear, a focus on domestic inflation does not imply that policymakers must entirely ignore the exchange rate; particularly in small open economies, stabilization of the domestic price level may entail some “leaning against the wind” with respect to exchange rate movements, because of their influence on domestic prices. This behavior does not imply that exchange rate stabilization is an independent objective, however; and should price stability and exchange rate stability come into conflict, it is the latter that should be jettisoned. In contrast to floating rates, fixed exchange rates - rather than being a mechanism for reducing macroeconomic instability - have often been a source of instability. Historically, governments have often defended their fixed parity even after the overvaluation of the exchange rate became obvious, leading to losses of foreign exchange reserves, a balance of payments crisis, and difficult domestic adjustments. Some observers have suggested that the solution to this problem is to tie the government’s hands even more forcefully by imposing a harder peg, by means of a currency board or dollarization for example. But market participants know that promises to maintain a fixed rate are almost never irrevocable, and so a speculative attack is always possible (as Argentina recently learned, for example). Another strategy for deterring speculative attacks on a fixed exchange rate is to build a “war chest” of foreign-currency reserves. To be effective in today’s world of highly mobile capital, the war chest may have to be sizable indeed; and for countries with large government debts and high domestic interest rates, holding great quantities of low-yielding reserves can have serious fiscal consequences. In any case, strategies to increase the defensibility of the peg ignore the broader issue of the role of the exchange rate in macroeconomic adjustment. For an individual country, forcing adjustment to a mis-valued exchange rate through domestic price changes is likely to be far more difficult and costly than an adjustment occurring through exchange rate depreciation or appreciation. For the world as a whole, macroeconomic adjustment may likewise be impeded if economically important countries attempt to maintain pegs at levels that differ from those dictated by fundamentals. If fixed exchange rates bear such risks, what explains their continued existence? One traditional argument in favor of fixed exchange rates for developing countries focuses on their usefulness in so-called heterodox programs for overcoming high inflation.8 According to this view, the advantage of fixing the exchange rate as one element of an anti-inflation program (along with fiscal reforms and other policy changes) is that fixing the rate is more visible, more credible, and easier to explain than a commitment to stabilizing prices directly. Even if we grant a role for a fixed exchange rate in combating high inflation, however, this argument provides no rationale for fixing the rate indefinitely. If the program is successful and the inflationary psychology is broken, nothing prevents a transition from targeting the exchange rate to targeting inflation. Two countries with chronic inflation problems, Argentina and Brazil, did not experience a sustained resurgence of high inflation when they abandoned fixed rates in recent years. Brazil now targets inflation, and by some reports Argentina has considered the option. Israel broke the back of its hyperinflation in the mid-1980s with the aid of a fixed exchange rate but then made a gradual and successful transition to inflation targeting. And, of course, this argument provides no rationale for the use of fixed exchange rates by countries, such as the East Asian emerging-market countries, that have not experienced episodes of high inflation. An interesting recent explanation for the continued existence of fixed exchange rates is the so-called fear-of-floating phenomenon (Calvo and Reinhart, 2000). According to this view, the poor credibility of policymakers in some countries implies that the exchange rate, if left unmanaged, would prove excessively volatile. High exchange rate volatility could prove very harmful in these countries, for at least two reasons. First, the openness of these economies to trade, coupled with the fact that the exchange rate may serve as a focal point for inflation expectations, may imply that exchange rate volatility translates quickly into instability in consumer prices. Second, because firms and households in these countries often borrow in foreign currencies but receive revenues and incomes in the domestic currency, swings in the exchange rate have major effects on the net worth of these borrowers. In particular, a sharp devaluation, by raising the value of foreign liabilities relative to domestic assets, might bankrupt large segments of the economy, with severe financial and economic implications. According to the fear-of-floating hypothesis, the severe consequences of exchange rate volatility in these countries may lead policymakers to manage their currencies quite closely to damp volatility, no matter what the putative exchange rate regime. Sargent (1982) notes the role of exchange rate stabilization in ending the European hyperinflations of the 1920s. Analysts of more recent stabilization programs in developing countries have observed that even if exchange rate-based policies succeed in reducing inflation initially, fixing the exchange rate may lead to subsequent problems (Vegh, 1992; Dornbusch and Warner, 1994). If we assume that the fear-of-floating hypothesis accurately describes behavior, what are the implications? Some have argued that, given the unwillingness to float, countries would be better off dollarizing or taking other measures to achieve a hard peg. This approach would have the benefits (the argument goes) of making explicit the country’s implicit policy, making a disruptive devaluation less likely, and consequently, possibly reducing the risk premium that borrowers in the country must pay to borrow abroad. I have already expressed reservations about so-called hard pegs for developing countries: Though less so than conventional pegs, they remain subject to speculative attacks, and they may make domestic macroeconomic adjustment more difficult. They also constrain the central bank’s ability to act as a lender of last resort in the event of a banking crisis. Moreover, the small amount of available evidence does not favor the view that a hard peg will significantly reduce the risk premium a country must pay on international loans; for example, the dollarized nations of El Salvador and Panama do not appear to be paying lower interest rate premiums on their debt than other similarly situated countries. Furthermore, to the extent that a hard peg encourages foreign-currency borrowing, the costs of devaluation, should it come, may be greatly increased. One may also question whether the fear of floating is a permanent and irremediable condition. An important underpinning of the fear-of-floating argument is the idea that borrowing and lending in international capital markets must take place only in a few key currencies, condemning most countries to borrow in a currency other than their own and exposing them to heavy losses in the event of a devaluation (Eichengreen and Hausman, 1999). In addition, because of creditor mistrust, the borrowing that does take place must be mostly in short-maturity instruments, greatly increasing the risk of a liquidity crisis. Continuing the tradition of colorful nomenclature in international economics, this hypothesis has been labeled “original sin,” because the need to borrow in foreign currencies and in short-maturity instruments supposedly constrains all but the largest and wealthiest countries regardless of economic policies and performance. However, recent developments in international capital markets challenge the inevitability of “original sin” (Eichengreen, Hausman, and Panizza, 2003; Burger and Warnock, 2004). First, some small countries have in fact been able to sell domestic-currency debt to foreigners (examples include New Zealand, Poland, and South Africa). Second, some developing countries have been able to establish active domestic credit markets in which borrowing may take place in long-term, fixed-rate debt, providing a partial substitute for foreigncurrency borrowing (examples include Chile, India, and Korea). In both situations, the quality of the country’s macroeconomic policies as well as the strength and transparency of its institutional framework have been critically important for improving the access of borrowers to capital. Redemption from “original sin” through good works may thus be possible. These experiences suggest that, whatever interim arrangements they adopt regarding exchange rates and capital mobility, developing countries would do well to shift their focus to the task of building institutions, protecting property rights, and establishing a sound fiscal and monetary framework, with the ultimate goal of making free capital flows and a floating exchange rate feasible. In the wake of the Asian crisis, the conventional wisdom asserted that a country should eschew fixed exchange rates in favor of either of the two extremes: a floating rate or a currency union. I agree with this “bipolar view” insofar as I think that a garden-variety fixed exchange rate is, in most instances, the worst of all worlds. Notably, fixed exchange rates often result in irresistible one-way bets for speculators, with crisis and painful economic adjustment the likely result. Large holdings of foreign exchange reserves reduce this risk but create other costs. Currency unions are considerably less prone to speculative attack and may reduce uncertainty and transactions costs in international trade and finance. But as I have indicated today, I believe that floating exchange rates are generally to be preferred either to fixed exchange rates or - except in those relatively rare cases in which the criteria for an optimum currency area are met - to currency unions. This view seems to be spreading. According to the International Monetary Fund (2004), for example, inflation-targeting countries are becoming more numerous as countries that fix the exchange rate become fewer.9 Consistent with this observation, average inflation rates in both industrial and developing countries are near their lowest levels in four decades, reflecting the new emphasis in policy. Politicians and policymakers around the world are being converted to the idea that monetary Reinhart and Rogoff (2002) argue that the move away from pegs is less pronounced in terms of actual policy behavior than in terms of official classifications. Their point is an important one. However, they do not dispute the direction of the change, and as their analysis compares 1991-2001 to earlier periods they miss a very recent acceleration toward floating exchange rates and inflation-focused monetary policies. policy should focus on delivering low and stable inflation, with the determination of exchange rates left to free markets. The most consequential exception to the general trend toward inflation stabilization, free capital markets, and floating exchange rates is, of course, China. China currently has relatively strict - though not absolutely impermeable - barriers to capital flows, as well as an exchange rate that is effectively pegged to the U.S. dollar. The governments of the United States and the other G-7 countries have urged China to make the transition to a market-determined exchange rate, in the interest of promoting global macroeconomic adjustment. I will add here only that moving toward exchange rate flexibility is in the interest of China as well as the rest of the world. As a large, increasingly wealthy, and increasingly market-oriented economy, China will benefit from the shock-absorber properties of an independent monetary policy and a floating exchange rate. Because it needs capital to fuel its rapid growth and because its citizens would benefit greatly from the opportunity to invest their own savings abroad, China will likewise benefit from increased capital freedom. Finally, the institutional developments needed to support ever-more-open capital markets, including a strengthened legal and regulatory framework, an increased capacity of its banks to allocate capital to the most productive uses, and a reduced role of the government in investment decisions, are themselves necessary and important steps in China’s economic modernization. The United States will also benefit as China and other East Asian countries make the transition to floating exchange rates and freer capital flows. More-open capital accounts and market-determined exchange rates will likely engender greater stability and improved resource allocation in Asia, setting the stage for sustained future growth. The development of the Asian economies will expand export markets for U.S. producers, particularly as independent monetary policies and institutional reform provide scope for stimulating demand by Asian households and firms. Some observers have expressed concern about the effects of reduced reserve accumulation by Asian central banks on U.S. bond markets; however, the U.S. bond market is extremely deep and has shown a remarkable capacity to handle transitions smoothly, particularly when they occur in a gradual and predictable manner. Moreover, under a regime of free capital mobility, private savers in China and the rest of East Asia may well wish to diversify into U.S. assets, including U.S. bonds. In summary, I have argued today for an international system based on the principles of flexible exchange rates, free capital mobility, and independent monetary policies, at least within the great majority of countries. Important complementary elements include free trade (though I have not discussed it today) and the further development of the “soft” infrastructure - the legal, regulatory, fiscal, and financial frameworks that characterize advanced economies. The fundamental virtue of this system is its flexibility and adaptability, qualities that will become increasingly essential in a complex and interdependent world.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at America¿s Community Bankers Annual Convention, Washington, DC, 19 October 2004.
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Alan Greenspan: The mortgage market and consumer debt Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at America’s Community Bankers Annual Convention, Washington, DC, 19 October 2004. * * * In recent years, banks and thrifts have been experiencing low delinquency rates on home mortgage and credit card debt, a situation suggesting that the vast majority of households are managing their debt well. Yet many analysts focusing on broader macroeconomic conditions are far less sanguine in their assessments. They have been disturbed particularly by the rising ratio of household debt to income and the precipitous decline in the household saving rate. The analysts point out, correctly, that the ratio of household debt to disposable income has risen especially steeply over the past five years and, at 1.2, is at a record high. Moreover, many have recently become increasingly concerned about the exceptional run-up in home prices. They argue that a collapse of such prices would expose large, recently incurred mortgage debt to decreasing values of home collateral. These concerns cannot be readily dismissed. Debt leverage of all types is often troublesome when one judges the stability of the economy. Should home prices fall, we would have reason to be concerned about mortgage debt; but measures of household financial stress do not, at least to date, appear overly worrisome. About three-fourths of all outstanding first-lien mortgages were originated with a loan-to-value ratio of 80 percent or less, and in aggregate, the current loan-to-value ratio is estimated to be around 45 percent. Even though some down payments are borrowed, it would take a large, and historically most unusual, fall in home prices to wipe out a significant part of home equity. Many of those who purchased their residence more than a year ago have equity buffers in their homes adequate to withstand any price decline other than a very deep one. Housing price bubbles presuppose an ability of market participants to trade properties as they speculate about the future. But upon sale of a house, homeowners must move and live elsewhere. This necessity, as well as large transaction costs, are significant impediments to speculative trading and an important restraint on the development of price bubbles. Some homeowners drawn by large capital gains do sell and rent. And certainly in recent years some homebuyers fearful of losing a purchase have bid through sellers’ offering prices. But these market participants have probably contributed only modestly to overall house price speculation. More likely participants in speculative trading are investors in single residence rental and second home properties. But even though in recent years their share of purchases of single family homes has been growing, in 2003 their mortgage originations were still less than 11 percent of total home mortgage originations. Overall, while local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely in the United States, given its size and diversity. *** Although I scarcely wish to downplay the threats to the U.S. economy from increased debt leverage of any type, ratios of household debt to income appear to imply somewhat more stress than is likely to be the case. For at least a half century, household debt has been rising faster than income, as everhigher levels of discretionary income have increased the proportion of income spent on assets partially financed with debt. The pace has been especially brisk in the past two years as existing home turnover and home price increase, the key determinants of home mortgage debt growth, have been particularly elevated. Most analysts, even those who do not foresee a mounting bubble, anticipate a slowdown in both home sales and the rate of price increase. Sales of existing homes increase debt because the home seller’s cancellation of debt on sale tends to average less than half the size of the mortgage origination of the buyer of the home. The difference, the net debt increase on the home upon sale, has historically closely approximated the realized capital gain on the transaction. Increases in debt from turnover tend to exceed those from the extraction of equity, most generally of unrealized capital gains, through cash-out refinancing and home equity loan extensions. The latter, however, has recently accelerated with the increased pace of home price appreciation. If house turnover and price increases both slow, and presumably mortgage debt extensions on new homes do as well, increases in home mortgage debt will slow. Outright declines in mortgage debt seem most unlikely. Home mortgage debt has increased every quarter since the end of World War II. *** Some of the rise in the ratios of household debt to income may not be evidence of stress. The dramatic increase during the past decade in home purchases by previous renters has expanded both the assets (that is, owned homes)and the liabilities (mortgages) of the total household sector without significantly affecting either overall household income or net worth. Federal Reserve staff members estimate that approximately one-tenth of current home mortgage debt outstanding, or almost 1 percentage point of the average annual growth of home mortgage debt, is attributable to renters who have become homeowners since the early 1990s. One can scarcely argue that those previous renters are less well off since becoming homeowners; yet, all else being equal, the overall household debt as a percentage of income is 8 percentage points higher currently than it presumably would have been had the homeownership ratio been stable since 1992. In addition, improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities. This extension of lending has increased overall household debt but has probably not meaningfully increased the number of households with already overextended debt. Finally, the pronounced rise in home equity loans, which have been a growing share of home mortgage debt since 1994, likely reflects the recent marked increase in home equity, the consequence of rapidly rising house prices. Despite the recent high debt-to-income ratios, at least some of which is more statistical than real, the ratio of households’ net worth to income has risen to a multiple of more than five after hovering around four and one-half for most of the postwar period. Taking into account this higher level of assets, all in all, the household sector seems to be in reasonably good financial shape with only modest evidence of an increased level of household financial strain. To be sure, some households are stretched to their limits. The persistently elevated bankruptcy rate remains a concern, as it indicates pockets of distress in the household sector. But the vast majority appear able to calibrate their borrowing and spending to minimize financial difficulties. Thus, short of a significant fall in overall household income or in home prices, debt servicing is unlikely to become destabilizing. *** The share of income committed by households for paying interest and principal on their debt is a useful measure of the likely inclination of households to default on their obligations when they suffer adversity, such as job loss or illness. As an indicator of stress, this debt-service measure has many advantages over debt-to-income ratios, but it is admittedly sensitive to assumptions about household debt contracts. The Federal Reserve publishes both the ratio of households’ debt-service to their incomes and a broader financial obligations ratio because debt payments are not the only regular payments faced by households. The financial obligations ratio incorporates other recurring expenses, such as rents, property taxes, and payments associated with homeowners’ insurance and auto leases, that might subtract from the uncommitted income available to households. The Federal Reserve also calculates separate aggregate financial obligations ratios for homeowners and renters. *** Both the debt-service ratio and the financial obligations ratio rose over the 1990s, but that upward trend has not continued in this decade. The debt-service ratio has been hovering close to 13 percent for three years, whereas the financial obligations ratio, after peaking above 18-1/2 percent in 2002, has moved down to near 18 percent. The recent stability of the aggregate debt-service and financial obligations ratios reflects largely the evolution of the financial situations of homeowners, who owe more than nine-tenths of all household debt. Despite average annual mortgage debt growth in excess of 12 percent over the past two years, the financial obligations of homeowners have exhibited little change as a share of their income because mortgage rates have remained at historically low levels. The enormous wave of mortgage refinancing, which ended only in the fall of 2003, allowed homeowners both to take advantage of lower rates to reduce their monthly payments and, in many cases, to extract some of the built-up equity in their homes. In the aggregate, the cash flows associated with these two effects seem to have roughly offset each other, leaving the financial obligations ratio little changed. Indeed, the surge in cash-out mortgage refinancings likely improved rather than worsened the financial condition of the average homeowner. Some of the equity extracted through mortgage refinancing was used to pay down more-expensive, non-tax-deductible consumer debt or to make purchases that would otherwise have been financed by more-expensive and less tax-favored credit. *** By our calculation, both homeowners and renters have seen an increase in the share of income used to cover credit card payments over the past decade. The Federal Reserve’s Survey of Consumer Finances suggests that renters who have recently purchased homes tend to carry higher levels of nonmortgage debt and, in particular, credit card debt. Moreover, credit card debt ratios have been rising among all households because of the use of credit cards for new purposes. The convenience of credit cards has caused homeowners to shift the way they pay for various expenditures to credit card debt. In short, credit card debt-service ratios have risen to some extent because households prefer credit cards as a method of payment, and hence, the increase does not necessarily indicate greater financial stress. All told, the rise in short-maturity, high-repayment-rate credit card debt has accounted for about one-third to more than one-half the increase in the debt-service ratio for homeowners since the early 1990s. Moreover, the rise in the share of income going to other homeowner nonmortgage financial obligations has also been relatively small so that the overall homeowner ratio has risen only modestly. In contrast, the rise in the financial obligations ratios for renters since the early 1990s has been steep. The increase for renters, as for homeowners, is concentrated in credit card lending and thus may reflect some of the same qualifying factors that have influenced homeowner debt-service ratios. But unlike homeowners, renters over the past decade have been using a materially higher fraction of their incomes for payments on student loans and used-car debt. Renters tend to be younger and have lower incomes than homeowners, so the fact that student loans and used-car payments are a larger share of their income is not surprising. However, this trend might be worrisome if it indicates greater difficulties in becoming financially established. In addition, some of the rise in the debt-service ratios of renters, unlike in those of homeowners, occurred during the most recent recession. This difference highlights the special risks to their incomes that renters face during economic downturns. Difficulties among renters may pose some risk to the economy overall, but this risk is likely to be limited, since renter households currently receive only one-sixth of overall after-tax household income. Renters’ debt-service and financial obligations ratios have trended down a little during the past two years, a hopeful sign that is likely correlated with the overall improvement in the economy. However, the longer-term rise in the renter debt-service ratio may indicate some trends among these households that may be problematic. *** One might expect interest rates and debt-service ratios to move in lockstep with each other. But other influences on debt-service ratios, such as significant changes in household income, play a major role in their movements. In addition, most consumer and mortgage loans have fixed rates, suggesting that debt-service payments respond only gradually to interest rate changes. That said, debt-service ratios are likely to remain high so long as mortgage debt continues to expand faster than historical trends relative to household income. Altogether, even in a rising interest rate environment, debt-service ratios at least for a while should rise only modestly. *** In summary, although some broader macroeconomic measures of household debt quality do not paint as favorable a picture as do the data on loan delinquencies at commercial banks and thrifts, household finances appears to be in reasonably good shape. There are, however, pockets of severe stress within the household sector that remain a concern and we need to be mindful of the difficulties these households face. In addition, a significant decline in consumer incomes or house prices could quickly alter the outlook; nonetheless, both scenarios appear unlikely in the quarters immediately ahead. If lenders, including community bankers, continue their prudent lending practices, household financial conditions should be all the more likely to weather future challenges.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, to the National Italian American Foundation, Washington, DC, 15 October 2004.
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Alan Greenspan: Oil Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, to the National Italian American Foundation, Washington, DC, 15 October 2004. * * * Owing to the current turmoil in oil markets, a number of analysts have raised the specter of the world soon running out of oil. This concern emerges periodically in large measure because of the inherent uncertainty of estimates of worldwide reserves. Such episodes of heightened anxiety about pending depletion date back a century and more. But, unlike past concerns, the current situation reflects an increasing fear that existing reserves and productive crude oil capacity have become subject to potential geopolitical adversity. These anxieties patently are not frivolous given the stark realities evident in many areas of the world. While there are concerns of seeming inadequate levels of investment to meet expected rising world demand for oil over coming decades, technology, given a more supportive environment, is likely to ensure the needed supplies, at least for a very long while. Notwithstanding the recent paucity of discoveries of new major oil fields, innovation has proved adequate to meet ever-rising demands for oil. Increasingly sophisticated techniques have facilitated far deeper drilling of promising fields, especially offshore, and have significantly increased the average proportion of oil reserves eventually brought to the surface. During the past decade, despite more than 250 billion barrels of oil extracted worldwide, net proved reserves rose in excess of 100 billion barrels. That is, gross additions to reserves have significantly exceeded the extraction of oil the reserves replaced. Indeed, in fields where, two decades ago, roughly one-third of the oil in place ultimately could be extracted, almost half appears to be recoverable today. I exclude from these calculations the reported vast reserves of so-called unconventional oils such as Canadian tar sands and Venezuelan heavy oil. Gains in proved reserves have been concentrated among OPEC members, though proved reserves in the United States, for the most part offshore, apparently have risen slightly during the past five years. The uptrend in world proved reserves is likely to continue at least for awhile. Oil service firms still report significant involvement in reservoir extension and enhancement. Nonetheless, growing uncertainties about the long-term security of world oil production, especially in the Middle East, have been pressing oil prices sharply higher. These heightened worries about the reliability of supply have led to a pronounced increase in the demand to hold larger precautionary inventories of oil. In addition to the ongoing endeavors of the oil industry to build inventories, demand from investors who have accumulated large net long positions in distant oil futures and options is expanding once again. Such speculative positions are claims against future oil holdings of oil firms. Currently, strained capacity has limited the ability of oil producers to quickly satisfy this markedly increased demand for inventory. Adding to the difficulties is the rising consumption of oil, especially in China and India, both of which are expanding economically in ways that are relatively energy intensive. Even the recent notable pickup in OPEC output, by exhausting most of its remaining excess capacity, has only modestly satisfied overall demand. Output from producers outside OPEC has also increased materially, but investment in new producing wells has lagged, limiting growth of production in the near term. Crude oil prices are also being distorted by shortages of capacity to upgrade the higher sulphur content and heavier grades of crude oil. Over the years, increasing demand for the environmentally desirable lighter grades of oil products has pressed refiners to upgrade the heavier crude oils, which compose more than two-thirds of total world output. But refiners have been only partly successful in that effort, judging from the recent extraordinarily large increase in price spreads between the lighter and heavier crudes. For example, the spread between the price of West Texas intermediate (WTI), a light, low-sulphur crude, and Dubai, a benchmark heavier grade, has risen about $10 per barrel since late August, to an exceptionally high $17 a barrel. While spot prices for WTI soared in recent weeks to meet the rising demand for light products, prices of heavier crudes lagged. This temporary partial fragmentation of the crude oil market has clearly pushed gasoline prices higher than would have been the case were all crudes available to supply the demand for lighter grades of oil products. Moreover, gasoline prices are no longer buffered against increasing crude oil costs as they were during the summer surge in crude oil prices. Earlier refinery capacity shortages had augmented gasoline refinery-marketing margins by 20 to 30 cents per gallon. But those elevated margins were quickly eroded by competition, thus allowing gasoline prices to actually fall during the summer months even as crude oil prices remained firm. That cushion no longer exists. Refinery-marketing margins are back to normal and, hence, future gasoline and home heating oil prices will likely mirror changes in costs of light crude oil. With increasing investment in upgrading capacity at refineries, the short-term refinery problem will be resolved. More worrisome are the longer-term uncertainties that in recent years have been boosting prices in distant futures markets for oil. Between 1990 and 2000, although spot crude oil prices ranged between $11 and $40 per barrel for WTI crude, distant futures exhibited little variation around $20 per barrel. The presumption was that temporary increases in demand or shortfalls of supply would lead producers, with sufficient time to seek, discover, drill, and lift oil, or expand reservoir recovery from existing fields, to raise output by enough to eventually cause prices to fall back to the presumed long-term marginal cost of extracting oil. Even an increasingly inhospitable and costly exploratory environment - an environment that reflects more than a century of draining the more immediately accessible sources of crude oil - did not seem to weigh significantly on distant price prospects. Such long-term price tranquility has faded dramatically over the past four years. Prices for delivery in 2010 of light, low-sulphur crude rose to more than $35 per barrel when spot prices touched near $49 per barrel in late August. Rising geopolitical concerns about insecure reserves and the lack of investment to exploit them appear to be the key sources of upward pressure on distant future prices. However, the most recent runup in spot prices to nearly $55 per barrel, attributed largely to the destructive effects of Hurricane Ivan, left the price for delivery in 2010 barely above its August high. This suggests that part of the recent rise in spot prices is expected to wash out over the longer run. Should future balances between supply and demand remain precarious, incentives for oil consumers in developed countries to decrease the oil intensity of their economies will doubtless continue. Presumably, similar developments will emerge in the large oil-consuming developing economies. Elevated long-term oil futures prices, if sustained at current levels or higher, would no doubt alter the extent of, and manner in which, the world consumes oil. Much of the capital infrastructure of the United States and elsewhere was built in anticipation of lower real oil prices than currently prevail or are anticipated for the future. Unless oil prices fall back, some of the more oil-intensive parts of our capital stock would lose part of their competitive edge and presumably be displaced, as was the case following the price increases of the late 1970s. Those prices reduced the subsequent oil intensity of the U.S. economy by almost half. Much of the oil displacement occurred by 1985, within a few years of the peak in the real price of oil. Progress in reducing oil intensity has continued since then, but at a lessened pace. *** The extraordinary uncertainties about oil prices of late are reminiscent of the early years of oil development. Over the past few decades, crude oil prices have been determined largely by international market participants, especially OPEC. But that was not always the case. In the early twentieth century, pricing power was firmly in the hands of Americans, predominately John D. Rockefeller and Standard Oil. Reportedly appalled by the volatility of crude oil prices in the early years of the petroleum industry, Rockefeller endeavored with some success to control those prices. After the breakup of Standard Oil in 1911, pricing power remained with the United States - first with the U.S. oil companies and later with the Texas Railroad Commission, which raised allowable output to suppress price spikes and cut output to prevent sharp price declines. Indeed, as late as 1952, U.S. crude oil production (44 percent of which was in Texas) still accounted for more than half of the world total. However, that historical role came to an end in 1971, when excess crude oil capacity in the United States was finally absorbed by rising demand. At that point, the marginal pricing of oil, which for so long had been resident on the Gulf coast of Texas, moved to the Persian Gulf. To capitalize on their newly acquired pricing power, many producing nations in the Middle East nationalized their oil companies. But the full magnitude of their pricing power became evident only in the aftermath of the oil embargo of 1973. During that period, posted crude oil prices at Ras Tanura, Saudi Arabia, rose to more than $11 per barrel, significantly above the $1.80 per barrel that had been unchanged from 1961 to 1970. A further surge in oil prices accompanied the Iranian Revolution in 1979. The higher prices of the 1970s brought to an abrupt end the extraordinary period of growth in U.S. oil consumption and the increased intensity of its use that was so evident in the decades immediately following World War II. Between 1945 and 1973, consumption of petroleum products rose at a startling 4-1/2 percent average annual rate, well in excess of growth of real gross domestic product. However, between 1973 and 2003, oil consumption grew, on average, only 1/2 percent per year, far short of the rise in real GDP. Although OPEC production quotas have been a significant factor in price determination for a third of a century, the story since 1973 has been as much about the power of markets as it has been about power over markets. The signals provided by market prices have eventually resolved even the most seemingly insurmountable difficulties of inadequate domestic supply in the United States. The gap projected between supply and demand in the immediate post-1973 period was feared by many to be so large that rationing would be the only practical solution. But the resolution did not occur quite that way. To be sure, mandated fuel-efficiency standards for cars and light trucks induced slower growth of gasoline demand. Some observers argue, however, that, even without government-enforced standards, market forces would have produced increased fuel efficiency. Indeed, the number of small, fuel-efficient Japanese cars that were imported into the United States markets rose throughout the 1970s as the price of oil moved higher. Moreover, at that time, prices were expected to go still higher. Our Department of Energy, for example, had baseline projections showing prices reaching $60 per barrel - the equivalent of about twice that in today’s prices. The failure of oil prices to rise as projected in the late 1970s is a testament to the power of markets and the technologies they foster. Today, despite its recent surge, the average price of crude oil in real terms is still only three-fifths of the price peak of February 1981. Moreover, the impact of the current surge in oil prices, though noticeable, is likely to prove less consequential to economic growth and inflation than in the 1970s. So far this year, the rise in the value of imported oil - essentially a tax on U.S. residents - has amounted to about 3/4 percent of GDP. The effects were far larger in the crises of the 1970s. But, obviously, the risk of more serious negative consequences would intensify if oil prices were to move materially higher. *** In summary, much of world oil supplies reside in potentially volatile areas of the world. Improving technology is reducing the energy intensity of industrial countries, and presumably recent oil price increases will accelerate the pace of displacement of energy-intensive production facilities. If history is any guide, oil will eventually be overtaken by less-costly alternatives well before conventional oil reserves run out. Indeed, oil displaced coal despite still vast untapped reserves of coal, and coal displaced wood without denuding our forest lands. Innovation is already altering the power source of motor vehicles, and much research is directed at reducing gasoline requirements. At present, gasoline consumption in the United States alone accounts for 11 percent of world oil production. Moreover, new technologies to preserve existing conventional oil reserves and to stabilize oil prices will emerge in the years ahead. We will begin the transition to the next major sources of energy perhaps before midcentury as production from conventional oil reservoirs, according to central tendency scenarios of the Energy Information Administration, is projected to peak. In fact, the development and application of new sources of energy, especially nonconventional oil, is already in train. Nonetheless, it will take time. We, and the rest of the world, doubtless will have to live with the uncertainties of the oil markets for some time to come.
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Distinguished Lecture Series, Darton College, Albany, Georgia, 21 October 2004.
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Ben S Bernanke: Oil and the economy Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Distinguished Lecture Series, Darton College, Albany, Georgia, 21 October 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * If you have regular occasion to fill your car’s tank with gas, you know that the price of gasoline has recently been both high and volatile - a consequence, for the most part, of similar movements in the price of crude oil.1 The weekly average price for a barrel of West Texas intermediate, a standard grade of crude oil, hovered around $30 during the second half of 2003 but began to rise around the turn of the year. The price per barrel reached $37 in March and nearly $41 in May. Oil prices have continued to rise erratically since the spring, even as other commodity prices have generally stabilized and overall inflation has been low. As of last week, the price of a barrel of West Texas intermediate stood at about $55.2 Some perspective is in order. Oil prices are at record levels when measured in nominal terms, but when adjusted for inflation the price of oil still remains well below its historical peak, reached in 1981. Measured in today’s dollars, crude oil prices in 1981 were about $80 per barrel, and the price of gasoline at the pump was nearly $3 per gallon. Moreover, energy costs at that time were a larger share both of consumers’ budgets and of the cost of producing goods and services than they are today. Clearly, the surges in oil prices of the 1970s and early 1980s had much more pronounced economic effects than the more recent increases have had or are likely to have, barring a substantial further rise. All that being said, prices of oil and oil products in the United States today are quite high relative to recent experience. During most of the 1990s, oil prices were roughly $20 per barrel, and for a short period in 1998 (remembered without fondness by oil explorers and producers) the price of a barrel of crude fell to just above $10. As I mentioned, only a year ago the price of oil was about $30 per barrel. The recent rise in oil prices has thus been large enough to constitute a significant shock to the economic system. The runup in oil prices raises a number of important questions for economists and policymakers. Why have oil prices risen by so much and why do they continue to fluctuate so erratically? What is the outlook for oil supplies and oil prices in the medium term and in the long term? What implications does the behavior of oil prices have for the ongoing economic expansion? And how should monetary policy respond to these developments? I will touch briefly on each of these questions today. Before doing so, I should note that the opinions I express today are my own and are not to be attributed to my colleagues in the Federal Reserve System.3 Recent and prospective developments in oil markets To assess recent developments in the oil market, it would be useful to know whether the high price of oil we observe today is a temporary spike or is instead the beginning of an era of higher prices. Although no one can know for sure how oil prices will evolve, financial markets are one useful place to learn about informed opinion. Contracts for future deliveries of oil, as for many other commodities, are traded continuously on an active market by people who have every incentive to monitor the energy Although gasoline prices generally rise and fall with the price of crude oil, in the short run the linkage can be relatively loose. One reason that oil and gasoline prices do not march in lockstep is that the margins that refiners and distributors of gasoline can command may vary significantly over time, depending on such factors as the availability of refinery capacity, seasonal variations in the demand for gasoline, and regional imbalances in gasoline supply. The price of West Texas intermediate (WTI) is often cited in the media, which is why I have used it as an example here. For consistency, in the remainder of the talk, when I refer to oil prices I mean the price of WTI. However, as a particularly desirable grade of “light, sweet” oil, WTI commands a premium price. The average price of crude oil imported into the United States is currently about $40 per barrel, about $15 less than the price of WTI. I thank William Helkie and Charles Struckmeyer, of the Board’s staff, for their excellent assistance. situation quite closely.4 Derivative financial instruments, such as options to buy or sell oil at some future date, are also actively traded. The prices observed in these markets can be used to obtain useful information about what traders expect for the future course of oil prices, as well as the degree of uncertainty they feel in predicting the future. One inference we can draw from recent developments in the oil market, in particular from the pricing of derivative instruments, is that traders in that market are unusually uncertain about how the price of oil will evolve over the next year or so. For example, as of last week, traders assigned about a two-thirds probability that the price of crude oil as of next June would be between $38 and $60 per barrel. Or, to say the same thing another way, traders perceived a one-third chance that the price of oil would fall outside the wide $38-$60 range. That well-informed traders would be so uncertain about what the price of oil will be only eight months in the future is striking, to say the least. Uncertainty can in itself be a negative factor for the economy; for example, I would not rule out the possibility that uncertainty about future energy costs has made companies a bit more cautious about making new capital investments. However, probably more economically significant than near-term uncertainty about oil prices is the fact that traders appear to expect tight conditions in the oil market to continue for some years, with at best only a modest decline in prices. This belief on the part of traders can be seen in the prices of oil futures contracts. Throughout most of the 1990s, market prices of oil for delivery at dates up to six years in the future fluctuated around $20 per barrel, suggesting that traders expected oil prices to remain at about that level well into the future. Today, futures markets place the expected price of a barrel of oil in the long run closer to $39, a near doubling.5 Thus, although traders expect the price of oil to decline somewhat from recent highs, they also believe that a significant part of the recent increase in prices will be long lived. What accounts for the behavior of the current and expected future price of oil? The writer George Bernard Shaw once said that, to obtain an economist, it was only necessary to teach a parrot to repeat endlessly the phrase “supply and demand.” Well, as an economist, I have to agree with the parrot. For the most part, high oil prices reflect high and growing demand for oil and limited (and uncertain) supplies. On the demand side, the International Energy Agency (IEA), perhaps the most reliable source of data on world oil production and consumption, has continued to revise upward its projections of global oil usage. To illustrate, world oil consumption for the second quarter of this year, the latest quarter for which we have complete data, is now estimated to have been about 3.7 million barrels per day higher than the IEA projected in July 2003.6 (For reference, total global oil consumption this year has averaged about 81 million barrels per day). A significant part of this unexpected increase in oil consumption, about 2.2 million barrels per day, reflected quickly growing oil demands in East Asia, notably China. However, an ongoing economic expansion across both the industrialized and the emerging-market economies has also contributed to the world’s growing appetite for oil. On the supply side, the production of oil has been constrained by the available capacity and by geopolitical developments. With oil consumption and prices rising briskly, Saudi Arabia and other members of the Organization of Petroleum Exporting Countries (OPEC) have promised to pump more oil. However, the relatively limited increases in production delivered so far by OPEC members, together with non-OPEC production that has fallen a bit below projections, have raised concerns that the spare production capacity available in the near term may be severely limited, perhaps below 1 million barrels per day. Interacting with the limits on capacity, and contributing to the exceptional volatility in oil prices of recent months, are uncertainties about the reliability and security of oil supplies. Of course, the oil-rich Middle East remains especially volatile. But political risks to the oil supply have emerged in nations outside Oil futures and other oil-related derivatives are traded on the New York Mercantile Exchange (NYMEX) and the International Petroleum Exchange (IPE) as well as over the counter. I should acknowledge that oil futures prices have a less-than-stellar record in forecasting oil price developments, but they are probably the best guide that we have. Chinn, LeBlanc, and Coibion (2001) find that futures quotes are unbiased predictors of future spot prices, though not very accurate ones. Saudi Arabia and other OPEC members, like the IEA and most participants in the oil markets, did not anticipate the surge in consumption we have seen this year either. OPEC actually reduced its production targets in 2003 and again in early 2004 out of concern that weak oil demand would cause price declines. the Middle East as well, including Russia, Venezuela, and Nigeria. Weather also has taken a toll, as recent hurricanes affected the production and distribution of oil on the U.S. Gulf Coast. Because neither the demand for nor the supply of oil responds very much to price changes in the short run, the recent unexpected rise in oil consumption together with disruptions to supply can plausibly account for much of the increase in prices. However, the sharp increases and extreme volatility of oil prices have led observers to suggest that some part of the rise in prices reflects a speculative component arising from the activities of traders in the oil markets. How might speculation raise the price of oil? Simplifying greatly, speculative traders who expect oil to be in increasingly short supply and oil prices to rise in the future can back their hunches with their money by purchasing oil futures contracts on the commodity exchange. Oil futures contracts represent claims to oil to be delivered at a specified price and at a specified date and location in the future. If the price of oil rises as the traders expect - more precisely, if the future oil price rises above the price specified in the contract - they will be able to re-sell their claims to oil at a profit. If many speculators share the view that oil shortages will worsen and prices will rise, then their demand for oil futures will be high and, consequently, the price of oil for future delivery will rise. Higher oil futures prices in turn affect the incentives faced by oil producers. Seeing the high price of oil for future delivery, oil producers will hold oil back from today’s market, adding it to inventory for anticipated future sale. This reduction in the amount of oil available for current use will in turn cause today’s price of oil to rise, an increase that can be interpreted as the speculative premium in the oil price. Many people take a dim view of speculation in general, and in some instances this view is justified.7 In many situations, however, informed speculation is good for society. In the case of oil, speculative activity tends to ensure that a portion of the oil that is currently produced is put aside to guard against the possibility of disruptions or shortages in the future. True, speculation may raise the current price of oil, but that increase is useful in stimulating current production and reducing current demand, thereby freeing up more oil to be held in reserve against emergencies. Speculative traders have no altruistic motives, of course; their objective is only to buy low and sell high. But speculators’ profits depend on their ability to induce a shift in oil use from periods when prices are relatively low (that is, when oil is relatively plentiful) to periods when prices are relatively high (when oil is scarce). Social welfare is likely increased by informed speculation in oil markets because speculative activities make oil relatively more available at the times when it is most needed.8 This discussion suggests three indicators to help us detect the influence of speculative activity on current oil prices. First, if speculative activity is an important source of the rise in oil prices, we would expect today’s oil price to react strongly to news bearing on future conditions of oil supply and demand. Second, we should see speculative traders holding claims to large amounts of oil for future delivery, in the hope of enjoying a profit by re-selling the oil should prices rise. Finally, corresponding to the speculative positions held by traders, we would expect to see significant increases in the physical inventories of oil being held for future use. The first indicator, rapid swings of oil prices in response to news about the prospective supplies and usage of oil, does appear to be present and to suggest a speculative element in pricing. It is thus somewhat puzzling that the other two indicators of speculative activity do not appear to be present: Our best-available measure of speculative traders’ holdings of contracts for future delivery of crude oil and petroleum products has decreased from earlier in the year and is not unusually high by historical standards.9 And official data imply that physical inventories of crude oil and petroleum products, at least within the industrial countries for which we have good data, have not risen to any significant For example, we know of historical examples of speculators “cornering” a market, leading to wild price fluctuations unjustified by fundamentals. In addition to helping ensure that oil is used at the socially most valuable time, speculation also reduces risks for producers and consumers of oil. For example, an oil producer who sells oil for future delivery receives a guaranteed price today and does not have to bear the risk that the price will drop sharply before the oil delivery date. The measure used here is net long futures positions of noncommercial traders (that is, traders who do not have a direct hedging need). These data, available from the Commodity Futures Trading Commission, do not perfectly measure speculative activity, as they do not cover all trading in oil futures, nor do they necessarily cleanly distinguish speculators from other traders. degree and at times have even been below seasonal norms.10 Perhaps the official data overlook important accumulations of crude oil stocks - in China and other emerging-market economies, for example - but that remains (if you will excuse the expression) speculation. My tentative conclusion is that speculative activity may help to account for part of the recent volatility in oil prices. However, the available evidence does not provide clear support for the view that speculative activity has made oil prices during the past year much higher on average than they otherwise would have been.11 A rather different explanation of the recent increase in oil prices holds that the rise is in large part a symptom of inflationary monetary policies. An extensive literature exists on this topic. The general idea is that, if most prices adjust slowly, the effects of an excessively easy monetary policy will show up first as a sharp increase in those prices that are able to adjust most quickly, such as the prices of commodities (including oil). If this idea were valid, then commodity price movements could be used as a guide for setting monetary policy. However, the consensus that emerges from this literature is that the relationship between commodity price movements and monetary policy is tenuous and unreliable at best. Moreover, applied to the recent experience, economic models that support the use of oil prices as a leading indicator of monetary policy make a number of other predictions that are strongly contradicted by the facts. These predictions include (1) that all commodity prices should move proportionally in response to changes in monetary policy (in fact, oil prices have risen sharply since the spring as other commodity prices have generally stabilized); (2) that the dollar should have rapidly depreciated as the oil price rose (in fact, the dollar has been broadly stable during 2004); (3) that inflation expectations should have increased substantially (but long-term nominal interest rates, the level of inflation compensation implicit in inflation-indexed bond yields, and survey measures of inflation expectations concur in showing no such rise); and (4) that general inflation, though lagging commodity-price inflation, should also rise over time (but inflation excluding energy prices remains quite low). Models of commodity-price “overshooting” also imply that the current surge in oil prices will be almost entirely temporary, a prediction strongly at variance with market expectations as revealed in the futures markets. I conclude that an increasingly tight supply-demand balance, rather than speculation or easy monetary policies, probably accounts for most of the recent run-up in oil prices. I have focused on near-term developments in the oil markets. What about the longer term? In that regard, we can safely assume that world economic growth, together with the rapid pace of industrialization in China, India, and other emerging-market economies, will generate increasing demands for oil and other forms of energy. If we are lucky, growth in the demand for energy will be moderated by continued improvements in energy efficiency that will be stimulated by higher prices and concerns about the security of oil supplies. Such improvements are certainly possible, even without new technological breakthroughs. For example, Japan is an advanced industrial nation that uses only about one-third as much energy to produce each dollar of real output as the United States does.12 Industrializing nations such as China appear to be quite inefficient in their energy use; for example, the underdeveloped electricity grid in China has induced heavy use of inefficient diesel-powered generators. As these countries modernize, their energy efficiency will presumably improve. Still, if the global economic expansion continues, substantial growth in the use of oil and other energy sources appears to be inevitable. Oil market data for the United States, including inventories data, are released weekly by the Energy Information Administration, part of the U.S. Department of Energy. Each month, the International Energy Agency releases analogous information covering the thirty member countries of the Organization for Economic Development and Cooperation (OECD). Weiner (2002) surveys the academic literature and concludes that, over the long term, speculative activity has not much affected the average price of oil. The apparently strong effect on oil prices of recent hurricanes in the Gulf of Mexico, which led to short-term reductions in production, is a bit of evidence that high prices reflect a tight supply-demand balance rather than speculative hoarding. If inventories or spare production capacity had been available, the shortfalls created by hurricanes could have been replaced, and the price effect would have been more muted. A somewhat different question is whether future prices for oil contain a significant risk premium. The finding of Chinn, LeBlanc, and Coibion (2001) that futures prices are unbiased predictors of future spot prices argues against a large risk premium. Estimates by the Board’s staff, based on the methods of Pindyck (2001), indicate that the risk premium in oil futures was no more than $2 or so even during the recent spikes in prices. Japan may set an unreasonably high standard: That country’s small area reduces the use of energy for transportation, and the low average size of homes on these densely populated islands reduces heating and cooling costs. Japan also produces a different mix of goods and services than the United States, a mix that may be less energy-intensive. On the other hand, not even Japan has made full use of the energy conservation potential of existing technologies, such as hybrid autos for example. The supply side of the oil market is even more difficult to predict. In a physical sense, the world is not in imminent danger of running out of oil. At the end of 2003, the world’s proved reserves of oil - that is, oil in the ground that is viewed as recoverable using existing technologies and under current economic conditions - reached more than 1.15 trillion barrels, 12 percent more than the world’s proved reserves a decade earlier and equal to about forty years of global consumption at current rates (BP Statistical Review of World Energy, 2004, p. 4). Of course, global oil consumption will not remain at current rates; it will grow. But, on the other hand, today’s proved reserve figures ignore not only the potential for new discoveries but also the likelihood that improved technology and higher oil prices will increase the amount of oil that can be economically recovered. The oil is there, but whether substantial new production sources can be made available over the next five years or so is in some doubt. Some important fields are in locations that are technically difficult and time-consuming to develop, such as deep-water fields off West Africa, in the Gulf of Mexico, or off the east coast of South America. In many cases, the development of new fields also faces the challenge of recovering the oil without damaging delicate ecosystems, if indeed the political process allows exploitation of ecologically sensitive fields at all. I have already noted the uncertainties generated by geopolitical instability; perhaps it is sufficient here to note that, despite the opening of fields in a number of new regions in the past decade, about 63 percent of known oil reserves today are in the Middle East. Oil producers are also aware from painful experience that oil prices can fall as quickly as they rise; hence, exploration projects launched when prices are high may come to fruition when prices are much lower. These risks help to explain why major oil companies have not rushed to increase exploration activities during this recent period of high prices. Thus, the supply-demand fundamentals seem consistent with the view now taken by oil-market participants that the days of persistently cheap oil are over. The good news is that, in the longer run, we have options. I have already noted the scope for improvements in energy efficiency and increased conservation. Considerable potential exists as well for substituting other energy sources for oil, including natural gas, coal, nuclear energy, and renewable sources such as wind and hydroelectric power. For example, the world has vast supplies of natural gas that, pending additional infrastructure development, might be transported in liquefied form to the United States, Europe, Asia, and elsewhere at BTU-equivalent prices below those expected for crude oil. Given enough time, market mechanisms (most obviously, higher prices) are likely to increase energy supplies, including alternative energy sources, while simultaneously encouraging conservation and substitution away from oil to other types of energy. These adjustments will not occur rapidly, however. Hence the next few years may be stressful ones for energy consumers, as stretched and uncertain supplies of oil and other conventional energy sources face the growing demands of a rapidly expanding world economy. Economic and policy implications of increased oil prices What are the economic implications of the recent increase in oil prices? In the long run, higher oil prices are likely to reduce somewhat the productive capacity of the U.S. economy. That outcome would occur, for example, if high energy costs make businesses less willing to invest in new capital or causes some existing capital to become economically obsolescent. Lower productivity in turn implies that wages and profits will be lower than they otherwise would have been. Also, the higher cost of imported oil is likely to adversely affect our terms of trade; that is, Americans will have to sell more goods and services abroad to pay for a given quantity of oil and other imports. The increase in the prices of our imports relative to the prices of our exports will impose a further burden on U.S. households and firms. Under the assumption that oil prices do not spike sharply higher from their already high levels, these long-run effects, though negative, should be manageable. As I have already discussed, conservation and the development of alternative energy sources will, over the long term, take some of the sting out of higher oil prices. Moreover, productivity gains from diverse sources, including technological improvements and a more highly educated workforce, are likely to exceed by a significant margin the productivity losses created by high oil prices. In the short run, sharply higher oil prices create a rather different and, in some ways, a more difficult set of economic challenges. Indeed, a significant increase in oil prices can simultaneously slow economic growth while stoking inflation, posing hard choices for monetary policy makers. An increase in oil prices slows economic growth in the short run primarily through its effects on spending, or aggregate demand. Because the United States imports most of its oil, an increase in oil prices is, as many economists have noted, broadly analogous to the imposition of a tax on U.S. residents, with the revenue from the tax going to oil producers abroad. Since the beginning of the year, the cost of oil imported into the United States has increased by about $75 billion (at an annual rate), or about 3/4 percent of the gross domestic product (GDP). Add to this the effects of the rise in natural gas prices, and the total increase in imported energy costs over a full year - the increase in the “tax” being paid to foreign energy producers - comes to almost $85 billion. The impact of this decline in net income on the U.S. GDP depends in large part on how the increase in the energy “tax” affects the spending of households and firms. For a number of reasons, an increase of $85 billion in payments to foreign energy producers is likely to reduce domestic spending by something less than that amount. For example, in the short run, people may be reluctant to cut non-energy spending below accustomed levels, leading them to reduce saving rather than spending. Because high energy costs lower firms’ profits, they normally reduce the willingness of firms to purchase new capital goods; however, if the increase in energy prices looks to be permanent, firms might decide that it makes sense for them to invest in more energy-efficient buildings and machines, moderating the decline in their capital spending. If higher energy prices reflect in part more rapid economic growth abroad - which seems to be the case in the recent episode - or if foreign energy producers spend part of their increased income on U.S. goods and services, then the demand for U.S. exports may be stronger than it would have been otherwise. With these and many other qualifications taken into account, a reasonable estimate is that the increased cost of imported energy has reduced the growth in U.S. aggregate spending and real output this year by something between half and three-quarters of a percentage point. At the same time that higher oil prices slow economic growth, they also create inflationary pressures. Higher prices for crude are passed through, with only a very short lag, to increased prices for oil products used by consumers, such as gasoline and heating oil. When oil prices rise, people may try to substitute other forms of energy, such as natural gas, leading to price increases in those alternatives as well. The rise in energy costs faced by households represents, of course, an increase in the cost of living, or inflation. This direct effect of higher energy prices on the cost of living is sometimes called the first-round effect on inflation. In addition, higher energy costs may have indirect effects on the inflation rate - if, for example, firms pass on their increased costs of production in the form of higher consumer prices for non-energy goods or services, or if workers respond to the increase in the cost of living by demanding higher wages. These indirect effects of higher energy prices on the overall rate of inflation are called second-round effects. The overall inflation rate reflects both first-round and second-round effects, of course. Economists and policymakers also pay attention to the so-called core inflation rate, which excludes the direct effects of increases in the prices of energy (as well as of food). By stripping out the first-round inflation effects, core inflation provides a useful indicator of the second-round effects of increases in the price of energy.13 In the past, notably during the 1970s and early 1980s, both the first-round and second-round effects of oil-price increases on inflation tended to be large, as firms freely passed rising energy costs on to consumers, and workers reacted to the surging cost of living by ratcheting up their wage demands. This situation made monetary policy making extremely difficult, because oil-price increases threatened to raise the overall inflation rate significantly. The Federal Reserve attempted to contain the inflationary effects of the oil-price shocks by engineering sharp increases in interest rates, actions which had the unfortunate side effect of sharply slowing growth and raising unemployment, as in the recessions that began in 1973 and 1981. Since about 1980, the Federal Reserve and most other central banks have worked hard to bring inflation down, and in recent years, inflation in the United States and other industrial countries has been both low and stable. An important benefit of these efforts is that the second-round inflation effect of a given increase in energy prices has been much reduced (Hooker, 1999). Because households and business owners are now confident that the Fed will keep inflation low, firms have both less incentive and less ability to pass on increased energy costs in the form of higher prices, and likewise workers have less need and less capacity to demand compensating increases in wages. Thus, increases in energy prices, though they temporarily raise overall inflation, tend to have modest and As discussed earlier, higher energy prices may also lower the economy’s productive capacity, by reducing investment and making a portion of the capital stock un-economical to operate. This decline in potential output puts additional upward pressure on the inflation rate. transient effects on core inflation; that is, currently, the second-round effects appear to be relatively small. Although the difficulties posed by increases in oil prices are less than in the past, the economic consequences are nevertheless unpleasant, as higher oil prices still tend to induce both slower growth and higher inflation. How then should monetary policy react? Unfortunately, monetary policy cannot offset the recessionary and inflationary effects of increased oil prices at the same time. If the central bank lowers interest rates in an effort to stimulate growth, it risks adding to inflationary pressure; but if it raises rates enough to choke off the inflationary effect of the increase in oil prices, it may exacerbate the slowdown in economic growth. In conformance with the Fed’s dual mandate to promote both high employment and price stability, Federal Reserve policy makers would ideally respond in some measure to both the recessionary and inflationary effects of increased oil prices. Because these two factors tend to pull policy in opposite directions, however, whether monetary policy eases or tightens following an increase in energy prices ultimately depends on how policymakers balance the risks they perceive to their employment and price-stability objectives. An important qualification must be added, however. The relatively small effects of higher oil prices on the underlying inflation rate that we have seen in recent years are a consequence of the public’s confidence that the Fed will maintain inflation at a low level in the medium term. As I have discussed, the public’s expectation that inflation will remain low minimizes the second-round effects of oil price increases, which (in a virtuous circle) helps to limit the ultimate effect on inflation. Moreover, wellanchored inflation expectations have been shown to enhance the stability of output and employment. Maintaining the public’s confidence in its policies should thus be among the central bank’s highest priorities.14 For this reason, I would argue that the Fed’s response to the inflationary effects of an increase in oil prices should depend to some extent on the economy’s starting point. If inflation has recently been on the low side of the desirable range, and the available evidence suggests that inflation expectations are likewise low and firmly anchored, then less urgency is required in responding to the inflation threat posed by higher oil prices. In this case, monetary policy need not tighten and could conceivably ease in the wake of an oil-price shock. However, if inflation has been near the high end of the acceptable range, and policymakers perceive a significant risk that inflation and inflation expectations may rise further, then stronger action, in the form of a tighter monetary policy, may well prove necessary. In directing its policy toward stabilizing the public’s inflation expectations, the Fed would be making an important investment in future economic stability. I will close by briefly linking this discussion to recent Federal Reserve policy. As a professor and textbook author, I was accustomed to discussing the effects of a particular phenomenon, such as rising oil prices, with all other factors held equal. However, as policymakers know, everything else is never held equal. The increases in oil prices this year did not take place in isolation. Along with the rise in oil prices, increases in the prices of other important commodities, such as steel and lumber, as well as higher import prices resulting from the earlier decline in the dollar, provided supply-side pressure on inflation in early 2004. Meanwhile, an economic expansion that took hold in the middle of 2003 resulted in strong output growth but, as of early this year, limited progress in creating new jobs. As a final complication, the beginning of the year also saw the Fed’s policy interest rate, the federal funds rate, at the historically low level of 1 percent, the result of the efforts of the Federal Open Market Committee (FOMC) to spark faster growth and minimize deflation risks in 2003. In January, with inflation low and the job market still weak, the FOMC indicated that it would be “patient” in removing the policy accommodation implied by the low value of the federal funds rate. The increase in inflation that occurred last spring posed a choice for the FOMC. Should the Committee remain “patient” in the face of this development, or should it move more aggressively to meet an emerging inflation threat? The answer, I would argue, properly depended on both the source of the inflation and the state of inflation expectations. In particular, if the pickup in inflation had largely resulted from an overheating economy and a consequent increase in pricing power and wage demands, a more-aggressive policy would have been appropriate. The FOMC’s analysis of the situation, however, was well described by the statement issued after its June meeting. In that statement, the Committee suggested that the increase in inflation was due at least in part to “transitory factors” - a heading under which I include the increases in oil prices, commodity prices, and import prices - and indicated as well that “underlying inflation” would likely remain low, which I interpret as As my colleague Edward Gramlich put it in his recent remarks on oil price shocks and monetary policy, “The worst possible outcome is for monetary policymakers to let inflation come loose from its moorings” (Gramlich, 2004). saying that, with medium-term inflation expectations well contained, second-round effects appeared likely to be small. The implication of this analysis was that the FOMC could remain “patient.” Thus far at least, the FOMC’s diagnosis appears to have been correct, as both headline and core inflation have receded from the levels of last spring. Looking forward, I am sure that the Committee will continue to watch the oil situation carefully. However, future monetary-policy choices will not be closely linked to the behavior of oil prices per se. Rather, they will depend on what the incoming data, taken as a whole, say about prospects for inflation and the strength of the expansion. Generally, I expect those data to suggest that the removal of policy accommodation can proceed at a “measured” pace. However, as always, the actual course of policy will depend on the evidence, including, of course, what we learn about how oil prices are affecting the economy. As the FOMC evaluates its policy options, retaining public confidence in the Federal Reserve’s commitment to price stability will continue to be essential. If the public were not fully assured of that commitment, the FOMC would find achieving its objectives of price stability and maximum sustainable employment to be difficult if not impossible. For that reason, I fully endorse the sentiment in the last few FOMC statements that “the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the University of Connecticut School of Law, Connecticut Law Review Symposium, Hartford, Connecticut, 21 October 2004.
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Susan Schmidt Bies: Enterprise perspectives in financial institution supervision Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the University of Connecticut School of Law, Connecticut Law Review Symposium, Hartford, Connecticut, 21 October 2004. * * * Thank you for inviting me to speak at your conference honoring Phillip I. Blumberg. I certainly wish to join you in congratulating him on publication of the new edition of The Law of Corporate Groups. Dean Blumberg speaks of the inadequacy of the traditional concept of separate corporate juridical personality when applied to the modern reality of large multinational corporations that have holding companies and subsidiaries around the globe. He makes the case that the promotion of corporate accountability requires an enterprise-wide view of the multinational firm. The concept of an enterprisewide view of business organizations resonates with me as a Federal Reserve Governor who has particular responsibility for banking regulation and supervision. I would posit that moving from an entity or functional view to an enterprise-wide view of the consolidated entity improves the parent organization’s accountability for the activities of its constituent subsidiaries and divisions around the world. Today, I would like to briefly discuss some issues related to the entity, function, and enterprise perspectives of an organization. I will start by considering these issues from the point of view of a regulator and then look at how corporate risk management is improving by moving toward an enterprise perspective. Regulatory perspectives on entity, function, and enterprise supervision As banking organizations have expanded their business lines and grown in scale and geographic reach, many of the traditional forms of business organization have been modified. Financial holding companies may now have multiple tiers of subsidiaries, some of which may have different primary regulators. While the trend has been to merge bank subsidiaries - a result in part of the easing of legal restrictions on interstate banking in the late 1990s - many organizations now have both state and federal supervisors. As large U.S. banks have expanded their international operations, they have also become subject to supervision in their host countries. And as foreign banking organizations, in a continuing expansion of their presence in the United States, have established branches of their home country banking entities and acquired regional and large U.S. banks that are separate legal entities, they, too have become subject to additional supervision. And the emergence of new forms of financial instruments has also affected the corporate structure, in that entities established to transfer and fund assets may or may not be consolidated for accounting purposes, depending on their structure. In short, the structure of large financial firms has become much more complex and varied over time and is increasingly reflecting the business strategy of the organization. Banking supervision at the Federal Reserve has long taken a consolidated view of risk management and internal controls, a focus that the 1999 passage of the Gramm-Leach-Bliley Act (GLBA) reinforced. Under GLBA, the Federal Reserve, as umbrella supervisor of banking organizations, has a special responsibility to determine whether bank holding companies are operated in a safe and sound manner so that their financial condition does not threaten the viability of affiliated depository institutions. Consolidated oversight of bank holding companies, and in particular the subset of bank holding companies that have elected financial holding company status in order to engage in a broader range of activities, is important because the risks associated with those activities can transcend legal entities and business lines. That is, risks in one entity can have an impact on another entity or functional area - and ultimately on the enterprise as a whole. Supervisory oversight at the bank holding company level is particularly critical because public disclosure and market discipline are exerted largely at the consolidated level. Therefore, the regulatory constraints imposed at the bank holding company level can be the most binding on the organization. Financial institution supervision in the United States generally is determined by type of charter - state or federal - and Federal Reserve membership. The dual banking system of state and federal banks has encouraged innovation and is an important contributor to the strength and flexibility of the U.S. financial system. However, supervision by charter can create an uneven playing field for competitors that offer similar services but are subject to different regulatory requirements. Supervision by function can ensure that competitors have a similar regulatory environment. But functional supervision has a weakness common to entity supervision. That is, business processes are often designed without regard to management organization or legal entity. This is becoming more common as technology is used to integrate varied activities and internal control systems are used to aggregate information across business lines. Thus, a supervisor that focuses on one part of the business process may not understand how activities earlier or later in the process flow may affect internal controls and risk exposures. Further, as we have seen in some notable public enforcement actions taken in the last couple of years, supervision of only a portion of the organization can leave gaps in risk coverage. Organizations that are run by business line, including risk management and compliance, can miss inherent conflicts of interest between lines of business. Thus, individuals can be motivated to support their line of business without due regard for the increased risk or potential for compliance failure that their actions create in other parts of the organization. In today’s regulatory environment, the focus is increasingly on supervision of the full enterprise. An example is the Federal Reserve’s umbrella supervision of financial and bank holding companies in the United States. Another is the consolidated supervision of financial institutions operating in the European Union resulting from implementation of the new Basel II capital accord. Enterprise supervision certainly provides a more integrated view of risks and internal controls. But the umbrella supervisor is still challenged if the supervisors of entities or functions have different prudential supervision frameworks. In this case, the umbrella supervisor, to be effective, must assess the gaps and inconsistencies in the supervisory process. An enhanced framework for looking at the consolidated banking organization: the new bank holding company rating system As the activities of banking organizations have increased in complexity over time, the focus of the Federal Reserve’s supervision of bank and financial holding companies has moved from historical analyses of financial condition on a separate legal entity basis toward more forward-looking assessments of the adequacy of risk management and financial factors of the consolidated organization. While the supervision of holding companies has been evolving, the rating system has not changed. To replace the BOPEC bank holding company rating system, which has served the Federal Reserve System well for twenty-five years, a proposal has been issued for comment to move to a new rating system that encompasses ratings for risk management, financial strength, and the impact of nondepository legal entities on affiliated depository institutions; a composite rating; and a depository institution rating. The proposed new rating system was published for comment in July of this year, and the system is expected to become effective in January 2005. The proposed bank holding company rating system is expected to (1) better emphasize risk management and the importance of the control environment; (2) introduce a more comprehensive, more adaptable framework for analyzing and rating financial factors based on the unique structure of each holding company; and (3) for the first time, provide an explicit framework for rating the impact of the nondepository entities of a holding company on its affiliated depository institutions. This new structure will better align the bank holding company rating system with our current supervisory practices. The proposed risk management and financial condition components are each supported by four subcomponents, which provide granularity and structure to their analysis. Specifically, the risk management component of the new system will include subcomponents that consider (1) the competence of the board of directors and senior management; (2) policies, procedures, and limits; (3) risk monitoring and management information systems; and (4) internal controls. These subcomponents will be evaluated in the context of the risks undertaken by, and inherent to, the banking organization and the overall level of complexity of the firm’s operations. The analysis of financial factors will include subcomponents rating consolidated capital adequacy, the quality of the bank holding company’s consolidated on- and off-balance-sheet assets and exposures, the quality and sustainability of earnings, and liquidity on both a consolidated company and a legal-entity basis. The analysis of the impact of nondepository entities on the consolidated entity will incorporate an evaluation of both the risk management practices and financial condition of the non-depository entities. It may consider strategic plans, the impact of losses or control breakdowns, and legal and reputational considerations, as well as financial factors such as capital distributions, intragroup exposures, and consolidated cash flow and leverage. What I hope is evident from my brief description of the new bank holding company rating system is that the framework looks at risk management and financial factors at the legal entity level, at the level of functional activities across corporate entities, and at the consolidated, enterprise-wide level. The COSO framework: enterprise-wide risk management for corporations The focus on oversight and risk management at each of the three levels of an organization - entity, functional unit, and enterprise - is not unique to the banking industry. In the context of business organizations in general, the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, has been engaged in a project to evaluate and improve enterprise risk management, or ERM. This effort culminated in the publication last month of an integrated framework for ERM. This framework may become a standard for enterprise risk management similar to the way the COSO Internal Control Framework has become the benchmark in its area. For those of you not familiar with the new COSO framework, let me briefly explain that ERM is a discipline that an organization can use to identify events that may affect its ability to achieve its strategic goals and manage its activities consistent with its risk appetite. Such events include not only those that may result in adverse outcomes, but also those that give rise to opportunities. When implemented effectively by an organization, an ERM framework improves the quality and flow of information for decisionmakers and stakeholders, focuses attention on the achievement of organizational goals, and improves the overall governance of the organization. ERM achieves these laudable objectives by looking within and across the business lines, functions, and activities of the organization as a whole to consider how one area of the organization may affect the risks facing the other business lines and functions - or the enterprise as a whole. The ERM approach contrasts markedly with the silo approach to risk management, which considers the risks of activities or business lines in isolation - a view similar to the traditional entity-based legal view of the corporation. It is important to note that ERM does not replace, but rather builds on, the risk management and internal control practices at the entity and functional levels. Indeed, it is essential to retain risk management and internal control activities at the level of the individual business line or function because that is where the individuals who best understand the activities being conducted and where the key risks of those activities reside. The enterprise-wide approach supplements the business lineor function-specific view with a “big-picture,” corporate-level view that encompasses all the firm’s operations and views risk throughout the consolidated organization. It is also important to emphasize the dynamic nature of ERM. ERM is truly effective only to the extent that it assesses changing risks when new business lines or activities or changes to existing activities are proposed. That is, ERM should function as a proactive, rather than reactive, mechanism to ensure that appropriate controls are in place before the product or activity begins and that the board of directors and senior management understand the nature of the new products or activities and their impact on the organization’s risk profile. This can be accomplished, in part, through the new product approval process, which should include participation across the organization from credit risk, market risk, operations, accounting, legal, compliance, audit, and senior line management. An integral part of a dynamic ERM structure is an enterprise-wide internal controls and compliance program, which considers not only the more readily quantifiable risks, such as credit and market risks, but also the less quantifiable legal and reputational risks with which this audience, by its training, is well acquainted. The enterprise-wide view is particularly important when products and activities cross business lines and management lines of responsibility. When business lines or managers share responsibility for internal controls and compliance, specific duties and chains of accountability need to be established at the entity or functional level and overseen by the chief risk officer. ERM as a common language ERM provides an enterprise-wide view of risk and facilitates enterprise-wide compliance by creating a common risk management language that allows the firm’s constituent business lines to better communicate about risk across functions. When ERM is implemented effectively, individuals working in the business line have a clear understanding of their roles in the overall risk-assessment and risk- management framework. Managers can look at the risks inherent in the businesses and processes they manage and establish risk measurement and management practices that reflect the risk appetite and strategic direction of the enterprise, as established by the board of directors. Communication of these practices to line managers and employees allows employees to gain a good sense of acceptable risks and have a process for communicating apparently unacceptable risk-taking to appropriate levels of management and to the compliance function. ERM also promotes a consolidated vision of corporate goals, objectives, and strategies. Lines of business and functional areas have standards that are set at the enterprise level, standards against which the success of individual operations can be measured. Line managers and employees can articulate how they address specific objectives and goals in their business areas. The consolidated vision allows for greater synergies and the promotion of the goals, objectives, and strategies of the organization as a whole rather than the competition of parochial interests. Finally, in the roll up from the individual business lines and functional areas, ERM produces entity-wide information that influences new or changed policies, business decisions, risk-response plans, and adjustments to incentives and internal capital allocations through a communication “feedback loop.” ERM as a mechanism for better disclosure In addition to facilitating corporate communication and a common enterprise-wide vision, ERM can enhance external communications between an organization and its stakeholders. I would challenge business organizations to use the enhanced information that is produced by a successful ERM feedback loop as a vehicle for improving public disclosure of their risk management activities, including their use of financial tools for managing risk. Before discussing how ERM can facilitate better risk management disclosure, it may be helpful to review some common risk management tools. Many businesses, including but certainly not limited to financial institutions, have increasingly used derivatives to manage their risk exposure to price fluctuations in currency, commodity, energy, and interest rate markets. Credit derivatives have also allowed financial firms to achieve a more diversified credit portfolio by acquiring exposure to borrowers with whom they do not have a lending relationship. Securitization has helped firms manage the risk of a concentrated exposure by transferring some of that exposure outside of the firm, thereby diversifying the firm’s balance sheet. In the legal arena, with which you are familiar, substantial progress has been made in standardizing legal agreements used in managing financial risk. This has helped to resolve issues related to the impact of bankruptcy or insolvency on transactions and netting contracts, reducing the potential for contractual disputes between market participants. These efforts are continuing through various industry groups, and the legal profession is making important contributions to improving the legal certainty of these instruments. Derivatives and other risk-transferring instruments have a salutary effect on the financial markets by facilitating more-liquid and more-efficient transfers of risk, creating the potential for greater economic efficiency through diversification benefits. Innovation in financial risk management inevitably will continue. Improvements in technology, the quick pace of financial innovation, and evolving risk management techniques almost ensure that businesses will increasingly use nearly limitless configurations of products and services and sophisticated financial structures. While I have pointed out the positive aspects of these developments, there is concern that investors and other stakeholders will find it increasingly difficult to understand the risk positions of large, complex organizations that use these mechanisms to alter risk exposures. The point-in-time measurement of a company’s balance sheet is insufficient to convey the full effects of credit-risktransfer instruments, such as credit derivatives and securitizations, on the firm’s risk profile. For example, moving assets off the balance sheet and into special-purpose entities in a securitization, with the attendant creation of servicing rights and high-risk residual interests retained by firms, generates its own risks and reduces transparency unless the firm takes additional steps to enhance disclosure. To address these concerns, firm managers need to do their part to ensure that public reporting and disclosures clearly identify all significant risk exposures - both on- and off-balance-sheet exposures and their effects on the company’s performance and future prospects, keeping in mind, of course, the need to safeguard proprietary information. An ERM framework can produce information that supplements point-in-time accounting disclosures with a more robust description of the firm’s risks and the compensating returns in various lines of business as well as a description of how the risk/reward tradeoffs of these business lines affect the volatility of earnings for the firm as a whole. Improved disclosure not only can provide more quantitative and qualitative information to the market and other stakeholders, but also help the market assess the quality of the risk oversight and make an informed judgment about the appropriateness of the organization’s risk appetite and its strategic direction. I would ask firms to answer the following questions about their public disclosures: Do investors have the information they need to accurately evaluate the financial position of the firm and the risks it takes? In addition to quantitative information, does the disclosure provide qualitative input as to the purpose of the transactions and how they reflect the risk appetite and strategic direction of the firm? Is the information provided in a manner that facilitates accurate assessments by investors? Disclosure is not a one-size-fits-all proposition. Instead, disclosure should be tailored to the activities and risks of the company and should tell the firm’s “story.” Better disclosure also reduces the legal and reputational risks that accompany market “surprises,” as we have seen from recent experience. Working with risk managers and accountants, the legal profession is well positioned to help large corporations strike the correct tone and balance in their disclosures to the marketplace. Conclusion The movement from an entity- or function-based approach to an enterprise-wide paradigm appears inevitable given the increasing complexity of corporations and the interrelatedness of business lines and their risks. Legal analysis, supervisory oversight, and firms’ internal risk management and control systems likewise need to adopt an enterprise-wide focus. Enterprise-wide risk management provides a framework for achieving and maintaining this focus by establishing a common risk management language within the organization and by facilitating a framework for improved disclosure.
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Speech by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the European Central Bank Conference on Monetary Policy and Imperfect Knowledge, Würzburg, Germany, 15 October 2004.
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Donald L Kohn: How should policymakers deal with low-probability, highimpact events? Speech by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the European Central Bank Conference on Monetary Policy and Imperfect Knowledge, Würzburg, Germany, 15 October 2004. * * * Considering how to deal with low-probability, high-impact events has always been an important aspect of central banking. Central banks and other government agencies use various policies, including supervisory vigilance and access to discount window credit, to make such situations less likely to occur and less costly when they do. Even so, from time to time monetary policy settings have been influenced by the perception of a potential for serious economic and financial dislocation. Before going further, I should say the views I will express today are my own and not necessarily those of other members of the Board of Governors or its staff.1 Adjusting monetary policy in such circumstances is an example of a more general phenomenon. When central banks are not tightly focused on achieving a specific objective for an exchange rate, a monetary aggregate, or an inflation rate, policymakers may be granted a degree of discretion and can take account of the entire distribution of potential economic outcomes and their effects on societal welfare. I used the words “may be granted” in that sentence quite deliberately. Discretion has gotten a bad reputation in the economics profession, in part because of a too-literal interpretation of the contributions of the two newest Nobel laureates. The effective use of discretion - the ability to deviate from the programmatic pursuit of a fixed goal - is only granted to central bankers when the public is confident that the opportunity will not be misused. As I reflect on my observation of central banking over the years, my impression is that policymakers these days are taking account of a broader array of potential outcomes than in the past. Policy seems more frequently to be deviating a bit from a stance that is calculated only to maximize the odds of achieving a specific, numerical, economic goal. More countries have recognized the benefits of allowing exchange rates to fluctuate freely, and the inflation-targeting regimes that have replaced exchange rate anchors in many countries have become more flexible over time. This evolution has not only allowed policymakers greater scope to weigh more than one short-run objective in the pursuit of long-term price stability, but it has also permitted them to pay greater attention to the consequences of potential economic outcomes with relatively low probabilities. Such possible outcomes tend naturally to get some weight when policymakers perceive that events are not necessarily a product of linear relationships among variables and that welfare is not always defined by the linear quadratic utility function that theorists find convenient to use. In Chairman Greenspan’s risk-management paradigm, low-probability, high-impact events are always factors in the calculus of monetary policy.2 This approach recognizes that “impact” is the product of two separate distributions - one for expected economic outcomes and one for the effect of those outcomes on welfare - that may be nonlinear. The two are closely related but not identical, and their relationship may well depend on the situation. In large part, central banks have been able to shift their attention more toward events in the tails of the probability distributions of possible outcomes because the centers of the distributions of key macroeconomic variables have been so much better behaved than they were a few decades ago. Inflation has been low and stable in most economies, expectations that inflation will remain contained are much better anchored, and output fluctuations have been damped. This favorable economic climate has reduced the risk that temporarily aiming somewhat away from hitting objectives dead on will engender behaviors, like rising inflation expectations, that could have seriously adverse and destabilizing consequences for the economy. In effect, the cost of “buying insurance” against events in the tail has been greatly reduced. Vincent Reinhart provided valuable ideas and comments. Alan Greenspan (2004), “Risk and Uncertainty in Monetary Policy,” The American Economic Review, vol. 94 (May), pp. 33-40. Buying insurance may also have appeared more attractive in recent years because the impact of tail events, especially those associated with financial markets, may have increased, even if their probability remains low. As wealth rises relative to income and more of the populace owns significant quantities of assets, wealth becomes an increasingly important factor in shaping spending decisions. In addition, the secular decline in the cost of financial transactions has facilitated balance sheet adjustments by businesses and households, potentially heightening their responses to financial market developments. Although a whole range of possible events with varying probabilities and effects can be taken into account by monetary policymakers, the influence of possible low-probability events is most evident when serious instability is a much greater threat than usual. It is in these circumstances that the distribution of possible outcomes is skewed noticeably, and the effect of a given outcome itself may also be especially large. Guarding against such a low-probability, high-impact event can in turn significantly skew policy temporarily away from the rate setting most likely to achieve longer-run objectives for inflation or output.3 I will illustrate the rationale for making such choices and their possible implications by relating some of the episodes in which the Federal Reserve has given unusual weight to possible tail events - in reaction to the financial market events of 1987 and 1998 and in response to the threat of deflation in 2001 through 2003. The Federal Reserve reacted strongly to both the stock market crash of 1987 and the “seizing up” of financial markets in the fall of 1998 after the Russian debt default and failure of Long Term Capital Management. In each of these situations, we were dealing with the aftermath of one low-probability, high-impact event - the market meltdown - in a manner also designed to limit another such event snowballing disruptions to intermediation and spending. In both instances, developments in financial markets caused forecasts of economic activity and inflation to be marked down. The 1987 stock market crash reduced wealth and raised the cost of capital, which seemed likely to trim both consumption and investment in 1988. The market disruptions of 1998 severely impaired the liquidity and functioning of a number of financial markets for a time, in effect closing them to many borrowers; even after more normal trading patterns were restored, many private firms - especially the riskiest borrowers - found that their cost of credit had risen, with negative implications for spending incentives. But concerns went beyond the direct macroeconomic fallout from the initial movement in asset prices, and in both cases the Federal Reserve, therefore, eased more than probably would have been justified by the change in the center of gravity of the forecast itself. Importantly, the potential effects of these events on confidence - on the psychology of market participants and of savers and spenders more generally - raised the specter of continuing flights to liquidity and safety that could disrupt the financial markets and economic activity even more severely. Such an outcome was unlikely - it would have been a nonlinear and unusual reaction to the prevailing economic circumstances and outside the ambit of standard models - but it was not unheard of in history. The policy actions were designed in part to build confidence; by demonstrating that the Federal Reserve was taking steps to deal with the downside risks, it intended to lower the probability that the very events that concerned us would occur. In addition, lower interest rates - taking some chances temporarily on the side of stronger activity should help to limit upward pressures on private interest rates and restore market liquidity. Such outsized policy actions have not been taken uniquely in response to shocks emanating from financial markets. We eased aggressively in early 2001 as the economy weakened. This easing was perhaps quicker than might have been anticipated from our past behavior, but it was not out of line with our perception of the center of gravity of the evolving economic situation. However, from late 2001 through the first half of 2003, as the lack of vigor of the economic rebound gradually became evident, we eased further, bringing the policy rate to an especially low level, whether viewed in nominal or in real terms. The extent of these latter actions was influenced by the accumulation of evidence that the economy was not responding to policy stimulus as much as might As an aside, the issue here is the appropriate setting of the policy rate, not the quantity of reserves or money. Central bankers recognize that it is necessary to accommodate increased demands for liquidity at times of stress in financial markets. To do otherwise would permit the increased demand for liquidity to put upward pressure on short-term rates and effectively tighten policy. have been anticipated, creating the remote possibility that a persistent, if not a widening, output gap would cause deflation, which in turn could further undermine economic performance. In these circumstances, the zero bound on nominal interest rates could potentially constrain conventional policy easing, further adding to the potential for nonlinear responses in the economy. Policy rates were already quite low, the economy had been weak for some time, and inflation had settled into the zone of price stability. Although other types of monetary policy actions likely would be effective at the zero bound, they had not been tried. We did not see a high probability of deflation, but in those circumstances the most prudent course appeared to be to ease aggressively - by more than the central economic outlook might call for - in order to raise the odds of forestalling what could have become a very disruptive and costly economic situation. I judge our policy in these cases to have been successful - though the record for the most recent episode is still being written. One can never know the counterfactual - what would have happened if the reaction of the Federal Reserve had been more in line with a standard response to a changing central tendency forecast, rather than the more forceful actions we took. And some believe that our easings contributed to difficulties that emerged subsequently - a subject to which I will return later. However, in 1987 and 1998 financial markets stabilized and we did not see the continuing disruptions to intermediation and spending that concerned us after the initial market shock had taken place. And in the last year or so economic growth has strengthened and the possibility of destabilizing deflation receded. Omitted from my list of examples of low-probability, high-impact events that the Federal Reserve has addressed with monetary policy are episodes in which a possible substantial deviation of key asset prices from fundamentals threatens future disruption when those prices correct. The reason for the omission is that I know of no such episodes in the past few decades. Our monetary policy certainly takes into account the effects of asset prices on the likely course of the economy and prices. But we have not attempted to damp fluctuations in asset prices by tightening or easing policy more than the medium-term macroeconomic outlook implies. In concept, a significant deviation of important asset prices from fundamental values raises the risk of a future reversal that would add to economic volatility, representing a low-probability event that, like many others, could be given some weight in the stance of policy. But we have been deterred by a number of uncertainties about dealing with this possibility and a consequent lack of confidence that the benefits of policy action in these circumstances would outweigh the costs. Among other things, we are uncertain (a) about any judgment that the level of a particular class of asset prices is moving far enough away from fundamentals to make a correction inevitable and disruptive; (b) about the timing of a reversal of those prices, so that a step to truncate a movement, say by raising rates in response to a perception that the prices of some assets were becoming unsustainably high, does not increase economic instability by hitting the economy and asset prices just as the reversal occurs; and (c) about the response of asset prices, possibly driven by self-fulfilling optimism for a time, to a change in rates. As a result of this last unknown, one has difficulty assessing whether a change in policy large enough to prevent asset-price disequilibrium would have a greater adverse effect over time on economic performance than would allowing asset prices to evolve. Moreover, we have also recognized that much of the extra damage that rapidly changing asset prices may inflict occurs through weakening the financial system enough to cause a constriction in credit flows that restrains spending. This potential problem can be addressed, in part, through the supervisory process and attention to the vulnerabilities of key intermediaries. From the vantage point of, say, 1999, when price-earnings ratios were at lofty levels and forecasts of annual-earnings growth over the longer term were in the high teens, an asset-price correction did not seem like a low-probability event. Although such a correction would result in considerable losses for those holding the assets when their prices fell and would damp demand for a time, its macroeconomic effect did not seem likely to be unusually large. Banks were well capitalized, and financial institutions more sophisticated in their risk-taking, so that the scope for significant knock-on effects appeared limited. Thus the risks seem higher than with many other possible low-probability events that the balance of costs and benefits will turn out to be adverse when monetary policy is aimed away from fundamental objectives to influence asset prices. Given these uncertainties, we have chosen to react to the assetprice correction when it occurs rather than to try to head it off. Monetary policymakers giving significant weight to low-probability events face several challenges. One serious potential pitfall is paying so much attention to the tails of the distributions of possible outcomes that the central tendencies veer well away from objectives for economic and price stability - in effect paying too much for insurance. A key issue in this regard is judging when to begin reversing the extra easing or tightening put in place to take account of the possible high-impact event. The policy actions we have been addressing are importantly based on concerns about the effects of nonlinearities, and it may be difficult to judge when the threat of those nonlinearities has diminished sufficiently to make unwinding the action - reducing or dropping the insurance policy - advisable. The difficulty is compounded because the reasons for the behavior that leads to heightened potential impact of a low-probability event often are not fully understood - for example, why the markets cracked or why the economy has not responded more strongly to previous stimulus. Moreover, when the threat of the low-probability event recedes into the past, policy may need to compensate over time in the other direction to preserve economic and price stability - to achieve the appropriate policy stance on average - a consideration that further complicates the policy decision in these circumstances. Another issue raised by some critics in connection with central bank efforts to guard against financial instability and other low-probability, high-impact developments is that such actions encourage undue risk-taking in financial markets and the economy. However, to the extent that the conduct of policy actually reduces the potential for high-impact events or more generally damps fluctuations in output and prices, risks are genuinely lower, and that situation should be reflected in the behavior of private agents. To me, this criticism is similar to asserting that mandating seat belts in cars has led to more traffic accidents because they give drivers a sense of security. And it is probably true when looked at narrowly. Policies should be judged from a general equilibrium perspective, however. Damped fluctuations in economic activity and the containment of financial crises has made the populace, at large, better off. That some view this security as reason to be less cautious does not seem especially damaging to welfare. To be sure, adverse consequences for resource allocation, and perhaps even for the stability of output and prices, will occur if private agents overestimate the ability or willingness of central banks to damp volatility in asset prices or the economy. In the context of the sorts of decisions we are discussing on this panel, the question is whether the tendency of a risk-managing central bank to lean particularly hard against the consequences of asset-price declines might not give market participants a false sense of security. However, experience should have taught market participants that risk management by central banks does not prevent sharp movements in asset prices. Policy actions in 1987, 1998, and 2001-03 cushioned the economy, but they did not stop major declines in the prices of risky credits in 1998 or equities in 1987 or 2001. Any asymmetries in central bank reactions were aimed at stabilizing the economy, not achieving particular asset-price configurations. The small effects of monetary policy asymmetries on the asset prices have been overwhelmed by the fundamentals of shifting perceptions of risk and future earnings. In gauging the effects of policy on asset prices, market participants should not be making systematic errors that distort resource allocation. In my view, these potential difficulties should not deter central banks from taking account of low-probability, high-impact events in judging the appropriate stance of monetary policy. To be sure, any such actions cannot be allowed to compromise the primary long-run policy goal of preserving price stability. And policymakers, through their words as well as their deeds, must remind market participants that monetary policy is but one of many influences on asset prices and that the level of those prices is not an objective of policy. But when inflation expectations are firmly anchored at price stability, policy has the flexibility to consider a range of outcomes and judicious use of this flexibility can improve economic welfare.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the American Association of Individual Investors Washington Chapter Meeting, Arlington, Virginia, 23 October 2004.
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Susan Schmidt Bies: The Federal Reserve System and the economy Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the American Association of Individual Investors Washington Chapter Meeting, Arlington, Virginia, 23 October 2004. * * * Good morning. I’m certainly pleased to be here with you. The programs of the American Association of Individual Investors play an important role in advancing the financial education of its members. Folks like you - individual investors - are important participants in our economic system. As financial services firms and their products continue to evolve, people are continually challenged to improve their ability to evaluate alternative consumer and investor services. The great strength of our financial markets is that they efficiently weigh and sort the judgments of literally millions of investors, large and small, as economic conditions evolve, channeling investment dollars, at least ideally, to where they can best be used. Programs such as this morning’s event doubtless help keep your members informed about where they may seek the highest risk-adjusted returns on their investments. I know that because you have a Federal Reserve policymaker here, you will want to hear how my own views of where our economy stands compare with yours. I’ll get to that. But first, let me offer the customary caution that the views I’ll express are my own and don’t necessarily reflect those of other policymakers or staff members of the Federal Reserve. And second, I want to spend some time offering you a broader perspective on the Federal Reserve’s purposes and functions, of which monetary policy is just one part, albeit a very important part, of the larger whole. At the Board, we sometimes nickname this topic “Fed 101.” In fact, the Fed has a wonderful website with just that name. You can find it at www.federalreserveeducation.org.1 The Federal Reserve System is generically described as the central bank of the United States. It represents our nation’s third, and I trust final, attempt to establish a central bank. You may well recall learning in school that, in the late eighteenth and early nineteenth centuries, the Congress chartered the First Bank of the United States and the Second Bank of the United States, but neither institution lasted more than twenty years. The Banks’ very existence was controversial and went to the heart of the great national debate, which continues to this day, over which responsibilities and powers should be handled at the federal level and which should be left to the states. Suffice it to say that, after the charter of the Second Bank of the United States expired in 1836, we went without a central bank for nearly eighty years. A series of financial panics in the late nineteenth and early twentieth centuries, most notably the Panic of 1907, revived the idea of creating a central bank to provide the nation with a safer, more flexible, and more stable monetary and financial system. But suspicion of centralized power remained at the core of the American psyche, and so the institution that the Federal Reserve Act established in 1913 was a central bank that assigned significant responsibilities for monetary-policy-making to regional Federal Reserve Banks. The System that resulted consists of a governmental agency - the Board of Governors - in Washington and, in twelve major cities, the regional Federal Reserve Banks, which combine public and private elements. The role of the Board vis-a-vis the regional Banks was elevated in the aftermath of the stock market crash of 1929 and in the early years of the Great Depression, but the combination of centralized and regional responsibilities remains an important strength of the the Federal Reserve System, as I’ll explain shortly when I discuss the formulation of monetary policy. The role that the Fed’s founders envisioned for the central bank was narrower, and more passive, than the role that the Fed plays today. The emphasis was on providing currency and reserves to meet seasonal demands and on assisting banks in accommodating the credit needs of commerce and business. Indeed, until the 1920s, it wasn’t clearly understood that the Reserve Banks’ purchases and sales of government securities influenced the supply of money and credit in the economy. These remarks draw from the following sources: Laurence H. Meyer (1998), “Come with Me to the FOMC,” speech delivered at Willamette University, April 2; Mark W. Olson (2004), “The Federal Open Market Committee and the Formulation of Monetary Policy,” speech delivered at the Twenty-sixth Conference of the American Council on Gift Annuities, May 5; and David J. Stockton (2002), “What Makes a Good Model for the Central Bank to Use?” speech delivered at the Federal Reserve Bank of San Francisco, March 2. Today, the Federal Reserve’s duties fall into four general areas - some that would have been familiar to the central bankers in the Fed’s early years and some that would have been unfamiliar: • maintaining the stability of the financial system and containing systemic risk that may arise in financial markets • supervising and regulating banking organizations to ensure the safety and soundness of the nation’s banking and financial system and to protect consumers from harm in their use of credit and banking services • playing a major role in operating and overseeing the nation’s payment system, including providing certain financial services to financial institutions, the U.S. government, and foreign official institutions • conducting monetary policy in pursuit of stable prices and maximum sustainable employment We have an all-too-recent example of the Fed as a source of financial stability in its response to the financial aftermath of the terrorist attacks of September 11, 2001, which occurred just before I joined the Board in December 2001. As a commercial bank executive, I was impressed with the speed at which the Fed responded when the normal settlement and information systems in check and securities markets were interrupted. The Fed worked immediately through discount window lending, open market operations, and other means to provide the financial and banking systems with sufficient liquidity. It worked with public- and private-sector participants to keep markets open or, if circumstances forced markets to close, to return them quickly to normal operations. As the operator and overseer of key payment systems, it had to ensure that its own systems, as well as those of the private sector, were operational. And on the Monday after September 11, it lowered the target federal funds rate to help cushion the economic fallout of the blow to consumers’ and businesses’ confidence. Because the Fed worked so effectively, bankers throughout the country could serve their consumer and business customers and thereby help to minimize the economic effect of the terrorist attacks. The Fed’s role as the supervisor of banking organizations - both as the federal supervisor of the roughly one thousand state-chartered banks that have joined the Federal Reserve System and as the umbrella overseer of financial and bank holding companies - gives the Fed’s staff and policymakers the kind of hands-on experience and knowledge that is essential for a central bank during a financial crisis. The Fed’s examiners and supervisors seek to ensure not only the safety and soundness of the banking system but also the strength of banking organizations, systems for complying with antimoney-laundering, consumer-protection, and other laws. In fact, the Congress charged the Federal Reserve Board with writing the rules that implement consumer protection laws such as the Truth in Savings Act and the Truth in Lending Act, though each of the various federal banking agencies enforces the regulations for the institutions within its purview. Given all the attention paid to the Board and its Chairman, you may be surprised to learn that more than 21,000 of the Federal Reserve System’s roughly 23,000 employees work not in Washington but at the twelve regional Federal Reserve Banks. A substantial portion of these employees work in vital but often unsung jobs, keeping the payment system operating smoothly. The System’s employees handle the distribution of U.S. currency and coin throughout the nation and the world. They also clear and process checks and electronic payments, such as the direct deposit of paychecks and they facilitate the electronic transfer of huge sums between large financial institutions. But it is monetary policy - and the Fed’s principal monetary lever, the federal funds rate, which is the interest rate on overnight loans of reserves between depository institutions - that earns the Federal Reserve all that ink and airtime. Deciding on the appropriate policy from among the various options keeps nineteen policymakers and a staff of more than four hundred Ph.D. economists at the Board and the Reserve Banks quite busy. The chief monetary-policy-making body within the Federal Reserve is the Federal Open Market Committee, or FOMC. It meets eight times a year but can confer by telephone more often if necessary, as it did in 2001 as it responded to incoming economic information as well as economic shocks from terrorism, and as it did again in 2003 as policymakers sought to understand the economic effect of the war in Iraq. The FOMC has nineteen members. Although all members actively participate in discussions at the meetings, only twelve have votes at any one time on the Committee. Each of the seven members of the Board wields a vote, as does the president of the Federal Reserve Bank of New York by virtue of that Bank’s unique responsibility for implementing monetary policy decisions through the open market operations of its Domestic Trading Desk. The responsibility for casting the remaining four votes alternates among the remaining eleven Reserve Bank presidents: Two vote every other year, and the other nine vote every third year. But the important point to remember is that, in a consensus-driven body such as the FOMC, the identity of a member who casts a vote in any given year is less significant than the fact that each member of the FOMC participates fully in the deliberations. The presidents, in particular, bring to the table analyses of economic and business conditions in their districts. The boards of the Reserve Banks also contribute a wealth of anecdotal information to supplement the torrent of hard economic data the Fed analyzes. Moreover, they make recommendations to the Board on the discount rate, the rate the Fed charges on its own loans to financial institutions. The information from the Reserve Bank boards, along with other economic intelligence, is summarized in a report known as the Beige Book, which is publicly released about two weeks before each FOMC meeting. The FOMC also consults other books of other colors. But I’m getting ahead of myself. Let me describe the routine at a typical FOMC meeting. After seating ourselves around the twentyseven-foot-long, polished mahogany-and-black-granite Board table, we begin punctually at nine o’clock. After approving the minutes of the previous meeting, our first order of business is a report from the Manager of the System Open Market Account at the New York Fed, who focuses on conditions in domestic and international financial markets. That report is followed by a presentation from the directors of the Board’s Divisions of Research and Statistics and International Finance, who deliver the Board staffs’ economic forecast as represented in the Greenbook, which FOMC members have usually had the weekend to study. The Greenbook contains the staffs’ summary of recent economic information, a baseline economic forecast, which is the staff’s best estimate, and scenarios based on possible alternative future events. Then comes the first “go-round,” in which every member of the Committee offers his or her assessment of current economic conditions. We may usefully digress here to consider how the Board staff arrives at its forecast and to describe what role the forecast plays in policymakers’ deliberations. An important, perhaps obvious, point to make is that it is not - I repeat, not - the FOMC’s forecast. The economic staff of each Reserve Bank independently advises its president. And the economic staffs of the Reserve Banks and the individual members of the FOMC may or may not agree with elements of the Board staff’s forecast. Indeed, FOMC members sometimes couch the presentation of their economic views in terms of where those views coincide with and diverge from the Greenbook’s forecast. That description, in and of itself, gives you some sense of the staff’s influence of the forecast. It sets the parameters of the discussion. So what kind of forecast is it? It is a forecast based on human judgment. But this judgmental forecast is informed by sophisticated econometric models. The staff’s core, large-scale structural model has been dubbed FRB/US - pronounced “ferbus.” But that model is not the only one the staff uses. Indeed, the staff uses its suite of smaller-scale models to probe the vulnerabilities of the core model. But as seductive as modeling is to us economists, we must remember that no model can fully capture a dynamic, ever-evolving economy such as ours. Thus, the staff’s forecast, and I’m sure the individual forecasts of each FOMC member, are in the end judgmental assessments. After the Greenbook session, the director of the Board’s Division of Monetary Affairs briefs the committee on the Bluebook, a document that presents policy options, usually two or three, for the Committee’s consideration and that offers arguments for and against each course of action. Not a recommendation from the staff, the briefing is instead a vehicle against which FOMC members can test their own thinking. Finally, after hours of discussion and analysis, the Chairman speaks on the policy choice for the first time. Until this point, his participation in the meeting has usually been limited to questions and to comments aimed at keeping the meeting moving. After the Chairman makes his recommendation, FOMC members react in the second go-round. Then we vote, and by then it is usually about one o’clock and time for lunch. About an hour later, at around quarter after two, a statement publicly announces our decision. As currently formulated, the announcement has four parts: the first states the target for the federal funds rate; the second briefly explains the Committee’s analysis of current economic conditions; the third provides the Committee’s assessment of the risks to price stability and economic growth; and the last provides Committee members’ votes. The statement is a relatively recent innovation; it is about a decade old and, over that period, it has evolved from a quite terse missive to the almost loquacious form it takes today. Before the advent of FOMC statements, market observers had to infer shifts in monetary policy by watching the New York Fed’s open market operations. The FOMC statement, as well as more-detailed minutes released about six to seven weeks after each meeting, twice-a-year reports to the Congress on monetary policy, and audits by outside auditors and the Government Accountability Office (formerly the General Accounting Office), are all important elements of the transparency necessary for an independent central bank to function within a democracy. As I mentioned, our goals - price stability and maximum sustainable employment - are set by law, but we are afforded the political independence to make the sometimes unpopular decisions required to achieve those goals. Appropriate transparency and accountability offer a necessary counterbalance to that independence. Now, as promised, let me turn to the state of the economy and the prospects ahead. The economic outlook As you know, real gross domestic product grew at an annual rate of 3.3 percent in the second quarter, building on larger increases since the middle of 2003. After having moderated a bit in late spring, partly in response to a substantial rise in energy prices, aggregate demand appears to have regained some traction. Consumer spending has begun expanding at a faster pace and housing activity remains strong. Business outlays for capital equipment also appear to be on an upward trend, continuing to rebound from their weakness of the past several years. And with financial conditions still accommodative, I expect that economic activity will continue to expand at a solid pace for the remainder of the year. Despite the continued expansion of output, the pace of job creation has been disappointing in recent months. Nonfarm payrolls have grown an average of only 101,000 jobs per month from June through September, after growing at nearly triple that pace in the prior three months. At the same time, despite the recent volatility in oil markets, inflation, on balance, remains subdued. The core consumer price index, which excludes food and energy, edged up only 0.1 percent in each of the three months from June through August and rose at a faster 0.3 percent in September. Last month’s increases occurred in varying sectors, including used cars and lodging. We will continue to monitor the pass through effect from energy and import prices on inflation, but I expect underlying inflation to remain relatively low. In my view, under these circumstances the Federal Reserve can remove its policy accommodation at a measured pace, consistent with its commitment to maintain price stability as a necessary condition for maximum sustainable economic growth. Household financial conditions Continued vigorous expansion depends importantly on consumer spending, so let me spend a few minutes on the financial condition of the household sector. Some commentators have expressed concern about the rapid growth in household debt in recent years. They fear that households have become overextended and will need to rein in their spending to keep their debt burdens under control. My view is considerably more sanguine. Although there are pockets of financial stress among households, the sector as a whole appears to be in good shape. Households have taken on quite a bit of debt over the past several years. According to the latest available data, total household debt grew at an annual rate of about 10 percent between the end of 1999 and the second quarter of 2004; in comparison, after-tax household income increased at a rate of about 5 percent. But looking below the aggregate data, we must understand that the rapid growth in household debt reflects largely a surge in mortgage borrowing, which has been fueled by historically low mortgage interest rates and strong growth in house prices. Indeed, many homeowners have taken advantage of low interest rates to refinance their mortgages, and some have done so several times over the past couple of years. Survey data suggest that homeowners took out cash in more than one-half of these “refis,” often to pay down loans having higher interest rates. On net, the resulting drop in the average interest rate on household borrowings, combined with the lengthening maturity of their total debt, has damped the monthly payments made by homeowners on their growing stock of outstanding debt. The Federal Reserve publishes two data series that quantify the burden of household obligations. The first series, the debt service ratio, measures the required payments on mortgage and consumer debt as a share of after-tax personal income. The second series, the financial obligations ratio, is a broader version of the debt service ratio that includes required household payments on rent, auto leases, homeowners insurance, and property taxes. Both ratios rose during the 1990s, and both reached a peak in late 2001. Since then, however, they have receded slightly on net, an indication that households, in the aggregate, have been keeping an eye on repayment burdens. Moreover, delinquency rates for a wide range of household loans have continued to drift down this year and lie below recent highs in 2001. To be sure, mortgage rates and other consumer loan rates have come off the lows reached early this year, and concerns have been heightened about interest payment burdens for households. Although some households will be pressured by the higher rates, I believe the concerns can be overstated. First, most household debt - mortgage and consumer debt combined - carries a fixed interest rate, which slows the adjustment of interest costs to rising rates. Second, although interest rates on some variable-rate loans will rise quickly, the adjustment for a large number of variable-rate loans could be a good deal slower. For example, many adjustable-rate mortgages start off with a fixed rate for several years, providing households with some protection from rising rates. This relatively upbeat assessment of household credit quality seems to be shared by lenders and by investors in securities backed by consumer debt. According to the Federal Reserve’s survey of senior loan officers, the number of banks tightening their standards on consumer loans has fallen over the past year. Moreover, credit spreads on securities backed by auto loans and credit card receivables have narrowed in recent months. These indicators do not point to much concern about household loan performance. Thus far, I have focused on the liability side of the household balance sheet. Favorable developments have occurred on the asset side as well. Equity prices rallied strongly last year and have held their ground this year; as a result, they have reversed a good portion of the losses sustained over the previous three years. In addition, home prices have appreciated sharply since 1997. All told, the ratio of household net worth to disposable income - a useful summary of the sector’s financial position - has climbed in the past couple of years and currently stands at a high level relative to the past decade. Financial conditions of businesses Businesses are also in good financial shape, having experienced a dramatic improvement in recent years. Indeed, starting last year, many firms found themselves in the unusual position of being able to finance a pickup in spending entirely out of rapidly rising cash flow, and those that turned to external markets generally found the financing environment to be quite accommodative. This improvement in financial conditions reflects a number of factors, namely low interest rates, a widespread restructuring of corporate liabilities, and significant cost-cutting and productivity gains that boosted profitability. In my view, even with an expected rise in interest rates and some moderation in profit growth, the financial condition of the business sector should remain strong and able to support continued expansion. I will address each factor in turn. First, firms are continuing to benefit from the accommodative stance of monetary policy. Even with the recent increase by the FOMC in the target funds rate to 1.75 percent, short-term borrowing costs remain low. For longer-term debt, the combination of low yields on benchmark Treasury securities and sharply reduced risk spreads from those of a couple of years ago has kept borrowing costs quite attractive. The reduced risk spreads reflect the improved financial positions and more positive investor sentiment, perhaps as accounting and corporate governance scandals have receded. Second, in response to low long-term rates and to investors’ concerns arising from some high-profile, unanticipated meltdowns, firms have greatly strengthened their balance sheets. Many firms have refinanced high-cost debt, a move that has reduced the average interest rate on the debt of nonfinancial corporations by about 1 percentage point on net since the end of 2000. Businesses have also substituted long-term debt for short-maturity debt to improve their balance sheet liquidity and to reduce the risk of rolling over funds. In addition, many firms - especially in the most troubled industries - have retired debt through equity offerings and asset sales, while others have used their growing profits to retire debt. As a result, the growth of nonfinancial corporate debt in the past two and a half years has been limited to its slowest pace since the early 1990s. These repairs to balance sheets have also reduced the exposure of many firms to rising interest rates, especially in the near term. In particular, the replacement of short-term debt by long-term bonds means that less debt will have to be rolled over in the near term at higher rates. In addition, because much of the long-term debt has a fixed rate, interest payments typically are unaffected over the life of the bond. Moreover, research by the Board’s staff suggests that firms that are more likely to rely on floating-rate debt, and for that reason might be more vulnerable to rising rates, have tended to use derivatives in recent years to hedge their exposure to interest rate risk.2 Thus, for many firms, the effect of rising interest rates will be mitigated and stretched out over time. In addition, a lesson we can take from the episode of policy tightening in 1994 is that rising interest rates have little detrimental effect on the financial health of the corporate sector when the rate increases occur in the context of an expanding economy. Specifically, corporate credit quality improved on balance after 1994 with the pickup in economic activity and corporate profits. Third, the improvement in financial conditions among businesses is due partly to some significant belttightening by many firms. Over the past few years, the drive to cut costs and boost efficiency has generated rapid productivity gains. Fuller utilization of the capabilities of capital already in place, ongoing improvements in inventory management, and streamlined production processes requiring fewer workers, to name but a few examples of efficiency enhancements, have boosted corporate profitability even when revenue growth was tepid. With the pickup in revenue growth in the second half of last year, companies were able to leverage the productivity gains and produce a dramatic recovery in overall corporate profitability. The profits of nonfinancial corporations as a share of sector output rose to almost 11 percent in the second quarter of this year. This share lies above its long-run average over the past few decades and well above the cyclical trough of 7 percent in 2001. To be sure, the profit share will likely slip a bit from its high level as the expansion gains steam and businesses are less able to keep a lid on their labor costs. Moreover, because cyclical factors likely contributed to the recent dramatic advances in productivity, we should expect productivity gains to moderate. But these developments and the decline in profit share are to be expected and will not, in my view, lead to a meaningful impairment of the financial health of companies. The improvements that businesses have made to their financial strength and profitability have been substantial and should help to support sustained, solid growth of the U.S. economy. Covitz, Daniel and Steven A. Sharpe, “Which Firms use Interest Rate Derivatives to Hedge? An Analysis of Debt Structure and Derivative Positions at Nonfinancial Corporations,” Working paper, July 2004.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Greater Issues Series, The Citadel, Charleston, South Carolina, 26 October 2004.
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Roger W Ferguson, Jr: Factors influencing business investment Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Greater Issues Series, The Citadel, Charleston, South Carolina, 26 October 2004. * * * Thank you for inviting me to speak today as part of the Citadel’s Greater Issues Series. I will speak about one of the forces likely to shape developments in the U.S. economy. In past speeches, I have addressed the so-called jobless recovery, trade, global imbalances, and national saving. Today, I round out this series on fundamental issues by reviewing business capital investment - that is, spending by businesses on such things as machines, computers, and new buildings. Although it makes up only about 10 percent of gross domestic product, business investment is a vital element of the U.S. economy, with important implications for a variety of broader economic issues. Investment has a large influence on the year-to-year fluctuations in economic activity. During the past six recessions, the drop in domestic investment has generally accounted for most of the decline in GDP. Business investment was a major factor in both the 1990s economic expansion and the subsequent recession. In fact, the decline in business outlays on investment goods in 2001 was even larger than the downturn in the overall economy. Although overall GDP edged down at an average annual rate of only 0.2 percent in the first three quarters of 2001, the decline in business investment subtracted nearly 2 percentage points from GDP growth over that period. Clearly, some insight into investment swings would enable us to better understand the economic cycles of recessions and expansions, which in turn have such a big effect on job creation, the budget deficit, and a host of other important issues. Business investment also affects the broader economy through labor productivity - or output per hour of work. Over the past fifty years, the average hourly output of American workers has increased nearly 200 percent. According to the Bureau of Labor Statistics, more than one-third of this improved efficiency likely reflects increases in the use of capital goods. Over the past decade, efficiency gains due to increased capital expenditures have been especially pronounced. Because rising productivity is the primary means through which standards of living increase, capital investment is clearly an important part of the economic engine. Accordingly, an understanding of investment is critical for insight into both cyclical and longer-run economic developments. In my discussion today, I want to address the outlook for the three categories of business investment: equipment and software, structures, and inventories. Forecasting business investment is complicated, however. Despite the importance of this subject, the policymakers, academics, and business economists who study it have limited knowledge regarding its behavior and the factors determining that behavior. By highlighting some of the thorny issues that need to be considered, I hope to provide a backdrop to help elucidate the likely performance of business investment in the quarters to come. Although forecasting involves considerable uncertainty, I think that the prospects for business investment over the next few quarters are, on balance, relatively positive. I should note, of course, that the comments that I make today reflect only my own views; they should not be taken to represent the views of my colleagues on the Board of Governors or in the Federal Reserve System. Equipment and software The largest component of business investment is expenditures on new equipment and software. This category includes computers, routers and switches, machinery, aircraft, trucks, software, and a wide variety of other types of equipment that are used to produce goods and services. Decisions of business people regarding equipment and software investment are based on their assessment of business prospects, the nature of the capital goods themselves, and financing conditions. In short, potential purchasers of business equipment will need to assess a plethora of variables that are at best known only imperfectly. For economists who forecast investment, the task is even harder: Not only must we form opinions about all these variables, we must try to discern the business community’s response to them. Currently, demand for business products and services appears to be rising. In addition, interest rates remain low, and the business sector has ample cash on hand. Historically, such conditions have been associated with increasing real business spending on equipment and software. At the moment, however, at least four additional factors are clouding our view. First, after the trough of the last recession, businesses seemed more hesitant than usual to expand their productive capabilities. Concerns about terrorism, war, and corporate governance scandals may have made it harder for firms to have confidence that a robust and durable recovery was under way. With heightened uncertainty, many firms may have been reluctant to increase capital spending. The issue we face now, nearly three years since the trough, is whether this reluctance has abated. The evidence we have for ongoing business hesitancy is suggestive but far from conclusive. One piece of evidence is found in the state of the “financing gap” - the difference between a firm’s capital expenditures and its cash flow, or internal funds. In the past, the financing gap for nonfinancial corporations was almost always positive - that is, capital spending was larger than internal funds. Between 1991 and 2000, the financing gap rose from less than $35 billion to a peak of more than $300 billion. The rapid rise largely reflected sharp increases in capital expenditures in the telecommunications, high-tech, and transportation industries that greatly outstripped the increases in internally-generated funds. However, the financing gap fell abruptly in 2001 and 2002, turned negative last year, and has stayed below zero since then. This negative financing gap, which is widespread across industries, indicates that the business sector as a whole is generating enough cash to purchase capital expenditures without borrowing. In fact, because it has been negative for a while, the gap has contributed to the accumulation of a large cushion of liquid assets. Over 2003 and the first half of 2004, liquid assets in the nonfinancial corporate sector rose $244 billion, or more than 20 percent, to $1.3 trillion. This news is good because it means that business balance sheets are in good shape and financial conditions are not holding back business investment. But the news is also troubling. Given the current low interest rates, the preference for holding financial assets over expanding operations suggests that businesses lack confidence in the future profitability of their potential ventures. The negative financing gap could very well be a sign that businesses remain cautious about the outlook - a condition that, unfortunately, can become a self-fulfilling prophesy. A second factor that complicates the outlook for investment is the state of the computer sector. About 12 percent of business spending on equipment and software is for computer gear. Some of that spending is to equip new plants and new employees, but a large share of it is to replace old machines and outdated technology. Over the past few decades, we have seen technology advance rapidly, and businesses have purchased a large amount of high-tech equipment. More recently, the growth rate of business spending on computers has slowed - from about 40 percent last year to less than half that pace, on average, in the first two quarters of this year. One possible explanation is that we are seeing a deceleration in the pace of technical advancement. Technological progress affects business investment in primarily two ways. First, it changes how businesses organize their operations. Second, even innovations that do not spur an entirely new way of doing business can encourage equipment spending because some firms will choose to retire obsolete equipment more rapidly than they otherwise would. Accordingly, if the pace of progress slows, increases in business investment, particularly of high-tech goods, may also slow. Of course, we cannot directly measure the pace of technological progress, but we can look at some indicators to help us judge. One indicator that economists often look at is prices, particularly “qualityadjusted prices” compiled by the Bureau of Labor Statistics and used by the Bureau of Economic Analysis to deflate nominal computer expenditures. Over time, these quality-adjusted prices tend to fall, as computers and related equipment become more and more powerful. Between 1992 and 2002, the quality-adjusted price of new computers fell at an annual rate of 18 percent. The speed at which these prices fall reflects mainly the pace of technological progress. Unfortunately, over the past several quarters, the rate of price decline slowed from that experienced during the preceding decade: Computer equipment prices fell just 9 percent at an annual rate in 2003 and the first half of 2004. Although we cannot be certain, at least some of this deceleration may represent some slowing in the rapid pace of technological improvement. Indeed, detailed data that we use in putting together the industrial production data suggest that the number of new PC models introduced this year has fallen markedly from the pace posted in the preceding few years, suggesting that the pace of innovation, at least in this one market, has slowed. A third factor for economists considering the outlook for the business sector is the question of whether the existing stock of business equipment is too high. As the high-tech boom of the nineties was ending, many observers claimed that companies had been overly optimistic and had purchased too many PCs and peripherals and laid too much fiber optic cable, resulting in an actual capital stock that exceeded the desired level for business. When such a “capital overhang” emerges, new investment spending tends to be curtailed for a while. Indeed, in 2001 and 2002, real outlays for equipment and software fell at an annual rate of nearly 6 percent. Determining whether a capital overhang exists is difficult, and estimates of the size of overhangs are subject to considerable error. First, capital stocks are hard to measure; although we know the amount of new capital goods purchased, we can only roughly estimate the rate of economic depreciation and obsolescence. Consequently, we cannot know with certainty the level of the existing capital that is still available to be used. Second, we do not know how much capital firms would ideally like to employ because their expectations and production processes are always changing. Of course, we can estimate both actual and desired capital stocks, but these estimates are quite dependent on our assumptions, especially our assumptions about technological change. Based on the depreciation rates used by the Bureau of Economic Analysis, we estimate that the growth rate of the capital stock of equipment and software slowed from around 7 percent in 1999 and 2000 to about 2-1/2 percent in 2002, a slowdown large enough to substantially shrink most estimates of the capital overhang. The final factor that complicates the outlook for equipment and software spending stems from the tax code. Currently, the partial-expensing provision in the tax law allows a firm to subtract a large fraction of the cost of new capital equipment from profits right away, rather than depreciating the cost over time, and thereby to lower its taxes. The partial-expensing provision, which provides an incentive to invest in new capital goods, will expire at the end of this year. The impending expiration is probably boosting investment spending in the second half of this year as firms rush to take the tax advantage before it disappears; however, at this point the evidence is not conclusive. The anecdotal evidence on whether firms are responding to the partial-expensing provision is sparse and somewhat contradictory. According to a summary of commentary on current economic conditions prepared by the San Francisco Fed in September, a number of contacted firms planned increases in capital spending, yet there was no mention of partial expensing. In contrast, a recent special question in the Philadelphia Fed’s Business Outlook Survey showed that about one-quarter of respondents thought that the tax provision was likely to boost their spending this year. The statistical evidence for a tax response is also inconclusive. Shipments of long-lived equipment (which should be more favorably affected than demand for short-lived equipment) have increased more than overall capital spending since the passage of the most recent version of the partial-expensing law - the pattern we would expect to see if businesses were taking advantage of the tax incentive. However, other explanations for this pattern are possible, and the difference between the long-lived and the short-lived categories is neither statistically significant nor terribly robust. The evidence that partial expensing is having an effect is not clear-cut, but my view is that capital spending is probably being influenced by the tax law and that its expiration in January will probably damp outlays in the early part of next year. Nonresidential structures Besides spending on equipment and software, businesses also build and purchase nonresidential structures. Although this category - which includes factories, warehouses, shopping malls, oil wells, cell phone towers, fiber optic cable tunnels, office parks, and more - is only about 10 percent as large as the equipment and software category, it too can contribute to swings in GDP. In 2001 and 2002, expenditures for new business structures declined more than $75 billion, subtracting nearly ½ percentage point from annual GDP growth on average in those two years. After having flattened out last year, spending in this sector appears to have turned up recently. Business outlays on structures rose 7 percent in the second quarter, and construction data indicate that the sector expanded further in both July and August. Still, nonresidential structures are notoriously difficult to project with any certainty. Many sectors of the economy wax and wane along with the overall business cycle, but the structures sector tends to follow long cycles of its own. Although a weak economy is generally detrimental to spending in this category, expenditures often continue to increase well into an economic downturn, making forecasting difficult. In addition, the nonresidential structures category includes a diverse set of buildings, and forecasting this sector requires keeping tabs on a wide variety of indicators. Purchases of one of the largest components, commercial buildings, tend to be associated with conditions in the retail sector. Retail rents rose 3.2 percent in the four quarters that ended in the second quarter, the fastest pace in four years, and the vacancy rate remains below 6 percent. Likewise, indicators for spending on drilling and mining wells, which usually rise after a jump in oil and natural gas prices, look quite strong. However, the outlook for outlays on office buildings, which tend to be correlated with activity and hiring in the business services sectors as well as in the finance and insurance industries, is less upbeat: Office rents have continued to fall, and the vacancy rate, at 15 percent, remains elevated. The vacancy rate for industrial buildings, a sector that generally keeps pace with manufacturing activity, has flattened out around 10 percent over the past six quarters after having risen markedly for the preceding three years. Thus, at the moment, the various indicators are giving fairly mixed signals. However, the mixed signals are still an improvement over the almost uniformly negative tone of the markets for nonresidential structures a year or two ago. To me, they suggest that the nascent upturn in this sector is likely to continue. Inventory investment So far I have discussed business fixed investment. Another important part of capital expenditures, however, is inventory investment. There are three types of inventory investment: materials and supplies, work in progress, and finished goods. In dollar terms, inventory investment is not large: From 1994 to 2003, it averaged about $37 billion - less than 1 percent of GDP. However, because it can swing from a sizable positive as firms stockpile goods in one quarter to a pronounced negative when they clear out the warehouses in the next quarter, the change in business inventories is generally considered to be one of the most important categories for understanding business-cycle volatility. The reasons that firms need to hold inventory stocks, unlike their reasons for investing in capital equipment and buildings, are not always obvious. For manufacturers, more than half of all inventories are held in the form of materials and supplies or as work in progress. These inventories are necessary, of course, to facilitate production. However, even inventories of finished goods are important. Businesses need to weigh the cost of running out of an item - perhaps forcing a customer to turn to a competitor - against the storage costs of carrying inventories from quarter to quarter. And, particularly in the retail sector, inventories of some goods - like clothing and cars - can spur sales because customers have the chance to try out different sizes or option packages before buying. With so many reasons for holding inventories, inventory investment may appear about as difficult to predict as investment in equipment or structures. It is probably even more difficult. So far I have mentioned only the reasons for which businesses intentionally change their inventory holdings. But inventory swings are often the result of miscalculations on the part of business owners. If a particular product is unexpectedly popular, inventories get drawn down; if the product is unpopular, inventories pile up. The situation is complicated for economists who are trying to draw inferences from flows into and out of inventories. We need not only to figure out how much inventory businesses have wanted to hold but also to discern when they have been surprised by sales. The difficulty of this task can be illustrated by the most recent period. In the second quarter of this year, businesses accumulated inventory stocks at a rapid pace, after having kept inventories relatively lean for several years. This acceleration in the pace of accumulation could mean that inventories had finally gotten too lean and that firms wanted to re-stock, or it could mean only that businesses were startled by the unexpectedly weak pace of demand for their products and that inventories piled up unintentionally. Answering this question is important for determining what is likely to happen to inventory building for the rest of the year. How do we begin to gauge whether businesses wanted to rebuild inventories in the second quarter? One way is to look at the ratio of inventories to sales. In the nonfarm sector, this ratio has fallen nearly 25 percent in the past fifteen years, from 2.59 months’ supply to 1.97 months’ supply. Most likely this secular decline represents improvements in inventory management, possibly related to better technology. In 2003, the inventory-sales ratio fell especially sharply, dropping from 2.02 to 1.94, or about 4 percent. Part of the decline likely reflected improvements in inventory-management techniques. However, unless the pace of technological change has improved markedly, the drop in the inventory-sales ratio probably also reflected sales outstripping the cautious expectations of businesses. The implication is that inventories may have been a bit on the lean side in the first part of this year. If so, then some of the inventory accumulation in the second quarter may have been an intentional re-stocking of inventories that had become too lean. Survey results from the Institute of Supply Management support this conjecture. For several years, a majority of respondents had said that their customers’ inventories were too low. The most recent data, however, suggest that many supply managers have reassessed that view, and the mix of those who think customers’ inventories are lean has moved more in line with those who think stocks are excessive. Thus, the recent upturn in inventory investment does not seem to be pointing toward another problematic inventory cycle, with its accompanying need to drastically reduce production to eliminate unwanted stocks. At the same time, the bulk of stock rebuilding appears to be behind us so that inventories are unlikely to be a major spur to GDP growth in the near future. Conclusions Today, I have highlighted some of the issues that continue to challenge economists in evaluating the outlook for business investment, an extremely important element in determining the outlook for the economy more broadly. With respect to investment in equipment and software, although we do not know with certainty just how rapidly technology is changing and how much businesses are expecting to sell and produce in the future, a number of indicators can help explain recent trends and likely developments. At this point, although there is uncertainty, these indicators on balance suggest that the outlook in this sector is relatively positive. Regarding nonresidential structures, the mixed indicators are a distinct improvement over the negative outlook of a few years ago. And, regarding business inventories, the recent upturn in inventory investment does not appear to be problematic, but it seems unlikely that further inventory investment will impart significant forward momentum to the economy. In short, although the economy may not experience the outsized growth rates of high-tech equipment spending or other business investment seen in the late 1990s, the fundamental features of the current U.S. economy argue for solid increases in the capital expenditures needed to produce and facilitate sales. With steady contributions from business investment, GDP growth is likely to continue expanding at a good pace, leading to further job gains and increases in family incomes. And in the longer run, the expansion of the capital stock can be expected to continue improving the efficiency of the American worker and thus to lead to additional increases in the standard of living.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the University of Connecticut School of Business Graduate Learning Center and the SS & C Technologies Financial Accelerator, Hartford, 29 October 2004.
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Roger W Ferguson, Jr: Equilibrium real interest rate - theory and application Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the University of Connecticut School of Business Graduate Learning Center and the SS&C Technologies Financial Accelerator, Hartford, 29 October 2004. * * * I want to thank the University of Connecticut for providing me this opportunity to comment on the important and challenging concept of the equilibrium real interest rate and its relevance to monetary policy. I will use this occasion to discuss the role that estimates of the equilibrium real federal funds rate can play in thinking about the desired degree of policy accommodation. Those views, I should add, are my own and are not necessarily shared by anyone else in the Federal Reserve System. I hope that at the end of this talk you will conclude, as I do, that while the concept of the equilibrium real rate is a useful aid in thinking about setting monetary policy, it is not measured and observed with such precision as to provide a practical guide to the appropriate stance of policy. Current situation As the most recent statement of the Federal Open Market Committee (FOMC) made clear, the U.S. economy appears to have moved out of the soft patch that characterized the second quarter. Supported by ongoing advances in productivity and the attendant increases in real incomes, household spending has picked up. Businesses, for their part, seem to have shaken off at least some of their hesitancy to spend, although the subdued pace of hiring may signal that they still retain a wary attitude toward making important commitments. But the strengthened balance sheets of the business sector, along with buoyant cash flow, should provide firms with the wherewithal to fund a healthy expansion of the capital stock in coming quarters. No doubt the recent run-up in energy prices poses some challenges, but the evidence indicates that, without some further material shock, aggregate demand is on a track consistent with sustained economic growth. That should gradually return the economy to full utilization of its resources, while inflation remains subdued. The FOMC was confident enough about its assessment of the vigor of spending to indicate in its most recent statement that it continues to believe that policy accommodation can be removed at a pace that is likely to be measured. That begs the question, of course, of how the Committee can be sure that policy is currently accommodative. I find it instructive to first consider how not to measure policy accommodation. In particular, the fact that the nominal federal funds rate remains quite low does not, by itself and without context, signal that policy is loose. After all, spending decisions should depend on real, not nominal, determinants, including the real federal funds rate, which is the nominal federal funds rate less prevailing inflation expectations. Although backward-looking measures of inflation - such as the four-quarter growth in core personal consumption expenditure (PCE) prices - imply that the FOMC’s cumulative 75 basis points of tightening so far this year has moved the real federal funds rate into positive territory for the first time in almost three years, that observation is not sufficient to calibrate the stance of policy. For example, the U.S. economy expanded at about the same average pace from 1981 to 1990 and from 1991 to 2000. In the earlier period, however, the real short-term rate averaged 4-3/4 percent whereas in the more recent one the real rate was 2 percentage points lower. Clearly, prevailing conditions matter in determining the degree of policy accommodation. It is only against a backdrop of an economy that seems poised to maintain sustained and solid economic growth, even as the funds rate rises, that the FOMC can determine that current policy is accommodative. The equilibrium rate in theory What is needed is a benchmark summarizing the economic circumstances - including, among other variables, the underlying strength of aggregate demand, the level of aggregate wealth, and economic developments in our trading partners - combining to shape the expansion of activity and the extent of pressures on inflation. One way of providing that benchmark is to consider what level of the real federal funds rate, if allowed to prevail for several years, would place economic activity at its potential and keep inflation low and stable. If the actual real rate is below that benchmark level, policy can be viewed as accommodative, in that if that stance were maintained, ultimately pressures on resources would build. If the actual real rate is kept above that benchmark level, policy would seem to be contractionary. This definition makes clear that the most relevant aid in policymaking is an intermediate-run measure, in that there may be forces at work in the shorter run that push spending away from potential output even if the real rate were pegged at this benchmark rate. It also makes clear that the concept involves a good amount of judgment - indeed, the same judgment that goes into making any economic forecast - about the determinants of spending, the trend of productivity, and the forces affecting inflation in the intermediate term. Economists famously cannot agree on much. In this case, we cannot even agree on the name of the benchmark concept that I have just described. The real interest rate consistent with the eventual full utilization of resources has been called the equilibrium real federal funds rate, the natural rate of interest, and the neutral real rate. I prefer the first name, the equilibrium real federal funds rate, because, by using the word “equilibrium,” it reminds us that it is a concept related to the clearing of markets. Even if economists settled on a name, however, we are not likely to agree on a single model to describe a system as richly complicated as the U.S. economy. Thus, there are as many ways of estimating the equilibrium real federal funds rate as there are different economic models. There is, however, one way of estimating the equilibrium real rate that I do not find especially convincing. Some economists derive point estimates of the equilibrium real rate by taking averages of the actual real rate over long periods of time. True, over a long-enough sample period, resource slack probably averages near zero, which suggests that the sample average of the real interest equals the equilibrium real rate. But decisions about the sample period - whether to include low-real-rate stretches, such as the 1950s, or high-rate periods, such as the early 1980s - have material bearing on the estimate. This indicates to me that there can be significant and persistent deviations in the equilibrium real rate from the observed long-run average measured over decades. The average interest rate that seems to have brought aggregate demand and aggregate supply into rough balance in the past may not be the same rate required in every conjunctural setting. Our inability to equate the long-run average interest rate to the equilibrium real interest rate that is relevant for setting policy is not surprising given the manner in which economic behavior, technology, and government policy can change over time. Put another way, an estimate derived from long-run observations may not be relevant for policy for two reasons. First, economic conditions during the policy-relevant period might differ from the average conditions during the observation period. Second, the economy changes in ways that tend to limit the relevance of historical observations for policymaking. That said, policymakers do strive to understand what the equilibrium real interest rate will be over the long run, but that is a forward-looking notion that depends on our sense of how the forces of productivity and thrift will evolve over time as measured in decades. An understanding of a likely long-run level of the equilibrium real rate is useful, even though the level is not directly observable, because it provides a general sense of the level that would, over that longer period, allow aggregate supply and demand to move into balance, given the evaluation of secular forces such as productivity and population growth. Such an understanding of the longer-term prospects for the real interest rate aids in identifying variations in the concept over the intermediate run that is relevant for setting monetary policy - a period of several years, when cyclical forces dominate. Critically, such deviations in the intermediate run can be especially important for policy choice. For example, an unusual hesitancy on the part of businesses to hire and spend emerged in 2001 after the collapse of equity prices and was subsequently reinforced by corporate-governance concerns; this hesitancy could be thought of as pulling the equilibrium real federal funds rate down temporarily below its longer-run value. In addition, other forces may also have weighed on growth, making it appropriate to move the real funds rate below the intermediate-run equilibrium for a time. From that perspective, the FOMC’s reduction in the actual nominal federal funds rate over this period from the level of 6-1/2 percent that prevailed at the beginning of 2001 to the forty-five-year low of 1 percent by mid-2003 had three components: (1) A reduction to match the decline in inflation expectations so as to prevent the real funds rate from rising inappropriately, (2) an effort to chase a downwardly moving equilibrium real rate given the pressures on aggregate demand, and (3) an effort to bring the actual real rate below its apparently lowered equilibrium to provide sufficient stimulus to cope with transitory adverse factors and to speed the recovery in production and employment. So while the real federal funds rate ultimately was pushed below zero, the extent of policy accommodation was less exceptional, in that many estimates of the equilibrium real rate had also fallen significantly. This is a tangible recent example of the need both to judge how the equilibrium real interest rate that is relevant for policy might have changed from a perceived long-run level and to set policy against the background of such an understanding. Indeed, in my judgment, the lingering hesitancy of businesses to make commitments, the restraint imposed on domestic consumers from an increase in the cost of energy, and the drag on domestic production from the excess of imports over exports all represent forces pulling the equilibrium real federal funds rate below its perceived longer-term level. And, in the context of well-contained inflation, the evidence of remaining underused resources gives us a good reason to hold the real rate below even the intermediate-run notion of its equilibrium to allow the economy to be firmly set on a path that will shrink the pool of these underused resources over a reasonable period. But as the expansion regains its footing and resource slack is worked down, we should expect both that the equilibrium real rate will move toward its longer-run level and that policymakers will no longer find it appropriate to keep the actual rate below its equilibrium. That is, the FOMC will likely be removing its policy accommodation over time. The pace of return to equilibrium I have thus far argued that the equilibrium rate that is relevant for actual policy determination can only be judged in the context of forces influencing economic developments. Several aspects of the current outlook lead me to suspect that the return of the equilibrium real rate from its currently somewhat depressed level to its long-run value might plausibly be expected to be gradual and attenuated compared with historical experience. Let me highlight just three of these aspects. I have already mentioned the role of business hesitancy in determining the past trajectory of monetary policy. Clearly, if evidence of that hesitancy remains - for example, if the labor market were to remain sluggish - that might be one indication that the return of the equilibrium rate to its longer-run level is likely to be relatively gradual. Secondly, the household saving rate has fallen to less than 1 percent, quite low in its range of historical variation. If households, on net, take steps to return the saving rate closer to the middle of that range (which, I might add, would provide welcome support to capital accumulation), then a sustained period in which consumption grows more slowly than income would result. Third, given government budgetary trends, some fiscal restraint is in order, and one might expect that those responsible for fiscal policy will move that policy to a more-balanced position (another development I would welcome), thereby removing some fiscal impetus. I believe that the combined force of these three factors restraining aggregate demand, plus others that I have not mentioned, would require a lower real rate than otherwise to avoid economic slack. Let me add, however, that there is a powerful force tending to make the equilibrium real rate higher than it would otherwise be. The rapid expansion of labor productivity has raised the growth of economic potential, increased permanent income and wealth, and created an important inducement to add to the capital stock. All else equal, a higher growth rate of productivity will be associated with a more elevated equilibrium real rate. As long as productivity grows steadily at its recent pace, however, there is no reason to suspect that it will produce a change in the equilibrium real rate. In addition, the factors that I mentioned above might not unfold as hypothesized. Business hesitancy might lift abruptly and would be evidenced by large increases in business demand for capital and labor resources; households might maintain a very low savings rate; and government policy might not return quickly to a more-balanced posture. Any of these factors might imply that the equilibrium rate relevant for policy returns more quickly to, or even moves above, its long-run level as fewer forces weigh on aggregate demand. Recognizing the uncertainty regarding these various forces and the interplay among them, I believe it important that the FOMC calibrate the return of policy to the equilibrium real rate so that the process is neither hasty nor overly attenuated. Clearly, incoming data and the implications for the outlook should play a particularly important role in policy determination at this juncture. However, theory and practice both indicate that policy works with long and variable lags. Therefore, the actual stance of policy will have to approximate more closely the equilibrium real rate before the pool of underutilized resources is fully exhausted. Otherwise, we risk a buildup of inflationary pressures. Clearly the execution of policy will require careful evaluation as the FOMC attempts to judge both the equilibrium rate that is relevant and the pace of removal of accommodation that is appropriate. Estimating the equilibrium rate in practice So much for the generality of theory. Economists have taken a variety of tacks to arrive at measures of the equilibrium real federal funds rate. I will touch on two techniques in particular. The first can be thought of as a mechanical attempt to implement my definition - the level of the real federal funds rate that, if allowed to prevail for a couple of years, would place economic activity at its potential - in models of the U.S. economy. For instance, we can use the many equations of a large-scale macroeconomic representation of the U.S. economy, such as the Federal Reserve Board’s staff model, FRB/US, to calculate at any point in time the level of the real rate that would eliminate economic slack in a reasonable period of time. Or we can rely on a reduced-form description of the economy that measures the output gap in terms of the actual real short rate. The value of the real rate that will move that gap to zero can be thought of as the equilibrium real rate. Besides the assumptions undergirding the construction of either model, such a calculation will require judgment in determining what is a “reasonable” period of time and how to cope with the run of prediction errors that are inevitable when trying to explain economic data. An attempt to employ a large model to calculate the equilibrium nominal federal funds rate can be found in an article by Antulio Bomfim.1 Using the MPS model, the predecessor to the Board staff’s current model, Bomfim found that the equilibrium nominal funds rate varied in a range from 2 percent to 14 percent over the period from 1965 to 1994, implying that his estimate of the equilibrium real rate turned negative at times. Laubach and Williams opted for the single-equation approach and estimated that the equilibrium real funds rate was around 3 percent in mid-2002 but that it varied from as low as 1 percent in the early 1990s to as high as 5 percent in the late 1960s.2 In addition to exhibiting large swings, the Laubach-Williams point estimate of the equilibrium rate is a very uncertain statistic. The confidence interval around the estimate is such that there was a 70 percent probability that the actual value of the equilibrium real rate was between 0.5 percent and 5.5 percent. Clearly, this estimate is not measured sufficiently precisely to be a useful guide to policy. An alternative approach turns to financial markets to infer the market’s assessment of the longer-term prospects for real interest rates. Since 1997, the U.S. Treasury has been issuing price-index-linked securities providing an assured real return. With about $250 billion of these inflation-protected securities now outstanding, we can get readings along the entire maturity structure of real interest rates. Currently, for instance, real short yields are close to zero, and longer-term rates are at about 1-5/8 percent. One could presume that the forward real rate of interest implied by yields on longerterm indexed debt - or the real return provided, say, over the period five to ten years from now conveys a sense of market participants’ view of the long-run equilibrium real interest rate.3 Unfortunately for such an inference, however, longer-term yields embody expectations of future interest rates, a term premium, and potentially a premium for the relative illiquidity of these instruments, so this technique will provide an overestimate of the equilibrium real rate. Conclusion This brief discussion highlights the uncertainties attending any attempt to measure the equilibrium real rate. I find these measures useful teaching tools to describe the complicated and iterative process of forecasting the path of the economy so as to arrive at the appropriate stance of policy. However, I believe it to be very important that the FOMC not go on a forced march to some point estimate of the equilibrium real federal funds rate. In my judgment, we should remove the current degree of accommodation at a pace that is importantly determined by incoming data and a changed outlook. Our knowledge of the workings of the economy is sufficiently imprecise that we could not attach much confidence to any single calculation that one might make of the equilibrium rate. Moreover, history provides a daunting record of challenges to economic forecasting associated with changes in Antulio Bomfim (1997), “The Equilibrium Fed Funds Rate and the Indicator Properties of Term-Structure Spreads,” Economic Inquiry, 54(4), pp. 830-46. Thomas Laubach and John C. Williams (2003), “Measuring the Natural Rate of Interest,” Review of Economic Statistics, 85(4), pp. 1063-70. See, for instance, Antulio Bomfim (2001), “Measuring Equilibrium Real Interest Rates: What Can We Learn from Yields on Indexed Bonds?” Finance and Economics Discussion Series 2001-53 (Washington: Board of Governors of the Federal Reserve System). economic behavior, the evolution of technology, and swings in governmental policy that would suggest that the equilibrium can vary over time. In such circumstances, the performance of the economy will provide feedback to assess the level of the equilibrium real federal funds rate over time.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Securities Industry Association Annual Meeting, Boca Raton, Florida, 5 November 2004.
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Susan Schmidt Bies: Financial supervision issues Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Securities Industry Association Annual Meeting, Boca Raton, Florida, 5 November 2004. * * * I want to thank you for the invitation to speak at this annual meeting of the Securities Industry Association (SIA). The financial services industry continues to evolve to meet the challenges posed by mergers, new financial instruments, and changing regulatory frameworks. The Federal Reserve Board, as the umbrella supervisor of financial holding companies, has been working with other regulators and financial institutions to improve the effectiveness and relevance of regulation and supervision in this changing environment. Some of the issues that we have been dealing with recently are of mutual concern to both broker-dealers and commercial bankers - albeit they may represent different sides of the coin. Others involve reconciling the differing perspectives and regulatory environments of investment firms and commercial banks around similar financial products and activities in the wake of financial conglomeration. Today I would like to bring you up-to-date on three such issues, as well as highlight some aspects of the Federal Reserve’s proposed anti-tying guidelines. In all of these areas, I encourage your participation as we work toward new regulatory guidance. Accounting for securities The first supervisory issue I would like to discuss involves accounting for investment securities. The recent accounting guidance, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, or EITF 03-1, has raised serious questions about accounting for investments that are held in available-for-sale portfolios. As many of you are aware, when the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) came to its consensus earlier this year, it was not intending to dramatically change accounting practices for debt securities. But in early August, the public accounting firms began interpreting the guidance very differently. Specifically, if a security was sold from the available-for-sale investment portfolio at a loss, the new interpretation called into question the facts and circumstances that should be used to determine if the remaining portfolio should be viewed as “other than temporarily impaired,” and thereby marked down to the lower of cost or market through earnings (LOCOM). At the Federal Reserve, we were concerned about the interpretation since most banks use their available-for-sale portfolio to manage their net interest margin on longer-term, fixed-rate deposits and funding. A LOCOM accounting model applied to such instruments is not consistent with this important management function. For asset-liability management purposes, historical cost accounting better reflects the use of the available-for-sale portfolio to hedge this type of interest rate risk. We have always expected banks to regularly review the fair values of all their securities. But the concept of “tainting” due to realized losses from the available-for-sale portfolio had not been widely applied in such a narrow way. I commend FASB for listening to questions raised by preparers, auditors, and bank regulators and for agreeing to defer the effective date of the impairment guidance in this interpretation. FASB has also issued some implementation guidance, and its comment period ran until October 29. To be sure, the fixed-income research groups of a number of SIA members have played an important role in educating their commercial bank customers on the issues surrounding EITF 03-1 over the past few months. However, more work may be needed and I would encourage you to closely monitor FASB’s deliberations. Pay particular attention to the facts and circumstances that should be considered. Note that the guidance allows sales of available-for-sale securities at a loss for the same reasons sales of held-to-maturity securities are permitted without tainting the remaining portfolio. For example, mergers or changes in regulatory capital justify untainted sales. The guidance also permits sales for unexpected and significant changes in liquidity needs or for increases in interest rates. In practice, EITF 03-1 should make all organizations that have available-for-sale securities review their procedures for identifying impairment. Clearly, investors should continue to monitor for credit downgrades and changes in prepayment speeds, especially for interest-only strips and mortgage-backed securities booked at a premium. But the trigger for recognizing impairments for changes in interest rates under EITF 03-1 would no longer be an intent to sell, but rather whether the investor no longer intends to hold the security until fair value recovers to its amortized cost. Also note that the disclosure aspects of EITF 03-1 do apply to third-quarter financial statements. The major change is separate disclosure of securities whose fair value is below carrying cost. Organizations must now disclose separately the amount of securities that have been in a continuous unrealized loss position for more than one year, and in the narrative discuss why the loss has not yet been recognized. As dealers in investment securities for banks and other investors, your organizations should be aware of the importance of remaining informed about emerging accounting interpretations that deal with longaccepted practices - not only in the context of providing products and services to your customers, but also in your own bank-like entities that may be affected as investors. Regulatory capital issues Let me now move on to some accounting issues that relate broadly to the new capital framework for the largest U.S.-based financial institutions, including broker-dealers who wish to have consolidated supervision for purposes of meeting European Union requirements. In general, this entails brokerdealer implementation of Basel II capital requirements. As you know, the Basel II effort to revise bank risk-based capital standards is now in its final stages and moving toward implementation. Importantly, that effort has adopted an approach to credit risk for instruments held in the banking book that differs from the current capital rules applied to instruments held in the trading book under the 1996 Market Risk Amendment (MRA) to the Basel Accord. Clearly, the fair valuing or “marking to market” of commercial bank trading portfolios and the implied short-term holding periods of such positions factor into the different approaches. We must remember, however, that the MRA was adopted at a time when bank trading portfolios looked very different from today. Significant growth in structured transactions, collateralized debt obligations, and credit derivatives are just a few examples of the significant developments over the past several years. Moreover, the MRA was structured with commercial banks in mind and not broker-dealers who, as you know, mark most of their balance sheets to market. Also, both banking organizations and investment firms appear to be holding less-liquid instruments at fair value over longer time horizons than has been traditionally associated with the concept of a commercial bank trading account. Taken together, these industry and regulatory dynamics suggest that the time may have arrived for supervisors to begin to review the appropriateness of the 1996 MRA for commercial bank trading accounts and investment firm fair-valued holdings. In an initial effort to fully identify the types and characteristics of instruments that banks hold in their trading accounts, and that securities firms hold at fair value, a joint subgroup of the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision is surveying the industry. This survey seeks to gain a better perspective on the range of techniques financial institutions are developing to more robustly measure the risk these instruments entail. The information acquired in the survey is to be fully incorporated in supervisors’ review of the current adequacy of the MRA. However, this effort to review the MRA is still in its early stages. As yet, it is uncertain whether the effort will result in minor revisions or significant changes to the current MRA. Challenges in securities accounting and auditing Both of these securities-accounting issues that I have just discussed should also be viewed in light of broader issues that are challenging corporate management, independent accountants, and regulators. Fair value accounting for securities, whether in the income statement or in disclosures, relies on key assumptions, modeling techniques and judgment. For example, modeling techniques are commonly used in valuing mortgage-backed securities. The present value of the estimated future net cash flows attempts to anticipate prepayments of mortgages due to forecasted changes in interest rates. Changes in the assumptions used in the modeling approach for any instrument or product will affect the resulting values. For example, if property values are rising rather than falling, the resulting buildup of home equity can affect a borrower’s desire to refinance the loan or use the equity to purchase a more expensive home. Thus, the auditing of model-based fair values for accounting purposes requires a high level of specialized knowledge. The auditor must fully understand how modeling or other sophisticated techniques are used to determine fair value, whether the assumptions used in the models are appropriate, and whether the data have integrity. Furthermore, “fair value” is not always clearly defined or easily determined for some products or instruments. The lack of observable market prices, differences in modeling assumptions, expectations of future events and market conditions, and customer behavior make the task of assigning appropriate valuations very difficult. Certainly, a noncomplex instrument that is highly liquid and that has an observable market price is easier to value with more precision than a highly complex, illiquid instrument. Given the myriad of complex financial instruments that currently exist and that are constantly being created, developing verifiable and auditable fair value estimates is a major concern. And because fair value models are forward looking, an auditor has an additional challenge: determining what is the normal variability in expectations that surrounds any forecast and what is earnings manipulation. To its credit, FASB has recently issued an exposure draft on fair value measurement. The proposal provides a framework for fair value measurement objectives, and it is just the initial phase of a long-term fair value project. The initial phase is generally intended to apply to financial and nonfinancial assets and liabilities that are currently subject to fair value measurement and disclosure. It is not intended to expand the use of fair value measurements in financial statements at the present time. In my view, the proposal is a good first step in enhancing fair value measurement guidance, but I believe additional guidance is warranted. The proposal should address reliability issues more comprehensively. Most important, FASB should develop additional guidance and conduct more research and testing to enhance the reliability of fair value measurements before the use of fair value is significantly expanded in primary financial statements. Furthermore, FASB should work with other organizations including the Public Company Accounting Oversight Board (PCAOB), the American Institute of Certified Public Accountants (AICPA), and accounting firms to enable the development of robust guidance that ensures fair value estimates can be verified and audited. Anti-tying restrictions on banks Finally, I want to discuss the nature of anti-tying regulations for financial institutions, an issue that can be very confusing to nonbankers. As innovations create new financial instruments, services, and markets, and as banks expand the scope of the financial services they offer, the process banks use to make business decisions is similar to the process many of you apply in your own business. Financial institutions are trying to build customer loyalty by offering a broader menu of financial services to corporate customers. Some of these financial services are more profitable than others, and thus, add greater shareholder value. The concern addressed by anti-tying restrictions is that banks may force customers to take unwanted products in order to obtain needed services - primarily loan products. As a brief background, a special anti-tying statute applies to banks. The statute generally prohibits a bank from conditioning the availability or price of one product on a requirement that a customer also obtain another product that is not a traditional bank product from the bank or an affiliate of the bank. For example, a bank may not inform a customer that it will provide the customer with a loan only if the customer engages the bank’s securities affiliate for an underwriting or obtains some other product or service that is not a traditional bank product from the bank or an affiliate. The words “that is not a traditional bank product” are important. Not all tying arrangements are illegal ties. The statute and the Federal Reserve Board’s regulations expressly permit a bank to condition the availability or price of a product or service on a requirement that the customer also obtain one or more traditional bank products from the bank or an affiliate. For example, banks for many years required customers obtaining construction financing to maintain compensating balances. A traditional bank product generally is defined as any “loan, discount, deposit, or trust service,” and the Board’s proposed interpretation provides guidance on what types of products fall within the scope of these terms. In light of the complexities of the anti-tying restrictions, the Board has published and received public comment on both an interpretation of the anti-tying statute and on related supervisory guidance. The proposed interpretation was published to help banking organizations and corporate customers clarify permissible practices under this complex statute in today’s financial services environment. Importantly, the interpretation proposes guidelines that a bank should follow when it seeks to engage in traditional “relationship banking,” that is, serving its customers on the basis of the profitability of the overall customer relationship with the entire banking organization. The proposed supervisory guidance communicates our expectations as to the types of policies, procedures, internal controls, and training programs that should help banks comply with the anti-tying restrictions. The proposed guidance also emphasizes the importance of the compliance and internal audit functions in ensuring compliance with the law and regulations. Ensuring compliance can be an extremely difficult endeavor because there is no prohibition against cross selling products or aggressive marketing. The goal is to ensure that banks don’t cross the line between offering choices and illegally tying products and services. The Federal Reserve Board and the other federal banking agencies have long required that banking organizations establish and maintain policies and procedures to ensure compliance with the anti-tying restrictions, and the agencies monitor these policies and procedures through the supervisory process. Admittedly, at times it can be difficult to determine whether a violation of the anti-tying statute has occurred. As I mentioned, some forms of tying by banks are expressly permitted, and the statute does not apply to tying arrangements imposed by a bank’s nonbank affiliates. Moreover, divining whether a bank imposed a prohibited tie often requires a close review of the facts and circumstances associated with a particular transaction. A prohibited tie, for example, may be conveyed orally and not memorialized in transaction documentation. Our supervisory reviews indicate that banks generally understand and have implemented systems to ensure compliance with the anti-tying provisions to which they are subject. In addition, although we have encouraged customers that believe they have been the subject of an illegal tie to come forward, we have received few complaints from bank customers. Moreover, few customers have sought to challenge their banks directly, although they are granted a private right of action under the statute and may obtain triple damages if successful. A 2003 report by the Government Accountability Office (GAO) on bank tying practices found that the available evidence did not substantiate claims that banks were engaging in illegal tying, but the report did note that borrowers were reluctant to file formal complaints. The GAO recommended that the Board consider taking additional steps to enforce compliance with the anti-tying provisions. Our proposed interpretation and guidance are intended to help banks and the customers understand this rather complex compliance area. I should mention that we also received a comment letter on the proposed interpretation from the Department of Justice. This letter, which is available on the Department’s web site, expresses concern that the bank anti-tying statute itself may suppress competition and harm consumers, especially as it is applied to large customers. The Justice Department recommends that the Board interpret the bank anti-tying statute in a manner similar to the federal antitrust laws. Under federal antitrust laws, which apply to independent broker-dealers, a showing of market power is essential to support a finding that a company has coerced its customer to purchase an unwanted product or service. In contrast, the courts historically have found that the special anti-tying statute that applies only to banks generally does not require a showing of market power to support a violation. Alternatively, the department recommends that the Board exercise its statutory authority to exempt large, corporate customers from the reach of the bank anti-tying statute. These are all issues the Board will have to carefully consider as it moves toward finalizing the anti-tying interpretation and guidance. Conclusion I know that the SIA and your financial firms have been devoting time to many of the regulatory issues that have made the headlines in the past several years. I hope that my comments today will also remind you that the evolution of the industry and financial products creates challenges that you are likely to encounter in the more normal course of business.
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Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Fraser Institute Roundtable Luncheon, Toronto, 15 November 2004.
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Mark W Olson: Recent economic experience and outlook Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Fraser Institute Roundtable Luncheon, Toronto, 15 November 2004. * * * Thank you for inviting me to speak to you today about my assessment of current economic conditions in the United States and what is required to maintain an economic environment conducive to growth, job creation, and price stability. I should note that my remarks today reflect my own views and do not necessarily represent those of my colleagues on the Board of Governors or in the Federal Reserve System. Commentaries on the economy often focus too heavily on the latest weekly and daily data. To put today’s economic performance in a broader context, I would like to step back briefly and touch on some recent economic history. As you know, the latter half of the 1990s was a time of remarkable economic performance, fueled importantly by an investment boom that contributed to rapid growth in labor productivity. However, by late 2000, that boom had come to an end, and businesses abruptly curtailed capital spending - particularly for high-tech equipment. The cutback in spending occurred as expectations about the potential profitability of new investment opportunities turned down, and many companies, such as those in the telecommunications sector, found that they had invested too much in equipment and office space during the boom. With the sudden drop-off in business demand, inventories began to pile up, and producers cut production of all types of goods in early 2001. Against this backdrop, the Federal Reserve reduced the target rate for the federal funds rate sharply over the course of 2001 to contain the weakness and head off a more serious deterioration following the terrorist attacks in September. This monetary policy stance, coupled with stimulative fiscal policy, was generally successful. In contrast to most U.S. recessions since World War II, consumer spending and residential investment were both relatively well maintained during this period. Even as firms cut employment and stock market losses eroded household wealth throughout 2001 and 2002, household spending was supported by tax cuts, low inflation, and low interest rates. Consumers took advantage of falling mortgage rates to buy new homes, to refinance their existing mortgage debt, and to tap into their increasing home equity to pay off more expensive debt or to finance spending on other things. As a result, the recession in 2001 turned out to be quite shallow, and activity in 2002 recovered modestly even though businesses continued to cut spending on capital and reduce employment throughout 2002. Despite the reduction in business investment, significant improvements in efficiency allowed firms to meet their sales and production goals without having to add workers. These improvements seem to have been the result both of organizational changes in business operations and of innovations in the use of existing technologies, perhaps the result of firms applying more effectively the new technologies they had acquired at a rapid pace in the late 1990s. In 2003, the recovery took hold: The pace of consumer expenditures stepped up, and housing activity boomed. These developments were supported by a pickup in personal income growth as job losses abated and hourly compensation moved up, as well as by rising stock market and housing wealth. In addition, the caution and uncertainty that had weighed on businesses began to dissipate, and investment turned up in the spring. A marked increase in capital spending in the second half of last year was spurred by significantly improving profits, low interest rates, and investment tax incentives. Nonetheless, the recovery remained “jobless” until the fall, when growth in private employment began to resume. Output in the first quarter of this year continued to expand at the robust pace of 2003, and employment gains picked up sharply. However, economic activity hit a soft patch in the late spring: The growth of real gross domestic product slowed to an annual rate of 3-1/4 percent in the second quarter after posting a 4-1/2 percent average pace in the first quarter of this year and over the four quarters of 2003. The second-quarter slowing was particularly evident in consumption, which was nearly unchanged on average between April and June. Furthermore, job gains in the private sector, which had averaged close to 300,000 per month between March and May of this year, slowed to about 100,000 per month on average during the summer. Economic developments this year have undoubtedly been influenced by the steep run-up in oil prices from about $30 per barrel for West Texas intermediate crude oil in December 2003 to a record level of $55 per barrel this past October. This rise in energy prices clearly has had a negative effect on the real purchasing power of households and has raised business costs. Nevertheless, the United States is probably less vulnerable to this year’s oil price shock than it was to the shocks of the 1970s and early 1980s, both because energy represents a smaller share of household purchases and business input costs than in those earlier periods and because the higher oil prices reflect, in part, stronger growth in the rest of the world, which in turn provides an offset in the form of higher demand for U.S. exports. Indeed, the most recent data suggest that the U.S. economy has regained some vigor in the second half of this year. According to the Bureau of Economic Analysis, real GDP expanded at an annual rate of 3.7 percent in the third quarter, and final sales grew at the fastest pace in a year. In particular, real consumer spending rebounded, as households responded to the aggressive incentives offered by motor vehicle companies by sharply increasing their purchases of new cars and trucks. In addition, low mortgage rates have helped sustain a high level of demand for new homes, and business investment in equipment and software posted another robust gain, led by a sharp increase in spending on non-high-tech equipment. Available indicators for the fourth quarter seem a little more mixed, but the general consensus of economic forecasters is that real GDP will expand in the fourth quarter at a pace similar to that in the third quarter. Although real incomes continue to be squeezed by significantly higher energy prices, recent spending indicators, including last Friday’s retail sales report, suggest that consumption was well maintained in October. In addition, housing construction and home sales have been maintained at a robust pace in recent months, and recent declines in mortgage rates should continue to support demand. Business demand for high-tech equipment seems to have softened a little in recent months, judging both from the data on new orders and from industry commentary. However, business investment on non-high-tech equipment should be buoyed by strong fundamentals, including low interest rates and strong corporate balance sheets, as well as by the partial-expensing provisions of the current tax code, which encourage businesses to accelerate investment spending on longer-lived equipment to take advantage of the temporary tax incentive before it expires at the end of the year. Presumably reflecting these factors, bookings for non-high-tech capital goods have been on a steep uptrend in recent months. The latest reading on the labor market, which has been a source of uncertainty for some time, was particularly encouraging. After slowing this summer, employment on private nonfarm payrolls rose nearly 300,000 in October, about the same as the robust pace reported during the spring of this year. October’s increase was boosted somewhat by a sizable increase in construction employment, which was partly related to rebuilding and cleanup activity following this summer’s hurricanes. But even so, the pace of hiring picked up for a wide range of other industries as well. That said, recent surveys and the continued, low level of labor force participation suggest that households remain concerned about a lack of employment opportunities, and we will have to wait and see whether this faster pace of hiring can be sustained. As you know, Canada is the United States’ largest trading partner, and hence trade provides an important link between our economies. Indeed, U.S. exports to Canada are rising briskly so far this year, albeit still not quite as fast as the rise in U.S. imports from Canada. More generally, a surge in Canadian exports has helped fuel the recovery in Canada this year despite an appreciation of the Canadian dollar. However, unlike the United States, Canada is a net exporter of oil and other commodities and thus has also benefited, on balance, from the sustained rise in oil and other commodity prices this year. Recent Canadian data are consistent with robust domestic demand growth in the third quarter, and employment gains have recently been strong. Over time, future improvements along these lines may also support higher demand for imports, which will in part come from the United States. Turning to the outlook for U.S. inflation, the rise in crude oil prices - coupled with rising margins for gasoline and higher prices for natural gas - contributed to a 25 percent annual rate of increase in consumer energy prices over the first half of the year. And, although energy prices turned down briefly during the summer as gasoline margins returned to more normal levels, the latest indicators are pointing to significant increases in energy prices again this quarter. As a result, headline consumer price inflation - as measured by the personal consumption expenditures (PCE) price index - rose at an annual rate of around 2-1/2 percent over the first three quarters of this year, up from 1-3/4 percent in each of the past three years. Despite the rise in oil prices, core consumer prices have risen at a moderate pace in recent months after picking up early this year from last year’s very low rate. On average, core PCE prices have increased at a 1-1/2 percent annual rate over the first three quarters of this year, up only slightly from a 1-1/4 percent increase over the four quarters of 2003. As with the real economy, the absence of a more significant effect from oil prices on core inflation reflects, in part, the smaller share of energy in firms’ production processes. But in addition, the Federal Reserve’s commitment to low inflation seems to have limited the pass-through of higher energy prices to wages and inflation expectations. Indeed, despite some rapid increases in benefit costs - most notably for health insurance and defined benefit pension plans - overall hourly compensation has been rising at roughly a 4 percent annual rate this year, similar to last year’s pace. Similarly, surveys of inflation expectations and implied inflation compensation from Treasury indexed security yields suggest that longer-term inflation expectations have been well anchored over this period, and short-term inflation expectations have actually eased on balance since midyear despite the rise in energy prices. Looking ahead, economic fundamentals are consistent with the U.S. economy posting solid growth over the next year. Indeed, most forecasters expect that output will continue to rise next year at a pace similar to this year’s. For example, the most recent Blue Chip forecast sees output rising at a 3-1/2 percent rate in 2005, just a touch slower than their forecast for growth over the four quarters of this year. With regard to inflation, the Blue Chip participants see the rise in the consumer price index slowing from 3.2 percent this year to 2.2 percent over the four quarters of 2005. There are a number of reasons for this reasonably favorable outlook. First, monetary policy remains accommodative, even with the rise of 100 basis points in the federal funds rate since late June. The nominal federal funds rate is currently 2 percent, a level that, using standard measures of core consumer price inflation, implies a real funds rate that is just above zero - considerably lower than the long-run average of about 2-3/4 percent. Of course, this long-run average may differ from the level of the real federal funds rate that is currently consistent with moving economic activity into line with its potential and keeping inflation low and stable. But even taking into account possible factors that would tend to push down the equilibrium rate - for example, business pessimism, energy prices, and our net export position - the real funds rate still seems low. Second, financial conditions in general look to be supportive of continued solid economic expansion. In addition to benchmark real interest rates being low, risk spreads are quite narrow, and lenders appear very willing to provide credit to businesses and households. Moreover, many businesses, through their actions to repair their balance sheets in recent years, have built up large holdings of cash that can be tapped to finance investment outlays, and the substitution of long-term debt for short-term debt has reduced the exposure of many firms to rising interest rates. Third, robust growth in underlying productivity should continue to support income growth and economic activity. I suspect that productivity will eventually slow from the extraordinary pace of the past few years - indeed, the recent figures offer some evidence that some of the slowing has already occurred. Nonetheless, I am optimistic that part of the step-up in productivity will be sustained and that it will be reinforced by a robust pace of capital spending. Continued solid gains in productivity will be an important plus for our economy over the longer run because faster increases in productivity lead over time to higher profits, wages, and living standards. On the inflation front, the best news is that inflation is expected to be relatively low. With inflation expectations well anchored, the existing amount of slack and underlying strength in productivity should be offsetting pressures from indirect energy effects and other commodity price increases, which themselves should diminish as oil prices stabilize and then begin to decline. Nevertheless, and as always seems to be the case, there are considerable uncertainties surrounding the outlook for real activity and inflation. An obvious source of risk for the U.S. expansion continues to be the behavior of energy prices. As I noted, the steep run-up in crude oil prices this year has significantly restrained real activity and pushed up overall inflation. And, the outlook for oil prices remains uncertain. Higher oil prices have damped the consumption of oil in the United States, but growing concerns about long-term supply, along with large prospective increases in demand from the rapidly growing economies of China, India, and other emerging-market economies have fueled an increase in futures prices of oil. In recent weeks, spot prices have eased back from mid-October’s record levels, and market participants in oil futures markets seem to expect spot prices to ease somewhat further over the next two years. But both the global demand for oil and the availability of new supplies are notoriously difficult to predict. Another uncertainty revolves around the effect of current tax policy on economic activity. Fiscal policy, which has been stimulative this year, is expected to shift to a fairly neutral stance in 2005, following the removal of the partial-expensing provision for various capital goods at the end of this year. Because the partial-expensing provision allows firms to subtract a large share of the cost of new capital equipment from profits right away, rather than depreciating the cost over time, it provides an incentive to firms to invest in new capital goods. However, estimates of the quantitative effect of this tax incentive on investment are highly uncertain. And anecdotal evidence that firms are responding to the partial-expensing provision is not clear-cut. As a result, the impact of its removal is equally unclear. Specifically, if partial expensing is having a very limited effect on firms’ investment decisions, recent increases in business spending on equipment would be consistent with a stronger underlying pace of investment and faster GDP growth next year. Finally, the sustainability of expansion will depend importantly on the pace of improvement in the labor market. To be sure, October’s payroll employment report was a positive sign. But as we saw earlier this year, one month of data does not make a trend. Robust job gains in the coming quarters would be a convincing sign that businesses have become more confident about the future course of the expansion and would provide households with the wherewithal to maintain a healthy pace of spending growth. Let me turn finally to a brief discussion of monetary policy. As I noted earlier, monetary policy has played an important role in providing support for the economy in recent years. But our work is not done. Now that the expansion seems to have taken hold, we face the challenge of making the transition to a policy stance more appropriate for sustained economic expansion. Our goal is to do so in a way that maximizes economic growth while sustaining the progress that we have made in achieving price stability. Keeping inflation low and stable will contribute importantly to sustaining financial conditions conducive for further gains in economic activity. Along these lines, the FOMC has raised the target federal funds rate by 25 basis points at each of our last four meetings. As indicated in its most recent statement, the FOMC continues to support the assessment that removal of accommodation will likely proceed at a measured pace. However, the Committee will respond to changes in economic prospects as needed to maintain price stability, and it is those developments that will ultimately determine the level and term structure of interest rates.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, to the International Association of Credit Portfolio Managers General Meeting, New York, 18 November 2004.
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Susan Schmidt Bies: Fair value accounting Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, to the International Association of Credit Portfolio Managers General Meeting, New York, 18 November 2004. * * * Good morning. I appreciate the opportunity to participate in your Fall General Meeting. As my colleagues at the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) will agree, fair value accounting poses many challenges and has sparked significant industry debate. As you may be aware, the subject of fair value accounting has been discussed in the United States for well over a decade. Advocates of fair value accounting believe that fair value is the most relevant measure for financial reporting. Others, however, believe that historical cost provides a more useful measure because it more clearly represents the economics of business performance and because fair value estimates may not be reliable or verifiable. So, which is more appropriate - fair value or historical cost? Let me share with you the Federal Reserve’s long-standing position on this issue. As a supervisor of the U.S. banking system, we want to ensure that financial institutions follow sound accounting policies and practices. We continue to support improved transparency and enhanced financial disclosures, which promote market discipline and provide useful information to decisionmakers. We also support fair value accounting for assets and liabilities used in the business of short-term trading for profit, such as the trading account for banks. And we support enhanced disclosures of fair-value-based information as part of broader descriptions of risk exposures and risk management. However, we believe that the accounting industry should be very careful before moving toward a more comprehensive fair value approach, where all financial assets and liabilities are recorded on the balance sheet at fair value and changes in fair value are recorded in earnings, whether realized or not. As many of you know, FASB recently issued a proposed standard on fair value measurements that provides a general framework for valuing assets and liabilities that are currently measured or disclosed at fair value. At this time, it does not expand the use of fair values in the primary financial statements. Although my colleague here from FASB is much better suited than I to address the details of the proposal, I would like to summarize and share with you the Federal Reserve’s views on the proposed standard, which were provided to FASB in a comment letter as part of the exposure process.1 We see the proposal as a good first step toward enhancing measurement guidance in this area. However, as I will discuss in a moment, a number of important issues warrant further consideration, especially before dramatic moves are made toward increased fair value accounting. But before discussing these specific issues, allow me to emphasize one important point. As a bank supervisor, the Federal Reserve believes that innovations in risk management are very important to the continued improvement of our financial system. New methods and financial instruments allow banking organizations to improve their risk-management practices by selecting target levels of risk exposures and shedding or limiting unwanted positions. Whenever possible, the accounting framework should avoid providing a disincentive to better management of risk. Fair value measurement issues that warrant further consideration Reliability and measurement If markets were liquid and transparent for all assets and liabilities, fair value accounting clearly would be reliable information useful in the decisionmaking process. However, because many assets and liabilities do not have an active market, the inputs and methods for estimating their fair value are more subjective and, therefore, the valuations less reliable. A copy of the letter can be found at www.fasb.org/ocl/1201-100/31186.pdf. Research by Federal Reserve staff shows that fair value estimates for bank loans can vary greatly, depending on the valuation inputs and methodology used. For example, observed market rates for corporate bonds and syndicated loans within lower-rated categories have varied by as much as 200 to 500 basis points. Such wide ranges occur even in the case of senior bonds and loans when obligors are matched. The FASB statement on the proposed fair value standard suggests that reliability can be significantly enhanced if market inputs are used in valuation. However, because management uses significant judgment in selecting market inputs when market prices are not available, reliability will continue to be an issue. The proposal identifies three levels of estimates, with the lowest priority given to level-3 estimates. These estimates are not based on quoted prices in active markets for either identical or similar assets or liabilities, but rather on mark-to-model estimates. The proposal suggests that the use of multiple approaches, such as the market, income, and replacement-cost methods, will improve reliability of these estimates. However, the number of approaches adds little to reliability if all the methods are based on the same underlying information, as would often be the case for financial instruments. In our role as a bank supervisor, we have observed that minor changes in a number of assumptions in a pricing model can have a substantial effect. Generally, we are comfortable with the fair value measurement process for liquid trading instruments that financial institutions have had significant experience in valuing. However, we believe that for less-liquid assets and liabilities, reliability is a significant concern. Management bias The fact that management uses significant judgment in the valuation process, particularly for level-3 estimates, adds to our concerns about reliability. Management bias, whether intentional or unintentional, may result in inappropriate fair value measurements and misstatements of earnings and equity capital. This was the case in the overvaluation of certain residual tranches in securitizations in recent years, when there was no active market for these assets. Significant write-downs of overstated asset valuations have resulted in the failure of a number of finance companies and depository institutions. Similar problems have occurred due to overvaluations in nonbank trading portfolios that resulted in overstatements of income and equity. As you are aware, the possibility for management bias exists today. We continue to see news stories about charges of earnings manipulation, even under the historical cost accounting framework. We believe that, without reliable fair value estimates, the potential for misstatements in financial statements prepared using fair value measurements will be even greater. Verification As the variety and complexity of financial instruments increases, so does the need for independent verification of fair value estimates. However, verification of valuations that are not based on observable market prices is very challenging. As I mentioned, many of the values will be based on inputs and methods selected by management. Estimates based on these judgments will likely be difficult to verify. Both auditors and users of financial statements, including credit portfolio managers, will need to place greater emphasis on understanding how assets and liabilities are measured and how reliable these valuations are when making decisions based on them. “Compound” values and revenue recognition The value of a financial instrument may, in some cases, be coupled with an intangible value. For example, a servicing asset can be considered to reflect two values: a financial instrument that is similar to an interest-only strip and an intangible value reflecting the contractual right to perform services over time in exchange for a fee. The current accounting framework often requires different accounting and disclosure treatments for financial and nonfinancial components. However, the accounting literature offers little guidance on when these assets should be separated and how to determine the separate valuations. This lack of guidance may in some cases result in questionable or inappropriate practices, such as including projected income from cross-marketing activities in the valuation of financial instruments. Additional guidance to address these issues is warranted. Also, consideration must be given to revenue-recognition issues in a fair value regime. We must ensure that unearned revenue is not recognized up front, as it inappropriately was by certain high-tech companies not so long ago. Disclosures Fair values reflect point estimates and by themselves do not result in transparent financial statements. Additional disclosures are necessary to bring meaning to these fair value estimates. FASB’s proposal takes a first step toward enhancing fair value disclosures related to the reliability of fair value estimates. I believe that additional types of disclosures should be considered to give users of financial statements a better understanding of the relative reliability of fair value estimates. These disclosures might include key drivers affecting valuations, fair-value-range estimates, and confidence levels. Another important disclosure consideration relates to changes in fair value amounts. For example, changes in fair values on securities can arise from movements in interest rates, foreign-currency rates, and credit quality, as well as purchases and sales from the portfolio. For users to understand fair value estimates, I believe that they must be given adequate disclosures about what factors caused the changes in fair value. Considerations for credit portfolio management Fair value estimates affect the information you use as credit portfolio managers. Today’s financial statements are based on a mixed-attribute accounting model. This means that an entity’s balance sheet may include certain values reported at historical cost and certain values reported at fair value. You probably learned more about this in yesterday’s break-out session about managing profit and loss volatility. Fair values may be used as an analytic tool in the lending process and are compared with historical cost values. This historical cost information, along with associated disclosures, contains reliable information that provides insights into a firm’s expected cash flows. As the industry moves toward expanded use of fair value, I believe disclosure of certain historical cost information will remain essential. As I mentioned earlier, the reliability of the valuations and the transparency of the methods and inputs used to calculate the values are critically important. Clearly, fair valuations will have an impact on leverage ratios, capital ratios, and other ratios used in the lending and credit-management process. Credit portfolio managers will need to identify and understand the impact of changes in fair value estimates that result from changes in specific factors, economic conditions, management judgment, modeling techniques, and so forth. Accounting treatment for credit derivatives Many of you may have seen earnings volatility resulting from the use of credit derivatives. I understand that credit derivatives were discussed in yesterday’s session, so you probably have already heard some perspectives on this topic. Under U. S. generally accepted accounting principles, credit derivatives are generally required to be recognized as an asset or liability and measured at fair value, and the gain or loss resulting from the change in fair value must be recorded in earnings. Most credit derivatives do not qualify for hedge accounting treatment, which would permit the gain or loss on the credit derivative to be reported in the same period as the gain or loss on the position being hedged, assuming the hedge is effective. Therefore, the use of credit derivatives can result in earnings volatility. Consider a credit derivative that hedges credit risk of a loan, for example. As the loan’s credit quality deteriorates, the value of the credit derivative improves. Since the loan is recorded at historical cost, and the credit derivative is marked to fair value, a gain from the change in value of the derivative is recognized in earnings. Conversely, if the loan’s credit quality improves, the value of the credit derivative declines, resulting in a reported loss. These gains and losses may be offset by the level of provisions that are established for estimated credit losses on the loan, but this would likely result in only a partial offset. As management attempts to reduce this earnings volatility, we may see changes in risk-management practices. Unfortunately, some managers might use fewer credit derivatives to reduce credit risk due to this potential earnings volatility. Accordingly, setters of accounting standards need to consider improvements to the accounting treatment that do not result in a disincentive to those who prudently use credit derivatives for risk-management purposes. You may be wondering if the answer to this volatility issue is fair value accounting. If the hedged asset were measured at fair value, the changes in values of the hedged item and the credit derivative may offset each other, reducing the volatility that arises when only the derivative is marked to market and not the hedged item. Of course, the degree of the earnings volatility under a full fair value accounting approach would depend on the effectiveness of the hedge. The IASB developed the new “fair value option” under International Accounting Standard (IAS) 39. Using this option, companies that use international accounting standards will be permitted to apply fair value accounting to certain financial instruments that they designate at the time of purchase or origination. Accordingly, firms using the fair value option could mark to market both the credit derivative and the hedged position and report changes in their fair values in current earnings. While at first glance the fair value option might be viewed as “the solution” to addressing the problems of the mixed-attribute model, it also raises a number of concerns. Many of these concerns, as well as recommendations to address them, were included in a comment letter to the IASB from the Basel Committee on Banking Supervision (Basel Committee) issued on July 30.2 Let me first summarize some of the Basel Committee’s concerns, many of which are similar to those I described earlier. Addressing reliability and verifiability issues, the committee suggested that, without observable market prices and sound valuation approaches, fair value measurements are difficult to determine, verify, and audit. It also suggested that reporting will become more complex and less comparable. The Basel Committee comment letter also discussed the “own credit risk” issue. If an entity’s creditworthiness deteriorates, financial liabilities would be marked down to fair value and a gain would be recorded in the entity’s profit and loss statement. In the most dramatic case, an insolvent entity might appear solvent as a result of marking to market its own deteriorated credit risk. To address these concerns, the Basel Committee recommended certain restrictions on the fair value option, such as disallowing the marking to market of credit risk of the institution’s own outstanding debt and prohibiting the fair value option for illiquid financial instruments. It also suggested that the fair value option be limited to transactions that seek to economically hedge risk exposures and to situations in which accounting volatility associated with the mixed-attribute model can be reduced. Lastly, it recommended enhanced disclosures related to the fair value option. Representatives of the Basel Committee continue to work constructively with the IASB on these issues, and I believe this dialogue can lead to a more-balanced approach to the fair value option that supports transparent accounting and sound risk-management policies in a manner consistent with safe and sound banking practices. As banking organizations using IASB standards consider how to use the fair value option for their own financial reporting purposes, additional issues should be considered. For example, if loans are accounted for under the fair value option, what impact would that have on loan loss allowances, which under risk-based capital standards are a component of regulatory capital? Would changes in loan-loss provisioning practices due to the fair value option reduce regulatory capital, and, if so, how would this capital be replaced? How would the fair value option affect important asset-quality measures, such as nonperforming assets? From an earnings perspective, how would net interest margin be affected? As you can see, a number of important practical issues need to be addressed. Conclusion FASB’s fair value measurement standard is a good first step toward developing enhanced guidance for the estimation of fair values. However, much more work needs to be done before fair value estimates are reliable, verifiable, and auditable. As credit portfolio managers, you need to be aware of A copy of the letter can be found at www.bis.org/bcbs/commentletters/iasb14.pdf. these movements to fair value accounting and how they will affect your understanding of companies you evaluate. Credit derivatives can be a useful tool in managing credit risk. However, they raise thorny accounting issues. While IASB’s fair value option is one possible approach to addressing these problems, further development of this alternative accounting method should move forward in a balanced fashion to ensure that it results in an actual improvement in accounting practices.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the European Banking Congress 2004, Frankfurt, 19 November 2004.
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Alan Greenspan: Euro in wider circles Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the European Banking Congress 2004, Frankfurt, 19 November 2004. * * * I am pleased to join my central bank colleagues in appraising an increasingly important issue - the globalization of trade and finance. I should emphasize that I speak for myself and not necessarily for the Federal Reserve. Among the many aspects of the euro addressed in today’s discussion, we should include its role in the ongoing globalization of economic activity. The euro ties together a sizable share of the world economy with a single currency and, by doing so, lowers transaction costs associated with trade and finance within the region. More generally, globalization of trade in goods, services, and assets continues to move forward at an impressive pace, despite some indications of increased resistance to that process and the evident difficulties in completing the Doha Round. The volume of trade relative to world gross domestic product has been rising for decades, largely because of decreasing transportation costs and lowered trade barriers. The increasing shift of world GDP toward items with greater conceptual content has further facilitated increased trade because ideas and services tend to move across borders with greater ease and speed than goods. Foreign exchange trading volumes have grown rapidly, and the magnitude of cross-border claims continues to increase at an impressive rate. Although international trade in goods, services, and assets rose markedly after World War II, a persistent dispersion of current account balances across countries did not emerge until recent years. But, as the U.S. deficit crossed 4 percent of GDP in 2000, financed with the current account surpluses of other countries, the widening dispersion of current account balances became more evident. Previous postwar increases in trade relative to world GDP had represented a more balanced grossing up of exports and imports without engendering chronic large trade deficits in the United States, and surpluses among many other countries. *** Home bias - the propensity of residents of a country to invest their savings disproportionately in domestic assets - prevailed for most of the post-World War II period. Indeed, Feldstein and Horioka found a remarkably high degree of home bias in their seminal 1980 study.1 Through most of the postwar period up to the mid-1990s, the GDP-weighted correlation coefficient between domestic saving and domestic investment across countries accounting for four-fifths of world GDP hovered around 0.95. That bias, however, diminished rather dramatically over the past ten years, arguably in large measure because of the acceleration in productivity growth in the United States. The associated elevation of expected real rates of return relative to those available elsewhere increased investment opportunities in the United States. The correlation coefficient accordingly fell from 0.95 in 1993 to less than 0.8 by 2002. When one excludes the United States, the correlation coefficient’s decline was even more pronounced. Preliminary estimates for a smaller sample of countries over the past two years indicate a continued decline on net. Basic national income accounting implies that domestic saving less domestic investment is equal to net foreign investment, a close approximation of a nation’s current account balance. The correlation coefficient between domestic saving and domestic investment varies inversely over time with the dispersion of current account balances across countries. Obviously, if the correlation coefficient is 1.0, meaning that every country allocates its domestic saving only to domestic investment, then no country has a current account deficit, and the variance of world current account balances is zero. As the correlation coefficient falls, as it has over the past decade, one would expect the near algebraic equivalent - the dispersion of current account balances - to increase. And, of course, it has. Over the Martin Feldstein and Charles Horioka (1980), “Domestic Saving and International Capital Flows,” The Economic Journal (June), pp 314-29. past ten years, a large current account deficit has emerged in the United States matched by current account surpluses in other countries. *** How far can the decline in home bias and the increase in the variance of current account balances be expected to proceed, and where will it lead? Current account imbalances, per se, need not be a problem, but cumulative deficits, which result in a marked decline of a country’s net international investment position - as is occurring in the United States - raise more complex issues. The U.S. current account deficit has risen to more than 5 percent of GDP. Because the deficit is essentially the change in net claims against U.S. residents, the U.S. net international investment position excluding valuation adjustments must also be declining in dollar terms at an annual pace equivalent to roughly 5 percent of U.S. GDP. *** The question now confronting us is how large a current account deficit in the United States can be financed before resistance to acquiring new claims against U.S. residents leads to adjustment. Even considering heavy purchases by central banks of U.S. Treasury and agency issues, we see only limited indications that the large U.S. current account deficit is meeting financing resistance. Yet, net claims against residents of the United States cannot continue to increase forever in international portfolios at their recent pace. Net debt service cost, though currently still modest, would eventually become burdensome. At some point, diversification considerations will slow and possibly limit the desire of investors to add dollar claims to their portfolios. Resistance to financing, however, is likely to emerge well before debt servicing becomes an issue, or before the economic return on assets invested in the United States or in dollars more generally starts to erode. Even if returns hold steady, a continued buildup of dollar assets increases concentration risk. Net cross-border claims against U.S. residents now amount to about one-fourth of annual U.S. GDP. A continued financing even of today’s current account deficits as a percentage of GDP doubtless will, at some future point, increase shares of dollar claims in investor portfolios to levels that imply an unacceptable amount of concentration risk. This situation suggests that international investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing of the U.S. current account deficit and rendering it increasingly less tenable. If a net importing country finds financing for its net deficit too expensive, that country will, of necessity, import less. *** It seems persuasive that, given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point. But when, through what channels, and from what level of the dollar? Regrettably, no answer to those questions is convincing. This is a reason that forecasting the exchange rate for the dollar and other major currencies is problematic. Our analytic difficulty is that the forces driving the current account deficit are more, perhaps far more, visible than those determining the ex ante financing of the deficit. The former are captured by reasonably reliable estimates of income- and price-driven trade imbalances and net interest income; the latter by the considerably more amorphous assessments of international portfolio choices. The inability to anticipate changes in supply and demand for a currency is at the root of the statistically robust finding that forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss.2 *** The exceptions to this conclusion are those few cases of successful speculation in which governments have tried and failed to support a particular exchange rate. Nonetheless, despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin. I am aware that, of the thousands who try, some are quite successful. So are winners of coin-tossing contests. The seeming ability of a number of banking organizations to make consistent profits from foreign exchange trading likely derives not from their insight into exchange rate determination but from the revenues they derive from making markets. U.S. policy initiatives can reinforce other factors in the global economy and marketplace that foster external adjustment. Policy success, of course, requires that domestic saving must rise relative to domestic investment. Policy initiatives addressing individual components of domestic saving in years past appear to have had significant effects on total domestic saving, even though changes in the individual components are not wholly independent of one another. Reducing the federal budget deficit (or preferably moving it to surplus) appears to be the most effective action that could be taken to augment domestic saving. Significantly increasing private saving in the United States - more particularly, finding policies that would elevate the personal saving rate from its current extraordinarily low level - of course would also be helpful. Corporate saving in the United States has risen to its highest rate in decades and is unlikely to increase materially. Alternative approaches to reducing our current account imbalance by reducing domestic investment or inducing recession to suppress consumption obviously are not constructive long-term solutions. It is of course possible that U.S. policy initiatives directed at closing the gap between our domestic investment and domestic saving, and hence narrowing our current account deficit, may not suffice. But should such initiatives fall short, the marked increase in the economic flexibility of the American economy that has developed in recent years suggests that market forces should over time restore, without crises, a sustainable U.S. balance of payments. At least this is the experience of developed countries, which since 1980, have managed and eliminated large current account deficits, some in double digits, without major disruption.3 Flexibility, as history persuasively shows, enables an economic system to better absorb and rebound from shocks. In the United States, for example, real output contracted very little during our most recent cyclical episode despite having been subjected to a number of shocks: the bursting of the technology bubble, the terrorist attack of September 2001, and the corporate governance scandals. Indeed, the U.S. economy has exhibited a degree of resilience in the face of these adversities not evident in previous decades. Presumably, the rise in product and labor market flexibility in the United States and in a number of other countries over the past quarter-century is continuing to pay off. If such flexibility can be achieved more fully on a global scale, adjustments to the future current account imbalances of both developed and emerging economies could be rendered significantly less stressful than in the past. An admittedly exceptional example of how a flexible system adjusts even with fixed exchange rates is seen at the state level in the United States. For more than two centuries, the United States has experienced largely unencumbered interstate free trade. Although we have scant data on cross-border transactions among the separate states, anecdotal evidence suggests that over the decades significant apparent imbalances have been resolved without precipitating interstate balance-of-payments crises. The dispersion of unemployment rates among the states - one measure of imbalances - has tended to spike up during periods of economic stress but has then rapidly returned to modest levels, reflecting a high degree of adjustment flexibility. That flexibility is even more apparent in regional money markets. Interest rates, which presumably reflect differential imbalances in states’ current accounts, and hence cross-border borrowing requirements, have exhibited very little interstate dispersion in recent years. This observation suggests either negligible cross-state-border imbalances, an unlikely occurrence given the pattern of state unemployment dispersion, or more likely very rapid financial adjustments. Although we have examples of the efficacy of flexibility in selected markets and evidence that, among developed countries, current account deficits, even large ones, have been defused without significant consequences, we cannot become complacent. History is not an infallible guide to the future. We in the United States need to continue to increase our degree of flexibility and resilience. Similar initiatives elsewhere will enhance global resilience to shocks. Many steps have been taken in the euro area to facilitate the free flow of labor and capital across national borders, and considerable progress is being made to enhance competition in product, labor, and financial markets. But more will need to be done in Europe as well as in the United States to ensure that our economies are sufficiently resilient to respond effectively to all the shocks and adjustments that the future will surely bring. Caroline Freund (2000), “Current Account Adjustment in Industrialized Countries,” Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December. Jean-Claude Trichet: Euro in wider circles Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the Conference “Goodbye Lisbon” organised by the European Banking Congress, Frankfurt, 19 November 2004. * * * Ladies and gentlemen, It is a pleasure for me to share with you some thoughts on the euro in wider circles. Reflecting on what the term “wider circles” means for the euro, I think of the EU Member States that still use their national currencies and that aim to adopt the single currency in the future, and in particular the ten new Member States that joined the EU earlier this year and their path towards the euro. Let me briefly say a few words on this aspect. The euro goes east It is now 15 years ago that the Berlin Wall fell, giving rise to one of the most astonishing political and economic transformations in European history. Who could have imagined 15 years ago that in May 2004, eight countries in central and eastern Europe, together with two countries in the Mediterranean, would be members of the European Union? The perspective of joining the European Union and eventually adopting a European single currency was out of sight for even the most imaginative minds. In only 15 years, these countries managed to restore and entrench democratic institutions and market economies, replacing the communist ones that were imposed there before. The accession of ten new countries to the EU was an important milestone in a process that will lead to the eventual adoption of the euro by these new Member States. The euro will go east and south and the road to the adoption of the euro is embedded in a well-defined institutional framework. A crucial phase before euro adoption is ERM II membership for at least two years. Although there are no formal criteria to be met for entry into ERM II, successful participation in the mechanism requires that major policy adjustments - for example relating to fiscal policy and price liberalisation - are undertaken before joining the mechanism. Participation in ERM II is an important means to anchor exchange rate and inflation expectations and to promote consistently sound policies. It helps to orient macroeconomic policies to stability, while at the same time allowing for a degree of flexibility, if needed, through the wide standard fluctuation band and the possibility of adjusting the central parity. As you know, three new EU countries have in the meantime entered the ERM II: with effect from 28 June 2004, Estonia, Lithuania and Slovenia joined Denmark as participants in the mechanism. The three new entrants joined with a standard fluctuation band of ±15% around their central rates against the euro, while Estonia and Lithuania kept their currency boards as a unilateral commitment. In order to ensure a smooth participation in ERM II, countries have firmly committed to take the necessary measures to preserve macroeconomic and exchange rate stability. Participation in ERM II has been smooth. The four currencies in the ERM II have traded continuously at or close to their central rates, while short-term interest rate differentials vis-à-vis the euro area have been small. Beyond ERM II membership lies the adoption of the euro, the crowning achievement of the monetary integration process. In order to adopt the euro, non-participating EU Member States have to achieve a high degree of sustainable economic and legal convergence. Every country will be assessed on its own merits and its own particular situation, on the basis of a strict analysis of the performance relating to the Maastricht convergence criteria. Let me stress that there is no pre-set timetable for the enlargement of the euro area. Economic challenges for the new Member States How far are the new Member States on this road towards the euro? The countries that joined the EU this year have shown impressive economic growth rates and have made great strides in reducing inflation. They belong to the most dynamic economies in the EU, having gone through profound structural changes. For example, they have taken thorough measures to reform their product and labour markets, and some new Member States, in some respects, may be even more advanced than other, existing EU countries. They have become more integrated with the euro area, with the major part of their trade now occurring with the euro area and tight financial links: as a matter of fact, the share of the new 10 Member States in the total external trade of the euro area stands around 11%, compared with around 14% for the US and 3% for Japan. In addition, the transition process has brought their economic structures closer to those of the euro area. At the same time, while remaining a diverse group in many respects, the new Member States still display distinct economic characteristics that differ from the euro area. Their income-per-capita and productivity levels are still low relative to the euro area, which may have an impact on their inflation rates. Let me mention two particularly important economic challenges that the new Member States are confronted with on the road to the euro: price stability and fiscal policy. Price stability is an essential requirement for a successful monetary integration process. Inflation rates in many new Member States have picked up recently to an average of almost 5%, following increases in food and energy prices and indirect tax changes. The challenge for the new Member States is to contain inflation and inflation expectations in an environment of rapid catching-up. Besides solid macroeconomic policy frameworks and prudent wage policies, progress in structural reforms is conducive to price stability by improving the supply side of the economy and enhancing the growth potential. This brings me to the second challenge that I want to mention: the need to achieve sound fiscal positions. Fiscal deficits are on average high or even very high in a number of new Member States and mostly despite very high economic growth. Their governments are confronted with competing expenditure demands, including public investment in infrastructure and the need to strengthen the effectiveness of public administration and the judicial systems. This, however, should not be seen as an excuse to delay fiscal consolidation, but as an additional reason to design and implement a credible consolidation path based on durable and growth-enhancing structural reforms. It is important to bear in mind that fiscal consolidation in the new Member States becomes increasingly important in the course of the monetary integration process and it is essential for a smooth participation in ERM II and the eventual adoption of the euro. Conclusion Let me conclude. The historic enlargement of the EU is now six months ago and I think we can say that is has been a genuine success. Following a remarkable transformation in the past 15 years, the further integration of the new Member States into the European family has progressed smoothly and without any disruptions. The new Member States have shown an impressive economic performance, though various important challenges still remain to be fully tackled, including those relating to the recent pick-up in inflation and to fiscal imbalances.
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the National Economists Club, Washington, DC, 2 December 2004.
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Ben S Bernanke: The logic of monetary policy Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the National Economists Club, Washington, DC, 2 December 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * When I speak about monetary policy at occasions like this one, more often than not the focus of my remarks is on recent policy actions or the near-term outlook. However, just as good tactics are useful only insofar as they serve a larger strategic purpose, so individual policy decisions are best understood in the context of an encompassing policy framework. Today I would like to step back a bit from current policy concerns to address the broader topic of the logical framework within which monetary policy is made. Specifically, I will introduce and briefly discuss two competing frameworks for making monetary-policy decisions, each of which has vigorous proponents among leading monetary economists, and I will relate these frameworks to policy practice at the Federal Reserve. In the latter portion of my remarks I will argue that the choice of policy framework has important practical implications, most notably for the communication policy of the central bank. Before proceeding further, I should say that the views I will express today are my own and are not necessarily shared by my colleagues in the Federal Reserve System.1 Car and driver: a misleading analogy Eight times each year the Federal Open Market Committee (FOMC) meets to set U.S. monetary policy - which, under current operating procedures, amounts to choosing a target for the federal funds rate, a short-term interest rate that the Federal Reserve influences by controlling the supply of bank reserves. What logical framework guides these decisions? Superficially, the FOMC decision process may appear straightforward. A commonly used analogy takes the U.S. economy to be an automobile, the FOMC to be the driver, and monetary policy actions to be taps on the accelerator or brake. According to this analogy, when the economy is running too slowly (say, unemployment is high and growth is below its potential rate), the FOMC increases pressure on the accelerator by lowering its target for the federal funds rate, thereby stimulating aggregate spending and economic activity. When the economy is running too quickly (say, inflation appears likely to rise), the FOMC switches to the brake by raising its funds rate target, thereby depressing spending and cooling the economy. What could be simpler than that?2 I wish it were that easy. Unfortunately, the simplistic view of monetary policymaking derived from the automobile analogy can be seriously misleading, for at least two reasons. First, policymakers working to keep the economy from going off the road must deal with informational constraints that are far more severe than those faced by real-world drivers. Despite the best efforts of the statistical agencies and other data collectors, economic data provide incomplete coverage of economic activity, are subject to substantial sampling error, and become available only with a lag. Determining even the economy’s current “speed,” consequently, is not easy, as can be seen by the fact that economists’ estimates of the nation’s gross domestic product (GDP) for the current quarter may vary widely. Forecasting the economy’s performance a few quarters ahead is even more difficult, reflecting not only problems of economic measurement and the effects of unanticipated shocks but also the complex and constantly changing nature of the economy itself. Policymakers are unable to predict with great confidence even how (or how quickly) their own actions are likely to affect the economy. In short, if making monetary policy is like driving a car, then the car is one that has an I thank a number of colleagues who provided constructive comments on an earlier draft. One complication that is not easily captured by the automobile analogy arises when the Fed’s objectives of price stability and maximum sustainable employment come into potential conflict, as sometimes occurs over short periods (for example, following an aggregate supply shock). In that case the choice of whether to slow down or speed up the economy is not straightforward and depends on a variety of considerations, such as the stability of inflation expectations and the credibility of the central bank. This issue is not central to the points I wish to make today and so I will not discuss it further. unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake. The second problem with the automobile analogy arises from the central role of private-sector expectations in determining the impact of monetary policy actions. If the automobile analogy were valid, then the current setting of the federal funds rate would summarize the degree of monetary stimulus being applied to the economy, just as the pressure a driver exerts on the accelerator at any particular moment determines whether the automobile speeds up or slows down. However, in fact, the current level of the federal funds rate is at best a partial indicator of the degree of monetary ease or restraint. The current funds rate imperfectly measures policy stimulus because the most important economic decisions, such as a family’s decision to buy a new home or a firm’s decision to acquire new capital goods, depend much more on longer-term interest rates, such as mortgage rates and corporate bond rates, than on the federal funds rate. Long-term rates, in turn, depend primarily not on the current funds rate but on how financial market participants expect the funds rate and other short-term rates to evolve over time. For example, if financial market participants anticipate that future short-term rates will be relatively high, they will usually bid up long-term yields as well; if long-term yields did not rise, then investors would expect to earn a higher return by rolling over short-term investments and consequently would decline to hold the existing supply of long-term bonds. Likewise, if market participants expect future short-term rates to be low, then long-term yields will also tend to be low, all else being equal. Monetary policy makers can affect private-sector expectations through their actions and statements, but the need to think about such things significantly complicates the policymakers’ task (Bernanke, 2004). In short, if the economy is like a car, then it is a car whose speed at a particular moment depends not on the pressure on the accelerator at that moment but rather on the expected average pressure on the accelerator over the rest of the trip - not a vehicle for inexperienced drivers, I should think. I hope that this short discussion convinces you that making effective monetary policy is no Sunday drive in the park. With both the informational limitations facing policymakers and the role of privatesector expectations in mind, I turn next to a discussion of two alternative frameworks for thinking about monetary policy. Making monetary policy: two candidate frameworks The two frameworks for monetary policymaking I will compare today are generally referred to in the recent economics literature as instrument rules and targeting rules (Svensson, 2003; McCallum and Nelson, 2004; Svensson, 2004b). Unfortunately, for my purposes at least, this terminology is somewhat misleading. First, the term “rule” suggests a rigid and mechanistic policy prescription that leaves no room for discretion or judgment. However, the argument that monetary policy should adhere mechanically to a strict rule, made by some economists in the past, has fallen out of favor in recent years. Today most monetary economists use the term “rule” more loosely to describe a general policy strategy, one that may include substantial scope for policymaker discretion and judgment. Here I will use the term “policy” instead of “rule” to avoid the connotations of the latter. Second, the terms “instrument” and “targeting” are products of the intellectual history of the debate and, to my mind, are not particularly descriptive. I will refer to the approaches known in the literature as instrument rules and targeting rules instead as simple feedback policies and forecast-based policies, respectively. I hope that the benefits of greater descriptive accuracy will outweigh the costs arising from any terminological confusion. How do these two policy approaches differ, and what are their underlying rationales? Under a simple feedback policy, the central bank’s policy instrument - the federal funds rate in the United States - is closely linked to the behavior of a relatively small number of macroeconomic variables, variables that either are directly observable (such as employment or inflation) or can be estimated from current information (such as the economy’s full-employment level of output). I exclude from my definition of simple feedback policies any policy that links the policy instrument to forecasts of macroeconomic variables, such as output and inflation; hybrid policies of this type raise difficult issues that would take me too far afield today.3 Generally, the macroeconomic variables that drive simple feedback policies Svensson (2001) presents some arguments against the use of feedback policies based on forecasts. McCallum and Nelson (2004) and Svensson (2004b) debate this issue. are chosen to reflect the central bank’s objectives, and policymakers are directed to adjust the shortterm interest rate (or other policy instrument) as needed to offset deviations of these variables from their desired levels. That is, current macroeconomic conditions “feed back” into the setting of the shortterm rate. The adjective “simple” refers to the presumption that, in this regime, policymakers will respond to only a relatively short list of economic variables. However, as I have already mentioned, contemporary advocates of simple feedback policies generally recommend applying these policies flexibly, subject to modification in special circumstances and as judgment dictates. A classic example of a simple feedback policy is the famous Taylor rule (Taylor, 1993). In its most basic version the Taylor rule is an equation that relates the current setting of the federal funds rate to two variables: the level of the output gap (the deviation of output from its full-employment level) and the difference between the inflation rate and the policy committee’s preferred inflation rate. Like most feedback policies, the Taylor rule instructs policymakers to “lean against the wind”; for example, when output is above its potential or inflation is above the target, the Taylor rule implies that the federal funds rate should be set above its average level, which (all else being equal) should slow the economy and bring output or inflation back toward the desired range.4 Numerous simple feedback policies other than those based on the Taylor rule have been proposed and analyzed.5 How does the use of simple feedback policies address the issues I raised earlier - namely, the problem of limited information and the need to account for private-sector expectations when making policy? With respect to the informational constraints, advocates argue that policies of this type, if judiciously chosen, are likely to give reasonably good results even when policymakers’ knowledge about the economy and its underlying structure is severely limited. The principal evidence for this claim comes from computer simulations of mathematical models of the economy. Specifically, researchers have attempted to identify particular simple feedback policies that lead to good economic outcomes when applied to a range of alternative economic models (McCallum, 1988; Taylor, 1999; Orphanides and Williams, 2002; Levin and Williams, 2003). As it turns out, simple feedback policies that produce good results in a variety of simulated economic environments - so-called robust policies can often be found. Proponents of simple feedback policies argue that, as we are far from certain about which of many possible economic models provides the best description of the U.S. economy, the safest course is to adopt one of these robust feedback policies, modified as necessary by policymakers’ insight and judgment, and to stick with it.6 The use of simple feedback policies also addresses to some degree the complications raised by the role of private-sector expectations. Because simple feedback policies link the central bank’s policy instrument to a short list of macroeconomic variables, these policies should be relatively easy for the public to understand and to use in forming expectations of the way monetary policy will evolve in the future. Say, for example, that the feedback policy employed by the central bank stipulates that, when inflation rises 10 basis points, policymakers will raise the short-term interest rate 15 basis points on average, subject to possible judgmental adjustments. Armed with this information and their own Actually, the Taylor rule has the stronger implication that the nominal funds rate should rise more than one-for-one when inflation rises, implying an increase in the real funds rate as well (this prescription is the so-called Taylor principle). The Taylor principle seems likely to be a feature of any good monetary policy and thus provides an important guidepost for policymakers. For example, one proposal would have the Federal Reserve adjust the growth of the monetary base in response to current macroeconomic conditions (McCallum, 1988). Another would replace the output gap in the Taylor rule with output growth, a variable that (unlike the output gap) can be measured directly without reference to unobserved variables like “fullemployment output” (Orphanides and Williams, 2002). Robust feedback policies may also be useful when members of the policy committee disagree among themselves about how the economy works, if such a policy seems likely to produce acceptable results in each of the competing models or frameworks. Although the simulation-based literature described in the text has produced many valuable insights, it also has a number of shortcomings: First, in conducting simulation exercises, researchers of necessity can consider only a relatively small number of simple and highly stylized economic models out of the large universe of possible alternatives. Thus, simulations cannot demonstrate conclusively that any particular simple feedback policy would be robust to the types of uncertainty actually faced by policymakers. Second, although these analyses are predicated on the assumption that policymakers do not know the structure of the economy, they usually assume (somewhat inconsistently) that private agents not only know the true model but also know the central bank’s feedback policy, which allows them to form accurate policy expectations. Allowing for symmetrical uncertainty on the part of policymakers and private agents is difficult analytically but might produce different results. Third, in assessing competing policies, these analyses (with some exceptions) often ignore the possibilities that policymakers will learn from their mistakes, modify or abandon policies that are producing bad results, or take into account their uncertainty about the underlying economic structure when they form their policies. estimates of how strong inflation pressures are likely to be over the next few quarters, financial market participants should be able to forecast future values of the short-term interest rate, allowing them to price bonds and other financial assets more efficiently. Because, under a simple feedback policy, private-sector expectations are likely to be broadly consistent with the central bank’s plans, the effectiveness of monetary policy would be enhanced as well. The second general approach to making monetary policy is what I am today calling a forecast-based policy (Svensson, 2004c). As the name suggests, under a forecast-based policy regime, policymakers must predict how the economy is likely to respond in the medium term - say, over the next six to eight quarters - to alternative plans for monetary policy. For example, monetary policy makers might be interested in evaluating a strategy of keeping the federal funds rate low for a period against an alternative plan that implies a gradual rise in rates.7 Under a forecast-based approach, for each policy plan under consideration, the policymakers and their staffs must make their best guess of how the economy is likely to evolve should that plan be implemented. They may also try to assess the likelihood of outcomes other than their principal scenario. For example, they might conclude that a certain policy plan is likely to produce good results under most circumstances but that less-probable scenarios also exist under which the policy plan under consideration would lead to very bad results. Taking both their baseline forecast and the various risks to that forecast into account, policymakers then choose the plan that seems most likely to produce the best results overall. Their current choice of interest rate corresponds to the first step in implementing the preferred plan. This process is to be repeated at each meeting, with the policy plan being modified as necessary in response to new information or new knowledge about the economy. How do forecast-based policies deal with informational constraints and the role of expectations, the two issues I raised at the beginning of my remarks? Clearly, forecast-based policies require more information to implement than simple feedback policies, a fact that is often stressed by opponents of this approach. Indeed, opponents of this approach argue, a major risk of using forecast-based policies is that monetary policy makers, like other human beings, may be prone to thinking that they know more than they really do. Excessive optimism about what monetary policy can realistically accomplish, some claim, might conceivably lead to worse economic outcomes than would a more intellectually modest stance. In response to this critique, proponents of forecast-based policies suggest that our ability to forecast the economy, though modest, is not nil, and that we should make use of the knowledge we do have. In particular, they note, the use of forecast-based policies does not require that the policy committee members adhere strictly to a particular econometric model or economic theory. Economic forecasts, in central banks as in the private sector, typically reflect the output of a suite of models and statistical methods, plus a heavy dose of the judgment and insights of experienced economists. Forecasts can also be structured to take into account model and data uncertainty - for example by down-weighting changes in variables, such as the output gap, that are known to be poorly measured (Williams, 2004). So long as policymakers and their staffs remain appropriately humble about their forecasting ability and their knowledge of the economy, proponents argue, forecast-based policies are likely to provide better results than simple feedback policies. Supporters also point out that, in comparison with simple feedback policies, the forecast-based approach provides more guidance about how to incorporate judgment and special information into policymaking. As I have noted, advocates of both approaches agree that, in principle, good policy practice leaves scope for discretion and the use of expert judgment. But how, specifically, is this to be done? Simple feedback policies, which presume a good deal of agnosticism about the economy’s underlying structure, do not provide a clear framework for answering this question, except in very qualitative terms. Under a forecast-based approach, in contrast, the answer is straightforward: Judgment or special information should affect policy choice to the extent that it affects the forecast or the risks to the forecast. For example, simulations of an econometric model may imply that policy A is likely to produce better outcomes than policy B; but if expert judgment suggests that the model’s More realistically, the plan might include contingent elements; for example, it might involve keeping the funds rate low unless inflation begins to rise, in which case rates would be allowed to rise as well. Stipulating a policy plan, at least in general terms, is essential in the context of forecast-based policies, as specifying only the current value of the policy rate does not provide enough information to construct a forecast. forecasts do not take special information or circumstances fully into account, or that policy A entails some economic risks not captured by the model, then policy B may be preferred instead. What about the role of private-sector expectations in determining the effect of policy? Again the information requirements of forecast-based policies are relatively more demanding. In contrast to the case of simple feedback policies, under a forecast-based policy financial market participants have no simple formula to guide them in forming expectations about future short-term rates; instead, they must infer the likely course of policy based on their own economic forecasts and their knowledge of policymakers’ outlook and objectives. Given the complexity of the central bank’s forecasting and policy evaluation processes, making these inferences is a daunting challenge. Clearly, under a forecastbased policy, central bankers have scope to provide considerable help to the private sector in its attempts to anticipate policy changes. To the extent that policymakers can accurately communicate their outlook, objectives, and tactics to the public, financial markets will be more efficient and monetary policy more effective (Bernanke, 2004). I will return to the issue of communication shortly. The policy framework of the Federal Reserve It would be nice, at this point, if I could tell you definitively whether simple feedback policies or forecast-based policies represent the superior approach to making monetary policy. But drawing strong conclusions at this juncture would be premature, to say the least. The debate in the monetary economics literature remains lively. Moreover, to some degree, central bank practice remains eclectic. At the Federal Reserve, both simple feedback and forecast-based approaches are used to provide information to policymakers. For example, FOMC members routinely compare their policy choices with both the prescriptions of various forms of the Taylor rule (as noted, a type of simple feedback policy) and the results of model simulations and forecasting exercises undertaken by staff at the Board and at the twelve Reserve Banks (as required by the forecast-based approach).8 Although I will not try here to resolve the deeper debate about frameworks, I can say something about the degree to which central banks rely on these approaches in practice. Both simple feedback policies and forecast-based policies influence how policymakers think about their decisions, as I have just noted. However, in my judgment, reliance on these two approaches is not symmetric; instead, the forecast-based approach has become increasingly dominant in the monetary policymaking of leading central banks. This dominance is reflected in the resources that central banks devote to data collection and modeling and in the increasing sophistication and detail of central bank forecasts.9 Indeed, a number of central banks with explicit inflation objectives publish regular forecasts and closely link monetary policy decisions to those forecasts.10 The Federal Reserve does not explicitly link policy actions to forecasts, but projections of how the economy is likely to perform under different policy plans are nevertheless central to the monetary policy process in the United States; that is, the Federal Reserve relies primarily on the forecast-based approach for making policy. To provide some evidence for this assertion, as well as some reasons for it, I draw your attention to a speech that Chairman Greenspan made earlier this year, entitled “Risk and Uncertainty in Monetary Policy” (Greenspan, 2004). To be sure, the Chairman’s remarks make clear that he is profoundly aware of the uncertainties that policymakers must face in making their decisions, and he is appropriately cautious about relying too heavily on any particular model, theory, or Reifschneider, Stockton, and Wilcox (1997) describe the forecasting process and its role in the policymaking process at the Federal Reserve. Sims (2002) analyzes the policy process in four major central banks, including the Federal Reserve. He describes the central role played by forecasts of inflation and output, developed by a combination of models and expert judgment. Forecasts may be contingent on different assumptions about the policy path or about the shocks hitting the economy. To an increasing degree, forecasts are accompanied with measures of uncertainty, such as the “fan charts” published by the Bank of England to describe the range of statistically probable outcomes. To obtain a more accurate assessment of the current state of the economy and to improve forecasts, central bank staffs collect and analyze large amounts of data; the hunger for data seems inconsistent with a simple feedback policy, which uses limited data inputs. Sims criticizes certain aspects of the forecasting methodologies that are used and suggests improvements, but he does not question that these central banks put forecasting at the center of their policymaking. In a comprehensive study of twenty inflation-targeting central banks, Fracasso, Genberg, and Wyplosz (2001) find that nineteen of the twenty routinely report their forecasts to the public. Forecast horizons typically range from one to two years, with two countries (New Zealand and Switzerland) extending their forecasts to three years. About half the central banks studied use fan charts to communicate the uncertainty of the forecasts. data series. Nevertheless, his speech presents several reasons for concluding that good policies must be primarily forecast-based. These reasons include the need for preemptive policymaking, the importance of taking account of the changing structure of the economy, and the value of what he terms a risk-management approach to policy. I will discuss each of these briefly. Preemption refers to the idea that policymakers achieve better results when they act in advance to forestall developing problems. Early action works best both because monetary policy works with a lag and because developing problems (such as rising inflation) may often be defused at lower cost in their early stages. In principle, simple feedback policies are not inconsistent with a preemptive approach; however, to the extent that each episode has unique features, more information than can be captured in a simple feedback policy may be needed to deal effectively with emerging issues. Referring to monetary policy developments in the 1980s, Greenspan writes: In recognition of the lag in monetary policy’s impact on economic activity, a preemptive response to the potential for building inflationary pressures was made an even more important feature of policy. As a consequence, this approach elevated forecasting to an even more prominent place in policy deliberations. Structural changes in the economy are notoriously difficult to assess as they happen, but to the extent that such changes can be identified and incorporated into the central bank’s forecast, forecast-based policies are again likely to perform better than simple feedback policies. In the mid-1990s, Chairman Greenspan and his FOMC colleagues famously recognized an important structural change, an apparent increase in trend productivity growth. To quote the Chairman’s speech: As a consequence of the improving trend in structural productivity growth that was apparent from 1995 forward, we at the Fed were able to be much more accommodative to the rise in economic growth than our past experiences would have deemed prudent. In short, upon determining that an important structural change was occurring, the FOMC did not feel constrained to respond to current developments in output and inflation as it had in the past - an indication that the Committee’s policymaking was based on a forecast-based analysis, not a simple feedback approach. Perhaps the most interesting confirmation of the role of forecasts in Federal Reserve policymaking, however, is Chairman Greenspan’s description of what he calls the risk-management approach to monetary policy. The risk-management approach is clearly a forecast-based policy. In describing the implementation of this approach, Greenspan describes how models and expert judgment are combined to project not only the most likely scenarios for the economy but also what amounts to a probability distribution of possible economic outcomes. Under the risk-management approach, policymakers choose the policy strategy that implies the most desirable of these probability distributions. To quote Greenspan one more time: Given our inevitably incomplete knowledge. . . . a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy. Moreover, under the risk-management approach, models, judgments, forecasts, and policies are continually updated in light of new information, as theory would suggest. Operationally, the risk-management approach differs from the forecast-based policies described in much of the monetary economics literature in only one important respect. For simplicity, researchers have generally analyzed forecast-based policies under the assumption that policymakers care only about average economic outcomes. However, in practice, policymakers are often concerned not only with the average or most likely outcomes but also with the risks to their objectives posed by relatively low-probability events. For example, although the probability last year of a pernicious deflation in the United States was small, the potential consequences of that event were sufficiently worrisome that the possibility of its occurring could not be ignored. In that spirit, Greenspan’s risk-management approach sensibly reflects the fact that the entire distribution of possible outcomes, not just the average or most likely expected outcome, matters for policy choice. This view is certainly realistic, and the analysis of forecast-based policies when the central bank cares about the whole probability distribution of potential outcomes is beginning to receive more attention in the literature (see, for example, Svensson, 2004a). To reiterate, however, the policy framework espoused by Chairman Greenspan is very much a forecast-based approach; indeed, because it requires making judgments about unlikely as well as likely economic outcomes, it places greater demands on our ability to forecast and to assess risks than do simpler forecast-based approaches that focus on average outcomes only. As I mentioned earlier, I will not try to draw definite conclusions today about the relative merits of simple feedback policies and forecast-based policies. I note, however, that not only have most central banks chosen to rely most heavily on forecast-based policies but also that the results, at least in recent years, have generally been quite good, as most economies have enjoyed low inflation and overall economic stability.11 So long as this good performance persists, at least, the simple feedback approach will face a sort of Catch-22 problem: Without a demonstrated record of success, central banks will be reluctant to adopt this approach; but unless some central banks begin to rely on simple feedback policies, real-world evidence in support of this approach will be lacking.12 Flexibility and communication In previous talks I have argued that clear communication by the central bank is an important element of effective monetary policy (Bernanke, 2004). I will conclude with a few brief remarks about how the distinction between simple feedback policies and forecast-based policies bears on the value of central bank communication and on the relationship between central bank communication and policy flexibility. Central bank communication and transparency are important precisely because of the role of privatesector expectations in determining the effectiveness of monetary policy, a theme I have highlighted today. The economic stimulus provided by monetary policy depends mostly on longer-term interest rates, which in turn are largely determined by the expectations of financial market participants about the future course of monetary policy. As a general matter, the more guidance the central bank can provide the public about how policy is likely to evolve (or about the principles on which policy decisions will be based), the greater the chance that market participants will make appropriate inferences - and thus the greater the probability that long-term interest rates will move in a manner consistent with the outlook and objectives of the monetary policy committee. My discussion today suggests, however, that the benefit of central bank communication depends crucially on the policy approach that is used. As I have noted, if the central bank follows a simple feedback policy (with relatively few judgmental deviations), the private sector’s problem of inferring future policy actions is greatly simplified. The principal task of market participants in this case would be to forecast the macroeconomic variables featured in the simple feedback policy, from which the course of policy could be inferred with reasonable accuracy. Extensive communication by the central bank may not be essential when a simple feedback policy is employed, except in those cases when policymakers decide to deviate substantially from the prescriptions of the simple feedback relationship. Under the forecast-based approach, in contrast, the public will generally find inferring the likely course of policy to be a great deal more difficult. In that regime, policy plans depend in a complex way on policymakers’ outlooks, risk assessments, and objectives, which the public is unlikely to deduce accurately without guidance. Clear communication thus appears to be especially important for central banks that employ a forecast-based approach to policy - a category that includes most contemporary central banks, including the Federal Reserve. This conclusion bears in turn on the relationship between communication and policy flexibility in modern central banking. One sometimes hears the view that providing information to the public about the central bank’s forecasts, plans, and objectives inhibits the flexibility of policy by effectively restricting policymakers’ future choices. This claim might be correct if the current setting of the federal funds rate fully described the overall degree of monetary stimulus or restraint, in the same way that the I attribute this improved performance not only to technical improvements in modeling and forecasting but, perhaps more importantly, to increased attention by policymakers to the objective of keeping inflation low and stable. The framework of what has been called constrained discretion - the idea that short-run stabilization policy must be constrained by the requirement that inflation remain low and stable - has enhanced overall stability by anchoring inflation expectations while giving policymakers some leeway to respond to short-run disturbances (Bernanke, 2003). An alternative approach to evaluating feedback policies is to compare their predictions to actual policy decisions during periods in which monetary policy was judged to be “successful.” Kozicki (1999) performs this exercise for Taylor rules and concludes that they do not provide robust guides to policy. In any case, this evaluation method has the shortcoming that it does not allow for the possibility that the use of an alternative policy approach would change how the private sector forms its expectations, which in turn would affect the optimal policy path. position of the gas pedal at a particular moment fully describes the impetus that a driver is providing to his or her vehicle. In that case, central bank talk could only limit future policy options, much as providing an advance itinerary for an automobile trip may reduce the flexibility to take unplanned detours if required. However, as we have seen, the automotive analogy is a poor one. Monetary policy works largely through indirect channels - in particular, by influencing private-sector expectations and thus long-term interest rates. Consequently, failing to communicate with the public does not create genuine policy flexibility but only reduces the potency and predictability of the effects of given policy actions. To keep monetary policy both flexible and effective, particularly under a forecast-based approach to policy like that employed by the Federal Reserve, clear communication on the part of the central bank is essential.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the International Center for Business Information¿s Risk Management 2004 Conference, Geneva, 7 December 2004.
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Susan Schmidt Bies: It’s not just about the models - recognising the importance of qualitative factors in an effective risk-management process Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the International Center for Business Information’s Risk Management 2004 Conference, Geneva, 7 December 2004. * * * Good afternoon. I am delighted to join you today. I have spent much of my career in the field of risk management, and of course the Federal Reserve has a keen interest in this topic. For those of us who have spent more than a few years in the business, it is easy to see the recent progress in the quantitative or scientific aspects of risk management brought about by improved databases and technological advances. These increased capabilities have opened doors and minds to new ways of measuring and managing risk. These advances have made possible the development of new markets and products that are widely relied upon by both financial and nonfinancial firms, and that in turn have helped to promote the adoption of the best risk measurement and management practices. They have also made the practice of risk management far more sophisticated and complex. These changes have come about because of better risk-measurement techniques and have the potential, I believe, to substantially improve the efficiency of US and world financial markets. Although the importance of the quantitative aspects of risk measurement may be quite apparent - at least to practitioners of the art - the importance of the qualitative aspects may be less so. In practice, though, these qualitative aspects are no less important to the successful operation of a business - as events continue to demonstrate. Some qualitative factors - such as experience and judgment - affect what one does with model results. It is important that we not let models make the decisions, that we keep in mind that they are just tools, because in many cases it is management experience - aided by models to be sure - that helps to limit losses. Some qualitative factors affect what the models and risk measures say, including the parameters and modelling assumptions used as well as choices that relate to the characteristics of the underlying data and the historical period from which the data are drawn. In my comments today, I will address three topics. First, sound risk management is more than technical skill in building internal models. Models of risk need to be integrated into a robust enterprise-wide program that encompasses even line management’s routine business practices. Second, regular testing of “data integrity” in its broadest sense as it relates to these risk measurement and management processes is essential to the effectiveness of these processes. Finally, I want to raise some issues around accounting and disclosure of risk. If there is a single theme to my remarks today, it is simply this: Keep improving, refining, and innovating in risk management. Although Basel II is a remarkable achievement, and the subject of this conference, don’t let your best practices be limited by what Basel II does or requires. Indeed, one of the more desirable aspects of Basel II is that it anticipates that it can evolve with best industry practices without creating a new framework. The designers have not intended to build a straitjacket, and the policymakers have insisted on this characteristic, which my colleague Vice Chairman Ferguson has referred to as Basel II’s “evergreen” aspect. Enterprise-wide risk management Within financial institutions, the better and greater focus on risk measurement has helped to bridge the gap between the perspective of the traditional credit risk officer and that of the “quant.” This is no small accomplishment, and a significant advance in credit culture. If you will pardon my use of stereotypes, historically the credit risk officer has been the fellow who always says “no” because it is the conservative thing to do, while the financial modeller has been the proponent of active-trading strategies that fulfil the promise of a data-mined efficient frontier that has been estimated to several decimal places of precision. The logic of risk and return in a competitive marketplace, as measured by return on economic capital that is founded in empirical analysis, has provided both sides with a common language and set of standards. It is not unusual anymore to hear chief credit officers describe their appetite for risk in terms of risk-adjusted return on capital (RAROC) or monitor current spreads on credit default swaps to look for market signals on borrower credit quality. With better credit cultures and improved tools, institutions can also measure and evaluate more objectively the results of their business strategies and use that information to enhance future performance. They can decide how much risk to take, rather than letting their risk profile be the consequence of other decisions. The evolution of interest rate risk management in the United States is a great illustration of how an enterprise-wide approach can help institutions customize products that better serve customers, set prices to reflect risk exposures and attain profit targets, and ensure that corporate earnings contributions are met. Thirty years ago, bankers who were used to taking fixed-rate deposits - capped under the old Regulation Q ceilings - and making fixed-rate term loans, found the cost of their deposits rising with the market after short-term rates rose dramatically late in 1979. Financial institutions found that, to meet market interest rates, they had to pay higher rates of interest on deposits than they were receiving on loans. As a banker, I went through that period in 1980 when the popular new six-month CDs that were booked in March, at annualized interest rates of around 15 percent, were funding loans at a negative carry when the prime rate fell to 11 percent by August. The roller coaster continued as lower CD rates in the second half of 1980 were funding loans at a prime rate of more than 20 percent by January 1981. One of the first challenges bankers faced in this environment was developing the information and analytical systems needed to manage the institution’s overall interest rate sensitivity. So, in the early 1980s, taking advantage of the newly emerging computer technology and software, they developed asset-liability management models that integrated information on deposit and loan repricing. Further, the management committees responsible for interest rate risk changed. Instead of committees that included only management from the funding-desk and investment-portfolio management, a new group was created - the Asset/Liability Committee, or ALCO. This committee included the old finance committee members and new ALCO staff but also, most important, added business-line managers responsible for major corporate and retail banking activities. For the first time, pricing of loans and deposits was moved from the silos of business-line management, recognizing that the enterprise as a whole had to coordinate balance sheet usage in order to maintain the net interest margin around a targeted level. While this enterprise-wide approach to market risk evolved at varying paces in different depository institutions, by the latter part of the 1980s all of the basic elements were in place and, by the 1990s, the process had matured. The ALCO process is now widely recognized as a critical element in both management and board governance processes. This discipline emerged not only because of better asset-liability risk measures, but also because these new risk measurement and management techniques and computer technology facilitated rapid innovation in financial instruments. The industry turned to new securitization techniques to pool mortgages and remove the interest rate risk from balance sheets, techniques that eventually expanded to other loan types as well. Interest rate derivatives, structured investment securities, and callable debt have allowed financial institutions to meet customer demands more effectively while managing the liquidity and interest rate risk exposures those relationships entail. Enterprise-wide market-risk management became a value-added activity and has been widely accepted as a critical element of the governance and strategic processes at financial institutions. The example I presented of how effective asset-liability management committees and processes can support business-line strategies as well as governance, is intended to illustrate that effective enterprise-wide risk-management processes are not built just to comply with regulations, such as banking regulations or Sarbanes-Oxley requirements in the United States. Rather, these processes can add value when they become an integral part of both strategic and tactical business-decision processes. Corporate strategies often focus on the “most likely” future scenario and the benefits of a strategic initiative. A sound governance, risk-management, and internal-control environment starts by stretching the strategic planning exercise to consider alternative outcomes. That is, while the strategy is being developed, management and the board should consider how risk exposures will change as part of the planning process. Then, appropriate controls can be built into the process design, the costs of errors and rework in the initial rollout can be reduced, and the ongoing initiative can be more successful because monitoring processes can signal when activities and results are missing their intended goals and corrective actions can be initiated more promptly. According to a global survey of governance at financial institutions conducted by PricewaterhouseCoopers (and reported in April), one of the reasons financial institutions are not making the grade is that they equate effective governance with meeting the demands of regulators and legislators, without recognizing that sound governance is also good for business.1 In other words, they tend to look at this as another compliance exercise. The study goes on to state that this compliance mentality is limiting these institutions’ ability to achieve strategic advantages through governance. I agree that any institution that views corporate governance as merely a compliance exercise is missing the mark. Over the years, corporate managers have learned that focusing on better process management and quality can enhance financial returns and customer satisfaction. They have learned that correcting errors, downtime in critical systems, and undertraining of staff all result in higher costs and lost revenue opportunities. I challenge you to consider the corporate governance structure appropriate to your bank’s unique business strategy and scale as an important investment, and to consider returns on that investment in terms of the avoidance of the costs of poor internal controls and of customer dissatisfaction. As you know, once an organization gets lax in its approach to corporate governance, problems tend to follow. We have some experience in that regard. Some of you may recall the time and attention that management of US banks devoted to section 112 of the Federal Deposit Insurance Corporation Improvement Act, which first required bank management reports on internal controls and auditor attestations in the early 1990s. Then the process became routine, delegated to lower levels of management and unresponsive to changes in the way the business was being run. Unfortunately, for organizations with weak governance, trying to change the culture again to meet Sarbanes-Oxley requirements is taking an exceptional amount of senior management and directors’ time - time taken away from building the business. The challenge, therefore, is not only to achieve the proper control environment at one point in time, but also to maintain that discipline and, indeed, ensure that corporate governance keeps pace with the changing risks that you will face in the coming years. One weakness we have seen is the delegation by management of both the development and the assessment of the internal-control structure to the same risk-management, internal-control, or compliance group. It is important to emphasize that line management has the responsibility for identifying risks and ensuring that the mitigating controls are effective - and to leave the assessments to a group that is independent of that line organization. Managers should be expected to evaluate the risks and controls within their scope of authority at least annually and to report the results of this process to the chief risk officer and the audit committee of the board of directors. An independent group, such as internal audit, should perform a separate assessment to confirm management’s assessment. Credit risk management The evolution of a portfolio approach to credit risk management has followed a path similar to that of asset-liability management. It began in the late 1980s, in the aftermath of serious credit-quality deterioration. Models and databases on defaults and credit spreads have since become more sophisticated, and loan review committees have evolved into committees that consider more broadly the various aspects of portfolio risk management. As a result, loans are priced better to reflect their varying levels of risk, they are syndicated and securitized to mitigate lenders’ risk, and credit derivatives have been created to limit credit-risk exposures that are retained. On that last topic, I would be remiss not to draw your attention to a recent consultative paper on credit-risk transfer issued by the Joint Forum in October. This consultative paper focuses on credit derivatives and related transactions - themselves an outgrowth of better risk measurement - and is open to public comment through January 2005. It documents the remarkable growth and innovation in these credit products, with aggregate notional value of $2.3 trillion and with about 1,200 regularly traded reference entities or “names.” The paper emphasizes that much more growth is likely, because these products are still in the early phases of their life cycle, and that the most important issue now facing market participants is the continuing development of their risk measurement and management capabilities. PricewaterhouseCoopers and the Economist Intelligence Unit, “Governance: From Compliance to Strategic Advantage,” (436 KB PDF) (April 2004). In that context, the consultative paper responds to three questions: whether the transactions accomplish a clean transfer of risk, whether participants understand the risks involved, and whether undue concentrations of risk are developing. Overall, the paper offers seventeen specific recommendations for improving the practice and supervisory oversight of credit risk transfer activity, drawing heavily on discussions with sophisticated market participants. I encourage you to review this paper and consider its recommendations seriously. Let me discuss two of them briefly. One recommendation is that firms understand fully and apply discipline to their credit models in order to ensure quality and manage the usage of these models appropriately. Correlation assumptions receive special attention here, including the growing presence of “correlation trading desks” and the observation from several market participants that there may be too much commonality in these assumptions across market participants. Insufficient diversity in views could lead to the kind of turmoil that occurred in markets for longer-term Treasury instruments in mid-2003. In that case, unexpected increases in rates led a large number of similarly positioned financial institutions to seek to take the same side of transactions simultaneously. Another recommendation is that participants properly understand the economic meaning of external ratings that are applied to credit risk transfer instruments, especially collateralized debt obligations or CDOs - as compared with ratings given to more traditional obligations. Identical ratings across different types of instruments do not guarantee identical risk characteristics, and in particular may imply equal probability of a loss event but unequal severity of loss. It is important to understand both the specific methodology used by the rating agency - which the agencies make available in extensive detail, including how default correlation is addressed - and the structure of a specific transaction in order to properly assess its contribution to a portfolio’s risk profile. Data integrity, broadly defined Even the best of processes suffers if the data used to measure risk and performance are flawed. In understanding the drivers of good risk management, qualitative factors are a critical influence on the reliability and characteristics of the “data” used to evaluate risk and performance. In this broader sense, “data integrity” can refer not only to the consistency, accuracy and appropriateness of the information in the data base and model, but also to the processes that produce and utilize these measures. Used this way, “data integrity” includes the quality of credit files, tracking of key customer characteristics, internal processes and controls, and even the training that supports them all. When one says “data integrity” in risk-management circles these days, most people think of the qualifying standards for the internal-ratings-based approaches to credit risk capital under Basel II. I think it is a broader concept, so let me spend a moment on that subject. The proposed timetable for US implementation of Basel II reflects the requirements of our rulemaking processes and the need for banks and supervisors to prepare for the introduction of the new standards. As you probably know, the US banking agencies envision formal release of the proposed regulations in mid-2005, with parallel running of Basel I and Basel II in 2007 and full implementation in 2008. Even on that timetable, the regulatory community recognizes that substantial data limitations may prevent banks from developing viable and robust parameter estimates in the near term - even for probability of default in some cases. For this reason, both banks and their supervisors will have to wait while data accumulate before banks can estimate and validate parameter inputs in a reliable, robust manner. In the interim, banks and supervisors will have to rely heavily on qualitative validation approaches although not entirely. Supervisors across countries are working together to address validation issues, and, I believe, will develop useful guidelines for banks and supervisors alike. In the early years, more weight may need to be placed on qualitative reviews of a bank’s internal policies and procedures, including its internal validation and documentation. But we expect that, soon after implementation, banks should have the ability to generate the needed parameters from actual data, and supervisors will want to see positive steps being taken by banking organizations to develop good databases to provide the sort of data integrity I am discussing. Qualitative and quantitative benchmarking studies, which compare methodologies and parameter estimates across banks, will be important tools for validation and for encouraging the diffusion of best practices throughout the industry during both the initial, more qualitative and the later more quantitative, intervals. But, as I noted, high-quality data are important for strong risk management, and not just for Basel II. Data are needed for other models and risk measures used in financial services, including credit scoring models, market-based measures such as KMV, and value-at-risk and other economic capital models. As you know, these economic capital models are a key element of Pillar 2. The broader concept of data integrity also applies to the development and maintenance of well-controlled processes including those that measure risk and performance. If the environment in which the models operate is not appropriate - if an institution considers internal controls just to be a checklist - its risk measures will not provide the performance it hopes to achieve. Accounting, disclosure, and market discipline Strong risk measurement and disciplined maintenance of data also improve the communication between the institution and its investors and counterparties. This sense of data integrity relates just as well to the information provided to these parties. I would like, now, to turn to some of the recent accounting issues surrounding complex instruments and the role of financial disclosure in promoting risk management. Some of you may have experienced earnings volatility resulting from the use of credit derivatives. Under US generally accepted accounting principles, credit derivatives are generally required to be recognized as an asset or liability and measured at fair value, and the gain or loss resulting from the change in fair value must be recorded in earnings. Most credit derivatives do not qualify for hedge accounting treatment, implying greater earnings volatility if the hedged portfolio or securities are carried at historic cost in their banking book. As a bank supervisor, I am concerned if the accounting treatment discourages the use of new risk-management financial instruments. You may be wondering if the answer to this volatility issue is fair value accounting. If the hedged asset were measured at fair value, the changes in values of the hedged item and the credit derivative would offset each other, reducing the volatility that arises when only the derivative is marked to market, depending of course on the effectiveness of the hedge. But some volatility is likely to remain, since it is the lack of close correlation that prevents hedge accounting treatment. The IASB developed the new “fair value option” under International Accounting Standard (IAS) 39, under which firms could mark to market both the credit derivative and the hedged position and report changes in their fair values in current earnings. While at first glance the fair value option might be viewed as the solution to addressing the problems of the current accounting model, it also raises a number of concerns. Without observable market prices and sound valuation approaches, fair value measurements are difficult to determine, verify, and audit. Reporting would become less comparable across institutions. Moreover, if an entity’s creditworthiness deteriorates significantly, there is potentially a peculiar result. In this circumstance, financial liabilities would be marked down to fair value and a gain would be recorded in the entity’s profit and loss statement. In the most dramatic case, an insolvent entity might appear solvent as a result of marking to market its own deteriorated credit risk. Many of these concerns, as well as recommendations to address them, were included in a July comment letter to the IASB from the Basel Committee.2 As heavy users of customer and investor corporate financial statements, bankers should also consider how a fair value measure may mask underlying reasons for the change in fair value. As institutions using IASB standards consider how to use the fair value option for their own financial reporting purposes, they should be aware of certain related complexities. For example, if loans are reported using the fair value option, changes in fair value would presumably affect loan loss allowances and thus regulatory capital, important asset-quality measures like nonperforming assets, and even net interest margins. One area in which improved disclosures by banking organizations are needed involves credit risk and the allowance for loan losses. As you know, a high degree of management judgment is involved in estimating the loan-loss allowance, and that estimate can have a significant impact on an institution’s balance sheet and earnings. Expanded disclosures in this area would improve market participants’ understanding of an institution’s risk profile and whether the firm has adequately provided for its estimated credit losses in a consistent, well-disciplined manner. Accordingly, I strongly encourage institutions to provide additional disclosures in this area. Examples include a breakdown of credit exposures by internal credit grade, allowance estimates broken down by key components, more-thorough discussions of why allowance components have changed from period to period, and A copy of the letter, dated July 30, 2004, can be found at www.bis.org/bcbs/commentletters/iasb14.pdf (59 KB PDF). enhanced discussions of the rationale behind changes in the more-subjective allowance estimates, including unallocated amounts. Thus, as both users and preparers of financial statements, bankers should encourage transparency in accounting and disclosure of risk positions. Conclusion In my remarks today, I have sought to encourage you to continue your efforts to support the evolution of risk measurement and risk management practices and to heighten the degree of professionalism that every effective risk manager should demonstrate. I want to leave by reminding all of you not to become so caught up in the latest technical development that you lose sight of the qualitative aspects of your responsibilities. Models alone do not guarantee an effective risk-management process. You should encourage continuous improvement in all aspects, including data integrity, legal clarity, transparent disclosures, and internal controls. For the risk managers at this conference, I hope the message you have heard is that you should be actively engaged with managers throughout the organization, talking about the merits of a consistent, sound enterprise-wide risk management culture. In doing so, you can help managers see that the risk-management process will allow them to better understand the inherent risks of their activities so that they in turn can more effectively mitigate these risks and achieve their profit goals.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the Andrew Brimmer Policy Forum: National Economic and Financial Policies for Growth, Employment, and the Improvement of Equity, at the 2005 Annual Convention, Allied Social Science Associations, Philadelphia, 7 January 2005.
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Roger W Ferguson, Jr: Interpreting labor market statistics in the context of monetary policy Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the Andrew Brimmer Policy Forum: National Economic and Financial Policies for Growth, Employment, and the Improvement of Equity, at the 2005 Annual Convention, Allied Social Science Associations, Philadelphia, 7 January 2005. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * In assessing the appropriate stance of monetary policy, policymakers must come to some judgment about the likely future course of economic performance and, especially, of inflation. To make this judgment, we find a useful concept to be the level of economic slack - defined as the difference between the current level of output and the level of output the economy could produce if all available resources were fully utilized. In many standard models of inflation, an economy operating above its potential is associated with upward pressure on inflation, and an economy operating below its potential is associated with downward pressure on inflation. Unfortunately, economic slack cannot be measured directly but must instead be inferred from the variables we do observe. Labor market measures have traditionally been a valuable source of information about economic slack. In particular, statistics like the unemployment rate can tell us something about the amount of available, but as yet unused, labor in the economy. But even this relation - between the unemployment rate and the concept of economic slack - is not necessarily constant, and thus a given unemployment rate may not indicate the same level of slack at two separate times. For example, shifts in the composition of unemployed individuals across different skill levels, industries, or occupations relative to the demand for workers with these characteristics can complicate this relationship, as can changes in the behavior of the individuals who are out of work. Moreover, the possibility of a change in the relationship between the unemployment rate and economic slack is likely to be greater - and thus the signals from the labor market may be harder to read - when the labor market behaves atypically, as in many respects it has behaved over the past three years. A particular question that is difficult to answer is whether the slow recovery of employment has left significant underutilized resources in the economy that could be readily re-employed, or whether the lag in hiring indicates that the supply of those resources is relatively less forthcoming given the state of demand? In this context, I would like to discuss two aspects of the recent labor market downturn that have received considerable attention and that have the potential to alter the relation between economic slack and the unemployment rate. The first is the possibility that the extended weakness in the labor market reflects permanent shifts in the composition of jobs - which is often referred to as industrial restructuring. The second development I will address is the decline in labor force participation in recent years.1 I should note, my comments today reflect only my views and should not be taken to represent the views of my colleagues on the Board of Governors or in the Federal Reserve System. Industrial restructuring I will begin by providing some background on the current labor market recovery. As shown in chart 1, which plots the level of private payroll employment relative to its level at the end of recessions, as dated by the NBER, and compares employment performances across recoveries, the current recovery in employment has been unusually slow - well below the average and even slower than during the “jobless recovery” of the early 1990s. This relatively poor employment performance has been due primarily to weak job creation. Though the rate of job destruction (chart 2, upper panel) rose at the beginning of the recession, it soon dropped below that seen immediately before the recession. In contrast, the pace of job creation (lower panel) continued to fall until the end of 2003, when My presentation today is based on work with Andrew Figura, Bruce Fallick, and William Wascher. employment finally began to turn up. Finally, as chart 3 shows, the rise in the layoff rate since the end of 2000 has been due primarily to an increase in permanent layoffs. To many observers, the coincidence of a large share of permanent job losses and sluggish job creation indicates a pronounced shift in the optimal allocation of workers across firms or industries that is, an elevated pace of economic restructuring. The basic story is as follows: Permanent reductions in employment in declining industries require workers to search for new jobs, a process made difficult and more time consuming by the likelihood that the skills these workers acquired on their previous jobs may be ill-suited to sectors of the economy in which labor demand is rising. Although some workers may accept whatever job is available - whether or not it meets their longer-run expectations for wages, benefits, or stability - our unemployment insurance system provides enough protection that many will search longer for a good match and thus remain out of work longer. Moreover, creating new jobs in expanding industries requires businesses to invest, and the most recent recovery was marked, for some time, by a reluctance of businesses to do so. A slowing in the pace of job creation resulted in limited new opportunities available to these displaced workers. Though these stories sound plausible, restructuring is, in practice, difficult to measure, and alternative measurement techniques have led to very different conclusions about the amount of restructuring that has occurred in recent years.2 For example, both Groshen and Potter (2003) and Aaronson, Rissman, and Sullivan (2004) construct summary measures of the extent of restructuring. While the Groshen-Potter measure shows an elevated level of restructuring in recent years, the Aaronson-Rissman-Sullivan measure indicates that the labor market has not experienced an unusual amount of restructuring recently. These authors will present updates of their earlier research at these meetings. Taking a somewhat different approach than previous analyses, we attempted to identify those industries that have performed especially poorly since the 2001 business cycle peak and assess whether these underperforming industries have been characterized by restructuring. We judged the performance of each industry according to two criteria: (1) an industry’s net employment change from March 2001 to November 2004, and (2) the change in an industry’s share of total employment between March 2001 and November 2004 compared with the change in employment shares exhibited over a pre-peak period of similar length.3 Table 1 ranks the performance of two-digit NAICS industries since March 2001 according to the first measure of underperformance. In an absolute sense, the poorest performing industries include durable and nondurable manufacturing, the information sector, retail trade, transportation and warehousing, and professional and technical services. Moreover, four of those six industries - durable manufacturing, information, transportation and warehousing, and professional and technical services also ranked among the six poorest performers according to the second criterion, which is based on relative performance. Table 1 Underperforming industries in terms of the change in employment since the latest cyclical peak (March 2001) Industry Performance ranking1 Durable manufacturing Nondurable manufacturing Information Retail trade Transportation and warehousing Professional and technical services Wholesale trade Company management Utilities Natural resources and mining Arts, entertainment, and recreation Real estate and leasing Construction Administrative support and waste Other Finance and insurance Education Accommodations and food services Health care and social assistance Note: Underlined industries ranked poorly according to both measures of underperformance. A higher rank indicates worse performance. The latter measure helps to distinguish industries that are in long-term decline (for example, textiles) from the industries that may have experienced a more recent episode of restructuring. It also allows us to identify those industries that have had upward trends but that have experienced a period of relatively weak job growth in recent years. Anecdotally, most of these industries can be associated with elements of restructuring. Within the information industry, for example, telecommunications has suffered from overcapacity - and significant downsizings or business failures - since the cyclical peak. Similarly, transportation includes the airline industry in which many firms have been under stress, and professional and technical services includes several industries that complement business investment and likely suffered in the wake of the sharp slowing in spending on equipment and software early this decade. Within durable goods manufacturing, computers and electronics, primary and fabricated metals, and machinery rank particularly poorly according to our criteria of underperformance, and these industries have also been identified with restructuring in recent years. Corroborating this anecdotal evidence, the durable manufacturing, information, and professional and technical services industries are also among the top six contributors to the post-peak increase in the aggregate permanent layoff rate. These underperformers are also at the top of the list of industries that experienced significant rates of job destruction during the labor market downturn of 2001 and 2002. In fact, the four industries that, according to our two criteria, were the key underperformers in recent years more than accounted for the overall increase in the average pace of job destruction between 1998-2000 and 2001-02. Finally, the relationship between our measures of underperformance and industry productivity growth is also informative about the importance of restructuring. Typically, productivity falls with employment in recessions, as firms - hesitant to sever ties to workers who will be valuable to them when demand recovers - reduce employment less than output. However, if firms perceive changes in demand to be permanent, the reluctance to reduce employment in proportion to output should diminish. In fact, productivity growth from 2000 to 2002 in the four key underperforming industries was not lower, on average, than in industries not experiencing large reductions in labor demand, supporting the notion that firms in these industries believed demand changes to have been permanent. Moreover, labor market underperformance, in general, was associated with slightly greater productivity growth between 2000 and 2002; this association suggests that underperforming industries reacted to changes in labor demand by destroying their least productive jobs - which is also consistent with the restructuring hypothesis. If our hypothesis that restructuring is associated with our four key underperforming industries is correct, the influence of this restructuring on aggregate labor market outcomes would be substantial. These industries, though together composing just 25 percent of private employment, accounted for net job losses totaling nearly 2.6 million from the March 2001 business cycle peak through November 2004 (compared with a net decline of 1.2 million jobs for the private sector as a whole) and for about half the deterioration in the average monthly employment change over this period relative to the average pace before the peak. Given this evidence that restructuring has been a notable feature of the labor market landscape in recent years, it is also worth assessing the relevance of some possible explanations for the high proportion of permanent job losses over this period. These explanations include technological change, international competition, offshoring of less productive jobs, and large industry-specific demand shocks, perhaps related to the 2001 terrorist attacks or the earlier overoptimism in the high-tech sector. To gauge the importance of these various explanations, we first examined the relationship between industry employment and industry output using data for sixty three-digit NAICS industries. As can be seen in chart 4, which plots the change in employment shares from 2000 to 2002 against the change in value added shares over the same period, there is a strong positive correlation between these changes, both for all industries and for the subset of industries that make up the four restructuring sectors we identified previously. In the chart, industries in this subset, designated with an R, are bunched in the lower left quadrant - an indication that most experienced declines in both employment and output shares over this period. These positive correlations suggest that restructuring has been caused mainly by adverse industry demand shocks rather than by positive supply shocks, although as I will highlight later, there are some exceptions. One possible source of these adverse demand shocks is increased international trade. To assess the potential relationship between international trade and restructuring, we examined correlations between changes in import and export shares and changes in employment shares for two-digit manufacturing industries for the period from the start of the recession to the third quarter of 2004. We found it difficult to discern any clear relationship in the data; this lack of clear relationship suggests that international trade has not been an important determinant of the recent pattern of underperformance in the labor market. Martin Baily and Robert Lawrence (2004) present a much more thorough analysis of this issue and come to a similar conclusion.4 To investigate further the relationship between restructuring and labor productivity, we compared the performance of industry employment to the performance of industry productivity for the period from 2000 to 2002 (chart 5). The fact that some industries experienced large declines in employment share and well-above-average gains in productivity suggests that adverse demand shocks may not be the only source of restructuring. Indeed, these industries include computer systems design, information and data-processing services, and publishing (which includes software) - all high-tech categories that have been associated either with positive technology shocks or with the outsourcing of low-productivity jobs. The criteria we use to identify restructuring industries are not designed to capture long-standing restructuring associated with foreign competition, such as in the textile industry. Also, both anecdotal evidence and the Bailey and Lawrence study suggest that foreign competition in the past couple of years has been an important factor for some industries. Overall, the evidence points to several tentative conclusions. First, although a period of permanent employment declines is admittedly difficult to distinguish from an extended period of cyclical weakness, the data, on balance, seem to indicate that restructuring has been an important characteristic of the post-2000 labor market downturn. Second, except for a few high-tech industries, restructuring appears to have been caused primarily by adverse shifts in the demand for the output of restructuring industries rather than by positive supply shocks. Finally, any slowing of the current labor market recovery from restructuring, if indeed restructuring has played such a part, has likely been due to a slow transition of workers from restructuring industries to expanding industries rather than a slow pace of restructuring in declining industries. The last conclusion is based on the absence of a positive relation between employment share changes and industry productivity growth and on the high rates of job destruction in underperforming industries, both of which suggest that restructuring industries responded aggressively to adverse demand shocks. Labor force participation As I noted at the outset, a second anomaly that may have influenced the recent relationship between the unemployment rate and economic slack is the behavior of the labor force participation rate. Although the participation rate - adjusted for trend movements - tends to decrease when job prospects are poor, recent declines have well exceeded the cyclical norm. In addition, though the unemployment rate has fallen since the middle of 2003, the participation rate currently remains near the low point reached in the first half of 2004. Together, these facts raise the question of whether economic slack is being reflected increasingly in the participation rate rather than in the unemployment rate. The answer to this question hinges on whether the recent declines in participation have been due to cyclical or to more-permanent factors. Distinguishing very long-term or permanent changes in labor supply from cyclical movements is difficult, but some information can be brought to bear on this issue. First, demographic changes seem not to be an important explanation of the decline in the participation rate. In general, one might expect the aging baby-boom generation to put downward pressure on the participation rate, as this cohort moves into their retirement years during which participation rates have traditionally been lower. Although this possibility is clearly a concern for the future, changes in the age composition of the population have, thus far, not accounted for much of the drop in the participation rate. Instead, the low participation rate reflects pronounced declines in participation rates for a number of demographic groups, most notably teenagers and young adults, as well as individuals between the ages of 25 and 44. In addition, as can be seen in chart 6, the timing of the downturn in labor force participation lines up closely with the weakening of economic activity that began in the second half of 2000. This concordance suggests that the recent weakness in participation is more likely to be associated with this business cycle than with an emerging downward trend, although one obviously cannot rule that out. Finally, we can perhaps learn something from the reasons that individuals give for being out of the labor force. As shown in chart 7, the proportion of the population who say that they are out of the labor force because they cannot find a job has increased only slightly. Instead, the rise in nonparticipation since 2000 is associated with an increase in the proportions of individuals attending school, reporting themselves as ill or disabled, or retired. Whether these patterns are more indicative of cyclical or of structural changes in participation is difficult to pin down, however. Although the absence of a sizable increase in discouraged workers might be viewed as evidence against a cyclical interpretation, the rise in school enrollment may reflect a decline in the opportunity cost of attending school associated with the lack of new job opportunities in a weak labor market. Similarly, the increase in disability rates - or even, to some extent, retirement rates - could have both cyclical and structural elements. In sum, the available information is far from definitive. The absence of any clear demographic shift suggests that at least some portion of the unusually large declines in labor force participation has been associated with this business cycle. Nevertheless, individuals who have recently exited the labor force likely have weaker ties to the labor market than currently unemployed individuals. Thus, it is an open question how quickly, if at all, recent increases in nonparticipation due to schooling, disability, or retirement will be reversed. Restructuring and participation As the number of puzzles concerning the labor market increases, so does the complexity of analysis necessary to relate observed variables to concepts relevant for monetary policy. Thus, it seems worthwhile to ask whether restructuring and the decline in participation might be part of the same phenomenon. Such a relation does not seem implausible. As I noted previously, restructuring destroys human capital specific to firms and industries and thus can significantly reduce the job opportunities available to some workers. As the benefit to remaining in the labor market falls, these individuals may become discouraged or choose to spend their time on activities outside the labor market, one of which may be schooling or retraining to prepare for future reentry to the labor force. To investigate this possibility further, we examined data from the most-recent displaced worker survey. Table 2 shows the proportions of displaced workers from restructuring and nonrestructuring industries (according to our classification scheme), as well as the shares of employment for these two groups of industries.5 Qualitatively, the data are similar to those I have already presented: displaced workers come disproportionately from restructuring industries. Of course, since more than half of displaced workers come from other industries, restructuring at the industry level is, by no means, the only cause of worker displacement. It is also true that displaced workers were more likely than other job losers to have been out of the labor force in January 2004. Putting these facts together, it would not be unreasonable to infer a linkage between restructuring and the decline in the participation rate. Table 2 Distribution of employment and of displaced workers by industry category Industry Employment Displaced workers Restructuring 23.1 42.2 Nonrestructuring 76.9 57.8 Total Source: Displaced Worker Supplement to the CPS. The labor market and monetary policy Let me conclude my talk as I began it, stressing the importance to monetary policy of measuring economic slack. As I’ve discussed, how much slack is indicated by the unemployment rate and other labor market data depends both on the extent of industrial restructuring and on the causes of the recent sharp declines in labor force participation. I believe that restructuring has been a visible part of the recent downturn and that much of the recent unusual behavior of labor force participation reflects cyclical forces. However, how we should adjust our interpretation of the unemployment rate as a measure of economic slack depends on the magnitudes of these effects, about which much uncertainty remains. In such a situation, I view the conduct of monetary policy as a balancing of risks. One risk is that industrial restructuring has been quite extensive. Because restructuring decreases the value of human capital that is specific to downsizing industries, it acts, in effect, as a negative supply shock, temporarily depressing the level of employment as the workers displaced by restructuring must either search longer to find a job appropriate for their skills or seek retraining. An additional risk is that declines in labor force participation have been predominantly structural, so that many of the individuals who have exited the labor force over the past three years will be unlikely to return, at least in the near- Displaced workers are defined here as those individuals who, at some point between 2001 and 2003, permanently lost a job on which they had at least three years of tenure. term. Under such conditions, the amount of economic slack could be very small, and thus expansive monetary policy could lead to a pickup in inflationary pressures. Alternatively, restructuring, though ongoing, may have resulted in relatively little mismatch between the skills needed in restructuring industries and the skills demanded in expanding industries and, thus, should not impede job creation. In addition, although the prolonged slow recovery in hiring may have taken a greater toll on worker confidence than in earlier cycles, those workers who have recently exited the labor force may not have significantly reduced their availability for work. In this scenario, a substantial pool of unused labor may remain in the labor market, and an overly restrictive monetary policy would prevent the economy from moving as quickly as possible to the level of full employment. As you can see, transforming the information available from published statistics into concepts useful for assessing the consequences of monetary policy is, in fact, quite complex. And, the evidence is more ambiguous than one would like, indicating that it would be unwise to assume that labor market indicators are complete predictors of slack. Nevertheless, I believe that our ability to interpret labor market statistics will continue to benefit greatly from additional research on the topics I have discussed today and from the exchange of ideas that this type of forum encourages.
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Annual Meeting of the American Economic Association, Philadelphia, 7 January 2005.
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Ben S Bernanke: Panel discussion - the transition from academic to policymaker Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Annual Meeting of the American Economic Association, Philadelphia, 7 January 2005. * * * I appreciate the opportunity to reflect on my two and a half years as an academic turned policymaker. One difference I have noticed since moving to Washington is that people seem to find my ideas and insights of greater interest than they used to - although, so far as I know, I have not become any smarter in the past few years. This increase in interest is particularly marked in regard to my views on current policy issues and the economic outlook. So, for the sake of truth in advertising, I should say at the outset that I will not be commenting on current issues today, except in the most general terms. Instead, keeping with the theme of this panel, I will offer a few thoughts on my transition from academia to the policy world - in particular, how the former experience has prepared me for the latter. Obviously, I will be speaking for myself and not the Federal Reserve Board. I should also note that my policy experience has been limited to my time at the Federal Reserve - in some ways, a unique institution in Washington - and may not generalize to other contexts. I always thought I would be an academic lifer. I went straight to graduate school from college and never considered any job other than an academic position when I graduated. Before I was appointed to the Board of Governors in August 2002, my adult work experience consisted of six years teaching at Stanford’s Graduate School of Business, seventeen years at Princeton (a joint appointment in the economics department and the Woodrow Wilson school of public policy), and several years spent as a visiting faculty member at other institutions, including MIT (my graduate alma mater). The sum of my political experience consisted of two terms on the local school board, six grueling years during which my fellow board members and I were trashed alternately by angry parents and angry taxpayers. On the administrative side, I served seven years as the chair of the Princeton economics department, where I had responsibility for major policy decisions such as whether to serve bagels or doughnuts at the department coffee hour. Academia appealed to me as a young person because of the freedom it offered to explore old ideas and develop new ones. I also liked the relaxed dress code. The biggest downside of my current job is that I have to wear a suit to work. Wearing uncomfortable clothes on purpose is an example of what former Princeton hockey player and Nobel Prize winner Michael Spence taught economists to call “signaling.” You have to do it to show that you take your official responsibilities seriously. My proposal that Fed governors should signal their commitment to public service by wearing Hawaiian shirts and Bermuda shorts has so far gone unheeded. Although the dress code continues to be a drawback, I am pleased to be able to report that the intellectual challenges of my new job have been as rewarding as those I encountered as an academic. The Federal Reserve’s responsibilities are quite broad, including not only monetary policy but the regulation and supervision of banks, oversight of the payments system, the making and enforcement of various regulations to protect consumers in their financial dealings, and the promotion of financial stability generally, among others. Getting up to speed on these diverse topics required some concentrated effort on my part. Much of what I had to absorb was institutional detail - some interesting, some less so - but I have also come to appreciate that the dictum that “the devil is in the details” applies with great force to all serious policy work. My academic training has helped considerably by leading me always to focus on the underlying conceptual framework on which the legal, procedural, and institutional details depend. With an underlying framework in mind, seeing what is at stake and making a reasonable and coherent decision on a policy issue becomes easier, though rarely easy. The development and implementation of consumer protection regulation provide one example. As economists, we have a predisposition in favor of free markets, but we also understand that missing or asymmetric information can undermine the efficiency and fairness of market-determined allocations. Financial contracts are inherently complex and consequently difficult for consumers to understand fully, even if the other party to the contract has no intention to mislead or deceive. From an economist’s perspective, the proper objective of consumer protection regulation is not to prohibit voluntary financial transactions but to ensure that consumers receive the information they need to make rational decisions at the lowest possible social cost. Setting industry standards for what information must be disclosed to consumers and, perhaps, for the format of the disclosure is one means by which a regulator can achieve this objective. Ideally, a regulator like the Federal Reserve serves as a coordinating device to help financial institutions as well as consumers minimize informational problems and transaction costs in the financial marketplace. Following guidelines established by the Congress, the Fed and other regulators can also improve market functioning by clarifying property rights of various kinds - for example, by making rules about the use of personal information collected in the course of financial relationships. Of course, to achieve its social objectives as efficiently as possible, a regulator needs to gather as much information as it can from market participants. The Fed never imposes a substantive regulation without extensive consultation with those who will be affected - in this case, both financial institutions and consumers - through formal comment periods, policy advisory groups, and a variety of more-informal contacts. Bank supervision and regulation, also a major responsibility of the Fed, provides another example of how conceptual frameworks developed by researchers inform the policy process. Many economists (myself included) have studied the special features of the banking industry, documenting its important role in the economy but also noting the potential instability of institutions that finance long-term, illiquid investments with short-term, liquid deposits. Deposit insurance and other government protections reduce the risk of banking instability but create the potential for moral hazard and other problems. The challenge for bank supervisors is to ensure the safety and soundness of banking institutions - that is, to minimize moral hazard and to protect the deposit insurance fund - without inhibiting economically valuable activities or technological innovation by banks. Designing regulations to accomplish these objectives has become markedly more difficult as banking organizations have become larger and more complex. The new Basel II international capital accord, which the Fed helped to design in collaboration with other banking regulators from the United States and around the globe, may well be the most economically sophisticated regulation scheme ever devised.1 The new system is designed to use information provided by the banks themselves about their loss experience, together with algorithms that mimic the most up-to-date risk-management techniques, to establish minimum capital standards for banks that approximate the appropriate level of economic capital. In addition, Basel II provides for enhanced supervisory oversight and public disclosure of financial information by banks. As many economists have noted, greater transparency on the part of financial institutions improves the efficiency with which financial markets price financial claims on banks, including equity and subordinated debt. By aggregating private-sector information about banks’ financial condition, prices and yields determined in financial markets may in turn provide important information to regulators. Difficult challenges lie ahead in implementing the new capital accord, and I do not want to enter into a full discussion of the many issues raised by Basel II today. My point here is only that Basel II is not your grandfather’s bank regulatory scheme; it is an approach that draws on the most sophisticated financial methodologies as well as on extensive research on banking and bank supervision. As with most other policy issues, getting the myriad details right will be critical to the success of this new regulatory regime. But the general design of Basel II owes a great deal to research conducted both in academia and in central banks. As in the case of consumer financial regulation, I have found my academic background to be quite helpful for understanding the critical issues in bank supervision policy. I have enjoyed very much being introduced to the wide range of Fed policy activities. However, because my professional background is in macroeconomics and monetary economics, monetary policy remains for me the most interesting aspect of my job at the Fed. Once again, I have found the knowledge and habits of thinking developed in my academic days to be quite useful. The models and forecasting methods used by the Federal Reserve staff, for example, draw heavily on decades of academic research and thus feel comfortably familiar. Academic research (by which I mean to include technical research done in central banks and other non-academic institutions) also bears directly on many strategic aspects of monetary policymaking. For example, the Federal Open Market Committee has recently been engaged in developing its communications strategy, a topic which I believe to be of vital importance and on which I have spoken on numerous occasions. My thinking on this and As a member of the Basel Committee, Fed Vice Chairman Roger W. Ferguson, Jr., has played a particularly key role in the development of Basel II. numerous other aspects of monetary policy is heavily influenced by contemporary research in monetary economics, as can be seen by the footnotes and citations in my speeches. A part of monetary policymaking for which my background left me imperfectly prepared is what central bankers call “current analysis.” One of the biggest practical challenges of making monetary policy and a prerequisite for any serious forecasting exercise - is getting an accurate assessment of the current economic situation. Doing this well requires a deep knowledge of the data mixed with a goodly dose of economic theory and economic judgment. Members of the Board staff continuously analyze the arriving data to learn what they can about the level and composition of economic activity, inflation, and other key aggregates. At the most mechanical level, this exercise requires a detailed understanding of how the U.S. statistical agencies use the information in current data releases to estimate economic aggregates - how the components of retail sales are linked to estimates of personal consumption, for example. But often the linkages between data releases and the key economic aggregates are not so straightforward. For example, drawing the implications of a surprisingly favorable employment report for consumer spending requires the analyst to take a view on how households are likely to respond to increased labor income and improved labor market conditions. A certain amount of uncertainty in the estimates is unavoidable, of course; indeed, identifying the sources of uncertainty is an important part of the analysis. However, the requirements of internal consistency - production must always equal sales plus inventory investment, for example provide numerous cross-checks and substantial discipline on this process. More generally, all of us involved in the monetary policy process must try to synthesize a range of disparate information, including official data, anecdotes, and qualitative developments, to construct a “story” about how the economy is evolving: What forces are determining economic activity now, and what do they portend for the future? Chairman Greenspan is, of course, a master of current analysis and near-term forecasting, and many members of the National Association for Business Economics have finely honed these skills as well. Current analysis is not taught in graduate school, probably for good reason; it seems more amenable to on-the-job training. It is, nevertheless, an intellectually challenging activity - analogous, it seems to me, to the efforts of a detective to reconstruct a sequence of events from a range of diverse and subtle clues - and I have enjoyed the opportunity to become more proficient at it. I will close with a personal observation. In focusing today on the substantial intellectual continuities between academia and the policy world, I have not yet mentioned an important aspect of the policymaker’s job: the satisfaction of public service. For me, knowing that I am using my skills to further the commonweal and the national interest is an important compensation for the personal sacrifices that a policy position can entail - a view that I know to be widely shared among my colleagues at the Federal Reserve. Whether you are a veteran economist or just starting out in the profession, I urge you to consider seriously any opportunity that arises to serve in a policymaking capacity, be it as a principal or as a supporting staff member. You will feel good about it, and you will learn a lot.
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Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Annual Meeting of the American Economic Association, Philadelphia, 9 January 2005.
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Donald L Kohn: Central bank communication Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Annual Meeting of the American Economic Association, Philadelphia, 9 January 2005. * * * A basic tenet of economics is that markets work better - reflect underlying economic forces, efficiently allocate resources - with more information. Because central banks are key players in financial markets, a better public understanding of central bank behavior should improve pricing in those markets. Over my career, I have witnessed notable efforts by central banks to improve the public’s understanding of their behavior by increasing the amount of “talk” they do about policy and the economy. The trend toward more talk reflects several interrelated developments. The demand for information has expanded along with the size and sophistication of financial markets; financial assets have increased far faster than gross domestic product, and a much greater variety of instruments are priced. At the same time, rising wealth has meant that increasing numbers of people have a stake and an interest - in the forces determining the prices in those markets. Technological change including the ubiquitous Internet - has made it easier to cater to and feed this interest by making more information available more quickly and cheaply. And, in part as the result of academic progress on the topic, central banks better appreciate that more-accurate expectations of market participants can help improve the performance of the economy and the achievement of economic objectives. Changes in the political environment surrounding central banks have reinforced the increased demand for transparency. Greater support for independent central banks with goals set by the political process was one of the results of the lessons of the great inflation of the 1970s. But an arm’s-length distance from immediate political pressures requires accountability and reporting to elected representatives. The quid pro quo is most evident in many of those countries that have shifted to inflation targeting, but the United States followed the same pattern earlier - in the late 1970s. In that period, laws for the first time established goals for monetary policy, albeit not as specific as inflation targets, and imposed reporting requirements in the form of reports and testimony to the Congress. Given the trends I have mentioned and the benefits of greater transparency, people sometimes wonder why central bank transparency has evolved as slowly as it has and why some central banks do not take additional steps to talk more - especially about what they see coming in the future. I will give you my own answer to this question, which I hasten to add, does not necessarily reflect the views of my colleagues on the Federal Open Market Committee or its staff.1 The answer, I believe, is that more is not necessarily always better, and at each step of the way central banks have needed to take account of the potential costs as well as the benefits of greater transparency. One consideration involves the nature of information and its relationship to market pricing. In fact, economists do not fully understand how markets incorporate information. Herding behavior, information cascades, multiple equilibria, and the amount of investment in financial research all pose puzzles about markets and information. The situation is complicated still more when an important participant is seen as having superior information owing to its investment in research or its understanding of its own behavior. In such circumstances, certain types of central bank talk might actually impinge on welfare-enhancing market pricing by being misunderstood and receiving too much weight relative to private judgments. We need to be particularly careful that people understand how limited our knowledge actually is - the uncertainty and conditionality around any statement we make about future developments. Moreover, what we are doing is complicated and involves weighing many factors; we should not misrepresent it for the sake of clarity in communication. The publication of useful information is complicated further by the fact that, in most countries, policy is made by a committee; representing the thinking of a diverse group is difficult and limits what can be said. Vincent R. Reinhart, of the Board’s staff, provided valuable advice and comments in the preparation of these remarks. A second type of consideration that has constrained the pace of increase in transparency is its potential interaction with monetary policy decisions. What we say is important, but what we do over time will ultimately determine economic outcomes. We should not allow a desire for clarity of expression to deflect our decisions from those that would contribute best to overall economic performance and which may be difficult to explain easily. And we must take care that policy expectations engendered by communication do not unduly constrain policy action. Furthermore, we cannot allow transparency to limit discussion in the Committee out of concern about how its publication will affect markets and the economy. Every decision about additional transparency is a balancing of possible costs and benefits. The preexisting structure of central bank talk reached its state for particular reasons; changing it entails adjusting the balance that previous Committees found. And reversing movements toward greater communication in the event of unforeseen consequences could be difficult. But circumstances change; markets change; we gain experience through our own actions or those of other central banks. More information, generally, is better, and markets and central bank governance have greatly benefited from the steps taken around the world to increase transparency over recent decades. Talk about “Policy inclination” and “Economic outlook” How many central banks weigh the costs and benefits of additional transparency can be illustrated by differentiating communication along the lines offered in the paper Brian Sack and I wrote that is part of this session.2 We separated the effect of talk between policy inclination - the likely near-term path of the policy interest rate - and the economic outlook - the evolution of prices and output over the intermediate and longer term. Experience shows that central bankers generally have been much more comfortable talking about the economic outlook than about policy inclination. Policy inclination This difference in comfort level relates in part to our evaluation of the interaction of each type of talk with market prices. The risks seem more sizable that markets will overweight our discussion of the possible path of policy interest rates than they will our discussion of the economic outlook. After all, if we possess any private information, it is most likely to be about the steps we might take in the immediate future. But we are concerned that markets will not appreciate the degree of conditionality behind our expectations in this regard and take them as a firmer precommitment than they were intended to be. The market reaction to our words could well be heightened by the behavior of market analysts, who tend not to place probabilities on their predictions of our actions over the next few meetings but instead tend to make “zero/one” calls. In any case, the risks of herding, of overreaction, of too little scope for private assessments of economic developments to show through, would seem to be high for central bank talk about policy interest rates. Because of concern about market interpretation, policymakers often see talk about policy inclination also as having the potential for constraining future decisions in ways that might interfere with the mosteffective achievement of policy objectives. The stronger the market expectations about near-term policy actions, the greater the risk of roiling markets and creating confusion in the event the decision differs from those expectations. The possibility that discussions of future policy, even nonspecific, could create presumptions about a string of policy actions makes finding a consensus among policymakers on what to say about future interest rates quite difficult - more so than agreeing on the policy today. It is no accident that the Reserve Bank of New Zealand stands out as about the only central bank to publish such a path and as one of the few in which decisions are the responsibility of only one individual. Sack and I found that actions, not words, dominated the policy inclination factor. However, the study was completed before the Federal Reserve became more explicit about future policy rates in the summer of 2003. Donald L. Kohn and Brian P. Sack (2003), “Central Bank Talk: Does It Matter and Why?” Finance and Economics Discussion Series 2003-55 (Washington: Board of Governors of the Federal Reserve System, November). The unusual situation at that time shifted our assessment of the balance of costs and benefits in favor of a public statement about our expectations for the near-term path of policy. Markets appeared to be anticipating that inflation would pick up soon after the expansion gained traction, and therefore that interest rates would rise fairly steeply. This expectation was contrary to our own outlook. We saw economic slack and rapid productivity growth keeping inflation down for some time. Our expectations about policy also took account of the fact that the level of inflation was already low - lower than it had been for several decades. We thought that our reaction to a strengthening economy would be somewhat different this time than it had been in many past economic expansions and unlike what the markets seemed to anticipate. Under most circumstances, this sort of disconnect between the central bank and the markets would not be a big problem; we could compensate for the market’s tendency to raise intermediate and longterm rates unduly by keeping policy easier for longer. But with the federal funds rate already at 1 percent, our scope for that was limited; and if the economy suffered any downward shocks, policy could reach the constraint of a zero federal funds rate, with uncertain consequences. Under these circumstances, giving markets more information about our policy inclination, and thereby holding down longer-term interest rates, seemed to be the less-risky way to stabilize inflation at a reasonable level and encourage a vigorous expansion. I would judge the outcome to have been successful. We did influence rates to better reflect the actual path of policy; economic outcomes have been good; and, to date, our discussion of the path for rates has not constrained our actions.3 That is partly because we have been able to pull back gradually on the degree of commitment on our near-term actions in a way consistent with incoming data and without roiling markets. As the FOMC’s minutes make clear, however, our experience has also illustrated how difficult it can be for a diverse committee to talk about the future course of rates. I take from this experience the lesson that, despite their drawbacks much of the time, conditional statements from the central bank about the near-term course of policy can be useful in certain circumstances. These circumstances might include a situation in which the policymakers and the markets seemed to have substantially conflicting forecasts about the economy and the path of policy; such differences persist despite the central bank’s efforts to explain its outlook; and the effect of those divergent views on financial conditions threaten to detract from economic performance. Economic outlook Monetary policy committees generally judge the costs and benefits of talking about the economic outlook much more favorably than discussing the path of rates. Of course markets can often infer from a discussion of the economy how the central bank thinks rates will evolve. But limiting communication to the economic outlook allows the markets to work out an expected path for rates by combining the central bank’s judgment about the economy with its own and with its understanding of the central bank’s reaction function. This gives greater scope for private assessments to show through to market prices, which itself can be helpful to a central bank trying to gauge public attitudes and expectations. In my view, the most useful service the central bank can provide in this arena is its analysis of the forces bearing on the outlook - the determinants of aggregate demand, potential supply, and inflation. This type of discussion can help the public interpret developments and allow markets to respond constructively to surprises in the data. Forecasts can be used as a framework for such a discussion, but the public should appreciate the limits of a numerical forecast. The relationship of the forecast to the policy decision is loose. Inevitably, point forecasts will be incorrect; they should be seen as the centers of wide distributions of possible outcomes; and low-probability outcomes can be very important in policy decisions in certain circumstances. Moreover, quite often, the FOMC can reach a consensus on policy without reaching one on a specific forecast - only a general agreement on the general degree of strength in economic activity and the likely tilt to inflation if alternative policy paths are chosen. A discussion of the effect of these statements on interest rates is in Ben S. Bernanke, Vincent R. Reinhart, and Brian P. Sack (2004), “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment,” Finance and Economics Discussion Series 2004-48 (Washington: Board of Governors of the Federal Reserve System, September). Sack and I note the power of even nonspecific central bank talk about the economic outlook to greatly influence expectations embodied in intermediate- and long-term interest rates. Is it too much, as some argue?4 Is central bank talk about the economy crowding out other legitimate perspectives? This is an empirical question, and I do not think we yet have the studies to provide an answer. One way to frame the question would be to ask whether market forecasts over the intermediate and longer run have improved or deteriorated as central banks have ramped up their talk. I suspect that the greater provision of informed analysis from central banks has led to an improvement. In the United States, we have some indirect evidence that crowding out of private views has not increased even as the Federal Reserve has become more talkative. Market interest rates have continued to respond substantially to surprises in economic data. The degree of the reaction to individual indicators has risen or fallen depending on the economic situation and the focus of policymakers; for example, the reaction to price data decreased in recent years as low, steady inflation became more firmly established, and the reaction to labor market data increased as the “jobless recovery” became more of a focus. But we do not see a general falloff in the strength of response, as one might expect if markets were relying more on central bank views and less on their own interpretation of data. That markets continue to react strongly to incoming data is not surprising. Predicting interest rates far enough into the future is not just about what others - including the central bank - think; over time those rates should be tied to objective factors - for example, the forces of productivity and thrift. Differing views about these factors give scope for opportunities to profit from independent research and betting against the crowd. Earlier release of the minutes As evidence that our communication policy is a work in progress, the FOMC has recently shifted its views in favor of expediting the release of its minutes.5 Minutes of FOMC meetings necessarily contain elements of both policy inclination and economic outlook. Benefits flow from a more timely release of a fuller, more nuanced explanation of why the policy decision was made than is possible in an announcement. The Committee’s discussion, and the minutes of it, help to spell out the linkage the Committee may see between any policy inclination and its economic outlook. The explanation can convey the conditionality of Committee thinking and the role of any concerns about the implications of low-probability events on its current or expected policy actions. Not surprisingly, Sack and I found a correlation between the amount of talk and its effect on expectations. Reactions to the minutes could be sizable, as they were last Tuesday, but because the minutes do elaborate on the rationale for the Committee’s decisions and outlook, these reactions should help markets anticipate policy actions and price assets in ways that foster economic stability. In addition, the minutes are another chance for the Committee, as a whole, to talk. One advantage is that they should give the public a broader context in which to interpret the many statements by individual members between meetings. In that regard, the fact that the minutes convey the range of Committee members’ views should be helpful. The minutes are not an attempt to articulate a single consensus explanation of our actions or outlook, but rather, reflecting a strength of the FOMC, they summarize the give and take in Committee discussion arising from differing perspectives on difficult issues. Early release of the minutes could have costs if Committee members became more guarded in their discussion out of concern about the effects of their remarks when reported or if, over time, the minutes themselves became less comprehensive. In my view, neither of these developments is an inevitable Jeffery D. Amato, Stephen Morris, and Hyun Song Shin (2002), “Communication and Monetary Policy,” Oxford Review of Economic Policy, vol. 18 (December), pp. 495-503. The Committee unanimously decided on December 14 to expedite the release of the minutes of each of its regularly scheduled meetings by issuing them three weeks after the date of the policy decision. The new schedule began with the release, on January 4, 2005, at 2 p.m. EST, of the minutes of the December 14, 2004, meeting. The previous practice had been to release the minutes of a regularly scheduled meeting on the Thursday following the subsequent regularly scheduled meeting. consequence of the new schedule, and I am sure the Committee will resist any temptation to allow them to occur. Early release had been considered before, but recent experience convinced members that the balance had swung in its favor. Successful dry runs alleviated concerns about the practical problems of getting timely agreement on minutes from nineteen geographically dispersed members. On one or two occasions in recent years, longer delays in release of the minutes had resulted in market confusion because the minutes were interpreted as pertaining to the most recent decision, not the one at the preceding meeting for which the minutes were prepared. Finally, the difficulty of structuring talk about the future in the brief announcement released immediately after the meeting has enhanced the perceived value of the minutes for this purpose. Expedited release is an incremental step. The market will not have information it did not eventually have before, but it will have it sooner. Conclusion Over the past several decades, central banks have become considerably more open about their decisions and the reasons for them. Progress has been incremental - and may have seemed slow to some - but we have been adapting to changing circumstances in financial markets and in the governance of central banks in democratic societies. In addition, we have tried to be careful not to allow steps toward greater transparency to impinge on discussions or deflect us from making the best possible decisions to reach our objectives. Finally, we have been conscious of the limits of our knowledge and desirous of allowing other views to be incorporated in asset prices. We have done a lot, but I am sure more can be accomplished and the Committee will look carefully at proposals as they are brought forward. Over time, I anticipate further steps toward explaining our views, but at a pace that is likely to be measured.
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Remarks by Mr Roger W Ferguson Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Stanford Institute for Economic Policy Research, Stanford, California, 12 January 2005.
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Roger W Ferguson, Jr: Recessions and recoveries associated with asset-price movements - what do we know? Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Stanford Institute for Economic Policy Research, Stanford, California, 12 January 2005. * * * Thank you for inviting me to address the associates of the Stanford Institute for Economic Policy Research; it is a pleasure to be here. As you know, the U.S. economy is currently continuing its recovery from the relatively mild recession in 2001, which ended the longest period of economic expansion in our nation’s recorded business-cycle history. The 1990s will be remembered not only for this remarkably long period of prosperity but also for the excitement of the “new economy” and, less happily, for the sharp decline in equity prices that marked its end. This market correction was most dramatic in sectors of the economy associated with new technologies, the very sectors that had experienced the most pronounced run-up in equity prices. The quick occurrence of a recession following soon after this significant asset-price correction prompted some observers to suggest that the boom-bust cycle in asset valuations was the proximate trigger of the economic downturn But a number of aspects of that argument have not yet been fully examined. In the interest of advancing the understanding on this issue, I will use this opportunity to provide a retrospective on the performance of the U.S. economy and of some other industrialized economies during and following recessions over the past three decades or so. In particular, I will focus on the role that asset prices may have played in expansions and recessions.1 Before going any further, however, I should emphasize that the views I will express today are my own and are not necessarily shared by my colleagues in the Federal Reserve System. What happens during asset-price run-ups? Asset prices serve multiple roles in a modern economy. They exert a direct influence by affecting the net worth of the assets’ owners. Consumers who hold assets become richer during an asset-price advance. This so-called wealth effect - always a key determinant of consumption - can be quite important during significant asset-price run-ups as consumers spend out of their capital gains. Historical evidence suggests that this effect ultimately raises the level of consumption spending by between 2 cents and 5 cents per dollar of increase in wealth.2 Similarly, asset prices also affect business balance sheets. Rising prices for assets raise the net worth of companies that own the assets. The value of the assets that a borrower owns is an important determinant of his or her creditworthiness. In the event of a default and foreclosure on a secured debt, collateral that caries a high price provides the lender with a high recovery rate, which makes lending less risky. During an asset-price boom, the creditworthiness of borrowers rises, the interest rates at which they borrow decline because of lower risk spreads, and business investment increases as firms take advantage of the relatively lower interest rates they face. A consequence of the positive influence of asset prices on investment is that if prospects for profitability as reflected in asset prices in one sector of the economy are advancing relative to asset prices in all other sectors, investment in that sector will outpace investment in the rest of the economy, all else equal. This circumstance may have important and potentially adverse allocative consequences on the economy. In particular, if asset prices do not accurately reflect the productive potential of the underlying asset, investment will be channeled to the wrong sectors. However, an asset-price boom in a specific sector might simply reflect investor expectations of higher productivity rather than a bubble, a term I will define in a few moments. Investment would still tend to be channeled to that sector, but for good reason in this instance. One example of a sector-specific jump in asset prices and an associated My presentation is based on work with Refet Gurkaynak and Athanasios Orphanides. See, for example, Morris A. Davis and Michael G. Palumbo (2001), “A Primer on the Economics and Time Series Econometrics of Wealth Effects,” Finance and Economics Discussion Series 2001-9 (Washington: Board of Governors of the Federal Reserve System, February). investment increase is the case of the U.S. technology sector in the late 1990s. Over the five years from the end of 1994 to the end of 1999, prices of nontech stocks tripled while those of tech stocks more than quintupled.3 Correspondingly, the average level of real investment in computers and other high-tech capital goods was more than 100 percent higher over the 1995-99 period than its level during 1994, while spending on other types of fixed capital was only about 15 percent higher than in 1994. Asset-price busts By definition, an asset-price bust is preceded by an asset-price boom. If a run-up reflects a bubble, the ensuing price bust could obviously be viewed as its bursting. Alternatively, asset prices may have been driven up by expectations of a productivity boom, which would lead to improved earnings. In that case, if the expected productivity boom does not subsequently materialize, asset prices will fall. The end result in this case would not be termed the bursting of a bubble. Nonetheless, this case may be indistinguishable from such an experience: Among other common elements, one could also see an investment overhang in the sector that saw its asset prices rise and subsequently fall. Recessions are almost always accompanied by asset-price declines. But such declines sometimes appear to be the source of adverse surprises, and asset-price busts may subsequently have disproportionately adverse consequences. Falling asset prices create a negative wealth effect and restrain consumption. By making collateral less valuable, they also increase the risk of lending to businesses and thereby worsen the lending terms faced by borrowers. When asset prices fall substantially, lenders may also find themselves holding substantial amounts of nonperforming loans that are backed by what may have become, in some cases, worthless collateral. For this reason, recessions that are preceded by asset-price booms and busts may also be associated with problems in the banking industry. In such episodes, the ensuing loss of intermediation may serve as an additional force acting to prolong and deepen what might otherwise have been a milder recession. Concerns about the severity of downturns that follow significant asset-price collapses suggest that the identification and analysis of boom-bust asset-price cycles could be useful for policy. For that reason, I would next like to briefly review some of the issues associated with detecting asset-price bubbles. Detecting bubbles The word bubble is sometimes employed to describe any quick and large increase in asset prices, but a more precise definition would associate bubbles with only those increases in asset prices that are not due to economic fundamentals.4 Under such a definition, a bubble is present when investors buy assets at prices above their fundamental values in the expectation of being able to sell them at even higher prices in the future.5 To be sure, such departures from fundamentals may start small, but over time they could grow explosively. The fundamental price of an asset typically is defined in terms of the discounted present value of the income stream or equivalent services that the asset is expected to provide over time. For stock prices, for example, this is the present discounted value of dividends; for real estate, it is the discounted value of the rents or services that are expected to accrue to the owner over time. In theory, the existence of bubbles, defined in this way, is possible in standard asset-pricing models and may even be consistent with rational, profit-maximizing behavior.6 Ascertaining the existence of bubbles in practice is a very different matter. An immediate difficulty is that the theoretical notion of the fundamental price does not have an easily measured empirical In this comparison, I use the Nasdaq composite index as a proxy for the high-tech sector and the Dow Jones industrials index as a proxy for the nontech sector. See John H. Cochrane (2001), Asset Pricing (Princeton: Princeton University Press), p. 402. Such a bubble would be called a “rational bubble.” It is also conceivable that bubbles are present because some investors are not pricing assets rationally; for an introduction to that notion, see Annette Vissing-Jorgensen (2004), “Perspectives on Behavioral Finance: Does ‘Irrationality’ Disappear with Wealth? Evidence from Expectations and Actions,” in Mark Gertler and Kenneth Rogoff, eds., NBER Macroeconomics Annual 2003 (Cambridge, Mass.: MIT Press), pp. 139-94. See, for example, Jean Tirole (1985), “Asset Bubbles and Overlapping Generations,” Econometrica, vol. 53 (November), pp. 1499-528; and Dilip Abreu and Markus K. Brunnermeier (2003), “Bubbles and Crashes,” Econometrica, vol. 71 (January), pp. 173-204. counterpart. In part as a result of this measurement problem, statistical tests using historical data cannot easily distinguish bubbles from failures of the standard asset-pricing model in some other dimensions, or no failure of the model at all. Indeed, for every study of historical data that finds evidence of a bubble, often another shows that the findings could be explained by an alternative specification of the fundamentals in the absence of bubbles.7 That is, even with the benefit of hindsight, statistical tests attempting to confirm the existence of bubbles in historical episodes can remain inconclusive. Of greater relevance for policy discussions, however, is not whether economists can identify a bubble long after it occurs, but whether the presence of a bubble could be detected in real time, when the information might be useful for policy decisions. Unfortunately, detection of a bubble, which is problematic even ex-post, is an even more formidable task and arguably becomes virtually impossible in real time. Indeed, in real time, it is not uncommon for economists and market participants to fail to recognize important shifts in underlying trends that may subsequently be viewed as the source of significant changes in market fundamentals. Current statistical methods are simply not up to the task of “detecting” asset-price bubbles, especially not in real time, when it matters most.8 “Detecting” a bubble appears to require judgment based on scant evidence. It entails asserting knowledge of the fundamental value of the assets in question. Unsurprisingly, central bankers are not comfortable making such a judgment call. Inevitably, a central bank claiming to detect a bubble would be asked to explain why it was willing to trust its own judgment over that of investors with perhaps many billions of dollars on the line. The issue of detecting bubbles notwithstanding, it is of interest to know whether recessions related to sizeable asset-price busts differ from other recessions in some way that might be important for policy considerations. Are recessions that are related to asset-price busts different? Two of the longest periods of economic weakness observed in the industrialized world during the twentieth century are often identified with the asset-price busts that preceded them: the Great Depression in the United States and the “lost decade” of the 1990s in Japan. In each case, rapidly falling asset prices, exacerbated by banking problems, marked the beginning of painfully long periods of economic malaise. In part because of these two experiences, it is sometimes suggested that assetprice booms more generally lead to imbalances in the economy, and that asset-price busts and the correction of these imbalances lead to recessions that are longer, deeper, and associated with a greater fall in output and investment than other recessions. But what is the evidence on this question? Additionally, can one make any other generalizations concerning recessions that follow asset-price booms and busts and how they differ from other recessions? To address those questions, it is instructive to examine recession episodes in the Group of Seven economies since 1970. Figure 1 presents a bird’s-eye view of the evolution of asset prices and the economy from 1970 to 2003 for three of these economies, the United States, the United Kingdom, and Japan.9 For each country, the top panel of the figure shows the evolution of an aggregate inflation-adjusted index of asset prices - which consists of an average of stock prices and residential and commercial real estate prices. The shaded areas cover recession periods, as determined by the business cycle dating committee of the National Bureau of Economic Research in the United States, and a comparable See, for example, Lubos Pastor and Pietro Veronesi (2004), “Was There a Nasdaq Bubble in the Late 1990s?” NBER Working Paper Series 10581 (Cambridge, Mass.: National Bureau of Economic Research, June). They argue that the high level of uncertainty about the future growth rate of dividends of tech firms helps explain these firms’ stock prices without resorting to a bubble. The difficulty of satisfactorily “detecting” bubbles is well known in the economics literature. For a recent survey see Refet Gurkaynak (2005), “Econometric Tests of Asset Price Bubbles: Taking Stock,” Finance and Economics Discussion Series 2005-4 (Washington: Board of Governors of the Federal Reserve System, January). For uniformity across countries, all data shown in this figure, and data discussed later on, including those for the United States, are drawn from international institutions. The asset-price data have been kindly provided by the Bank for International Settlements (BIS). For detailed explanations of these data see C.E.V. Borio, N. Kennedy, and S.D. Prowse (1994), “Exploring Aggregate Asset Price Fluctuations across Countries: Measurement, Determinants, and Monetary Policy Implications,” BIS Economic Papers 40 (Basel: Bank for International Settlements). methodology for the other countries.10 The bottom panels show the evolution of gross domestic product in these economies together with a historical estimate of the economy’s potential.11 To be sure, business cycle chronologies may differ somewhat depending on the underlying methodology. The dates of peaks and troughs in economic activity for the analysis that follows are from the Economic Cycle Research Institute. For the United States, these match the dates determined by the National Bureau of Economic Research (NBER). For other nations, the institute’s methodology yields dates that are comparable to the NBER dates for the United States, which facilitates comparisons across countries. Recession dating is monthly. To obtain the quarterly time series used here, we converted the monthly expansion/recession phases to a quarterly frequency by designating the cyclical peak (the first quarter of recession) as the quarter containing the first full recession month - that is, the month following the monthly peak designation. Table 1 shows the dates of all recessions in the sample. Table 1 Business cycles of G7 countries United States Japan Britain Canada Peak Trough 1969:Q4 1970:Q3 1973:Q4 1975:Q1 1980:Q1 1980:Q2 1981:Q3 1982:Q3 1990:Q3 1991:Q1 2001:Q1 2001:Q3 1973:Q4 1974:Q4 1992:Q2 1993:Q4 1997:Q1 1999:Q2 2000:Q3 2003:Q1 1974:Q3 1975:Q2 1979:Q2 1981:Q1 1990:Q2 1992:Q1 1981:Q4 1982:Q3 1990:Q1 1992:Q1 Table 1 (cont) Business cycles of G7 countries Peak Germany Italy France Trough 1973:Q3 1975:Q2 1980:Q1 1982:Q3 1991:Q1 1994:Q1 2001:Q1 2003:Q2 1970:Q4 1971:Q2 1974:Q2 1975:Q1 1981:Q2 1983:Q1 1992:Q1 1993:Q3 1974:Q3 1975:Q2 1979:Q3 1980:Q2 1982:Q2 1984:Q4 1992:Q1 1993:Q2 The quarterly peak and trough dates shown are based on the monthly business cycle chronology from the Economic This episode is excluded because it begins outside of the sample period. This episode is Cycle Research Institute. excluded because it coincides with German reunification. The relationship of asset prices to the economy near turning points shows varying patterns (figure 1, top and bottom panels). In some episodes, asset-price declines do not appear to have preceded the recession. During some recessions, asset prices appear to have simply moved sideways, not registering substantial declines at all. But in other episodes, significant asset-price booms and subsequent declines do appear before the onset of a recession and continue during the downturn. For the United States, for example, the figure highlights the long run-up and subsequent fall in asset prices before the 2001 recession. The size of these recent movements dominates earlier boom-bust cycles in the U.S. economy in this sample. For Japan, one can see the remarkable run-up of the 1980s and its agonizing reversal during the 1990s. For the United Kingdom, one may notice the asset-price boombust cycle of the early 1970s followed by the painful recession beginning in 1974. Indeed, these three episodes stand out as perhaps the clearest suggestions of an asset-price boom-bust cycle significantly influencing or possibly triggering a subsequent recession and recovery. How do these three cyclical turning points compare with other recessions? To be sure, such a comparison rests on (1) our identification of these three episodes as the ones that appear to have been preceded by significant asset-price booms and busts and (2) separating these recessions from the rest. Such a classification necessarily involves some element of ambiguity, but the three episodes highlighted in figure 1, the U.S. recession in 2001, the Japanese recession in 1992, and the U.K. recession in 1974, do appear to stand out.12 Estimates of real gross domestic product (GDP), the output gap, potential output, and real investment are from the Economic Outlook database of the Organisation for Economic Co-operation and Development. The investment data (shown in later displays) reflect total fixed investment. In figure 1, both actual and potential output are expressed relative to the value of actual real GDP in 1985. By definition, output should equal the economy’s potential - and the corresponding measure of the output gap should equal zero - when productive factors in the economy are employed at their normal levels. Output is below the economy’s potential when resources are underutilized and above it when the economy is overheated. To be sure, assessing the economy’s potential with much accuracy is inherently difficult, and historical estimates of the implicit output gap are highly imprecise; however, these measures can serve as helpful summary indicators in historical comparisons such as those discussed below. There are at least two reasons for the ambiguity in such classifications. The first relates to how one defines an asset-price bust. The second relates to the dating of cyclical peaks, which, as noted earlier, may differ somewhat depending on the methodology underlying business cycle chronologies. The three episodes on which I concentrate my attention are relatively uncontroversial in that the recessions followed rather substantial asset-price boom-bust cycles. But other recessions, which followed milder boom-bust cycles, could be added to this list. Examples would be the recessions that started in 1974 in the United States, in 1981 in Canada, and in 1990 in the United Kingdom. We have compared the average path of asset prices around the onset of the recession in these three episodes to the average path of asset prices in the other episodes in our sample (figure 2, top panel). The vertical line marks the quarter in which the recession began. The dotted curve shows the average of the three asset-price related episodes, and the solid curve shows the average of the remaining twenty-two recession episodes in the sample.13 This comparison suggests that in recessions related to asset-price busts, asset prices fall before the recession more, on average, than they do in other episodes. This is, of course, as it should be, given our selection criteria for the classification of the three episodes. The more interesting question is whether these recessions are different in other dimensions as well. Consider, for example, the average paths of estimated output gaps during asset-price busts relative to the remaining recessions (figure 2, middle panel). The data are centered as they were for asset prices, but the output gap is normalized to equal zero in the first quarter of a recession. As one would expect, the output gap for both groups of episodes on average falls after recessions start, but it falls less for the asset-price-bust episodes. Finally, looking at investment (figure 2, bottom panel), the data also suggest that, on average at least, investment, like the output gap, was not affected more adversely in the three asset-price-bust episodes. If anything, these three episodes on average appear to be slightly shallower in terms of output losses and investment declines than the average of other recessions. But the comparisons of the averages provided in figure 2 could obscure valuable insights that might be obtained by looking at each of our three asset-price-bust episodes individually, as I do next. Three asset-price-bust episodes Let us first examine the U.K. recession of 1974. To put that episode in perspective, we present an overview of the U.K. economy for the 1970-2003 period (figure 3). The boom-bust cycle that preceded the 1974 cyclical peak is the most pronounced (and, by the way, not just for the United Kingdom but for all of the G-7 countries). The large fall in average asset prices (figure 3, top panel) followed the 1973-74 oil crisis, which is also associated with somewhat smaller asset-price declines in numerous other nations. We take a closer look at the components of the aggregate asset-price index and compare their evolution around this U.K. cyclical peak to their average evolution during all recessions excluding our three asset-price-bust episodes (figure 4). Equity prices registered a remarkably sharp decline in this episode. But arguably a more distinctive characteristic of this asset-price boom-bust episode is the swing in real estate prices. Residential real estate prices, and especially commercial real estate prices (figure 4, bottom panels), also registered rather dramatic declines in this episode. It may thus be surprising that this recession does not appear to have been deeper than the average of recessions excluding the three asset-price-bust episodes. The output gap (figure 5) fell along with asset prices before the recession, but the decline was from an unsustainably overheated level. And investment (figure 5) stayed relatively strong compared with other recessions. Despite this episode being associated with rather severe declines in equity and commercial real estate prices, no evidence of an investment overhang appears in this comparison. Next, let us turn to the Japanese experience. The Japanese economy saw rapidly increasing equity and real estate prices during the 1980s (figure 6), a remarkably long period of stability and prosperity. These run-ups in asset prices were accompanied by a rapid expansion of bank credit, which was especially important for financing real estate purchases. But asset prices collapsed at the turn of the decade. This “bursting of the bubble,” as the episode is often referred to by Japanese officials, was followed by a decade of relative stagnation marked by three arguably related recessions. Concentrating attention on just the first of these three recessions, beginning in 1992, proves insufficient to capture the severity of the overall problem. The detailed comparisons of the 1992 recession with other episodes (figure 7 and figure 8) do not indicate unusual weakness associated with the 1992 recession. Rather, the 1990s in Japan are more notable for the succession of incomplete recoveries than for the recessions themselves (figure 6). To compute these averages, we first centered the path of asset prices around each recession episode. The quarter in which the recession began is marked as zero, and quarters from –8 to +8 denote the preceding and subsequent two years. Asset prices in each episode are normalized to 100 at the quarter marking the recession start. The bursting of the bubble importantly shaped subsequent developments in this case. The asset-price collapse hit the Japanese banking system hard, eroding bank capital. The ensuing disintermediation subsequently proved an important impediment to the economy’s recovery. However, the extent of the problem was not fully appreciated at the time by policymakers. Despite steps toward an expansionary policy, the monetary easing of the early 1990s was insufficient to mitigate the underlying weakness during the expansion from 1994 to 1996. The continued fragility of the financial system arguably left the Japanese economy especially vulnerable to additional disturbances that could have otherwise been easily weathered. An economic crisis in Southeast Asia, coupled with a previously planned increase in consumption taxes, resulted in a larger-than-anticipated drag on domestic demand and set the stage for the recession that started in 1997. Following a brief recovery, monetary policy was tightened in 2000, and the third recession in a decade followed soon after. The Japanese experience offers a reminder of the importance of monitoring the health of the financial system and the need to be especially wary of signs of fragility following a period of sharp asset-price declines. It also serves to highlight how the behavior of the banking system during the asset-price run-up may influence subsequent outcomes. Lastly, it points to the potentially crucial role played by fiscal and monetary policies in recoveries following asset-price-bust recessions. Last, let us examine the U.S. recession of 2001 and the subsequent, ongoing recovery. We have prepared the U.S. data in the same manner as in the U.K. and Japanese cases (figure 9-figure 11). The evolution of disaggregated asset prices (figure 10) shows that the unusually large changes surrounding the 2001 recession reflected the movement of equity prices alone. Relative to the average episode, commercial real estate prices neither fell much during the recession nor rose a lot during the expansion. And instead of declining during the recession, residential real estate prices continued their upward trend. The behavior of real economic activity around the recent cyclical peak (figure 11) suggests a second interesting comparison. Relative to other recessions, this recession was shallow and did not appear to impart an unusual drag on investment, despite the sharp asset-price correction. Why was the 2001 recession relatively short and shallow even though the preceding swing in asset prices was so severe? In my opinion, two reasons stand out. The first regards the health of the financial sector. During the 1980s and early 1990s, the U.S. banking sector faced a succession of challenges: the savings and loan crisis of the early 1980s, the international debt crisis of the mid-1980s, waves of bank failures and consolidation, and the need to build capital in response to the adoption of the Basel I standards in 1988. But by the mid-1990s the banking sector had regained a solid footing, and regulators were careful to keep it that way. Prudential regulation coupled with good risk management meant that financial firms limited their exposure to risk during the boom years of the late 1990s. This approach paid off handsomely when the asset-price break occurred. Despite the recession, banks remained well capitalized, and their strength eliminated the threat of a vicious credit crunch or the risk of fragility in the system. As a result, the elements that appear to have been so detrimental for the recovery of the Japanese economy during the 1990s were absent during this episode. Following the “bursting of the bubble” in Japan, the banking system found itself holding a substantial amount of bad loans. And, as already seen, the woes of the banking system turned into a recessionary force in itself, curtailing the recovery. This comparison points to a useful policy lesson: A healthy financial sector and strong prudential regulation during an asset-price boom offer valuable insurance in case the boom turns to bust with an asset-price break. The second, and perhaps equally important, reason that the recent U.S. episode was unusually benign was, in my view, the quick response of policy. Both fiscal and monetary policy were eased quickly and effectively in this episode. The Federal Reserve cut the federal funds rate rapidly to create monetary accommodation and maintained conditions of substantial monetary policy ease for a considerable period well into the expansion. As well, the Administration and the Congress took quick steps early in the recession to provide fiscal stimulus that helped to prop up aggregate demand. Placing the policy response in its proper historical context may be critical for drawing the appropriate policy lessons for the future. Countercyclical fiscal and monetary policies are unlikely to have been as swift and strong during 2001 had earlier policies not set the stage for such action. On the fiscal side, the budgetary prudence of the 1990s yielded comfortable surpluses at the onset of the 2001 recession that facilitated the large fiscal policy easing. And on the monetary side, the successful completion of the last stage on the long path to price stability during the 1990s allowed substantial easing in response to the downturn. As policymakers stressed repeatedly, the prevalence of low- and wellanchored inflation expectations ultimately facilitates pursuit of such countercyclical policy. A clear lesson emerges from this experience for policy over the long haul. By pursuing fiscal prudence and price stability during booms, policymakers greatly enhance their ability to take swift, effective countercyclical action when it is needed most. Conclusions In closing, let me reiterate some of the key points and lessons I draw from this review. First, as already understood, detecting asset-price overvaluations and undervaluations is controversial in hindsight and arguably impossible in real time. As a result, although asset-price booms and busts are often linked to recessions, a clear-cut policy response to suspected waves of exuberance cannot be suggested. Second, sweeping generalizations regarding asset-price-bust recessions and subsequent recoveries are not easily made. Idiosyncrasies dominate comparisons in the historical data. As such, each recession-and-recovery episode would seem to call for its own tailor-made policy response. Third, to the extent that comparisons across recessions are informative, asset-price-bust recessions do not appear to be necessarily more costly than other recession episodes. Specifically, at a macroeconomic level, recessions that follow swings in asset prices are not necessarily longer, deeper, and associated with a greater fall in output and investment than other recessions. That said, particular industrial segments and classes of investment, such as the high-tech sector in the recent U.S. episode, may suffer disproportionately during such recessions. Also, the health of the financial system, the strength of the banking sector, and the ability and willingness of policy to take appropriate countercyclical action seem to importantly influence the economic outcomes of an asset-price-bust. Which brings me to my last point: Over the long haul, preparation for a potential problem seems to be the best course of action. Prudential supervision and good risk management in banking, and the pursuit of fiscal prudence and price stability during booms, may ultimately serve as the best insurance for dealing with the inevitable occasional asset-price breaks observed in our modern economy.
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Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Wharton/Sloan/Mercer Oliver Wyman Institute Conference, ¿Financial Risk Management in Practice¿, Philadelphia, 6 January 2005.
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Donald L Kohn: Crisis management - the known, the unknown, and the unknowable Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Wharton/Sloan/Mercer Oliver Wyman Institute Conference, “Financial Risk Management in Practice”, Philadelphia, 6 January 2005. * * * In pursuing its policy objectives, a central bank must make decisions in the face of uncertainty related to incomplete knowledge about the evolving condition of the economy and the financial system as well as about the potential effects of its actions. This uncertainty implies that the central bank must incorporate into its decisions the risks and consequences of several alternative outcomes. That is, it needs to assess not only the most likely outcome for a particular course of action but also the probability of the unusual - the tail event. And it needs to weigh the welfare costs of the possible occurrence of those tail events. This risk-management approach has been articulated by Chairman Greenspan for monetary policy, and it is equally applicable to a central bank’s decisions regarding crisis management, the topic I will focus on today.1 Crises are themselves tail events, and the policy response to them is focused on the possibility and cost should the outcome be especially adverse. As I am sure we will hear time and again today, knowledge - reliable information - is essential to managing risks. In a financial crisis, however, information inevitably will be highly imperfect. The very nature of a crisis means that the ratio of the unknown and unknowable will be especially large relative to the known, and this, in turn, can influence how policymakers judge risks, costs, and benefits. Although the subject of my contribution to this panel is crisis management, I want to emphasize at the outset that the far-preferable approach to financial stability is to reduce the odds on such crises developing at all. To this end, central banks seek to foster macroeconomic stability, encourage sound risk-taking practices by financial market participants, enhance market discipline, and promote sound and efficient payment and settlement systems. In this arena, an ounce of prevention is worth many pounds of cure. Before going further, I should say that the views I will express today are my own and not necessarily those of other members of the Board of Governors or its staff.2 Costs, benefits, and policy options But even prevention has costs that must be weighed along with its benefits. No financial system that is efficient and flexible is likely to be completely immune from episodes of financial instability from time to time, and policymakers will be forced to make judgments about the costs and benefits of alternative responses with very incomplete information. In a financial crisis, the potential cost of inaction or inadequate action is possible disruption to the real economy, which would damp activity and put undesirable downward pressure on prices. Such disruptions can come about because crises heighten uncertainty about the financial status of counterparties and about the eventual prices of assets. In an especially uncertain environment, lenders may become so cautious that credit supplies are cut back more than would be justified by an objective assessment of borrowers’ prospects; concerns about counterparty risk can impair the smooth functioning of payment and settlement systems, interfering with a wide variety of markets; asset prices can be driven well away from equilibrium values; and confidence can be undermined. These types of tail events could depress economic activity for a time and, if prolonged, could also adversely affect efficiency and productivity by impairing the ability of financial markets to channel savings into the most productive investments. Although policy action may be able to reduce the odds of adverse effects or alleviate their impact, some policy responses to a crisis can themselves have important costs that need to be balanced Alan Greenspan (2004), “Risk and Uncertainty in Monetary Policy,” American Economic Review, vol. 94 (May), pp. 33-40. Edward C. Ettin, Myron L. Kwast, and Patrick M. Parkinson, of the Board’s staff, provided valuable ideas and comments. against their possible benefits. In short, intervening in the market process can create moral hazard and weaken market discipline. If private parties come to believe in the possibility of policy actions that will relieve them of some of the costs of poor decisions or even just bad luck, their incentives to appropriately weigh risks in the future will be reduced and discipline on managers watered down. Weaker market discipline distorts resource allocation and can sow the seeds of a future crisis. The possible real costs of policy actions implies that they should be taken only after the determination that, in their absence, the risk is too high that the crisis will disrupt the real economy. Once that judgment is reached, the central bank and other authorities have a variety of instruments to use, and the degree of potential moral hazard created will depend on the instrument chosen. Approaches that work through the entire market rather than through individual firms run a lower probability of distorting risk-taking. Thus, a first resort to staving off adverse economic effects is to use open market operations to make sure aggregate liquidity is adequate. Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if they are not satisfied, these extra demands will tighten financial markets at exactly the wrong moment. This was an important consideration after the stock market crash of 1987, when demand for liquid deposits raised reserve demand; and again after 9/11, when the destruction of buildings and communication lines impeded the flow of credit and liquidity. Second, we must determine whether the stance of monetary policy has to be adjusted to counteract the effects on the economy of tighter credit supplies and other consequences of financial instability. Policy adjustments also can help head off some of those effects in that, by showing that the central bank recognizes the potential seriousness of the situation, they bolster confidence. As a consequence, meetings of the Federal Open Market Committee (FOMC) - often in conference calls if the situation is developing rapidly - have been an element in almost every crisis response. Those meetings allow us to gather and share information about the extent of financial instability and its effects on markets and the economy as we also discuss the appropriate policy response. Some critics have argued that the FOMC’s policy adjustments in response to financial instability encourage undue risk-taking in the financial markets and the economy. However, to the extent that the conduct of policy successfully cushions the negative macroeconomic effects of financial instability, it genuinely lowers risk and that fact should be reflected in the behavior of private agents. Other instruments to deal with instability - discount window lending, moral suasion, actions to keep open or slowly wind down ailing financial institutions - are much more likely than monetary policy adjustments to have undesirable and distortionary effects on private behavior. By making credit available to individual firms on terms more favorable than would be available in the market, or by affording a measure of protection to existing creditors, these other instruments carry substantial potential for moral hazard. Hence, they are and should be used only after a finding that more generalized instruments, like open market operations, are likely to be inadequate to stave off significant economic disruption. If it is determined that actions to support the credit of specific firms are necessary, such actions should be designed to minimize moral hazard. Sometimes moral suasion will be sufficient - simply by calling attention to the potential consequences of withholding payments or credit, private parties may be persuaded that avoiding such an outcome is in their self-interest. But central banks must be careful that moral suasion is not perceived as coercion or an implied promise of official indemnification for private losses. If the central bank concludes that it must lend to individual depository institutions to avoid significant economic disruption, in most situations any such loans should be on terms sufficiently onerous to discourage reliance on public-sector credit. The Federal Reserve tries to find the approach that reduces the odds on economy-wide spillover effects while interfering as little as possible with the market and allowing people and institutions to suffer the consequences of decisions that turn out to be bad. Nearly every major bout of financial instability has called for some degree of monetary easing - most often only temporarily until the threat of the low-probability but high-cost economic disruption has passed. Other tools have been used occasionally, and an assessment of their costs and benefits has depended on the nature of the crisis. Moral suasion was an element in dealing with the panicky private-sector actions associated with the sharp and apparently self-feeding market price breaks of 1987 and 1998. Lending through the discount window helped to promote an orderly unwinding of distressed institutions in the period of prolonged and widespread problems among important intermediaries in the late 1980s and early 1990s. And such lending was crucial in getting liquidity to the right places after the disruption of 9/11. In each case, the nature of the response has depended on the state of the economy and financial markets before the event. When the economy is strong and financial systems robust, a shock to the financial system is less likely to feed back on the economy. Information flows in a crisis Clearly, judgments in a crisis must balance a number of difficult considerations in rapidly changing circumstances in which up-to-date, accurate, information is scarce. Our experience suggests some of the key questions that might arise when confronting a crisis: how large is the financial disruption - how many firms or market participants are involved and how large are they? What is the potential for direct and indirect contagion, both domestic and international? Who are the counterparties and what is their exposure? Who else has similar exposures and might be vulnerable to further changes in asset prices that could be triggered by a firm’s failure and unwinding of positions? How long are the financial disruptions likely to last? Are substitute providers of financial services available, and how easily and quickly can they be employed? And, critically, what are the initial and expected states of the macroeconomic and financial environments under various scenarios? Coming to grips with these questions requires a considerable amount of detailed, up-to-the-minute information - more than can be known ahead of time. Even in the best of circumstances, much of the information on variables relevant to decisions about whether or how to intervene will be unknown (especially if a crisis materializes quickly) or unknowable. Published balance sheets and income statements - or old examination reports - give only a starting place for analysis when asset prices and risk profiles are changing rapidly and in ways that had not been anticipated. In addition, crises invariably reveal previously unknown interdependencies among financial intermediaries and among intermediaries and the ultimate suppliers and demanders of funds. Central banks and others that might be involved in crisis management must take steps to push back the frontiers of the “unknown” before a crisis hits and to develop procedures for obtaining the “knowable” quickly when needed. More information is not just a “nice to have.” Policymakers want to choose the path with the lowest moral hazard consequences. But they are in a difficult position in a crisis. The costs of not acting forcefully enough will be immediate and obvious - additional disruption to financial markets and the economy. The costs of acting too forcefully - of interfering unnecessarily in markets and creating moral hazard - manifest themselves only over a longer time and may never be traceable to a particular policy choice. The natural tendency to take more intrusive actions that minimize the risk of immediate disruptions is probably exacerbated by ignorance and uncertainty; the less you know, the easier it is to imagine bad outcomes and the more reliant you may be on people in the market whose self-interest inevitably colors the information they are giving you. Each episode of financial instability is different and teaches us something new about what information is useful and who needs to call whom to share information. For example, clearing mechanisms for futures and options were an issue in the 1987 crash; capital impairment of depositories, its effect on lending, and the response of regulators took center stage in the late 1980s and early 1990s; the importance of market liquidity came to the fore in 1998 when even the prices of off-the-run Treasury securities took a beating; and physical infrastructure issues dominated developments after the terrorist attacks on 9/11. Although a knowledge base is helpful, the answers to the questions I posed earlier will depend critically on a free flow of new information. In a world of financial institutions with a presence in many lines of business crossing national boundaries, obtaining such information and developing cogent analysis requires widespread cooperation among many agencies. The Federal Financial Institutions Examination Council - in which all U.S. depository institution regulators participate - is a forum for developing information and relationships within the regulatory community. The President’s Working Group itself was a product of the 1987 stock market crash, which revealed a need for better communication and coordination among all financial regulators. In addition, we build bilateral relationships with foreign authorities through participation in various international groups, such as the Basel Committee on Banking Supervision, the Committee on Payment and Settlement Systems, the Financial Stability Forum, and so on. A number of the phone calls I made and received in the hours and days after 9/11 were with people in other central banks with whom I had established working relationships on monetary policy groups or in international preparations for Y2K. But although agencyto-agency communication is important, it is in a sense only a secondary source of information. The primary and best sources are the contacts we all develop with major financial participants as we carry out our daily operations and oversight responsibilities. Whatever the origin of the crisis, the Federal Reserve has usually found itself near the center of the efforts to assess and manage the risks. To be sure, we have some authorities and powers that other agencies do not. But in addition, we bring a unique perspective combining macro- and microeconomic elements that should help us assess the likelihood of disruptions and weigh the consequences of various forms of intervention. Because of our responsibility for price and economic stability, we have expertise on the entire financial system and its interaction with the economy. Central banks need to understand - to the limited extent anyone can - how markets work and how they are likely to respond to a particular stimulus. Our role in operating and overseeing payment systems gives us a window into a key possible avenue for contagion in a crisis. At the Federal Reserve, our supervisory responsibilities provide us with knowledge of the banking system and the expertise to interpret information we get from other agencies. We have people at the Board and Reserve Banks who are expert in macroeconomics, in banking, in payment and settlement systems, and in various financial markets, and all have market contacts; our colleagues at the Federal Reserve have proven to be our best source and filter of information in the midst of a crisis. Despite our efforts, much will still be unknown and some things will be unknowable as we make decisions in a crisis. Financial instability is by definition a tail event, and it is the downside possibilities of that tail event that concern the authorities. Market participants are reacting under stress, on incomplete and often false information, in situations they have not faced before. Uncertainty - in the Knightian sense of unquantifiable risk - is endemic in such situations. Uncertainty drives people to protect themselves - to sell the asset whose price is already declining, to avoid the counterparty whose financial strength might conceivably be impaired, to load their portfolios with safe and liquid assets. Market mechanisms are tested in ways that cannot be modeled ahead of time. Contagion is always a key underlying issue in trying to assess the potential for sustained disruption of the financial system and the economy. Contagion, in turn, is partly a question of psychology - how will people react under conditions of stress? So, too, is moral hazard - once the stressful situation passes, how will people adapt their behavior as a consequence of any intervention? Thus, much of the most desirable information is “unknowable” in any quantitative sense. The authorities must rely, therefore, on judgment, based on experience and on as much information as can be gathered under adverse circumstances. The changing financial system and the known, the unknown, and the unknowable The evolution of financial markets and institutions over recent years may well have made the financial system more resilient and reduced the need for intervention. The lowering of legal and regulatory barriers across financial services and geography, the development of derivative markets, and the securitization of so much credit has enabled intermediaries to diversify and manage risk better, reduced the number of specialized lenders who would be vulnerable to sector- or area-specific shocks, and left borrowers far less dependent on particular lenders and consequently the economy much less vulnerable to problems at individual or even classes of institutions. In the past few years, the financial markets have come through an extraordinarily stressful period, but one that was not marked by the sort of financial-sector distress that accompanied and intensified the economic problems in many previous such episodes. I attribute that relatively good record, in no small part, to greater diversification of risk, to the growing sophistication of risk management techniques being applied at more and more institutions, and to stronger capital positions going into the period of stress. This may be the typical experience in the future; one hopes so, and the regulators are working in various ways to make it so - through the Basel II effort as one prominent example. But, unfortunately, we cannot count on that outcome. Crises remain a threat, and the increasing complexity of the financial system and of the laws governing it are affecting how crises are likely to be managed. The greater variety and utilization of risk transfers will put new demands on information flows to answer the questions I posed earlier. The growing reach of major financial institutions across industry boundaries and national borders is increasing the necessity for cooperation and coordination among regulators here in the United States and around the world. At the same time, institutions manage risk on an integrated basis and understanding and dealing with the effect of financial instability and the feedback of their actions on markets and other institutions will call for an integrated overview. No institution can be “too big to fail.” Handling the failure of a large, complex organization - imposing the costs of failure on management, shareholders, and uninsured creditors while minimizing the effects on the wider economy - will certainly be complicated. But we cannot allow the public interest in containing moral hazard to be held hostage to complexity. Indeed, U.S. law requires that we do not. In dealing with the failure of an insured depository institution, the authorities are required to use the method that yields the least cost to the insurance fund unless they find that the least-cost method entails systemic risk and that a more costly method would mitigate that risk. In setting out a procedure to follow in such circumstances and holding authorities explicitly accountable for their decisions against a reasonably clear set of objectives, the law puts a premium on preparing for the type of analysis that will be needed. The Federal Reserve is in continuing conversations with other agencies on approaches to these issues. The growing complexity of institutions elevates the importance of avoiding crises, rather than managing them. We must continue to adapt our supervision of financial institutions and payment systems to encourage and reward good risk management and enhance market discipline.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, to the Financial Executives International Baltimore Chapter, Baltimore, 18 January 2005.
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Susan Schmidt Bies: The economy and challenges in retirement savings Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, to the Financial Executives International Baltimore Chapter, Baltimore, 18 January 2005. * * * I am very pleased to join you for this meeting of The Baltimore Chapter of Financial Executives International. Today I want to begin with a brief assessment of the economic outlook before discussing financial conditions of households and businesses in more detail. Then, I will turn to some important trends in retirement savings, including the responsibilities that both businesses and households have in planning for the financial security of workers later in life. I also need to add that I am expressing my own opinions, which are not necessarily those of my colleagues on the Board of Governors or on the Federal Open Market Committee. The economic outlook As you know, the economy has been expanding at a healthy pace lately. Real gross domestic product grew at an annual rate of 4 percent in the third quarter and growth in the fourth quarter looks to have remained solid, although the further widening of our trade deficit was disappointing. Labor markets have continued to improve gradually, with private nonfarm payroll employment posting a sizable gain in 2004. Consumer spending appears to have been robust during the holiday season, despite some restraint from higher energy prices, and business outlays for capital equipment are on an upward trend. And with financial conditions still accommodative, I expect that the economy will continue to expand at a solid pace this coming year. On the inflation front, broad measures of consumer inflation have risen somewhat faster than they did in the year-earlier period, boosted by higher energy prices. Focusing on the core price index, which excludes food and energy, it has been a bit higher than it was the year before. This reflects changes in the pattern of prices of goods (as opposed to services) purchased by consumers, as prices of goods that had been falling in 2003 began to stabilize and rise slightly in 2004. These effects should taper off and I expect that core inflation will remain in its current range. Moreover, surveys indicate that inflation expectations over the longer-term appear to have remained well-anchored. I believe that, with underlying inflation expected to moderate, the Federal Reserve can continue to remove its policy accommodation at a measured pace, consistent with its commitment to maintain price stability as a necessary condition for maximum sustainable economic growth. Household financial conditions Continued economic expansion depends importantly on consumer spending, so let me spend a few minutes on the financial condition of the household sector. Some analysts have expressed concern about the rapid growth in household debt in recent years and the decline in the household saving rate. They fear that households have become overextended and will need to rein in their spending to keep their debt burdens under control. My view is considerably more sanguine. Although pockets of financial stress exist among households, the sector as a whole appears to be in good shape. It is true that households have taken on quite a bit of debt over the past several years. According to the latest available data, total household debt grew at an annual rate of about 10 percent between the end of 1999 and the third quarter of 2004; in comparison, after-tax household income increased at a rate of about 5 percent over this period. This rapid growth in household debt largely reflects a surge in mortgage borrowing, which has been fueled by historically low mortgage interest rates and strong growth in house prices. Indeed, many homeowners have taken advantage of low interest rates to refinance their mortgages, some having done so several times over the past couple of years. Survey data suggest that homeowners took out cash in more than one-half of these “refis,” often to pay down loans having higher interest rates. On net, the resulting drop in the average interest rate on household borrowings, combined with the lengthening maturity of their total debt, has damped the monthly payments made by homeowners on their growing stock of outstanding debt. The Federal Reserve publishes two data series that quantify the burden of household obligations. The first series, the debt-service ratio, measures the required payments on mortgage and consumer debt as a share of after-tax personal income. The second series, the financial-obligations ratio, is a broader version of the debt-service ratio that includes required household payments on rent, auto leases, homeowners insurance, and property taxes. Both ratios rose during the 1990s, and both reached a peak in late 2002. Since then, however, the debt-service ratio has been stable and the financial obligations ratio has receded a bit, an indication that households, in the aggregate, have been keeping an eye on their financial commitments. Consistent with these patterns, delinquency rates for a wide range of household loans either have drifted down over the past year or held about steady at levels below recent highs. The low interest rates of the past few years, however, will give way as the economy continues to expand, and we have already seen an uptick in mortgage rates and on some other consumer loans during this past year. To be sure, some households will be pressured by the higher rates, but I believe that concerns about their effect on repayment burdens can be overstated. First, most household debt mortgage and consumer debt combined - carries a fixed interest rate, which slows the adjustment of interest costs to rising rates. Second, although interest rates on some variable-rate loans will rise quickly, the adjustment for a large number of variable-rate loans could occur rather slowly. For example, many adjustable-rate mortgages start off with a fixed rate for several years, providing households with some protection from rising rates. Another concern is that house prices will reverse and erase a considerable amount of home equity built up in recent years. Recent gains in house prices have been notable: the average house price rose 13 percent in the year through the third quarter of 2004, and cumulative gains since 1997 now top 60 percent.1 Despite a rise in mortgage debt, the current loan-to-value ratio for outstanding mortgages is estimated to be around 45 percent, roughly the level that has prevailed since the mid-1990s. It is true that some households have considerably less equity in their homes, and these households tend to have lower income and fewer other financial assets to cushion shocks. Based on the 2001 Survey of Consumer Finances (SCF), a small share, 7 percent, of households had a loan-tovalue ratio of 90 percent or more. Unfortunately, we cannot characterize the current share as accurately, at least not until the 2004 survey becomes available early next year, but it is unlikely that the share has risen by a lot. While new originations of mortgages with high loan-to-value ratios in recent years would push this share up, the substantial house price appreciation in that same period likely improved the financial positions of the households with high loan-to-value ratios in 2001. This relatively upbeat assessment of household credit quality seems to be shared by lenders and by investors in securities backed by consumer debt. According to the Federal Reserve’s survey of senior loan officers, banks were in a relatively neutral stance, neither tightening nor easing on net, with respect to lending standards for consumer loans or mortgage loans through most of last year. Moreover, credit spreads on securities backed by auto loans and credit card receivables have narrowed in recent months. Some analysts have also expressed concerns about the decline in the personal saving rate. Aggregate personal saving, measured by the Bureau of Economic Analysis, averaged about 1 percent of disposable income during the first three quarters of 2004, more than 6 percentage points lower than the average that has prevailed since the early 1960s. The saving rate, measured by the Board’s flow of funds accounts is higher, at 5 percent of disposable income, though it, too, is significantly lower than its average level in the past. Analysis by Board staff using data from the SCF indicate that households in the top income quintile can account for nearly all of the decline in the aggregate saving rate since 1989. Given that these higher-income households have more financial resources to weather shocks, the significant decline in savings is less troublesome than if it had occurred in the lower part of the income distribution. This points out two different perspectives on household financial health. While analysts usually focus on the savings rate as a share of current income and funds flow, some argue that a more relevant measure of saving adequacy is the change in net worth. And in this regard, the picture of household saving looks more favorable than suggested by the saving rate. The ratio of net worth-to-disposable income has come down from its peak in 2000, but remains at a high level relative to the past few decades, because capital appreciation on household assets, such as equities and real estate, has Office of Federal Housing Enterprise Oversight House Price Index. considerably outpaced income gains. This is a passive perspective on savings, though, where households rely on the markets to raise the value of their assets over time. But to create these assets, households need to consistently set aside some of their current earnings to invest for their future needs. While the experience of the past three years of exceptionally low interest rates and lower expected stock returns encouraged a rational consumer to spend and not save, as the markets return to more long-term trends, we should see consumers moderate their behavior as well. Financial conditions of businesses The business sector is in good financial shape - a dramatic turnaround from the situation in 2001. Firms have reduced leverage and restructured their liabilities, responding in part to investors’ concerns arising from some high-profile unanticipated meltdowns in the early part of this decade. In addition, firms have significantly cut costs through dramatic gains in productivity, which has boosted profits. In my view, even with a rise in interest rates and some moderation in profit growth, the business sector should remain financially strong and continue to expand. The improvement in corporate balance sheets in the past few years has been substantial. Firms have taken advantage of low long-term interest rates to refinance high-cost debt. Businesses have also improved their balance sheet liquidity by substituting long-term debt for short-maturity debt and by building up their cash positions. In addition, many firms - especially in the most troubled industries have retired debt through equity offerings and asset sales, and others have used their mounting profits to retire debt. As a result, nonfinancial corporate debt grew at an annual rate of less than 2-1/2 percent in the past few years, its slowest pace since the early 1990s. These repairs to balance sheets have also reduced the exposure of many firms to rising interest rates, especially in the near term. In particular, the replacement of short-term debt by long-term bonds means that less debt will have to be rolled over in the near term at higher rates. In addition, because much of the long-term debt has a fixed rate, interest payments typically are unaffected over the life of the bond. Moreover, research by the Board staff suggests that firms that rely more on floating-rate debt, and for that reason might be more vulnerable to rising rates, have in recent years tended to use derivatives to hedge some of their exposure to interest rate risk. Thus, for many firms, the effect of rising interest rates will be mitigated and spread out over time. Also, as we learned from the episode of policy tightening in 1994, rising interest rates have little detrimental effect on the financial health of the corporate sector when the rate increases occur in the context of an expanding economy. Indeed, corporate credit quality improved on balance after 1994 with the pickup in economic activity and corporate profits. Some of the improvement in financial conditions among businesses is due to significant belt-tightening by many firms. Over the past few years, the drive to cut costs and boost efficiency has generated rapid productivity gains. Fuller utilization of the capabilities of capital already in place, ongoing improvements in inventory management, and streamlined production processes requiring fewer workers, to name but a few examples of efficiency enhancements, have boosted corporate profitability. The pickup in revenue growth since mid-2002, combined with outsized productivity gains, has produced a dramatic recovery in overall corporate profitability. The profits of nonfinancial corporations as a share of sector output continued to climb and reached almost 11 percent in the third quarter of last year. This share lies above its long-run average over the past few decades and well above the cyclical trough of 7 percent in 2001. To be sure, the profit share likely will slip a bit from its high level as the expansion gains steam and businesses hire new workers more aggressively. But some decline in the profit share is to be expected and will not, in my view, significantly impair the financial health of companies. This favorable view is reflected in risk spreads on corporate bonds, which have dropped dramatically from their historic highs in the fall of 2002. And firms that have turned to capital markets for financing have found them to be accommodative. A remaining financial hurdle for some companies is the underfunding of defined benefit retirement plans, though this burden is notably less than it was two years ago. At the end of 2002, the majority of S&P 500 plans were underfunded, with a net shortfall that had grown to more than $200 billion, as stock market losses from 2000-02 eroded the value of assets and declining interest rates raised the current value of plan liabilities. Since then, companies have made large cash contributions to shore up these plans and equity prices have risen, reducing the aggregate underfunding for S&P 500 companies to around $125 billion at the end of 2004. In addition, plan sponsors received some temporary relief from federal legislation passed early last year that allowed firms to use a discount rate for their liabilities based on corporate bond yields rather than one based on Treasury yields. The replacement effectively reduced the stated value of liabilities and thus estimates of underfunding and required cash payments for tax purposes. Nonetheless, important longer-term issues regarding defined benefit plans remain. In decades past, workers might spend most or all of their careers at a single firm and might receive generous preset benefits from traditional defined benefit plans, with a guaranteed benefit to be provided by the Pension Benefit Guaranty Corporation (PBGC), the government entity that insures defined benefit plans, if the firm were to go bankrupt. As workers began to change jobs more frequently, however, they increased their demand for defined contribution retirement plans because of their portability and the more-even pattern of benefit accruals over a worker’s career. Also, many companies were attracted to these plans as a way to limit their future funding obligations for traditional defined benefit retirement plans. As a result, financially solvent older companies have been terminating their defined benefit plans and only a rare few companies have been starting new defined benefit plans. This trend weakens the PBGC because it is left increasingly with pension plan sponsors with relatively weak financial positions. Currently, the PBGC is facing a potential financial crisis. Its funding status deteriorated in 2004, for the fourth consecutive year, with the value of its assets now falling short of its liabilities by nearly $24 billion. Most of the deterioration is due to the large number of firms with underfunded pension plans that declared bankruptcy in recent years. However, the legislation that offered relief to plan sponsors also contributed to the worsening position because it reduced not only the cash contributions made to plans but also the premiums to be paid to the PBGC. The PBGC has fundamental structural problems as well, which include the inability to raise premiums or to charge premiums based on the credit quality of the plan sponsor, and the lack of authority to mandate adequate contributions to defined benefit plans. These flaws, if left unaddressed, combined with the shift toward defined contribution plans, raise serious questions about the retirement security of workers currently under defined benefit plans. Retirement savings The shift from defined benefit to defined contribution plans also raises significant issues about how effectively employees are handling their new freedoms and responsibilities and what the appropriate role for employers should be in helping workers plan for their retirement. A particularly popular type of defined contribution plan is the 401(k), which lets workers make pre-tax contributions to retirement accounts through payroll deduction. Twenty-five years ago, such plans did not exist. Today, they cover more than 40 million workers, take in $150 billion in annual contributions, and hold assets of about $2 trillion. And with a decline in the number of workers being covered by defined benefit plans over this period, the growth of 401(k) plans has put greater responsibility on the part of individuals to actively manage their retirement wealth. For example, workers must decide whether to participate in the plan, how much to contribute every pay period and in what type of assets, and when to rebalance their asset mix. In addition, they need to decide what to do with balances when changing jobs. Economic theory provides the basis for making these types of choices, but the average employee may not have developed the skills or the interest to formally evaluate the alternatives. And, in fact, recent research has found some troubling patterns: Many workers do not participate, contribute only a small portion of their wages if they do participate, and make questionable investment and distribution choices. Let me take a couple of minutes to cite some telling facts about individual savings in 401(k) plans, suggesting that workers may not be giving adequate attention to their savings in the retirement plans sponsored by their employer. First, despite the tax advantages of 401(k) contributions, one-quarter of workers eligible for 401(k) plans do not participate at all, even if the employer would match a portion of their own contributions.2 These workers are effectively giving up a pay raise. And among those that Deloitte and Touche, 2003 401(k) Annual Benchmarking Survey. contribute, many save just a little. In a survey last year, one-quarter of firms reported that their rankand-file 401(k) participants saved an average of less than 4 percent of pay.3 Another concern relates to the way employees manage their 401(k) plans. Some participants simply invest contributions equally across the investment options or according to plan defaults, which in many cases is a low-risk, low-return money market fund.4 And, as has been publicized widely in recent years, many 401(k) participants invest heavily in employer stock. Among companies that offer company stock as an investment option, more than one-quarter of 401(k) balances are in company stock.5 This high concentration cannot be attributed entirely to an employer match that is required to be held in company stock. Instead, employees appear to voluntarily purchase abundant amounts of company stock, despite the obvious risk of linking their current income and retirement wealth to the financial health of their employer. These patterns are troubling because they raise doubts about the financial security of workers in later life. Fortunately, new research in the discipline of behavioral finance provides some important insights into the behavior of 401(k) participants and suggests some promising changes that can lead workers to make savings choices that will leave them better prepared for retirement. Contrary to predictions of traditional finance theory, the way the retirement-plan options are framed affects the choices made by participants. As compelling evidence that framing matters, researchers have found that “opt-out” plans - those that automatically enroll workers unless they actively choose not to enroll - have substantially higher participation rates.6 Moreover, when defaults are designated, many workers tend to enroll using the default contribution rates and investment options and to leave these in place for many years after enrollment, even though the default may be set too low to allow for the accumulation of sufficient retirement assets.7 Moreover, the default investment choice is often a low risk asset that, while safe, does not allow for sufficient expected returns to build up retirement wealth. If workers are influenced by how choices are offered, then employers can make changes to the plans to help participants make better decisions. For example, employers might set default contribution rates to rise as workers receive pay raises, or set the default investment option to a diversified portfolio that adjusts as the worker ages.8 In addition, employees have increasingly expressed interest in employerprovided financial education, and firms are responding. In this regard, the Congress passed legislation in December 2001 that removes obstacles for employers to hire a third-party to provide financial advice. Previously, firms had been reluctant to provide investment advice for fear of being held liable should such advice lead to losses, even if an adviser was considered to be competent. Reportedly, more firms now provide access to a third-party who will, for a fee, advise employees about how much to contribute and how to invest their contributions. Some employers will be reluctant to move in this direction because they will appear to be paternalistic. But a significant and inescapable implication of this line of research is that employers cannot avoid responsibility in this area because there is no “neutral” plan design. Whatever design they choose will affect the retirement wealth of employees. To wrap up, employers play an important role in their workers’ financial security in later life and will continue to do so even with the shift away from defined benefit to defined contribution plans. An increasing amount of evidence indicates that how firms set up these plans will affect worker participation and contribution rates and what types of assets they will buy. As research continues to further our understanding of the connection between plan design and worker choices, changes can be Deloitte and Touche, 2003 401(k) Annual Benchmarking Survey. Nellie Liang and Scott Weisbenner (2001), “Investor Behavior and Purchase of Company Stock in 401(k) Plans - The Importance of Plan Design,” FEDS Working Paper 2002-36 and NBER Working Paper W9131; James Choi, David Laibson, Brigitte Madrian, and Andrew Metrick (2001), “For Better or for Worse: Default Effects and 401(k) Savings Behavior,” NBER Working Paper W8651. Sarah Holden and Jack VanDerhei (2004), “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2003,” ICI Perspective (August). Brigitte Madrian and Dennis Shea (2001), “The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior,” Quarterly Journal of Economics. James Choi, David Laibson, and Brigitte Madrian (2004), “Plan Design and 401(k) Plan Savings Outcomes,” NBER Working Paper W10486. Shlomo Benartzi and Richard Thaler (2004), “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving,” Journal of Political Economy. instituted to promote financial security. For their part, workers have a responsibility to improve their financial literacy and develop the skills and confidence to practice strategies for effective financial management. This improvement of financial literacy will become even more crucial if individual accounts are introduced as a modification to the current Social Security system, as proposed by the Administration.
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the C Peter McColough Roundtable Series on International Economics, Council on Foreign Relations, 19 January 2005.
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Ben S Bernanke: Productivity Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the C Peter McColough Roundtable Series on International Economics, Council on Foreign Relations, 19 January 2005. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * Almost certainly, the most important economic development in the United States in the past decade has been the sustained increase in the rate of growth of labor productivity, or output per hour of work. From the early 1970s until 1995, productivity growth in the U.S. nonfarm business sector averaged about 1-1/2 percent per year - a disappointingly low figure relative both to historical U.S. experience and to the performance of other industrial economies over the same period.1 Between 1995 and 2001, however, the rate of productivity growth picked up significantly, to about 2-1/2 percent per year - a figure that contributed to a growing perception that the United States might be entering a new economic era. Talk of the “new economy” faded with the sharp declines in the stock valuations of hightech firms at the turn of the millennium; yet, remarkably, productivity growth continued to rise. The pace of productivity gains averaged better than 4 percent per year since 2001 despite adverse developments that included the 2001 recession, the September 11 terrorist attacks, corporate governance scandals, and, most recently, a sharp rise in energy costs. Why is the rate of productivity growth so important? Economists agree that, in the long run, productivity growth is the principal source of improvements in living standards. The link between productivity growth and the standard of living of the average person is somewhat looser in the shortto-medium run, as factors such as the share of the population that is employed and the division of income between capital and labor also play a role. Nevertheless, the rate of productivity growth influences the economy in important ways even in the short run, affecting key variables such as output growth, employment growth, and the rate of inflation. In my remarks today, I will discuss the pickup in U.S. productivity growth and its implications for the economy. I will first review our current understanding of the causes of the recent productivity resurgence. With that background, I will next consider the near-term prospects for productivity growth. Finally, I will discuss briefly how the evolving productivity picture affects both the economic outlook and the appropriate stance of monetary policy. As always, my remarks today do not necessarily reflect the views of my colleagues at the Federal Reserve.2 The U.S. productivity resurgence and its causes Why has productivity growth increased? The favored explanation of the rise in productivity growth since about 1995 has evolved somewhat over time. By 2000 or so, an emerging consensus held that the pickup in productivity growth was, for the most part, the product of rapid technological progress and increased investment in new information and communication technologies (ICT) during the 1990s (Jorgenson and Stiroh, 2000; Oliner and Sichel, 2000). According to this view, rapid developments in ICT promoted U.S. productivity growth in two ways. First, technological advances allowed the ICT-producing sectors themselves to exhibit rapid productivity growth. For example, the development of more reliable semiconductor manufacturing equipment and faster wafer-inspection technologies increased the rate at which companies such as Intel were able to produce microprocessors. In part as a reaction to heightened competitive pressures, Intel also shortened its product cycle and increased the frequency of new chip releases, shifting its product mix toward more-powerful (and, consequently, higher-value) chips. Both the more-rapid pace of production and the higher average quality of output raised productivity at Intel and competing firms. I will use “labor productivity” and “productivity” interchangeably in my remarks today. An alternative productivity concept, multifactor productivity, measures the quantity of output that can be produced by a fixed combination of capital and labor. Changes in labor productivity generally reflect changes in both multifactor productivity and the amount of capital per worker. I thank Board staff members Flint Brayton, Charles A. Fleischman, Paul Lengermann, and Dan Sichel for excellent assistance and comments. Second, ICT advances also promoted productivity growth outside the ICT-producing sector, as firms in a wide range of industries expanded their investments in high-tech equipment and software and used the new technologies to reduce costs and increase quality (McKinsey, 2001). For example, some large retailers, most notably Walmart, developed ICT-based tools to improve the management of their supply chains and to increase their responsiveness to changes in the level and mix of customer demand. Securities brokers and dealers achieved substantial productivity gains by automating their trading processes and their back-office operations. In the durable goods sector, General Motors and other automobile producers developed programmable tooling systems to increase the flexibility of their manufacturing processes - for example, to permit vehicles based on different platforms to be produced on the same assembly line. One study found that nearly two-thirds of U.S. industries, comprising about 70 percent of total employment, experienced an acceleration of productivity in the latter part of the 1990s. Significantly, the study also found the gains to be the greatest in industries using ICT capital most intensively (Stiroh, 2002). Undoubtedly, the ICT revolution and the productivity resurgence in the United States after 1995 were closely connected, but several puzzles have arisen that challenge the view that ICT investment leads mechanically to higher productivity. First, the United States was not the only country to see a rapid expansion in ICT investment, as other industrial countries also invested heavily in these technologies in the 1980s and 1990s. Yet, with a few exceptions, productivity growth in other advanced countries has not increased recently to the extent seen in the United States. The comparison with the member states of the European Union is particularly interesting. Throughout most of the post-World War II period, labor productivity growth in Europe exceeded that in the United States, reflecting, first, rapid gains during the postwar reconstruction and then a gradual convergence of European technology and business practices to American standards. By one estimate, on average, European productivity increased from 44 percent of the U.S. level in 1950 to 94 percent in 1995 (Gordon, 2004). However, since about 1995, productivity growth in Europe has slowed, in contrast to the U.S. experience, and productivity levels in the United States and Europe have begun to diverge.3 Researchers have made the important point that U.S.-European differences in productivity growth do not appear to have been particularly large in the ICT-producing sectors, where U.S. strengths in the development of information technologies have been offset by European leadership in communications. Rather, the U.S. advantage has been most evident in the ICT-using sectors, which have performed better in the United States than elsewhere. What accounts for the apparent U.S. advantage in applying ICT to a wide range of industries? One popular hypothesis, put forth by Alan Greenspan (2000) and Martin Feldstein (2001), holds that European economies have been less successful in applying new technologies because of a relatively heavy regulatory burden that inhibits flexibility. For example, taking full advantage of new information and communication technologies may require extensive reorganization of work practices and the reallocation of workers among firms and industries. Regulations that raise the cost of hiring and firing workers and reduce employers’ ability to change work assignments, as exist in a number of European countries, may make such changes difficult to achieve. Likewise, the presence of government-owned firms with a degree of monopoly power, together with restrictions on the entry of new firms, may diminish competitive pressures that often foster innovation and greater efficiency (Nicoletti and Scarpetta, 2003). Recent empirical research has generally found that economies with highly regulated labor and product markets are indeed less able to make productive use of new technologies (Gust and Marquez, 2004). Industry-specific regulations may also be an important barrier to productivity improvement; for example, some writers have argued that restrictions on land use and on shopping hours in Europe have impeded the development of “big box” retail outlets, denying European firms the economies of scale that have been important for productivity growth in the U.S. retail sector (Gordon, 2004). Differences in regulatory burden do not appear to be a complete explanation of comparative productivity performance, however. For example, the United Kingdom, whose approach to the regulation of labor and product markets is closer to that of the United States than to that of continental Europe, has not done noticeably better in the productivity arena than other advanced European countries (Basu, Fernald, Oulton, and Srinivasan, 2003). A shortage of workers with appropriate skills may be part of the problem in the United Kingdom, as average educational attainment in that country Correcting for national differences in productivity measurement in some cases reduces the apparent differential in recent productivity growth but does not eliminate it. See Ahmad and others (2003) and Gordon (2004). is lower than in many other industrial countries. Skill shortages may have also been a factor in continental Europe, possibly because high youth unemployment has reduced opportunities for workers to acquire new skills on the job. Other suggested explanations for the relatively better productivity performance of the United States in recent years include the depth and flexibility of U.S. capital markets, its relatively open immigration policies (at least before 9/11), and the role of U.S. research universities in fostering innovation. Further study of the productivity differentials among the United States, Europe, and other regions clearly is warranted. A second puzzle that challenges the conclusion that advances in ICT are the primary source of recent productivity gains is the observation that, over the past twenty years or so, increases in ICT investment have not been followed reliably and in short order by increases in productivity growth. Instead, the lag between investments in new technologies and their putative productivity benefits appears to be long and variable. For example, ICT investment in the United States began in earnest in the 1980s, but productivity did not begin to accelerate until the mid-1990s. Indeed, an oft-quoted quip by economist Robert Solow held that, as of the late 1980s, “computers are everywhere except in the productivity statistics.”4 Likewise, although ICT investment declined sharply after the meltdown in tech stocks in 2000, productivity growth has continued to rise in recent years, as I have already noted. Perhaps the link between investment in high-tech capital and improving productivity is not so tight as we thought. In attempting to explain the relatively loose temporal link between ICT investment and productivity growth, economists have emphasized that much more than the purchase of new high-tech equipment is needed to achieve significant gains in productivity. First, managers must have a carefully thought-out plan for using new technologies before they acquire them. Case studies of individual industries show that, in some cases, the planning for technological modernization has not always been adequate, with the result that some purchases of high-tech equipment and software have not added much to productivity or profits. The idea that managers can buy the hardware first and then decide what to do with it - sometimes heard as an explanation for the apparently delayed effects of ICT investments made during the late-nineties boom - does not square with the case-study evidence. Effective planning alone does not guarantee that ICT investments will be beneficial, however. Some observers have characterized the new information and communications technologies as generalpurpose technologies (GPTs), which means that - like earlier GPTs such as electrification and the internal combustion engine - they have the potential to revolutionize production and consumption processes in a wide variety of contexts (Bresnahan and Trajtenberg, 1995). To make effective use of a GPT within a specific firm or industry, however, managers must supplement their purchases of new equipment with investments in research and development, worker training, and organizational redesign - all examples of what economists call intangible capital. For example, to realize the benefits of its ICT investments, Walmart had to reorganize work assignments, retrain workers, develop new relationships with suppliers, and modify its management systems. Although investments in intangible capital are (for the most part) not counted as capital investment in the national income and product accounts, they appear to be quantitatively important.5 One recent study estimated that, by the late 1990s, investments in intangible capital by U.S. businesses were as large as investment in traditional, tangible capital (Corrado, Hulten, and Sichel, 2004). Recognizing the importance of intangible capital has several interesting implications. First, because investment in intangible capital is typically treated as a current expense rather than as an investment, aggregate saving and investment may be significantly understated in the U.S. official statistics. Second, firms’ need to invest in intangible capital - and thus to divert resources from the production of market goods or services - helps to explain why measured output and productivity may decline initially when firms introduce new technologies. Finally, the importance of intangible investment explains to some degree why the lags between ICT investment and the resulting productivity gains can be long and variable. Because investments in high-tech capital typically require complementary investments in intangible capital for productivity gains to be realized, the benefits of high-tech investment may become visible only after a period of time. In fairness to ICT proponents, Solow’s claim that computers were “everywhere” in the 1980s is somewhat exaggerated. Aggregate ICT investment was considerably higher in the 1990s than in the 1980s. Software is one intangible investment that is treated as part of business fixed investment in the U.S. national accounts. Medium-term prospects for productivity growth Historical analysis of the sources of the productivity acceleration is challenging, but not nearly so challenging as trying to predict how productivity will evolve over the next few years. However, because the rate of productivity growth is a primary determinant of economic performance, policymakers have few options other than to try to forecast future productivity gains. What can be said about the mediumterm prospects for productivity growth? The task of trying to predict the medium-term behavior of productivity is complicated by the fact that productivity growth tends to vary with the business cycle. According to one popular hypothesis, this tendency reflects cyclical variations in the intensity with which labor is utilized.6 Because adjusting the size of a company’s labor force may involve significant fixed costs (including training costs as well as costs of hiring and firing), employers are generally reluctant to add or subtract workers at the first sign of a change in the demand for their products. Thus, in the earliest stages of a contraction, for example, employers may choose not to dismiss workers but instead to use them less intensively or assign them tasks that do not involve current production, such as maintenance or training. Measured productivity growth consequently declines when the economy enters a recession. Similarly, during the early stages of an economic recovery, employers may hesitate to add new workers and instead may ask existing employees to work harder, at least until the expansion seems better established. Output per hour of work thus tends to rise faster than its secular (long-run) rate early in the recovery. Finally, as the expansion matures and hiring picks up, productivity growth tends to slow again as the level of employee effort returns to normal and as the need to devote firm resources to hiring and training new workers detracts from current production. At present, three years from the official end of the 2001 recession, the U.S. economy has likely entered this latter stage, as productivity growth appears to be falling from its recent high levels to a rate that is likely below its longer-term trend. Cyclical factors tend to unwind, however; and so, looking ahead a couple of quarters, say, to the second half of 2005, we can reasonably assume that productivity growth will approach its secular trend. What is that trend? Using various econometric methods, together with a liberal dose of judgment, several leading economists have recently offered estimates for secular productivity growth of about 2-1/2 percent per year, close to the rate of productivity growth achieved during 1995-2001 (Baily, 2003; Gordon, 2003; Jorgenson, Ho, and Stiroh, 2004). If these estimates turn out to be correct - and they are certainly subject to a great deal of uncertainty, as I will discuss - then the increase in productivity growth of the mid-1990s may come to be seen as having initiated a new era for the U.S. economy. Of course, as the saying goes, past returns are not a guarantee of future results; not all the evidence supports the emerging consensus that secular productivity growth will remain at its current elevated level. For example, although spending on high-tech equipment and software has recovered smartly from its recent lows, growth in ICT spending still remains well below rates seen before the 2001 recession. Some industry participants have suggested that less-rapid growth in ICT spending reflects the absence of major new business applications for ICT - “killer apps,” as they are called - and that ICT investment for the foreseeable future will largely reflect replacement demands. Researchers have also found some evidence that the technological frontier may not have advanced as quickly recently as it did in earlier years; as one indicator, the price of computing power has recently declined more slowly than it did in the 1980s and 1990s. These caveats notwithstanding, I think the productivity optimists have a good case. Computing power may not be falling in price quite so rapidly now as in the late 1990s, but a dollar nevertheless buys a great deal more computational capacity today than it did even five years ago. And if rapidly improving information and communication technologies are truly general-purpose technologies, history suggests that they will continue to stimulate new ways of producing and of organizing production (DeLong, 2002). In particular, the enormous expansion in available computing power has already contributed to advances in other emerging fields, such as biotechnology. Moreover, even if the technological frontier advances more slowly during the next few years, further diffusion of the existing technologies and applications can continue to raise aggregate productivity. The available evidence suggests that this diffusion process is not complete. For example, a survey conducted in 2003 by the Institute of Supply Management and Forrester Research found that most See Basu and Fernald (2001) for a discussion. managers consider their company to be at a relatively early stage in exploiting the potential gains from using the Internet for their purchasing activities. In a more formal analysis, Jason Cummins and Giovanni Violante constructed a measure of the “technological gap” in U.S. industry, defined as the difference in efficiency between state-of-the-art capital equipment and the actual mix of equipment held by firms (Cummins and Violante, 2002). As of 2000, the last year included in their study, the authors found this gap to be 40 percent and rising, suggesting that substantial opportunities remain for increasing productivity. This gap is unlikely to have declined much since 2000, for even if the rate of technological progress has slowed, so has the pace of ICT investment. I draw two conclusions: first, on the whole, the relatively optimistic estimates of secular productivity growth espoused by leading scholars in the field do not seem unreasonable, so that, for the longer term, continued growth in productivity in the range of, say, 2 percent to 2-1/2 percent per year probably represents a good baseline assumption. Second, qualifying the first conclusion, the range of uncertainty in forecasts of productivity growth is inevitably quite wide. For example, a 2004 study by three leading scholars produced an estimate of trend productivity growth of 2.6 percent, but with a range of plausible outcomes between 1.4 percent and 3.2 percent (Jorgenson, Ho, and Stiroh, 2004). This qualification naturally leads us to ask: Suppose that, over the next year, the incoming evidence suggests that the trend rate of productivity growth is either substantially higher or substantially lower than we currently expect. How would that development affect the economy and monetary policy? In the final portion of my remarks, I will address this important question. Implications for the economy and monetary policy For concreteness, suppose that the pace of productivity gains in the latter part of 2005 and in 2006 proves disappointing, sufficiently so to suggest that current estimates of the sustainable rate of productivity growth may be overoptimistic. Let us first consider what this information would likely imply for the medium-term economic forecast. To anticipate the conclusion, we will see that the strength of the response of aggregate demand to productivity developments is the key determinant of their overall impact.7 In the first instance, incoming evidence of a secular slowdown in productivity would likely result in slower growth in consumption spending, capital investment, and aggregate output relative to what would have been otherwise expected. Consumption growth would weaken as downwardly revised profit expectations limit stock market gains, thereby reducing household wealth, and as moreforesighted consumers perceive that smaller productivity gains portend lower real wage growth. Lower expected rates of productivity growth should also tend to moderate growth in business investment by reducing the prospective return to capital. As consumption and investment spending make up more than four-fifths of aggregate output, slower productivity growth would perforce reduce output growth as well. What about inflation? In principle, the medium-term effect of slowing productivity growth on inflation is ambiguous. As a number of analysts have noted, under the reasonable assumption that nominal wages adjust slowly, slower productivity growth results in a more rapid rise in unit labor costs (the nominal-wage cost of producing a unit of output).8 All else equal, a more rapid increase in unit labor costs will tend to increase inflation as well. However, the effect of higher unit labor costs may be offset if the decline in consumption and investment spending induced by the productivity slowdown is particularly sharp. Indeed, a large deceleration in spending could conceivably cause inflation to slow following a productivity slowdown, as firms’ markups contract more than unit labor costs rise. The effect of a productivity slowdown on employment growth is likewise ambiguous in the medium term. Slower output growth depresses employment growth as firms face weaker demand, but slower productivity growth implies that firms need more workers to produce a given level of output. As in the case of inflation, the strength of the spending response is crucial. The more sharply spending and output decline following a productivity slowdown, the more adverse the effects on employment will be. Both the late 1990s and the more recent period illustrate the central role of the spending response in determining the macroeconomic effects of a change in productivity growth, although (as I have Kohn (2003) explores some of the issues of this section in greater detail. Braun (1984) and Ball and Moffitt (2001) discuss the effect on inflation of a change in the rate of productivity growth. discussed today) in both of these episodes the productivity surprise was to the upside rather than the downside. The rise in productivity growth after 1995 was accompanied by surges in both consumption and investment spending, supported by a booming stock market. Employment rose and unemployment fell, as the strength of aggregate demand induced employers to hire, the increases in productivity notwithstanding. Inflation remained fairly stable during this period, as upward pressures from increased aggregate demand were balanced by downward pressures on unit labor costs (for any given level of wages) and by the increase in aggregate supply created by higher productivity. In contrast to the experience of the late 1990s, during the early part of the new millennium the response of spending to rising productivity growth was comparatively weak. Investment spending was particularly slow to respond to the further increase in productivity growth, for reasons that are still debated. Possible explanations for the weak investment response include an unusually high degree of corporate caution, cost-cutting pressures, and the after-effects of the corporate governance scandals of 2002. An explanation suggested by my discussion today is that, for most of this period, companies were enjoying the fruits - in terms of higher productivity - of earlier investments in both tangible and intangible capital. The extra productive capacity created by those investments, together with a recovery whose durability in the early stages was not assured, may have implied little need for further investment, at least until relatively recently. Whatever the cause, the weaker response of spending in the more-recent period, coupled with impressive gains in productivity, helped to generate both a pattern of slow job growth (the “jobless recovery”) and the worrisome decline in inflation in 2003. What are the implications of these observations for current monetary policy? Certainly, monetary policy makers should pay close attention to developments on the productivity front, as the effects of changing productivity trends permeate the economy. However, as we have seen, the appropriate policy response to any perceived change in the trend rate of productivity growth will depend to a significant degree on the response of private-sector spending. For example, if productivity growth appears poised to decelerate, but (for whatever reason) aggregate private spending does not slow materially in response, then inflation risks would rise, but employment would not be adversely affected. The appropriate response in this case would be a tightening of monetary policy (or a more rapid removal of accommodation). On the other hand, if slower productivity growth were accompanied by a sufficiently large slowdown in aggregate demand and economic activity, then easier monetary policy (or a slower removal of policy accommodation) might be called for. My best guess - and it is only a guess - is that future responses of consumption and investment spending to changes in the pace of productivity growth are likely to be less powerful than those of the late 1990s, if for no other reason than that we may have learned to be more careful in our enthusiasms. If so, then the principal effect of an unexpected slowdown in productivity growth during the next few years would likely be higher inflation, with the short-term impact on the growth of output and employment likely to be relatively minor. In this scenario, the appropriate monetary policy response would be toward less accommodation. By similar reasoning, if productivity growth were to accelerate in the next few years, then easing inflation pressures and slowing employment growth would likely allow for less-restrictive policies. As I have emphasized, however, these conclusions depend on other developments in the economy, most importantly on how strongly aggregate spending responds to any perceived change in secular productivity growth. Of course, it should go without saying that the world is more complicated than theoretical arguments suggest. Notably, imperfect data and the difficulties of distinguishing permanent from temporary changes will make changes in secular productivity growth exceptionally difficult to identify in real time, both for the private sector and for the Federal Reserve. The need to discern the underlying economic forces and to react appropriately in an environment of incomplete information makes monetary policy an exceptionally challenging endeavor.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Adam Smith Memorial Lecture, Kirkcaldy, Scotland, 6 February 2005.
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Alan Greenspan: Adam Smith Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Adam Smith Memorial Lecture, Kirkcaldy, Scotland, 6 February 2005. * * * Kirkcaldy - the birthplace, in 1723, of Adam Smith and, by extension, of modern economics - is also, of course, where your Chancellor of the Exchequer was reared. I am led to ponder to what extent the Chancellor's renowned economic and financial skills are the result of exposure to the subliminal intellect-enhancing emanations of this area. *** In the broad sweep of history, it is ideas that matter. Indeed, the world is ruled by little else. As John Maynard Keynes famously observed: "Practical men, who believe themselves to be quite exempt from intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."1 Emperors and armies come and go; but unless they leave new ideas in their wake, they are of passing historic consequence. The short list of intellectuals who have materially advanced the betterment of civilization unquestionably includes Adam Smith. He is a towering contributor to the development of the modern world. In his Wealth of Nations, Smith reached far beyond the insights of his predecessors to frame a global view of how market economies, just then emerging, worked. In so doing, he supported changes in societal organization that were to measurably enhance world standards of living. For most of recorded history, people appear to have acquiesced in, and in some ways embraced, a society that was static and predictable. A young twelfth-century vassal could look forward to tilling the same plot of his landlord's soil until disease, famine, natural disaster, or violence ended his life. And that end often came quickly. Life expectancy at birth was, on average, twenty-five years, the same as it had been for the previous thousand years. Moreover, the vassal could fully expect that his children and doubtless their children, in turn, would till the same plot. Perhaps such a programmed life had a certain security, established by a rigid social and legal hierarchy that left little to individual enterprise. To be sure, improved agricultural techniques and the expansion of trade beyond the largely self-sufficient feudal manor increased the division of labor and raised living standards and populations, but growth in both was glacial. In the fifteenth century, the great mass of people were engaged in the same productive practices as those of their forebears many generations earlier. Smith lived at a time when market forces were beginning to erode the rigidities of the remaining feudal and medieval practices and the mercantilism that followed them. Influenced by the ideas and events of the Reformation, which helped undermine the concept of the divine right of kings, a view of individuals acting independently of ecclesiastic and state restraint emerged in the early part of the eighteenth century. For the first time, modern notions of political and economic freedom began to gain traction. Those ideas, associated with the Age of Enlightenment, especially in England, Scotland, and France, gave rise to a vision of a society in which individuals guided by reason were free to choose their destinies unshackled from repressive restrictions and custom. What we now know as the rule of law - namely protection of the rights of individuals and their property - widened, encouraging people to increase their efforts to produce, trade, and innovate. A whole new system of enterprise began to develop, which, though it seemed bewildering in its complexity and consequences, appeared nonetheless to possess a degree of stability as if guided by an "invisible hand." The French Physiocrats, among others, struggled in the middle of the eighteenth century to develop rudimentary principles to untangle that conundrum. Those principles were an attempt to explain how an economy governed by a calculable regularity - that is, natural law and, as characterized by the Physiocrat Vincent de Tournay, "Laissez-faire, laissez-passer" - would function. The Physiocrats' influence, however, waned rapidly along with the influence of other political economists as evidence grew that their models were, at best, incomplete. J.M. Keynes, The General Theory of Employment, Interest, and Money, 1936, p. 383. It was left to Adam Smith to identify the more-general set of principles that brought conceptual clarity to the seeming chaos of market transactions. In 1776, Smith produced one of the great achievements in human intellectual history: An Inquiry into the Nature and Causes of the Wealth of Nations. Most of Smith's free-market paradigm remains applicable to this day. Smith was doubtless inspired by the Physiocrats, as well as by his friend David Hume, his mentor Francis Hutcheson, and other participants in the Enlightenment. Early political economists had made impressive contributions, many of them anticipating parts of Smith's global view. But Smith reached beyond his predecessors and subjected market processes to a far more formidable intellectual analysis. One hears a good deal of Franz Joseph Haydn in the string quartets and symphonies of Wolfgang Amadeus Mozart; yet to my ear, at least, Mozart rose to a plateau beyond anything Haydn and his contemporaries were able to reach. So, too, in his sphere, did Smith. He concluded that, to enhance the wealth of a nation, every man, consistent with the law, should be "free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of ... other ... men."2 "It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest."3 The individual is driven by private gain but is "led by an invisible hand" to promote the public good, "which was no part of his intention."4 This last insight is all the more extraordinary in that, for much of human history, acting in one's self-interest - indeed, seeking to accumulate wealth - had been perceived as unseemly and was, in some instances, illegal. In the opening paragraphs of the Wealth of Nations, Smith recognized the crucial role played by the expansion of labor productivity in improving welfare when he cited "the skill, dexterity, and judgment with which labor is generally applied" as one of the essential determinants of a nation's standard of living. "Whatever be the soil, climate, or extent of territory of any particular nation, the abundance or scantiness of its annual supply must in that particular situation, depend upon ... the productive powers of labor."5 More than two centuries of economic thought have added little to those insights. Smith, on remarkably little formal empirical evidence, drew broad inferences about the nature of commercial organization and institutions that led to a set of principles that would profoundly influence and alter a significant segment of the civilized world of that time. Economies based on those principles first created levels of sustenance adequate to enable the population to grow and later - far later - to create material conditions of living that fostered an increase in life expectancy. The latter development opened up the possibility that individuals could establish long-term personal goals, a possibility that was remote to all but a sliver of earlier generations. *** Smith's ideas fell on fertile ground and within a very few decades verged on conventional wisdom. The ancient political power of the landed gentry, the major beneficiaries of the older order, was giving way to a new class of merchants and manufacturers that was a product of the Industrial Revolution, which had begun a quarter-century earlier. Pressures were building in Britain and elsewhere to break down mercantilist restrictions. But with Smith, the emerging elite found their voice and sanction. Smith's sanction, however, was directed to the freedom of markets and trade, not to the new business elite, many of whose business practices Smith severely deprecated. He concluded that the competitive force unleashed by individuals in pursuit of their rational self-interest induces each person to do better. Such competitive interaction, by encouraging specialization and division of labor, increases economic growth. *** Smith's essentially benevolent views of the workings of competition counteracted pressures for market regulation of the evident excesses of the factory system that had begun early in the eighteenth century. Those excesses were decried a century later by the poet William Blake as "... the dark Satanic mills" that by then characterized much of industrial England. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776, p. 687. Ibid., p. 26-27. Ibid., p. 456. Ibid., p. 10. Perhaps if the Wealth of Nations had never been written, the Industrial Revolution would still have proceeded into the nineteenth century at an impressive pace. But without Smith's demonstration of the inherent stability and growth of what we now term free-market capitalism, the remarkable advance of material well-being for whole nations might well have been quashed. Pressures conceivably could have emerged to strengthen mercantilistic regulations in response to the stresses created by competition and to the all-too-evident ills of industrialization. *** Smith was the first in a line of political economists whom we now identify as the classical school. Foremost of his followers was David Ricardo, a stockbroker, parliamentarian, and skilled essayist. Ricardo's major work, The Principles of Political Economy and Taxation, published in 1817, offered a rigorous, though less optimistic, analysis of the structure of a system of wholly free commerce. Under the political onslaught of a rising industrialist class intellectually supported by the classical school, mercantilism was gradually dismantled, and economic freedom spread widely. This process reached its apex with the repeal of Britain's Corn Laws in 1846. The acceptance of classical economics was, by then, broad enough to prompt reorganization of commercial life in most of the civilized world. *** Adam Smith died in 1790, well before his extraordinary impact could have been assessed. But Ricardo lived until 1823, and John Stuart Mill, another member of the school, lived until 1873. Would they and the other early followers of Smith find the current economic landscape at all familiar? In one sense, not likely. Among the developed countries, famine is now virtually nonexistent. Thomas Robert Malthus's penetrating analysis at the end of the eighteenth century of the limits of subsistence, to which many of the classical school subscribed, proved wrong. Malthus built his pessimistic vision on a notion that the long-evident forces of stagnation would persist: A human population with a propensity to grow geometrically would be thwarted by limits to growth in the means of subsistence. Having observed crop yields that had changed only marginally for millennia, Malthus could not have foreseen the dramatic increase in agricultural yields. In the United States, for example, corn yields - or should I say maize yields - rose from 25 bushels per acre in the early 1800s to 160 by 2004. Moreover, those living in the early part of the nineteenth century could not have imagined that life expectancy in developed countries two centuries later would rise on average to more than twice that which they experienced. That increase directly and indirectly resulted largely from the almost twentyfold increase in average real per capita gross domestic product gained since 1820, according to estimates of Angus Maddison, the economic historian. From this expanding output, society has been able to devote more resources to nutrition, sanitation, and health care. And yet, regrettably, much of today's developing world would appear familiar to our forebears. Pestilence is present in the form of AIDS, and as a consequence, life expectancy in much of Africa is not much different from what it was in most of the world two centuries ago. Significant parts of the world still experience periodic famine. Although workers in developed and many emerging nations have witnessed an extraordinary rise in living standards, some shadow of worker angst of the earlier period remains. Today's vast technological advances and the labor turnover associated with it have not sparked the violence of the early nineteenth-century Luddites, but they are nonetheless associated with significant job insecurity. Finally, classical economists, who battled the rear guard of mercantilism in their days, would certainly recognize the assault on their paradigm in the anti-capitalist, anti-free-trade rhetoric currently prevalent in some contemporary discourse. *** Yet, with all of today's economic shortcomings, there can be little doubt that the Industrial Revolution and the emergence of free-market capitalism have brought civilization to a material level that could not have been imagined two centuries ago. The late eighteenth century, when the dramatic rise in standards of living and in population began after millennia of virtual stagnation, was one of the seminal turning points of history. With few exceptions, that advance has carried forward to this day. Average global real per capita GDP has risen 1.2 percent annually since 1820, enough to double standards of living every fifty-eight years. In the same period, world population has increased sixfold. In the previous two millennia average per capita incomes barely exceeded levels required to support, at minimum subsistence, a marginally noticeable rise in population. *** Today, Adam Smith's insights still resonate as they did after the publication of the Wealth of Nations. However, during the intervening generations the esteem in which Smith's contributions were held waxed and waned with the acceptance of free-market capitalism. After its initial acceptance in the late eighteenth century, the new economic order soon attracted criticism. The Industrial Revolution brought "the dark Satanic mills" and all the squalor associated with them. To be sure, life for a significant part of the population at the margin of subsistence during the early days of the Industrial Revolution was misery. But it was life. A half-century earlier, many of those miserable souls would have died as infants or children. Nonetheless, within decades of the emergence of the new order the visible misery and the evident wretched struggle for subsistence inspired competing visions of economic organization. Robert Owen, a successful British factory owner, in a challenge to Smith, averred that unrestrained laissez-faire by its nature would lead to poverty and disease. He led a school of so-called Utopian Socialists who advocated, in Owen's phrase, "villages of cooperation." In 1826, he set up such a community in the United States, which he named New Harmony. Ironically, communal strife brought the New Harmony experiment to collapse within two years. Many saw the initiative as opposed to the laws of human nature, a component of natural law. But Owen's charismatic devotion to his cause continued to draw large followings among those barely able to eke out subsistence in an appalling working environment. The elevation to a more civilized state of work was still a century in the future. Karl Marx was dismissive of Owen and his utopian followers. Indeed, Marx was attracted to the intellectual rigor of Smith and Ricardo, who to his mind, up to a point, accurately described the evolution of capitalism. As we all know, Marx viewed capitalism as a transition to the inevitable emergence of communism. Unlike Marx, the Fabian socialists who emerged in the last decades of the nineteenth century advocated evolution rather than revolution to a more collectivized economy. Indeed, many of the restraints on laissez-faire advanced by the Fabians and other reformers were eventually enacted into law. However, throughout the nineteenth century, notwithstanding widespread criticism of market capitalism, standards of living continued to increase, propelling the world's population to more than 11/2 billion by 1900. The major advances in life expectancy by the early twentieth century were attributable largely to efforts to ensure a clean water supply, the result of the increased capital stock associated with rising affluence. *** In the nineteenth century, criticism of capitalism emphasized abuses of business practice. Aside from Marxist views of the exploitation of workers by capitalists, monopoly was seen by many as a natural consequence of unfettered capitalism. Even earlier, Smith had weighed in with his oft-quoted insight that "people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."6 Yet standards of living of the average worker moved inexorably higher, serving through most of the nineteenth and early twentieth centuries as an effective political buffer to the widespread emergence of socialism. Because agriculture so dominated the world's economies at that time, the industrial recessions, which appeared from time to time, did not provoke a severe enough political response to alter the capitalistic order. 6I Ibid., p. 10. The writings of Jean Baptiste Say, an early nineteenth-century follower of Smith, were significant in this regard. He postulated that supply creates its own demand and concluded that marked contractions in economic activity would, with time, be unwound.7 The widespread acceptance of Say's Law and the associated confidence in the self-stabilizing property of a market-based price system were dominant factors inhibiting government intervention in periods of economic distress, especially during the latter part of the nineteenth and early twentieth centuries. But the Great Depression of the 1930s subjected the optimistic conclusions of classical economics, especially Say's Law, to a much broader assault. As the economic stagnation of the 1930s dragged on, the critical notion that capitalism was self-correcting fell into disrepute. The marked increase in government intervention into markets, in effect a partial reversion to mercantilism, was perhaps an inevitable response to the distress of the Great Depression. At the same time, the notions of Marx gained influence in the West, perhaps because the repressions of the Soviet Union, the major avowed practitioner of Marx, were not well known before World War II. But cracks in the facade of economic management by government emerged early in the post-World War II years, and those cracks were to widen as time passed. Britain's heavily controlled economy, a carryover from the war, was under persistent stress as it encountered one crisis after another in the early postwar decades. In the United States, unbalanced macroeconomic policies led to a gradual uptrend in the rate of inflation in the 1960s. The imposition of wage and price controls to deal with rising inflation in the 1970s proved ineffective and unworkable. The notion that the centrally planned Soviet economy was catching up with the West was, by the early 1980s, increasingly viewed as dubious, though the view was not fully discredited until the collapse of the Berlin Wall in 1989 exposed the economic ruin behind the Iron Curtain. The East-West divisions following World War II engendered an unintended four-decade-long experiment in comparative economic systems - Smith versus Marx, so to speak. The results, evident with the dismantling of the Iron Curtain, were unequivocally in favor of market economies. The consequences were far-reaching. The long-standing debate between the virtues of economies organized around free markets and those governed by central planning came to an end. There was no eulogy for central planning; it just ceased to be mentioned, leaving the principles of Adam Smith and his followers, revised only in the details, as the seemingly sole remaining effective paradigm for economic organization. A large majority of developing nations quietly shifted to more market-oriented economies. But even earlier in the postwar decades, distortions induced by regulation were viewed as more and more disturbing in the developed world. Starting in the 1970s, American Presidents, supported by bipartisan majorities in the Congress, deregulated large segments of America's transportation, communications, energy, and financial services industries. Similar initiatives were advanced in Britain and elsewhere. The stated purpose was to enhance competition, which following Adam Smith was increasingly seen as a significant spur to the growth of productivity and standards of living. The slow, but persistent, lowering of barriers to cross-border trade and finance assisted in the dismantling of economic rigidities. By the 1980s, the success of that strategy in the United States confirmed the earlier views that a loosening of regulatory restraint on business would improve the flexibility of our economies. Flexibility implies a faster response to shocks, a correspondingly greater ability to absorb their downside consequences, and a quicker recovery in their aftermath. Enhanced flexibility has the advantage of enabling market economies to adjust automatically and not having to rest on policymakers' initiatives, which often come too late or are misguided. Such views, which echo Jean Baptiste Say in some ways, clearly have been paramount in a renewed twenty-first century appreciation of Adam Smith's contributions. *** Classical economics, especially as refined and formalized by Ricardo and Alfred Marshall, emphasized competition in the marketplace among economic participants governed by rational selfinterest.8 The value preferences of these participants would be revealed by their actions in that J.B. Say, Traité d'économie politique, 1803. A. Marshall, Principles of Economics, 1890. marketplace. But the ultimate source of value preference was assumed to be outside the scope of economics. Adam Smith's purview was broader: He sought in his Theory of Moral Sentiments, published nearly two decades before the Wealth of Nations, to delve into the roots of human motivation and interaction. He concluded that human sympathy, by fostering the institutions supporting human civil interaction and life, was a major contributor to societal cohesion. To guide their own lives, people also exhibit a seeming inborn sense of right and wrong, presumably tested by the laws of nature. Those sentiments fashion each person's value preferences and their intensity. Rational thought, in Smith's thesis, apparently emerges only in the contemplation and initiation of those actions that will make manifest the innate propensities. Over the past two centuries, scholars have examined these issues extensively, but our knowledge of the source of inbred value preference remains importantly shaped by the debates that engaged the Enlightenment. The vast majority of economic decisions today fit those earlier presumptions of individuals acting more or less in their rational self-interest. Were it otherwise, economic variables would fluctuate more than we observe in markets at most times. Indeed, without the presumption of rational self-interest, the supply and demand curves of classical economics might not intersect, eliminating the possibility of market-determined prices. For example, one could hardly imagine that today's awesome array of international transactions would produce the relative economic stability that we experience daily if they were not led by some international version of Smith's invisible hand. The inference is not that people always act rationally in commercial transactions. The periodic bubbles in product and financial markets prove otherwise. But, by and large, the description of economic process that Smith developed, and others have since extended, does appear to adequately describe today's determinants of world commerce and the wealth of nations. *** A notable aspect of economics as a major discipline is its emergence largely on British soil. Smith, Ricardo, Mill, Marshall, and Keynes developed and extended classical economics. Even Marx constructed much of his revolutionary thesis in London. The incredible insights of a handful of intellectuals of the Enlightenment - especially the Scottish Enlightenment, with Smith and Hume toiling in the environs of Kirkcaldy - created the modern vision of people free to choose and to act according to their individual self-interest. As a consequence, today we enjoy material benefits and longevity that Smith's generation could not have remotely imagined. We owe them, especially Adam Smith, a debt of gratitude that can never be repaid.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Advancing Enterprise 2005 Conference, London, England, 4 February 2005.
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Alan Greenspan: Current account Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Advancing Enterprise 2005 Conference, London, England, 4 February 2005. * * * International trade has been expanding as a share of world gross domestic product since the end of World War II. Yet through 1995, the expansion was essentially a balanced grossing up of cross-border flows. Only in the past decade has expanding trade been associated with the emergence of ever-larger U.S. current account deficits, lesser deficits elsewhere, matched by a corresponding widening of external surpluses in a majority of trading nations. The increased dispersion of these external imbalances is mirrored in a decline in the tight association between national saving rates and domestic investment rates. The correlation between the two, for countries representing four-fifths of world GDP, declined from a coefficient of around 0.96 in 1992, where it had hovered for a half-century, to an estimated low of 0.8 last year.1 A number of factors have recently converged to lessen restraints on cross-border financial flows as well as on trade in goods and services. The advance of information and communication technology has effectively shrunk the time and distance that separate markets around the world. The vast improvements in these newer technologies have broadened investors' vision to the point that foreign investment appears less exotic and risky. Combined with improvements in transportation networks, these developments have expanded the range of tradable goods and services that can be brought to each market and have enabled greater integration of the productive resources of national economies. Both deregulation and technological innovation have driven the globalization process by tearing down the barriers that have separated economic agents, thus lowering costs. The effect of these developments has been to markedly increase the willingness and ability of financial market participants to reach beyond national borders to invest in foreign countries, just as a century and more ago savings moved beyond local investment opportunities to develop national markets. Implicit in the movement of savings across national borders to fund investment has been the significant increase in the dispersion of national current account balances. In recent years, the negative tail of the distribution of current account balances has been, of course, dominated by the U.S. deficit. The decline in home bias, as economists call the parochial tendency to invest domestic savings at home, has clearly enlarged the capacity of the United States to fund deficits. Arguably, however, it has been economic characteristics special to the United States that have permitted our current account deficit to be driven ever higher, in an environment of greater international capital mobility. In particular, the dramatic increase in underlying growth of U.S. productivity over the past decade lifted real rates of return on dollar investments. These higher rates, in turn, appeared to be the principal cause of the notable rise in the exchange rate of the U.S. dollar in the late 1990s. As the dollar rose, gross operating profit margins of exporters to the United States increased even as trade and current account deficits in the United States widened markedly.2 But these deficits have continued to grow over the past three years despite a decline in the dollar, whose broadly weighted real index is now much of the way back to its previous low in 1995. Although the dollar's exchange rate has been declining since early 2002, increasingly tight competitive conditions in the United States, as elsewhere, in 2002 and 2003 apparently induced exporters to the United States to hold dollar prices to competitive levels to ensure their market share and foothold in The seminal work on this issue by Martin Feldstein and Charles Horioka a quarter-century ago ("Domestic Savings and International Capital Flows," Economic Journal, vol. 90 [1980], pp. 314-29) implied that global savings are inefficiently distributed to investment, meaning that savers are bearing too much risk for the returns they achieve and that countries with high-potential investment projects are getting less financing than they could productively employ. Savers tend, to their own detriment, to over-discount foreign returns. Such suboptimal allocation of capital lowers living standards everywhere. Data on profits and profit margins for export sales to the United States are generally not available for our major trading partners. However, indirect evidence of levels and trends can be gleaned from U.S. import prices converted to exporters' currencies and foreign unit labor costs. the world's largest economy. For example, from early 2002 to early 2004, the dollar's exchange rate against the euro and sterling, on average, declined about 30 percent, yet dollar prices of imported manufactured goods from the European Union rose by only 9 percent, slightly more than dollar prices of U.S. manufactured goods during the same two years. The consequence of the relatively small rise in the dollar price was a significant compression of gross operating profit margins on European exports to the United States. In recent years, exporters, not only in Europe but in many other trading partners of the United States as well, have tended to increasingly absorb declines in prices denominated in their own currencies when their currencies rose and to fatten profit margins when their currencies fell. Unit labor costs in euros and sterling, for example, increased nearly 2 percent between the first quarter of 2002 and the first quarter of 2004. So, given the average fall in euro and sterling prices of European exports to the United States, gross operating profit margins on those sales must have declined more than 20 percentage points.3 The margin squeeze, in effect, absorbed about three-quarters of the decline in the dollar's exchange rate relative to the euro and the pound, on average, over the two years. Export margins, as I indicated earlier, had apparently risen to high levels by early 2002, following the roughly 40 percent increase in the value of the dollar in terms of euro and sterling from 1995 to 2002. Hence, margins in early 2004 might still have exceeded their levels of 1995. However, with the strengthening of sterling and the euro that resumed in the last three quarters of 2004, exporters to the United States exhibited significant resistance to further lowering of euro and sterling prices. Accordingly, dollar prices of imports from Europe picked up a bit. This pickup suggests that profit margins were minimal at best a year ago and hence that exporters were willing to lose some U.S. market share rather than compress margins still further. A noticeable downtrend in the share of European exports in U.S. imports has been apparent over the past year. *** Gains from increased currency hedging against the dollar since early 20024 may have enabled European exporters to tolerate a fall in operating profit margins beyond what they otherwise would have been able to tolerate. Hedging, however, can only partially and temporarily alter the impact of exchange rates on export prices. To be sure, very long-dated contracts can transcend short-run fluctuations in currencies. But, long-term hedging is expensive, and therefore, most currency futures contracts are short-term. Once hedges expire, export revenues are no longer protected from past and future changes in exchange rates, and any new hedges must reflect the new exchange rates. Thus, successful currency hedges can at best delay but cannot prevent the ultimate effects of changes in exchange rates on trade. Many other exporters to the United States have exhibited pricing strategies similar to those of European firms. Chinese exporters, of course, have not had to address this issue because China continues to hold its renminbi at a fixed rate against the dollar. U.S. exporters have also faced large exchange rate movements relative to many of their destination markets. The ratio of U.S. merchandise export prices to manufacturing unit labor costs provides some evidence of margin movements linked to exchange rates that is analogous to the effects I described earlier for foreign exporters. Given the dollar's depreciation since 2002, U.S. exporters' profit margins appear to be increasing, which bodes well for future U.S. exports and the adjustment process. *** A consequence of the contraction in profit margins of exporters to the United States, and thus low pass-through of dollar depreciation to U.S. import prices, has been minimal pressure on U.S. consumer price inflation in recent years. A corollary is that the adjustment of U.S. real imports - that is, the quantity of imported goods and services - has been negligible. The other significant component of unit costs, other than labor costs, is materials prices. Over this period, the IMF primary commodities price index denominated in euros and sterling - a proxy for materials costs - was roughly unchanged on balance. The Bank for International Settlements BIS Quarterly Review, December, 2004), for example, points out that the increase in certain forward foreign exchange market transactions that has occurred in recent years, could reflect heightened interest in hedging. However, we may be approaching a point, if we are not already there, at which exporters to the United States, should the dollar decline further, would no longer choose to absorb a further reduction in profit margins. Although the limited response, to date, of import prices to the dollar's decline has likely forestalled a decline in U.S. real imports, the effect of the low pass-through of exchange rates into import prices on the nominal dollar value of imports, and thus on the trade balance, is more complex. Increases in import prices lower the quantity of imports but leave the resulting value of imports uncertain. *** To understand why the nominal trade deficit - the nominal dollar value of imports minus exports - has widened considerably since 2002, even as the dollar has declined, we must consider several additional factors. First, partly as a legacy of the dollar's previous strength, the level of imports exceeds that of exports by about 50 percent. Thus exports must grow half again as quickly as imports just to keep the trade deficit from widening - a benchmark that has yet to be met. Second, as is well-documented, the responsiveness of U.S. imports to U.S. income exceeds the responsiveness of U.S. exports to foreign income; this difference leads to a tendency - even if the United States and foreign economies are growing at about the same rate - for the growth of U.S. imports to exceed that of our exports. Third, as of late, the growth of the U.S. economy has exceeded that of our trading partners, further reinforcing the factors leading imports to outstrip exports. Finally, our import bill has expanded significantly as oil prices have risen in recent years. To be sure, the lower dollar has undoubtedly boosted the competitiveness of U.S. exports and the profitability of U.S. exporters. These factors help explain the considerable increase in exports over the past couple of years. Yet the positive effect of the dollar's decline on exports and on the trade balance has been offset by the other aforementioned factors. *** Besides market pressures, which appear poised to stabilize and over the longer run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction. The voice of fiscal restraint, barely audible a year ago, has at least partially regained volume. If actions are taken to reduce federal government dissaving, pressures to borrow from abroad will presumably diminish.5 An increase in household saving should also act to diminish borrowing from abroad. The growth of home mortgage debt has been the major contributor, at least in an accounting sense, to the decline in the personal saving rate in the United States from almost 6 percent in 1993 to its current level of 1 percent. The fall in U.S. interest rates since the early 1980s has supported both home price increases and, in recent years, an unprecedented rate of existing home turnover. This combination has led to a significant increase in home mortgage debt. The rise in home prices creates capital gains, which become realized with the subsequent sale of a home. The amount of debt paid off by the seller of an existing home averages about three-fifths of the mortgage debt taken on by the buyer, effectively converting to cash an amount of home equity close to the realized gain. This cash payout is financed by the net increase in debt on the purchased home, and hence on total mortgage debt outstanding. Even after accounting for the down payments on any subsequent home purchase, sellers receive, net, large amounts of cash, which they view as unencumbered. The counterpart of that cash, the increased debt taken on by the homebuyers, is supported by the new home values enhanced by capital gains. In addition, low mortgage interest rates have encouraged significant growth of home equity loan advances and cash-out refinancings, which are another channel for the extraction of previously unrealized capital gains on homes. A recent Federal Reserve study, however, points out that only one-fifth of reductions in budget deficits tend to show through to reduced current account deficits. (See Christopher Erceg, Luca Guerrieri, and Christopher Gust [2005], "Expansionary Fiscal Shocks and the Trade Deficit," Board of Governors of the Federal Reserve System, International Finance Division, Paper 825.) All told, home mortgage debt, driven largely by equity extraction, has grown much more rapidly in the past five years than during the previous five years. Surveys suggest that approximately half of equity extraction shows up in additional household expenditures, reducing savings commensurately and thereby presumably contributing to the current account deficit. Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit.6 To be sure, correlation is not causation, and there have been many influences on both mortgage debt and the current account. Nevertheless, over the past two decades, major innovations in the United States have improved the availability and lowered the costs of home mortgages. These developments likely spurred homeowners to tap increasing home equity to finance consumer expenditures beyond home purchase. In contrast, mortgage debt is not so readily available among our trading partners as a vehicle to finance consumption expenditures. *** Because exporters to the United States are willing to countenance wide swings in profit margins, the level of international trade may be less variable than under previous price-setting regimes when exchange rate pass-through was greater. Arguably, this development has contributed to a higher level of trade. Accordingly, the competitive benefits of globalization may be greater than if exporters allowed exports rather than profit margins to swing widely with exchange rate changes, as they apparently did earlier in the post-World War II period. Exports, of course, were a much smaller share of world GDP in those years. And many, perhaps most, producers, as exchange rates moved in their favor, accordingly chose to pick off only the low-hanging trade fruit, so to speak. Such opportunistic exports obviated large up-front financial commitments to foreign markets. As trade barriers have been lowered over the decades, much has changed, evidenced by the emergence of critical mass in many export markets, the growing importance of multinational firms, and the rise of production processes that are integrated across borders. *** The interaction of a wide range of economic forces, which adjust at national borders to create what we call the current account balance, has proved difficult to predict with any precision, primarily because of the difficulty of forecasting exchange rates. These same forces have lessened our ability to anticipate the consequences of a buildup of either a surplus or a deficit. In addition, numerous issues that have arisen with respect to the adjustment of the U.S. current account remain unresolved. One is the effect of Asian official purchases of dollars in support of their currencies. Such intervention may be supporting the dollar and U.S. Treasury bond prices somewhat, but the effect is difficult to pin down. Another issue is the influence of still-growing globalization, arguably one of the key factors that has facilitated the financing of the U.S. current account deficit. There is little evidence that the growth of globalization has yet slowed. The dramatic advances over the past decade in virtually all measures of globalization have resulted in an international economic environment with little relevant historical precedent.7 I have argued elsewhere that the U.S. current account deficit cannot widen forever but that, fortunately, the increased flexibility of the American economy will likely facilitate any adjustment without significant consequences to aggregate economic activity.8 That argument will be tested, I suspect, by possibly new twists and turns that will emerge in a seemingly ever-more complex international economic and financial structure. The R² of a simple regression using quarterly data since 1952 is 0.5. Adding a trend to reflect the influence of other factors such as the greater income elasticity of demand of U.S. imports relative to that of exports raises the R² to 0.7 and does not reduce the significance of the connection between home mortgage debt and the current account. To be sure, the rapid globalization of the latter part of the nineteenth century exhibited many of the characteristics of today's international economy. But the far lower level of technology and the existence of the gold standard adjustment process renders that period of little use for current comparisons. Alan Greenspan, speech at the European Banking Congress in Frankfurt, Germany, on November 19, 2004.
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Stanford Institute for Economic Policy Research Economic Summit, Stanford, California, 11 February 2005.
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Ben S Bernanke: Inflation in Latin America - a new era? Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Stanford Institute for Economic Policy Research Economic Summit, Stanford, California, 11 February 2005. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * The Federal Reserve is justly proud of its success in reducing and stabilizing inflation in the United States. When Paul Volcker became Fed chairman twenty-five years ago, Americans were enduring double-digit inflation rates and subpar economic performance. Under the leadership of Volcker and, subsequently, Alan Greenspan, the Federal Open Market Committee took the actions necessary to bring the nation to price stability. In my view, the conquest of inflation has been a major source of the more-rapid economic growth and the greater stability of output and employment that the United States has enjoyed since the mid-1980s (Bernanke, 2004). Impressive as the Fed's inflation-fighting accomplishments may be, however, inflation developments to our south, in Latin America, may prove to be more impressive yet. For much of the latter half of the twentieth century, Latin America experienced recurrent bouts of high inflation together with erratic growth and periods of economic and financial crisis. Since the mid-1990s, however, inflation rates in virtually all of Latin America have come down dramatically, to the single digits in most cases. What explains this remarkable turnaround? Will Latin American progress on inflation be sustained, or is the recent improvement only a temporary lull? These are challenging questions of monetary economics and political economy, and their answers have important implications for the economic future of the Western Hemisphere - including the United States, which stands to benefit greatly from increased trade with and investment in a more prosperous Latin America. In my remarks today I will offer some tentative answers to these questions, noting as always that the views I will express are not necessarily shared by my colleagues at the Federal Reserve.1 The roots of Latin American inflation For those of us here in the United States, acclimated as we have become to price stability, the severity of inflation in many Latin American countries in recent decades may be difficult to comprehend. A measure of price changes in nine of the most populous Latin American countries shows that inflation in the region averaged nearly 160 percent per year in the 1980s and 235 percent per year in the first half of the 1990s.2 Indeed, high inflation morphed into hyperinflation - conventionally defined as inflation exceeding 50 percent per month (Cagan, 1956) - in a number of Latin countries during the latter part of the 1980s and in the early 1990s. Brazil's inflation rate, for example, exceeded 1,000 percent per year in four of the five years between 1989 and 1993. Other Latin American countries suffering hyperinflations at about that time included Argentina, Bolivia, Nicaragua, and Peru. A particularly striking aspect of this poor inflation performance is that it occurred while most of the rest of the world was reducing inflation to low levels. Inflation in the region began to moderate in the mid-1990s, however. Inflation in nine major countries which, as already noted, averaged nearly 235 percent per year in the first half of the 1990s - averaged only 13 percent per year in 1995-99 and less than 8 percent in 2000-04 despite the spike in Argentine inflation that followed that country's crisis in 2002.3 Why was inflation a perennial problem in Latin America until about ten years ago, and what explains the recent improvement? Fundamentally, in my I thank Board staff members Carlos Arteta, Jane Haltmaier, and Patrice Robitaille for excellent assistance and comments. The nine countries are Mexico, Colombia, Venezuela, Brazil, Bolivia, Uruguay, Peru, Argentina, and Chile. Inflation in each country is weighted according to relative gross domestic product, as in International Monetary Fund (2004). Median inflation rates for the nine countries, which may be more representative of typical experience, averaged 61 percent per year in the 1980s and 26 percent in the first half of the 1990s. Argentina, Brazil, and Peru, all of which had four-digit inflation rates in both 1989 and 1990, succeeded in reducing inflation to single-digit levels by 1997. Median inflation in the nine countries likewise declined, averaging 9-1/2 percent in 1995-99 and 5 percent in 2000-04. view, inflation trends are driven by ideas and politics, which in turn influence economic institutions and economic policies. In the realm of ideas, the current consensus among economists - that money growth generated by fiscal deficits is the driving force behind virtually all episodes of very high inflation - has not always held sway in the region.4 For example, during the 1950s and 1960s, the United Nations Economic Commission for Latin America and the Caribbean (ECLAC), under the direction of Raul Prebisch, promoted so-called structuralist theories of development. The structuralist theory drew a strong distinction between the economies making up the developed "center" and those in the less-developed "periphery" and concluded that policies appropriate for the center were unlikely to be right for the much poorer and structurally less developed nations on the periphery. Notably, this approach supported the use of so-called import-substitution policies, which call for the government to protect domestic manufacturers from foreign competition in order to promote industrialization and reduce dependence on commodity exports. In practice, the application of this approach involved extensive government intervention in the economy, including the provision of subsidies to firms and heavy protection and regulation of industry. The outsized role of the government in the economies that pursued the import substitution strategy, together with relatively narrow tax bases and inefficient tax collection, led to chronic fiscal deficits and pervasive economic inefficiency in the protected industries. Importantly, structuralism placed little weight on monetary factors in explaining inflation. Proponents of this approach viewed price increases as being determined largely on the real side of the economy - for example, by spot shortages arising from uneven patterns of development and by the efforts of labor and other groups to increase their shares of aggregate income. From the structuralist perspective, monetary policy makers have little option other than to accommodate wage and price increases, as these increases are determined outside the monetary sphere - a conclusion that rationalized central banks' abdication of responsibility for inflation. Structuralists also promoted extensive indexation of wages and contracts as a way of minimizing unintended distributional consequences of the unavoidable inflation. Unfortunately, pervasive wage-price indexation only increased the virulence of inflationary cycles, as price increases were rapidly transmitted to wages and then back to prices. Among the political sources of inflation, populist views exerted strong influence in many Latin American countries, supported by understandable public dissatisfaction over the degree of income inequality. Unfortunately, more often than not, populist macroeconomic policies pushed the economy into crisis (Dornbusch and Edwards, 1991). In their zeal for rapid social and economic change, governments often introduced aggressive new spending programs that could not be financed through taxes or borrowing. The programs were consequently financed - with the (willing or unwilling) cooperation of central banks - by printing new money. These over-expansionary fiscal and monetary policies were generally followed in short order by wage and price controls and new rounds of subsidies as the overheating economy stoked inflation and inflation expectations and created bottlenecks and shortages. Currency overvaluation, capital flight, declining real tax revenues, sharp increases in external debt, and accelerating inflation completed the downward spiral, which typically ended in general economic and political crisis. Ironically, the poor often were among those most hurt by extreme populist policies because they were the most vulnerable to rising unemployment and real-wage declines and the least able to protect themselves against inflation.5 Latin America's macroeconomic problems reached their apogee during the so-called Lost Decade of the 1980s. Governments had run up large amounts of external debt in the 1970s in an attempt to maintain growth in the face of oil price shocks and macroeconomic mismanagement at home. But in 1982, during a period of high real interest rates and slow growth around the globe, Mexico briefly defaulted on its debt, an event that marked the beginning of the debt crisis of the 1980s. The crisis effectively closed off the region's access to international credit. Currencies were sharply devalued as current accounts were forced to adjust, rising fiscal deficits were again financed by money creation, and inflation soon rose to new heights. Several "heterodox" stabilization plans initiated in the mid-1980s, such as Argentina's Austral Plan and Brazil's Cruzado Plan, attempted to stabilize the currency and rein in inflation by using a fixed exchange rate as a nominal anchor. As a fixed exchange rate (if successfully maintained) ties down Fischer, Sahay, and Vegh (2002) present evidence of a strong correlation between fiscal deficits and money creation in high-inflation economies. They also show that high inflations are correlated with poor macroeconomic performance. Some of the more extreme examples of this pattern include Argentina in 1973-76, Chile in 1970-73, and Peru in 1985-90. the level of import prices, policymakers hoped that this approach would stabilize inflation and inflation expectations more generally. Other features of heterodox plans included the scaling back of indexation provisions and, in some cases, the imposition of wage and price controls. However, in most cases, the underlying fiscal problems were not addressed, resulting in the collapse of the stabilization plans and further acceleration of inflation. The experience of Chile was the most important exception to this pattern, as that country adopted market-friendly reforms in the latter part of the 1970s and pursued a more disciplined fiscal policy. Notwithstanding a sharp banking and balance-of-payments crisis early in the decade, inflation in Chile averaged less than 20 percent in the 1980s, compared with rates of about 350 percent in Argentina and 265 percent in Brazil. The achievement of price stability in the 1990s After so many years of failed stabilization attempts, an observer in 1990 might have been forgiven for concluding that low and stable inflation would remain elusive in Latin America. But during the subsequent decade, better economic analysis and better policies led to far-better outcomes on the inflation front, as I have already noted. What accounts for this remarkable change? Worldviews tend to evolve slowly, and it is far too soon to claim that ideas and politics in Latin America have changed fundamentally or irrevocably. Nevertheless, during the past fifteen years or so, both the political elites and the broader public in the region have, for the most part, shown an increased willingness to abandon the failed economic models of earlier decades in favor of new approaches that emphasize improved fiscal discipline, the benefits of free trade and free markets, and the vital importance of building strong economic institutions. The visible success of more market-oriented development strategies, notably the examples of the "East Asian Tigers" and (closer to home) of Chile, was not lost on Latin American policymakers. In addition, to restructure external debts and restore access to international financial markets, countries necessarily faced outside pressure to improve their policies, both from multilateral institutions and from the discipline of market forces. The conquest of inflation in Latin America is a particularly interesting case study of the beneficial effects of the new thinking, although, as we shall see, success came only through persistent experimentation. After the debacles of the late 1980s, the view that inflation - particularly very high inflation - carries significant economic costs became more widely accepted, supported by empirical analyses and accumulated experience (Khan and Senhadji, 2001). In the early 1990s, consequently, many Latin American countries attacked their inflation problems with a new energy. Initially, a common tactic was to fix the exchange rate, in the hope that an exchange-rate peg might stabilize inflation expectations and help to "import" some necessary monetary discipline. The use of fixed exchange rates was reminiscent of the earlier heterodox programs, although in the more market-oriented programs of the 1990s, wage-price controls and similar restrictions were generally not employed. This approach enjoyed some early successes. For example, Mexico maintained a pegged exchange rate from 1987 through 1991, as part of a program that included a substantial reduction in government spending. Inflation fell from 160 percent in 1987 to less than 20 percent in 1991, and growth picked up. Greater exchange-rate flexibility was introduced in late 1991 by the adoption of exchange-rate bands. However, in 1994, a speculative attack on the peso led to a sharp currency devaluation and a financial crisis. Brazil adopted a stabilization program in 1994, the Real Plan, which included aggressive de-indexation of wages and prices along with other structural reforms (Bogdanski, de Freitas, Goldfajn, and Tombini, 2002). At first, the exchange rate was allowed to float. However, after the Mexican crisis in late 1994, the Brazilians adopted a crawling-band regime, under which the exchange rate was devalued at a pre-determined rate. This regime was successful in ending the country's rapid inflation of the first half of the decade: Inflation in Brazil fell to less than 2 percent in 1998. The most radical example of an exchange-rate-based stabilization plan, of course, was Argentina's adoption in 1991 of a currency board, a form of "hard peg" under which the government attempted to establish permanent one-to-one convertibility between the Argentine peso and the U.S. dollar. The currency board helped Argentina enjoy price stability for more than a decade. With the benefit of hindsight, many economists would now agree that exchange-rate pegs, if combined with other policy measures such as fiscal consolidation, can be useful in the transition from high to low inflation.6 However, a key lesson of the recent experience is that fixed exchange rates are generally not a long-run solution to problems of monetary and fiscal instability, at least not in a world of high capital mobility. Indeed, despite the early successes, virtually all the Latin American exchange-rate pegs proved unsustainable and collapsed in a disorderly way. Exchange-rate over-valuation, imperfect credibility of both monetary and fiscal policy, and short-duration external debt all contributed to a high incidence of costly speculative attacks and financial crises in Latin America during the 1990s and into the new millennium. As already noted, Mexico was compelled to devalue in 1994. Brazil was forced from its peg in 1999, and Argentina (its currency board notwithstanding) in 2002. If not fixed exchange rates, then what? Ecuador and El Salvador have pursued strategies of official dollarization, the replacement of the local currency by the U.S. dollar as legal tender. (Panama has been dollarized for many years.) Dollarization seems unlikely to be a good option for the larger Latin American countries, however. Thus, the principal Latin American nations, forced to float their currencies, needed a new nominal anchor for monetary policy. Following a growing trend in the industrialized world, a number of countries made the decision to adopt explicit, quantitative targets for inflation.7 As with many other reforms, Chile was the Latin American pioneer, adopting an inflation target in 1990 after the passage of a new central-banking law in 1989. Like a number of other early adopters, particularly among emerging markets, Chile eased into the new approach by combining inflation targets with a reference band for the exchange rate. The exchange rate band did not disappear entirely until 1999. The Central Bank of Chile's initial inflation target, for 1991, was the range between 15 and 20 percent; the actual outcome for that year was 18.7 percent. Over the next decade, both the target and actual inflation came down gradually. Since 2001, the target has been fixed at 2 to 4 percent. Following the 1994 peso crisis, Mexico, while setting a goal for inflation, adopted a dual monetary regime that focused primarily on money growth. In the early years, the inflation target was almost always missed, perhaps because of the use of a framework with multiple objectives. In 1999, Mexico instituted a formal inflation-targeting regime. Since then, Mexican inflation, which had been declining from its recent peak of 52 percent in 1995, has fallen further, to around 5 percent. The central bank recently tightened policy to bring inflation down to its current target range of 2 to 4 percent. Brazil also adopted inflation targeting in 1999, following the collapse of its crawling-peg exchange-rate regime in the months after the 1998 Russian debt crisis. After a transition period that included monetary and fiscal tightening, President Cardoso issued a decree in June 1999 announcing multiyear inflation targets. He assigned responsibility for setting the targets to the National Monetary Council and gave the central bank full responsibility for implementing monetary policy as needed to achieve the targets.8 The Brazilian Central Bank has taken this responsibility seriously; for example, it has tightened monetary policy several times since inflation moved above the target range last year. Brazil also moved more quickly than other Latin American inflation targeters to adopt procedures to improve communication with the public, including the publication of an Inflation Report that includes the central bank's inflation forecasts (Mishkin, 2000). Although Brazilian inflation rose temporarily following a capital outflow and a sharp depreciation of the real in 2002, inflation in that country has otherwise remained in the 6 to 8 percent range since the adoption of inflation targets. The rapid Israeli stabilization of the mid-1980s is an instructive, non-Latin American example. Mishkin (2000) distinguishes the setting of inflation targets from a full-fledged inflation-targeting regime. The latter involves not only the announcement of a medium-term inflation target and an institutional commitment by the central bank and the government to meet that target but also an increased emphasis on independence, transparency, and accountability for the central bank. In Latin America, countries have usually begun only by announcing quantitative inflation targets, adopting the other important features of an inflation-targeting regime over a period of time. Bernanke, Laubach, Mishkin, and Posen (1999) discuss the rationale for and experience with inflation-targeting regimes in more detail. Mishkin (2000) and Corbo and Schmidt-Hebbel (2001) provide useful analyses of inflation targeting in emerging-market countries and in Latin America in particular. The governor of the Brazilian Central Bank, Arminio Fraga, played an important role in establishing the new regime and achieved early successes. I had the pleasure of serving on Fraga's dissertation committee when he was a doctoral student at Princeton. Other Latin American countries that have turned to inflation targets include Colombia, which began using the approach in 1999, and Peru; the Central Bank of Peru has been announcing inflation target ranges since 1994, although it did not adopt a full-fledged inflation-targeting regime until 2002. Argentina, which is still recovering from its 2002 debt crisis and the collapse of its currency board, has set unofficial target ranges for inflation. The new monetary approach is a good one for Latin America, I believe, for several reasons. First, in contrast to the structuralist past, the inflation-targeting approach recognizes the key role of the central bank's monetary policies in determining the inflation rate. No longer can the monetary authorities claim that inflation is not under their control. Second, the accountability and transparency that are part of a mature inflation-targeting regime fit well, I believe, with the increasingly democratic nature of Latin American governments and the growing economic sophistication of the public. Third, a well-designed inflation-targeting regime can help to stabilize and anchor the public's expectations of long-run inflation; well-anchored inflation expectations, in turn, promote macroeconomic stability and reduce the vulnerability of the domestic economy to exchange-rate fluctuations and other shocks. Finally, inflation targeting and flexible exchange rates together serve to reduce the conflict between domestic economic stability and the free movement of capital across borders that is inherent in some other arrangements, most obviously the fixed-exchange-rate regimes favored by these countries in the past. How have inflation targets worked in Latin America? As you can infer from the data I have already presented, the early returns are encouraging. Among the major inflation-targeting countries, the inflation rate has recently been in the range of 1 to 3 percent in Chile, 5 to 8 percent in Colombia, 4 to 6 percent in Mexico, 1 to 4 percent in Peru, and (as already noted) 6 to 8 percent in Brazil. Central bankers in these countries are also making progress in adapting the new regime to deal with the special issues that arise in an emerging-market context. For example, inflation is typically more difficult to control in developing economies than in the industrialized economies because of the greater influence of exchange-rate fluctuations, the heavy weight of volatile food and commodity prices in the consumer basket, and the volatility of the public's inflation expectations resulting from a history of high and unstable inflation. Emerging-market central banks that adopt inflation targeting must not only develop the forecasting and monetary-policy tools needed to meet their targets, they must also choose target ranges that are not so narrow as to be unachievable but narrow enough to allow monetary policymakers to build credibility (Fraga, Goldfajn, and Minella, 2003). As the list of middle-income inflation targeters grows - outside of Latin America, it now includes, among others, the Czech Republic, Hungary, Poland, South Korea, Thailand, South Africa, and Israel - and as more experience is gained, knowledge about how to best manage this approach in the emerging-market context will grow as well. Underlying causes of improved inflation performance I do not mean to claim, however, that Latin America conquered inflation simply by choosing a particular framework for monetary policy. Rather, my more fundamental point is that inflation has declined in Latin America because new ideas and new political realities have fostered the development of economic institutions and policies that promote macroeconomic stability more generally. Recent changes in the policy environment have been especially important in three areas: fiscal policy, banking regulation, and central bank independence.9 No monetary-policy regime, including inflation targeting, will succeed in reducing inflation permanently in the face of unsustainable fiscal policies - large and growing deficits. In light of their painful experiences, Latin American citizens certainly understand that unchecked deficits will eventually exhaust the government's capacity to borrow, leading to excess money creation and a breakout of inflation. Fiscal policy does seem to have become more conservative in the region in the past decade, although there have been setbacks and variations across countries. Important developments include significant privatization, the reduction of marginal tax rates, the addition of new revenue sources such as value-added taxes, and the passage of laws that restrict the use of public funds for certain purposes. Throughout the region, lower inflation and greater fiscal discipline bear the promise of creating a virtuous circle, in which lower interest rates reduce the portion of government spending devoted to debt service. Domestic real interest rates have indeed moderated considerably and Fraga, Goldfajn, and Minella (2003) discuss the broader policies and reforms needed to make inflation targeting successful. currently stand at 2-3 percent in Chile and Mexico and about zero in Argentina. Brazil's real interest rate remains stubbornly high, at about 11 percent, but that rate is down from nearly 30 percent less than a decade ago. Sovereign bond spreads in the region are also at historic lows for most of the region, with the exception of Argentina, which is still in the process of working out its recent default. Modernization of the banking system and the improvement of bank regulation and supervision are likewise essential for promoting stable monetary policy and low inflation. If the banking system is considered by foreign and domestic investors to be financially unstable or not transparent, then the fear of inducing a banking crisis may constrain the central bank's willingness to change interest rates and exchange rates as needed to fight inflation. Financial-sector reforms in the region have included reducing or eliminating targeted credit programs, decontrolling interest rates, privatizing state-owned banks, and allowing foreign banks greater scope to operate in the domestic market, among other measures. Authorities in a number of countries have also made important progress in the past decade in bringing their bank supervisory and regulatory regimes in line with international best practices, as codified in the Basel Core Principles for Effective Banking Supervision. Recent enhancements in banking supervision include the expansion of supervisory powers, more frequent and thorough bank examinations, and tougher capital rules. Deposit insurance has also been introduced in most of the region. Quite a bit remains to be done on the supervision and regulation front, however: In particular, in some countries, supervisory independence from the government is not up to international standards, and the human and financial resources necessary to carry out fully supervisory responsibilities are lacking. A final institutional improvement that supports macroeconomic stability is increased independence for the central bank. A central bank that is dominated by the government may be forced to ease policy inappropriately to reduce the financing costs of government debt or to help re-elect incumbents. Inflation-targeting regimes make sense only if the central bank has independent control of the instruments of monetary policy, as holding the central bank responsible for meeting its inflation target is hardly possible otherwise. Here, once again, the trends in Latin America generally appear favorable. In the late 1980s and early 1990s, several countries took steps to enhance central bank independence, both through constitutional provisions and through changes in the central bank law. That central bank independence promotes lower inflation in developed countries is well-established by the economic literature. Although the evidence for developing countries is more mixed, several studies have found that central bank independence promotes low inflation in those countries as well, especially when de facto rather than de jure measures of independence are used (Cukierman, Webb, and Neypati, 1992; Cukierman, Miller, and Neypati, 2002). The distinction between de facto and de jure central-bank independence remains important in the region. For example, although a number of features of Brazilian law promote the independence of the nation's central bank, the bank's de facto independence may be limited by the power of the president to remove members of the Monetary Policy Committee. However, the fact that the left-of-center Lula administration in Brazil has been able to support disciplined monetary and fiscal policies without significant loss of popularity is itself testimony to the degree that such policies are becoming more widely accepted in the region. The outlook and prospects for the future The near-term outlook for Latin America suggests that better monetary, fiscal, and structural policies are paying off. In its September World Economic Outlook, the International Monetary Fund projects real output growth of 3-1/2 percent for the developing Western Hemisphere (including the Caribbean) in 2005, following an estimated gain of 4-1/2 percent in 2004. Inflation in the broader region is estimated to have been about 6-1/2 percent on average in 2004 and is expected to be a bit lower than that in 2005 (annual average basis). If these projections are realized, and if the good performance of the U.S. and Canadian economies continues, then the macroeconomic environment in our hemisphere as a whole will be better than it has been in many decades. Will improved macroeconomic policies and outcomes continue in Latin America? The track record is still too short to draw definitive conclusions. Some writers have warned that the short-term costs of reform and overly optimistic projections by reform supporters may be leading to "reform fatigue" in a number of countries (Lora, Panizza, and Quispe-Agnoli, 2003). I am inclined to be more optimistic, however. I am encouraged by the fact that governments of all ideological stripes, including left-leaning governments in Brazil, Argentina, and Chile, as well as the incoming administration in Uruguay, have actively supported reform. (Venezuela is a notable exception.) In important ways, these efforts are paying off. Notably, as I have discussed today, the inflation situation has improved markedly, and real interest rates have fallen. Current account positions in the region have also strengthened considerably. On the other hand, although near-term growth prospects appear good, many Latin American economies have grown at rates below their potential in recent years, in part as a result of the financial crises of the 1990s. Much still needs to be done to alleviate income inequality and poverty. The next few years will be an interesting test of the efficacy and sustainability of economic reform in Latin America.
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Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington, 16 February 2005.
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Alan Greenspan: Federal Reserve Board's semiannual Monetary Policy Report to the Congress Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington, 16 February 2005. * * * Mr. Chairman and members of the Committee, I am pleased to be here today to present the Federal Reserve's Monetary Policy Report to the Congress. In the seven months since I last testified before this Committee, the U.S. economic expansion has firmed, overall inflation has subsided, and core inflation has remained low. Over the first half of 2004, the available information increasingly suggested that the economic expansion was becoming less fragile and that the risk of an undesirable decline in inflation had greatly diminished. Toward midyear, the Federal Reserve came to the judgment that the extraordinary degree of policy accommodation that had been in place since the middle of 2003 was no longer warranted and, in the announcement released at the conclusion of our May meeting, signaled that a firming of policy was likely. The Federal Open Market Committee began to raise the federal funds rate at its June meeting, and the announcement following that meeting indicated the need for further, albeit gradual, withdrawal of monetary policy stimulus. Around the same time, incoming data suggested a lull in activity as the economy absorbed the impact of higher energy prices. Much as had been expected, this soft patch proved to be short-lived. Accordingly, the Federal Reserve has followed the June policy move with similar actions at each meeting since then, including our most recent meeting earlier this month. The cumulative removal of policy accommodation to date has significantly raised measures of the real federal funds rate, but by most measures, it remains fairly low. The evidence broadly supports the view that economic fundamentals have steadied. Consumer spending has been well maintained over recent months, buoyed by continued growth in disposable personal income, gains in net worth, and accommodative conditions in credit markets. Households have recorded a modest improvement in their financial position over this period, to the betterment of many indicators of credit quality. Low interest rates and rising incomes have contributed to a decline in the aggregate household financial obligation ratio, and delinquency and charge-off rates on various categories of consumer loans have stayed at low levels. The sizable gains in consumer spending of recent years have been accompanied by a drop in the personal saving rate to an average of only 1 percent over 2004 - a very low figure relative to the nearly 7 percent rate averaged over the previous three decades. Among the factors contributing to the strength of spending and the decline in saving have been developments in housing markets and home finance that have spurred rising household wealth and allowed greater access to that wealth. The rapid rise in home prices over the past several years has provided households with considerable capital gains. Moreover, a significant increase in the rate of single-family home turnover has meant that many consumers have been able to realize gains from the sale of their homes. To be sure, such capital gains, largely realized through an increase in mortgage debt on the home, do not increase the pool of national savings available to finance new capital investment. But from the perspective of an individual household, cash realized from capital gains has the same spending power as cash from any other source. More broadly, rising home prices along with higher equity prices have outpaced the rise in household, largely mortgage, debt and have pushed up household net worth to about 5-1/2 times disposable income by the end of last year. Although the ratio of net worth to income is well below the peak attained in 1999, it remains above the long-term historical average. These gains in net worth help to explain why households in the aggregate do not appear uncomfortable with their financial position even though their reported personal saving rate is negligible. Of course, household net worth may not continue to rise relative to income, and some reversal in that ratio is not out of the question. If that were to occur, households would probably perceive the need to save more out of current income; the personal saving rate would accordingly rise, and consumer spending would slow. But while household spending may well play a smaller role in the expansion going forward, business executives apparently have become somewhat more optimistic in recent months. Capital spending and corporate borrowing have firmed noticeably, but some of the latter may have been directed to finance the recent backup in inventories. Mergers and acquisitions, though, have clearly perked up. Even in the current much-improved environment, however, some caution among business executives remains. Although capital investment has been advancing at a reasonably good pace, it has nonetheless lagged the exceptional rise in profits and internal cash flow. This is most unusual; it took a deep recession to produce the last such configuration in 1975. The lingering caution evident in capital spending decisions has also been manifest in less-aggressive hiring by businesses. In contrast to the typical pattern early in previous business-cycle recoveries, firms have appeared reluctant to take on new workers and have remained focused on cost containment. As opposed to the lingering hesitancy among business executives, participants in financial markets seem very confident about the future and, judging by the exceptionally low level of risk spreads in credit markets, quite willing to bear risk. This apparent disparity in sentiment between business people and market participants could reflect the heightened additional concerns of business executives about potential legal liabilities rather than a fundamentally different assessment of macroeconomic risks. Turning to the outlook for costs and prices, productivity developments will likely play a key role. The growth of output per hour slowed over the past half year, giving a boost to unit labor costs after two years of declines. Going forward, the implications for inflation will be influenced by the extent and persistence of any slowdown in productivity. A lower rate of productivity growth in the context of relatively stable increases in average hourly compensation has led to slightly more rapid growth in unit labor costs. Whether inflation actually rises in the wake of slowing productivity growth, however, will depend on the rate of growth of labor compensation and the ability and willingness of firms to pass on higher costs to their customers. That, in turn, will depend on the degree of utilization of resources and how monetary policymakers respond. To date, with profit margins already high, competitive pressures have tended to limit the extent to which cost pressures have been reflected in higher prices. Productivity is notoriously difficult to predict. Neither the large surge in output per hour from the first quarter of 2003 to the second quarter of 2004, nor the more recent moderation was easy to anticipate. It seems likely that these swings reflected delayed efficiency gains from the capital goods boom of the 1990s. Throughout the first half of last year, businesses were able to meet increasing orders with management efficiencies rather than new hires. But conceivably the backlog of untapped total efficiencies has run low, requiring new hires. Indeed, new hires as a percent of employment rose in the fourth quarter of last year to the highest level since the second quarter of 2001. There is little question that the potential remains for large advances in productivity from further applications of existing knowledge, and insights into applications not even now contemplated doubtless will emerge in the years ahead. However, we have scant ability to infer the pace at which such gains will play out and, therefore, their implications for the growth of productivity over the longer run. It is, of course, the rate of change of productivity over time, and not its level, that influences the persistent changes in unit labor costs and hence the rate of inflation. The inflation outlook will also be shaped by developments affecting the exchange value of the dollar and oil prices. Although the dollar has been declining since early 2002, exporters to the United States apparently have held dollar prices relatively steady to preserve their market share, effectively choosing to absorb the decline in the dollar by accepting a reduction in their profit margins. However, the recent somewhat quickened pace of increases in U.S. import prices suggests that profit margins of exporters to the United States have contracted to the point where the foreign shippers may exhibit only limited tolerance for additional reductions in margins should the dollar decline further. The sharp rise in oil prices over the past year has no doubt boosted firms' costs and may have weighed on production, particularly given the sizable permanent component of oil price increases suggested by distant-horizon oil futures contracts. However, the share of total business expenses attributable to energy costs has declined appreciably over the past thirty years, which has helped to buffer profits and the economy more generally from the adverse effect of high oil and natural gas prices. Still, although the aggregate effect may be modest, we must recognize that some sectors of the economy and regions of the country have been hit hard by the increase in energy costs, especially over the past year. Despite the combination of somewhat slower growth of productivity in recent quarters, higher energy prices, and a decline in the exchange rate for the dollar, core measures of consumer prices have registered only modest increases. The core PCE and CPI measures, for example, climbed about 1-1/4 and 2 percent, respectively, at an annual rate over the second half of last year. All told, the economy seems to have entered 2005 expanding at a reasonably good pace, with inflation and inflation expectations well anchored. On the whole, financial markets appear to share this view. In particular, a broad array of financial indicators convey a pervasive sense of confidence among investors and an associated greater willingness to bear risk than is yet evident among business managers. Both realized and option-implied measures of uncertainty in equity and fixed-income markets have declined markedly over recent months to quite low levels. Credit spreads, read from corporate bond yields and credit default swap premiums, have continued to narrow amid widespread signs of an improvement in corporate credit quality, including notable drops in corporate bond defaults and debt ratings downgrades. Moreover, recent surveys suggest that bank lending officers have further eased standards and terms on business loans, and anecdotal reports suggest that securities dealers and other market-makers appear quite willing to commit capital in providing market liquidity. In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening. In the current episode, however, the more-distant forward rates declined at the same time that short-term rates were rising. Indeed, the tenth-year tranche, which yielded 6-1/2 percent last June, is now at about 5-1/4 percent. During the same period, comparable real forward rates derived from quotes on Treasury inflation-indexed debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation expectations. Some analysts have worried that the dip in forward real interest rates since last June may indicate that market participants have marked down their view of economic growth going forward, perhaps because of the rise in oil prices. But this interpretation does not mesh seamlessly with the rise in stock prices and the narrowing of credit spreads observed over the same interval. Others have emphasized the subdued overall business demand for credit in the United States and the apparent eagerness of lenders, including foreign investors, to provide financing. In particular, heavy purchases of longer-term Treasury securities by foreign central banks have often been cited as a factor boosting bond prices and pulling down longer-term yields. Thirty-year fixed-rate mortgage rates have dropped to a level only a little higher than the record lows touched in 2003 and, as a consequence, the estimated average duration of outstanding mortgage-backed securities has shortened appreciably over recent months. Attempts by mortgage investors to offset this decline in duration by purchasing longer-term securities may be yet another contributor to the recent downward pressure on longer-term yields. But we should be careful in endeavoring to account for the decline in long-term interest rates by adverting to technical factors in the United States alone because yields and risk spreads have narrowed globally. The German ten-year Bund rate, for example, has declined from 4-1/4 percent last June to current levels of 3-1/2 percent. And spreads of yields on bonds issued by emerging-market nations over U.S. Treasury yields have declined to very low levels. There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world's productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience. This is but one of many uncertainties that will confront world policymakers. Over the past two decades, the industrial world has fended off two severe stock market corrections, a major financial crisis in developing nations, corporate scandals, and, of course, the tragedy of September 11, 2001. Yet overall economic activity experienced only modest difficulties. In the United States, only five quarters in the past twenty years exhibited declines in GDP, and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward. Yet history cautions that people experiencing long periods of relative stability are prone to excess. We must thus remain vigilant against complacency, especially since several important economic challenges confront policymakers in the years ahead. Prominent among these challenges in the United States is the pressing need to maintain the flexibility of our economic and financial system. This will be essential if we are to address our current account deficit without significant disruption. Besides market pressures, which appear poised to stabilize and over the longer run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction. Central to that adjustment must be an increase in net national saving. This serves to underscore the imperative to restore fiscal discipline. Beyond the near term, benefits promised to a burgeoning retirement-age population under mandatory entitlement programs, most notably Social Security and Medicare, threaten to strain the resources of the working-age population in the years ahead. Real progress on these issues will unavoidably entail many difficult choices. But the demographics are inexorable, and call for action before the leading edge of baby boomer retirement becomes evident in 2008. This is especially the case because longerterm problems, if not addressed, could begin to affect longer-dated debt issues, the value of which is based partly on expectations of developments many years in the future. Another critical long-run economic challenge facing the United States is the need to ensure that our workforce is equipped with the requisite skills to compete effectively in an environment of rapid technological progress and global competition. Technological advance is continually altering the shape, nature, and complexity of our economic processes. But technology and, more recently, competition from abroad have grown to a point at which demand for the least-skilled workers in the United States and other developed countries is diminishing, placing downward pressure on their wages. These workers will need to acquire the skills required to compete effectively for the new jobs that our economy will create. At the risk of some oversimplification, if the skill composition of our workforce meshed fully with the needs of our increasingly complex capital stock, wage-skill differentials would be stable, and percentage changes in wage rates would be the same for all job grades. But for the past twenty years, the supply of skilled, particularly highly skilled, workers has failed to keep up with a persistent rise in the demand for such skills. Conversely, the demand for lesser-skilled workers has declined, especially in response to growing international competition. The failure of our society to enhance the skills of a significant segment of our workforce has left a disproportionate share with lesser skills. The effect, of course, is to widen the wage gap between the skilled and the lesser skilled. In a democratic society, such a stark bifurcation of wealth and income trends among large segments of the population can fuel resentment and political polarization. These social developments can lead to political clashes and misguided economic policies that work to the detriment of the economy and society as a whole. As I have noted on previous occasions, strengthening elementary and secondary schooling in the United States - especially in the core disciplines of math, science, and written and verbal communications - is one crucial element in avoiding such outcomes. We need to reduce the relative excess of lesser-skilled workers and enhance the number of skilled workers by expediting the acquisition of skills by all students, both through formal education and on-the-job training. Although the long-run challenges confronting the U.S. economy are significant, I fully anticipate that they will ultimately be met and resolved. In recent decades our nation has demonstrated remarkable resilience and flexibility when tested by events, and we have every reason to be confident that it will weather future challenges as well. For our part, the Federal Reserve will pursue its statutory objectives of price stability and maximum sustainable employment - the latter of which we have learned can best be achieved in the long run by maintaining price stability. This is the surest contribution that the Federal Reserve can make in fostering the economic prosperity and well-being of our nation and its people.
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Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Government Affairs Conference of the Credit Union National Association, Washington, DC, 28 February 2005.
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Mark W Olson: Loan quality and how it reflects the overall economy Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Government Affairs Conference of the Credit Union National Association, Washington, DC, 28 February 2005. * * * Thank you for inviting me to speak here today. Let me begin by congratulating all of you who take time away from your responsibilities in your respective institutions to participate in this government affairs conference. I am sure that some of your colleagues back home think you are on a junket, and there are elements of your trip to Washington, D.C., that are a welcome respite from your day-to-day activities. Nonetheless, you are taking time away from professional responsibilities and families to participate in this important event, and your efforts are both commendable and valuable. My talk today will address the sometimes complex interactions between business cycles in the economy at large and financial institutions like banks and credit unions. On the whole, these continue to be favorable times for the financial services providers, whether commercial banks or credit unions. Returns, which continue to be attractive, have been driven recently more by loan volume than margins. Household income has grown nicely while unemployment has remained low, and, together with low mortgage interest rates, these factors have contributed to appreciation in home values. A great number of households have used this historic opportunity to refinance their mortgages and reduce their debt service costs. Many have sought the tax advantages of home equity loans as an alternative to credit cards or other consumer debt. And, despite the publicity accorded to several big mergers, smaller institutions - including credit unions and community banks - have fared quite well in this environment. Risk-management strategies and processes of course need to adapt to these changing conditions. Growth in mortgage loans and mortgage-backed securities requires lenders to monitor and manage the significant and sometimes complex interest rate risk profiles associated with such exposures, especially as market interest rates have risen over the past several months. Compliance, too, has received more attention from both bankers and regulators. Historically, however, credit risk has been the most affected by changes in the economic cycle. Fortunately for financial institutions with a retail business focus, this time the growth opportunities have come in products that we don't usually associate with large potential credit losses, namely, conforming or jumbo mortgages and home equity lines of credit. Our past experience, however, suggests limits as to how much we should rely on historic experience for analyzing today's management challenge. With continuing innovation in loan products and heightened competitive pressures, risk profiles will not be identical to those of earlier cycles, and it would be unwise to rely too heavily on these past patterns without careful analysis and management. Financial institutions and financial regulators rightly spend a fair amount of time and energy monitoring economic conditions as they seek to better understand the growth opportunities that exist and the outlook for the quality of the loans being made. Let's turn that around for a moment and ask the question: What can indicators of asset quality at financial institutions tell us about where we are in the business cycle? The question is an interesting and timely one, given that many in the industry believe that credit quality is about as good as it can get. At the Federal Reserve, we've recently looked at measures of asset quality - problem assets, chargeoffs, and provisions for loan losses - and related them to the economic cycle, measured as growth in real gross domestic product. The usual way to look at cyclical indicators is to line up the high points and low points - or "peaks" and "troughs" in the specialized language of business cycle analysts - and see how they compare with each other. It is usually helpful to screen out normal seasonal variations, so that one ends up with a cycle that unfolds smoothly over several years. Let me refer now to the exhibit we prepared for you. It contains two charts that compare changes in GDP with aggregate problem-asset ratios for commercial banks and credit unions respectively. upper chart shows quarterly data for commercial banks (the blue line) since 1990. The lower chart shows delinquency rates for all credit unions (the blue line). This chart uses a semiannual frequency because that was the regulatory filing frequency for many credit unions through much of this period. The first conclusion we can drawn from the data is that asset quality is a lagging indicator of what is happening in the economy at large. This idea has intuitive appeal and is probably consistent with your business experience. In a nutshell, when economic conditions deteriorate, the ability of many borrowers to service their debt erodes in turn, along with their cash flow. More generally, we know that a recession is a period in which economic activity declines. Speaking broadly, a recession begins when GDP starts declining, and it ends when GDP stops declining. The end of a recession is usually termed the low point or "trough." This lagging pattern can be seen clearly for commercial banks but is not as evident for credit unions because of differing reporting schedules. Looking back to the 1990-91 recession, economic activity stopped declining in the first quarter of 1991 whereas asset quality at commercial banks was at its worst point in the following quarter. Similarly, in the 2001 recession GDP reached its nadir in the fourth quarter of that year, but asset quality reached its worst point about nine months later. Turning to credit unions, the same pattern emerges for the 2001 recession as asset quality hit its worst point about six months after the low point in GDP. The picture is a little less clear for the 1990-1991 recession. Although the timing appears to be reversed - asset quality at its worst about a year before the low point in GDP - it is hard to draw any conclusion because the data are not as robust. There is also a mild wave of higher delinquencies in the late 1990s that was not associated with an economic downturn. Presumably those modestly higher delinquencies reflected specific lending decisions made by some credit unions during this period. A second conclusion to be drawn from the data is that the deterioration in asset quality was much less severe in 2001-02 than in the early 1990s. Of course, the 2001 recession itself was mild by historical standards. Moreover, in this most recent credit cycle, the deterioration in asset quality was less pronounced at smaller institutions - including community banks and credit unions - than at some large lending institutions that had concentrations in the high-tech and telecommunications sectors. The more favorable experience in the more recent period speaks well for the credit-risk management at smaller institutions, even in the context of a mild recession. That said, it also means that it has been a decade and a half since many lenders have seen a serious overall downturn in asset quality. We know from surveys of senior lenders that lending standards have eased overall. Some easing is normal for this phase of the business cycle, but this easing is always of concern to regulators. Some lenders have recently expanded their offerings of interest-only mortgages and mortgage loans with maturities beyond thirty years. In this context, prudent lenders should weigh their alternatives carefully before compromising established underwriting standards or pricing in the face of competitive pressures. There is a third interesting result. As asset quality improves and eventually comes to a peak, the data suggest that the cyclical erosion comes gradually rather than abruptly. In other words, inflection points in asset quality do not signal a turning point in the economic cycle. Applying this experience to the current situation, there is no reason to believe that a modest near-term cyclical increase in problem assets or charge-offs portends ill for the continuing economic recovery. The two perspectives on cycles in the financial services business - the performance of financial services firms in this phase of the business cycle, and what asset quality indicators tell us about the state of the economy - together suggest that growth in economic activity will continue to support favorable conditions for financial institutions for at least the near term. Banks and credit unions today face important challenges, such as finding a way to replace the revenue surge that came with the mortgage origination boom of 2002-03 and generating continued earnings growth without the support that has been provided recently by lower provisions and cyclical improvements in asset quality. As in the past, without strong risk management and credit discipline, the prolonged period of favorable conditions could breed behavior by lenders that will contribute to a more severe credit cycle the next time around. In closing, let me again commend you for taking the time to participate in CUNA's Government Affairs Conference. Your participation is valuable, and I thank you for inviting me to join you today. Exhibit
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Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the President¿s Advisory Panel on Federal Tax Reform, Washington, DC, 3 March 2005.
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Alan Greenspan: The tax system Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the President’s Advisory Panel on Federal Tax Reform, Washington, DC, 3 March 2005. * * * The President has assembled a very able panel to address an issue that is both important and exceptionally challenging. The U.S. economy is the world's most dynamic and flexible, and the federal government's system for raising revenue must not hinder the processes generating that economic success. However, since the exemplary 1986 reform, the tax code has drifted back to be overly complicated and burdened by higher marginal rates and by many special provisions that have undesirably narrowed the tax base. Changes since the 1986 act have been largely incremental without the appropriate all-encompassing context that broad reform brings to the table. It is perhaps inevitable that, every couple of decades, drift needs to be addressed and reversed. I believe some useful lessons can be learned by examining earlier systematic reforms of the tax code, such as those of 1954, 1969, and 1986. Among those reforms, the 1986 effort is widely regarded as having been the most successful of the post-war era. This success was achieved, in large measure, I believe, because the reform hewed to an explicit set of principles. I am not suggesting that today's reform should follow the specifics of the 1986 reform. Both the economic and fiscal conditions, as well as the existing state of the tax system, have changed in important ways since that time, and some aspects of the framework that worked well in 1986 may be inappropriate today. Nevertheless, I believe that a number of the principles underlying that reform are still applicable. A defining feature of the 1986 reform was the broadening of the tax base and the lowering of tax rates, and it is widely believed that these changes enhanced economic efficiency. High tax rates (whether the base is income or consumption) exacerbate the distortions that taxes invariably create. Moreover, distortions arise when similar activities are subject to different tax treatments. Such distortions reduce economic efficiency as households and businesses respond to the tax code rather than to underlying economic fundamentals. Lowering tax rates by broadening the tax base generally will reduce the costs of such distortions, which are approximately proportional to the square of the tax rate. Over the years, economists have disagreed about the size of the efficiency gains that might be achieved from a broader base and lower rates, but there can be little doubt regarding their positive effect. The 1986 reform also strove to achieve a measure of comity in the tax code, by treating taxpayers in similar circumstances in a roughly comparable manner and by maintaining progressivity in the tax system. In addition, the 1986 reform broadly applied the constraints of revenue and distributional neutrality, which appear to have facilitated bipartisan coalition building. Setting rough distributional neutrality as a rule of the game limited the number of losers created and likely made sacrifices in the name of efficiency easier for different groups of taxpayers who knew that losses would be relatively limited. Of course, public views about the fairness of proposed changes to the tax code will surely play a significant role in the current debate, and these views will be driven by perceptions of the fairness of the current tax system. The standards by which the public judges fairness are deeply rooted in judgments of whether, and which, incomes are the consequence of individual effort. The contours of economic policy since the nation's founding have closely followed changing standards of fairness over time. Simplification of an overly complex structure was another important accomplishment of the 1986 reform. Unfortunately, tax code drift since 1986 has evolved to a point where taxpayers are again confronted with great complexity. Indeed, an individual taxpayer may have difficulty even knowing his or her marginal tax rate because of the overlapping web of deductions and exemptions and the provisions that attempt to limit those deductions and exemptions. And many taxpayers are now required to compute their liability under two systems - the regular income tax and the alternative minimum tax. Such challenges also affect lower-income households, who face the complexities of the Earned Income Tax Credit. A simpler tax code would reduce the considerable resources devoted to complying with current tax laws, and the freed-up resources could be used for more productive purposes. Thus, greater simplicity would, in and of itself, engender a better use of resources. A principle that I believe is important now - but appears not to have weighed so heavily on those involved in the earlier reforms - is predictability in the tax code. By this I mean creating a tax system in which households and businesses can look into the future and have some reasonable degree of certainty about the future tax implications of decisions made today. Just as price stability facilitates economic decisionmaking by limiting the potential distortions from unanticipated changes in the price level, some semblance of predictability in the tax code also would facilitate better forward-looking economic decisionmaking by households and businesses. Given the expertise on this panel and the ultimate responsibility of the Congress and the President for the tax system, I would not presume to suggest the best specific path for reforming the tax system. However, past experience suggests that as the panel's work gets under way, one of the first decisions that you will confront is the choice of tax base; possibilities include a comprehensive income tax, a consumption tax, or some combination of the two, as is done in many other countries. As you know, many economists believe that a consumption tax would be best from the perspective of promoting economic growth - particularly if one were designing a tax system from scratch - because a consumption tax is likely to encourage saving and capital formation. However, getting from the current tax system to a consumption tax raises a challenging set of transition issues. In 1986, tax reformers considered a consumption tax base and, despite the arguments in favor of such a system, they decided to enhance the comprehensiveness of the income tax system then in place. Circumstances are different today, and the right choice will require assessing anew the tradeoffs between complexity, fairness, and economic growth. The choice of the tax base and other provisions of the code must also be taken in light of coming demographic changes. I believe that, as the baby boom generation begins to retire in a few years, it will become increasingly important for the nation to boost resources available in the future through greater national saving and enhanced incentives for participation in the labor force. The tax system has the potential to contribute importantly to those goals, and, at a minimum, tax reform should not hinder the achievement of those objectives. Finally, fundamental, thoroughgoing tax reform will require tradeoffs among competing objectives and will create both winners and losers. In the past, these difficult choices were facilitated by bipartisan cooperation. In the 1954 reform, congressional support was bipartisan, and President Eisenhower signed the legislation. In the 1969 reform, efforts were started under President Johnson but were completed during the Nixon Administration. Similarly, in 1986, President Reagan worked with Democratic congressional leaders to see reform through. I am confident that this panel can lay the groundwork for another historic reform and can get this process started off on the right foot. Thank you for the opportunity to share some thoughts with you today. I look forward to the results of your deliberations.
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Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on the Budget, US House of Representatives, 2 March 2005.
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Alan Greenspan: Economic outlook and current fiscal issues Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on the Budget, US House of Representatives, 2 March 2005. * * * Mr. Chairman, Ranking Member Spratt, and members of the Committee, I am pleased to be here today to offer my views on the federal budget and related issues. I want to emphasize that I speak for myself and not necessarily for the Federal Reserve. The U.S. economy delivered a solid performance in 2004, and thus far this year, activity appears to be expanding at a reasonably good pace. However, the positive short-term economic outlook is playing out against a backdrop of concern about the prospects for the federal budget, especially over the longer run. Indeed, the unified budget is running deficits equal to about 3-1/2 percent of gross domestic product, and federal debt held by the public as a percent of GDP has risen noticeably since it bottomed out in 2001. To be sure, the cyclical component of the deficit should narrow as the economic expansion proceeds and incomes rise. And the current pace of the ramp-up in spending on defense and homeland security is not expected to continue indefinitely. But, as the latest projections from the Administration and the Congressional Budget Office suggest, our budget position is unlikely to improve substantially in the coming years unless major deficit-reducing actions are taken. In my judgment, the necessary choices will be especially difficult to implement without the restoration of a set of procedural restraints on the budget-making process. For about a decade, the rules laid out in the Budget Enforcement Act of 1990 and in the later modifications and extensions of the act provided a framework that helped the Congress establish a better fiscal balance. However, the brief emergence of surpluses in the late 1990s eroded the will to adhere to these rules, which were aimed specifically at promoting deficit reduction rather than at the broader goal of setting out a commonly agreed-upon standard for determining whether the nation was living within its fiscal means. Many of the provisions that helped restrain budgetary decisionmaking in the 1990s - in particular, the limits on discretionary spending and the PAYGO requirements - were violated ever more frequently; finally, in 2002, they were allowed to expire. Reinstating a structure like the one provided by the Budget Enforcement Act would signal a renewed commitment to fiscal restraint and help restore discipline to the annual budgeting process. Such a step would be even more meaningful if it were coupled with the adoption of a set of provisions for dealing with unanticipated budgetary outcomes over time. As you are well aware, budget outcomes in the past have deviated from projections - in some cases, significantly - and they will continue to do so. Accordingly, a well-designed set of mechanisms that facilitate midcourse corrections would ease the task of bringing the budget back into line when it goes off track. In particular, you might want to require that existing programs be assessed regularly to verify that they continue to meet their stated purposes and cost projections. Measures that automatically take effect when costs for a particular spending program or tax provision exceed a specified threshold may prove useful as well. The original design of the Budget Enforcement Act could also be enhanced by addressing how the strictures might evolve if and when reasonable fiscal balance came into view. I do not mean to suggest that the nation's budget problems will be solved simply by adopting a new set of rules. The fundamental fiscal issue is the need to make difficult choices among budget priorities, and this need is becoming ever more pressing in light of the unprecedented number of individuals approaching retirement age. For example, future Congresses and Presidents will, over time, have to weigh the benefits of continued access, on current terms, to advances in medical technology against other spending priorities as well as against tax initiatives that foster increases in economic growth and the revenue base. Because the baby boomers have not yet started to retire in force, we have been in a demographic lull. But this state of relative stability will soon end. In 2008 - just three years from now - the leading edge of the baby-boom generation will reach 62, the earliest age at which Social Security retirement benefits can be drawn and the age at which about half of those eligible to claim benefits have been doing so in recent years. Just three years after that, in 2011, the oldest baby boomers will reach 65 and will thus be eligible for Medicare. Currently, 3-1/4 workers contribute to the Social Security system for each beneficiary. Under the intermediate assumptions of the program's trustees, the number of beneficiaries will have roughly doubled by 2030, and the ratio of covered workers to beneficiaries will be down to about 2. The pressures on the budget from this dramatic demographic change will be exacerbated by those stemming from the anticipated steep upward trend in spending per Medicare beneficiary. The combination of an aging population and the soaring costs of its medical care is certain to place enormous demands on our nation's resources and to exert pressure on the budget that economic growth alone is unlikely to eliminate. To be sure, favorable productivity developments would help to alleviate the impending budgetary strains. But unless productivity growth far outstrips that embodied in current budget forecasts, it is unlikely to represent more than part of the answer. Higher productivity does, of course, buoy revenues. But because initial Social Security benefits are influenced heavily by economywide wages, faster productivity growth, with a lag, also raises benefits under current law. Moreover, because the long-range budget assumptions already make reasonable allowance for future productivity growth, one cannot rule out the possibility that productivity growth will fall short of projected future averages. In fiscal year 2004, federal outlays for Social Security, Medicare, and Medicaid totaled about 8 percent of GDP. The long-run projections from the Office of Management and Budget suggest that the share will rise to 9-1/2 percent by 2015 and will be in the neighborhood of 13 percent by 2030. So long as health-care costs continue to grow faster than the economy as a whole, the additional resources needed for such programs will exert pressure on the federal budget that seems increasingly likely to make current fiscal policy unsustainable. The likelihood of escalating unified budget deficits is of especially great concern because they would drain an inexorably growing volume of real resources away from private capital formation over time and cast an ever-larger shadow over the growth of living standards. The broad contours of the challenges ahead are clear. But considerable uncertainty remains about the precise dimensions of the problem and about the extent to which future resources will fall short of our current statutory obligations to the coming generations of retirees. We already know a good deal about the size of the adult population in, say, 2030. Almost all have already been born. Thus, forecasting the number of Social Security and Medicare beneficiaries is fairly straightforward. So too is projecting future Social Security benefits, which are tied to the wage histories of retirees. However, the uncertainty about future medical spending is daunting. We know very little about how rapidly medical technology will continue to advance and how those innovations will translate into future spending. Consequently, the range of possible outcomes for spending per Medicare beneficiary expands dramatically as we move into the next decade and beyond. Technological innovations can greatly improve the quality of medical care and can, in some instances, reduce the costs of existing treatments. But because technology expands the set of treatment possibilities, it also has the potential to add to overall spending - in some cases, by a great deal. Other sources of uncertainty - for example, the extent to which longer life expectancies among the elderly will affect medical spending may also turn out to be important. As a result, the range of future possible outlays per recipient is extremely wide. The actuaries' projections of Medicare costs are, perforce, highly provisional. These uncertainties - especially our inability to identify the upper bound of future demands for medical care - counsel significant prudence in policymaking. The critical reason to proceed cautiously is that new programs quickly develop constituencies willing to fiercely resist any curtailment of spending or tax benefits. As a consequence, our ability to rein in deficit-expanding initiatives, should they later prove to have been excessive or misguided, is quite limited. Thus, policymakers need to err on the side of prudence when considering new budget initiatives. Programs can always be expanded in the future should the resources for them become available, but they cannot be easily curtailed if resources later fall short of commitments. I fear that we may have already committed more physical resources to the baby-boom generation in its retirement years than our economy has the capacity to deliver. If existing promises need to be changed, those changes should be made sooner rather than later. We owe future retirees as much time as possible to adjust their plans for work, saving, and retirement spending. They need to ensure that their personal resources, along with what they expect to receive from the government, will be sufficient to meet their retirement goals. Addressing the government's own imbalances will require scrutiny of both spending and taxes. However, tax increases of sufficient dimension to deal with our looming fiscal problems arguably pose significant risks to economic growth and the revenue base. The exact magnitude of such risks is very difficult to estimate, but, in my judgment, they are sufficiently worrisome to warrant aiming, if at all possible, to close the fiscal gap primarily, if not wholly, from the outlay side. In the end, I suspect that, unless we attain unprecedented increases in productivity, we will have to make significant structural adjustments in the nation's major retirement and health programs. Our current, largely pay-as-you go social insurance system worked well given the demographics of the second half of the twentieth century. But as I have argued previously, the system is ill-suited to address the unprecedented shift of population from the workforce to retirement that will start in 2008. Much attention has been focused on the forecasted exhaustion of the Social Security trust fund in 2042. But solving that problem will do little in itself to meet the imperative to boost our national saving. Raising national saving is an essential step if we are to build a capital stock that by, say, 2030 will be sufficiently large to produce goods and services adequate to meet the needs of retirees without unduly curbing the standard of living of our working-age population. Unfortunately, the current Social Security system has not proven a reliable vehicle for such saving. Indeed, although the trust funds have been running annual surpluses since the mid-1980s, one can credibly argue that they have served primarily to facilitate larger deficits in the rest of the budget and therefore have added little or nothing to national saving. In my view, a retirement system with a significant personal accounts component would provide a more credible means of ensuring that the program actually adds to overall saving and, in turn, boosts the nation's capital stock. The reason is that money allocated to the personal accounts would no longer be available to fund other government activities and - barring an offsetting reduction in private saving outside the new accounts - would, in effect, be reserved for future consumption needs. The challenge of Medicare is far more problematic than that associated with Social Security. A major reason is the large variance of possible outcomes mentioned earlier coupled with the inadequacy of the current medical information base. Some important efforts are under way to use the capabilities of information technology to improve the health-care system. If supported and promoted, these efforts could provide key insights into clinical best practices and substantially reduce administrative costs. And, with time, we should also gain valuable knowledge about the best approaches to restraining the growth of overall health-care spending. Crafting a budget strategy that meets the nation's longer-run needs will become ever more difficult the more we delay. The one certainty is that the resolution of the nation's unprecedented demographic challenge will require hard choices and that the future performance of the economy will depend on those choices. No changes will be easy, as they all will involve setting priorities and, in the main, lowering claims on resources. It falls to the Congress to determine how best to address the competing claims on our limited resources. In doing so, you will need to consider not only the distributional effects of policy changes but also the broader economic effects on labor supply, retirement behavior, and private saving. In the end, the consequences for the U.S. economy of doing nothing could be severe. But the benefits of taking sound, timely action could extend many decades into the future.
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Speech by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Benjamin Rush Lecture, Dickinson College, Pennsylvania, 2 March 2005.
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Edward M Gramlich: The importance of raising national saving Speech by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Benjamin Rush Lecture, Dickinson College, Pennsylvania, 2 March 2005. * * * An old saw has it that central bankers are paid to worry. They are supposed to look past any superficial good news and try to discern longer-run problems - perhaps inflation heating up, perhaps something else. For a central banker, every silver lining has a cloud. The present time provides a good illustration. We are just completing the forecasting season, at which time various economists make their projections. The Blue Chip survey of leading business forecasters predicts that the growth of real gross domestic product will average 3.5 percent over the next two years and that unemployment rates will decline slightly. Unemployment rates are near their normal, or equilibrium, level, yet these forecasters still look for basic stability in core inflation rates. According to the Blue Chip survey, investment should grow at healthy rates, and productivity growth should remain strong. In these forecasts, the Federal Reserve is expected to keep raising short-term interest rates toward their equilibrium level. It all seems pretty healthy - what is there to worry about? Well, unfortunately, there could be something to worry about, and that is what I want to talk about today. It is the nation's low national saving rate, basically the share of our output that is devoted to building up the country. This share can be defined either as the share of output not consumed either by households or government, or as the share of output devoted to capital investment less the share represented by borrowing from foreigners. The last clause is important - high investment is a good thing, but if much of this investment is financed by borrowing from foreigners rather than by our own saving, there could be trouble spots down the road. Whether there will be such trouble spots, I don't know. That is another issue I'd like to discuss. National saving As important as I think it is, national saving has always been relegated to the B list of economic measures. When economic data are released, there is always a great deal of attention to overall output, unemployment, inflation, interest rates, and budget and trade deficits. National saving rates have a lot to do with shaping each of these variables, but one searches in vain for mention of such rates. Today I am going to elevate national saving rates to center stage. I begin with a simple identity, taken from the national income accounts: NS = S - BD = I - B The left side of this identity covers the sources of national saving (NS), which are private saving in the economy (S) less budget deficits (BD). Budget deficits are subtracted because budget deficits imply that private saving is in part going to pay for the deficits of the government and not going into private investment. The more interesting part of the equation involves the uses of national saving, given on the right side of the identity. In an economy closed to international trade and capital flows, the long-time staple of undergraduate macroeconomics classes, national saving equals just domestic investment (I), which is spending on new capital equipment. This is the spending that raises productivity and output in the long run, and for that reason it is of special interest. But since economies are now open to international trade and capital flows, the identity must also account for the portion of national saving lent abroad or the portion of investment financed by borrowing from abroad (B). This is done by deducting B, essentially the nation's current account deficit (through another accounting identity of which I will spare you discussion). One value of writing out the national saving identity is to bring out an important short-run, long-run dichotomy. In the short-run, international borrowing can go up or down depending on cyclical movements, exchange rates, and a host of other factors. Very few countries do without any international borrowing or lending in a particular year. But over a longer period of time international borrowing kept close to zero stabilizes a country's ratio of international obligations to its gross domestic product (GDP).1 When this liability ratio is stable, a nation's saving is implicitly financing most of its domestic investment. Persistent borrowing, keeping investment above saving, may be possible, but it is not common, and in any case it automatically implies a buildup of international liabilities relative to its national output. If a nation wants to have its investment and not pay increasing shares of income in interest or dividends, it has to finance this investment by its own national saving. Or, turning the equation around, high national saving will raise future living standards whether it finances investment directly or reduces international borrowing. A further value in writing out the identity is to tie all this to budget and current account deficits, which are the focus of much popular discussion. In a word, both deficits are subtraction items. Budget deficits reduce national saving by, as I said earlier, siphoning off some private saving to pay for government deficits. Current account deficits can be associated with low national saving if a nation borrows to finance its investment. Some economists talk about a "twin deficit" scenario in which budget deficits lead to current account deficits of exactly the same size. There are macroeconomic scenarios that can lead to that result, and these, according to the equation, imply that investment and private saving move together or are fixed. But it is also possible to imagine many scenarios in which budget and current account deficits move independently. These deficits are certainly linked through their impact on national saving, but they are not twins. Finally, the numbers. National saving rates can be given in two ways, either by comparing gross national saving with gross domestic product, or by subtracting depreciation from both sides and comparing net national saving with net domestic product. It turns out not to matter for this discussion by either definition, national saving rates are at a post-World War II low. The numbers since the mid-1960s are shown in figure 1. As suggested in the preceding discussion, when national saving rates are this low, the nation suffers from some combination of low investment and high borrowing. The former is bad from the standpoint of future productivity, the latter is likely not sustainable. Neither situation is desirable. Sources side National saving has dropped because private saving rates have dropped, especially those for households.2 Moreover, in recent years federal budget deficits have shot up. From a national saving point of view, the rise in deficits would not be particularly alarming if private saving rates were high, nor would the decline in private saving rates be particularly alarming if the budget were in surplus. But the combination of low private saving rates and deficits can lead to problems. While there are ways to influence private saving rates by policy measures, changes in national saving for the most part follow changes in fiscal policy.3 Figure 2 shows the historical path for fiscal policy, specifically the federal deficit (in effect consigning state and local governments to the private sector). The dotted line shows the primary deficit, which is the total federal deficit less interest payments, as a share of GDP. To stabilize the ratio of the stock of federal debt to GDP, this primary deficit should be kept close to zero.4 The solid line gives just this federal debt to GDP ratio. When viewed in a historical context the federal deficit picture does not look particularly troubling. The primary deficit ratio has cycled around zero, and the debt-GDP ratio has cycled between 25 and 50 percent. The debt-GDP ratio had a long downswing in the 1960s and early 1970s, followed by a The precise proposition is that the primary, or noninterest, component of both budget and current account deficits must remain close to zero to stabilize the ratio of debt to national output. For a demonstration see Edward M. Gramlich (2004), "Budget and Trade Deficits: Linked, Both Worrisome in the Long Run, but Not Twins," speech delivered at the Euromoney Bond Investors Congress, February 25, 2005. Leonard Nakamura (2005), The Personal Saving Rate and the Future of Consumption, Federal Reserve Bank of Philadelphia, February, demonstrates a systematic tendency for personal saving rates to be revised upward. If this is so, it is possible that some of the recent dip will be revised away. Economists have a Ricardian equivalence exception - national saving rates do not follow changes in fiscal policy if private households offset fiscal actions with their own saving. In general, the evidence does not support this proposition. See Douglas W. Elmendorf and N. Gregory Mankiw (1999), "Government Debt," in J.B. Taylor and M. Woodford, eds., Handbook of Macroeconomics, (Elsevier). Shown in Gramlich, "Budget and Trade Deficits." long upswing in the 1980s. The United States ran fairly large primary surpluses in the 1990s, enough so to inspire talk of paying off the entire outstanding federal debt. But that brief period of good fortune has passed; primary deficits are back, and the debt-GDP ratio is rising again. For the intermediate future, the picture worsens somewhat. Recently, the Congressional Budget Office (CBO) made projections for the next decade. One of their scenarios took the so-called baseline budget, added in likely military spending for Iraq and Afghanistan, extended the recently enacted tax cuts, and adjusted the alternative minimum tax for inflation.5 Under these assumptions, the recent turn for the worse is likely to be reversed only slowly. The primary deficit averages around 2 percent of GDP for the next few years before gradually shrinking, and the debt-GDP ratio climbs back to about 45 percent by 2015. But these projections include only relatively certain budget obligations, and one can be forgiven for fearing that the actual numbers will turn out to be worse than the CBO projections, as they often do through no fault of the CBO. Hence, the medium-term projections do not give much reason for thinking that the downward pressure on overall national saving rates will be quickly reversed. If the medium term looks uncertain, the far future looks much worse. As is well known, the population of the United States is aging, and in a few decades a much larger share of the population will be in its retirement years, drawing on both Social Security and Medicare. The share of output devoted to these two programs will rise rapidly, putting even further downward pressure on national saving rates. The trends, especially for Medicare, are so alarming that these two programs alone could, in the space of little more than a decade, account for about half of federal spending. Changes have to be made in these large entitlement programs to avoid a real fiscal disaster. Of course changes can be made. While there are as yet not a great number of feasible ideas for significantly reducing the cost of Medicare, there are a number of proposals to reform Social Security. The President is touting a proposal, and ten years ago as chair of another Presidential advisory council on Social Security, I devised a proposal of my own.66 This is not the place to get into a full discussion of Social Security reform proposals, but one aspect of Social Security reform is important. Given the low national saving rates, and the fact that many American households do not save enough to avoid a big cut in their standard of living in retirement, it would seem desirable to have Social Security reforms that also raise national saving. One obvious and immediate way to do that would be to raise payroll taxes; another obvious, and perhaps less painful, way to do that would be to have individual accounts on top of Social Security. If these "add-on" individual accounts were to be mandated, as I proposed, those households who already save amply could reduce their other individual accounts while those who do no private saving for retirement would be forced to do more. Hence national saving would be increased, and increased for just those households who presently do little saving. Other types of Social Security reform seem less promising from a national saving point of view. If, for example, the individual accounts were to be "carved out" of present payroll tax payments, as President Bush has recently proposed, household saving would go up but government saving, in the first instance, would go down by the same amount, meaning that the initial impact on overall national saving would be nil. But carve-out individual accounts might eventually reduce saving because households getting individual accounts who are already saving for retirement might cut back on their pre-existing saving. Hence carve-out individual accounts seem more likely to reduce than increase national saving. This is not the only criterion for judging between add-on and carve-out individual accounts, but I think it is an important one. There may also be some way to compromise between mandatory add-on individual accounts that raise national saving but could be a tough sell politically, and carve-out individual accounts that are not likely to raise national saving. Some have suggested raising employee pension contribution rates by automatic default options for employer defined-contribution account. Under such a plan employees would be automatically enrolled in the employer's plan and would have to "opt out" to reject participation. Moreover, firms could be forced to carry employer defined-contribution accounts, as is done in Ireland. See Congressional Budget Office (2005), Budget and Economic Outlook, January 25. Edward M. Gramlich (1998), Is It Time to Reform Social Security? (University of Michigan Press). Other measures that might raise national saving are tax incentives to increase private saving, such as Individual Retirement Accounts (IRAs). These essentially reduce or eliminate the taxation of interest income and hence provide a price inducement for households to save more. While such measures are often advertised as ways to increase saving, one must be very careful. On one side, many households can easily claim the tax advantages by diverting existing assets into IRAs and not saving any more. On the other side, IRAs entail a federal revenue loss and a rise in deficits. Since national saving is defined as private saving less deficits, the larger deficits can actually make national saving decline in response to a measure that purports to increase national saving. If the private saving effect were large enough and the revenue loss small, it is also possible that IRAs would have the anticipated effect of increasing national saving. One cannot give a purely theoretical answer to the question - it depends on how the numbers come out.7 For years the economics profession has been engaged in a strenuous debate about these numbers, but it should be noted that overall household and national saving rates have declined significantly since IRA-type provisions were first introduced to the tax code. Even the mortgage interest deduction can enter in to the question. Through this deduction, households can borrow, add to their mortgage, reduce their taxes, and invest the proceeds in IRAs. Hence the mere presence of the mortgage interest deduction means that IRA-type measures, or consumption tax measures, that purport to increase private saving will, in fact, not increase private saving and could reduce national saving. That is why consumption-tax reform measures that omit treatment of the mortgage interest deduction are unlikely to promote national saving. Uses side We have seen that national saving is likely to continue to be low, the result of a combination of low personal saving in the presence of possibly persisting budget deficits. As was mentioned, this sets up a difficult quandary - either investment will have to decrease, lowering future productivity, or international borrowing will have to continue at high levels, raising international liability ratios. The real question is whether the large-scale borrowing is sustainable. The historical record for the United States, presented in a form similar to that for budget deficits, is shown in figure 3. Again, the dotted line is the primary deficit ratio, which in the case of international accounts is just the trade deficit. The solid line is the ratio of net international liabilities to domestic GDP, a measure of the nation's ability to afford its liabilities. As recently as 1985, net U.S. liabilities to foreigners were zero. But since 1990 the United States has embarked on a long-term period of high trade deficits, and now the international liability rate is close to 25 percent of GDP and rising sharply. International wealth portfolios are getting increasingly heavy in dollar-denominated assets. How long can this process continue? We can first examine the international record. The international deficit that determines the growth or decline in a country's international liability ratio is the trade deficit, and there are few cases of countries running large-scale trade deficits for more than four or five years. By this standard, the U.S. borrowing spurt should have ended a long time ago. In line with this record, many authors have been predicting for some time that the combination of interest rates, income, prices, and exchange rates would adjust to end the U.S. trade deficits.8 But the deficits have not ended, and international economists are searching for reasons to explain the situation. Perhaps the simplest explanation is that the current situation meets the apparent needs of many countries. Under this view, which has been labeled the "co-dependency" view, the United States is permitted to overconsume through the combination of its inability to cut budget deficits and its unwillingness to save much privately. Other countries are permitted to support their export industries by keeping the dollar strong and their own currencies weak.9 These countries in effect create reserves by buying and holding stocks of U.S. Treasury debt. These international open-market purchases keep the dollar strong, the home currencies weak, and export industries competitive. Were countries trying The fall 1996 issue of the Journal of Economic Perspectives contained several articles summarizing empirical work on this question. See, for example, articles in C. Fred Bergsten, ed. (2005), The United States and the World Economy (Washington: Institute for International Economics). The co-dependency term was coined by Catherine L. Mann (2004), "Managing Exchange Rates: Achievement of Global Rebalancing or Evidence of Global Co-dependency?" Business Economics, vol. 39 (July). to keep their own currencies strong, they would run out of the foreign assets to sell to support their own currency. But in keeping the dollar strong, all central banks have to do is to create reserves, and central banks can create reserves. Another possibility is that other countries, in Europe and much of Asia, have populations that are aging more rapidly than those in the United States. They may want to build up a stock of assets to prepare for their own retirement spending crises. Largely because of the productivity revolution here, these countries have been able to get better returns on their assets in this country than in their own, and they have been putting great quantities of saving in world capital markets, perhaps explaining the present low level of world long-term real interest rates. As a result, foreigners may be quite willing to accumulate dollar-denominated assets, and may appreciate the low U.S. national saving rate. A third possibility is that the so-called "home bias" in international saving-investment choices is gradually eroding.10 In this view, globalization has generally reduced the barriers to international asset diversification, and we are witnessing a rebalancing of wealth portfolios which, in the transition, can lead to persisting current account deficits or surpluses. It is very difficult to tell which of these explanations, or some combination of them, is on the mark and whether there are unknown fourth or fifth explanations. In each case there is an international self-interest argument to explain the situation, and it is difficult to assess the durability of this self-interest. The co-dependency view could have a natural stopping point when foreign central banks begin to worry about their heavy asset concentration in dollar-denomination assets and diversify their stock. The world-saving view could have a natural stopping point when the populations of the accumulating countries begin to retire, run down their assets, and sell their dollar-denominated assets to support the consumption of retirees. The disappearing-home-bias view could have a natural stopping point when wealth portfolios are rebalanced. This is all new and unexplored territory. But determining what explanation may be correct and stable may also be somewhat beside the point. However stable the underlying phenomena, it is much more stable for the United States to increase its own national saving and finance its own investment. This approach would support investment in the short run and make this investment more profitable in the long run, because the returns on capital would not be sent abroad. Other countries may still invest their saving here, but the United States would have a higher base of its self-financed investment. This situation would seem to be far and away the preferred course from a risk-management standpoint. Under such an approach, which I will term co-independence, the United States would gradually cut its budget deficit. Doing so would reduce aggregate demand and hence require other changes to preserve full employment. One such change would be that currency rates might shift in the direction of increasing U.S. net exports. To the extent that stimulation of net exports did not offset the fiscal actions fully, there is always monetary accommodation. One of the key mandates of the Federal Reserve is to preserve sustainable employment levels, and the Fed certainly could do that. In this strategy, other countries would have two requirements. To the extent that currency rates might need to adjust to restore international balance, foreign central banks should permit normal market readjustments. And to the extent that foreign net exports might decline as the United States cut its own trade deficits, foreign countries may need to stimulate their own economies, which they could do with some combination of monetary and fiscal policy. The result would be to preserve full employment around the world but with reduced capital account imbalances. Conclusion The message here could be worrisome but is really designed to provoke action. In the short run, output growth is healthy and inflation rates are stable. Investment shares are reasonable, but that is largely because the United States is borrowing such a huge amount from world capital markets. The key question is whether this borrowing is sustainable. However sustainable it is, the United States would seem well-advised to minimize risks by raising its own national saving to finance its own investment. That would stabilize investment in the short run and 10 The home bias term originally stemmed from results in a paper by Martin Feldstein and Charles Horioka (1980), "Domestic Savings and International Capital Flows," Economic Journal, vol. 90. increase profitability in the long run. It could raise national saving with some combination of fiscal tightening and measures to raise private saving, coupled with other measures, here and abroad, to increase demand throughout the world economy.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Independent Community Bankers of America National Convention, San Antonio, Texas (via videoconference), 11 March 2005.
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Alan Greenspan: Bank regulation Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Independent Community Bankers of America National Convention, San Antonio, Texas (via videoconference), 11 March 2005. * * * I am pleased to join you once again at the annual meeting of the Independent Community Bankers of America. In past years, I have discussed many and varied issues with you, from technological change to the future of community banking in the United States. Today, I sense that concern about the burden of regulation is high on your agenda. I thought it might therefore be useful to share some views on regulatory burden from the perspective of a bank regulator. A Framework American banking dates to the earliest days of our nation, and its long history has, I believe, taught us some valuable lessons. Foremost is that our banking system plays a central role in allocating resources, pooling capital, and funding and fostering economic growth. That role has not changed as our financial system has become more complex and diverse. We also have learned that leveraged banking systems can be both an initiator and a conduit of painful financial and real economic instability. We must keep both of these historical lessons in mind in any evaluation of banking regulation for they explain the tension between our appreciation for the central role that banks play in our prosperity and our concern about banks' potential effects on economic stability. Over the years, that tension has been reflected primarily in "safety and soundness" regulation, the supplement to banking supervision. Banking supervision is intended to be flexible and to be carried out case by case; it is designed to limit--not eliminate--the risk of failure. Over the past fifteen or so years, supervision has focused on ensuring that bank management has in place policies and procedures that will contain such risk and that management adheres to those policies and procedures. Supervision has become increasingly less invasive and increasingly more systems- and policyoriented. These changes have been induced by evolving technology, increased complexity, and lessons learned from significant banking crises, not to mention constructive criticism from the banking community. Regulations, on the other hand, prescribe and proscribe what must be done and what may not be done in specific areas, and most reflect past events. Many regulations are thus backward-looking, adopted in response to specific problems but often remaining after the problems are resolved. However, public comments, changing market realities, and our internal programs help us to identify regulations that no longer serve public policy objectives. We then update or remove those regulations. In other cases, market changes and innovations often require changes in regulations, or even new regulations, to ensure that policy objectives continue to be achieved. The need for safety and soundness supervision and regulation has been greatly reinforced in the past century to address the market distortions that are unavoidable consequences of the special benefits provided to banks, benefits that were promulgated because of the tensions between bank contributions to growth and concerns about banks' role in economic instability. These benefits are access to the Federal Reserve's discount window; access to the payment system, especially Fedwire; and deposit insurance. These provisions, collectively often called the bank safety net, were designed to minimize the potential for asset or other problems in the banking system to disrupt the real economy, but, as an unavoidable byproduct, also provide an important subsidy to banks. By protecting depositors and counterparties, they also reduce, if not eliminate, much of the market discipline that constrained risk-taking by nineteenth-century banks. While there is some evidence that the Federal Deposit Insurance Corporation Improvement Act of 1991 has reduced the value to banks of the safety net, bank safety and soundness regulation and supervision still must act as a supplement to, if not a substitute for, the market discipline that the safety net undermined The increasing scale and diversity of our nonbank financial institutions has suggested to some that those institutions, too, need to be subject to bank-like supervision and regulation, since their risktaking, while contributing to our economic growth, also has implications for stability. However, it is clear from leverage ratios and other indicia of their funding process that the market monitors and disciplines nonbank entities far more intensively than banks. Indeed, the real difference between banks and these entities is the difference we have made for banks: the creation of the safety net and the resultant need to find a mechanism to substitute for the market discipline displaced by the safety net. To be sure, we have increasingly tried to make supervision and regulation more like the discipline the market would impose if there were no safety net, but human beings cannot duplicate the market, or adjust as adroitly, and hence we turn to rules and to insistence on prudential policies and procedures. Traditional banking regulation is well understood and appreciated, or at least tolerated, by bank management. But other forms of regulation have been required by the Congress in the last three or so decades. One class of regulations is concerned mostly with ensuring that banking institutions serve their communities by addressing possible instances of discrimination and, more recently, by assisting law enforcement. Examples are regulations adopted to carry out provisions of the Equal Credit Opportunity Act (ECOA), the Community Reinvestment Act (CRA), the Home Mortgage Disclosure Act (HMDA), and, the Bank Secrecy Act (BSA). Another class of regulations addresses "consumer protection," which the agencies, at the direction of the Congress, have implemented by adopting rules designed primarily to provide consumers with information to protect themselves (in some cases, however, the rules also involve substantive restrictions on certain practices). More generally, these regulations, if crafted carefully, should enhance market efficiency by providing consumers with more complete, consistent, and timely information; by promoting consumer awareness and shopping; and by opening the way for moreeffective competition. That is surely our intention with our Truth-in-Lending and Truth-in-Saving regulations, for example. The same factors that make banks candidates for supervision and regulation--their central role in the financing process coupled with the benefits of the safety net provided to banks by government--have also made banks prime candidates for lawmakers to select as vehicles to achieve desired social and economic objectives. Not only can banks deliver because of their economic role and expertise, but also legislators often believe banks have an obligation to do so because of the special benefits that have been provided for them. In implementing the law of the land, cost-benefit calculations often require compromises and modifications. The recently announced proposal by the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Federal Reserve to modify CRA exams is an example. In addition, the agencies constantly struggle to avoid unintended consequences, particularly to limit the extent to which our rules, as well as our compliance supervision, cause an undesirable change in credit availability or in bank behavior that undermines the objective of the rules. To be effective regulators, we must also attempt to balance the burdens imposed on banks with the regulations' success in obtaining the intended benefits and to discover permissible and more-efficient ways of doing so. Because we understand that regulatory changes can be quite costly, we recognize as well the important regulatory responsibility to balance the cost of change with the desired benefits. But markets are not static, and changes must be made from time to time to fulfill the objectives of the law being implemented. Basel II All of these factors--unintended consequences, balancing burdens and benefits, as well as the need for and the cost of change--enter the calculus for the implementation of the proposed new Basel Capital Accord. As you know, although they will not be required to adopt the new capital rules, many community and regional banks are uneasy that they may be left at a competitive disadvantage after the 2008 adoption of the new rules by their larger rivals. To gauge whether these concerns are warranted, the Federal Reserve has been studying the competitive implications of Basel II implementation. Some of our studies have been completed and made public; others will be published in coming weeks. For some business lines, the studies have suggested that competitive impacts are not likely, while for others, such as some types of small business loans, it does appear that unintended competitive advantages and disadvantages might be created. Where concerns appear valid, we and the other federal banking agencies will this summer propose some options for simple revisions to the current capital rules that would mitigate any unintended and undesired competitive distortions engendered by the new Accord. Moreover, as in the past, if competitive or other issues later arise that we cannot now adequately foresee, the Federal Reserve would make appropriate further adjustments to the rules. HMDA Disclosure Another example of the need for and the cost of change--and perhaps the risk of unintended consequences--can be found in the new rules regarding HMDA disclosures. Several factors have substantially changed the structure of residential mortgage lending over the past decade or so. Prominent among these are developments in information processing technology that permit more-efficient and more-accurate risk assessment and management. In addition, the dynamics of the marketplace have induced banks to seek new lending opportunities. Moreover, earlier HMDA data collections have led many institutions to review and, in some cases, to modify their marketing and underwriting practices. These developments have induced banks to change their policies from simply not making riskier mortgage loans to making such credit available but charging for the additional risk taken. Banks are now making many more such loans to higher-risk borrowers, and they justifiably seek compensation for the higher risk through higher interest rates. An economist would suggest that in perfect markets nominal rates on loans would be different, but risk-adjusted real rates, that is, the rate after deduction of expected losses, would be about the same on all loans. Such risk-based pricing is consistent with expanding access to credit. Indeed, many of those receiving higher-rate loans would in the past have been denied credit at lower rates. However, some banks are concerned about the risk to their reputation that might be precipitated by the new HMDA data on rates charged for the higher-rate segment of the market. Specifically, by doing what public policy intended-increasing credit availability to less creditworthy, often minority, borrowers--banks might be accused unfairly of discrimination by those who fail to connect risk to price or to evaluate rates in terms of risk measures. Such concerns are understandable as, indeed, also are concerns that race, gender, ethnicity or other characteristics not reflective of risk per se may still adversely affect the cost of credit to some borrowers. The adoption of risk-based pricing, together with elements of discretion that are often afforded loan officers or brokers in the pricing of credit, does raise the concern that some borrowers, in fact, may not be treated fairly. The changes in market structure coupled with such concerns suggested to us the need to revise our HMDA data collection in order to gather information on rates charged to aid us in seeing if, in fact, differences in rates are truly driven by differences in risks and costs and not tainted by discrimination. We recognized that such conclusions require far more detailed evaluations than is possible using HMDA information alone, with or without the additional data on rates. Nonetheless, the pricing data will assist as a screening tool to facilitate self-monitoring and enforcement activities. If screening suggests that there might be a fairness issue, additional information will need to be collected from banks' loan files or other sources. Bank Secrecy Act and Suspicious Activity Reports In the last year or so, banks have also become concerned about the scope of their obligations to file Suspicious Activity Reports (SARs) under Bank Secrecy Act regulations and the sanctions used to address deficiencies, which have included criminal prosecutions. The purpose of the law and its associated regulation is to capitalize on the banks' central role in payments and financial flows by, in effect, making banks partners with law enforcement to address criminal activities such as money laundering by drug dealers, the financing of terrorist activities, and fraud. As you know, SAR regulations call for banks to report what they believe to be "known or suspected" violations and suspicious activities by their customers that could be associated with such criminal activities. Bank regulations and supervisory oversight are designed to reinforce the building of systems and the development and application of bank policies, both of which are to highlight for management what could be suspicious or unlawful activity by customers and employees, the basis of the SARs reports. But banks are to make the judgment of what is likely to be useful information for law enforcement. The banking agencies are in the process of developing compliance examination guidelines under the Bank Secrecy Act, which we hope can provide uniform direction on SAR filing requirements. The Federal Reserve is working closely, and will continue to work closely, with the staff of the Treasury Department responsible for anti-money-laundering and terrorist-financing enforcement, as well as with other bank regulatory agencies and the Justice Department, to support a fair, effective, and consistent approach to Bank Secrecy Act compliance. All of us want the system to work, including the bankers who want to do their part in curbing criminal and terrorist activities. Besides participating in interagency discussions, we intend to monitor developments so as to be in a position to help make the system work without excessive burden. Such assistance will, we believe, require that all parties, including law enforcement authorities, better understand not only how banks and banking supervision operates but also the unintended consequences that will surely accompany a misunderstanding of these operations. Conclusion In closing, let me underline just a few key points. When implementing the law, we try to avoid unintended consequences and excessive burden. Our regulatory programs go through intensive initial reviews that include extensive public comment, periodic review, and more-or-less continuous evaluation. Our cost-benefit analysis goes beyond burden to encompass likely effects on credit flows and bank behavior that may unintentionally defeat the purposes of the regulation. We are particularly aware that changes in regulations, even if intended to lighten burden or to reflect new market realities, carry new costs that must be evaluated. But we can always do better, and I encourage this association and each of you individually to continue your efforts to make sure that we implement the law in the most efficient manner possible.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Council on Foreign Relations, New York, New York, 10 March 2005.
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Alan Greenspan: Globalization Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Council on Foreign Relations, New York, New York, 10 March 2005. * * * The U.S. economy appears to have been pressing a number of historic limits in recent years without experiencing the types of financial disruption that almost surely would have arisen in decades past. This observation raises some key questions about the longer-term stability of the U.S. and global economies that bear significantly on future economic developments. Among the limits that we have been pressing against are those in our external and budget balances. In the United States, we have been incurring ever-larger trade deficits, with the broader current account measure moving into the neighborhood of 6 percent of our gross domestic product. Yet the dollar's real exchange value, despite its recent decline, remains above its 1995 low. Meanwhile, we have moved from a budget surplus in 2000 to a deficit that is projected by the Congressional Budget Office to be around 3-1/4 percent of GDP this year. In addition, we have enacted commitments to our senior citizens that, given the impending retirement of our huge baby-boom generation, will create significant fiscal challenges in the years ahead. Yet the yields on Treasury notes maturing a decade from now remain at low levels. Nor are households experiencing inordinate financial pressures as a consequence of record-high levels of household debt relative to income. * * * Has something fundamental happened to the U.S. economy that enables us to disregard all the timetested criteria for assessing when economic imbalances become worrisome? Regrettably, the answer is no; the free lunch has still to be invented. We do, however, seem to be undergoing what is likely, in the end, to be a one-time shift in the degree of globalization and innovation that has temporarily altered the specific calibrations of those criteria. Globalization has altered the economic frameworks of both advanced and developing nations in ways that are difficult to fully comprehend. Nonetheless, the largely unregulated global markets, with some notable exceptions, appear to move smoothly from one state of equilibrium to another. Adam Smith's "invisible hand" remains at work on a global scale. Because of deregulation, increased innovation, and lower barriers to trade and investment, crossborder trade in recent decades has been expanding at a far faster pace than GDP. As a result, many economies are increasingly exposed to the rigors of international competition and comparative advantage. In the process, lower prices for some goods and services produced by our trading partners have competitively suppressed domestic price pressures. Production of traded goods and services has expanded rapidly in economies with large, low-wage labor forces. Most prominent are China and India, which over the past decade have partly opened up to market forces, and the economies of central and eastern Europe, which were freed from central planning by the fall of the Soviet empire. The consequent significant additions to world production and trade have clearly put downward pressure on prices in the United States and in the economies of our trading partners. Over the past two decades, inflation has fallen notably, virtually worldwide, as has economic volatility. Although a complete understanding of the reasons remains elusive, globalization and innovation would appear to be essential elements of any paradigm capable of explaining the events of the past ten years. If this is indeed the case, because the extent of globalization and the speed of innovation are limited, the current apparent rapid pace of structural shift cannot continue indefinitely. While the outlook for the next year or two seems reasonably bright, the outlook for the latter part of this decade remains opaque because it is uncertain whether this transitional paradigm, if that is what it is, is already far advanced and about to slow, or whether it remains in an early, still-vibrant stage of evolution. * * * Globalization--the extension of the division of labor and specialization beyond national borders--is patently a key to understanding much of our recent economic history. With a deepening of specialization and a growing capacity to conduct transactions and take risks throughout the world, production has become increasingly international.1 The pronounced structural shift over the past decade to a far more vigorous and competitive world economy than that which existed in earlier post-World War II decades apparently has been adding significant stimulus to world economic activity. This stimulus, like that which resulted from similar structural changes in the past, is likely a function of the rate of increase of globalization and not its level. If so, such impetus would tend to peter out as we approach the practical limits of globalization. Full globalization, in which production, trade, and finance are driven solely by risk-adjusted rates of return and in which risk is indifferent to distance and national borders, will likely never be achieved. The inherent risk aversion of people, and the home bias that is one manifestation of that aversion, will limit how far globalization can proceed. But because so much of our recent experience has little precedent, as I noted earlier, we cannot fully determine how long the current globalization dynamic will take to play out. And even then we have to be careful not to fall into the trap of equating the achievement of full globalization with the exhaustion of opportunities for new investment. The closing of our frontier at the end of the nineteenth century, for example, did not signal the onset of a new era of economic stagnation. * * * The increasing globalization of the post-World War II era was fostered at its beginnings by the judgment that burgeoning prewar protectionism was among the primary causes of the depth of the Great Depression of the 1930s. As a consequence, trade barriers began to fall after the war. Globalization was enhanced further when the inflation-ridden 1970s provoked a rethinking of the philosophy of economic policy, the roots of which were still planted in the Depression era. In the United States, that rethinking led to a wave of bipartisan deregulation of transportation, energy, and finance. With respect to macropolicies, there was a growing recognition that inflation impaired economic performance.2 Moreover, a tightening of monetary policy, and not increased regulation, came to be seen by the end of that decade as the only viable solution to taming inflation.3 Of course, the startling recovery of war-ravaged West Germany following Ludwig Erhard's postwar reforms, and Japan's embrace of global trade, were early examples of the policy reevaluation process. It has taken several decades of experience with markets and competition to achieve an unwinding of regulatory rigidities. Today, privatization and deregulation have become almost synonymous with "reform." * * * By any number of measures, globalization has expanded markedly in recent decades. Not only has the ratio of international trade in goods and services to world GDP risen steadily over the past half- Much of what is assembled in final salable form in the United States, for example, may consist of components from many continents. Companies seek out the lowest costs of inputs to effectively compete for their customers' dollars. This international competition, left unfettered, history suggests, would tend to direct output to the comparatively most efficient producers of specific products or services and, hence, maximize standards of living of all participants in trade. Given the skills and education of its workforce and a number of institutional factors, such as its legal structure, each economy will achieve its maximum possible average living standard. Indeed, the Group of Seven leaders, at their 1977 economic summit, identified inflation as a cause of unemployment. This had not always been the case. For example, wage and price controls were imposed in the United States in 1971 as a substitute for a tighter monetary policy and higher interest rates to address rising inflation. century, but a related measure--the extent to which savers reach beyond their national borders to invest in foreign assets--has also risen. Through much of the post-World War II years, domestic saving for each country was invested predominantly in its domestic capital assets, even when there existed the potential for superior riskadjusted returns from abroad. Because a country's domestic saving less its domestic investment is essentially equal to its current account balance, such balances, positive or negative, were therefore generally modest, with the exception of the mid-1980s. But in the early 1990s, "home bias" began to diminish appreciably, and, hence, the dispersion of current account balances among countries has increased markedly. The widening current account deficit in the United States has come to dominate the tail of the distribution of external balances across countries. Nonetheless, the worldwide dispersion of current account balances has risen since the early 1990s, even excluding the United States. 4 Thus, the decline in home bias, or its equivalent, expanding globalization, has apparently enabled the United States to finance and, hence, incur so large a current account deficit. As a result of these capital inflows, the ratio of foreign net claims against U.S. residents to our annual GDP has risen to approximately one-fourth. While some other countries are far more in debt to foreigners, at least relative to their GDPs, they do not face the scale of international financing that we require. A U.S. current account deficit of 6 percent of GDP would probably not have been readily fundable a half-century ago or perhaps even a couple of decades ago.5 The ability to move that much of world saving to the United States in response to relative rates of return almost surely would have been hindered by the far-lesser degree of both globalization and international financial flexibility that existed at the time. Such large transfers would presumably have induced changes in the prices of assets that would have proved inhibiting. Nonetheless, we have little evidence that the economic forces that are fostering international specialization, and hence cross-border trade and increasing dispersion of current account balances, are as yet diminishing. To be sure, as I pointed out earlier this year, we may be approaching a point, if we are not already there, at which exporters to the United States, should the dollar decline further, would no longer choose to absorb a further reduction in profit margins. An acceleration of U.S. import prices, of course, would impede imports and give traction to the process of adjustment in our trade balance. Moreover, international investors, private and official, faced with an increasing concentration of dollar assets in their portfolios, will at some point choose greater balance in their asset accumulation. That shift, over time, would likely induce contractions in both the U.S. current account deficit and the corresponding current account surpluses of other nations. To date the proportional shift out of dollars from the total of official and private sector foreign currency accounts has been modest, when adjusted for exchange rate changes.6 Of course, the shift has been larger on an unadjusted dollar equivalent basis. However, the market has absorbed this change in an orderly manner. The more-rapid aging of European and Japanese populations relative to the aging of the U.S. population should slow the flow of foreign saving available to the United States. Although those population dynamics are already in train, little evidence as yet of slowed savings transfers has surfaced. The correlation coefficient between paired domestic saving and domestic investment, a conventional measure of the propensity to invest at home for OECD countries constituting four-fifths of world GDP, fell from 0.97 in 1990 to less than 0.8 in 2003. This correlation coefficient has been even lower recently when the United States is excluded from the sample. With rare exceptions, a decline in the correlation of countries' paired domestic saving and domestic investment implies an increased dispersion of current account balances. It is true that estimates of the ratios of the current account to GDP for many countries in the nineteenth century are estimated to have been as large as, or larger, than we have experienced in recent years. However, the substantial net flows of capital financing for those earlier deficits were likely motivated in large part by specific major development projects (for example, railroads) bearing high expected rates of return. By contrast, diversification appears to be a more salient motivation for today's large net capital flows. Moreover, gross capital flows are believed to be considerably greater relative to GDP in recent years than in the nineteenth century. (See Alan M. Taylor (2002), "A Century of Current Account Dynamics," Journal of International Money and Finance, vol. 21 (November), pp. 725-48, and Maurice Obstfeld and Alan M. Taylor (2002),"Globalization and Capital Markets," NBER Working Paper 8846 (March).) Based on data provided by the Bank for International Settlements for cross-border bank liabilities and international bonds outstanding. * * * Can market forces incrementally defuse a buildup in a nation's current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of market flexibility. In a world economy that is sufficiently flexible, as debt projections rise, product and equity prices, interest rates, and exchange rates presumably would change to reestablish global balance. We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis.7 Should globalization continue unfettered and thereby create an ever-more flexible international financial system, history suggests that current account imbalances will be defused with modest risk of disruption. Two Federal Reserve studies of large current account adjustments in developed countries, the results of which are presumably applicable to the United States, suggest that market forces are likely to restore a more long-term sustainable current account balance here without substantial disruption.8 Indeed, this was the case in the second half of the 1980s. I say this with one major caveat. Protectionism, some signs of which have emerged in recent years, could significantly erode global flexibility and, hence, undermine the global adjustment process. We are already experiencing pressure to slow down the expansion of trade. The current Doha Round of trade negotiations has faced difficulties largely because the low-hanging fruit available through negotiation has already been picked in the trade liberalizations that have occurred since the Kennedy Round. On a more encouraging note, some recent indications of progress may be pointing to a heightened probability of completion of the Doha Round. * * * The remarkable technological advances of recent decades have doubtless augmented and fostered the dramatic effect of increased globalization on economic growth. In particular, information and communication technologies have propelled the processing and transmission of data and ideas to a level far beyond our capabilities a decade or two ago. The advent of real-time information systems has enabled managers to organize a workforce without the redundancy required in earlier decades to ensure against the type of human error that technology has now made far less prevalent. Real-time information, by eliminating much human intervention, has markedly reduced scrappage rates on production lines, lead times on purchases, and errors in many forms of recordkeeping. Much data transfer is now electronic and far more accurate than possible in earlier times. The long-term path of technology and growth is difficult to discern. Indeed, innovation, by definition, is not forecastable. In the United States, we have always employed technologies at, or close to, the cutting edge, and we have created many innovative technologies ourselves. The opportunities of many developing economies to borrow innovation is not readily available to us. Thus, even though the longer-term prospects for innovation and respectable U.S. productivity growth are encouraging, our productivity growth has rarely exceeded an average rate of 3 percent annually for any protracted period. Although increased flexibility apparently promotes resolution of current account imbalances without significant disruption, it may also allow larger deficits to emerge before markets are required to address them. Moreover, the apparent ability of the U.S. economy to withstand the stock market plunge of 2000, the terrorist attacks of September 11, 2001, corporate governance scandals, and wars in Afghanistan and Iraq indicates a greater degree of economic flexibility than was apparent in the 1970s and earlier. Caroline Freund (2000), "Current Account Adjustment in Industrialized Countries," Board of Governors of the Federal Reserve System, International Finance Discussion Paper 692 (December); Hilary Croke, Steven B. Kamin, and Sylvain Leduc (2005), "Financial Market Developments and Economic Activity during Current Account Adjustments in Industrial Economies," Board of Governors of the Federal Reserve System, International Finance Discussion Paper 827 (February). * * * We have, I believe, a reasonably good understanding of why Americans have been able to reach farther into global markets, incur significant increases in debt, and yet not suffer the disruptions so often observed as a consequence. However, a widely held alternative view of the past decade cannot readily be dismissed. That view holds that the postwar paradigm is still largely in place, and key financial ratios, rather than suggesting an evolving economic structure, reflect extreme values that have materialized within an unchanged structure and must eventually adjust, perhaps abruptly. To be sure, even with the increased flexibility implied in a paradigm of expanding globalization and innovation, the combination of exceptionally low saving rates and historically high ratios of household debt to income can be a concern if incomes unexpectedly fall. Indeed, virtually any debt burden doubtless will become oppressive if incomes fall significantly. But rising debt-to-income ratios can be somewhat misleading as an indicator of stress. Indeed the ratio of household debt to income has been rising sporadically for more than a half-century, a trend that partly reflects the increased capacity of ever-wealthier households to service debt. Moreover, a significant part of the recent rise in the debt-to-income ratio reflects the remarkable gain in homeownership. Over the past decade, for example, the share of households that own homes has risen from 64 percent to 69 percent. During the decade, a significant number of renters bought homes, thus increasing the asset side of their balance sheets as well as increasing their debt. It can scarcely be argued that the substitutions of debt service for rent materially impaired the financial state of the new homeowner. Yet the process over the past decade added more than 10 percent to outstanding mortgage debt and accounted for more than one-seventh of the increase in total household debt over that period.9 Thus, short of a period of appreciable overall economic weakness, households, with the exception of some highly leveraged subprime borrowers, do not appear to be faced with significant financial strain. With interest rates low, debt service costs for households have been essentially stable for the past few years. Accounting for other fixed charges such as rent, utilities, and auto-leasing costs does not materially alter this assessment of stability. Even should interest rates rise materially further, the effect on household expenses will be stretched out because four-fifths of debt is at fixed rates and varying maturities, and it will take time for debt to mature and reflect the higher rates. Despite the almost 2-percentage-point rise in mortgage rates on new originations from mid-1999 to mid-2000, the average interest rate on outstanding mortgage debt rose only slightly, as did debt service. In a related concern, a number of analysts have conjectured that the extended period of low interest rates is spawning a bubble in housing prices in the United States that will, at some point, implode. Their concern is that, if this were to occur, highly leveraged homeowners would be forced to sharply curtail their spending. To be sure, indexes of house prices based on repeat sales of existing homes have significantly outstripped increases in rents, suggesting at least the possibility of price misalignment in some housing markets. But a destabilizing contraction in nationwide house prices does not seem the most probable outcome. To be sure, the recent marked increase in the investor share of home purchases suggests rising speculation in homes. (Owner occupants are rarely home speculators because to sell, they must move.)10 However, nominal house prices in the aggregate have rarely fallen and certainly not by very much. And even should more-than-average price weakness occur, the increase in home equity as a consequence of the recent sharp rise in prices should buffer the vast majority of homeowners. For statistical methodology see Karen Dynan, Kathleen Johnson, and Karen Pence (2003),"Recent Changes to a Measure of U.S. Household Debt Service," Federal Reserve Bulletin, vol. 89 (October), pp. 417-26. A new survey by the National Association of Realtors reports that purchases of vacation homes and homes for investment amounted to more than a third of total existing home purchases last year. Mortgage originations data reported under the Home Mortgage Disclosure Act (HMDA) indicate that the share has been rising significantly since 1998. House prices, however, like those of many other assets, are difficult to predict, and movements in those prices can be of macroeconomic significance. There appears, at the moment, to be little concern about corporate financial imbalances. Debt-toequity ratios are well within historical ranges, and the recent prolonged period of low long-term interest rates has enabled corporations to refinance liabilities and stretch out bond maturities. * * * The resolution of our current account deficit and household debt burdens does not strike me as overly worrisome, but that is certainly not the case for our fiscal deficit, which, according to the Congressional Budget Office, will rise significantly as the baby boomers start to retire in 2008. Our fiscal prospects are, in my judgment, a significant obstacle to long-term stability because the budget deficit is not readily subject to correction by market forces that stabilize other imbalances. One issue that concerns most analysts, especially in the context of a widening structural federal deficit, is inadequate national saving. Fortunately, our meager domestic savings, and those attracted from abroad, are being very effectively invested in domestic capital assets. The efficiency of our capital stock thus has been an important offset to what, by any standard, has been an exceptionally low domestic saving rate in the United States. Although saving is a necessary condition for financing the capital investment required to engender productivity, it is not a sufficient condition. The very high saving rates of the Soviet Union, of China, and of India in earlier decades often did not foster significant productivity growth in those countries. Saving squandered in financing inefficient technologies does not advance living standards. In light of the uncertain link between saving and productivity growth, it is difficult to measure the exact extent to which our relatively low gross national saving rate will limit the future growth of an efficient capital stock. What we know for sure, however, is that the 30 million baby boomers who will reach 65 years of age over the next quarter-century are going to place enormous pressures on the ability of our economy to supply the real benefits promised to retirees under current law, and our success in attracting savings from abroad may be masking the full effect on investment of deficient domestic saving. * * * Our day-by-day experiences with the effectiveness of flexible markets as they adjust to, and correct, imbalances can readily lead us to the mistaken conclusion that once markets are purged of rigidities, macroeconomic disturbances will become a historical relic. However, the penchant of humans for quirky, often irrational behavior gets in the way of this conclusion. A discontinuity in valuation judgments, often the cause or consequence of the building and bursting of a bubble, can occasionally destabilize even the most liquid and flexible of markets. I do not have much to add on this issue except to reiterate our need to better understand it. * * * The last three decades have witnessed a significant coalescing of economic policy philosophies. Central planning has been judged as ineffective and is now generally avoided. Market flexibility has become the focus, albeit often hesitant focus, of reform in most countries. All policymakers are struggling to understand global and technological changes that appear to have profoundly altered world economic developments. For most economic participants, these changes appear to have had positive effects on their economic well-being. But a significant minority, trapped on the adverse side of the market's process of creative destruction, are suffering. This is an issue that needs to be more fully addressed if globalization is to sustain the public support it requires to make further progress.
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, 10 March 2005. The references for the speech can be found on the Board of Governors of the Federal Reserve System¿s website.
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Ben S Bernanke: The global saving glut and the US current account deficit Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, 10 March 2005. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * On most dimensions the U.S. economy appears to be performing well. Output growth has returned to healthy levels, the labor market is firming, and inflation appears to be well controlled. However, one aspect of U.S. economic performance still evokes concern among economists and policymakers: the nation's large and growing current account deficit. In the first three quarters of 2004, the U.S. external deficit stood at $635 billion at an annual rate, or about 5-1/2 percent of the U.S. gross domestic product (GDP). Corresponding to that deficit, U.S. citizens, businesses, and governments on net had to raise $635 billion on international capital markets. The current account deficit has been on a steep upward trajectory in recent years, rising from a relatively modest $120 billion (1.5 percent of GDP) in 1996 to $414 billion (4.2 percent of GDP) in 2000 on its way to its current level. Most forecasters expect the nation's current account imbalance to decline slowly at best, implying a continued need for foreign credit and a concomitant decline in the U.S. net foreign asset position. Why is the United States, with the world's largest economy, borrowing heavily on international capital markets - rather than lending, as would seem more natural? What implications do the U.S. current account deficit and our consequent reliance on foreign credit have for economic performance in the United States and in our trading partners? What policies, if any, should be used to address this situation? In my remarks today I will offer some tentative answers to these questions. My answers will be somewhat unconventional in that I will take issue with the common view that the recent deterioration in the U.S. current account primarily reflects economic policies and other economic developments within the United States itself. Although domestic developments have certainly played a role, I will argue that a satisfying explanation of the recent upward climb of the U.S. current account deficit requires a global perspective that more fully takes into account events outside the United States. To be more specific, I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving - a global saving glut - which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today. The prospect of dramatic increases in the ratio of retirees to workers in a number of major industrial economies is one important reason for the high level of global saving. However, as I will discuss, a particularly interesting aspect of the global saving glut has been a remarkable reversal in the flows of credit to developing and emerging-market economies, a shift that has transformed those economies from borrowers on international capital markets to large net lenders. To be clear, in locating the principal causes of the U.S. current account deficit outside the country's borders, I am not making a value judgment about the behavior of either U.S. or foreign residents or their governments. Rather, I believe that understanding the influence of global factors on the U.S. current account deficit is essential for understanding the effects of the deficit and for devising policies to address it. Of course, as always, the views I express today are not necessarily shared by my colleagues at the Federal Reserve.2 The U.S. Current Account Deficit: Two Perspectives We will find it helpful to consider, as background for the analysis of the U.S. current account deficit, two alternative ways of thinking about the phenomenon - one that relates the deficit to the patterns of U.S. trade and a second that focuses on saving, investment, and international financial flows. As U.S. capital outflows in those three quarters totaled $728 billion at an annual rate, gross financing needs exceeded $1.3 trillion. I thank David Bowman, Joseph Gagnon, Linda Kole, and Maria Perozek of the Board staff for excellent assistance. Although these two ways of viewing the current account derive from accounting identities and thus are ultimately two sides of the same coin, each provides a useful lens for examining the issue. The first perspective on the current account focuses on patterns of international trade. You are probably aware that the United States has been experiencing a substantial trade imbalance in recent years, with U.S. imports of goods and services from abroad outstripping U.S. exports to other countries by a wide margin. According to preliminary data, in 2004 the United States imported $1.76 trillion worth of goods and services while exporting goods and services valued at only $1.15 trillion. Reflecting this imbalance in trade, current payments from U.S. residents to foreigners (consisting primarily of our spending on imports, but also including certain other types of payments, such as remittances, interest, and dividends) greatly exceed the analogous payments that U.S. residents receive from abroad. By definition, this excess of U.S. payments to foreigners over payments received in a given period equals the U.S. current account deficit, which, as I have already noted, was on track to equal $635 billion in 2004 - close to the $618 billion by which the value of U.S. imports exceeded that of exports. When U.S. receipts from its sales of exports and other current payments are insufficient to cover the cost of U.S. imports and other payments to foreigners, U.S. households, firms, and governments on net must borrow the difference on international capital markets. Thus, essentially by definition, in each period U.S. net foreign borrowing equals the U.S. current account deficit, which in turn is closely linked to the imbalance in U.S. international trade. That the nation's imports currently far exceed its exports is both widely understood and of concern to many Americans, particularly those whose livelihoods depend on the viability of exporting and importcompeting industries. The extensive attention paid to the trade imbalance in the media and elsewhere has tempted some observers to ascribe the growing current account deficit to factors such as changes in the quality or composition of U.S. and foreign-made products, changes in trade policy, or unfair foreign competition. However, I believe - and I suspect that most economists would agree - that specific trade-related factors cannot explain either the magnitude of the U.S. current account imbalance or its recent sharp rise. Rather, the U.S. trade balance is the tail of the dog; for the most part, it has been passively determined by foreign and domestic incomes, asset prices, interest rates, and exchange rates, which are themselves the products of more fundamental driving forces. Instead, an alternative perspective on the current account appears likely to be more useful for explaining recent developments. This second perspective focuses on international financial flows and the basic fact that, within each country, saving and investment need not be equal in each period. In the United States, as in all countries, economic growth requires investment in new capital goods and the upgrading and replacement of older capital. Examples of capital investment include the construction of factories and office buildings and firms' acquisition of new equipment, ranging from drill presses to computers to airplanes. Residential construction - the building of new homes and apartment buildings - is also counted as part of capital investment. All investment in new capital goods must be financed in some manner. In a closed economy without trade or international capital flows, the funding for investment would be provided entirely by the country's national saving. By definition, national saving is the sum of saving done by households (for example, through contributions to employer-sponsored 401k accounts) and saving done by businesses (in the form of retained earnings) less any budget deficit run by the government (which is a use rather than a source of saving) . For simplicity, I will use the term "net foreign borrowing" to refer to the financing of the current account deficit, though strictly speaking this financing involves the sale of foreign and domestic assets as well as the issuance of debt securities to foreigners. As illustrated by the data in footnote 1, U.S. gross foreign borrowing is much larger than net foreign borrowing, as gross borrowing must be sufficient to offset not only the deficit in current payments but also U.S. capital outflows. This definition of capital investment ignores many less tangible forms of investment, such as research and development expenditures. It also ignores investment in human capital, such as educational expenses. Using a more inclusive definition of investment could well change our perceptions of U.S. saving and investment trends quite substantially. I will leave that topic for another day. The Bureau of Economic Analysis treats government investment - in roads or schools, for instance - as part of national saving in the national income accounts. Thus, strictly speaking, national saving is reduced by the government deficit net of government investment, not by the entire government deficit. The difference between domestic investment and As I say, in a closed economy investment would equal national saving in each period; but, in fact, virtually all economies today are open economies, and well-developed international capital markets allow savers to lend to those who wish to make capital investments in any country, not just their own. Because saving can cross international borders, a country's domestic investment in new capital and its domestic saving need not be equal in each period. If a country's saving exceeds its investment during a particular year, the difference represents excess saving that can be lent on international capital markets. By the same token, if a country's saving is less than the amount required to finance domestic investment, the country can close the gap by borrowing from abroad. In the United States, national saving is currently quite low and falls considerably short of U.S. capital investment. Of necessity, this shortfall is made up by net foreign borrowing - essentially, by making use of foreigners' saving to finance part of domestic investment. We saw earlier that the current account deficit equals the net amount that the United States borrows abroad in each period, and I have just shown that U.S. net foreign borrowing equals the excess of U.S. capital investment over U.S. national saving. It follows that the country's current account deficit equals the excess of its investment over its saving. To summarize, I have described two equivalent ways of interpreting the current account deficit, one in terms of trade flows and related payments and one in terms of investment and national saving. In general, the perspective one takes depends on the particular analysis at hand. As I have already suggested, most economists who have offered explanations of the high and rising level of the U.S. current account deficit and the country's foreign borrowing have emphasized investment-saving behavior rather than trade-related factors (and I will do the same today). Along these lines, one commonly hears that the U.S. current account deficit is the product of a precipitous decline in the U.S. national saving rate, which in recent years has fallen to a level that is far from adequate to fund domestic investment. For example, in 1985 U.S. gross national saving was 18 percent of GDP, and in 1995 it was 16 percent of GDP; in 2004, by contrast, U.S. national saving was less than 14 percent of GDP. Those who emphasize the role of low U.S. saving often go on to conclude that, for the most part, the U.S. current account deficit is "made in the U.S.A." and is independent (to a first approximation) of developments in other parts of the globe. That inadequate U.S. national saving is the source of the current account deficit must be true at some level; indeed, the statement is almost a tautology. However, linking current-account developments to the decline in saving begs the question of why U.S. saving has declined. In particular, although the decline in U.S. saving may reflect changes in household behavior or economic policy in the United States, it may also be in some part a reaction to events external to the United States - a hypothesis that I will propose and defend momentarily. One popular argument for the "made in the U.S.A." explanation of declining national saving and the rising current account deficit focuses on the burgeoning U.S. federal budget deficit, which in 2004 drained more than $400 billion from the national saving pool. I will discuss the link between the budget deficit and the current account deficit in more detail later. Here I simply note that the so-called twindeficits hypothesis, that government budget deficits cause current account deficits, does not account for the fact that the U.S. external deficit expanded by about $300 billion between 1996 and 2000, a period during which the federal budget was in surplus and projected to remain so. Nor, for that matter, does the twin-deficits hypothesis shed any light on why a number of major countries, including Germany and Japan, continue to run large current account surpluses despite government budget deficits that are similar in size (as a share of GDP) to that of the United States. It seems unlikely, therefore, that changes in the U.S. government budget position can entirely explain the behavior of the U.S. current account over the past decade. The Changing Pattern of International Capital Flows and the Global Saving Glut What then accounts for the rapid increase in the U.S. current account deficit? My own preferred explanation focuses on what I see as the emergence of a global saving glut in the past eight to ten years. This saving glut is the result of a number of developments. As I will discuss in more detail later, one well-understood source of the saving glut is the strong saving motive of rich countries with aging populations, which must make provision for an impending sharp increase in the number of retirees relative to the number of workers. With slowly growing or declining workforces, as well as high capitallabor ratios, many advanced economies outside the United States also face an apparent dearth of national saving is not affected by this qualification, however, as government investment and the implied adjustment to national saving cancel each other out. domestic investment opportunities. As a consequence of high desired saving and the low prospective returns to domestic investment, the mature industrial economies as a group seek to run current account surpluses and thus to lend abroad. Table 1. Global Current Account Balances, 1996 and 2003 (Billions of U.S. dollars) Countries Industrial 46.2 -342.3 United States Japan -120.2 65.4 -530.7 138.2 Euro Area France Germany Italy Spain 88.5 20.8 -13.4 39.6 0.4 24.9 4.5 55.1 -20.7 -23.6 Australia Canada Switzerland United Kingdom 12.5 -15.8 3.4 21.3 -10.9 25.3 -30.4 17.1 42.2 -30.5 Developing Asia China Hong Kong Korea Taiwan Thailand -87.5 -40.8 7.2 -2.6 -23.1 10.9 -14.4 148.3 45.9 11.9 29.3 Latin America Argentina Brazil Mexico -39.1 -6.8 -23.2 -2.5 3.8 7.4 -8.7 Middle East and Africa 5.9 47.8 E. Europe and the former Soviet Union -13.5 5.1 Statistical discrepancy 41.3 137.2 Other By "high desired saving" I mean a supply schedule for saving that is shifted far to the right. Actual or realized saving depends on the equilibrium values of the real interest rate and other economic variables. Although strong saving motives on the part of many industrial economies contribute to the global saving glut, the saving behavior of these countries does not explain much of the increase in desired global saving in the past decade. Indeed, in a number of these countries - Japan is one example household saving has declined recently. As we will see, a possibly more important source of the rise in the global supply of saving is the recent metamorphosis of the developing world from a net user to a net supplier of funds to international capital markets. Table 1 provides a basis for a discussion of recent changes in global saving and financial flows by showing current account balances for different countries and regions, in billions of U.S. dollars, for the years 1996 (just before the U.S. current account deficit began to balloon) and 2003 (the most recent year for which complete data are available). I should note that these current account balances of necessity reflect realized patterns of investment and saving rather than changes in the rates of investment and saving desired from an ex ante perspective. Nevertheless, changes in the pattern of current account balances together with knowledge of changes in real interest rates should provide useful clues about shifts in the global supply of and demand for saving. The table confirms the sharp increase in the U.S. current account deficit, about $410 billion between 1996 and 2003. (Data from the first three quarters of 2004 imply that the current account deficit rose last year by an additional $140 billion at an annual rate.) In principle, the current account positions of the world's nations should sum to zero (although, in practice, data collection problems lead to a large statistical discrepancy, shown in the last row of table 1). The $410 billion increase in the U.S. current account deficit between 1996 and 2003 must therefore have been matched by a shift toward surplus of equal magnitude in other countries. Which countries experienced this change? As we can infer from table 1, most of the swing toward surplus did not occur in the other industrial countries as a whole (although some individual industrial countries did experience large moves toward surplus, as we will see). The collective current account of the industrial countries declined more than $388 billion between 1996 and 2003, implying that, of the $410 billion increase in the U.S. current account deficit, only about $22 billion was offset by increased surpluses in other industrial countries. As table 1 shows, the bulk of the increase in the U.S. current account deficit was balanced by changes in the current account positions of developing countries, which moved from a collective deficit of $88 billion to a surplus of $205 billion - a net change of $293 billion - between 1996 and 2003. The available data suggest that the current accounts of developing and emerging-market economies swung a further $60 billion into surplus in 2004. This remarkable change in the current account balances of developing countries raises at least three questions. First, what events or factors induced this change? Second, what causal relationship (if any) exists between this change and current-account developments in the United States and in other industrial countries? Third, to the extent that the movement toward surplus in developing-country current accounts has had a differential impact on the United States relative to other industrial countries, what accounts for the difference? In my view, a key reason for the change in the current account positions of developing countries is the series of financial crises those countries experienced in the past decade or so. In the mid-1990s, most developing countries were net importers of capital; as table 1 shows, in 1996 emerging Asia and Latin America borrowed about $80 billion on net on world capital markets. These capital inflows were not always productively used. In some cases, for example, developing-country governments borrowed to avoid necessary fiscal consolidation; in other cases, opaque and poorly governed banking systems failed to allocate those funds to the projects promising the highest returns. Loss of lender confidence, together with other factors such as overvalued fixed exchange rates and debt that was both short-term and denominated in foreign currencies, ultimately culminated in painful financial crises, including those in Mexico in 1994, in a number of East Asian countries in 1997-98, in Russia in 1998, in Brazil in 1999, and in Argentina in 2002. The effects of these crises included rapid capital outflows, currency depreciation, sharp declines in domestic asset prices, weakened banking systems, and recession. The statistical discrepancy also increased substantially, by $96 billion on net. As asset accumulation in developing countries may be less completely measured than in industrial countries, a significant part of the change in the discrepancy may represent an additional movement toward surplus in developing-country current accounts. In response to these crises, emerging-market nations either chose or were forced into new strategies for managing international capital flows. In general, these strategies involved shifting from being net importers of financial capital to being net exporters, in some cases very large net exporters. For example, in response to instability of capital flows and the exchange rate, some East Asian countries, such as Korea and Thailand, began to build up large quantities of foreign-exchange reserves and continued to do so even after the constraints imposed by the halt to capital inflows from global financial markets were relaxed. Increases in foreign-exchange reserves necessarily involve a shift toward surplus in the country's current account, increases in gross capital inflows, reductions in gross private capital outflows, or some combination of these elements. As table 1 shows, current account surpluses have been an important source of reserve accumulation in East Asia. Countries in the region that had escaped the worst effects of the crisis but remained concerned about future crises, notably China, also built up reserves. These "war chests" of foreign reserves have been used as a buffer against potential capital outflows. Additionally, reserves were accumulated in the context of foreign exchange interventions intended to promote export-led growth by preventing exchange-rate appreciation. Countries typically pursue export-led growth because domestic demand is thought to be insufficient to employ fully domestic resources. Following the 1997-98 financial crisis, many of the East Asian countries seeking to stimulate their exports had high domestic rates of saving and, relative to historical norms, depressed levels of domestic capital investment - also consistent, of course, with strengthened current accounts. In practice, these countries increased reserves through the expedient of issuing debt to their citizens, thereby mobilizing domestic saving, and then using the proceeds to buy U.S. Treasury securities and other assets. Effectively, governments have acted as financial intermediaries, channeling domestic saving away from local uses and into international capital markets. A related strategy has focused on reducing the burden of external debt by attempting to pay down those obligations, with the funds coming from a combination of reduced fiscal deficits and increased domestic debt issuance. Of necessity, this strategy also pushed emerging-market economies toward current account surpluses. Again, the shifts in current accounts in East Asia and Latin America are evident in the data for the regions and for individual countries shown in table 1. Another factor that has contributed to the swing toward current-account surplus among the nonindustrialized nations in the past few years is the sharp rise in oil prices. The current account surpluses of oil exporters, notably in the Middle East but also in countries such as Russia, Nigeria, and Venezuela, have risen as oil revenues have surged. For example, as table 1 shows, the collective current account surplus of the Middle East and Africa rose more than $40 billion between 1996 and 2003; it continued to swell in 2004 as oil prices increased yet further. In short, events since the mid1990s have led to a large change in the collective current account position of the developing world, implying that many developing and emerging-market countries are now large net lenders rather than net borrowers on international financial markets. Of course, developing countries as a group can increase their current account surpluses only if the industrial countries reduce their current accounts accordingly. How did this occur? Little evidence supports the view that the motivation to save has declined substantially in the industrial countries in recent years; indeed, as I have noted already, demographic factors should lead the industrial countries to try to save more, not less. Instead, the requisite shift in the collective external position of the industrial countries was facilitated by adjustments in asset prices and exchange rates, although the pattern of asset-price changes was somewhat different before and after 2000. From about 1996 to early 2000, equity prices played a key equilibrating role in international financial markets. The development and adoption of new technologies and rising productivity in the United States - together with the country's long-standing advantages such as low political risk, strong property rights, and a good regulatory environment - made the U.S. economy exceptionally attractive to international investors during that period. Consequently, capital flowed rapidly into the United States, helping to fuel large appreciations in stock prices and in the value of the dollar. Stock indexes rose in other industrial countries as well, although stock-market capitalization per capita is significantly lower in those countries than in the United States. The current account positions of the industrial countries adjusted endogenously to these changes in financial market conditions. I will focus here on the case of the United States, which bore the bulk of the adjustment. From the trade perspective, higher stock-market wealth increased the willingness of U.S. consumers to spend on goods and services, including large quantities of imports, while the strong dollar made U.S. imports cheap (in terms of dollars) and exports expensive (in terms of foreign currencies), creating a rising trade imbalance. From the saving-investment perspective, the U.S. current account deficit rose as capital investment increased (spurred by perceived profit opportunities) at the same time that the rapid increase in household wealth and expectations of future income gains reduced U.S. residents' perceived need to save. Thus the rapid increase in the U.S. current account deficit between 1996 and 2000 was fueled to a significant extent both by increased global saving and the greater interest on the part of foreigners in investing in the United States. After the stock-market decline that began in March 2000, new capital investment and thus the demand for financing waned around the world. Yet desired global saving remained strong. The textbook analysis suggests that, with desired saving outstripping desired investment, the real rate of interest should fall to equilibrate the market for global saving. Indeed, real interest rates have been relatively low in recent years, not only in the United States but also abroad. From a narrow U.S. perspective, these low long-term rates are puzzling; from a global perspective, they may be less so. The weakening of new capital investment after the drop in equity prices did not much change the net effect of the global saving glut on the U.S. current account. The transmission mechanism changed, however, as low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices. Indeed, increases in home values, together with a stock-market recovery that began in 2003, have recently returned the wealth-to-income ratio of U.S. households to 5.4, not far from its peak value of 6.2 in 1999 and above its long-run (1960-2003) average of 4.8. The expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home equity lines of credit, has kept the U.S. national saving rate low - and indeed, together with the significant worsening of the federal budget outlook, helped to drive it lower. As U.S. business investment has recently begun a cyclical recovery while residential investment has remained strong, the domestic saving shortfall has continued to widen, implying a rise in the current account deficit and increasing dependence of the United States on capital inflows. According to the story I have sketched thus far, events outside U.S. borders - such as the financial crises that induced emerging-market countries to switch from being international borrowers to international lenders - have played an important role in the evolution of the U.S. current account deficit, with transmission occurring primarily through endogenous changes in equity values, house prices, real interest rates, and the exchange value of the dollar. One might ask why the currentaccount effects of the increase in desired global saving were felt disproportionately in the United States relative to other industrial countries. The attractiveness of the United States as an investment destination during the technology boom of the 1990s and the depth and sophistication of the country's financial markets (which, among other things, have allowed households easy access to housing wealth) have certainly been important. Another factor is the special international status of the U.S. dollar. Because the dollar is the leading international reserve currency, and because some emergingmarket countries use the dollar as a reference point when managing the values of their own currencies, the saving flowing out of the developing world has been directed relatively more into dollardenominated assets, such as U.S. Treasury securities. The effects of the saving outflow may thus have been felt disproportionately on U.S. interest rates and the dollar. For example, the dollar probably strengthened more in the latter 1990s than it would have if it had not been the principal reserve currency, enhancing the effect on the U.S. current account. Most interesting, however, is that the experience of the United States in recent years is not so nearly unique among industrial countries as one might think initially. As shown in table 1, a number of key industrial countries other than the United States have seen their current accounts move substantially toward deficit since 1996, including France, Italy, Spain, Australia, and the United Kingdom. The principal exceptions to this trend among the major industrial countries are Germany and Japan, both of which saw substantial increases in their current account balances between 1996 and 2003 (and significant further increases in 2004). A key difference between the two groups of countries is that the In pointing out the possible effects of strong global saving on real interest rates, I do not mean to rule out other factors. For example, a lowering of risk premiums resulting from increased macroeconomic and monetary stability has likely played some role. Greenspan (2005) notes a strong correlation between U.S. mortgage debt and the U.S. current account deficit. countries whose current accounts have moved toward deficit have generally experienced substantial housing appreciation and increases in household wealth, while Germany and Japan - whose economies have been growing slowly despite very low interest rates - have not. For example, wealthto-income ratios have risen since 1996 by 14 percent in France, 12 percent in Italy, and 27 percent in the United Kingdom; each of these countries has seen their current account move toward deficit, as already noted. By contrast, wealth-to-income ratios in Germany and Japan have remained flat. The evident link between rising household wealth and a tendency for the current account to shift toward deficit is consistent with the mechanism that I have described today. Economic and Policy Implications I have presented today a somewhat unconventional explanation of the high and rising U.S. current account deficit. That explanation holds that one of the factors driving recent developments in the U.S. current account has been the very substantial shift in the current accounts of developing and emerging-market nations, a shift that has transformed these countries from net borrowers on international capital markets to large net lenders. This shift by developing nations, together with the high saving propensities of Germany, Japan, and some other major industrial nations, has resulted in a global saving glut. This increased supply of saving boosted U.S. equity values during the period of the stock market boom and helped to increase U.S. home values during the more recent period, as a consequence lowering U.S. national saving and contributing to the nation's rising current account deficit. From a global perspective, are these developments economically beneficial or harmful? Certainly they have had some benefits. Most obviously, the developing and emerging-market countries that brought their current accounts into surplus did so to reduce their foreign debts, stabilize their currencies, and reduce the risk of financial crisis. Most countries have been largely successful in meeting each of these objectives. Thus, the shift of these economies from borrower to lender status has provided at least a short-term palliative for some of the problems they faced in the 1990s. In the longer term, however, the current pattern of international capital flows - should it persist - could prove counterproductive. Most important, for the developing world to be lending large sums on net to the mature industrial economies is quite undesirable as a long-run proposition. Relative to their counterparts in the developing world, workers in industrial countries have large quantities of highquality capital with which to work. Moreover, as I have already noted, the populations of most of these countries are both growing slowly and aging rapidly, implying that ratios of retirees to workers will rise sharply in coming decades. For example, in the United States, for every 100 people between the ages of 20 and 64, there are currently about 21 people aged 65 or older. According to United Nations projections, by 2030 the population of the United States will include about 34 people aged 65 or over for each 100 people in the 20-64 age range; for the Euro area and Japan, the analogous numbers in 2030 will be 46 and 57, respectively. Over the remainder of the century, the populations of other major industrial countries will age much more quickly than that of the United States. In 2050, for example, the number of retirees for each 100 working-age people in the United States should be about the same as in 2030, about 34, but the number of retirees per 100 working-age people is projected to increase to about 60 in the Euro area and about 78 in Japan. We see that many of the major industrial countries - particularly Japan and some countries in Western Europe - have both strong reasons to save (to help support future retirees) and increasingly limited investment opportunities at home (because workforces are shrinking and capital-labor ratios are already high). In contrast, most developing countries have younger and more-rapidly growing workforces, as well as relatively low ratios of capital to labor, conditions that imply that the returns to capital in those countries may potentially be quite high. Basic economic logic thus suggests that, in the longer term, the industrial countries as a group should be running current account surpluses and lending on net to the developing world, not the other way around. If financial capital were to flow in this "natural" direction, savers in the industrial countries would potentially earn higher returns and enjoy increased diversification, and borrowers in the developing world would have the funds to make the These data are from Annex Table 58, OECD Economic Outlook, vol. 76, 2004, p. 226. The latest year for which data are available is 2003 for Germany and the United Kingdom, 2002 for France, Italy, and Japan. China is an important exception to the generalization that developing countries have young populations. The country's fertility rate has declined since the 1970s, and its elderly dependency ratio is expected to exceed that of the United States by midcentury. capital investments needed to promote growth and higher living standards. Of course, to ensure that capital flows to developing countries yield these benefits, the developing countries would need to make further progress toward improving conditions for investment, as I will discuss further in a bit. A second issue concerns the uses of international credit in the United States and other industrial countries with external deficits. Because investment by businesses in equipment and structures has been relatively low in recent years (for cyclical and other reasons) and because the tax and financial systems in the United States and many other countries are designed to promote homeownership, much of the recent capital inflow into the developed world has shown up in higher rates of home construction and in higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things. However, in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be. A third concern with the pattern of capital flows arises from the indirect effects of those flows on the sectoral composition of the economies that receive them. In the United States, for example, the growth in export-oriented sectors such as manufacturing has been restrained by the U.S. trade imbalance (although the recent decline in the dollar has alleviated that pressure somewhat), while sectors producing nontraded goods and services, such as home construction, have grown rapidly. To repay foreign creditors, as it must someday, the United States will need large and healthy export industries. The relative shrinkage in those industries in the presence of current account deficits - a shrinkage that may well have to be reversed in the future - imposes real costs of adjustment on firms and workers in those industries. Finally, the large current account deficit of the United States, in particular, requires substantial flows of foreign financing. As I have discussed today, the underlying sources of the U.S. current account deficit appear to be medium-term or even long-term in nature, suggesting that the situation will eventually begin to improve, although a return to approximate balance may take some time. Fundamentally, I see no reason why the whole process should not proceed smoothly. However, the risk of a disorderly adjustment in financial markets always exists, and the appropriately conservative approach for policymakers is to be on guard for any such developments. What policy options exist to deal with the U.S. current account deficit? I have downplayed the role of the U.S. federal budget deficit today, and I disagree with the view, sometimes heard, that balancing the federal budget by itself would largely defuse the current account issue. In particular, to the extent that a reduction in the federal budget resulted in lower interest rates, the principal effects might be increased consumption and investment spending at home rather than a lower current account deficit. Indeed, a recent study suggests that a one-dollar reduction in the federal budget deficit would cause the current account deficit to decline less than 20 cents (Erceg, Guerrieri, and Gust, 2005). These results imply that even if we could balance the federal budget tomorrow, the medium-term effect would likely be to reduce the current account deficit by less than one percentage point of GDP. Although I do not believe that plausible near-term changes in the federal budget would eliminate the current account deficit, I should stress that reducing the federal budget deficit is still a good idea. Although the effects on the current account of reining in the budget deficit would likely be relatively modest, at least the direction is right. Moreover, there are other good reasons to bring down the federal budget deficit, including the reduction of the debt obligations that will have to be serviced by taxpayers in the future. Similar observations apply to policy recommendations to increase household saving in the United States, for example by creating tax-favored saving vehicles. Although the effect of saving-friendly policies on the U.S. current account deficit might not be dramatic, again the direction would be right. Moreover, increasing U.S. national saving from its current low level would support productivity and wealth creation and help our society make better provision for the future. However, as I have argued today, some of the key reasons for the large U.S. current account deficit are external to the United States, implying that purely inward-looking policies are unlikely to resolve this issue. Thus a more direct approach is to help and encourage developing countries to re-enter international capital markets in their more natural role as borrowers, rather than as lenders. For example, developing countries could improve their investment climates by continuing to increase macroeconomic stability, strengthen property rights, reduce corruption, and remove barriers to the free flow of financial capital. Providing assistance to developing countries in strengthening their financial institutions - for example, by improving bank regulation and supervision and by increasing financial transparency - could lessen the risk of financial crises and thus increase both the willingness of those countries to accept capital inflows and the willingness of foreigners to invest there. Financial liberalization is a particularly attractive option, as it would help both to permit capital inflows to find the highest-return uses and, by easing borrowing constraints, to spur domestic consumption. Other changes will occur naturally over time. For example, the pace at which emerging-market countries are accumulating international reserves should slow as they increasingly perceive their reserves to be adequate and as they move toward more flexible exchange rates. The factors underlying the U.S. current account deficit are likely to unwind only gradually, however. Thus, we probably have little choice except to be patient as we work to create the conditions in which a greater share of global saving can be redirected away from the United States and toward the rest of the world - particularly the developing nations.
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Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Special Committee on Aging, US Senate, Washington DC, 15 March 2005.
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Alan Greenspan: Future of the social security programme and economics of retirement Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Special Committee on Aging, US Senate, Washington DC, 15 March 2005. * * * Mr. Chairman, Senator Kohl, and members of the Committee, I am pleased to be here today to discuss the issues of population aging and retirement. In so doing, I would like to emphasize that the views I will express are my own and do not necessarily represent those of the Federal Reserve Board. The economics of retirement are straightforward: Enough resources must be set aside over a lifetime of work to fund consumption during retirement. At the most rudimentary level, one could envision households actually storing goods purchased during their working years for use during retirement. Even better, the resources that would have otherwise gone into producing the stored goods could be diverted to the production of new capital assets, which would produce an even greater quantity of goods and services for later use. In the latter case, we would be raising output per worker hour, our traditional measure of productivity. The bottom line in the success of all retirement programs is the availability of real resources at retirement. The financial systems associated with retirement plans facilitate the allocation of resources that supply retirement consumption of goods and services; they do not produce goods and services. A useful test of a retirement system for a society is whether it sets up realistic expectations as to the future availability of real resources and, hence, the capacity to deliver postwork consumption without overly burdening the standard of living of the working-age population. In 2008, the leading edge of what must surely be the largest shift from work to retirement in our nation's history will become evident as some baby boomers become eligible for Social Security. According to the intermediate projections of the Social Security trustees, the population 65 years of age and older will be approximately 26 percent of the adult population in 2030, compared with 17 percent today. This huge change in the structure of our population will expose all our financial retirement systems to severe stress and will require adjustments for which there are no historical precedents. Indeed, retirement, generally, is a relatively new phenomenon in human history. Average American life expectancy a century ago, for example, was only 47 years. Relatively few of our citizens were able to enjoy many postwork years. One consequence of the sizable baby boom cohort moving from the workforce to retirement is an inevitable slowing in the growth of gross domestic product per capita relative to the growth of output per worker. As the ratio of workers to population declines, so too must the ratio of output to population, assuming no change in the growth of productivity. That result is simply a matter of arithmetic. The important economic implication of that arithmetic is that, with fewer workers relative to dependents, each worker's output will have to support a greater number of people. Under the intermediate population projections of the Social Security trustees, for example, the ratio of workers to total population will shrink about 7 percent by 2030. This shrinkage means that, by 2030, total output per person will be 7 percent lower than it would be if the current population structure were to persist. The fact that a greater share of the dependents will be elderly rather than children will put an additional burden on society's resources, as the elderly consume a relatively large share of per capita resources, whereas children consume relatively little. This inevitable drop in the growth rate of per capita GDP relative to the growth of productivity could be cushioned by an increase in labor force participation, which would boost the ratio of workers to population. Increasing labor force participation seems a natural response to population aging, as Americans not only are living longer but are also generally living healthier. Rates of disability for the elderly have been declining, reflecting both improvements in health and changes in technology that accommodate the physical impairments that are associated with aging. In addition, work is becoming less physically strenuous and more demanding intellectually, continuing a century-long trend toward a more conceptual and a less physical economic output. Despite the improving feasibility of work at older ages, Americans have been retiring at younger and younger ages. For example, in 1940, the median age of retirement for men was 69; today, the median age is about 62. In recent years, labor force participation among older Americans has picked up somewhat, but it is far too early to determine the underlying causes of this increase. Rising pressures on retirement incomes and a growing scarcity of experienced labor could induce further increases in the labor force participation of the elderly and near-elderly in the future. In addition, policies that specifically encourage greater labor force participation would also lessen the necessary adjustments to consumption. Workers nearing retirement have accumulated many years of valuable experience, so extending labor force participation by just a few years could have a sizable impact on economic output. Another way to boost future standards of living is to increase saving.1 We need the additional saving in the decades ahead if we are to finance the construction of a capital stock that will produce the additional real resources needed to redeem the retirement claims of the baby boomers without having to severely raise claims on tomorrow's workers. However, by almost any measure, the required amount of saving that would be necessary is sufficiently large to raise serious questions about whether we will be able to meet the retirement commitments already made. Much has been made of shortfalls in our private defined-benefit plans, but the gross underfunding currently at $450 billion, although significant as a percentage of the $1.8 trillion in assets of private defined-benefit plans, is modest compared with the underfunding of our publically administered pensions. At present, the Social Security trustees estimate the unfunded liability over the indefinite future to be $10.4 trillion. The shortfall in Medicare is calculated at several multiples of the one in Social Security. These numbers suggest that either very large tax increases will be required to meet the shortfalls or benefits will have to be pared back. Because benefit cuts will almost surely be at least part of the resolution, it is incumbent on government to convey to future retirees that the real resources currently promised to be available on retirement will not be fully forthcoming. We owe future retirees as much time as possible to adjust their plans for work, saving, and retirement spending. They need to ensure that their personal resources, along with what they expect to receive from government, will be sufficient to meet their retirement goals. Conventional advice from personal-finance professionals is that one should aim to accumulate sufficient resources to provide an overall replacement rate of about 70 percent to 80 percent in retirement. Under current law, Social Security promises a replacement rate of about 42 percent for workers who earn the economywide-average wage each and every year through their careers and about 56 percent for low-wage workers who earn 45 percent of the economywide-average wage.2 Assuming that taxes are capped at the current 12.4 percent of payroll, revenues will be sufficient to pay only about 70 percent of current-law benefits by the middle of this century. Thus, for the average worker, a replacement rate of only about 30 percent would be payable out of contemporaneous revenues, assuming that benefit reductions are applied proportionately across the board. For a lowwage worker, the payable replacement rate would be about 40 percent. Assuming that the goal is still to replace 70 percent to 80 percent of pre-retirement income, average workers by the middle of this century should be aiming to replace about 45 percent of their pre-retirement income, rather than today's 33 percent, out of some combination of private employer pension benefits and personal saving. The required increases in private saving would be less to the extent that Social Security tax increases are part of the solution. However, to avoid any changes in replacement rates, the Social Security tax rate would have to be increased from the current 12.4 percent to about 18 percent at the middle of the century. *** Once we have determined the level of benefits that we can reasonably promise, we must ensure that we will have the real resources in the future to fulfill those promises. When we evaluate our ability to meet those promises, focusing solely on the solvency of the financial plan is, in my judgment, a mistake. Focusing on solvency within the Social Security system, without regard to the broader macroeconomic picture, does not ensure that the real resources to fulfill our commitments will be Additionally, we could borrow from abroad, which would build up the capital stock. In so doing, however, we would also build up a liability to foreigners that we would have to finance in the future. The replacement rate is the ratio of Social Security benefits to wages in the year preceding retirement. there. For example, if we build up the assets in the Social Security trust fund, thereby achieving solvency, but offset those efforts by reducing saving elsewhere, then the real resources required to meet future benefits will not be forthcoming from our economy. In the end, we will have accomplished little in preparing the economy to meet future demands. Thus, in addressing Social Security's imbalances, we need to ensure that measures taken now to finance future benefit commitments represent real additions to national saving. We need, in effect, to make the phantom "lock-boxes" around the trust fund real. For a brief period in the late 1990s, a common commitment emerged to do just that. But, regrettably, that commitment collapsed when it became apparent that, in light of a less favorable economic environment, maintaining balance in the budget excluding Social Security would require lower spending or higher taxes. Last year, Social Security tax revenues plus interest exceeded benefits by about $150 billion. If those funds had been removed from the unified budget and "locked up" and Congress had not made any adjustments in the rest of the budget, the unified budget deficit would have been $564 billion. A reasonable hypothesis is that the Congress would, in fact, have responded by taking actions to pare the deficit. In that case, the end result would have been lowered government dissaving and correspondingly higher national saving. A simple reshuffling from the unified accounts to the lockboxes would not have, in itself, added to government savings; but higher taxes or lower spending would have accomplished that important objective. The major attraction of personal or private accounts is that they can be constructed to be truly segregated from the unified budget and, therefore, are more likely to induce the federal government to take those actions that would reduce public dissaving and raise national saving. But it is important to recognize that many varieties of private accounts exist, with significantly different economic consequences. Some types of accounts are virtually indistinguishable from the current Social Security system, and the Congress would be unlikely to view them as truly off-budget. Other types of accounts actually do transfer funds into the private sector as unencumbered private assets. The Congress is much more likely to view the transfer of funds to these latter types of accounts as raising the deficit and would then react by taking measures to lower it. *** Failure to address the imbalances between our promises to future retirees and our ability to meet those promises would have severe consequences for the economy. The most recent projections by the Office of Management and Budget show that spending on Social Security, Medicare, and Medicaid will rise from about 8 percent of GDP today to about 13 percent by 2030.3 Under existing tax rates and reasonable assumptions about other spending, these projections make clear that the federal budget is on an unsustainable path, in which large deficits result in rising interest rates and ever-growing interest payments that augment deficits in future years. But most important, deficits as a percentage of GDP in these simulations rise without limit. Unless the trend is reversed, at some point these deficits would cause the economy to stagnate or worse. Closing the gap solely with rising tax rates would be problematic; higher tax rates rarely achieve a comparable rise in tax receipts, and the level of required taxation could in itself severely inhibit economic growth. In light of these sobering projections, I believe that a thorough review of our commitments - and at least some adjustment in those commitments - is urgently needed. The necessary adjustments will become ever more difficult and larger the longer we delay. No changes will be easy. All programs in The projections for Medicare and Medicaid should be viewed as highly uncertain. Health spending has been growing faster than the economy for many years, the growth fueled, in large part, by significant increases in technology. How long this trend will continue is extremely difficult to predict. We know very little about how rapidly medical technology will continue to advance and how those innovations will translate into future spending. Technological innovations can greatly improve the quality of medical care and can, in some instances, reduce the costs of existing treatments. But because technology expands the set of treatment possibilities, it also has the potential to add to overall spending - in some cases, a great deal. In implementing policy, we need to be cognizant that the uncertainties - especially our inability to identify the upper bound of future demands for medical care - counsel significant prudence in policymaking. The critical reason to proceed cautiously is that new programs quickly develop constituencies willing to fiercely resist any curtailment of spending or tax benefits. As a consequence, our ability to rein in deficit-expanding initiatives, should they later prove to have been excessive or misguided, is quite limited. Thus, policymakers need to err on the side of prudence when considering new budget initiatives. Programs can always be expanded in the future should the resources for them become available, but they cannot be easily curtailed if resources later fall short of commitments. our budget exist because a majority of the Congress and the President considered them of value to our society. Adjustments will thus involve making tradeoffs among valued alternatives. The Congress must choose which alternatives are the most valued in the context of limited resources. In doing so, you will need to consider not only the distributional effects of policy changes but also the broader economic effects on labor supply, retirement behavior, and national saving. The benefits to taking sound, timely action could extend many decades into the future.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Institute of International Bankers Annual Washington Conference, Washington, DC, 14 March 2005.
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Susan Schmidt Bies: Bank Secrecy Act and capital compliance issues Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Institute of International Bankers Annual Washington Conference, Washington, DC, 14 March 2005. * * * Good morning. I want to thank you for the invitation to speak at the Institute's annual Washington conference. International banking organizations are playing an increasingly important role in the U.S. financial sector. Foreign banking organizations hold more than $3.5 trillion in banking and nonbanking financial assets in the United States - making these organizations some of the biggest financial holding companies operating in this country. For two broad reasons, U.S. banking supervisors give a great deal of thought to the foreign banking organizations here. First, the management of complex international banking businesses creates inherent risks, which must be mitigated through sophisticated enterprise-wide risk management and internal controls. International organizations face difficult questions of management and control across their geographically dispersed offices. They often operate in new and unfamiliar financial terrain, which poses strategic challenges. And they are vulnerable to terrorist financing, money laundering, and other customer fraud issues that tend to involve cross-border transactions. Second, international banking organizations are regulated by supervisors in various national jurisdictions that have different legal, regulatory, and supervisory frameworks. Thus, the supervision and regulation of these organizations requires the continuous coordination and cooperation of hostand home-country supervisors. While banks operate globally, supervisory and regulatory responsibility for the various operating units of the organizations is still based on laws and regulations of sovereign states. Complying with diverse laws and regulations can be complex and costly for global banking organizations. Today, I want to touch on two regulatory issues that are currently high on the list of both bankers and supervisors: Bank Secrecy Act compliance and Basel II implementation. Compliance with the Bank Secrecy Act Since the passage of the USA Patriot Act in 2001, which significantly amended the Bank Secrecy Act, compliance in this area has been a major concern for the banking industry. In large part, bankers' concerns center on the increased burden of complying with the amended Bank Secrecy Act, the apparent lack of consistency in oversight and supervision, and law enforcement issues. The Federal Reserve recognizes that banking organizations have devoted significant resources to helping the government identify and prosecute those who are involved with money laundering, the funding of terrorist activities, and other crimes. But some recent events are affecting bankers' perceptions about their role in this critical area, and have raised serious questions about what bank regulators and other government authorities - most notably law enforcement agencies - expect of bankers. Today, I want to provide some background information and describe what the Federal Reserve is doing, in coordination with the Justice and Treasury departments, to clarify expectations and dispel misconceptions about compliance with the Bank Secrecy Act. But first I want to emphasize an important point about the Bank Secrecy Act: Implementation of the act has traditionally been accomplished through a partnership among banks, supervisors, and law enforcement authorities. The law requires reports and recordkeeping that is useful to all these entities. Further, the law capitalizes on the role of banks in payment systems. As collectors of financial information, banks are in a good position to identify questionable or suspicious payments or activities. For the past decade, the key obligation of banks within this partnership has been the filing of Suspicious Activity Reports, or SARs, in accordance with regulations issued by the U.S. Department of the Treasury and all of the federal banking and thrift regulators. The agencies' rules require banking organizations to file SARs to alert law enforcement authorities and federal bank supervisors about a known or suspected violation of law, or about any suspicious activity being conducted at, by, or through a bank, thrift, or credit union. By filing SARs, banking organizations put critical information into the hands of the proper law enforcement authorities in a timely and effective manner. Since the SAR system was started in 1996, banking organizations have filed more than 1.7 million SARs. That is an enormous amount of cooperation and information sharing. However, recent criminal investigations and prosecutions based on Bank Secrecy Act and SAR reporting violations have attracted significant industry attention. Most importantly, these cases have generated complaints from the financial industry about the increased burden of Bank Secrecy Act compliance, as well as the uncertainty of future requirements - particularly for the filing of SARs. Believing that regulators and law enforcement authorities have set a zero-tolerance level for SAR-filing deficiencies, banking organizations are concerned that in certain situations failing to file a SAR could result in a criminal prosecution. Bankers are telling us that regulatory criticism and criminal prosecutions based on SAR-filing deficiencies can produce collateral consequences. For example, banks are tending to avoid customers, such as money transmitters and check cashers, who present perceived heightened risks. Yet the closing of accounts for these types of businesses is effectively a denial of banking services to many categories of legitimate customers. Banking organizations have also begun to file "defensive" SARs in an effort to avoid any criticism of their judgment about whether some activity is illegal or suspicious, and to avoid sanctions for failing to file particular SARs. The Treasury Department's Financial Crimes Enforcement Network (FinCEN) has reported that these defensive filings threaten to clutter the SAR database with information that cannot be properly analyzed due to the volume. Bank regulators and FinCEN recognize that no process for fraud or money laundering detection and control can reasonably be expected to perfectly detect every transaction. But, financial institutions are expected to have a sound anti-money-laundering compliance program. This must include well-defined processes to identify suspicious activities, and those processes should be tailored to the risk and complexity of each business line. Banks should provide sufficient training to line staff, compliance officers, internal auditors, and legal staff to keep employees on the alert for suspicious activities. Further, when questionable activity is detected, the bank must respond promptly and effectively, and work with appropriate law enforcement authorities and bank regulators. I am sure that you are aware by now of the interagency efforts to develop and issue new, enhanced Bank Secrecy Act examination guidelines and procedures within the next few months. The Federal Reserve and the other federal banking supervisors, with the active participation of FinCEN, are drafting these more-detailed uniform examination guidelines and procedures. We are reaching out to the industry during this stage of the project. Once the procedures are completed, we will work hard to educate our examination forces and the industry about the guidelines and procedures. These efforts are intended to better ensure consistency in the Bank Secrecy Act and anti-money-laundering supervision programs of the bank regulators and FinCEN - the entity within the U.S. Treasury that is statutorily responsible for the implementing the Bank Secrecy Act. In addition, the Federal Reserve and the other federal bank supervisory agencies recently signed a Memorandum of Understanding with FinCEN to share critical information about banking organizations' compliance with the Bank Secrecy Act. By providing pertinent Bank Secrecy Act information to FinCEN, which is adding additional staff to fulfill its responsibilities, the Federal Reserve and the other regulators can now better coordinate their supervision and enforcement efforts, thus further reducing the potential for unwarranted compliance burdens. FinCEN is also committed to providing both bankers and regulators information about emerging money-laundering schemes and guidance for continually improving Bank Secrecy Act compliance. The Federal Reserve is also working with senior Justice and Treasury officials to ensure they understand the efforts of banks and the regulators to ensure compliance with the Bank Secrecy Act. We want awareness of these compliance efforts to be consistent throughout the criminal justice system so that the industry and its regulators can continue building partnerships with law enforcement authorities. I would now like to move on to a discussion of Basel II implementation. Basel II Implementation Basel II represents a fundamental change in how bank capital is determined for regulatory purposes. The advanced approaches require banking organizations to make significant investments to improve risk-management processes and measurement so that minimum regulatory capital better reflects each institution's unique business mix, risk appetite, and control structure. Internationally active banking organizations, in particular, have understandable concerns about the prospect of each national supervisor across the expanse of their global operations asking a multitude of questions about Basel II implementation, demanding considerable amounts of data, applying the framework differently, or taking other actions that increase costs. Inevitably, some of you will find your institutions calculating capital under different approaches in the various jurisdictions in which you operate. To help national supervisors coordinate and achieve greater consistency in the implementation of Basel II within their individual countries, the Basel Committee, as you all know, has established the Accord Implementation Group (AIG), headed by our colleague Nick Le Pan, Canada's superintendent of financial institutions and the vice chairman of the Basel Committee. Nick is here today and will be addressing the recent efforts of the AIG and the greater issue of home-host supervisory coordination in some depth. I want to assure you that U.S. supervisors are sensitive to the need to coordinate their efforts. We will do our best to make compliance manageable for global banking organizations and to improve our coordination efforts with foreign supervisors. These initiatives include entering into written supervisory cooperation and information-sharing arrangements with financial institutions' supervisors in countries that share cross-border banking operations with the United States. However, while we can strive to minimize the burden on regulated institutions, we cannot eliminate it. A critical point for this audience, and this is true for Bank Secrecy Act issues as well, is that we as regulators are committed to applying the same rules to foreign-owned organizations that we apply to domestic ones. Foreign-owned U.S. bank holding companies, banks, and thrifts that meet the criteria for mandatory Basel II institutions will be required to follow the advanced approaches. U.S. bank holding companies, banks, and thrifts owned by foreign organizations that do not meet these criteria including the great majority of institutions represented in this audience - will have a choice to either follow our current capital framework in the United States or to "opt in" to the advanced Basel II approaches. If you decide to opt in, you will have to meet the same qualification requirements as domestic organizations. The new Basel II rules are expected to take effect on January 1, 2008. To qualify by that date, both supervisors and bankers have substantial work to accomplish. Currently, we are reviewing the submissions received from various banking organizations as part of a quantitative impact study, QIS-4, to assess the effects of Basel II rules on bank capital levels. This summer, the agencies will issue a notice of proposed rulemaking (NPR) for Basel II. We will also issue for comment, amendments to the existing capital framework. Thus, bankers will be able to compare the two alternatives and to evaluate which is appropriate for their U.S. operations. In the run-up to 2008, institutions subject to the new rules will be required to conduct a year of parallel calculations; that is, institutions will have to perform a dress rehearsal, if you will, to demonstrate not only that the design of the Basel II systems is sound but also that the rules can be practically implemented. As you know, the federal banking agencies in the United States have stated that a small number of large, internationally active banking organizations will be required to follow the advanced approaches of calculating capital under Basel II. A year and a half ago, we proposed setting the threshold at $250 billion or more in total banking assets or $10 billion or more in foreign banking assets. The criteria in the forthcoming notice of proposed rulemaking are unlikely to differ materially from those levels. At the same time, U.S. regulators - especially those among us who spent the greater part of our careers as bankers - are very sensitive to the competitive implications of having two sets of rules for the banking industry. Regulators recognize that Basel I can be enhanced and that the Basel II standardized approach is not well suited to the needs of our domestic-focused community banking organizations. Accordingly, we are now seriously considering making some targeted adjustments to our existing regulatory capital rules and looking for ways to enhance their risk sensitivity without increasing regulatory burden. The staffs of the agencies are drafting an advance notice of proposed rulemaking (ANPR) suggesting possible changes to our existing capital rules. This advance notice will be published close to the publication of the Basel II notice of proposed rulemaking. Finally, those institutions considering adoption of the advanced approaches at the earliest possible date should begin defining the details of their own implementation plans, while identifying gaps and placeholders for further discussion with supervisors. In this regard, the U.S. banking agencies recently issued guidance describing how we expect the implementation process will work in the United States and some steps that banking organizations could consider. To be sure, several important implementation issues still need to be worked out, but the focus on enhanced risk management in Basel II (especially in the advanced approaches) means that banking organizations should not view Basel II preparations with a checklist mentality. Rather, they should be moving ahead on many fronts, looking at how to make the fundamental changes needed for better risk identification, measurement, management, and control. By doing so, banking organizations can position themselves to succeed in implementing the accord on a timely basis. Throughout the process, it will be critical that you regularly communicate with your primary supervisor about whether you plan to "opt-in" to the advanced approaches and about your timeframe for compliance. Regular communication can help the supervisor allocate resources to support the qualification process. It can also help the supervisor focus on your implementation efforts, identify issues that need to be addressed, and provide prompt responses to your questions.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the 2005 National Community Reinvestment Coalition Conference, Washington DC, 18 March 2005.
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Alan Greenspan: Empowering communities, attracting development capital and creating opportunities Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the 2005 National Community Reinvestment Coalition Conference, Washington DC, 18 March 2005. * * * It is a pleasure to join this group that is dedicated to developing strategies for ensuring that opportunities for economic advancement are available to all Americans, including members of lower-income families and communities. In a couple of years, we will celebrate the thirtieth anniversary of the Community Reinvestment Act (CRA). To date, this act has brought many successes, but much remains to be accomplished. Before passage of the CRA, lending to underserved populations was often considered an act of goodwill, not good business. I do not disparage benevolence, but I believe that one of the most enduring achievements of the CRA has been that lenders, often to their surprise, have found low-income community lending to be a normal extension of their outreach for profitable business. Mortgage and consumer lending is driven by credit analysis, and for small-business lending, also by a belief in the potential success of the business venture. Because it is critical that low- and moderate-income lending be, and be perceived as, an extension of regular business practice, we have been building a substantial database on low-income credit experience and business opportunities. This information has been critical to the successes in low-income lending. But information collection and analysis must reach further. If communities are going to be empowered, they need hard evidence of their successes and, yes, hard evidence of their failures, which, as you know, can point the way toward success. Accordingly, I would like to emphasize the important role of program assessment in the community development process. Success of these programs can be understood only through measurement and critical analysis. To date, systematic research on community economic development programs has been limited. One of your challenges then is to expand the information about the impact of your activities so that you can demonstrate the viability of your efforts and replicate local models of success for the benefit of other communities and families. Measuring the impact of community economic development programs The overarching objective of community economic development and empowerment is to help underserved populations accumulate assets and improve their economic well-being. Measuring the results of programs dedicated to this objective is essential to effectively managing scarce resources and maximizing the impact of these programs. Achieving the objective, particularly in areas and among populations where biases and negative perceptions may have contributed to market failures, helps people improve their financial standing, regardless of their current economic status. For nearly four decades, numerous policies and programs have been implemented with the intent of increasing economic opportunity. A variety of management and funding strategies have been implemented, ranging from federal government appropriations to debt and equity financing from private sources. Despite the broad spectrum of programs, the length of time they have been in place, and the array of funding participants, empirical research quantifying their impact is rare, regardless of whether government agencies, nonprofit organizations, or private entities sponsor the programs. The lack of empirical data is particularly regrettable in the case of government-sponsored programs, because quantifying the impact of these programs is crucial to the legislative process. When a bill is proposed in Congress, the nature of the problem and the factors presumed to be contributing to that problem typically are explicitly stated. And generally included is a projection of the outcomes that would indicate success. This process of problem diagnosis, program justification, and projection of results, if fully embraced, provides a framework for assessing a program's value. The program can be judged worthwhile when the data demonstrate that the benefits exceed the costs, including the opportunity costs of any investment. Even with such a framework, conducting research on community development and economic empowerment programs can be challenging, in part because the effects these programs intend to achieve are often quite difficult to measure and may not become apparent for relatively long periods of time. Initiatives aimed at addressing complex economic and social problems that were decades in the making most likely require many years to achieve their goals. Also, virtually no specifically defined standards exist for monitoring the value of social and economic improvement programs. For community development researchers, the challenge is to develop parameters for objectively assessing the value of their programs. For example, the measures that affordable-housing organizations use could illustrate the extent to which their programs have, or have not, increased homeownership rates and property values, reduced crime, improved school performance, or spurred new private-sector investment in a disadvantaged neighborhood. Research must isolate the variables that best convey the impact of a program, define the specific data that must be collected, and develop a system for maintaining and retrieving the data over time. In other words, the challenge is to quantify the marginal effect of a program. The value of such a system is clear. So too, however, is the complexity of creating it. Consider, for example, the difficulty of measuring the marginal impact of a financial education program. It requires unique data collection techniques and unconventional tracking systems to gauge the benefit that an individual derives from making informed financial decisions that resulted from that educational program. Socioeconomic trends for underserved populations and communities The relative paucity of data and research on community development programs has limited the ability to fully demonstrate the programs' impact and to credibly differentiate those that are effective from those that are not. Undeniably, impressive local community development initiatives have been undertaken, and individual testimonials reveal advances in the economic well-being of many of the beneficiaries. However, the absence of formal data collection and research for the numerous neighborhood revitalization efforts over the past several decades has resulted in a reliance on mostly anecdotal reporting at a neighborhood or individual level. Anecdotal information is not without value. It offers clues to the construction of a more-formal statistical analysis. But, as I am sure all of you know from experience, anecdotes are selective and can convey a false message about the success or failure of a program. Given the lack of data that can be used to measure the success of new initiatives, the inclination is to examine the data that does exist to identify trends in areas where community development organizations have been a consistent presence for some time. When broad positive trends cannot be completely attributed to conventional market forces, perhaps community development is at least a partial explanation. Since community development initiatives focus on traditionally underserved populations - lower-income families and communities - economic indicators relating to these markets may offer some insight into the influence of local economic and social programs. For example, according to a 2003 study by the Brookings Institution, the number of people living in high-poverty neighborhoods decreased 24 percent between 1990 and 2000. Much more dramatic improvements occurred in some cities, such as Detroit, where the decrease was 75 percent. In addition, the report found that concentrated poverty decreased among all racial and ethnic groups, with the percentage of African-Americans living in high-poverty neighborhoods declining from 30 percent in 1990 to 19 percent in 2000. These data present an encouraging picture of improvement in the economic condition of very low-income families and communities. The data also reveal gains in homeownership among low-income and minority populations. The Federal Reserve Board's 2001 Survey of Consumer Finances (SCF) concluded that, between 1998 and 2001, families in the lowest quintile of the income distribution increased their rate of homeownership nearly 5 percent. Although results from the 2004 SCF are not available, data reported under the Home Mortgage Disclosure Act indicate that home-purchase lending to lower-income families increased 11 percent between 2001 and 2003. These data also reveal a 17 percent increase in home mortgage loans to African-Americans and a 30 percent increase in home mortgage loans to Hispanics. Further, HMDA data for the same period show a 45 percent increase in home mortgage loans in low-income tracts, while lending in higher-income tracts rose by only 19 percent. In weighing the implications of the trends reflected by the data, it is important to consider the presence of changes in external market influences. For example, advances in mortgage underwriting and delivery systems have resulted in increased availability of funding for homeownership, which has resulted in increased efficiencies in extending credit in harder-to-reach markets. However, despite the difficulty of distinguishing between outcomes attributable to macroeconomic conditions and those attributable to localized community interventions, we must attempt to make this differentiation. Indeed, understanding the effects of the multiple influences on the economic conditions of a market is the only means of achieving the highest possible use of public funding and establishing appropriate expectations for private-sector participation in redevelopment activities. Information gains in community development Despite the lack of empirical data about the effectiveness of specific community development programs, many community development corporations (CDCs) have modified their strategies and their structures to enhance their efficiency and impact. Most notably, CDCs have realized the necessity of diversifying their funding sources and reducing their reliance on government support, which is vulnerable to the vagaries of shifting political priorities. In expanding the range of financing for their programs, community development leaders have gained a better understanding of the risk tolerance and return requirements of their various capital providers. In addition to diversifying sources of funding, community developers have sought to broaden the types of financing they use. They once viewed debt as the primary, if not the sole, vehicle available for capitalizing community development efforts, but now they recognize the vital role of equity investment in helping communities withstand economic downturns. New sources of equity - community development venture capital funds and secondary markets that securitize community development loan pools - have become available to energize market forces in economically distressed neighborhoods. Technological advances have significantly improved the development of new financing strategies. With increased information-processing capacity, loan portfolio managers can better assess risk and monitor credit performance. Additionally, the ever-increasing availability of data facilitates the development of neighborhood profiles that can be useful in understanding and tracking community socioeconomic trends. For example, cross-referencing data sets on mortgage lending patterns, business start-ups, and employment against crime statistics and property values can provide a valuable perspective. Community developers have made important strides in establishing performance parameters and developing information systems to promote rigorous evaluation of programs and organizations. Data collection programs have produced insights into the markets that community economic development lenders serve and the characteristics and financial performance of the institutions providing these services. For example, the Department of Treasury's Community Development Financial Institutions (CDFI) Fund launched its Community Investment Impact System in mid-2004, with the goal of establishing a comprehensive repository of data on community development finance institutions and activities. The systematic collection and standardization of information on these institutions' customers, transactions, and markets holds promise for increasing understanding of the institutions' impact on the communities and populations they serve. Other information collection systems have been launched within the community development field in an attempt to assess organizations' effectiveness in fulfilling their expressed mission. These data collection programs underscore the importance of identifying the organizational structures and policies characteristic of effective enterprises. For example, the Neighborhood Reinvestment Corporation has adopted a data system that defines and tracks success measures of its member organizations. The Success Measures Data System is a participatory evaluation model designed to document the outcomes and measure the impact of community development programs, using parameters defined by the leaders and stakeholders in the field. Another program, the CDFI Assessment and Rating System, was developed by the National Community Capital Association to help investors and donors assess the social impact and financial strength of community development finance organizations. While these systems are in the early stages, they are a critical step in advancing understanding of the community economic development finance field and in designing policies and practices that can improve economic opportunity for low-income families and neighborhoods. Benefits of research Undoubtedly, we have learned many valuable lessons over the years, and it is essential to disseminate and apply these lessons to improve program effectiveness. Only through a comprehensive understanding of the outcomes of a program can success be emulated and failures reduced. By consistently and reliably measuring outcomes, and thus helping current and prospective investors better assess their risks and predict their returns, community development organizations can attract more funding. Such accountability is crucial for any organization, regardless of its size. In addition to increasing funding options, research can also increase the scope and scale of programs. As effective strategies are identified, they can be replicated and incorporated into efforts in other communities, as well as by organizations seeking to develop programs to address related issues. In conclusion, I want to emphasize the importance of the role of those who interpret the research. Analysts must be scrupulous in characterizing research results, or their work becomes advocacy rather than research. Objectivity is paramount because research findings from previous efforts become the basis for subsequent efforts to target scarce resources as effectively as possible. Objectivity requires great discipline and integrity; it requires that researchers resist any innate desire to characterize results in the most- or least-favorable light possible. The failure of a program is not a research failure; it is a source of information. And acknowledgment of the research findings, regardless of how disappointing, contributes to a foundation of knowledge upon which future successes can be built. In the quest to do good for our society's most-vulnerable populations and communities - the objective compelling the work of this group - analysts must embrace the challenge to develop objective and quantifiable standards for assessing community development programs. Ultimately, research is the only means for determining whether we are making advances in distressed neighborhoods by improving access to economic opportunities for traditionally underserved populations. I applaud your efforts and look forward to learning of your future progress.
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Redefining Investment Strategy Education Symposium, Dayton, Ohio, 30 March 2005.
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Ben S Bernanke: Implementing monetary policy Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Redefining Investment Strategy Education Symposium, Dayton, Ohio, 30 March 2005. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * Among the most important of my duties at the Federal Reserve is serving on the Federal Open Market Committee (FOMC), the body that makes U.S. monetary policy. Nineteen men and women - the seven members of the Board of Governors and the Presidents of the twelve Reserve Banks - gather in Washington eight times each year to participate in FOMC deliberations on the course of monetary policy.1 If necessary, the FOMC can also convene by conference call between regularly scheduled meetings. The FOMC's decisions are guided by the dual mandate given to the Federal Reserve by the Congress, which enjoins the Committee to use its powers to pursue both price stability and maximum sustainable employment. To achieve its mandated objectives, the FOMC must influence the course of the U.S. economy, helping it to grow rapidly enough to make full use of available resources but not so rapidly as to stoke inflation. How, specifically, does the Committee exert this influence? The person in the street might tell you that the Fed "controls interest rates." That statement is not literally accurate. In fact, the Fed has little or no direct influence over the interest rates that matter most for the economy, such as mortgage rates, corporate bond rates, or the rates on Treasury securities. Instead, the Fed affects these key rates, as well as the prices of financial assets such as stocks, only indirectly. Since many of you plan to work in the financial markets, I thought that you might find it interesting to hear some of the details of how U.S. monetary policy is actually implemented and how policy decisions affect asset prices and yields. I will begin by discussing how the Federal Reserve influences the federal funds rate, the one market interest rate over which it has fairly direct control. I will then discuss the effects of changes in the federal funds rate on the asset prices and yields that matter the most for economic activity and inflation.2 Monetary Policy and the Federal Funds Rate Broadly speaking, the Federal Open Market Committee's principal task is to determine the degree of financial stimulus needed to steer the economy onto a desirable path and then to set monetary policy so as to provide that amount of stimulus. "Financial stimulus" is not a precisely measured concept, but in general, financial conditions are stimulative to the extent that the asset prices and yields prevailing in financial markets induce households and firms to spend more freely. For example, low mortgage rates promote increased spending on new homes, low auto-financing rates tend to increase the sales of new cars, and low corporate bond yields and high stock prices generally induce firms to invest in new capital goods, such as factories and machines, at a faster pace. When the economy is growing too sluggishly to fully employ its capital and labor resources, and if insufficient aggregate demand is the cause of slow growth, increased financial stimulus can help return the economy to full employment by expanding the aggregate demand for goods and services. Similarly, if the economy is growing at an unsustainably quick rate, more-restrictive financial conditions (in the form of higher mortgage rates, auto financing rates, and corporate bond rates, for example) can help to restrain spending and reduce the risk of an inflationary overshoot. Although the FOMC's ultimate objective is to provide the appropriate degree of financial stimulus to the economy, the Committee has no direct control over the key interest rates and asset prices that jointly determine the extent of financial stimulus, as I have already noted. Instead, the FOMC's monetary policy decision is expressed in terms of the Committee's target value for an otherwise Though nineteen policymakers participate in FOMC deliberations, only twelve vote at any given meeting. The seven members of the Board and the President of the Federal Reserve Bank of New York have a permanent vote. The remaining eleven Presidents vote on a rotating basis. As always, my remarks today reflect my own views and not necessarily those of my Federal Reserve colleagues. I thank Seth Carpenter for excellent assistance. obscure short-term interest rate, the federal funds rate. For example, the FOMC's current target for the federal funds rate, as established at its meeting last week, is 2.75 percent. What is the federal funds rate (often called the funds rate for short)? The funds rate is the interest rate prevailing in the market for borrowing and lending reserve balances, also called the federal funds market. Reserve balances are deposits held at the Federal Reserve by commercial banks and other depository institutions.3 Banks hold reserve balances at the Fed for several reasons. First, balances at the Fed can be used to satisfy banks' legal requirement to hold reserves in proportion to the level of their own customers' transactions deposits (checking accounts, for example).4 A bank's legal reserve requirement is calculated based on the average level of deposits held by the bank's own customers over a two-week period, called the computation period, and must be satisfied by having sufficient reserves on average over a subsequent two-week period, called the maintenance period. Second, banks can choose to hold what are called contractual clearing balances. Unlike balances held at the Fed for reserve purposes, which pay no interest, contractual clearing balances earn implicit interest in the form of earnings credits. Banks can use these credits to pay for services provided by the Federal Reserve, such as check clearing and the use of the Fedwire, the Federal Reserve's electronic large-value payment system.5 Together, balances held at the Fed to satisfy reserve requirements and contractual clearing balances are referred to as required balances. Total required balances in recent years have been around $20 billion, divided roughly equally between required reserves and contractual clearing balances.6 Banks may also choose to hold balances at the Fed in excess of their required balances. These so-called excess balances are costly for banks because they earn no interest and do not satisfy legal reserve requirements. Nevertheless, a bank may hold them to facilitate financial transactions with other institutions.7 Whenever a bank makes or receives large payments electronically over Fedwire, either as a result of its own activities or those of its depositors, reserves are shifted out of the account of the paying bank into the reserve account of the receiving bank. Payments made by check also result in a transfer of reserves between banks. Trillions of dollars of reserves are transferred between banks every day as a result of these financial settlements, which end each day at 6:30 p.m. ET when the Fed closes its Fedwire system. Payments flows may be exceptionally large on certain days, such as major tax dates and days on which the purchases of bonds in Treasury auctions are settled. In the face of large and often unpredictable payments flows, a financially-active bank must confront the problem of managing its reserve account both to meet its reserve requirement for the period and also to avoid ending any day with its account at the Fed overdrawn (which may carry a financial penalty). At the same time, banks try to accumulate as few excess reserves as possible, because holding non-interest-paying excess reserves instead of interest-bearing securities is costly. A bank that finds itself short of reserve balances on a given day can borrow in the federal funds market from other institutions that happen to hold more balances at the Fed than they need on that day. The interest rate that banks pay when they borrow in the federal funds market is the aforementioned funds rate. Banks generally contract to borrow fed funds on an unsecured basis and for very short periods, typically overnight. Loans of fed funds can be made through brokers whose For convenience, from now on I will refer to banks and other depository institutions collectively as "banks." Banks holdings of vault cash also count toward meeting legally required reserves. Reserve requirements are established by the Federal Reserves Regulation D. Banks contract with their regional Federal Reserve Banks to hold a specified level of these balances on average over an ensuing two-week maintenance period. They are free to change their contractual balances between periods. Strictly speaking, contractual clearing balances are not "reserves" in the legal sense. However, balances held at the Fed to satisfy a reserve requirement are indistinguishable from contractual clearing balances; for simplicity, both types of balances are referred to as "reserve balances." The Federal Reserve permits institutions some flexibility to carry forward a limited amount of their reserve surpluses or deficiencies to the next maintenance period. With this flexibility, some institutions are able to reduce the average level of their excess balances nearly to zero. But for the system as a whole, excess balances typically average $1.5 billion to $2 billion. Current data on reserve holdings and other assets and liabilities of the Federal Reserve are available at www.federalreserve.gov/releases/h41/current. business is to arrange such transactions, or they can be made directly between institutions.8 Of late, the daily volume of overnight fed funds transactions handled by brokers has ranged between $60 billion and $80 billion, an amount several times greater than the total level of reserves in the banking system. The volume of direct (that is, non-brokered) transactions is not reported but is estimated to be of similar magnitude. The funds rate is a market rate, not an administered rate set by fiat - that is, the funds rate is the rate needed to achieve equality between the demand for and the supply of reserves held at the Fed. As I have already discussed, the demand for reserve balances arises both because banks must hold required reserves and because reserve balances are useful for facilitating transactions. Because of the scale of and volatility in daily payments flows, the demand for reserve balances can vary substantially from one day to the next. The supply of reserve balances is largely determined by the Federal Reserve - at the operational level, by the specialists at the Federal Reserve's Open Market Desk, located in the Federal Reserve Bank of New York in the New York financial district. For example, to increase the supply of reserves, the Open Market Desk purchases securities (usually government securities) on the open market, crediting the seller with an increase in reserve balances on deposit at the Fed in the amount of the purchase.9 Thus, a purchase of a billion dollars' worth of securities by the Open Market Desk increases the supply of funds available to lend in the fed funds market by the same amount. Similarly, sales of securities from the Fed's financial portfolio result in debits against the accounts of commercial banks with the Fed and thus serve to drain reserve balances from the system.10 Collectively, these transactions are called open-market operations. Factors outside the control of the Open Market Desk can also affect the supply of reserve balances. For example, when the Federal Reserve receives an order for currency from a bank, it debits the reserve account of the bank in payment when the currency is shipped, thereby reducing reserve supply. When deciding upon open market operations to control the supply of reserves, the Open Market Desk must take account of these external factors. In practice, the Open Market Desk uses several methods of performing open-market operations. In some cases it purchases securities outright, that is, with the intention of holding the securities in its portfolio indefinitely. Outright purchases are used to offset long-lasting changes in factors affecting the demand for and supply of reserves. For example, long-term increases in the private sector's demand for currency have largely been met by outright purchases of securities. Over the years, the Fed has accumulated a portfolio of more than $700 billion of Treasury securities, mostly as an offset to its issuance of currency. In contrast, in cases in which variations in the demand for reserves or in external factors affecting reserve supply appear likely to be temporary, the Desk typically prefers to conduct open-market operations through short-term or long-term repurchase agreements, known as repos. Under a repurchase agreement, the buyer and seller of a security agree to reverse the transaction after a certain fixed period. Thus, when the Open Market Desk purchases securities under a repo agreement, the resulting increase in reserve balances lasts only until the time at which the transaction is reversed. Over the course of a year, the value of repos on the Fed's books on any given day may range from a few billion dollars to $30 billion or more. In the period before the millennium date change (Y2K), when the demand for currency was temporarily very high, the daily value of repos peaked at nearly $150 billion. The manager of the Open Market Desk and his team bear the responsibility of adjusting the supply of fed funds to maintain the funds rate at or near the target established by the FOMC. Meeting this objective on a daily basis is technically challenging. To hit the funds rate target, the Desk staff must forecast the daily demand for balances as well as changes in external factors affecting reserves supply. Open-market operations are then set in motion to balance the supply of and demand for reserves at the target funds rate. Large banks dealing in high volumes of fed funds typically use brokers, whereas a small bank is more likely to borrow directly from a larger bank with which it has an ongoing relationship. If the seller is not a bank, the Fed credits the reserve account of the sellers correspondent bank. Typically, the counterparties to the Open Market Desk are large private securities dealers, called primary dealers. Actual sales of securities in the open market have been rare. In practice, when the Fed wishes to drain reserves, it usually lets some securities mature without replacing them. Shortly after 9 a.m. each morning, the Desk staff and staff members at the Board of Governors confer over the phone to discuss their respective estimates of the day's demand for balances as well as to consider factors that may affect supply. The Desk manager and his staff also keep in close touch with fed funds brokers and other market participants so as to be able to assess general market conditions. The Desk's market contacts are useful not only for controlling the funds rate but also for obtaining broader financial-market information for the use of Fed policymakers. At 9:20 a.m., a conference call is held between the Desk staff, Board staff, and the President of a Reserve Bank.11 The Desk staff summarize the projections for reserves demand and supply, report on conditions in the federal funds market and global financial market developments, and present to the President their plans for open-market operations for his or her comment. Open-market operations will be arranged shortly after this "call," and the results are disclosed to the public generally within a few minutes. The Desk is in the market on most business days, adding from $2 billion to $10 billion in reserves to keep the funds rate near the FOMC's target. As an additional means for managing the fed funds, the Federal Reserve stands ready to lend reserves to depository institutions that request them. Financially sound banks are eligible to borrow from the Fed at what is called the primary credit rate, which to date has been set at 100 basis points (1 percentage point) above the target funds rate. Historically, reserve shortages occasionally caused the funds rate to "spike" well above its target, once even hitting 100 percent (in 1991). The primary credit facility is designed to avoid such spikes by providing an elastic supply of reserves at a rate not far above the funds rate target. Since the introduction of the primary credit facility, the rate has exceeded the primary credit rate only in a few unusual circumstances, such as the power outage in the eastern United States in August 2003. The Federal Reserve's multiple means of injecting reserves into the banking system - a belt-and-suspenders approach - was shown in its best light following the September 11 terrorist attacks. With a significant part of the financial system inoperative and with many payments not being made as scheduled, the banking system's demand for reserve balances rose sharply. Those reserve needs were met initially through large amounts of direct borrowing from the Fed. As market functioning improved, needed reserves were provided by means of open-market operations. The increase in the supply of reserves topped $80 billion by the end of the week. The Funds Rate and Other Market Rates I have discussed at some length how the Federal Reserve manages the federal funds rate, the most direct instrument of monetary policy. As I have already hinted, however, monetary policy is effective only to the extent that Federal Reserve actions can affect a wide range of interest rates and asset prices. What is the link between the funds rate and these key financial variables? The interest rates most closely linked to the funds rate are those prevailing in short-term money markets. Financial market participants are able to trade short-term liquid funds in a number of markets, including, for example, the market for repurchase agreements based on Treasury securities (the repo market). The federal funds market is tied particularly closely to the so-called Eurodollar market. Technically, Eurodollar deposits are dollar-denominated deposits held at non-U.S. banks, but regulatory and technological developments have made these deposits easily tradable even by U.S. banks and by many nonbank institutions not eligible to participate in the fed funds market. Accessible to a wide range of borrowers and lenders and operating virtually around the clock, the Eurodollar market has grown rapidly and become highly liquid. Because large banks can trade in either the federal funds market or the Eurodollar market and because fed funds and Eurodollars are easily substitutable forms in which to hold short-term liquidity, it should not be surprising that overnight Eurodollar interest rates line up closely with the funds rate, even within the day (Bartolini, Gudell, Hilton, and Schwarz, 2005). Were that not the case, then banks could profit by borrowing in the cheaper market and lending in the market in which the rate is higher. As a consequence of this potential arbitrage, the FOMC's target for the funds rate effectively To be eligible to participate, the President must be a current voting member of the FOMC, other than the President of the Federal Reserve Bank of New York. determines other very short-term rates as well. This linkage establishes one important connection between the FOMC's target funds rate and interest rates more broadly. As I have noted, however, to affect overall financial conditions, the FOMC's actions must affect not only very short-term rates but also longer-term yields and asset prices, including mortgage rates, corporate bond rates, and stock prices. Considerable empirical evidence suggests that monetary-policy actions do affect these longer-term yields and asset prices as well as very short-term rates.12 But what is the mechanism? To keep things simple, we can focus on the relationship between the FOMC's actions and the yield on longer-term Treasury securities, such as five-year or ten-year Treasury notes. If monetary policy can affect Treasury yields, then clearly it can affect other yields and asset prices as well. For example, mortgage rates are closely linked to long-term Treasury yields, the spread between the two rates being explained largely by factors such as the risk of default on mortgage loans and the so-called prepayment risk (that is, the risk that homeowners will choose to pay off their mortgages early). Likewise, changes in Treasury yields affect stock prices by affecting both the profit prospects of publicly traded companies as well as the rate at which expected future profits are discounted to the present. Basic financial theory suggests that any long-term interest rate, such as a five-year or ten-year Treasury rate, is the sum of two components: a weighted average of expected short-term interest rates and a term premium, which in turn depends on risk, liquidity, and other factors affecting the desirability of the financial instrument in question. Monetary policy probably influences the term premium on Treasury securities to some extent.13 However, in all likelihood, the more important means by which monetary policy affects Treasury yields is through the effect of policy on the expected future path of short-term interest rates, and I will focus on that channel. Expected short-term interest rates influence long-term rates because any investor has the choice of holding either a long-term security or a series of short-term securities, re-investing his or her funds in a new short-term security as the old short-term security matures. All else being equal, the choice between the two strategies depends on the expected return. If, on the one hand, short-term rates are expected to be higher on average than the long-term rate that spans the same period, investors will choose the strategy of rolling over short-term securities. If, on the other hand, the long-term rate exceeds the average of expected future short-term rates, the long-term security will be the more attractive. Since both short-term and long-term Treasury securities are willingly held in the marketplace, investors must be roughly indifferent between short-term and long-term securities, implying that (on average and abstracting from any term premiums) expected future short-term rates must be similar to the current long-term yield. You may be beginning to understand at this point why making monetary policy is not a simple matter and, in particular, why the Fed has only very indirect control over long-term yields and asset prices. The Fed controls very short-term interest rates quite effectively, but the long-term rates that really matter for the economy depend not on the current short-term rate but on the whole trajectory of future short-term rates expected by market participants. Thus, to affect long-term rates, the FOMC must somehow signal to the financial markets its plans for setting future short-term rates. How can this be done? The most direct method is through talk. The FOMC's post-meeting statement, the minutes released three weeks after the meeting, and speeches and congressional testimony by the Chairman and other Federal Reserve officials all provide information to the markets and the public about the near-term economic outlook, the risks to that outlook, and the appropriate course for monetary policy. With the aid of this information, financial market participants make estimates of the likely future path of short-term interest rates, which in turn helps them to price longer-term bonds. FOMC talk probably has the greatest influence on expectations of short-term rates a year or so into the future, as beyond that point the FOMC has very little, if any, advantage over market participants in forecasting the economy or even its own policy actions. See, for example, Bernanke and Kuttner (2004) for evidence that monetary policy actions affect stock prices. Kuttner estimates the effects of monetary policy on Treasury yields at different maturities. For example, if monetary policy were such as to create highly volatile inflation, the risk of holding conventional Treasury securities (as opposed to Treasury securities that are indexed to inflation) would rise, increasing required compensation for risk and thus the term premium. Influencing policy expectations for the more distant future may be more difficult. However, the FOMC has two general ways to help financial market participants divine the long-run course of policy. First, to the extent practical, the FOMC strives to be consistent in how it responds to particular configurations of economic conditions and transparent in explaining the reasons for its response. By building a consistent track record, the FOMC increases its own predictability as well as public confidence in its policies. Second, more generally, comments by FOMC officials about the Committee's general policy framework, including the Committee's economic objectives and members' views about the channels of monetary policy transmission and the structure of the economy, help the public deduce how policy is likely to respond to future economic circumstances. Importantly, FOMC members do not have to guess about the effects of their words and actions on the public's expectations of future policy actions. Information about those expectations is revealed in a number of ways in financial markets. For example, market prices on actively-traded futures contracts on the funds rate or on the Eurodollar rate tell us a great deal about the funds rate that market participants expect to prevail at various dates in the future.14 Options on fed funds and Eurodollar futures are also actively traded; the prices of these options provide useful information about the degree of uncertainty that market participants have about future monetary policy. By watching financial markets and listening to the views of market participants, FOMC members are able to know with considerable accuracy what the markets expect for monetary policy. This information helps Committee members deduce how their own actions and statements are likely to affect asset prices and yields. To conclude, the FOMC controls very short-term interest rates fairly directly. However, as I have emphasized today, the Committee's control over longer-term yields and over the prices of long-lived financial assets depends crucially on its ability to influence market expectations about the likely future course of policy. In the past decade or so, the Federal Reserve has become substantially more transparent and open in its communication with the public. Growing appreciation of the fact that greater openness makes monetary policy more effective is, I believe, an important reason for this welcome trend. Gürkaynak, Sack, and Swanson (2002) provide evidence on the predictive power of various futures contracts for monetary policy. Piazzesi and Swanson (2004) show that more-distant futures prices must be adjusted for risk in order to provide good policy forecasts.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Financial Services Roundtable Annual Meeting, Palm Beach, Florida, 31 March 2005.
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Susan Schmidt Bies: Home Mortgage Disclosure Act, Bank Secrecy Act and capital issues Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Financial Services Roundtable Annual Meeting, Palm Beach, Florida, 31 March 2005. * * * Good afternoon. Thank you for inviting me to speak at your annual meeting. I know that regulatory issues are an important part of the Financial Services Roundtable’s agenda this year. Today, I want to touch on three regulatory issues that are currently high on the list of both bankers and supervisors: new disclosures under the Home Mortgage Disclosure Act (HMDA), Bank Secrecy Act compliance and Basel II implementation. HMDA Price Data Disclosure The importance of effective risk management is brought into sharp focus by the imminent public release of home mortgage price data by lenders such as your organizations. Lenders covered by HMDA will have to make additional information about their home loans, including, for the first time, price information, available to the public as early as today. I recognize that many of you are concerned about the potential legal and reputational risks that accompany the disclosure of price data. Over the next few minutes, I want to put those risks in context by reviewing with you why the Federal Reserve decided in 2002 to require disclosure of price data on higher-priced loans and how lenders, government agencies, and the broader public should think about and use the data. The requirement to disclose price data grew out of the objectives that motivated Congress’ initial adoption of HMDA. In enacting HMDA in 1975, Congress sought to make mortgage markets work more efficiently and strengthen compliance with anti-discrimination laws. Congress believed those objectives would be served by requiring depository institutions to disclose mortgage loan information publicly, not just on an aggregate basis, but institution by institution and application by application. Congress later came to believe that the law’s objectives would be better-served by requiring disclosure by non-depository lenders, not just depository institutions. Thus, HMDA now covers more than 80 percent of all home lending. Since Congress last added major data disclosure requirements under HMDA in 1989, mortgage markets have changed dramatically as information and technology have improved, permitting more-efficient and more-accurate risk assessment and management. These developments have made it feasible for institutions to lend to higher-risk borrowers, albeit at prices commensurate with the higher risk. Many borrowers receiving higher-priced loans would in the past have been denied credit. The growth of lending to higher-risk borrowers, known as subprime borrowers, is generally a positive development. It has expanded access to credit, helping to increase homeownership and opportunities for consumers to tap the equity in their homes. However, the growth of the subprime market has also raised public policy concerns. Among the concerns are whether consumers who obtain higher-priced loans are sufficiently informed about their options to make the market work as efficiently as it could and to protect themselves from unfair or deceptive lending practices. Those concerns have played into ongoing debates about the adequacy and efficacy of proposed or existing disclosures and limitations on mortgage lending intended to protect consumers from abuse. In addition, the wider range of prices available in the marketplace has raised concerns about whether price variations reflect, even in part, unlawful discrimination rather than legitimate risk- and cost-related factors. In response to these concerns, the Federal Reserve updated the regulation that implements HMDA, effective last year. For the first time, the regulation requires lenders to publicly disclose information about the prices of some of the home mortgage loans they originate. The requirement to disclose price data is limited to higher-priced loans, where concerns about market efficiency and consumer protection that I just described are greatest, and excludes the vast majority of prime loans, where limited variation in prices helps to allay such concerns. Price disclosure, while understandably a source of anxiety for some lenders, provides an opportunity to advance market efficiency and compliance with consumer protection and anti-discrimination laws. The price data, in combination with other data disclosed under HMDA, can be used as a screen that identifies aspects of the higher-priced end of the mortgage market that warrant a closer look. For example, the price data can be used by lenders, government agencies, and the public to identify institutions, product types, applicant types, and geographic markets where price differences among racial or other groups are sufficiently large to warrant further investigation. Although these potential uses of the data have received the most attention, other uses are possible. The price data might be used by lenders to identify markets with relatively large numbers of higher-priced loans, where entry may bring opportunities to lenders and increase options available to consumers. Also, the data may help community organizations and public agencies decide where to invest in consumer education and community development. To realize the potential benefits of the price data, we must acknowledge and take into account the data’s inherent limitations, which reflect in part concerns about the substantial costs of mandatory data reporting, which policymakers must weigh against public policy benefits. One of the most important limitations of the HMDA data set is that it does not include data about many of the legitimate factors lenders use to determine prices in the mortgage market, including key credit-risk factors. Credit-risk factors absent from the HMDA data set include loan-to-value ratio, consumer debt-to-income ratio, and a consumer’s experience with credit. Thus, price disparities by race or ethnicity, if revealed in the HMDA data, will not alone prove unlawful discrimination. Such disparities will, however, indicate a need for closer scrutiny - a look at these other variables. If the HMDA data set’s inherent limitations are not acknowledged and understood, conclusions purportedly drawn from these data alone run a risk of being unsound. Unsound conclusions, in turn, may reduce the data set’s effectiveness in promoting HMDA’s objectives of improving market efficiency and legal compliance. For example, the unwarranted tarnishing of a lender’s reputation could reduce the willingness of that lender or another to remain in, or enter, certain higher-priced segments of the market. That discouragement, in turn, could potentially reduce competition in those segments and curtail the availability of credit to higher-risk borrowers. But those concerns, however real, must be viewed in the light of the valuable contribution the data will make to enforcement of anti-discrimination laws. The Federal Reserve, for its part, will conduct a statistical analysis of the HMDA data of each institution that reports HMDA data. Following past practice, the Fed will share the analyses with the responsible federal agencies. The analyses will not draw definitive conclusions about the fairness or lawfulness of a lender’s practices, because, as I have said, the HMDA data do not permit such conclusions. These analyses will be screens, albeit relatively sophisticated screens, to help agencies decide which institutions merit a closer look. The Federal Reserve recognizes both the opportunities and risks the new price data will bring. It is keenly interested in promoting a clear-eyed use of the data that advances, rather than undermines, the statute’s objectives. To that end, the Federal Reserve will take opportunities such as this one throughout the year to publicly discuss the HMDA data - both what the data can tell us, and what they cannot. In addition, we plan to publish an article in the Federal Reserve Bulletin discussing and interpreting the data. The article will be published at the same time that the Federal Financial Institutions Examination Council (FFIEC) publishes summary tables of the HMDA data, in late summer or early fall. An institution that might soon - as early as today - have to disclose its own price data, should already have analyzed its data and be prepared to respond to comments from others interpreting its data. First, an institution should take the steps necessary to reach a high degree of confidence that its data are accurate. After that, an institution may want to determine how its data will appear to the public in the disclosure tables the FFIEC will release by the early fall; the precise formats of those tables were published in December. A lender may also want to determine if the HMDA data reflect price disparities that are not adequately explained by other information in the HMDA data set - such as income, loan size, and lien status - and, if so, to analyze those disparities in light of price variables known to the lender. The analysis could include a review of pricing discretion provided to loan officers. It also could include, where applicable, a review of the pricing patterns of mortgage brokers through which the lender has originated loans. Should a lender discover risks in its HMDA data, it goes without saying that the lender should manage those risks. As with other risks, those related to the HMDA disclosures should be managed with an eye to the entire enterprise, including the bank and the non-depository affiliates. Compliance with the Bank Secrecy Act Since the USA Patriot Act of 2001 significantly amended the Bank Secrecy Act, compliance in this area has been a major concern for the banking industry. In large part, bankers’ concerns center on the increased burden of complying with the additional requirements, the apparent lack of consistency in oversight and supervision, and law enforcement issues. The Federal Reserve recognizes that banking organizations have devoted significant resources to helping the government identify and prosecute those who are involved with the funding of terrorist activities, money laundering, and other crimes. But some recent events are affecting bankers’ perceptions about their role in this critical area, and have raised serious questions about what bank regulators and other government authorities - most notably law enforcement agencies - expect of bankers. Today, I want to provide some background information and describe what the Federal Reserve is doing, in coordination with the Justice and Treasury departments, to clarify expectations and dispel misconceptions about compliance with the Bank Secrecy Act. But first I want to emphasize an important point about the Bank Secrecy Act: Compliance with the act and the significant benefits that result from that compliance are achieved through a partnership among banks, supervisors, and law enforcement authorities. The law requires reports and recordkeeping that are useful to all these entities. Further, the law capitalizes on the role of banks in payment systems. As collectors of financial information, banks are in a good position to identify questionable or suspicious payments or activities. For the past decade, the key obligation of banks within this partnership has been the filing of Suspicious Activity Reports, or SARs, in accordance with regulations issued by the Treasury Department and all of the federal banking and thrift regulators. The agencies’ rules implementing the Bank Secrecy Act require banking organizations to file SARs to alert law enforcement authorities and federal bank supervisors about a known or suspected violation of law, or about any suspicious activity being conducted at, by, or through a bank, thrift, or credit union. By filing SARs, banking organizations put critical information into the hands of the proper law enforcement authorities in a timely and effective manner. Since the SAR system was started in 1996, banking organizations have filed more than 1.7 million SARs. That is an enormous amount of cooperation and information sharing. However, recent criminal investigations and prosecutions based on Bank Secrecy Act and SAR reporting violations have attracted significant industry attention. Most importantly, these cases have generated complaints from the financial industry about the increased burden of Bank Secrecy Act compliance, as well as the uncertainty of future requirements - particularly for the filing of SARs. Believing that regulators and law enforcement authorities have set a zero-tolerance level for SAR-filing deficiencies, banking organizations are concerned that in certain situations failing to file a SAR could result in a criminal prosecution. Bankers are telling us that regulatory criticism and criminal prosecutions based on SAR-filing deficiencies can produce collateral consequences. For example, banks are tending to avoid customers, such as money transmitters and check cashers, who present perceived heightened risks. Implicitly, banks are making the decision that the revenues garnered from such customers do not cover the necessary costs of compliance while providing an acceptable return on legal and reputational risks. Yet the closing of accounts for these types of businesses runs the risk of effectively denying banking services to many categories of legitimate customers. Banking organizations have also begun to file "defensive" SARs in an effort to avoid any criticism of their judgment about whether some activity is illegal or suspicious, and to avoid sanctions for failing to file particular SARs. The Treasury Department’s Financial Crimes Enforcement Network (FinCEN) has reported that these defensive filings threaten to clutter the SAR database with information that cannot be properly analyzed due to the volume. Bank regulators and FinCEN recognize that no process for fraud or money-laundering detection and control can reasonably be expected to perfectly detect every transaction. But, financial institutions are expected to have a sound anti-money-laundering compliance program. This must include well-defined processes to identify suspicious activities, and those processes should be tailored to the risk and complexity of each business line. Banks should provide sufficient training to line staff, compliance officers, internal auditors, and legal staff to keep employees on the alert for suspicious activities. Further, when questionable activity is detected, the bank must respond promptly and effectively, and work with appropriate law enforcement authorities and bank regulators. I am sure that you are aware by now of the interagency efforts to develop and issue new, enhanced Bank Secrecy Act examination guidelines and procedures within the next few months. The Federal Reserve and the other federal banking supervisors, with the active participation of FinCEN, are drafting these more-detailed uniform examination guidelines and procedures. Supervisors, on a pilot basis, have been using the new guidelines at financial institutions. Once the procedures are completed, we will work hard to educate our examination forces and the industry about the new guidelines and procedures. These efforts are intended to better ensure consistency in the Bank Secrecy Act and anti-money-laundering supervision programs of the bank regulators and FinCEN - the entity within the U.S. Treasury that is statutorily responsible for the implementing the Bank Secrecy Act. In addition, the Federal Reserve and the other federal bank supervisory agencies recently signed a Memorandum of Understanding with FinCEN to share critical information about banking organizations’ compliance with the Bank Secrecy Act. By providing pertinent Bank Secrecy Act information to FinCEN, which is adding additional staff to fulfill its responsibilities, the Federal Reserve and the other regulators can now better coordinate their supervision and enforcement efforts, thus further reducing the potential for unwarranted compliance burdens. FinCEN is also committed to providing both bankers and regulators information about emerging money-laundering schemes and guidance for continually improving Bank Secrecy Act compliance. The Federal Reserve is also working with senior Justice and Treasury officials to ensure they understand the efforts of banks and the regulators to ensure compliance with the Bank Secrecy Act. We want awareness of these compliance efforts to be consistent throughout the criminal justice system so that the industry and its regulators can continue building partnerships with law enforcement authorities. I would now like to move on to a discussion of Basel II implementation. Basel II Implementation and Current Framework Amendments Basel II represents a fundamental change in how bank capital is determined for regulatory purposes. The advanced approaches require banking organizations to make significant investments to improve risk-management and measurement processes so that minimum regulatory capital better reflects each institution’s unique business mix, risk appetite, and control structure. In moving forward with Basel II in the United States, the U.S. banking and thrift regulatory agencies acknowledge that a certain amount of burden will be placed on institutions moving to the new framework - but we firmly believe that the costs of doing so will be well worth it for all parties. However, successful implementation of Basel II in the United States will require that supervisors and bankers maintain a productive dialogue, given that both sides must complete a substantial amount of work between now and adoption in January 2008. Right now, the U.S. banking and thrift agencies are engaged in a concerted effort to deliver by mid-2005 their latest proposals for U.S. implementation of Basel II, which include a notice of proposed rulemaking (NPR) and release of additional draft supervisory guidance. These come on the heels of a recent statement outlining the agencies’ expectations for the Basel II qualification process. From now until the final rule is issued - we hope by mid-2006 - whatever the agencies propose will be open for comment and subject to change. Past comments from the industry have had a substantial impact on the framework’s evolution. In fact, we are reaching the end of a very long process that has included multiple comment periods. For example, global regulators heard and accepted the industry’s call for addressing only unexpected loss in the framework. The ongoing work with so-called "double-default" is another area in which regulators have listened to industry concerns and are working to respond. As most of you are aware, there are still a few difficult issues that need to be sorted out, such as estimating loss given default during periods of economic downturn and finalizing the double default proposal. We have been quite open about these issues and are continually engaging the industry in trying to find solutions. And if we are presented with compelling evidence that a certain approach is flawed or inadequate, we will certainly consider making adjustments. Substantial work remains to be accomplished before Basel II can "go live." As you are aware, several areas in particular will require special efforts. Data collection and validation are examples. While supervisors are working diligently to provide guidance on what is expected for data warehouses and validation methods, financial institutions are responsible for collecting the data they will need for the advanced approaches. Similarly, validation starts with institutions’ own independent checks on the adequacy of risk management and internal control processes. Accordingly, those institutions considering adoption of the advanced approaches at the earliest possible date should now be defining the details of their own implementation plans, including a self-assessment, gap analysis and a remediation plan. The recently issued interagency statement on qualification describes some steps that banking organizations should follow if they wish to be positioned to adopt the final rules at the earliest possible implementation date. The focus on enhanced risk management in Basel II means that banking organizations should not view Basel II preparations with a checklist mentality. Rather, they should be moving ahead on many fronts, looking at how to make the fundamental changes needed for better risk identification, measurement, management, and control. By doing so, banking organizations can position themselves to succeed in implementing the accord on a timely basis. We do, however, recognize that a certain time constraint exists for institutions wishing to implement the new framework: On the one hand, those institutions are encouraged to start preparations as soon as possible; on the other hand, we leave open the possibility that elements of the framework are subject to change. I will not try to pretend that this is a trivial matter. As a former banker, I sympathize with the challenges you face in deciding on investments and upgrades to your systems and personnel. When it comes to Basel II, we recognize that certain details relating to systems and processes will depend on what the final U.S. rule and guidance contain. Accordingly, we are available to discuss your implementation efforts at any time and we desire to hear specifics about which elements of the proposal, from your perspective, will demand the greatest investments or appear to generate the greatest uncertainty. Using that information, the agencies can then understand where to target resources to assist institutions during the transition to Basel II. We certainly hope that many upgrades made for Basel II are those that would have been made anyway. I would like to say a few words directly to the potential "opt-in" institutions. An institution that does not meet the mandatory criteria in the Framework will be under no obligation to adopt Basel II. As noted, Basel II is an extensive undertaking; thus for a potential opt-in institution, the choice of moving to Basel II resides with the institution itself. Firms should decide for their own reasons whether to attempt to qualify for Basel II at the earliest possible date, to qualify at a later date, or to remain within the existing capital framework. The agencies will continue to provide as much information as possible to assist potential opt-in institutions in making their decisions. For example, the fourth Quantitative Impact Study, or QIS-4, and the Loss Data Collection Exercise, or LDCE, should help institutions make decisions about their Basel II preparations - including the decision by non-mandatory institutions as to whether they should opt-in, and if so, when. Furthermore, our supervisory teams continue to stand ready to discuss Basel II-related issues with all banking organizations and answer any questions that arise; this includes discussing preparatory steps those institutions may be taking for Basel II. The federal banking and thrift agencies acknowledge the substantial work involved for institutions looking to adopt Basel II in the United States and are committed to ensuring that Basel II is implemented in a fair and equitable manner. As indicated, the agencies remain unequivocally committed to fulfill all procedural requirements in working toward a final Framework-based rule. In addition, the agencies remain committed to offering equal information to all parties with an interest in Basel II, which of course includes proposed mandatory institutions and potential opt-in institutions. In this regard, the agencies have provided a substantial amount of public information relating to the proposed adoption of the Framework-based rule - including the aforementioned release on the proposed U.S. Basel II qualification process. We have also met individually with a wide range of institutions to discuss the proposals and institutions’ preparatory work, and have offered access to several Basel II-related activities (such as QIS-4 and LDCE exercises) to any institution wishing to participate. Let me state quite clearly that we value the participation of all institutions in these efforts and welcome the continued dialogue. U.S. regulators - especially those among us who spent the greater part of our careers as bankers - are very sensitive to the competitive implications of having two sets of rules for the banking industry. Regulators recognize that Basel I can be enhanced and that the Basel II standardized approach is not well suited to the needs of the vast majority of our domestic-focused community banking organizations. Accordingly, to enhance risk sensitivity without increasing regulatory burden, staffs of the agencies are drafting an advance notice of proposed rulemaking suggesting possible targeted adjustments to our existing regulatory capital rules. This advance notice will be published close to the publication of the Basel II notice of proposed rulemaking so that the industry and others can view the proposals side-by-side. We expect that the comments we receive on each of the proposals will help us refine the proposals and identify competitive issues between the alternatives. In closing, I would like to underscore our commitment to maintain an ongoing dialogue with all members of the banking industry - regardless of their potential Basel II status - and to continue providing equal information to all parties interested in Basel II implementation. This pertains to the entire scope of Basel II - including the proposed U.S. rule, the qualification process, home-host issues, and potential competitive effects. If we can improve on the manner in which we carry out those tasks, please let us know.
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board of governors of the federal reserve system
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Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing and Urban Affairs, US Senate, 6 April 2005.
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Alan Greenspan: Regulatory reform of the government-sponsored enterprises Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing and Urban Affairs, US Senate, 6 April 2005. * * * Mr. Chairman, Senator Sarbanes, and Members of the Committee, thank you for again inviting me to discuss the role of housing-related government-sponsored enterprises (GSEs) in our economy. As I described at length last year, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation (hereafter Fannie and Freddie) have contributed importantly to the development of the secondary home mortgage market and thereby to the diversification of funding sources for depository institutions and other mortgage originators. In particular, Fannie and Freddie played a critical role in promoting mortgage securitization - the key to the success of secondary mortgage markets in the United States.1 The stated intent of the Congress is to use the housing-related GSEs to provide a well-established channel between housing credit and the capital markets and, through this channel, to promote homeownership, particularly among lower-income families. Although prospectuses for GSE debt are required by law to say that such instruments are not backed by the full faith and credit of the U.S. government, investors have concluded that the government will not allow GSEs to default, and as a consequence offer to purchase GSE debt at substantially lower interest rates than required of comparably situated financial institutions without such direct ties to government.2 Given this advantage, which private competitors are not able to fully overcome, the housing-related GSEs have grown rapidly in recent years. The strong belief of investors in the implicit government backing of the GSEs does not by itself create safety and soundness problems for the GSEs, but it does create systemic risks for the U.S. financial system as the GSEs become very large. Systemic risks are difficult to address through the normal course of financial institution regulation alone and, as I will stipulate shortly, can be effectively handled in the case of the GSEs by limiting their investment portfolios funded by implicitly subsidized debt. The government guarantee for GSE debt inferred by investors enables Fannie and Freddie to profitably expand their portfolios of assets essentially without limit.3 Private investors have granted them a market subsidy in the form of lower borrowing rates. Unlike subsidies explicitly mandated by the Congress, the implicit subsides to the GSEs are incurred wholly at the discretion of the GSEs. Because Fannie and Freddie can borrow at a subsidized rate, they have been able to pay banks, thrifts, mortgage companies, and other home mortgage originators slightly higher prices for mortgages than their potential competitors have paid. This edge has enabled Fannie and Freddie to gain gradually but inexorably an ever-larger share of the home mortgage market. Investors have provided Fannie and Freddie with a powerful vehicle for pursuing profits through the rapid growth of their balance sheets, and the resultant scale has given them an advantage that their potential private-sector competitors cannot meet. But the higher prices that these two GSEs pay for mortgages are only a small part of their subsidy, as evidenced by their persistent and well-above-market returns on equity capital. Their annual return on equity, often exceeding 25 percent, is far in excess of the average approximately 15 percent annual Under securitization, mortgages are bundled into pools and then turned into securities that can be easily bought and sold along side other debt securities. Mortgage securitization continues to perform this important function, and such securitization techniques now have been applied extensively by the private sector to many other types of financial instruments. For example, the government provides the GSEs with a line of credit from the Department of the Treasury, fiscal agency services through the Federal Reserve, exemptions from securities registration requirements, exemptions from bank regulations on security holdings, and tax exemptions. The Boards of Directors of Fannie and Freddie are allowed to invest in almost anything as long as there is some link, direct or indirect, to their mission of supporting conforming mortgage markets. As demonstrated by recent innovations in the home equity lending and asset-backed securities markets, much of the $9 trillion in household credit can potentially be secured by real estate and thus may be available to the GSEs as investments. Moreover, the GSEs have been allowed to invest in many forms of non-mortgage debt, such as corporate bonds and commercial paper, to the degree the GSEs' can argue such investments support the GSEs' liquidity goals and thus indirectly support mortgage markets. returns achievable by other large financial competitors holding substantially similar assets. Virtually none of the GSE excess return reflects higher yields on assets; it is almost wholly attributable to subsidized borrowing costs. The ability of the GSEs to borrow essentially without limit has been exploited only in recent years. At the end of 1990, for example, Fannie's and Freddie's combined portfolios amounted to $132 billion, or 5.6 percent of the single-family home-mortgage market. By 2003, the GSEs' portfolios had grown tenfold, to $1.38 trillion or 23 percent of the home-mortgage market. The almost unlimited low credit risk profit potential from exploiting subsidized debt has been available to the GSEs for decades. The management of Fannie and Freddie, however, chose to abstain from making profit-centers out of their portfolios in earlier years, and only during the mid-1990s did they begin rapidly enlarging their portfolios. Typically in a market system, lenders and investors monitor and discipline the activities, including leverage, of their counterparties to assure themselves of the financial strength of those to whom they lend. However, market discipline with respect to the GSEs has been weak to nonexistent. Because the many counterparties in GSE transactions assess risk based almost wholly on the GSE's perceived special relationship to the government rather than on the underlying soundness of the institutions, regulators cannot rely on market discipline to contain systemic risk. When these institutions were small, the potential for such risk, if any, was small. Regrettably, that is no longer the case. From now on, limiting the potential for systemic risk will require the significant strengthening of GSE regulation and the GSE regulator. Determining the suitable amount of capital for Fannie and Freddie is a difficult and technical process, and in the Federal Reserve's judgment, a GSE regulator must have as free a hand as a bank regulator in determining the minimum and risk-based capital standards for these institutions. Beyond strengthening GSE regulation, the Congress will need to clarify the circumstances under which a GSE can become insolvent and, in particular, the resultant position - both during and after insolvency - of the investors that hold GSE debt, as well as other creditors and shareholders. This process must be unambiguous before it is needed. Current law, which contemplates conservatorship and not receivership for a troubled GSE, requires the federal government to maintain GSEs as ongoing enterprises, but other than the symbolic line of credit at the U.S. Treasury, provides no means of financing to do so. Left unresolved, such uncertainties could threaten the stability of financial markets. *** World class regulation, by itself, may not be sufficient and, indeed, might even worsen the potential for systemic risk if market participants inferred from such regulation that the government would be more likely to back GSE debt in the event of financial stress. This is the heart of a dilemma in designing regulation for GSEs. On the one hand, stiffening their regulation might strengthen the market's view of GSEs as extensions of government and their debt as government debt. The result, short of a very substantial increase in equity capital, would be to expand the size of the implicit subsidy and allow the GSEs to play an even-larger unconstrained and potentially destabilizing role in the financial markets. On the other hand, if we fail to strengthen GSE regulation, we increase the possibility of insolvency and crisis. We at the Federal Reserve believe this dilemma would be resolved by placing limits on the GSEs' portfolios of assets, perhaps as a share of single-family home mortgages outstanding or some other variation of such a ratio. Almost all the concerns associated with systemic risks flow from the size of the balance sheets of the GSEs, not from their purchase of loans from home-mortgage originators and the subsequent securitization of these mortgages. We have been unable to find any purpose for the huge balance sheets of the GSEs, other than profit creation through the exploitation of the market-granted subsidy. Some maintain that these large portfolios create a buffer against crises in the mortgage market. But that notion suggests that the spreads of home-mortgage interest rates against U.S. Treasuries, a measure of risk, would narrow as GSE portfolios increased. Despite the huge increase in the GSE portfolios, however, mortgage spreads have actually doubled since 1997, when comparable data for interest rate spreads on mortgage-backed securities first became available.4 A recent study by Federal Reserve Board staff found no link between the size of the GSE portfolios and mortgages rates.5 The past year provides yet more evidence, with GSE portfolios not growing and mortgage spreads, as well as the spread between yields on GSE debentures and Treasury securities, declining further. Indeed, while GSE stock prices have fallen substantially and turmoil has continued at the GSEs, mortgage markets have functioned well. Others have asserted that fixed-rate mortgages would be more difficult, or perhaps even impossible, to obtain without the GSEs' portfolios. But, again, we see little empirical support for this argument. We have found no evidence that fixed-rate mortgages, for example, were difficult to obtain during the early 1990s when GSE portfolios were small. Indeed, the share of adjustable-rate mortgage originations averaged slightly more than 20 percent in 1992, when GSE portfolios were small, and averaged 34 percent in 2004, when GSE portfolios were large; these data suggest that the size of the GSEs' portfolios is unrelated to the availability or popularity of fixed-rate mortgages. As far as we can tell, GSE mortgage securitization, in contrast to the GSE's portfolio holdings, is the key ingredient to maintaining and enhancing the benefits of the GSEs to homebuyers and secondary mortgage markets. And mortgage securitization, unlike the GSE portfolio holdings, does not create substantial systemic risks. *** We at the Federal Reserve remain concerned about the growth and magnitude of the mortgage portfolios of the GSEs, which concentrate interest rate risk and prepayment risk at these two institutions and makes our financial system dependent on their ability to manage these risks. Although Fannie and Freddie have chosen not to expand their portfolios significantly this past year (presumably at least partly in light of their recent difficulties), the potential for rapid growth in the future is not constrained by the existing legislative and regulatory regime. It is a reasonable presumption that rapid growth is likely to resume once Fannie and Freddie believe they have resolved their current difficulties.6 Without changes in legislation, Fannie and Freddie will, at some point, again feel free to multiply profitability through the issuance of subsidized debt. To fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later. Limiting the debt of Fannie and Freddie, while comparably expanding their role in mortgage securitization, would be consistent with the original congressional intent that these institutions provide stability to the secondary market for home mortgages and liquidity for mortgage investors. Indeed, in 1989, before the rapid expansion of its portfolio, Freddie testified before the Congress that the need for safe and sound operation and provision of affordable mortgages to homebuyers was inconsistent with holding a substantial portfolio. As argued by Freddie's CEO at that time, by financing mortgages with mortgage-backed securities sold to investors, Freddie avoided interest rate risks and thus could keep mortgages flowing when depository institutions were suffering an interest rate squeeze.7 Freddie's message changed after 1989 when it became owned by private shareholders and it began to exploit the risk-adjusted profit-making potential of a larger portfolio. *** The creation of mortgage-backed securities for public markets is the appropriate and effective domain of the GSEs. Deep and liquid markets for mortgages are made using mortgage-backed securities that are held solely by investors rather than the GSEs. Fannie's and Freddie's purchases of their own or each other's mortgage-backed securities with their market-subsidized debt do not contribute usefully Spreads averaged 148 basis points in 1997 and 280 basis points in 2003. See Andreas Lehnert, Wayne Passmore, and Shane Sherlund (2005), "GSEs, Mortgage Rates, and Secondary Market Activities," Board of Governors of the Federal Reserve, Finance and Economic Discussion Series 2005-7, January. Press reports indicate that during a recent open conference call, Freddie Mac said it is poised to start growing its portfolio again. For example, see "Freddie Earnings Fell Sharply in 2004; But GSE Sees Growth Potential and Rising Market Share in 2005," Inside MBS & ABS, April 1, 2005, page 4. Leland C. Brendsel, Government-Sponsored Enterprises, Hearing before the Subcommittee on Oversight of the Committee on Ways and Means, House of Representatives, the 101st Congress, September 28, 1989. to mortgage-market liquidity, to the enhancement of capital markets in the United States, or to the lowering of mortgages rates for homeowners. The bulk of the GSEs' portfolio growth over the past decade has occurred mainly through the acquisition of their own mortgage-backed securities - which reflect the AAA-rating of pools of home mortgages. As I indicated earlier, holding their own securities in portfolio often yielded Fannie and Freddie subsidized annual returns on equity of more than 25 percent, far in excess of the returns to purely private financial institutions from holding such securities. *** Limiting the systemic risks associated with GSEs would require that their portfolio holdings be significantly smaller. At the same time, reducing portfolios would have only a modest effect on financial markets. Currently, these portfolios are financed largely by the issuance of GSE debt, which, in turn, is held by investors. If mortgage-backed securities were sold into the market or allowed to self-amortize - and accordingly GSE debt was redeemed - the transaction from the point of view of the supply and demand for high-quality credit is essentially a wash. In the simplest outcome, the holders of GSE debt would be seen as exchanging their debt instruments for the mortgage-backed securities previously held on GSE balance sheets.8 As for homebuyers, whether GSE mortgage purchases are held in GSE portfolios or securitized and sold to investors appears to have no noticeable effect on mortgage rates. Limitations on portfolio holdings could be imposed gradually over several years and then adjusted upward or downward depending on the growth of the single-family mortgage market. Very short-term Treasury holdings needed for liquidity and other assets employed for business operations could be exempt from these limitations. Such a restriction would provide the GSEs with ample liquidity and would focus the GSEs almost exclusively on the purchase and securitization of mortgages, including mortgages for affordable housing. In other words, this restriction frees the GSEs of the difficulties of hedging large-scale interest rate risk. I should note that, even with such portfolio limits, Fannie and Freddie would likely remain among the most formidable of financial institutions in our country. *** As I concluded last year, the GSEs need a regulator with authority on a par with banking regulators, with a free hand to set appropriate capital standards, and with a clear and credible process sanctioned by the Congress for placing a GSE in receivership, where the conditions under which debt holders take losses are made clear. However, if legislation takes only these actions and does not limit GSE portfolios, we run the risk of solidifying investors' perceptions that the GSEs are instruments of the government and that their debt is equivalent to government debt. The GSEs will have increased facility to continue to grow faster than the overall home-mortgage market; indeed since their portfolios are not constrained, by law, to exclusively home mortgages, GSEs can grow virtually without limit. Without restrictions on the size of GSE balance sheets, we put at risk our ability to preserve safe and sound financial markets in the United States, a key ingredient of support for homeownership. If GSE debt holders do not want to hold mortgage-backed securities directly because of interest rate and prepayment risks, other forms of collateralized mortgage obligations are available to meet their needs.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the National Petrochemical and Refiners Association Conference, San Antonio, Texas, (via satellite), 5 April 2005.
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Alan Greenspan: Energy Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the National Petrochemical and Refiners Association Conference, San Antonio, Texas, (via satellite), 5 April 2005. * * * Markets for oil and natural gas have been subject to a degree of strain over the past year not experienced for a generation. Increased demand and lagging additions to productive capacity have combined to absorb a significant amount of the slack in energy markets that was essential in containing energy prices between 1985 and 2000. This tendency has been especially pronounced for oil. Although the recent price of light sweet crude oil is only a bit above the highs of last October, overall market prices of recent weeks, in fact, have been much more elevated. The prices of heavier, sour grades, which make up a significant part of the world production mix, are notably higher than in October. Dubai crude for instance, at yesterday's close, sold for more than $12 per barrel above its October price level. Moreover, although the price of six-year futures for light sweet crude did not match the overall run-up of oil prices last fall, in recent weeks it has largely kept pace with spot prices, leading to record levels for contracts maturing in 2011. Reflecting a low short-term elasticity of demand, higher prices in recent months have slowed the growth of oil demand, but only modestly. The slowdown in the growth of demand coupled with expanded production, which the price firmness has induced, has required markets to absorb an increased pace of inventory investment. The markets' response has been a shift in the spread between spot prices and near-term futures that has facilitated inventory hedging. Futures prices for delivery of both West Texas Intermediate and Brent crudes for the summer exceed spot prices. That will likely support increased inventories of crude oil. If sustained, these market technicals could encourage enough of an inventory buffer to damp the current price frenzy. Natural gas prices, seasonally adjusted, have not returned to their peak of last October, but remain significantly above the levels at year-end 2004. Working levels of gas inventories are seasonally moderate, but domestic dry gas production plus net imports has not expanded sufficiently over the past few years to prevent a marked rise in price. The inexorable rise in residential and utility use has priced the more marginal industrial gas users partially out of the market and has induced significant gains in gas efficiency among a number of gas users such as petroleum refineries, steel mills, and paper and board mills. Industrial gas use overall in the United States has declined 12 percent since 1998. *** The longer-term outlook for oil and gas is, if anything, more conjectural. Much will depend on the response of demand to price over the longer run. Prices of spot crude oil and natural gas have risen sharply over the past year in the face of constrained supply and the firming of overall demand. But if history is any guide, should higher prices persist, energy use will over time continue to decline, relative to GDP.1 Long-term demand elasticities have proved noticeably higher than those that are evident short term. Altering the magnitude and manner of U.S. energy consumption will significantly affect the path of the U.S. economy over the long term. For years, long-term prospects for oil and gas prices appeared benign. When choosing capital projects, businesses in the past could mostly look through short-run fluctuations in oil and natural gas prices to moderate prices over the longer haul. The recent shift in expectations, however, has been substantial enough and persistent enough to bias business investment decisions in favor of energy-cost reduction. The energy intensity of the United States economy has been reduced by about half since the early 1970s in response to sharply higher prices. Much of the displacement was achieved by 1985. Progress in reducing energy intensity has continued since then, but at a lessened pace. This more-modest rate of decline in intensity should not be surprising, given the generally lower level of real oil prices that prevailed between 1985 and 2000. With real energy prices again on the rise, more rapid decreases in the intensity of use in the years ahead seem virtually inevitable. Of critical importance will be the extent to which the more than 200 million light vehicles on U.S. highways, which consume 11 percent of total world oil production, become more fuel efficient as vehicle buyers choose the lower fuel costs of lighter or hybrid vehicles. *** Aside from uncertain demand, the resolution of current major geopolitical uncertainties will materially affect oil prices in the years ahead. That, in turn, will significantly influence the levels of investments over the next decade in raising crude oil productive capacity and, only slightly less importantly, investment in refining facilities. Because of the geographic concentration of proved reserves, much of the investments in crude oil productive capacity will need to be made in countries where foreign investment is prohibited or restricted. Unless those policies are changed, a greater proportion of the cash flow of producing countries will be needed for oil reinvestment if capacity is to keep up with projected world demand. Concerns about potential shortfalls in investment certainly have contributed to current record-high long-term futures prices. To be sure, world oil supplies and productive capacity continue to expand. Major advances in recovery rates from existing reservoirs have enhanced proved reserves despite ever-fewer new discoveries of major oil fields. But investment to convert reserves to productive capacity has fallen short of the levels required to match unexpected recent gains in demand, especially gains in China. Besides feared shortfalls in crude oil capacity, the status of world refining capacity has become worrisome as well. Of special concern is the need to add adequate coking and desulphurization capacity to convert the average gravity and sulphur content of the world's crude oil to the lighter and sweeter needs of product markets, which are increasingly dominated by transportation fuels that must meet ever-more stringent environmental requirements. *** U.S. natural gas prices have historically displayed greater volatility than prices of crude oil, doubtless reflecting, in part, the less-advanced development of price-damping global trade in natural gas. Over the past few years, notwithstanding markedly higher drilling activity, the U.S. natural gas industry has been unable to noticeably expand production, or to increase imports from Canada. Significant pressure on prices ensued. North America's limited capacity to import liquefied natural gas (LNG) has effectively restricted our access to the world's abundant gas supplies. Because international trade in natural gas has been insufficient to equalize prices across markets, U.S. natural gas prices since late 2002 have been notably higher, on average, than prices abroad, thereby putting significant segments of the North American gas-using industry in a weakened competitive position. Indeed, ammonia and fertilizer plants in the United States have been particularly hard hit as the costs of domestic feedstocks have risen relative to those abroad. The difficulties associated with inadequate domestic supplies will eventually be resolved as consumers and producers react to the signals provided by market prices. Indeed, the process is already under way. As a result of substantial cost reductions for liquefaction and transportation of LNG, significant global trade in natural gas is developing. This activity has accelerated sharply over the past few years as profitable arbitrage has emerged in natural gas prices across international markets. At the liquefaction end of the process, new investments are in the works across the globe. In Qatar alone, five large-scale projects have begun construction or are at advanced stages of development. In January, Egypt exported its first LNG cargo. Enormous tankers to transport LNG are being constructed, even without being dedicated to specific long-term delivery contracts. The increasing availability of LNG around the world should lead to much greater flexibility and efficiency in the allocation of energy resources. According to tabulations of BP, worldwide imports of natural gas in 2003 were only 24 percent of world consumption, compared with 59 percent for oil. Clearly, the gas trade has significant margin to exercise its price-damping opportunities. In the United States, import terminals in Georgia and in Maryland have reopened after having been mothballed for more than two decades. The added capacity led to a noticeable increase in LNG imports last year, but LNG imports still accounted for less than 3 percent of U.S. consumption.2 U.S. natural gas consumption in 2004 amounted to 22.3 trillion cubic feet. Additional import facilities, both onshore and offshore, are being developed. According to the Federal Energy Regulatory Commission, the number of approved and proposed new or expanded LNG import terminals in the United States stood at thirty-two as of last month with a capacity to import 15 trillion cubic feet annually, far in excess of any pending needs. Clearly, not all of these projects will come to fruition. Some will be abandoned for economic and business considerations, and others will fail because of local opposition, motivated by environmental, safety, and other concerns. The larger question, of course, is what will increased world trade in LNG and expanded U.S. import capacity do to currently uncompetitive natural gas prices in the United States? During the past couple of years, when U.S. prices of natural gas hovered around $6 million Btu, import prices of LNG in Europe have ranged between $2 and $4 per million Btu, and those in Japan and Korea have generally been between $3 and $5 per million Btu. Estimates of production and delivery costs of LNG to North America appear to hover around $3 per million Btu. In the short run, exporters to the United States are likely to receive our domestic price, currently above $7 per million Btu. But unless world gas markets tighten aggressively, competitive pressures will arbitrage the U.S. natural gas price down, possibly significantly, through increased imports. In addition to increased supplies from abroad, North America still has numerous unexploited sources of gas production. Significant quantities of recoverable gas reserves are located in Alaska and the northern territories of Canada. Negotiations over the construction of pipelines connecting these northern supplies to existing delivery infrastructure are currently under way. *** To be sure, the dramatic changes in technology in recent years have made existing oil and natural gas reserves stretch further while keeping energy costs lower than they otherwise would have been. Seismic imaging and advanced drilling techniques are facilitating the discovery of promising new reservoirs and are enabling the continued development of mature fields. But because of inexorably rising demand, these improved technologies have been unable to prevent the underlying long-term prices of oil and natural gas in the United States from rising. Conversion of the vast Athabasca oil sands reserves in Alberta to productive capacity has been slow. But at current market prices they have become competitive. Moreover, new technologies are facilitating U.S. production of so-called unconventional gas reserves, such as tight sands gas, shale gas, and coalbed methane. Production from unconventional sources has more than doubled since 1990 and currently accounts for roughly one-third of U.S. dry gas production. According to projections from the Energy Information Administration, the majority of the growth in the domestic supply of natural gas over the next twenty years will come from unconventional sources. In many respects, the unconventional is increasingly becoming the conventional. In the more distant future, perhaps a generation or more, lies the potential to develop productive capacity from natural gas hydrates. Located in marine sediments and the Arctic, these ice-like structures store immense quantities of methane. Although the size of these potential resources is not well measured, mean estimates from the U.S. Geological Survey indicate that the United States alone may possess 200 quadrillion cubic feet of natural gas in the form of hydrates. To put this figure in perspective, the world's proved reserves of natural gas are on the order of 6 quadrillion cubic feet. *** In the decades ahead, natural gas and oil will compete in the United States with coal, nuclear power, and renewable sources of energy. As the manner in which energy is produced and consumed evolves, it is not unreasonable to expect that, in the long run, the prices per unit of energy from various sources would tend to converge. At present, long-term futures prices for natural gas are, on a Btu-equivalent basis, notably less expensive than those for crude oil. Clearly, limited substitution possibilities across fuels have resulted in persistent cost differentials, but those very differentials inspire the technologies that, over time, reduce such limitations. A clear example is gas-to-liquids (GTL) technology, which converts natural gas to high-quality naphtha and to diesel fuel. Given the large-scale production facilities that are currently being contemplated (and some that have already begun construction), GTL is poised to become an increasingly important component of the world's energy supply. Current projections of production however remain modest. GTL promises to add a good measure of flexibility in the way natural gas resources are utilized. In addition, given the concerns over the long-term adequacy of liquid production capacity from conventional oil reserves, GTL may provide an attractive, competitively priced, option for making use of stranded gas, which, for lack of access to transportation infrastructure, cannot be brought to market. *** We are unable to judge with certainty how technological possibilities will play out in the future, but we can say with some assurance that developments in energy markets will remain central in determining the longer-run health of our nation's economy. The experience of the past fifty years--and indeed much longer than that--affirms that market forces play the key role in conserving scarce energy resources, directing those resources to their most highly valued uses. Adequate productive capacity, of course, is driven also by nonmarket and policy considerations. To be sure, energy issues present policymakers and citizens with difficult decisions and tradeoffs to make outside the market process. But those concerns, one hopes, will be addressed in a manner that, to the greatest extent possible, does not distort or stifle the meaningful functioning of our markets. We must remember that the same price signals that are so critical for balancing energy supply and demand in the short run also signal profit opportunities for long-term supply expansion. Moreover, they stimulate the research and development that will unlock new approaches to energy production and use that we can now only scarcely envision.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Federal Reserve System¿s Fourth Annual Community Affairs Research Conference, Washington, DC, 8 April 2005.
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Alan Greenspan: Consumer finance Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Federal Reserve System’s Fourth Annual Community Affairs Research Conference, Washington, DC, 8 April 2005. * * * It is a pleasure to be here today as you conclude your discussions about our dynamic consumer finance market. Our nation's vibrant financial services industry is remarkable in many respects, with myriad providers offering consumers a broad range of transaction and credit options. The industry is central to the functioning of our robust consumer sector. Therefore, it is essential that policymakers, regulators, bankers, researchers, and consumer groups remain fully engaged in monitoring developments in the consumer finance market and continually seek to better understand the strengths and weaknesses of the financial services industry, including how well it serves lower-income and underserved consumers. Evolution of the consumer finance market A brief look back at the evolution of the consumer finance market reveals that the financial services industry has long been competitive, innovative, and resilient. Especially in the past decade, technological advances have resulted in increased efficiency and scale within the financial services industry. Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country. From colonial times through the early twentieth century, most people had quite limited access to credit, and even when credit was available, it was quite expensive. Only the affluent, such as prominent merchants or landowners, were able to obtain personal loans from commercial banks. Working-class people purchased goods with cash or through barter, since banks did not make consumer loans to the general public. However, more-intense industrialization and urbanization during the late nineteenth and early twentieth centuries dramatically changed the market for small consumer loans. Urban wage earners used credit to help them purchase the vast array of durable goods being produced by the new industrial economy, such as automobiles, washing machines, and refrigerators. Naturally, this growth in demand fostered increased competition for consumer credit, and, most important, the development of new intermediaries to supply it. Early in the twentieth century, many new organizations that focused exclusively on the needs of consumers entered the field, and the structure of consumer finance began to change dramatically. Semi-philanthropic groups, called remedial loan societies, were formed to combat the high-rate cash lenders. "Morris Plan" banks, which made loans based on savings plans by borrowers, and the first credit unions, accessible exclusively to consumers with a common place of employment, soon followed. By the 1930s, a wide array of lenders served consumers, including credit unions, small local savings banks, and a nationwide network of state-licensed consumer finance companies. Savings and loans were created, in large part, because commercial banks and other local lenders would not make home mortgage loans. Hundreds of sales finance companies were formed to help manufacturers and retailers provide credit to their customers. Although commercial banks continued to finance merchants, manufacturers, and farmers, they were forced to turn more to consumer lending during the Depression, when their primary business sharply contracted. As these structural changes continued, market demand and growing competition among this wider variety of lenders spawned further innovation. As early as 1900, some hotels began offering credit cards to their regular customers. By 1914, gasoline companies and large retail department stores were also issuing credit cards to their most-valued patrons. These first cards were simply a convenient way for good customers to run a tab with a particular retail business concern, since balances had to be paid in full each month. Later versions, introduced by retail giants Sears Roebuck and Montgomery Ward, allowed customers to pay their bills in installments, with interest charged on unpaid outstanding balances. This shift to revolving credit, and another innovation - allowing one card to be used at multiple businesses - later generated increasing competition in the card industry. In the 1950s, commercial banks entered into the credit card business. Home mortgage loans, as we know them today, are a fairly recent product born of the failures of the mortgage finance system during the Great Depression. Clearly, radical change was needed. One of the most significant responses to this need was creation of the Federal Housing Administration, which instituted a new type of mortgage loan - the long-term, fixed-rate, self-amortizing mortgage - which became the model that transformed conventional home mortgage lending. A whole industry - thrift institutions - grew up around this one product. The development of a broad-based secondary market for mortgage loans also greatly expanded consumer access to credit. By reducing the risk of making long-term, fixed-rate loans and ensuring liquidity for mortgage lenders, the secondary market helped stimulate widespread competition in the mortgage business. The mortgage-backed security helped create a national and even an international market for mortgages, and market support for a wider variety of home mortgage loan products became commonplace. This led to securitization of a variety of other consumer loan products, such as auto and credit card loans. The current banking structure Today's fiercely competitive market for consumer credit evolved into its present form slowly but persistently. Along the way, critical structural changes occurred, including entry of, and expansion through, new players. Deregulation of U.S. banking markets has contributed to an approximately 50 percent decline in the number of banking and thrift organizations since the mid-1980s, when industry consolidation began. From 1995 to 2004, the ten largest U.S. banking and thrift organizations, ranked by the total assets of their depository subsidiaries, have increased their share of domestic banking and thrift assets from 29 percent to 48 percent. However, according to most studies, this ongoing consolidation of the U.S. banking system has not reduced overall competitiveness for consumer financial services. When consolidation occurs, it is not uncommon for the merger to result in de novo entry to take advantage of any inefficiencies or transition difficulties of the newly consolidated enterprise. Over the past five years, for example, for every five bank mergers that have been approved, two de novo bank charters have been granted. Even in the face of consolidation, competition is fought on the battlefield of the local market, where most households obtain the majority of their banking services. And, it is noteworthy that our measures of local market competition have remained quite stable over the past fifteen years. Deregulation and consolidation have also cultivated the expansion of the financial services marketplace, as evidenced by the proliferation of many nonbank entities that provide the credit and transaction services that were once mainly the province of depository institutions. The impact of technology on financial services markets As has every segment of our economy, the financial services sector has been dramatically transformed by technology. Technological advancements have significantly altered the delivery and processing of nearly every consumer financial transaction, from the most basic to the most complex. For example, information processing technology has enabled creditors to achieve significant efficiencies in collecting and assimilating the data necessary to evaluate risk and make corresponding decisions about credit pricing. With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s. For some consumers, however, this reliance on technology has been disconcerting. Credit-scoring models are complex algorithms designed to predict risk. Consumer advocates have raised concerns about the transparency and completeness of the information fit to the algorithm, as well as the rigidity of the types of data used to render credit decisions. Consumer advocates contend that the lack of flexibility in the models can result in the exclusion of some consumers, such as those with little or no credit history, or misrepresentation of the risk that they pose. To address these concerns, some firms have worked to customize credit-scoring systems to include new data and to revalue the weight of the variables employed. Also, new organizations have emerged, developing new systems for collecting alternative data, such as rent payments and other recurring payments that will enable creditors to evaluate creditworthiness of consumers who lack experience with credit. Improved access to credit for consumers, and especially these more-recent developments, has had significant benefits. Unquestionably, innovation and deregulation have vastly expanded credit availability to virtually all income classes. Access to credit has enabled families to purchase homes, deal with emergencies, and obtain goods and services. Home ownership is at a record high, and the number of home mortgage loans to low- and moderate-income and minority families has risen rapidly over the past five years. Credit cards and installment loans are also available to the vast majority of households. The more credit availability expands, however, the more important financial education becomes. In this increasingly competitive and complex financial services market, it is essential that consumers acquire the knowledge that will enable them to evaluate products and services from competing providers and determine which best meet their long- and short-term needs. Like all learning, financial education is a process that should begin at an early age and continue throughout life. This cumulative process builds the skills necessary for making critical financial decisions that affect one's ability to attain the assets, such as education, property, and savings, that improve economic well-being. Conclusion As we reflect on the evolution of consumer credit in the United States, we must conclude that innovation and structural change in the financial services industry have been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means. Without these forces, it would have been impossible for lower-income consumers to have the degree of access to credit markets that they now have. This fact underscores the importance of our roles as policymakers, researchers, bankers, and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers.
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Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the 2005 Conference of Twelfth District Directors, Federal Reserve Bank of San Francisco, San Francisco, 14 April 2005.
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Donald L Kohn: Economic outlook Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the 2005 Conference of Twelfth District Directors, Federal Reserve Bank of San Francisco, San Francisco, 14 April 2005. * * * The economy has been performing well of late. Economic activity has shown a good bit of forward momentum as businesses have stepped up their purchases of capital equipment and households have continued to increase their spending on consumer goods and services and on houses. As a result, economic growth has been sufficient to continue eroding slack in labor and product markets. Inflation has picked up over the past year or so, but from very low levels and with much of the overall acceleration attributable to an increase in energy prices that should not be repeated any time soon. Still, as solid growth has become more firmly entrenched and slack has diminished, our focus at the Federal Reserve has naturally and predictably shifted more to the outlook for inflation. The strength of the economy has reflected in part the stance of monetary policy; we have been holding interest rates at very low levels for some time. We adopted that policy a few years ago to encourage economic expansion when several forces - such as the decline in equity prices and the pullback in investment spending - were holding back demand and economic activity, and we knew that it would become increasingly inappropriate as those forces waned. Unless policy is tightened as slack diminishes, inflation will pick up, undermining growth and destabilizing the economy when the inevitable correction occurs. Our view has been that we could probably remove our accommodative policy gradually - "at a measured pace" in our jargon. But that expectation has depended on an outlook for inflation remaining contained and growth only moderately exceeding that of the economy's potential. Recently, some indicators have raised questions about this outlook, and I thought this would be an opportune time to offer my appraisal of some of the forces shaping the economy and their implications for policy. I underscore that these views are my own and are not necessarily shared by my colleagues on the Federal Open Market Committee.1 Economic activity Robust spending by the household sector has supported economic activity for several years - during the downturn and early stages of the subsequent recovery and now in the economic expansion. Consumer spending has been boosted by growth in disposable personal income, interest rates that are low by historical standards, and gains in net worth. The increase in wealth in recent years has come in part from the rebound in equity prices, as well as from the rapid rise in house prices. Borrowing against the resulting buildup of equity in homes has provided a relatively low-cost source of funds for financing consumption. Rising home prices, income gains, and low interest rates also have fueled expansion in the housing sector. Businesses increased investment outlays considerably in the second half of last year, and recent data on orders and shipments suggest that business spending on capital equipment has continued to grow rapidly early this year. One question coming into this year was how strong such spending would be. It was not clear how much of last year's very rapid growth could be attributed to special tax incentives for equipment spending that expired at the end of last year; those incentives could have been inducing businesses to pull forward spending into 2004. Apparently, however, most of the demand last year was driven by fundamentals, and the expiration of the tax incentives has had little apparent damping effect on equipment outlays. Labor markets have shown gradual but steady improvement. Growth in employment has been uneven, but job gains have averaged 160,000 per month over the past six months, and the unemployment rate is at its lowest level of the current expansion, down 1/2 a percentage point from a year ago. Slack in I thank Wendy Dunn and Lawrence Slifman, of the Board's staff, for their help in preparing these remarks. the use of capital also has diminished. In manufacturing, capacity utilization has risen 2-1/2 percentage points over the past year and is now only modestly below its long-term average. Growing confidence and accommodative monetary policy seem to have been important influences behind the recent strength in the economy. Persistent low saving out of current income suggests that households believe that gains in their net worth from the increase in the prices of equities and homes will not be reversed, and that jobs and income will continue to rise at a healthy pace. The key new element in the picture is the behavior of the business sector. Apparently, the persistence of good growth in sales and profits has been restoring business confidence. At the same time, low interest rates, in part a product of accommodative monetary policy, are also playing an important role in encouraging investment in houses and business capital equipment by holding down the cost of borrowing and spending. Indeed, growing confidence may also be interacting with accommodative policy to help keep interest rates low. A number of factors have contributed to the unusually low long-term interest rates that we have seen, but one of them has been the changing attitude of savers toward risk.2 Economic growth has been relatively steady at a moderate pace, and inflation, although higher, is expected to remain fairly low. As people have become increasingly confident that good economic performance will last for a while, they have asked for less extra compensation for taking the risks of lending for longer periods and to borrowers whose odds on default are usually viewed as high. These changing attitudes have helped produce an unusual phenomenon - the failure of longer-term interest rates to move higher in an expanding economy with rising short-term interest rates; for many businesses, longer-term borrowing costs have actually fallen since last summer. In this environment, the economy is likely to remain on a path of solid growth, strong enough to continue to gradually reduce unemployment and raise operating rates in industry for a while. Perhaps the logical question, given my description of favorable changes in confidence and financial conditions, is why "gradually" and only "for a while" - why not a much more rapid rate of expansion that will raise employment and production more quickly than we have experienced so far this expansion? The answer is that several forces seem to be leaning the other way, and will tend to restrain spending growth going forward. Over the near-term, increases in energy prices are siphoning purchasing power of both households and businesses to suppliers overseas, leaving less for non-energy goods and services produced here at home. How large that effect will be is hard to predict. The rise in energy prices last year seems to have damped spending to a limited extent. But the persistence of higher prices may have a cumulating effect on spending, early hints of which might now be showing up in the latest reading on retail sales. In the housing market, prices are unlikely to fall on a national basis, but the increases well above the rise in rents and incomes that we have seen in recent years cannot continue indefinitely, and rising interest rates will probably damp these increases even more. Home building should cool a bit as a result, but perhaps more consequentially, as capital gains on housing slow, households will likely turn to reducing the growth of their consumption out of current income as a way of building assets to finance their children's education, their retirement, and so forth. Finally, economic policy is becoming less expansionary. After the personal tax cuts of recent years and the special incentives for capital spending, fiscal policy will no longer be providing a special impetus to spending. Let me be clear: This is a positive development; the economy does not need this extra boost, and it is time to turn our attention to the need to raise domestic saving to finance the investment that will help us prepare for the coming surge in retirements. On the monetary side, policy is still accommodative and will need to tighten to avoid inflation building up - the source of my "for a while" prediction. Even if short-term rates rise gradually, long-term rates probably will increase in a more-normal pattern of response than we have seen over the past year, since the offset provided by declining risk spreads should not be in operation. Risk spreads actually have widened a bit in recent weeks, perhaps indicating somewhat more caution on the part of lenders. The rise in interest rates will tend to damp investment spending and could inject some added uncertainty into still-settled financial market conditions. The pace and extent of policy adjustment will depend critically on the inflation outlook, so let me turn to that next. My colleague, Ben Bernanke, has pointed to the global pattern of saving and investment as another reason for low longterm interest rates. See "The Global Saving Glut and the U.S. Current Account Deficit," remarks by Governor Ben S. Bernanke at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia (March 10, 2005). Inflation Consumer price inflation - both total and core - rose somewhat in 2004. Much of the increase in total inflation, but not all, reflected the upward movement of energy prices. Core inflation, which abstracts from food and energy price changes and better reflects underlying price pressures over time, also rose. The increase in core inflation reflected a reversal of some of the factors that had temporarily lowered it in 2003 and it also was elevated in the first half of last year by the pass-through of increases in the prices of energy, commodities, and other imports. Core inflation shifted down in the second half of 2004, providing evidence and assurance that an inflationary spiral was not under way. More recently, we have seen some hints that inflation pressures could be intensifying. Greater price increases have been most evident for goods at earlier stages of production with an uptick in prices for commodities and other materials, for energy, and for non-energy imports. A number of our business contacts across the nation report greater success in passing these cost increases through to customers, including other business customers. Judging from a few months of data, which is always risky, consumers may also be experiencing a slightly faster rate of increase in prices, even excluding the effects of rising energy prices. The direct contribution of rising commodity, energy, and other import prices to consumer inflation is likely to lessen considerably, however. Commodity price increases have slowed; the dollar has flattened out in recent months, which should damp import price increases; and, if they conform to the expectations implicit in futures markets, oil prices should level off and then drop back a bit. But the indirect effects of these sorts of price increases are still a potential concern. To contain inflation pressures, upward adjustments to the levels of these prices must not get built into higher inflation expectations. A rise in inflation expectations would induce people to seek protection against an expected erosion of their purchasing power by raising prices and wages even faster. The evidence regarding inflation expectations has been mixed. Since last fall, expectations of inflation over the next year or so have risen notably. However, surveys and readings from financial markets indicate that expectations for inflation rates several years out remain stable; in fact they have not changed materially for several years. People apparently view the near-term changes in inflation as temporary, perhaps associated with rising energy prices. Given that perspective, they are less likely to change their behavior in labor and product markets in ways that perpetuate short-term variations in inflation. Over time, both inflation and inflation expectations will be determined not by adjustments of particular prices but by fundamental factors - the competitive environment in labor and product markets that in turn reflects the extent of resource utilization, and the pace of productivity growth and its effect on costs. The recent news on both fronts suggests that inflation pressures will remain contained, but substantial uncertainty surrounds that outlook. As I noted earlier, resource utilization has risen substantially as the economy has expanded. Naturally, as the margin of underutilized labor and capital is drawn down, some resources - particular skills in labor markets and certain goods and services - come into short supply. But, judging from aggregate measures of wages and labor compensation, the economy is still operating a little below its long-run sustainable level of production. The growth of compensation in 2004 was not much different from that in 2003; some measures registered a little faster growth, some a little slower. These flat compensation gains occurred along with an erosion of purchasing power from rising energy prices and faster increases in the productivity of workers in recent years that, all else being equal, would tend to push up the rate of wage inflation. The fact that compensation gains did not rise under these circumstances suggests that slack in markets provided a countervailing influence, and the utilization of labor could increase at least a little more without creating extensive shortages that would prompt ever-increasing rates of growth of compensation and prices. The amount of labor available to be put back to work as the economy expands is determined not only by the demand for labor but also by the response of its supply. In this regard, we are struggling to understand a major surprise. Despite the recent improvements in job prospects, the percentage of the population either working or looking for work - that is the labor force participation rate - has not yet risen from its recessionary lows. Apparently, the demand for workers has been strong enough to allow many of those actively looking for jobs to find them but not strong enough to pull people back into the labor force who may have dropped out - perhaps for early retirement or additional schooling. Also, some of the trends that we had been seeing for some time - such as the rising participation rate of women - may have recently downshifted, irrespective of the strength of labor demand. The unusual behavior of labor force participation will present a challenge to policymakers. If the workers who dropped out of the labor force during the recession begin returning to it in substantial numbers over the coming year, then considerable gains in output and employment will be associated with little further tightening of the labor market and limited pressures on costs and prices. If, in contrast, the labor market attachment of those out of the labor force is weak, then they will be less likely to seek jobs, which will mean that robust gains in output and employment could be associated with greater scarcity and an appreciable step-up in labor cost pressures. The productivity of labor is another source of uncertainty about how fast the economy can grow on a sustained basis. However, swings in productivity growth are extremely difficult to predict. Productivity growth was very strong through the first half of last year, partly because of delayed efficiency gains from the capital goods boom of the 1990s. One implication of these productivity gains was that, for much of the current expansion, businesses were able to meet increasing sales with management efficiencies rather than with a large number of new hires. Another implication was that unit labor costs of businesses fell, even as the economy was gathering momentum. In the latter half of last year, the growth of output per hour slowed, giving a boost to unit labor costs after two years of declines. Those increases were not large, however, and productivity growth seems to have increased at a good clip in the first quarter of this year. A limited slowdown in productivity growth would not be a major concern. The margin of prices over unit labor costs is high by historical standards, and firms should be able to absorb some increases in labor costs without passing them on in prices. Not that firms would do so voluntarily, of course, but they could be forced to by a competitive economic environment characterized by good profit opportunities. However, a more substantial and permanent slowdown in productivity growth would put continuing upward pressure on costs that firms eventually would need to recover by raising prices more quickly. To some extent, though, the monetary policy response to slower productivity growth also depends on whether or not these changes take businesses and workers by surprise. If they do, demand might also be reduced as capital investment looked less profitable and as households cut back on consumption to match their lower expected earnings over time. Unfortunately, we cannot directly observe some of these critical determinants of inflation - slack in the economy, the intentions of people not in the labor force, or structural productivity growth. We infer them indirectly by analyzing information on costs, prices, compensation, profit margins, and levels of capital and labor utilization compared with history. When the economy is in the early stages of an expansion, these inferences are relatively easy, and we can be confident that aberrations from expectations will soon reverse. That is not where we are now. The unemployment rate is close to what some economists believe to be its lowest sustainable level; capacity utilization in manufacturing is moving closer to its long-term average level; and unit labor costs have begun to creep higher. At this time, the odds are that inflation pressures are contained and will remain so. The behavior of labor compensation, the height of profit margins, and still-strong productivity growth all suggest that workers and businesses continue to face very competitive market conditions and that cost increases will remain in check. But in the current circumstances, we need to be vigilant for signs of persistent upward pressure on costs, a marked tightening of labor and product markets, a reduction in global discipline on domestic pricing decisions, or increases in inflation expectations - especially expectations of price increases over the longer run. Over time, of course, it is monetary policy, conducted while taking account of these indicators of cost and price pressures, that determines the rate of inflation. And that brings me to my last topic. Monetary policy As I already noted, monetary policy is still accommodative, and favorable financial conditions have contributed importantly to solid growth and rising levels of resource utilization. But, over time, this policy stance will not be consistent with keeping inflation down. Interest rates need to rise to forestall a buildup of imbalances between aggregate demand and potential supply that would threaten to raise inflation and undermine stability. The FOMC has said that it believes it can remove policy accommodation gradually. That strategy should be successful if, as I have outlined, growth ahead is moderate and inflation pressures are contained. Such a strategy has advantages. Importantly, the gradual approach should enable us to better gauge the ongoing effects of our actions in an uncertain world - give us more opportunities to assess the effects of past increases in rates when we know that those effects can vary and will occur with a lag - and hence to calibrate our actions better to the needs of the economy. Moreover, to date, announcing that we expect to remove accommodation at a measured pace has not materially impeded market participants from responding meaningfully to incoming data, primarily by extending the anticipated series of gradual rate increases when these data suggested the potential for greater inflation pressures. But I would like to underline an important message from the minutes of our most recent meeting that were released Tuesday. The path of interest rates is not an end in itself - it is a means to an end, which is fulfilling our mandate for maximum employment and stable prices. A measured pace of rate increases is our best guess, for now, of what will accomplish these objectives. But that guess is conditional and contingent on our expectations that the economy will evolve roughly along the lines I have described. Communicating our expectations for policy has been unusual for us. In my view, when it is possible, such communication should help to align expectations better with reality and thereby improve pricing in asset markets and the effectiveness of policy. Some observers have objected because they think our words have removed too much uncertainty from markets, encouraging people to take financial positions that they will regret eventually and, by holding down long-term interest rates, work at cross purposes with firming policy. I believe the performance of the economy, rather than our words, has shaped expectations beyond the very near term. I hope I have conveyed the uncertainties in the outlook and the conditionality of our policy expectations; I know that many of my colleagues have been doing the same thing, and market participants should understand the nature of the chances they are taking. Markets price best if they take account not only of the most likely outcome but also of the risks of alternative developments - that is how we behave in central banking. We central bankers are by nature a gloomy lot, trained to focus on what could go wrong; avoiding really bad outcomes helps to shape our policy, and a dose of central banker-like risk assessment is also good advice for investors. A time will come when we cannot provide guidance about our policy intentions because we ourselves will not be confident about the strategy that will be needed. Even then, indicating the uncertainty of policymakers and our assessment of the major threats to sustained good economic performance might prove helpful to the public. In the meantime, all should understand that the guidance we do provide cannot and will not deflect us from changing our strategy whenever we believe doing so to be necessary to meet our objectives.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Canisius College Richard J Wehle School of Business Community Business Luncheon, Buffalo, New York, 18 April 2005.
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Susan Schmidt Bies: The economy and managing personal finances Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Canisius College Richard J Wehle School of Business Community Business Luncheon, Buffalo, New York, 18 April 2005. * * * I am very pleased to join you. Today I want to begin with a brief assessment of the economic outlook before discussing financial conditions of businesses and households in more detail. Then, I will turn to some issues related to the management of personal credit and savings and the greater need that consumers have to improve their understanding of financial services and providers as the financial marketplace has expanded. I also need to add that I am expressing my own opinions, which are not necessarily those of my colleagues on the Board of Governors or on the Federal Open Market Committee. The economic outlook As you know, the economy has been expanding at a solid pace lately. Real gross domestic product grew at an annual rate of 3-3/4 percent in the fourth quarter and growth in the first quarter looks to have remained solid. Labor markets have continued to improve, albeit at a slow pace, with private nonfarm payroll employment posting moderate gains in 2004 and in the first three months of this year. Business outlays for capital equipment grew robustly in the past two quarters. Consumer spending also has continued to expand, although higher energy prices may be crimping household purchases recently. Consumer and business confidence remain favorable, despite a slight dip in consumer sentiment in early April, and, with accommodative financial conditions, I expect that the economy will continue to expand at a solid pace this year. On the inflation front, broad measures of consumer inflation have risen somewhat faster than they did in the year-earlier period, boosted by higher energy prices. Focusing on the core price index, which excludes food and energy, it too has been a bit higher than it was the year before, likely reflecting the indirect effects of rising energy prices and the falling dollar. Productivity is slowing from its exceptional pace of the past couple years and unit labor costs are again increasing. Though inflation pressures have risen somewhat in recent months, longer-term inflation expectations appear to have remained well contained. I believe that, while underlying inflation is expected to continue to be low, the Federal Reserve must be more alert to monitoring incoming data, and continue to remove policy accommodation at a measured pace, consistent with the incoming data and its commitment to maintain price stability. Financial conditions of businesses Business expansion solidified last year and continued growth by businesses will depend in part on their financial conditions. So let me take a few minutes to review the financial position of the business sector, and especially the dramatic improvement from a few years ago. Since 2001, firms have improved their balance sheet liquidity, reduced leverage, and restructured their liabilities, responding in part to investors’ concerns arising from some high-profile unanticipated meltdowns in the early part of this decade. In addition, firms have significantly cut costs through dramatic gains in productivity, which has boosted profits. In my view, even with a rise in interest rates and some moderation in profit growth, the business sector should remain financially strong and continue to expand. The improvement in corporate balance sheets in the past few years has been substantial. Most noteworthy are the gains achieved in balance sheet liquidity. Firms have taken advantage of low longterm interest rates to pay down short-term debt with longer-maturity debt. At the same time, firms have built up their cash positions to extraordinary levels. At the end of last year, the ratio of cash and equivalents to short-term debt at nonfinancial corporations stood at about twice its average level since the 1950s. In addition, many firms have taken advantage of low long-term interest rates to refinance high-cost debt, and others have used profits from operations or asset sales to retire debt. As a result, interest expense burdens have declined on balance and nonfinancial corporate debt has grown only modestly in recent years, its slowest pace since the early 1990s. These repairs to balance sheets have also reduced the exposure of many firms to rising interest rates, especially in the near term. In particular, the replacement of short-term debt by long-term bonds means that less debt will have to be rolled over in the near term at higher rates. In addition, because much of the long-term debt has a fixed rate, interest payments typically are unaffected over the life of the bond. Moreover, research by the Board staff suggests that firms that rely more on floating-rate debt, and for that reason might be more vulnerable to rising rates, have in recent years tended to use derivatives to hedge some of their exposure to interest rate risk. Thus, for many firms, the effect of rising interest rates will be mitigated and spread out over time. Also, as we learned from the episode of policy tightening in 1994, rising interest rates have little detrimental effect on the financial health of the corporate sector when the rate increases occur in the context of an expanding economy. Indeed, corporate credit quality improved on balance after 1994 with the pickup in economic activity and corporate profits. Some of the improvement in financial conditions among businesses is due to significant belt-tightening by many firms. Over the past few years, the drive to cut costs and boost efficiency has generated rapid productivity gains. Fuller utilization of the capabilities of capital already in place, ongoing improvements in inventory management, and streamlined production processes requiring fewer workers, to name but a few examples of efficiency enhancements, have boosted corporate profitability. The pickup in revenue growth since mid-2002, combined with outsized productivity gains, has produced a dramatic recovery in overall corporate profitability. The profits of nonfinancial corporations as a share of sector output continued to climb and reached almost 12 percent in the fourth quarter of last year, up from its cyclical trough of 7 percent in 2001. This share lies well above its long-run average over the past few decades. To be sure, the profit share likely will slip a bit from its high level as the expansion gains steam and businesses hire new workers more aggressively. But some decline in the profit share is to be expected and will not, in my view, significantly impair the financial health of companies. This favorable view is reflected in risk spreads on corporate bonds and credit default swaps, which have dropped dramatically from their historic highs in the fall of 2002. Household financial conditions In the household sector, some analysts have expressed concern about the rapid growth in household debt in recent years and the decline in the household saving rate. They fear that households have become overextended and will need to rein in their spending to keep their debt burdens under control. My view is considerably more sanguine. Although pockets of financial stress exist among households, the sector as a whole appears to be in good shape. It is true that households have taken on quite a bit of debt over the past several years. According to the latest available data, total household debt grew at an annual rate of about 10 percent between 1999 and 2004; in comparison, after-tax household income increased at a rate of about 5 percent over this period. This rapid growth in household debt largely reflects a surge in mortgage borrowing, which has been fueled by historically low mortgage interest rates, strong growth in house prices, and an increasing share of households owning their home rather than renting. Indeed, many homeowners have taken advantage of low interest rates to refinance their mortgages, some having done so several times over the past couple years. Survey data suggest that homeowners took out cash in more than one-half of these “refis,” often to pay down loans having higher interest rates. On net, the resulting drop in the average interest rate on household borrowings, combined with the lengthening maturity of their total debt, has damped the monthly payments made by homeowners on their growing stock of outstanding debt. The Federal Reserve publishes two data series that quantify the burden of household obligations. The first series, the debt-service ratio, measures the required payments on mortgage and consumer debt as a share of after-tax personal income. The second series, the financial-obligations ratio, is a broader version of the debt-service ratio that includes required household payments on rent, auto leases, homeowners insurance, and property taxes. Both ratios rose during the 1990s, and both reached a peak in late 2002. Since then, however, the debt-service ratio has been stable and the financial obligations ratio has receded a bit, an indication that households, in the aggregate, have been keeping an eye on their financial commitments. Consistent with these patterns, delinquency rates for a wide range of household loans either have drifted down over the past year or held about steady at levels below recent highs. The low interest rates of the past few years, however, will give way as the economy continues to expand, and we have already seen an increase in mortgage rates and on some other consumer loans during this past year. To be sure, some households will be pressured by the higher rates, but I believe that concerns about their effect on repayment burdens can be overstated. First, most household debt mortgage and consumer debt combined - carries a fixed interest rate, which slows the adjustment of interest costs to rising rates. Second, although interest rates on some variable-rate loans will rise quickly, the adjustment for a large number of variable-rate loans could occur rather slowly. For example, many adjustable-rate mortgages start off with a fixed rate for several years, providing households with some protection from rising rates. Another concern is that house prices will reverse and erase a considerable amount of home equity built up in recent years. Recent gains in house prices have been notable: the average house price rose 11 percent in 2004, and cumulative gains since 1997 now top 65 percent.1 Despite a rise in mortgage debt, the current loan-to-value ratio for outstanding mortgages is estimated to be around 45 percent, roughly the level that has prevailed since the mid-1990s. It is true that some households have considerably less equity in their homes, and these households tend to have lower income and fewer other financial assets to cushion shocks. Based on the 2001 Survey of Consumer Finances (SCF), a small share, 7 percent, of households had a loan-to-value ratio of 90 percent or more. Unfortunately, we cannot characterize the current share as accurately, at least not until the 2004 survey becomes available later this year, but it is unlikely that the share has risen by a lot. While new originations of mortgages with high loan-to-value ratios in recent years would push this share up, the substantial house price appreciation in that same period likely improved the financial positions of the households with high loan-to-value ratios in 2001. However, we are beginning to see signs that housing prices may be reaching a peak in some markets. An increasing share of new mortgages is being taken out by investors rather than by occupants of the property. Some borrowers are stretching to buy their new homes using adjustable-rate, interest-only mortgages. Not only will these households face higher monthly payments as interest rates rise, they are also not building equity in their homes as quickly as they would with a traditional amortizing mortgage. Some analysts have also expressed concerns about the decline in the personal saving rate. Aggregate personal saving, measured by the Bureau of Economic Analysis, averaged just above 1 percent of disposable income in 2004, more than 6 percentage points lower than the average that has prevailed since the early 1960s. The saving rate, measured by the Board’s flow of funds accounts, is higher, at 4 percent of disposable income, though it, too, is significantly lower than its average level in the past. Analysis by Board staff using data from the SCF indicate that households in the top income quintile can account for nearly all of the decline in the aggregate saving rate since 1989. Given that these higher-income households have more financial resources to weather shocks, the significant decline in savings is less troublesome than if it had occurred in the lower part of the income distribution. This comparison points out two different perspectives on household financial health. While analysts usually focus on the saving rate as a share of current income and funds flow, some argue that a more relevant measure of saving adequacy is not the portion of current income set aside for saving but rather the change in net worth. And in this regard, the picture of household saving looks more favorable than suggested by the saving rate. The ratio of net worth-to-disposable income has come down from its peak in 2000, but remains at a high level relative to the past few decades, because capital appreciation on household assets, such as equities and real estate, has considerably outpaced income gains. This is a passive perspective on savings, though, where households rely on the markets to raise the value of their assets over time. But, to create these assets, households need to consistently set aside some of their current earnings to invest for their future needs. While the experience of the past few years of exceptionally low interest rates and lower expected stock returns encouraged a rational consumer to spend and not save, as the markets return to more long-term trends, we should see consumers moderate their behavior as well. Office of Federal Housing Enterprise Oversight House Price Index. Managing personal finances I now want to turn from an aggregate view of household finances to savings and credit at the individual level. In particular, I want to discuss issues relating to managing personal finances, including managing personal credit and saving for retirement, and the special importance of financial education. College graduates preparing to enter the labor force will soon assume a new level of responsibility for managing their finances. Personal financial management includes the strategic use of both credit and savings to enhance asset accumulation and financial well being. Just as the choices that students have made regarding their education play a vital role in determining career opportunities, the decisions they make and behaviors they establish regarding financial management in the coming years will also impact future opportunities and their ability to capitalize on them. Compared to a generation ago, the financial marketplace of today is significantly more complex. There is now an extensive range of consumer financial products and services, and providers of these goods and services. Advances in communications technologies and other technological tools have dramatically broadened the provision of financial services. For example, the development of sophisticated credit-scoring models permits lenders to more efficiently evaluate credit risk and underwrite loans and thus provide a broader array of loans to more closely meet the specific financial needs of different consumers. In addition, as workers have become more mobile and more likely to change jobs several times over the course of their careers, they have increased their demand for retirement savings vehicles that are portable and have benefits that are less tied to longevity at a single firm. These developments have increased the opportunity for consumers to build their asset base through education and home ownership, exercise greater control over their retirement savings, as well as acquire at lower cost the goods and services that enhance daily life. With this increased access and availability of financial products, consumers also have to assume greater personal responsibility for managing the use of credit and their financial outcomes. As I have already noted, in the aggregate, household debt has grown more rapidly than income in recent years. Of special relevance to this audience is that the increase in consumer debt loads in recent years is particularly apparent among younger adults. The majority of this increase is attributable to student loans, with a 2002 survey by Nellie Mae indicating a 66 percent increase in the average undergraduate student loan debt from 1997.2 Credit card debt is another factor contributing to the increased level of debt among young adults. The Survey of Consumer Finances (SCF) data shows that 18-to-24 year olds experienced on average about a 100 percent increase in credit card debt between 1992 and 2001, albeit from a small base, but still substantially higher than the rate for other households.3 Moreover, there are indications that some of these younger households are having difficulty managing their debt successfully. The 2001 SCF indicates that delinquency rates (one debt payment more than 60 days past due) were twice as high among households headed by someone less than 35 years old than for households in the 35-to-44-year age group.4 Finally, surveys continue to indicate that many workers are not currently saving for retirement, and many that are saving, by their own calculations, are not saving enough.5 Clearly, these statistics are sobering and raise some concerns about financial security. In recognition of the reality of both the promises and pitfalls of the consumer finance market, there has been a heightened appreciation for consumer protection. Lawmakers and regulators are mindful of the possibility of abusive and fraudulent credit practices, commonly known as predatory lending, and have undertaken efforts to thwart such activity. In addition, employers have adopted strategies through plan design and education programs to encourage retirement savings of its workers. But consumers cannot rely solely on the efforts of others for financial security. They need to develop an understanding of the available options and be able to comprehend the implications of their financing and savings decisions. National Student Loan Survey - College on Credit: How Borrowers Perceive their Education Debt Results of the 2002 National Student Loan Survey, February 2003. Draut, Tamara and Silva, Javier,“Generation Broke: The Growth of Debt Among Young Americans,” Demos: A Network for Ideas and Action, October 2004. Aizcorbe, Ana; Kennickell, Arthur, and Moore, Kevin, “Recent Changes in U.S. Family Finances: Evidence from the 1998 and 2001 Survey of Consumer Finances,” January 2003. Employee Benefit Research Institute,“Will Americans Ever Become Savers? The 14th Retirement Confidence Survey, 2004,” April 2004. Indeed, lawmakers, regulators, and employers look to consumer savvy to promote efficiency in the consumer financial services industry. In recent years, surveys and other studies that evaluate the understanding of financial concepts have demonstrated the need for improved financial education, especially among younger consumers. One nonprofit organization dedicated to increasing financial education for youth, the Jump$tart Coalition, has conducted a survey of financial literacy of high school seniors every two years since 1997. Overall, the results have been disappointing: Results from the 2004 survey showed more than 65 percent of students failed the survey’s questionnaire, with only 6 percent scoring a “C” or better. In terms of credit card usage by college students, a Government Accountability Office (GAO) study found that students were more likely than other borrowers to run up debts they could not pay because of financial inexperience. In recognition of this behavior, many credit card issuers provided access to financial education materials, and debt counseling services for students who faced repayment difficulties, but the GAO did not try to determine the effectiveness of these education efforts.6 Some preliminary research by others suggests some possible benefits from online credit education tutorials to college student cardholders, but it is possible that more responsible usage only reflects the type of student who would participate in the tutorial.7 Clearly, more research is needed to assess the efficacy of consumer education, and the Federal Reserve System has been an active promoter. In fact, the System hosted a conference in early April on consumer financial awareness, including a session on the efficiency of delivering financial education to consumers. So what resources are available to consumers to help them become sufficiently familiar with financial concepts to make sound financial decisions? Many public, private, and nonprofit organizations have developed a variety of financial education programs, and many are available on the Internet. These educational materials address the full range of personal financial management, from the essential fundamentals of creating a budget and defining specific savings plans to understanding more complex transactions, such as applying for mortgage credit. Valuable information on consumer protection matters is also available, concerning the rights of consumers if a credit or ATM card is stolen or if they are a victim of identity theft. Similarly, many federal agencies publish a variety of consumer protection and financial education materials. In fact, the Federal Reserve System offers a wide variety of consumer information relating to financial services on its web site. In addition, the Federal Reserve launched a national personal financial education campaign in 2001 to promote the importance of financial education, as well as to provide support for the wide variety of resources committed to this topic. In addition, in recognition of the importance of financial education, Congress established the Financial Literacy and Education Commission in 2003. This Commission, headed by the Treasury Department, is composed of the heads of twenty federal agencies, including the Federal Reserve Board, to encourage collaboration and coordination of government and private-sector efforts to promote financial literacy. The Commission is also charged with establishing a web site and toll-free number for obtaining financial education resources offered by the government resources, as well as for developing a national strategy for promoting financial literacy and education. Under the direction of the Treasury Department, interagency task forces have worked to streamline access to the wide variety of consumer information and financial education materials offered by government agencies. These resources are available on the Internet at www.mymoney.gov. Consumers can also call 1-888MYMONEY to obtain a tool kit of financial education information that can assist them in understanding credit, savings, and investment products before they become obligated, and provide a foundation for shopping for financial products and providers that are most appropriate for their circumstances and needs. By obtaining a firm grasp of the fundamentals of financial management, consumers can create savings and spending plans that are compatible with their earnings throughout their lives and that help them meet their short- and long-term life goals. Turning to retirement savings in particular, workers entering the labor force today will bear more of the risk of financial security later in life than workers of a generation ago. Far fewer workers will be covered by defined-benefit pension plans established by their employers, which provide pre-set “College Students and Credit Cards,” (1,082KB PDF) Government Accountability Office, June 2001. Kimberly Gartner and Richard M. Todd (2005),“Effectiveness of Online ‘Early Intervention’ Financial Education for Credit Card Holders,”(303KB PDF) presented at Federal Reserve System Community Affairs Research Conference, April 7-8, 2005. benefits after retirement. Data from the SCF indicate that among workers with a retirement savings plan, nearly 60 percent of workers aged 25 to 34 were covered by a defined-benefit plan in 1989; by 2001, this share had declined to 31 percent. Instead the vast majority of employees with retirement benefits will be offered the opportunity to contribute to a defined-contribution pension plan, most likely a 401(k) plan, which allows workers to take their retirement assets with them as they change jobs over the course of their careers. Under a typical 401(k) plan, retirement wealth will depend primarily on workers’ own contributions, often supplemented with some matching contributions by the employer, returns realized on the investments chosen, and what workers choose to do with balances when they change jobs. However, studies have found some troubling patterns related to individual savings in 401(k) plans that suggest that workers may not be giving adequate attention to their retirement savings. First, despite the tax advantages of 401(k) contributions, one-quarter of workers eligible for 401(k) plans do not participate at all, even if the employer would match a portion of their own contributions.8 These workers are effectively giving up a pay raise. And among those that contribute, many save just a little. In a survey last year, one-quarter of firms reported that their rank-and-file 401(k) participants saved an average of less than 4 percent of pay.9 Another concern relates to the way employees manage their 401(k) plans. Some participants simply invest contributions equally across the investment options or according to plan defaults, which in many cases is a low-risk, low-return money market fund.10 And, as has been publicized widely in recent years, many 401(k) participants invest heavily in employer stock. Among companies that offer company stock as an investment option, more than one-quarter of 401(k) balances are in company stock.11 This high concentration cannot be attributed entirely to an employer match that is required to be held in company stock. Instead, employees appear to voluntarily purchase and hold abundant amounts of company stock, despite the obvious risk of linking their current income and retirement wealth to the financial health of their employer. These patterns are troubling because they raise doubts about the financial security of workers in later life. Fortunately, new research in the discipline of behavioral finance provides some important insights into the behavior of 401(k) participants and suggests some promising changes that can lead workers to make savings choices that will leave them better prepared for retirement. Contrary to predictions of traditional finance theory, the way the retirement-plan options are framed affects the choices made by participants. Researchers have found that “opt-out” plans - those that automatically enroll workers unless they actively choose not to enroll - have substantially higher participation rates than plans in which employees must take the initiative to opt in.12 Moreover, when defaults are designated, many workers tend to enroll using the default contribution rates and investment options and to leave these in place for many years after enrollment, even though the default may be set too low to allow for the accumulation of sufficient retirement assets.13 If workers are influenced by how choices are offered, then employers can make changes to the plans to help participants make better decisions. For example, employers might set default contribution rates to rise as workers receive pay raises, or set the default investment option to a diversified portfolio that adjusts as the worker ages.14 In addition, employees have increasingly expressed interest in employer-provided financial education, and firms and lawmakers are responding. Congress has Deloitte and Touche, 2003 401(k) Annual Benchmarking Survey.(398KB PDF) Deloitte and Touche, 2003 401(k) Annual Benchmarking Survey. Nellie Liang and Scott Weisbenner (2001), “Investor Behavior and Purchase of Company Stock in 401(k) Plans The Importance of Plan Design,” FEDS Working Paper 2002-36 and NBER Working Paper W9131; James Choi, David Laibson, Brigitte Madrian, and Andrew Metrick (2001), “For Better or for Worse: Default Effects and 401(k) Savings Behavior,” NBER Working Paper W8651. Sarah Holden and Jack VanDerhei (2004),“401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2003,” ICI Perspective (August). Brigitte Madrian and Dennis Shea (2001),“The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior,” Quarterly Journal of Economics. James Choi, David Laibson, and Brigitte Madrian (2004),“Plan Design and 401(k) Plan Savings Outcomes,” NBER Working Paper W10486. Shlomo Benartzi and Richard Thaler (2004), “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving,” Journal of Political Economy. passed legislation that makes it easier for firms to provide investment advice with less fear of being held liable should such advice lead to losses. Some firms have started to provide access to a thirdparty who will advise employees about how much to contribute and how to invest their contributions. Moreover, a recent study by the Employee Benefit Research Institute (EBRI ) suggests that education about retirement planning provided by employers led to a substantial portion of employees altering their retirement savings. In closing, as credit availability and financial alternatives continue to expand, it has become ever-more important for consumers to develop the skills necessary to make informed financial choices. I encourage prospective graduates to place the same priority and attention to managing their personal finances as they do to developing their careers. Beginning early and remaining committed to thoughtful management of personal finances throughout one’s life is an essential element to long-term financial success.
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Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Budget Committee, US Senate, Washington DC, 21 April 2005.
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Alan Greenspan: Budget process reforms Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Budget Committee, US Senate, Washington DC, 21 April 2005. * * * Mr. Chairman, Senator Conrad, and members of the Committee, I am pleased to be here today to offer my views on the federal budget and related issues. I want to emphasize that I speak for myself and not necessarily for the Federal Reserve. The U.S. economy delivered a solid performance in 2004, and thus far this year, activity appears to be expanding at a reasonably good pace. However, the positive short-term economic outlook is playing out against a backdrop of concern about the prospects for the federal budget, especially over the longer run. Indeed, the unified budget ran a deficit equal to about 3-1/2 percent of gross domestic product in fiscal 2004, and federal debt held by the public as a percent of GDP has risen noticeably since it bottomed out in 2001. To be sure, the cyclical component of the deficit should narrow as the economic expansion proceeds and incomes rise. And the recent pace of the ramp-up in spending on defense and homeland security is not expected to continue indefinitely. But, as the latest projections from the Administration and the Congressional Budget Office suggest, our budget position is unlikely to improve substantially in the coming years unless major deficit-reducing actions are taken. In my judgment, the necessary choices will be especially difficult to implement without the restoration of a set of procedural restraints on the budget-making process. For about a decade, the rules laid out in the Budget Enforcement Act of 1990 and in the later modifications and extensions of the act provided a framework that helped the Congress establish a better fiscal balance. However, the brief emergence of surpluses in the late 1990s eroded the will to adhere to these rules, which were aimed specifically at promoting deficit reduction rather than at the broader goal of setting out a commonly agreed-upon standard for determining whether the nation was living within its fiscal means. Many of the provisions that helped restrain budgetary decisionmaking in the 1990s - in particular, the limits on discretionary spending and the PAYGO requirements - were violated ever more frequently; finally, in 2002, they were allowed to expire. Reinstating a structure like the one provided by the Budget Enforcement Act would signal a renewed commitment to fiscal restraint and help restore discipline to the annual budgeting process. Such a step would be even more meaningful if it were coupled with the adoption of a set of provisions for dealing with unanticipated budgetary outcomes over time. As you are well aware, budget outcomes in the past have deviated from projections - in some cases, significantly - and they will continue to do so. Accordingly, a well-designed set of mechanisms that facilitate midcourse corrections would ease the task of bringing the budget back into line when it goes off track. In particular, you might want to require that existing programs be assessed regularly to verify that they continue to meet their stated purposes and cost projections. Measures that automatically take effect when costs for a particular spending program or tax provision exceed a specified threshold may prove useful as well. The original design of the Budget Enforcement Act could also be enhanced by addressing how the strictures might evolve if and when reasonable fiscal balance came into view. I do not mean to suggest that the nation's budget problems will be solved simply by adopting a new set of rules. The fundamental fiscal issue is the need to make difficult choices among budget priorities, and this need is becoming ever more pressing in light of the unprecedented number of individuals approaching retirement age. For example, future Congresses and Presidents will, over time, have to weigh the benefits of continued access, on current terms, to advances in medical technology against other spending priorities as well as against tax initiatives that foster increases in economic growth and the revenue base. Because the baby boomers have not yet started to retire in force, we have been in a demographic lull. But this state of relative stability will soon end. In 2008 - just three years from now - the leading edge of the baby-boom generation will reach 62, the earliest age at which Social Security retirement benefits can be drawn and the age at which about half of those eligible to claim benefits have been doing so in recent years. Just three years after that, in 2011, the oldest baby boomers will reach 65 and will thus be eligible for Medicare. Currently, 3-1/4 workers contribute to the Social Security system for each beneficiary. Under the intermediate assumptions of the program's trustees, the number of beneficiaries will have roughly doubled by 2030, and the ratio of covered workers to beneficiaries will be down to about 2. The pressures on the budget from this dramatic demographic change will be exacerbated by those stemming from the anticipated steep upward trend in spending per Medicare beneficiary. The combination of an aging population and the soaring costs of its medical care is certain to place enormous demands on our nation's resources and to exert pressure on the budget that economic growth alone is unlikely to eliminate. To be sure, favorable productivity developments would help to alleviate the impending budgetary strains. But unless productivity growth far outstrips that embodied in current budget forecasts, it is unlikely to represent more than part of the answer. Higher productivity does, of course, buoy revenues. But because initial Social Security benefits are influenced heavily by economywide wages, faster productivity growth, with a lag, also raises benefits under current law. Moreover, because the long-range budget assumptions already make reasonable allowance for future productivity growth, one cannot rule out the possibility that productivity growth will fall short of projected future averages. In fiscal year 2004, federal outlays for Social Security, Medicare, and Medicaid totaled about 8 percent of GDP. The long-run projections from the Office of Management and Budget suggest that the share will rise to approximately 13 percent by 2030. So long as health-care costs continue to grow faster than the economy as a whole, the additional resources needed for these programs will exert intense pressure on the federal budget. Indeed, under existing tax rates and reasonable assumptions about other spending, these projections make clear that the federal budget is on an unsustainable path, in which large deficits result in rising interest rates and ever-growing interest payments that augment deficits in future years. But most important, deficits as a percentage of GDP in these simulations rise without limit. Unless that trend is reversed, at some point these deficits would cause the economy to stagnate or worse. The broad contours of the challenges ahead are clear. But considerable uncertainty remains about the precise dimensions of the problem and about the extent to which future resources will fall short of our current statutory obligations to the coming generations of retirees. We already know a good deal about the size of the adult population in, say, 2030. Almost all have already been born. Thus, forecasting the number of Social Security and Medicare beneficiaries is fairly straightforward. So too is projecting future Social Security benefits, which are tied to the wage histories of retirees. However, the uncertainty about future medical spending is daunting. We know very little about how rapidly medical technology will continue to advance and how those innovations will translate into future spending. Consequently, the range of possible outcomes for spending per Medicare beneficiary expands dramatically as we move into the next decade and beyond. Technological innovations can greatly improve the quality of medical care and can, in some instances, reduce the costs of existing treatments. But because technology expands the set of treatment possibilities, it also has the potential to add to overall spending - in some cases, by a great deal. Other sources of uncertainty - for example, the extent to which longer life expectancies among the elderly will affect medical spending may also turn out to be important. As a result, the range of future possible outlays per recipient is extremely wide. The actuaries' projections of Medicare costs are, perforce, highly provisional. These uncertainties - especially our inability to identify the upper bound of future demands for medical care - counsel significant prudence in policymaking. The critical reason to proceed cautiously is that new programs quickly develop constituencies willing to fiercely resist any curtailment of spending or tax benefits. As a consequence, our ability to rein in deficit-expanding initiatives, should they later prove to have been excessive or misguided, is quite limited. Thus, policymakers need to err on the side of prudence when considering new budget initiatives. Programs can always be expanded in the future should the resources for them become available, but they cannot be easily curtailed if resources later fall short of commitments. I fear that we may have already committed more physical resources to the baby-boom generation in its retirement years than our economy has the capacity to deliver. If existing promises need to be changed, those changes should be made sooner rather than later. We owe future retirees as much time as possible to adjust their plans for work, saving, and retirement spending. They need to ensure that their personal resources, along with what they expect to receive from the government, will be sufficient to meet their retirement goals. Crafting a budget strategy that meets the nation's longer-run needs will become ever more difficult the more we delay. The one certainty is that the resolution of the nation's unprecedented demographic challenge will require hard choices and that the future performance of the economy will depend on those choices. No changes will be easy. All programs in our budget exist because a majority of the Congress and the President considered them of value to our society. Adjustments will thus involve making tradeoffs among valued alternatives. The Congress must choose which alternatives are the most valued in the context of limited resources. In doing so, you will need to consider not only the distributional effects of policy changes but also the broader economic effects on labor supply, retirement behavior, and national saving. The benefits to taking sound, timely action could extend many decades into the future.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the Economics Club of the University of North Carolina at Chapel Hill, Chapel Hill, North Carolina, 20 April 2005.
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Roger W Ferguson, Jr: US current account deficit - causes and consequences Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the Economics Club of the University of North Carolina at Chapel Hill, Chapel Hill, North Carolina, 20 April 2005. * * * I would like to address an issue that is receiving increasing attention lately: the U.S. current account deficit. Not since joining the Federal Reserve Board have I seen this topic show up in the financial press as frequently - and so often with such ominous overtones - as it does these days. Several reasons for this come to mind. Most obviously, at about 6 percent of gross domestic product, the current account deficit is now larger than it has ever been in our nation's history; that, by itself, attracts attention. Also, because the current account deficit reflects the excess of our country's imports over our exports, the deficit's descent into record territory has helped crystalize fears that the economy is losing competitiveness and that U.S. jobs and incomes are suffering as a result. Finally, the larger the current account deficit becomes, the greater the number of observers who believe that a correction, and one with significant implications for the U.S. economy, is imminent. Such expectations have contributed to, and in turn have been reinforced by, the slide in the dollar over the past few years. Although views differ as to when a correction will take place, nearly all agree that the current trajectory of the U.S. current account deficit is unsustainable. This consensus reflects the simple logic that the deficit is causing the net indebtedness of the U.S. economy to rise more rapidly than U.S. income. In 1985, our foreign assets were about equal to our foreign liabilities, so that our net international investment position was roughly zero. By 1995, our investment position had deteriorated to negative 4 percent of GDP, and by 2004, we estimate this negative position to have reached about one-fourth of GDP. If current account deficits continue to boost the negative international investment position, eventually the cost of servicing that position, which so far has been quite modest, would rise to an unsustainable level. Obviously, the current account would have to adjust to ensure that excessive debt burdens are not maintained. If nearly all observers agree that an adjustment of the U.S. current account deficit is inevitable, few agree on when the adjustment will occur and what will cause it to happen. Many argue that U.S. households must raise to a more prudent level a saving rate that has fallen to less than 3 percent of disposable income in recent years. Others place the onus of adjustment on foreign economies to boost lackluster domestic demand and increase their purchases of U.S. exports. While some call upon coordinated governmental action to address the pattern of global external imbalances, others place their faith in market mechanisms to do the job. A large part of the reason that people disagree about what will be needed to bring about current account adjustment is that they disagree about what has led the deficit to become so large in the first place. If one believes that the expansion of the current account deficit has been caused by government policies, such as budget deficits, then it is natural to identify a reversal of those policies as the action that will bring about current account adjustment. Conversely, if the current account deficit primarily reflects developments in the private sector, it is more likely that the marketplace will be the source of subsequent correction. Surprisingly, researchers have made relatively few attempts to assess and compare the full range of explanations that have been proposed for the emergence of the large U.S. external deficit.1 In my remarks today, I would like to survey some of the factors that have been put forward to explain the deficit. As I do so, I will be referring to several macroeconomic model simulations, implemented by my colleagues on the Federal Reserve Board's staff, that are designed to gauge the impact of these factors on the U.S. external imbalance. The proposed causes of the deficit are by no means mutually exclusive, of course. It is possible and even likely that the deficit is the outcome of several different Analyses of the widening of the deficit include, among others, Catherine L. Mann (2002), "Perspectives on the U.S. Current Account Deficit and Sustainability," Journal of Economic Perspectives, vol. 16 (Summer), pp.131-52; and Nouriel Roubini and Brad Setser (2004), "The U.S. as a Net Debtor: The Sustainability of the US External Imbalances," (679 KB PDF) unpublished paper. developments. I should also note at the outset that the views I will express are my own and do not necessarily reflect those of my colleagues in the Federal Reserve System. Approaches to characterizing the current account Before getting to these explanations, however, I'd like to take a few moments to clear up what - for some, at least - has been a prominent source of confusion. At least three approaches characterize the current account balance, and each of them shines the spotlight on different factors that may be influential. Perhaps most commonly, the current account balance is portrayed as the difference between a nation's exports, broadly defined, and its imports. From this perspective, the determinants of the current account balance are roughly the same as the determinants of the trade balance: exchange rates, prices, and incomes at home and abroad. Accordingly, the widening of the U.S. current account deficit is frequently attributed to the strengthening of the dollar since the mid-1990s, which led U.S. imports to be cheaper measured in dollars and U.S. exports to be more expensive in foreign currency. According to a second perspective, the current account balance is defined as the difference between a nation's saving and its investment. This definition highlights the decline in the ratio of national saving to GDP over the past ten years, even as investment rates have moved up a bit on balance, as the central cause of the widening of the U.S. current account deficit. Finally, because any excess of national spending over income must be financed by foreigners, the current account deficit is equivalent to the net inflow of capital from abroad. This approach points to the surge of capital inflows into our economy as the key development underlying the emergence of the large external deficit. These three approaches - the trade balance, the saving-investment balance, and net capital inflows might, at first blush, appear to attribute the emergence of the large U.S. current account deficit to highly distinct factors. In reality, however, these approaches are merely three alternative means of characterizing the outcomes of the same underlying, fundamental developments. To see this more concretely, consider, for example, the effects of a rise in investor perceptions of the rate of return on investment in the United States. The rise will likely attract foreign capital inflows. It may also lead to a strengthening of the dollar, thereby weakening exports and strengthening imports. Finally, through various channels, the rise in the perceived rate of return may boost the investment rate and lower the saving rate. In this example, the fundamental shock causing the current account deficit to widen is the change in investor expectations. The other elements of the story - the inflow of capital, the strengthening of the dollar, and the movements in saving and investment rates - represent diverse aspects of the economy as they respond to that initial shock and lead, ultimately, to the larger deficit. The story can be played out using any of the three approaches to the current account that I have reviewed. To be sure, some approaches may be more helpful in highlighting certain types of shocks than others. But any compelling explanation of the current account deficit must identify not merely the proximate influences on the deficit - be they exchange rates, capital flows, or aggregate saving and investment - but also the fundamental, underlying sources of the imbalance. Explanations for the large U.S. current account deficit I would like now to address five different explanations for the large U.S. current account deficit, and even these do not exhaust the possibilities. The first three explanations focus primarily on domestic developments: the fiscal deficit, an autonomous drop-off in private saving rates, and the surge in productivity growth. The remaining explanations encompass developments abroad as well: the slowdown in foreign demand and the apparent rise in global financial intermediation. I will not discuss yet another factor that undoubtedly has contributed to the widening of the deficit - the rise in oil prices but it is worth noting that our oil import bill has risen by about $110 billion, from $68 billion in 1999 to $180 billion in 2004, and most of this increase reflects higher oil prices. 1. Expansion of the fiscal deficit The view that the current account deficit arises from the widening U.S. budget deficit has received considerable attention of late and recalls the discussion of the mid-1980s, when the simultaneous emergence of fiscal and current account deficits in the United States gave rise to the "twin deficits" hypothesis. The simplest version of this hypothesis starts with the identity that the current account balance is equal to saving minus investment. Since the expansion of the fiscal deficit lowered public saving, the story runs, it must have lowered national saving and thus widened the current account balance to a similar extent. This version of the story is a bit too simple, however, as it assumes that private saving and investment remain constant, whereas in reality these quantities can and probably will change in response to a change in the fiscal balance. In the more sophisticated version of the story, a larger fiscal deficit boosts domestic demand, pushing up domestic interest rates relative to foreign rates; this, in turn, attracts investors and raises the value of the dollar, thereby leading to a larger current account deficit. In theory, the fiscal explanation of the current account deficit is entirely plausible. In practice, however, the support for this proposition is weak. The United States has had episodes in which the fiscal and current account balances moved together, but it has also had episodes in which they diverged. Most notably, the fiscal factor cannot explain the widening of the trade deficit in the late 1990s, when the U.S. budget moved into surplus. At the international level, countries such as Japan and Germany are running large current account surpluses even as their budget balances are substantially in deficit. More generally, research into the determinants of current account balances has produced only mixed support for the linkage between fiscal and current account deficits.2 Why don't the reductions in public saving associated with widening fiscal deficits lead more consistently to higher current account deficits? Most likely, larger budget deficits increase the government's draw on available credit and dampen private consumption and investment spending, thereby limiting the deterioration of the current account. This explanation is supported by a simulation of the Federal Reserve Board staff's macroeconomic model, to which I alluded earlier. The results of this simulation, depicted in figure 1, suggest that, compared with a scenario in which no fiscal expansion had taken place, the loosening of fiscal policy since 2001 boosted the rate of private saving and lowered the rate of private investment. Accordingly, the effect on the trade deficit is estimated to have been fairly small.3 Rather than crowding out net exports, fiscal expansion appears to have primarily crowded out private investment and consumption.4 Much has been written on the relationship between the fiscal and current account balances. Recent work include Edwin M. Truman (2004), "Budget and External Deficits: Not Twins but the Same Family," (159 KB PDF) paper presented at the Annual Research Conference, held at the Federal Reserve Bank of Boston, June 14-16; Mathieu Bussiere, Marcel Fratzscher, and Gernot J. Muller (2004), "Productivity Shocks, Budget Deficits and the Current Account," unpublished paper, European Central Bank, November; and Christopher J. Erceg, Luca Guerrieri, and Christopher Gust (2005), "Expansionary Fiscal Shocks and the Trade Deficit," International Finance Discussion Paper 2005-825 (Washington: Board of Governors of the Federal Reserve System, January). The trade balance accounts for nearly all of the deterioration in the current account balance and is the component of the current account that is most reliably analyzed by the model. The other components of the current account balance consist of net investment income, other income flows, and transfers. This result is consistent with other model-based analyses of the effect of fiscal policy on the current account, including Erceg, Guerrieri, and Gust, "Expansionary Fiscal Shocks." In sum, the recent experience both of the United States and of other countries, as well as the results of model simulations, lead me to conclude that the budget deficit has probably been only a small factor in the emergence of the large U.S. external imbalance. Of course, even if it does not narrow the current account deficit by much, reducing the budget deficit would be highly desirable for other reasons: It would free up resources for private investment, and it would reduce the burden on future taxpayers of repaying the federal debt. 2. Decline in the private saving rate For observers who view the large current account deficit as an example of the profligacy of Americans, the sharp decline in private saving rates looms as large in their thinking as the sharp rise in the budget deficit. Since the mid-1990s, the personal saving rate has declined from roughly 5 percent of disposable income to less than 2 percent, and gross private saving (which includes corporate saving) has edged down from about 16 percent of GDP to less than 15 percent. As I noted earlier, it is important to distinguish between fundamental shocks affecting the current account and other developments which might merely represent economic responses to those shocks. On one hand, the decline in private saving could reflect a response to other developments in the economy - for example, a rise in the value of equity holdings and housing wealth, increases in expected future income, or declines in interest rates - and thus might not represent a fundamental cause of the U.S. current account deficit. On the other hand, the decline in saving rates could reflect a structural shift in household saving and spending behavior. Continued financial liberalization and innovation have made it easier for Americans to borrow, particularly against their real estate wealth, and this easing may have led to greater consumption. If Americans have experienced a structural decline in private saving rates, how much of the widening of the external imbalance could this explain? As shown in figure 2, the answer provided by our macroeconomic simulation model is: not much. The reason is virtually the same as in the case of a rise in fiscal deficits. According to our simulation, high private consumption boosts GDP growth and all else equal - forces up interest rates; although the rise in interest rates strengthens the dollar, it leads to much lower investment spending. Accordingly, and as in the case of a fall in public saving, a fall in private saving appears to crowd out investment more than it crowds out net exports, and thus leads to little change in the trade balance. I should note, however, that just as a decline in the budget deficit is desirable even if it would not substantially reduce the trade deficit, a rise in private saving rates also would be helpful because it would strengthen private balance sheets and provide additional resources for investment and growth. 3. Productivity growth In both the fiscal story and the private-saving story, the large U.S. current account deficit implicitly is the outcome of a rise in consumption relative to income. The third story I'd like to discuss highlights a more impressive achievement of the U.S. economy, the surge in labor productivity growth from about 1-1/2 percent annually in the two decades preceding 1995 to roughly 3 percent in the period since then. This surge is viewed as having several important consequences. First, higher productivity growth boosted perceived rates of return on U.S. investments, thereby generating capital inflows that boosted the dollar. Second, these higher rates of return also led to a rise in domestic investment. Finally, expectations of higher returns boosted equity prices, household wealth, and perceived long-run income, and so consumption rose and saving rates declined. Under this explanation, all of these factors helped to widen the current account deficit. I find this story compelling. It links two key economic developments of the past decade: the rise in productivity growth and the widening of the current account deficit. It also helps to explain several other important developments, including the fall in U.S. saving rates and the 1990s boom in asset prices. In fact, a simulation of our macroeconomic model shown in figure 3 suggests that the surge in productivity growth, while hardly explaining all of the deterioration in the trade balance since the mid-1990s, accounts for more of that deterioration than do the public and private saving shocks combined. Moreover, the effect of higher productivity growth on the trade balance could have been even larger than the simulation indicates because it likely worked through several channels that the model does not incorporate. The simulation does not fully take into account the rise in stock prices and household wealth - and hence, consumption - that would have been spurred by expectations of higher productivity growth. Also, because the simulation does not fully account for the effect of enhanced perceptions of equity returns on exchange rates, it does not produce the rise in the dollar that, in all likelihood, resulted from the productivity surge. 4. Slump in foreign domestic demand I would like to turn now to developments at the global level that may have helped to widen the U.S. current account deficit. Domestic demand growth has slumped in many foreign economies because of varying combinations of an increase in saving rates and a decline in investment. This weakening of foreign spending has enhanced the supply of capital available to the United States, put downward pressure on U.S. interest rates, and put upward pressure on the dollar. As I said before, I like the U.S. productivity surge story and find it compelling. However, I also like the foreign demand slump story, and I find it compelling. Some of the largest industrial economies in the world - Japan and the euro area - have been running current account surpluses while experiencing very subdued growth. In the developing world, the East Asian economies that went through financial crises in the late 1990s have seen a plunge in their investment rates even as their saving rates have remained extremely high; the weakness in domestic demand has likely motivated the authorities in these countries to keep their exchange rates competitive to promote export-led growth, a strategy that has also contributed to the U.S. external deficit.5 More generally, since 1999, the developing countries as a whole have been running current account surpluses - with the industrial countries, mainly the United States, necessarily running current account deficits - for the first time in many years. What does our macroeconomic simulation model say about the likely effect of a slump in foreign consumption and investment spending? The slump lowers the path of foreign GDP, which in turn limits U.S. export sales. Additionally, by depressing perceived rates of return abroad, the weakness in foreign demand explains a considerable portion of the run-up in the dollar, as shown in figure 4. Finally, weaker U.S. net exports reduce overall U.S. activity and depress interest rates a bit, thus raising domestic consumption and investment spending. Taken together, these factors contribute importantly to the widening of the trade deficit since the mid-1990s. 5. Improvements in global financial intermediation Another global factor that has been cited as contributing to the widening of the U.S. current account deficit has been an increase in global financial intermediation. Some suggest that home bias - the disinclination of investors to invest outside their own country - has been eroding and that this trend has permitted larger current account imbalances to be financed than would have been possible previously. This hypothesis is supported by the reduced correlation of national saving and investment rates in recent years, which implies that savings increasingly are being used to finance investment in other countries.6 Of course, an increased capacity of global financial markets to finance current account deficits does not, by itself, mean that it is the United States that would tap this enlarged capacity. However, observers suggest that the United States' unusually favorable investment climate, protections of investor rights, and prospects for rates of return made it likely that once international financing constraints were lifted, the U.S. economy would enjoy larger capital inflows. Investment rates in some of the major East Asian developing economies, excluding China, plunged more than 10 percentage points of GDP after their peak in the mid-1990s and generally stayed depressed thereafter. A desire to offset this loss of domestic demand, as well as to rebuild their foreign exchange reserves, are likely reasons that authorities in the region intervened to stem upward pressures on their currencies. See Steven B. Kamin (2005), "The Revived Bretton Woods System: Does It Explain Developments in Non-China Developing Asia?" (253 KB PDF) paper presented at the conference "The Revived Bretton Woods System: A New Paradigm for Asian Development?" held at the Federal Reserve Bank of San Francisco, February 4. Declines in the correlation of investment and saving across countries are documented in Olivier Blanchard and Francesco Giavazzi (2002), "Current Account Deficits in the Euro Area: The End of the Feldstein-Horioka Puzzle?" Brookings Papers on Economic Activity, 2:2002, pp. 147-209; and Joseph Gruber (2004), "Increased Current Account Dispersion: Differential Growth, Demographic Dispersion, or Greater Financial Integration?" unpublished paper, Board of Governors of the Federal Reserve System, December. So, how much of the enlargement of the U.S. current account deficit can we attribute to improved international intermediation? This is difficult to answer because it is hard enough to measure a concept as amorphous as international financial intermediation, let alone to gauge its effect on the current account. As a step in this direction, however, we reasoned that any reduction in home bias by foreign investors toward the United States would show up as a decline in the risk premium these investors demand for holding U.S. assets. This decline in the risk premium, in turn, would lead to a greater demand for U.S. assets and a rise in the dollar. Based on an estimate of the decline in the risk premium that occurred since the mid-1990s, our macroeconomic model suggests, as shown in figure 5, that the decline contributed importantly to the rise in the dollar, and, therefore, to the widening of the trade deficit. Assuming that the lower risk premium can be attributed to growing international intermediation, this latter development apparently exerted an important influence on the U.S. current account. Putting it all together I would now like to step back and consider the relative contributions to the trade deficit of each of the explanations I have discussed, as shown in figure 6.7 To the extent that the contributions of these shocks are reasonably well measured by the macroeconomic model simulations, the most important message I draw from them is that no single factor constitutes a dominant explanation of the deterioration in the U.S. current account balance. That said, our model accords the greatest roles to increased productivity growth, which has made the United States a magnet for foreign saving, and to the slump in foreign domestic demand, which has led to an excess of saving in those economies. The narrowing of the risk premium on dollar assets appears to explain a bit less of the widening of the trade deficit, with the loosening of fiscal policy and reduction of private saving making still-smaller The contributions to the trade deficit shown in figure 6 do not precisely match those shown in figures 1 through 5 because of the non-linearity of the model. contributions. Of course, these results are the product of our model-based analysis, with all of the strengths and weaknesses that model simulations entail; it would be useful to complement these findings with more direct historical and empirical analysis of the U.S. external imbalance. Attributing the historically unprecedented widening of the trade deficit, as well as the similarly unprecedented rise in our international indebtedness, to the coincidence of many random and unrelated developments would not make for a very satisfying story. However, my sense is that many of the developments that contributed to the U.S. trade deficit are not unrelated and may be part of a broader evolution of the global economy. The same types of liberalization and innovation that have improved financial intermediation within the United States, for example, have likely been instrumental in reducing home bias and increasing intermediation among countries. Improvements in financial markets, both at home and abroad, may have amplified the effects on the U.S. current account of other developments I have discussed, including the U.S. productivity surge and the perceived weakening of foreign investment opportunities. It is even possible that the expansion of the U.S. budget deficit would have been smaller had policymakers perceived global financial markets to be less willing to finance the gap. The view that the current account deficit stems from economic developments that are varied and yet intertwined has important implications for how the deficit will be corrected. Such a view suggests to me, first, that government policies such as budget-cutting or encouragement of private saving are unlikely, by themselves, to correct the current account deficit, much as they might be desirable for other reasons. Such policies probably do not address all or even most of the root causes of the current account deficit. However, the fact that I have deemphasized government policy as the source of the adjustment process does not mean that the public sector has no role to play. Reducing our budget deficit can ease the adjustment process by releasing resources that can be channeled into higher net exports, so that a reduced trade deficit does not require a curtailment of investment. The public sector in several nations has an important role in creating flexible markets for products, labor and financial assets. Appropriate macroeconomic and structural policies in many economies can contribute to the privatesector adjustment process by fostering an environment of innovation, increased productivity and morerapid growth of domestic demand. Recognizing the role for pubic policy, the Group of Seven industrial nations recently stated that vigorous action is needed to address global imbalances and foster growth. The primary impetus toward adjustment of the U.S. current account deficit, when it occurs, likely will come from private markets. Here, however, the multiplicity of factors underlying the large U.S. current account deficit raises questions about how that adjustment will come about. Some of the developments that may have supported the expansion of the U.S. current account deficit might reverse themselves - foreign domestic demand could recover, U.S. private saving rates could rise. And some of the factors that boosted the U.S. trade deficit, such as higher productivity growth or financial innovations that support greater spending, may show up more fully in foreign economies. Notably, all of these developments would take time to restrain the deficit, and any one of them, by itself, might have only a small effect. A final possibility is that, as U.S. deficits widen and foreign claims on the United States mount, actions by investors to re-balance their accumulation of assets could lead to changes in exchange rates, interest rates, and other asset prices that might contribute to a reversal of the deficit. To the extent that the adjustment of the U.S. current account is driven by fundamental changes in the global economy, it is less likely, in my view, to be disruptive or disorderly. Our own experience with external adjustment in the 1980s was comparatively orderly, and so was the experience of many other industrial economies undergoing adjustment in recent decades.8 Of course, should adjustment prove disruptive to sustainable growth and stable prices, the Federal Reserve will certainly be prepared to act. However, my sense is that the implications of current account adjustment for U.S. economic growth and inflation will most likely be benign. See Hilary Croke, Steven B. Kamin, and Sylvain Leduc (2005), "Financial Market Developments and Economic Activity during Current Account Adjustments in Industrial Economies," International Finance Discussion Paper 2005-827 (Washington: Board of Governors of the Federal Reserve System, February).
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Spring 2005 Banking and Finance Lecture, Widener University, Chester, Pennsylvania, 21 April 2005.
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Edward M Gramlich: A first step in dealing with growing retirement costs Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Spring 2005 Banking and Finance Lecture, Widener University, Chester, Pennsylvania, 21 April 2005. * * * Population aging is a worldwide phenomenon. In this country the looming retirement of the baby boom generation will take the United States ratio of workers to retirees from 3.3 today to 2 in about thirty years. Around the world, under present policies and demographic trends, the ratio of workers to retirees is likely to fall to less than 2 for countries as diverse as Australia, Brazil, Canada, China, France, Germany, Korea, Mexico, Russia, Turkey, and the United Kingdom. The ratio is likely to fall to less than 1 for Italy and Japan - that's right, in a few decades these two countries will be looking at a population situation in which they will have fewer workers than retirees. Demographic movements of this magnitude will require significant policy changes. The public costs of retirement systems will rise markedly unless countries raise their age of eligibility for retirement program benefits or cut these benefits. Moreover, small tax increases or benefit cuts will not do the job - the implicit actuarial deficits of these programs are so large that halfway measures will not be adequate. The United States is in relatively good shape by international standards. In contrast to other countries, the United States birth rate is not far below the rate that stabilizes population levels, and the tax rates necessary to finance our main retirement programs, Social Security and Medicare, are relatively low. But while the present situation of the United States may not be alarming, the outlook comes closer to being so. Outlays are projected to rise slightly more than program revenues for Social Security and much more than program revenues for Medicare. The recent annual report of the trustees of Social Security and Medicare projected rapid deterioration in the trust funds financing both programs, with the Medicare fund being exhausted in fifteen years. Their implication was that substantial tax increases or benefit cuts would be necessary to put both programs in long-term actuarial balance. What should we do to ensure the viability of Social Security and Medicare? Disaster is not imminent, but it seems pretty clear that in the not too distant future the United States, too, will have to confront some distinctly unpleasant policy choices. In this talk, I want to anticipate some of these choices. Up to now, discussions of Social Security and Medicare have been fragmented - there are a sizable number of proposals to reform Social Security, a few to reform Medicare, and none to unify the reforms for both programs. I will propose a joint approach that treats both programs alike and applies to them the same retirement ages and tax arrangements. This joint proposal fully corrects the long-term actuarial deficit for Social Security and would also make a start on a solution for Medicare. The Trustees' Report Programs such as Social Security and Medicare could in principle be funded in many ways. But the tradition here, and in many other countries, has been to tie these public, defined benefit programs to a trust fund, with the revenues coming mainly from dedicated payroll taxes levied on employers and employees. To economists, the exact split between employers and employees is immaterial, because even the employer share is likely to be shifted back to employees in the form of reduced wages. The trust funds have been financed basically on a pay-as-you-go basis, though it would certainly be possible to pre-fund benefits through accumulations in advance of later spending. To some extent this has been done for Social Security by reforms made in the 1980s. At that time, the retirement of the large baby boom population was anticipated, and payroll tax revenues were accumulated in advance of benefit payments, steps that created the present-day cash surpluses for the Social Security component of the overall federal budget. The Social Security retirement program began seventy years ago, and disability insurance was added fifty years ago. The combined expenses are financed by the Old Age, Survivors, and Disability Insurance (OASDI) Trust Funds. Medicare programs were added forty years ago. Part A of Medicare, covering hospital insurance is financed, just like Social Security, out of a payroll tax and trust fund. Part B, covering physician and outpatient costs, is optional, with about one-fourth of the costs financed by premiums paid by those who participate in the program and the remainder by general revenues. Part D, covering drug costs, was added last year and is also optional, financed by participants, general revenues, and some state contributions. To measure the adequacy of long-term financing, the four government trustees of the Social Security and Medicare trust funds convene every March with two outside members to review the projections. The actuaries make a number of long-term projections for life expectancy, birth rates, economic growth variables, prices, in general as well as specifically for health care; they then compute the expected actuarial situation for the trust funds for both programs. In recent years these projections have been made for seventy-five years, a horizon that seems long but in some sense is really not long enough. Because trust fund outlays are running well ahead of tax inflows by the end of the forecast period, the mere passage of time throws these seventy-five-year forecasts out of actuarial balance. To correct this tendency, the actuaries now provide forecasts that show costs if the ratio of trust fund assets to outlays is stable in the eighth decade out. This adjustment provides a reasonable approximation to the tax rates necessary to balance the system in perpetuity. The flow results for these projections, using the trustees' intermediate assumptions, are given in figure 1. The present combined employer-employee tax rate for the OASDI trust funds, the "income rates" line in the figure, is 12.4 percent and is assessed on the first $90,000 of taxable wages and salaries. Outlay rates are less than 12.4 percent of taxable wages and salaries now, but they rapidly rise above 12.4 percent as the huge baby boom population moves into retirement over the next thirty years. Even after that, time outlay rates continue to rise gradually because of steadily growing projected life expectancies. The pattern is qualitatively similar for the portion of Medicare financed by the payroll tax - Part A, or the hospital insurance (HI) portion. However, the outlay rates for Part A rise more steeply because of the rising relative costs of health care. Flow numbers are flow numbers, and given the steep inclines of at least some of the outlay rates, it makes sense to switch over to present values of liabilities, as shown in table 1. Over the next seventy-five years the unfunded liability for OASDI, essentially the discounted cumulated area between the cost and income lines in figure 1, is $4.0 trillion, 0.6 percent of the discounted present value of gross domestic product (GDP) over this period. An immediate payroll tax increase of 1.9 percentage points would be sufficient to pre-fund this liability. But because outlays greatly exceed revenues at the end of the projection period, the infinite-horizon unfunded liability is much larger, $11.1 trillion, or 1.2 percent of the discounted present value of GDP, which is tantamount to an immediate 3.5 percentage point increase in payroll tax rates. Table 1 Measures of Trust Fund Actuarial Deficiency, 2005 Seventy-Five-Year Horizon Infinite Horizon Exhaustion Date Payroll Tax Shortfall (percent) Open Group Liability (trillions of dollars) Share of GDP1 (percent) Payroll Tax Shortfall (percent) Open Group Liability (trillions of dollars) Share of GDP1 (percent) OASDI 1.9 4.0 0.6 3.5 11.1 1.2 Medicare, Part A 3.1 8.6 1.4 5.8 24.1 2.5 Medicare, Parts B&D - - 19.8 3.1 - 45.8 4.8 Trust Fund GDP is the present discounted value of GDP over the relevant period. expenditures less the present 1.3 percent of GDP devoted to parts B and D. The present discounted value of gross Source: 2005 Annual Report of the Boards of Trustees of the Federal Old-Age and Survivors Insurance, Disability Insurance, Federal Hospital Insurance, and Federal Supplementing Medical Insurance Trust Funds. For Medicare, the initial size of the program is much smaller, but the outlay increases are larger, and the unfunded liabilities are much larger. Part A, the hospital insurance component, has a seventy-fiveyear unfunded liability of $8.6 trillion, or 1.4 percent of discounted GDP, and an infinite-horizon liability of $24.1 trillion, 2.5 percent of discounted GDP. It is more difficult to compute the liabilities for parts B and D because they have no dedicated trust funds. The gross expenditures for these programs, covering participant costs, general revenues, and state contributions, are $27.8 trillion (4.4 percent of GDP) over a seventy-five-year horizon or $58.0 trillion (6.1 percent of GDP) over an infinite horizon. Currently, participants and general revenues finance 1.3 percent of these costs (state payments under part D have not started yet). Hence, a reasonable estimate of the future unfunded liability is the difference - $19.8 trillion (3.1 percent of GDP) for seventy-five years or $45.8 trillion (4.8 percent of GDP) for the infinite horizon. And these humongous numbers do not even include Medicaid, which is financed entirely by general revenues and states, and also growing rapidly because of costs related to the aged. Policy approaches Despite the fact that the long-term financial problem is far worse for Medicare than Social Security, most policy proposals have focused on Social Security. There are three reasons for this. One is that with numerous legislated and designated advisory councils, groups are forced to make Social Security proposals more often than Medicare proposals. Another reason is that the numbers are less daunting it is hard enough to deal with unfunded liabilities of $11 trillion, but it is virtually impossible to deal with unfunded liabilities of $70 trillion. The third reason is that changes to Social Security just involve money - cutting benefits means cutting someone's defined-benefit pension payments. Cuts in Medicare, on the other hand, while partly mitigating financial burdens on the aged, could also involve the much more difficult question of limiting, or even rationing, health care treatments. Medicare cuts could be quite literally a life-and-death affair. I have participated in the Social Security debate in the past, as chair of the 1994-96 Social Security Advisory Council, but today I want to look at both programs together. I freely admit that my proposal is only partial, a first step. I will focus only on ages of eligibility and tax rates for both programs, and will leave aside questions about privatizing Social Security or "carve out" or "add on" individual accounts. I also leave aside difficult questions about the structure of Medicare - whether and how to make more use of economic incentives or rationing. My idea on the tax side is relatively straightforward. Today, Medicare Part A is financed by a 2.9 percent combined payroll tax on all wages, and Social Security is financed by a combined 12.4 percent combined payroll tax on wages up to $90,000, a threshold that is increased each year with the growth in wages. One of my goals is to standardize treatment across the programs, and I would do that by removing the $90,000 cap on wages and salaries that are taxable for Social Security purposes. Let's treat both programs alike by taxing all wages for both programs. Will this represent a tax increase for Social Security? Of course it will, though in part the removal of the cap merely adjusts for the fact that because of the widening of the income distribution, substantially more wages are above the cap than in earlier times. But the main reason for removing the taxable payroll cap is that both programs together are woefully underfunded, and this would be a small step in the direction of fiscal responsibility. The basic idea on the benefit side is nearly as straightforward. We already have two relevant retirement ages for Social Security - the so-called normal retirement age (NRA), at which an individual qualifies for full benefits on the basis of his or her earnings history; and the age of early eligibility (EEA), at which an individual can receive actuarially reduced benefits. Historically the NRA has been 65 and the EEA has been 62. Recently the NRA has begun slowly climbing from 65 to 67 and is now near 66, but the EEA has remained fixed at 62. As I will argue below, there is a good rationale for raising the NRA beyond age 67, but I also think we should raise the EEA at the same pace. There are two reasons: As the NRA rises with no change in the EEA, the actuarial reductions get larger and larger. Pretty soon, benefit payments at the EEA get pretty low, and what we are thinking of as a retirement insurance program becomes progressively less so. Because of shifting demographics, the country will just plain need more workers to pay for growing retirement costs. If all workers were perfectly rational in comparing benefits and costs, they could possibly decide for themselves when to retire. But study after study has shown that many workers seem to be highly myopic and retire at the first instant at which they are eligible for any money at all from Social Security. In such cases a reasonable policy response is to nudge workers in the direction of working longer careers by the simple expedient of moving the EEA up along with the NRA. The next part of the age program is to keep the two ages common across both Social Security and Medicare. Confusion already exists because people qualify for full benefits under Medicare at age 65 and full benefits under Social Security at an age nearing 66. As the NRA increases for Social Security, the disparity will widen and the confusion will grow. So at the slowly rising NRA, I would give full benefits for both Social Security and Medicare. At the EEA, which would rise at the same slow rate as the NRA, I would give actuarially reduced benefits for Social Security and early buy-in opportunities for Medicare. One illustrative schedule is that individuals might be allowed to buy in to Medicare by paying, say, 90 percent of the average Medicare costs for parts A, B, and D once they hit the EEA, 60 percent a year later, 30 percent a year later, and only the standard part B and D premiums when they fully qualify for Medicare. Tying the program conventions together has programmatic value, but these programs are different and one must proceed cautiously. Medicare is a health insurance program, and health insurance performs two functions - it mitigates financial loss for households getting treatment, and it permits households to get health treatment in the first place. To the extent that the latter motive is dominant, as it could be for low-income or disabled households, measures to raise the eligibility age could be problematic. For this reason, it would be important to provide a generous schedule of buy-in substitutes for households with low-income or disabled beneficiaries, to encourage greater use of health care in the years before the NRA. The subsidies could be offset by surcharges on the premiums for well-off households, who could more easily afford the buy-in. Retirement ages The hardest question here is how rapidly to increase the basic retirement age, at which individuals qualify for full benefits under both programs. There are several ways of dealing with the question. I begin with the underlying logic for a rising retirement age. Historically most workers contributing to Social Security have been males. Males in my grandparents' generation who were lucky enough to attain age 65 could be expected to live, and collect benefits, for another thirteen years. Males in my grandchildren's generation lucky enough to attain age 65 are projected to live another twenty years. Had the NRA not been raised, this factor alone would have made Social Security a better deal by almost 60 percent for the younger generation. Obviously there have been many other changes in society, the economy, and Social Security over this time. But, still, it is my guess is that if the designers of Social Security had known back in the 1930s that postwar life expectancies would increase so significantly, they would have built rising retirement ages into the system. Of course, when asked, people do not favor rising retirement ages. But given the various undesirable choices for moving these programs back toward actuarial soundness, a slowly rising retirement age seems far and away the fairest across generations. One standard for how fast to raise the retirement age is to invoke life expectancies. Life expectancies at age 65 speak to the question of how many years into retirement individuals are likely to collect benefits. Life expectancies at age 20 address the question from a different perspective - as individuals enter adulthood, we might have them spend a constant percent of their time in work and retirement. The age-65 standard shows that, for males born between 1875 and 1995, life expectancy at age 65 has increased 7.4 years, an average of 0.6 years every decade (table 2). It also turns out that life expectancy has increased more rapidly for those born in the twentieth century - over this shorter period improvement has been about 0.7 years every decade. The age-20 proportionate standard works out as follows. In 1940, at the dawn of Social Security, 20-year-old males could expect to work another 45 years and to live just 1.9 more after retirement. That is, they could expect to spend 96 percent of their remaining life in the work force and 4 percent in retirement. Today, 20-year-old males can expect to live another 55.6 years. If they were to spend 96 percent of that time in the work force, the NRA would be slightly more than 73. By this standard, the NRA would have advanced 1.4 years every decade. Health status is also relevant. One measure is the share of men near death, defined as being in the last two years of life. In 1960 this share, for men around today's Social Security early retirement age of 62, was about 6 percent (figure 2). In 2000, the share of 68-year-old men near death was at this baseline level of 6 percent. By this health standard, in 40 years healthy life expectancies have increased 6 years, or 1.5 years per decade. Table 2 Male Life Expectancies Year of Birth Year Turning Mean Life Expectancy at 65 Year of Birth Year Turning Mean Life Expectancy at 20 12.7 46.9 13.8 49.5 16.5 55.6 18.4 n.a. 20.1 n.a. Mean life expectancy at 65 is from the Social Security Administration and assumes individuals experience average mortality rates over the span of their remaining life. The assumption underlying life expectancy at 20 is more crude: individuals experience mortality rates for that year over their remaining life. Source: Social Security Administration and National Vital Statistics Reports. One can also consider a broader measure of health status. Since 1970 the National Health Interview Survey has asked a direct question about health status. Typically, the proportion of people describing their own health as fair or poor is taken as a measure of poor health status. Since the numbers bounce around, I have made comparisons with trend lines estimated by Cutler, Liebman, and Smyth (figure 3).1 The trend lines show that, in the mid-1970s, 28 percent of men aged 62 reported that their health status was fair or poor. By the mid-1990s the 28 percent standard was not reached until men David Cutler, Jeffrey B. Liebman, and Seamus Smyth (forthcoming), "How Fast Should the Social Security Retirement Age Rise?" were about 73, an improvement of 11 years in just two decades. By this standard, the retirement age should increase by a whopping 5.5 years per decade. These health standards give varying estimates, so the conclusions are not as tight as for life expectancy. But they suggest that health standards are improving even more rapidly than life expectancies. If the retirement age were increased about a year per decade from the standpoint of life expectancy alone, the increase would be more rapid from the standpoint of health status. A sensible compromise would seem to be to raise the NRA and the EEA slightly more than a year every decade maybe three months every two years - a pace slightly slower than the present rate of increase for the NRA. This rate of increase should be reviewed periodically to adjust to future changes in health status or life expectancy. There is one final point. A standard argument against raising the retirement age is that people are working physically demanding jobs and are simply not able to continue. Of course, workers can and do switch careers as they age, or claim early retirement. But it still makes sense to look at the share in demanding jobs, as is done in table 3. In 1950, one-fifth of the work force worked in jobs judged by the Labor Department to be physically demanding. But this share has dropped an average of 24 percent per decade since then. By 1996 it was down to only 7.5 percent of workers in physically demanding jobs, and by the time any of my suggested measures take effect, the share should be on the order of 3 or 4 percent - not zero, but probably not high enough to argue against measures to raise the retirement age at a gradual rate. It is not popular to raise the retirement age. Workers have a valid desire to consume some of their increasing productivity in the form of leisure time, or earlier retirement. At the same time, Social Security and Medicare together pose huge financial problems. It is also not popular to raise payroll taxes, or to ration health care. Among very unpleasant alternatives, raising the retirement age seems to be one of the fairest approaches across generations. Table 3 U.S. Workers in Physically Demanding Jobs Year Percent in Demanding Jobs 20.3 13.8 11.1 9.1 7.8 7.5 Source: Eugene Steuerle, Christopher Spiro, and Richard W. Johnson (1999), Straight Talk on Social Security and Retirement Policy, The Urban Institute, August 15. Budget savings Let's then take a policy change that raises the retirement age three months every two years, or 1.25 years every decade, and taxes all wages for both Social Security and Medicare. How does it stack up? The tax change is easy to compute. Right now about 85 percent of wages are taxable and this coverage rate is slated to decline slightly over time. Applying the 12.4 percent tax rate to the15 percent of wages that are untaxed leads to an effective change based on now-taxable wages and salaries of 2.1 percentage points. This change more than solves the seventy-five-year Social Security problem (for the intermediate assumptions), and solves more than half of the infinite-horizon Social Security problem. It is only a first step, but a strong one. Increasing the NRA by three months every two years would improve the actuarial balance of Social Security by slightly less than 1 percentage point of taxable wages and salaries. I ignore any costsaving effect on Medicare, permitting the early buy-in costs for low-income households to use up any budget savings from higher premiums for high-income households whose primary breadwinner is just over 65. If we were to combine this increase in the retirement age with a few standard measures to improve the horizontal equity of Social Security - including all newly-hired state and local workers and using a chained price index - the total improvement reaches about 1.4 percentage points. On net, the changes recommended here might improve the overall balance of Social Security plus Part A of Medicare by about 3.5 percentage points of taxable wages and salaries. These steps alone are enough to finance Social Security in perpetuity. Or, they could finance Social Security for seventy-five years and extend the life of Part A trust fund by about three decades. Huge general revenue liabilities for parts B and D of Medicare remain, but this package is still a start in dealing with growing retirement costs. As said above, the package of taxing all payrolls for Social Security and advancing the normal retirement age is indeed strong medicine. My approach here has been to unify proposals for the financial reform of Social Security and Medicare on the tax side and for retirement ages. Will the changes be pleasant or popular? No. Will something like them, or worse, be necessary some day? Yes. We might as well begin now thinking about those changes that seem to be the fairest across generations.
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board of governors of the federal reserve system
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Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the 15th Annual Hyman P Minsky Conference, The Levy Economics Institute of Bard College, Annandale-on-Hudson, New York, 22 April 2005.
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Donald L Kohn: Imbalances in the US economy Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the 15th Annual Hyman P Minsky Conference, The Levy Economics Institute of Bard College, Annandale-on-Hudson, New York, 22 April 2005. * * * I am pleased to be here today at this conference considering U.S. financial and macroeconomic conditions and the economy’s prospects, puzzles, and imbalances. You have considered a broad range of issues of interest to us at the Federal Reserve, and I am sorry I could not be here for your discussions. I thought it might be useful for me to close the conference by giving you my perspective on some of the imbalances currently evident in the U.S. and global economies, how they might be resolved, and their implications for policy - including monetary policy. I must emphasize that these views are my own and not necessarily those of my colleagues on the Federal Open Market Committee.1 The current state of the economy The United States has been doing well over the past few years by most measures of overall economic performance. Real gross domestic product growth has rebounded smartly from the 2001 recession, and slack both in labor and product markets has eroded appreciably. After a substantial period of little or no increase in employment, payroll gains have picked up to an average of 160,000 per month over the past half year, and the unemployment rate has fallen to 5-1/4 percent, almost 1 percentage point below where it was two years ago. Household spending on goods and services and housing has been strong throughout the expansion, and, more recently, business investment in capital equipment has surged. The increase in output has been accompanied by large increases in labor productivity that, since 2002, have been in excess of even the elevated pace of the second half of the 1990s. To be sure, the rise in energy prices seems to have taken a toll on consumer confidence and spending most recently. But with financial conditions still accommodative, profits and cash flow still healthy, and incomes continuing to increase, most forecasters expect growth to remain solid. Excluding food and energy, the rate of inflation has fluctuated around 1-1/2 percent over the past few years, measured by the chain-weighted price index for personal consumption expenditures. Core inflation has been running somewhat faster more recently, in part because of the increases in the prices of energy, commodities, and imports that began last year. Nevertheless, barring further sizable increases in the prices of oil and natural gas, both core and headline inflation rates should moderate later this year. Buttressing this view, long-run inflation expectations have been, on balance, fairly stable in the face of these price gyrations. Imbalances in the economy Although the overall state of the economy is favorable, some aspects of the current situation might be viewed as worrisome. In particular, beneath this placid surface are what appear to be a number of spending imbalances and unusual asset-price configurations. At the most aggregated level, the important imbalance is the large and growing discrepancy between what the United States spends and what it produces. This imbalance, measured by the current account deficit, has risen to a record level, both in absolute terms and as a ratio to GDP. Moreover, the cumulative value of past current account deficits - the net foreign indebtedness of the United States - is also at a record high, again both in absolute terms and as a ratio to GDP. The growing current account deficit has been associated with a pronounced decline in the saving proclivities of both the private and public sectors. Over the past year, households have saved only about 1 percent of their after-tax income, compared with about 8 percent on average from 1950 to 2000. In the public sector, the federal-budget deficit has been larger in the past, at least relative to the Eileen Mauskopf and David Reifschneider, of the Board’s, staff contributed greatly to the preparation of these remarks. size of GDP, but the deterioration in the balance over recent years has been sizable, moving from a surplus of $236 billion in fiscal year 2000 to a deficit of more than $400 billion last year. The resultant overall decline in national saving contrasts with the pace of capital spending: Residential investment as a share of GDP now stands at its highest level since the 1950s, while the share of GDP devoted to investment in plant and equipment has recovered sufficiently from its recent slump to return to the neighborhood of its long-run average. One might have thought that, with probably limited economic slack remaining, such a pronounced imbalance between national saving and domestic investment would have placed substantial upward pressure on interest rates. One also might have expected real interest rates to be high at a time when we are experiencing rapid productivity growth. But, as you know, nominal and real yields on both short-term and long-term Treasury securities are low by historical standards. Moreover, although premiums on private bonds relative to Treasury yields have risen somewhat of late, they are still at the low end of their historical range, suggesting that investors are sanguine about default risk and other types of uncertainty. Low interest rates have, in turn, been a major force driving the phenomenal run-up in residential real estate prices over the past few years, and the resultant boost to net worth must be one of the reasons households have felt comfortable directing so little of their current income to saving. However, whether low interest rates and other fundamental factors can fully explain the current lofty level of housing prices is the subject of substantial debate. This situation raises some difficult questions. Can the aforementioned spending imbalances and possible asset-price anomalies continue without threatening macroeconomic stability? And if they cannot be sustained, how will they unwind? Will the transition be relatively benign, or will it be a rocky adjustment with deleterious effects on economic growth, inflation, and other factors? And finally, what role will government policies play in influencing the path of adjustment? Sustainability of current imbalances On the question of sustainability, it is worth noting that these sorts of imbalances are not new. The trade account has been persistently in deficit since the late 1970s, and the current account has been in a similar state almost continuously since the early 1980s. The personal saving rate has been declining since the mid 1980s. And the federal government has spent more than it has taken in every year since 1970 except for a brief respite between 1998 and 2001. So these imbalances have been around for a long time, and our economy is still churning out high rates of productivity and income growth. But, the magnitude of these imbalances is increasingly moving into unfamiliar territory. I have already noted the unprecedented level of the current account deficit and the depressed household saving rate. As for the federal budget, the projected funding shortfall in Social Security and exploding Medicare and Medicaid costs mean that without a reassertion of fiscal discipline, the long-run outlook for the federal budget balance is for worse to come. The sustainability of these large and growing imbalances has become especially suspect because it would require behavior that appears to be inconsistent with reasonable assumptions about how people spend and invest. For example, it seems unlikely that foreigners would be willing to continue to indefinitely increase the proportion of their wealth held in dollars without upward movements in the expected return on these assets. And if the government tried to honor its current long-run commitments to future retirees without raising tax rates, it seems unlikely that it could borrow the massive amounts needed without paying creditors higher returns - returns potentially so high over coming decades as to be economically debilitating. Similar considerations apply to the current low rate of household saving. Most theories of consumer behavior emphasize the desire of households to save for retirement. However, given average life expectancies and the typical number of working years, a sustained saving rate of less than 2 percent is too low for households to accumulate enough wealth to maintain their standard of living after retirement - unless, of course, those households are lucky enough to receive outsized capital gains on their homes and other assets. Although many households have received such windfalls over the past few years, such gains are not likely to be continually repeated in the future. The current imbalances will ultimately give way to more sustainable configurations of income and spending. But that leaves open the question of the nature of that adjustment. Ideally, the transition would be made without disturbing the relatively tranquil macroeconomic environment that we now enjoy. But the size and persistence of the current imbalances pose a risk that the transition may prove more disruptive. The underlying causes of the imbalances Speculating on the adjustment path would be more fruitful if we understood how we got to where we are today. Unfortunately, the situation is complicated and, even after the fact, not fully understood, which is why we hold conferences like this one. Nevertheless, I think we can identify several factors that have played an important role in the emergence of these imbalances, and in so doing gain some insight into their likely resolution.2 A rise in the net supply of saving in other countries, the perception that dollar assets are a relatively favorable vehicle in which to place that saving, and an increase in global financial integration that has facilitated the transfer of savings have been important factors in our growing trade and current-account imbalances. The increased desire to hold dollar assets resulted in part from the jump in the rate of increase in productivity that materialized in the United States in the mid- to late-1990s and that, in turn, raised the perceived rate of return on U.S. assets. At the same time, sluggish growth and recessions in other developed countries and the Asian financial crisis of 1997 damped returns elsewhere. Moreover, foreign governments - especially in Asia - took the lesson from the financial crisis that a large war chest of reserves was needed to protect against the volatility of capital flows. Such a buildup of dollar reserves was also consistent with an emphasis on stable exchange rates that fostered exports as means to sustaining high growth rates in their countries. The resultant shift toward dollardenominated assets was associated with capital inflows into the United States and a deterioration of the current-account balance. In addition, the increased willingness of the rest of the world to hold U.S. assets, along with the jump in our productivity growth, contributed to a sharp increase in U.S. equity valuations. And the associated capital gains, in turn, caused the net worth of U.S. households to soar relative to their income and induced a reduction in personal savings rates. Then, in 2000 and 2001, global stock markets slumped and business investment was slashed. In the United States and elsewhere, monetary and fiscal policies turned stimulative to bolster demand and to stave off unwelcome disinflation. The size of the stimulus required to accomplish our macroeconomic objectives in the United States was further increased by the sluggish economic growth of our trading partners and by continued demand for dollar assets, which further exacerbated our trade imbalance. In the aftermath of the recession in the United States, private aggregate demand, both here as well as in Europe and Japan, has strengthened only gradually. This slow rebound has meant that many central banks around the world have held real interest rates low to support real activity and keep inflation stable. The climate of low interest rates has in turn bolstered asset markets in some countries, especially residential real estate markets. The associated capital gains, coupled with financial market innovations that make extracting housing equity easier in the United States, help to explain the depressed level of the personal saving rate here; low interest rates themselves also have probably boosted consumption relative to income by reducing the return to saving. At the same time, demands for dollar-denominated assets have been sustained at a high level. Returns on these assets have apparently continued to look reasonably attractive to private investors. And some foreign governments have continued to accumulate dollar assets, adding to already high levels of reserves. Their actions likely reflect in part a concern about the adequacy of their domestic demand to support the advances in economic activity required for job creation. This explanation has emphasized a favorable relative return on U.S. investment, coupled with increased foreign willingness to hold dollar assets, as causal factors driving the United States’ growing current account deficit and low national saving rate. But causation may in part also have run from structural influences that contributed to reduced U.S. saving. That is, a fiscal policy shift toward greater deficits and innovations in financial markets and other structural changes that facilitated household spending worked to lower national saving relative to domestic investment. The resultant upward pressure on rates of return here relative to those abroad have helped to draw in capital and increase the current account deficit. For a model-based examination of this question, see “U.S. Current Account Deficit: Causes and Consequences,” remarks by Vice Chairman Roger W. Ferguson, Jr. to the Economics Club of the University of North Carolina at Chapel Hill, Chapel Hill, North Carolina (April 20, 2005). Unwinding the imbalances What can we say about the likely path by which these spending imbalances will resolve themselves and about the effects those resolutions will have on the broader economy? Almost a year ago, the Federal Reserve started a process of removing the unusual degree of policy accommodation, which was outliving its usefulness as the economic expansion gathered strength and the possibility of declines in inflation receded. We have not yet finished this task: The federal funds rate appears to be below the level that we would expect to be consistent with the maintenance of stable inflation and full employment over the medium run, and, if growth is sustained and inflation remains contained, we are likely to raise rates further at a measured pace. By increasing the return to saving and by damping the upward momentum in housing prices, rising interest rates should induce an increase in the personal savings rate, and thereby lessen one of the significant spending imbalances we have noted. Forecasting the path of the overall spending-production imbalance is more difficult. To a great extent, continuation of the current account deficit depends on the willingness of investors to provide financing. One factor that will influence their willingness is the rate at which U.S. dollar assets are increasing in global portfolios relative to other assets. We can speculate that unless a persistently large current account deficit in the United States is accompanied by further and continuous shifts in the world’s willingness to increase holdings of dollar-denominated assets in their total portfolios, investors will ultimately require higher ex ante rates of return on their U.S. assets relative to those available on foreign assets. This presumably applies to foreign governments as well as private investors. Governments will eventually see that returns from encouraging domestic investment will outstrip those expected on their growing holdings of dollar reserves, or that more-flexible exchange rates are required to exercise a stabilizing monetary policy. Over the past few years, we have seen a moderate decline in the dollar, indicating that the demand for dollar-denominated assets is not infinitely elastic. And, at some point, the current account deficit should start to narrow. In addition, the process of narrowing deficits may be helped by an autonomous rise in domestic saving. We do not understand all the reasons for recent low personal saving rates, and the rise in the saving rate could exceed the increase that results from likely movements in interest rates and house prices - especially as households contemplate the adequacy of their retirement income. And fiscal policymakers do seem to be more aware of the need to change the medium-term trajectory of the federal budget. To the extent that current spending behavior is built on realistic expectations - in particular, for future short-term interest rates, the exchange rate, rates of return on capital investments in the United States relative to those abroad, and housing price appreciation - the transition should be relatively orderly: Asset prices should adjust gradually to changing developments, as should the spending patterns of households and firms. But if current expectations are badly distorted, then the way forward may not be so smooth. Eventually, reality always asserts itself over wishful thinking, and such realignments are sometimes abrupt, as illustrated by the collapse of the high-tech bubble a few years ago. In such circumstances, asset prices can adjust sharply, and private spending may also respond quickly, making it difficult for monetary and fiscal policy actions to provide a timely enough counterweight to keep the economy continuously on track. Are expectations substantially distorted? Because we seldom have direct and reliable readings, it is hard to say. Still, some observations can be made. First, even after their recent increases, both Treasury yields and risk premiums on private securities are low by historical standards. To a considerable extent, Treasury yields reflect two factors: low actual and expected inflation; and the market’s belief that, with growth moderate and inflation contained, the federal funds rate will move up only gradually as the expansion proceeds. In addition, with the macroeconomic climate expected to remain calm, investors seem to require less compensation for the risks inherent in lending over a longer term or of supplying credit to borrowers who usually have a greater chance of defaulting. In this environment, the likelihood that major credit problems will develop would seem limited, and that limited risk makes it not unreasonable for private bond premiums to be at the low end of their historical range. Still, investors seem to expect short-term interest rates to remain on the low side of historical averages for some time. These subdued expectations may reflect a belief that underlying global demand will remain damped and that the world will continue to be willing to invest heavily in the United States. A second observation concerns the housing market, which you have already discussed. A couple of years ago I was fairly confident that the rise in real estate prices primarily reflected low interest rates, good growth in disposable income, and favorable demographics. Prices have gone up far enough since then relative to interest rates, rents, and incomes to raise questions; recent reports from professionals in the housing market suggest an increasing volume of transactions by investors, who (along with homeowners more generally) may be expecting the recent trend of price increases to continue. Even so, such a distortion would most likely unwind through a slow erosion of real house prices, rather than a sudden crash. Moreover, experience suggests that consumer spending would respond only gradually to any loss in wealth - an important consideration because a gradual adjustment in spending would give offsetting policy actions time to work. In any event, I take some comfort from the continuing disagreement among close students of the market about whether houses are overvalued, and, given the widespread press coverage of this issue, from my expectation that people should now be aware of the risks in the real estate market. Finally, there is the exchange rate. The inability of anyone to predict movement in the dollar accurately and consistently has been evident. Presumably, the dollar’s value is based partly on market expectations about future interest rates, trade flows, and portfolio preferences, among other things. There is no particular reason to think that these expectations are substantially distorted. Certainly no investor out there buying dollar assets could be surprised to learn that the United States has a growing current account deficit! And, I do not anticipate a marked and persistent downshift in U.S. productivity growth that would greatly reduce the expected returns from holding dollar-denominated assets. Governments who have been accumulating dollar assets also would seem to have no reason for shifting their preferences suddenly and disruptively, even in the context of allowing greater exchange rate flexibility. Financial markets are flexible and increasingly integrated around the world, facilitating continuous and gradual adaption of capital flows to changing circumstances. Markets for goods and services are also becoming more integrated and flexible, though this trend has been, perhaps, more subject to government actions to slow the process. In fact, the dollar has risen in 2005, reflecting the interplay of portfolio preferences and shifting patterns of saving and investment in markets. In all likelihood, adjustments toward reduced imbalances in the United States and globally will be handled well by markets without, by themselves, disrupting the good, overall performance of the U.S. economy provided, of course, that the Federal Reserve reacts appropriately to foster price and economic stability. Still, complacency would be ill-advised. Although the odds seem favorable for an orderly adjustment, the current imbalances are large and - importantly for gauging risks - unusual from a historical perspective. Thus, we have little experience to call on in judging when and how they will be corrected. In such circumstances, we cannot rule out sudden shifts in expectations, whether or not they are unreasonable to begin with, and asset prices may change suddenly. Investors may recognize the unsustainability of some flows and prices, but believe they can adjust in advance of the market - as apparently many thought they could in the tech-stock bubble - and their reactions when prices move could add to volatility. Moreover, we cannot rule out governments engaging in unwise policies policies that might undermine confidence or might hinder market adjustments and associated changes in asset prices. The role of policy Sound public policies are essential to enhance the chances that any transition will be smooth. A permanent correction to the spending imbalances must involve the restoration of fiscal discipline and long-run solutions to the financing problems of Social Security, Medicare, and Medicaid. Achieving these objectives are important in any event, but they take on added weight to the extent that we cannot count on an ever-increasing flow of global savings coming to the United States. Without a resolution of these fiscal problems, the balancing of aggregate production and spending would be much more difficult and would result in intensified pressures on interest rates. Those pressures would tend to hold down the growth of investment and productivity and they would exacerbate asset-price movements and adjustment difficulties in other markets. Adjustment of global current-account imbalances could also be aided by changes over time in the policies of our trading partners. To some extent, it would seem appropriate for them to use their macroeconomic policies to stimulate domestic spending. In many cases, however, the root cause of deficient demand seems to be more structural than cyclical in nature, and would thus call for more micro-oriented measures. Combined, these policy initiatives on the part of our trading partners should yield higher productivity growth, generate more vigorous spending abroad, raise rates of return on their capital investment, and ease their adjustment to smaller U.S. deficits. These changes, in turn, would boost the demand for U.S. exports and could shift portfolio preferences away from dollar-denominated assets. Other public policies here and abroad can have an important influence on the transition process by working with markets and facilitating adjustment. For example, governments should strive to maintain and enhance the flexibility of markets. In particular, the United States and its trading partners should vigorously protect the current degree of market openness and should aim to reduce trade barriers further. Over time, increased exchange rate flexibility abroad would also be beneficial. These and other types of market flexibility help facilitate needed shifts in spending and prices; without them, rigidities might impede such stabilizing changes, causing adjustments to break out forcefully in other, more disruptive ways. Strong financial institutions are especially important at this time when asset prices could move by large amounts unexpectedly. By ensuring that financial institutions are adequately capitalized and well prepared in general to deal with major changes in asset prices, prudential regulation decreases the risk that the actions of impaired financial institutions could disrupt the flow of credit and thereby intensify what might already be difficult adjustments. In addition, strong institutions should be positioned to weather any necessary changes in short-term interest rates as policy is adjusted. Finally, there is the role that monetary policy plays in reacting to these imbalances and their inevitable unwinding. The Federal Reserve’s mandate is to keep inflation low and stable and to promote full resource utilization, with the economy expanding at its maximum sustainable rate. Thus, anything that has the potential to threaten the stability of output and prices is of concern to us. These imbalances certainly affect the forces of supply and demand and have consequences for price stability. Nevertheless, their direct influence on monetary policy is limited: They are important to us in so far as they affect the macro economy, and in this regard they are just a few of the factors that the Federal Open Market Committee considers in assessing the prospects for the stability of prices and output. Hence, we should take into account the claim on resources implied by the federal budget, as we should the effect that housing wealth has on consumer spending and the economy more broadly. We should note the implications of changes in the exchange rate or borrowing rates by U.S. corporations that result from shifts in global investor sentiment. But, in the same vein, we should not hesitate to raise interest rates to contain inflation pressures just because it might set off a retrenchment in housing prices, just as we were willing to keep rates unusually low as house prices rose rapidly. Nor should we hesitate to raise rates because higher rates mean higher debt-servicing burdens for the current account, the fiscal authority, or households. In my view, our role is to anticipate as best we can the macroeconomic effects of imbalances and their correction and to respond to unexpected changes in asset prices and spending propensities as they occur. It is through such actions that we aim to achieve our objective of economic stability.
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Remarks by Mr Roger W Ferguson Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at a European Central Bank Colloquium in Honor of Tommaso Padoa-Schioppa, The European Central Bank, Frankfurt, Germany, 27 April 2005.
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Roger W Ferguson, Jr: The evolution of central banking in the United States Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at a European Central Bank Colloquium in Honor of Tommaso Padoa-Schioppa, The European Central Bank, Frankfurt, Germany, 27 April 2005. The references for the speech can be found on the website for the Board of Governors of the Federal Reserve System. * * * This conference honors the many contributions of Tommaso Padoa-Schioppa. As a staff member at the Banca d’Italia starting nearly four decades ago and as a member of the Executive Board of the European Central Bank (ECB) since 1998, Tommaso has been deeply involved in what central banks do and how they are organized. Tommaso has stated: “In shaping monetary policy operations, the role of the financial environment is not less important than the charter.”1 That observation was made in the context of the way open market operations ought to be conducted, but I would like to interpret it more broadly in my remarks today. In particular, I will address the question of whether a central bank’s operations depend in an important way on the architecture of the financial system and the economy it serves. The charter imposes a certain framework, but events may require changes to procedures and, on rare occasion, changes to the charter. To explore this topic, I would like to discuss the evolution of central banking in the United States, with particular reference to currency, relations between the regions and the center, mandates, and communication. Along the way, I will compare our experience with that of the ECB. I will, of course, be speaking for myself and not my colleagues at the Federal Reserve. To start, let me address the title of this session: “A Single Currency and a Team of Thirteen Central Banks.” How did the United States develop a single currency, and what are the parallels that we can draw with the euro? A single currency Although the notes of the First and Second Banks of the United States achieved relatively wide circulation, not until the 1860s, during our Civil War, did a national paper currency become established. The first step was an issuance of Treasury currency, commonly known as “greenbacks” because of the color of the ink used to print the notes. Shortly thereafter, the Congress authorized the establishment of national banks, which issued notes that were backed by holdings of government bonds. National bank notes of different banks were similar in design and widely accepted in transactions, but the system had some flaws - the main one being that there was no means of quickly adjusting the supply of national bank notes to changing circumstances. In other words, we had established a national currency system but not a central bank to manage it. This beginning contrasts with the way the euro was established as a single currency out of many European currencies. Rather than having no central bank, what was to become the euro area had, in fact, twelve national central banks, each managing its own currency. Those currencies were brought into line with one another, first through the exchange rate mechanism and later by the permanent fixing of exchange rates. The ECB then was created as a central bank to manage the euro even before a euro paper currency came into existence. Federal Reserve notes began to circulate in 1914. The System’s treatment of these notes serves as an example of Tommaso’s observation that central bank operations respond to financial events. Initially, notes issued by one Reserve Bank could not be reissued into circulation by another Reserve Bank. A person could travel from Boston to New York with notes from the Federal Reserve Bank of Boston in his pocket, spend the notes in New York, and have them accepted. But when the notes made their way to the Federal Reserve Bank of New York, that Bank returned the notes to Boston for re-issue. With regard to currency, then, the Federal Reserve System’s charter established twelve banks issuing similar, but not identical, currency. Over time, however, financial practice made this distinction unimportant, and the treatment was later discontinued. Today, currency is treated fungibly Padoa-Schioppa (2004), pg. 86. by the Reserve Banks, regardless of which Bank issued the note. The notes still carry identifiers that let us track the Reserve Bank to which the notes were originally assigned, and they are still allocated as liabilities to individual Reserve Banks. But there is no practical distinction between the notes of the Reserve Banks. My understanding is that euro banknotes circulate in a similar fashion within the euro area and that any national central bank can re-issue fit euro banknotes regardless of the original issuer. Although the country that originated the production order is indicated by the letter prefix to the euro banknotes’ serial number, even that designation is becoming less important as the Eurosystem moves to a pooled system of printing banknotes. Even though the Eurosystem contains the central banks of sovereign nations, the unified treatment of euro banknotes recognizes the unifying force of a single currency. Clearly, then, as one considers currency, the history of the Federal Reserve supports and reflects the truth of Tommaso’s statement. As our economy evolved from regional to national, our currency moved more completely in that direction. I would argue that the euro reflects a different perspective, with the currency playing a catalytic role in the development of a continental economy as well as reflecting developments in that regard. Regions and the center In 1913, the very idea of a central bank was contentious in the United States. The result of the Federal Reserve Act was a compromise, with regional Reserve Banks owned by their member commercial banks and a Board in Washington to provide oversight. Although the integration of U.S. financial markets was considerable by the time the Federal Reserve Act was passed, remaining segmentation made it possible to have different prices for Reserve Bank credit in different regions during the System’s early years. To be sure, these differences were not huge - basic discount rates differed by as much as 1-1/2 percentage points, with differences of 50 to 100 basis points persisting for long periods. In Tommaso’s terms, monetary policy operations - that is, discount policy - reflected both the regional nature of the System’s charter and the partial segmentation of the financial environment. Further integration of the money market over time shifted the focus of policy from twelve regional discount policies to a single national policy. In addition, concern about operational efficiencies and about the level of borrowing led to a move from discount rates to open market operations as the policy instrument of choice. This shift may also have been aided by the expansion of the government bond market during and after World War I. The use of open market operations accelerated the desire for coordination of policy at the national level, so that one Reserve Bank was not draining liquidity at the same time that another was adding liquidity. Again, the financial environment contributed to developments in policy implementation. The balance of policy power shifted from the regions to the center, when the Banking Act of 1935 established the Federal Open Market Committee in its modern form, with the Board having the majority of votes. From the perspective of monetary policy, it was at that point that the Federal Reserve System became a single central bank rather than a confederation of regional central banks. Thus, as Tommaso might suggest, charter changes also played an important role in the structure of policy. In the Eurosystem, the balance between the center and the regions is still evolving. The composition of the Governing Council, the Eurosystem’s equivalent to the FOMC, and the administrative roles of the Governing Council and the Executive Board reflect the relative strength of the national central banks. This difference in the relative power of the center, however, should not have great significance for the conduct of monetary policy. As in the Federal Reserve System, each Eurosystem policymaker is expected to act in the interest of the entire currency area. In the United States, once policy implementation boiled down to managing the consolidated balance sheet of the Federal Reserve Banks, it made sense to concentrate open market operations in New York, where most major banks and dealers had offices. New York bought and sold on the FOMC’s orders, but the resulting portfolio was allocated to each Reserve Bank based on its capital. In the Eurosystem, open market operations are conducted in a unified but decentralized manner. Each national central bank collects bids from financial entities in its country and relays those to the ECB where they are ranked and allocated accordingly. I would argue that these slight variations in the implementation of monetary policy reflect the financial circumstances under which each institution operates, with a unified money market in the United States and more-fragmented (but consolidating) money markets in the eurozone. Internal dynamics Although the 1935 legislation that created the Federal Open Market Committee of today shifted monetary policy power from the regions to the center, important questions remained about the internal workings of the FOMC itself. With only five of the twelve Reserve Bank Presidents on the Committee at any one time, how were these seats to be allocated?2 The FOMC finally settled on a rotation system that was a compromise between strict equality and relative importance of each District in the financial system. New York was given a permanent seat. Cleveland and Chicago were grouped together, and the remaining Reserve Banks were put into groups of three. Thus, Presidents of Reserve Banks other than New York would be FOMC members every other year or every third year. That rotation structure has remained unchanged since 1942. The FOMC operates through formal votes on policy questions, yet in recent years dissents in the recorded votes have been remarkably rare. Through discussion and with the leadership of the Chairman, the Committee often crafts a policy action that all members can agree on. Yet, if one looked only at the final vote, one would miss the lively and wide-ranging debate that goes on within the meetings themselves. We try to give the flavor of this debate in the minutes released three weeks after each meeting, and we do release detailed transcripts with a lag of five years. My understanding is that the ECB’s Governing Council operates by consensus, although a procedure is in place for a majority vote to determine the course of monetary policy. So far, the ECB has maintained the principle of one member, one vote, with the six Executive Board members and the twelve national central bank presidents voting equally regardless of the economic size of the country that they represent. The ECB has had to wrestle with how to adjust voting as the euro area expands over the next decade or so. The European Council has accepted a proposal from the ECB to cap the number of voting national central bank presidents at fifteen and to begin rotational voting once the number of countries in the euro area exceeds fifteen. The voting rotation would look a bit like that initially established by the Federal Reserve, with the frequency of voting by individual members depending in part on the economic and financial size of their regions. The big difference, however, is that the national central bank presidents would have fifteen votes versus the six votes of the Executive Board members, whereas Federal Reserve Board members have a seven-to-five voting advantage over regional Fed Presidents. Clearly the system that we follow, with strong regional representation but a majority in the center, reflects the judgment made in 1935 regarding the primacy of political appointees with a national mandate. I would argue, although those closer to the scene might correct me, that the ECB’s approach to its regional representation reflects an evolving compromise that attempts to balance the ongoing legitimacy of national monetary authorities with the need for a practical solution to the challenges posed by the increasing number of nations within the eurozone. Mandates and approaches to monetary policy The original Federal Reserve Act contained almost no explicit macroeconomic goals for the System to follow. The gold standard was thought to be sufficient to produce price stability, and the central bank’s lending to meet the needs of trade (“real bills”) was seen as fostering financial stability and the smooth functioning of the economy. Nonetheless, fairly early in its history, the Federal Reserve interpreted its mandate to be the promotion of monetary and credit conditions that would foster sustainable growth At any given time, the FOMC consists of only twelve members - the seven members of the Board of Governors and five of the twelve Reserve Bank Presidents on a somewhat complicated rotating basis. By custom, however, all twelve Reserve Bank Presidents attend the meetings of the Committee. The extra seven presidents are not considered nonvoting members of the FOMC; they are just not on the Committee at that time. Since there are no nonvoting members of the FOMC, the term “voting member of the FOMC” is redundant. A more accurate term is “non-voting participant.” To complicate matters further, some of the extra seven Reserve Bank Presidents are designated as alternate members of the FOMC, depending on the rotation group arrangement. and a stable value of the dollar. After the Great Depression and World War II, the federal government took a more-active role in managing the macroeconomy. The Employment Act of 1946 committed the federal government to use its resources to foster maximum employment. This act provided some broad guidance for the Federal Reserve but not explicit goals for monetary policy. Against the backdrop of poorer economic performance in the 1970s, the Congress gave the Federal Reserve explicit goals in a 1977 amendment to the Federal Reserve Act. These goals were stated in terms of maintaining long-run growth of monetary and credit aggregates that would promote “maximum employment, stable prices, and moderate long-term interest rates.” Thus, the mandate really contained three goals, but the last one has been widely interpreted as those long-term interest rates consistent with the first two goals, giving the Federal Reserve a “dual mandate” of maximum employment and stable prices. Many times in recent decades, the Federal Reserve has stressed its long-run goal of stable prices, linking it with the other half of our mandate by noting that in the long run the two do not conflict. However, at times the Federal Reserve has used the flexibility that our dual mandate provides to consider the variability of real output in policymaking. For the ECB, the Maastricht treaty mandated that price stability would be the primary objective. The treaty also established that the ECB should support the general economic policies of the European Community, aiming at growth and employment but only insofar as price stability is not endangered. This focus on price stability helped establish credibility for the new central bank and has helped anchor inflation expectations among the public. A case can be made that the primacy of the inflation goal also reflected the Bundesbank’s distaste for inflation in light of the German hyperinflation of the 1920s and that this legacy was bequeathed to the new European Central Bank. Still, policymakers need to be free to act when severe supply shocks occur. The ECB has wisely interpreted its mandate as maintaining price stability “over the medium term,” giving it flexibility to deal with temporary shocks. Obviously, in both the United States and Europe, external conditions and experiences have guided the development of the mandate, as Tommaso would have suggested and common sense dictated. Communication and transparency As the conduct of monetary policy has changed over time, it has become increasingly important that the central bank communicate in an effective and transparent manner. The Federal Reserve’s communications efforts are a work in progress, with several significant advances being implemented over the past few years. In March 2002, the FOMC began to release the vote of its members immediately after its meetings. In December 2004, the FOMC accelerated the release of its minutes from an average of six weeks after the meetings to just three weeks after the meetings. As part of its communication efforts, the Federal Reserve, since the late 1970s, has been providing forecasts of inflation and real economic activity twice a year, as several other central banks have elected to do more recently. Until recently, these forecasts had a horizon that could be as short as one year. This past January, the semiannual FOMC forecasts reported in the Monetary Policy Report were extended to include the following calendar year. ECB communication practices differ in some notable aspects from those of the Federal Reserve, with the differences partly reflecting the ECB’s unusual situation as a multinational central bank. The ECB does not release minutes or transcripts and does not provide information on Governing Council votes. Rather than detailing the differing views of individual members, who might feel pressure to represent their national interests if their votes were made public, the ECB focuses on explaining the analysis behind the Governing Council’s consensus. In particular, the ECB follows its monetary policy meetings with a news conference in which the president reads a statement reflecting the Council’s deliberations and then answers questions. Changes to ECB communication policy in recent years also have reflected the ECB’s multinational status. In December 2000, when the ECB started releasing twice-yearly forecasts of gross domestic product and inflation, it chose to release its staff forecasts, in contrast to the practice of the Federal Reserve, which releases the range and central tendencies of projections of the individual FOMC members. I would argue that the Federal Reserve’s ongoing process of transparency may also reflect the highly developed state of our financial markets and a growing recognition that, against that financial backdrop, shaping the expectations of market participants can on occasion be an important adjunct to monetary policy. I would be curious to learn the degree to which the ECB’s approaches to communications reflect the financial circumstances as well as the multinational nature of the institution. Conclusion In conclusion, I would like to stress the importance of Tommaso’s observation about policy that I quoted at the outset. Monetary policy arrangements do, and should, adjust over time to changes in the economic and financial environment. This brief review of the history of the Federal Reserve shows this adjustment process at work over our ninety-year history. The charter lays out a structure for policy implementation that is appropriate for the financial system of the day. The financial system then changes and policy implementation must adapt. Eventually, changes in the financial system can trigger changes in the charter that give policy implementation a new context. While there is no single best way to arrange monetary policy and central bank functions within a multiregional system, I am struck by the broad similarities between the Federal Reserve and the Eurosystem as each grapples with a large, complex, and ever-changing macroeconomy. In some ways, your experience has collapsed into several years changes that evolved over decades for the Federal Reserve. But both experiences, and the ongoing changes in the economic environment in which we operate, suggest that the art of central banking is certainly likely to undergo further changes.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, to the Federal Reserve Bank of Chicago¿s Fourty-first Annual Conference on Bank Structure, Chicago, Illinois, (via satellite), 5 May 2005.
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Alan Greenspan: Risk transfer and financial stability Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, to the Federal Reserve Bank of Chicago’s Fourty-first Annual Conference on Bank Structure, Chicago, Illinois, (via satellite), 5 May 2005. * * * Chicago is the birthplace of modern financial derivatives markets. So this conference seems an appropriate place in which to reflect once more on the prodigious growth of these risk-transfer instruments and their implications for financial stability. Two years ago at this conference I argued that the growing array of derivatives and the related application of more-sophisticated methods for measuring and managing risks had been key factors underlying the remarkable resilience of the banking system, which had recently shrugged off severe shocks to the economy and the financial system. At the same time, I indicated some concerns about the risks associated with derivatives, including the risks posed by concentration in certain derivatives markets, notably the over-the-counter (OTC) markets for U.S. dollar interest rate options. Today I will pursue those concerns about concentration in greater depth, drawing on discussions that Federal Reserve staff have had with market participants. I will also address concerns that some observers have expressed about the use of credit derivatives to transfer risk outside the banking system and about the growing role of hedge funds in bearing risk in derivatives markets and the financial system generally. Derivatives - potential benefits and risk-management challenges Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth. As a consequence of the increasing demand for these products, the size of the global OTC derivatives markets, according to the Bank for International Settlements (BIS), reached a notional principal value of $220 trillion in June 2004. Indeed, the growth rate of the OTC markets was more rapid in 2001-04 than over the previous three years. At the same time, the growth rate of exchange-traded derivatives exceeded the growth rate of OTC derivatives over 2001-04. Throughout the 1990s, the Chicago futures and options exchanges debated whether the growth of the OTC markets was good or bad for their markets. The data seem to have resolved that debate. In the United States, the Commodity Futures Modernization Act of 2000 has permitted healthy competition between the exchanges and the OTC markets, and both sets of markets are reaping the benefits. The benefits are not limited to those that use derivatives. The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions, which was so evident during the credit cycle of 2001-02 and which seems to have persisted. Derivatives have permitted the unbundling of financial risks. Because risks can be unbundled, individual financial instruments now can be analyzed in terms of their common underlying risk factors, and risks can be managed on a portfolio basis. Partly because of the proposed Basel II capital requirements, the sophisticated risk-management approaches that derivatives have facilitated are being employed more widely and systematically in the banking and financial services industries. To be sure, the benefits of derivatives, both to individual institutions and to the financial system and the economy as a whole, could be diminished, and financial instability could result, if the risks associated with their use are not managed effectively. Of particular importance is the management of counterparty credit risks. Risk transfer through derivatives is effective only if the parties to whom risk is transferred can perform their contractual obligations. These parties include both derivatives dealers that act as intermediaries in these markets and hedge funds and other nonbank financial entities that increasingly are the ultimate bearers of risk. Concentration in derivatives markets - the case of U.S. dollar interest rate options Financial consolidation has reduced the number of firms that, by acting as dealers, provide liquidity to the OTC derivatives markets. Two years ago I expressed particular concern about the implications of dealer concentration for risks in derivatives markets. Among the markets identified as appearing to be especially concentrated were the markets for U.S. dollar interest rate options. Those markets have become increasingly large and important as the U.S. markets for fixed-rate mortgage-backed securities (MBS) have grown and as an increasing share of those securities have come to be held by investors that manage the prepayment risks associated with those instruments. The dealers intermediate between these mortgage hedgers, who seek to purchase swaptions and interest rate caps, and sellers of various types of interest rate options. The mortgage hedgers include Fannie Mae and Freddie Mac and mortgage servicers. The options sellers include issuers of traditional callable debt and issuers of structured notes with interest rate caps or other embedded options. Hedge funds at times have been important sellers of options and suppliers of options market liquidity, especially during periods when increases in interest rate volatility have caused spikes in options prices. Concentration in the OTC options markets raises at least three specific concerns. First, market illiquidity may result from a leading dealer's exit and that illiquidity has the potential to adversely affect Fannie and Freddie and other hedgers of mortgages and MBS. Second, meeting the demands for options by mortgage hedgers involves market risk to dealers, a concern that has been heightened by the fact that the notional value of options sold by dealers significantly exceeds the notional value purchased. Third, the failure of a leading dealer could result in counterparty credit losses for market participants. The extent to which these concerns are valid depends on how effectively market participants manage market risk and counterparty credit risk. To obtain information on participants' risk-management practices, members of the Federal Reserve staff last summer interviewed some of the leading market participants, including Fannie and Freddie and half a dozen leading derivatives dealers. The potential for a dealer's exit to adversely affect mortgage hedgers is dependent upon hedgers' diversification of counterparties, the way in which hedgers use options, and the underlying reason for such an exit. Fannie and Freddie have about twenty dealers as options counterparties, including investment banks and foreign banks as well as U.S. commercial banks. However, only about five or six of them have direct access to the supply of options from debt issuers; the others must depend on the interdealer market for a substantial portion of their supply. The exit of one of these five or six may or may not adversely affect market liquidity, depending on the reason for the exit and on the way in which other dealers react. If a dealer is forced to exit because of a credit problem unrelated to its options dealing, other dealers are likely to take its place quickly. If the exit is the result of losses from options dealing, possibly in difficult market conditions, other dealers with similar positions are likely to be pulling back as well, which could leave the options markets quite illiquid. In any event, Fannie and Freddie and other mortgage hedgers do not rely on continuous liquidity in the options markets. Rather, they purchase options periodically and opportunistically. Provided that options market illiquidity is not protracted (say more than a month), they could postpone transacting in those markets until liquidity returns, without exceeding their internal risk limits. By contrast, mortgage hedgers do rely on continuous liquidity in the swaps market because they currently use swaps to execute dynamic hedges of the prepayment risk that is not hedged up front with options, and those markets are less concentrated and easier to intermediate than the options markets. Still, as the hedgers are aware, the supply of liquidity available to them in the swaps market is not unlimited. Their periodic purchases of interest rate options are intended to limit their reliance on dynamic hedging and their potential demands on swaps market liquidity. Nonetheless, concerns about potential disruptions to swaps market liquidity will remain valid until the vast leveraged portfolios of mortgage assets held by Fannie and Freddie are reduced and the associated concentrations of market risk and risk-management responsibilities are correspondingly diminished. Articles that appeared in the financial press in early 2004 called attention to the fact that the BIS data showed that the notional value of U.S. dollar interest rate options sold by OTC derivatives dealers exceeded the notional value of options purchased. This difference had been growing as the options markets had grown and had reached more than $800 billion in notional value (an amount equal to 15 percent of the notional value of options purchased) as of year-end 2003. Not surprisingly, an analysis of risks based solely on notional amounts turns out to be misleading. The interviews that Federal Reserve staff members conducted last year indicate that dealers run fairly well-balanced books in terms of sensitivities to changes in interest rates and especially to changes in interest rate volatility. The options that dealers sell tend to have terms that create less sensitivity to changes in interest rate volatility than the options that they buy. Thus, in order to limit the overall sensitivity of their options portfolios to changes in interest rate volatility, dealers must sell a larger notional value of options than they buy. Because the terms of the options that they sell differ substantially from the terms of the options that they buy, dealers do assume significant basis risks, and their hedging strategies are dependent on options market liquidity when rates and volatilities are changing rapidly. In general, such risks are monitored and limited by various internal controls. If the options markets were to become illiquid, dealers could suffer significant losses; but their controls appear to be sufficiently tight that the losses seem quite unlikely to be large enough to jeopardize such large, diversified intermediaries. Participants in the OTC derivatives markets typically manage their counterparty credit risks to dealers by transacting only with counterparties that are perceived to be highly creditworthy, by entering into legal agreements that provide for closeout netting of gains and losses, and with the exception of most exposures to the few Aaa-rated dealers, by agreeing to collateralize net exposures above a threshold amount. All the major participants in the markets for U.S. dollar interest rate options markets that Federal Reserve staff interviewed follow these practices. The widespread use of collateral, in particular, usually is a powerful means of limiting counterparty credit losses.1 However, when counterparties hold very large net positions in illiquid markets, as the hedge fund Long-Term Capital Management (LTCM) did in 1998, the effectiveness of collateral as a risk mitigant may be reduced significantly. In such circumstances, when the nondefaulting counterparties seek to close out their positions with a defaulting counterparty, those actions can cause market prices to move rapidly in directions that may amplify losses to levels significantly exceeding even very conservative collateral requirements. In contrast to LTCM, however, dealers typically limit the size of their net open positions in markets, even though their gross positions often substantially exceed the size of LTCM's. Thus, the collateralization of exposures to dealers is likely to be quite effective in limiting the counterparty risks from dealer concentration. Nonetheless, participants in the interest rate options markets and other derivatives markets should carefully evaluate the potential market effects of the failure of a dealer or any other large market participant and the ways in which such effects could magnify both their counterparty credit risks and their market risks. In summary, as we have come to understand more clearly how participants in the OTC interest rate options markets use those markets and manage the risks associated with their use, wariness about concentration in these markets, though diminished, has not disappeared. The Federal Reserve remains concerned that the stress tests that some large participants are using to evaluate potential losses in the event of a large participant's default do not fully capture the potential interaction of counterparty credit risk and market risk, especially in concentrated markets. Use of credit derivatives to transfer risk outside the banking system Perhaps the most significant development in financial markets over the past ten years has been the rapid development of credit derivatives. Although the first credit derivatives transactions occurred in the early 1990s, a liquid market did not emerge until the International Swaps and Derivatives Association succeeded in standardizing documentation of these transactions in 1999. According to the BIS, the notional value of credit derivatives outstanding increased sixfold between 2001 and 2004, reaching $4.5 trillion in June of last year. Moreover, this growth has been accompanied by significant product innovation, notably the development of synthetic collateralized debt obligations (CDOs), which allow the credit risk of a portfolio of underlying exposures to be divided or "tranched" into different segments, each with different risk and return characteristics. Recent growth of credit derivatives has been concentrated in these more-complex structured products. As is generally acknowledged, the development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively. In particular, the largest banks have found single-name credit default swaps a highly attractive mechanism for reducing exposure concentrations in their loan books while allowing them to meet the needs of their largest corporate customers. But some observers argue that what is good for the banking system may not be good for the financial system as a whole. They are concerned that banks' efforts to lay off risk using credit derivatives may Concerns about the availability of high-quality collateral sufficient to meet the growing demands in these markets have abated as the use of cash as collateral has become widespread. The International Swaps and Derivatives Association estimates that, at the beginning of 2005, cash accounted for nearly three-quarters of the collateral held to support derivatives exposures. be creating concentrations of risk outside the banking system that could prove a threat to financial stability. A particular concern has been that, as credit spreads widen appreciably at some point from the extraordinarily low levels that have prevailed in recent years, losses to nonbank risk-takers could force them to liquidate their positions in credit markets and thereby magnify and accelerate the widening of credit spreads.2 A definitive evaluation of these concerns about nonbank risk-takers would require information on the extent of credit risk transfer outside the banking system and on the identities and risk-management capabilities of the entities to which the risk has been transferred. Unfortunately, available data do not provide this information. Data on the size of the credit derivatives markets are limited largely to the notional principal amounts of transactions. As discussed earlier, notional amounts often are misleading indicators of risk, and this problem is acute regarding credit derivatives. Critical to any evaluation of the CDO markets is an understanding that, per dollar of notional value, the risk (and risk transfer) associated with various CDO tranches varies enormously. The risk per dollar of notional amount of the "first loss," or equity, tranche can be thirty or forty times the risk per dollar of the senior tranche, which would be required to absorb losses only after the protection provided by the equity tranche and other more-junior tranches had been exhausted. While available data cannot resolve these issues, a study conducted last year by the Joint Forum, which was based on interviews with market participants, does shed some light.3 The study concluded that notional values had significantly overstated the amount of credit risk that had been transferred outside the banking system to that point and that the amount of risk transfer was quite modest relative to the total amount of credit risk that exists in the financial system. The study found no evidence of "hidden concentrations" of credit risk. Risk-takers outside the banking system included monoline insurers and other insurance companies; private asset managers acting on behalf of pension funds, mutual funds, and other institutional investors; and hedge funds. As to the risk-management capabilities of these nonbank entities, the study found that they seem largely aware of the risks associated with credit derivatives. The study did note that understanding the credit risk profile of CDO tranches poses challenges to even the most-sophisticated market participants. An especially difficult issue is the assessment of default correlation across different reference entities. In general, the valuation of CDO tranches is model dependent, and market participants need to carefully evaluate the models that they use and the model parameter assumptions that they make, notably the assumptions regarding default correlations. To limit legal and reputational risks, dealers should seek to foster a complete understanding of transactions among the investors to which they sell CDO products. The report cautioned investors in CDO tranches not to rely solely on rating-agency assessments of credit risk, in part because a CDO rating cannot possibly reflect all the dimensions of the risk of these complex products. The report also called attention to significant operational risks that have emerged as market participants' back offices have struggled to keep pace with growing transactions volumes and more complex products. Despite recent automation initiatives, the lack of timely documentation of new transactions and assignments of existing transactions remains a significant problem. Some other concerns about the transfer of credit risk outside the banking system seem to be based on questionable assumptions. Some observers believe that credit risks will be managed more effectively by banks because they generally are more heavily regulated than the entities to which they are transferring credit risk. But those unregulated and less heavily regulated entities generally are subject to more-effective market discipline than banks. Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties. In essence, prudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities. Such private prudential regulation can be impaired - indeed, even displaced - if some counterparties assume that government regulations obviate private prudence. We regulators are often perceived as constraining excessive risk-taking more effectively than is demonstrably possible in practice. Except where market discipline is undermined by moral hazard, for example, because of federal guarantees of private debt, private regulation generally has proved far better at constraining excessive risk-taking than has government regulation. Recent spikes in some credit default swap spreads do not appear to have induced significant stress, although this experience has been too limited to be definitive. The Joint Forum (2004), Credit Risk Transfer (Basel: Bank for International Settlements). In fact, while many focus on the dangers of risk transfer to highly leveraged entities that might be vulnerable to a sharp widening of credit spreads, a significant portion of the risks that are being transferred outside the banking system are being transferred through private asset managers to institutional investors that have much lower leverage than banks. Indeed, the increasing transfer of systematic risks from banks to entities with lower leverage and longer time horizons may, other things equal, push credit spreads lower. Such investors may naturally have a greater tolerance for risk than banks. The growing role of hedge funds in derivatives markets and the financial system generally Of course, much of the unease about credit risk transfer outside the banking system reflects the growing role that hedge funds play in those markets and in the financial system generally. Although comprehensive data on the size of the hedge fund sector do not exist, total assets under management are estimated to be around $1 trillion. Inflows to hedge funds have been especially heavy since 2001, as investors have sought alternatives to long-only investment strategies in the wake of the bursting of the equity bubble. By some estimates, the size of the hedge fund sector doubled between 2001 and 2004. A substantial portion of the inflows to hedge funds in recent years reportedly has come from pension funds, endowments, and other institutional investors rather than from wealthy individuals. Hedge funds have become increasingly valuable in our financial markets. They actively pursue arbitrage opportunities across markets and in the process often reduce or eliminate mispricing of financial assets. Their willingness to take short positions can act as an antidote to the sometimes-excessive enthusiasm of long-only investors. Perhaps most important, they often provide valuable liquidity to financial markets, both in normal market conditions and especially during periods of stress. They can ordinarily perform these functions more effectively than other types of financial intermediaries because their investors often have a greater appetite for risk and because they are largely free from regulatory constraints on investment strategies. But some legitimate concerns have been expressed about the possible adverse effect of hedge funds' activities on market liquidity in some circumstances. One such concern is the potential for rapid outflows from the sector in the event that returns prove disappointing. Disappointments seem highly likely given the number of recent investors in this sector, all seeking arbitrage opportunities that of necessity will diminish as more capital is directed to exploiting them. Furthermore, some (perhaps many) hedge fund managers are likely to prove incapable of delivering the returns that investors apparently expect. Indeed, investors have already forced many hedge funds to fold after producing disappointing returns. Provided that investors do not force exiting funds to suddenly liquidate their assets, such exits contribute to the efficiency of the financial system and do not adversely affect market liquidity. Historically, investors have not been able to force the sudden liquidation of a hedge fund because investments have been subject to lengthy redemption or "lock up" requirements. However, there are reports that institutional investors have been able to negotiate much shorter redemption periods. If institutional money proves to be "hot money," hedge funds could become subject to funding pressures that would impair their ability to supply liquidity to markets and might cause them to add to demands on market liquidity. Another circumstance in which hedge funds could negatively affect market liquidity is if they became so leveraged that adverse market movements could lead to their failure and force their counterparties to close out their positions and liquidate their collateral. For example, the fear of the market effects of closeout and liquidation of LTCM's very large net positions motivated its counterparties to recapitalize the hedge fund in 1998. LTCM was able to become so large and so highly leveraged because its derivatives and repo market counterparties, perhaps awed by the reputations of its principals, failed to effectively manage their credit risk to LTCM. In the wake of the LTCM episode, the large banks and securities firms that were counterparties to hedge funds strengthened their management of hedge fund risk very significantly. Those improvements were motivated by their self-interest, which was reinforced by recommendations from their prudential supervisors and from the Counterparty Risk Management Policy Group (CRMPG), a group of twelve banks and securities firms that were among the most significant counterparties to hedge funds.4 However, recently there have been reports that competitive pressures have resulted in some weakening of risk-management practices. In light of these reports and of the rapid growth of the hedge fund industry, the Federal Reserve recently reviewed banks' management of hedge fund credit risk in relation to the recommendations that supervisors and the CRMPG made in 1999. The review indicated that, despite some recent slippage, banks have made considerable progress in implementing many of those recommendations and thereby in strengthening their risk-management practices. In particular, banks can now capture their aggregate credit exposures to individual funds, and their measures of the credit exposures now incorporate the risk-mitigating effects of collateral requirements. Furthermore, most banks now stress test the potential effects of volatile or illiquid markets on their exposures. Banks' due diligence procedures and hedge funds' disclosures have improved sufficiently that banks now can qualitatively assess the risk-management capabilities and overall risk profiles of the funds. Nonetheless, the review noted some remaining weaknesses. First, because many fund managers are reluctant to provide banks with complete information about their portfolios or with forward-looking measures of the risks that the funds are assuming, the banks often cannot fully evaluate a fund's risk profile. Banks sometimes tighten collateral requirements and other credit terms to compensate for this lack of transparency, but most banks' policies could be improved by the establishment of clearer and firmer links between credit terms and transparency. Second, banks do not always aggregate stress test results across hedge fund counterparties to assess concentrations of exposures in volatile and illiquid markets. Third, and perhaps of greatest concern, in certain highly liquid markets, especially OTC interest rate swaps and repos, there are signs that competitive pressures may be eroding the protection that banks achieve through collateral requirements by reducing the initial margins that they obtain from hedge funds. Thus, the review suggests that banks and their supervisors need to be alert to the possibility that further slippage of credit terms could result in material increases in credit risk to banks, a material loss of market discipline on hedge funds, and a material increase in the potential for hedge fund leverage to adversely affect market dynamics. Perhaps the recent widening of credit spreads will engender increased caution by managers of credit risk. Moreover, as in 1999, cooperative private-sector efforts to identify and implement sound risk-management practices have the potential to reinforce the efforts of individual firms and their prudential supervisors. In this regard, a very encouraging development is the recent formation, by leading banks, securities firms, insurance companies, asset managers, and hedge funds, of a new group (CRMPG II) to assess improvements in risk management since 1999 and to update the CRMPG recommendations to reflect subsequent changes in risk-management practices and in the financial, regulatory, and legal environment. Ensuring sound credit-risk management by hedge funds' counterparties remains the most promising approach to addressing concerns about hedge fund leverage. Some may believe that government regulation of hedge fund leverage would be more effective. But it would be very difficult to design a set of capital requirements for hedge funds that is appropriately sensitive to the diversity and flexibility of investment strategies that different funds employ and to the lack of diversification in the portfolios of individual funds. A regulatory capital regime that was not extraordinarily risk-sensitive would be ineffective at constraining hedge funds' risk-taking. At the same time, it would impair their capacity to pursue strategies that enhance the efficiency and liquidity of our financial markets and thereby to contribute to the productivity and resilience of our economy. Conclusion The rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress. Even with sound credit-risk management, a sudden widening of credit spreads could result in unanticipated losses to investors in some of the newer, more complex structured credit products, and those investors could include some leveraged hedge funds. Risk management involves judgment as well as science, and the science is based on the past behavior of markets, which is not an infallible guide to the future. Yet the history of the development of these products encourages confidence that many of the newer products will be successfully embraced by Counterparty Risk Management Policy Group (1999). "Improving Counterparty Risk Management Practices (348 KB PDF)," report available through the House Committee on Financial Services. the markets. To be sure, for that favorable record to be extended, both market participants and policymakers must be aware of the risk-management challenges associated with the use of derivatives to transfer risk, both within the banking system and outside the banking system. And they must take steps to ensure that those challenges are addressed.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the Association for Financial Professionals Global Corporate Treasurers Forum, San Francisco, California, (via videoconference), 12 May 2005.
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Roger W Ferguson, Jr: Globalisation - evidence and policy implications Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the Association for Financial Professionals Global Corporate Treasurers Forum, San Francisco, California, (via videoconference), 12 May 2005. * * * Thank you for inviting me to address the Association for Financial Professionals Global Corporate Treasurers Forum. Given that this is a global forum, I have chosen economic and financial globalization as my topic today. Proponents of globalization cite a wider array of goods and services available for consumers, greater market competition and lower prices, new financial instruments for savers, possibilities for greater and more-productive investments, and strengthened market discipline of government policies. All of these benefits could translate into faster economic growth and higher real incomes for most people. Opponents point to lost manufacturing jobs in advanced economies and financial crises in emerging-market nations. Some have argued that it is better to put sand in the wheels of the world economic and financial system to prevent such apparently undesirable and unstable outcomes. Notwithstanding these concerns, I believe that globalization is, on balance, a positive development for the world economy. Perhaps more to the point, I think that globalization is here to stay and that further globalization is inevitable. Today, I want to review where we are in the process of globalizing product markets and the factors of production - capital and labor. I also want to speculate about some implications of globalization for policymakers. As always, my views are not necessarily shared by my colleagues in the Federal Reserve System. Globalization of financial markets Let me begin with capital or financial markets. As financial professionals, most of you have probably experienced changes in your professional lives arising from financial globalization. Besides such experiences, statistics, too, imply big changes. For example, cross-border investments are far larger now than they were twenty years ago. From 1984 to 2003, U.S. investment holdings abroad more than tripled after controlling for inflation, while real U.S. gross domestic product did not quite double. Foreign investments in the U.S. rose proportionately much more, by almost a factor of six.1 Because of increased market turnover, cross-border transactions have grown even faster than cross-border holdings. In 2002, the gross value of cross-border equity trades was 80 percent of worldwide equity market capitalization, whereas in 1989 cross-border trades equaled only 18 percent of a much smaller world equity market.2 Given these developments, it is not surprising that financial asset prices in various countries appear to move together more than they used to. For example, from the end of World War II to 1971, the average correlation of monthly equity market index returns among the United States, the United Kingdom, France, and Germany was around 0.1; but from 1972 to 2000, it rose to 0.5.3 Since 2000, the average correlation has risen further, to about 0.8.4 Financial globalization is not limited to the securities markets. Financial institutions have also stretched their global reach. According to Federal Reserve data, U.S. offices of foreign banking organizations increased their share of U.S. bank deposits from around 2 percent in the early 1970s to around 15 percent in recent years.5 Several of the largest U.S. financial institutions have vastly expanded their global operations over this period. These figures include both direct investments and financial claims. See U.S. Department of Commerce, Bureau of Economic Analysis, Yearend Positions, 1976-2003. McKinsey Global Institute (2005), $118 Trillion and Counting: Taking Stock of the Worlds Capital Markets, February. William Goetzmann, Lingfeng Li, and K. Geert Rouwenhorst (2002), "Long-Term Global Market Correlations," Yale ICF Working Paper 00-60, Table 3 (correlations of monthly returns in dollars), pp. 37-38. Monthly correlations of S&P500, DAX, CAC40, and FTSE index returns in dollars over the period January 2000 to March 2005. Board of Governors of the Federal Reserve System, "Structure of Share Data for U.S. Offices of Foreign Banks," How much further will financial globalization go? Economists disagree about answers to this question, but I believe that considerable scope remains for further globalization. Let me offer a few reasons. In the case of quantities of financial assets held by investors in various nations, the simplest version of portfolio theory implies that every investor should hold assets in proportion to the world portfolio. For example, the listed equity of U.S. firms is about half of global market capitalization, and so the simple theory implies that about half the equity portfolios of U.S. investors should be in U.S. firms and half in non-U.S. firms. And about half the equity portfolios of investors in any other nation should be invested in U.S. firms. The simple theory is too simple to be realistic, and policymakers should not take it too seriously, but it is a benchmark that provides some perspective. Progress toward the benchmark has been relatively rapid in recent years. For example, the share of foreign equities in U.S. equity portfolios rose from 2 percent in 1980 to 14 percent in 2003.6 But this share still falls well short of the simple benchmark of 50 percent. The shortfall is spread fairly evenly across European, Asian, and emerging-market stocks. And U.S. holdings of foreign debt securities fall even further short of their 55 percent benchmark.7 The weights of foreign securities in the portfolios of investors in other nations are also far smaller than the benchmark.8 These facts imply that the aggregate portfolio of each nation is overweight in its own stocks and bonds; such a departure from the benchmark is thus sometimes called "home bias." Home bias will probably continue to decline, but how fast and how far are difficult to predict. Many potential sources of home bias have been suggested, including regulatory barriers, differences in expected returns to investments in different nations, differences in corporate governance or in consumption patterns across countries, smaller transaction costs or costs of staying informed for home-country investments, and delays in adjustment to the removal of regulatory and institutional barriers to cross-border investment. Without getting into an extended discussion about the relative importance of such possible sources, I note that many of them are expected to continue to diminish, and so investors' portfolios will likely become more diversified as time passes.9 What about prices of financial assets? Here a simple benchmark is the law of one price: The same asset should have the same price everywhere, after proper adjustment for transaction and transport costs, taxes, risk, and so forth. In cases where this strict definition can be applied, the law of one price usually does hold to a very good approximation - for example, on bonds of multinational corporations issued in the same currency in different jurisdictions or on depositary receipts of foreign equities relative to the underlying equities in their home markets. But in many cases, what is of interest is whether similar financial assets are priced similarly - for example, similarly rated bonds in different countries. Determining the market value of differences in characteristics of assets is difficult, so judgments about similarity of pricing can be hard to make. On the other hand, prices of at least some low-risk, liquid instruments appear to be comparable around the world, and prices of liquid assets all around the world react very quickly to news.10 On the other Charles P. Thomas, Francis E. Warnock, and Jon Wongswan (2004), "The Performance of International Portfolios," International Finance Discussion Paper 2004-817 (Washington: Board of Governors of the Federal Reserve System, September, latest version October 2004). Carol C. Bertaut and William L. Griever (2004), "Recent Developments in Cross-Border Investment in Securities," Federal Reserve Bulletin, vol. 90 (Winter), pp. 19-31. Carol C. Bertaut and Linda S. Kole (2004), "What Makes Investors Over or Underweight? Explaining International Appetites for Foreign Equities," International Finance Discussion Paper 2004-819 (Washington: Board of Governors of the Federal Reserve System, September). See Thomas, Warnock, and Wongswan (2004) for evidence that casts doubt on explanations focused on differences in expected returns, and Goetzman, Li, and Roouwenhorst (2002), Table 2. See Fang Cai and Francis E. Warnock (2004), "International Diversification at Home and Abroad," International Finance Discussion Paper 2004-793 (Washington: Board of Governors of the Federal Reserve System, February, last revision December 2004) for evidence on the role of multinational firms in providing diversification. For example, money markets in the major industrial countries have long been well integrated in the sense that covered interest parity relationships usually hold. This means that term structures of benchmark high-grade bond yields converted into a common currency with forward foreign exchange rates are similar across the major countries. For evidence about price reactions to news, see Jon Faust, John H. Rogers, Shing-Yi B. Wang and Jonathan H. Wright (2003), "The High-Frequency Response of Exchange Rates and Interest Rates to Macroeconomic Announcements," International Finance Discussion Paper 2003-784 (Washington: Board of Governors of the Federal Reserve System, October), and also Jon Wongswan (2003), "Transmission of Information across International Equity Markets," International Finance Discussion Paper 2003-759 (Washington: Board of Governors of the Federal Reserve System, February). hand, research shows that markets are not as efficient at equating the prices of risky assets, particularly those that are not liquid, so there may still be considerable scope for convergence of asset prices.11 As with the equity-price correlations I described earlier, the correlations of monthly changes in government bond yields have trended up over the past twenty years, to around 0.8 for correlations between yields in the United States and those in major European countries since early 2000. Currently, bond yields in Europe, the United States, and Canada are quite similar and are at low levels not seen in decades. Globalization may have played a role in this convergence, though the channel is not clear. I suspect that the convergence of inflation rates and inflation expectations to common low levels is an important factor. I will return later to the possibility that globalization has helped lead to low inflation around the world. Other possible contributing factors to low global bond yields include expectations that real activity and investment demand in the major regions will continue to grow at a moderate pace, reduced concerns about shocks to this growth outlook, and large purchases of bonds by Asian central banks. Globalization of labor markets Labor is an even more important factor of economic production than capital. In most advanced countries, the share of income earned by labor is about double the share earned by capital. I think it is fair to say that globalization has had much less influence on labor markets than on financial markets. Nevertheless, we see some evidence of the forces of globalization in labor markets. In just the past ten years, the share of the U.S. population born in a foreign country rose from less than 9 percent to almost 12 percent. Of the more than 34 million foreign-born individuals in the United States last year, more than half entered the country after 1990.12 This inflow of new workers has had a major effect on some categories of U.S. jobs. For example, a recent survey by the Pew Hispanic Center revealed that one out of every three U.S. jobs in the following categories are filled by foreign-born Hispanics: groundskeepers, housecleaners, bricklayers, painters, construction laborers, meatpackers, and butchers. Nearly half of all drywall installers and plasterers are foreign-born Hispanics.13 Remittances sent by such workers back to relatives in their home countries have become increasingly large. Remittances to Mexico grew from $700 million in 1980 to more than $13 billion in 2003, an amount equivalent to more than 2 percent of Mexican GDP.14 These changes are affecting other industrial countries as well. For the G-7 countries overall, immigration is at around 3 million people per year, of which a little more than 1 million reflects immigration to the United States.15 In Europe, commuting across borders also has risen, facilitated by the expansion of the European Union and the emergence of cheap air travel and faster rail links. A further development that has gained attention in industrial countries is the outsourcing of call centers and professional services to low-wage countries such as India - in other words, moving jobs to people rather than people to jobs. Despite these developments, there is plenty of evidence of barriers to labor mobility and to the integration of labor markets. Magazine and newspaper stories have pointed out the costs and difficulties of outsourcing, including prominent cases in which large companies abandoned or For example, forward exchange rates are not good predictors of future spot exchange rates. But any attempt to profit from this anomaly carries a high degree of risk because exchange rates are so volatile. See Sergey V. Chernenko, Krista B. Schwarz, and Jonathan H. Wright (2004), "The Information Content of Forward and Futures Prices: Market Expectations and the Price of Risk," International Finance Discussion Paper 2004-808 (Washington: Board of Governors of the Federal Reserve System, June). See Mark Carey and Gregory P. Nini (2004), "Is the Corporate Loan Market Globally Integrated? A Pricing Puzzle," International Finance Discussion Paper 2004-813 (Washington: Board of Governors of the Federal Reserve System, August) for evidence that spreads on corporate loans, which are not very liquid, differ materially between the U.S. and European syndicated loan markets. U.S. Department of Commerce, Bureau of the Census, Foreign-Born Profiles . Rakesh Kochhar (2005), Latino Labor Report, 2004: More Jobs for New Immigrants but at Lower Wages (124KB PDF) (Washington: Pew Hispanic Center) . World Bank (2004), World Development Indicators 2004 (Washington: World Bank). Organisation for Economic Co-operation and Development (2004), Trends in International Migration 2004 (Paris: OECD) and OECD Migration database for latest available year, 2002. downsized their outsourcing programs because of problems of culture and control.16 France and Germany recently rejected a proposal to liberalize regulations so that services professionals could more easily compete across countries within the European Union. Most industrial countries have strict limits on legal migration that are far lower than the volume of visa applications. The high cost to would-be immigrants of entering illegally includes not only the risk of detection and deportation but, in many cases, fees of several hundred to several thousand dollars demanded by smugglers who promise to get immigrants into their destination countries. Perhaps the most telling evidence that barriers to labor mobility are still high is that wage rates for workers in similar categories are vastly different across countries. For example, the minimum manufacturing wage in Mexico is less than 20 percent of the U.S. minimum wage, and average manufacturing wages in Pakistan are less than 10 percent of the U.S. minimum.17 Despite this evidence of barriers, immigration has probably held down wages in a number of low-wage occupations, an issue I will revisit shortly. Globalization of product markets In addition to the evidence of globalization in the markets for economic inputs, evidence of globalization in the markets for economic outputs is abundant. A big part of this evidence is the expansion of international trade. The ratio of worldwide exports to worldwide GDP rose from about 8 percent in 1960 to 20 percent in 2001. Over this period, barriers to trade fell. Average tariffs in the United States, Germany, and Japan fell by more than half.18 The membership of the World Trade Organization (formerly the General Agreement on Tariffs and Trade) rose from 18 countries in 1948 to 146 countries in 2003. And free-trade areas, led by the European Union and NAFTA, have increased from 1 in 1958 to 161 in 2003. Transportation and communication costs have also fallen over time. Despite all this progress, significant barriers to trade still exist. Policy barriers such as tariffs, quotas, and licensing restrictions are especially important in the areas of agriculture and services. According to some research, moreover, official trade policy is only one of several barriers; some others are transportation costs, language barriers, and information costs.19 The threat of renewed protectionism, which captured headlines here and elsewhere in recent weeks, poses a serious challenge to the lowering of policy barriers in the ongoing Doha Round of trade negotiations. Whatever happens to trade policy barriers, however, technological innovations are likely to continue lowering nonpolicy barriers to trade. The other main aspect of globalized product markets is the growth of foreign direct investment. Between 1980 and 2003, U.S. corporations' direct ownership or control of affiliates overseas rose from 13 percent of U.S. GDP to 18 percent. Over the same period, foreign corporations' ownership or control of affiliates in the United States rose even faster, though from a lower level, from 4 percent of U.S. GDP to 14 percent. Since 1988, employment in U.S. operations of foreign corporations has risen by 2.3 million jobs to a total of 5.4 million, or roughly 5 percent of total U.S. employment.20 A relatively recent development in international direct investment is the rise of multinationals that have grown out of emerging markets, including companies such as Mittal Steel, Hyundai Motors, and the Haier Group of home-appliance makers. See, for example, Stephanie Overby (2003), "The Hidden Costs of Offshore Outsourcing," CIO Magazine, September 1, and Paul J. Davies (2005), "Outsourcing: Get a Grip on All the Links in the Chain," Financial Times, April 18. International Labour Organization (2003), Statistics on Occupational Wages and Hours of Work and on Food Prices: October Inquiry Results, 2002-2003 (Geneva: ILO). Minimum (Mexico) and average (Pakistan) wages differ by industry and skill level; these comparisons are based on a broad range of unskilled and semi-skilled job classes. Average U.S. manufacturing wages are roughly three times the U.S. minimum wage. B.R. Mitchell (1998), International Historical Statistics, 1750-1993, 3 vols. (London: Macmillan). The three volumes are on the Americas, Europe, and Asia, respectively. These data end in 1993, but there has been no widespread increase in official tariff rates in these countries since then. See James E. Anderson and Eric van Wincoop (2004), "Trade Costs," Journal of Economic Literature, vol. 42 (September), pp. 691-751. U.S. Department of Commerce, Bureau of Economic Analysis. The economic implications of globalization: pro and con What does globalization mean for workers and investors? What does it mean for consumers and producers? I cannot claim to give you a complete answer. And if I could, it would make for a very long speech. So let me cover just a few areas. One of the most obvious effects of globalization is the introduction of new brands and products from foreign countries. The benefits of greater selection and variety are immediately obvious to the consumer. But the benefits go deeper than the surface. Opening up markets to greater competition leads to lower prices and higher-quality products, which translates into higher real incomes for most people. Globalization has also changed the very structure of production both within multinational firms and between firms. It has become quite common for high-value U.S. components to be shipped to foreign destinations for assembly into finished products, many of which are shipped back to the United States.21 This so-called round-tripping enables firms to take advantage of economies of scale at each stage of the production process as well as different wage and skill mixes in different locations. These changes in the production process are likely to be particularly pronounced within multinational firms. Indeed, recent research shows that multinationals have made a disproportionate contribution to the acceleration of U.S. productivity since the mid-1990s.22 So if globalization has helped to increase competition and variety while lowering costs, why do so many oppose it? One answer is that competition and progress invariably produce winners and losers. Even if all consumers gain, a few producers may gain a lot and few others may lose a lot. Another answer is that, for the advanced economies, opening up markets to products from low-wage countries may disproportionately benefit those with the highest incomes, while greater immigration may hold down blue-collar wages, thereby creating greater inequality of incomes. Economists who have studied rising income inequality in America generally conclude that, although international trade and migration have contributed slightly, the main factor by far has been progress in information technology, which has boosted the demand for educated workers relative to those with low skills.23 Yet another potential implication of globalization is that the distribution of incomes across countries will shift. Professors Edward Leamer of UCLA and Peter Schott of Yale have recently suggested that the significant gains in Chinese and Indian per capita income over the past twenty years may have come at the expense of income growth in the so-called "middle income" developing countries such as Argentina and Brazil. Per capita incomes in many middle-income countries have stagnated while per capita incomes in the industrial countries have continued to grow. Leamer and Schott argue that few Chinese or Indian products compete with products made in the industrial countries, whereas many Chinese and Indian products do compete with products made in the middle-income countries.24 This is an interesting and provocative hypothesis, but as yet it has not been subjected to careful testing. In the realm of finance, globalization, on the whole, promotes diversification and helps savings flow to high-value investments. Spreading risk makes risk easier to bear, and more-efficient investment increases real incomes in the long run. Of course, as always in finance, mistakes can be made. Sometimes projects are financed that turn out to be fraudulent or otherwise unworthy, and sometimes national financial systems are not ready to deal with the higher volumes of capital flows and the quicker and harsher market discipline that comes with globalization. In the past couple of decades, We have no comprehensive data on this phenomenon. Here are two indicators: (1) the share of U.S. merchandise exports destined for further processing by a foreign affiliate of a U.S. multinational corporation rose from 14 percent in 1982 to 19 percent in 1999, the latest available year of data (Bureau of Economic Analysis) and (2) the share of U.S. merchandise exports to Mexican maquiladoras rose from 3 percent in 1992 to 8 percent in 2004 (Mexican National Institute of Statistics and U.S. Department of Commerce, Bureau of Economic Analysis). See Carol Corrado, Paul Lengermann, and Lawrence Slifman (2003), "The Contribution of Multinational Corporations to U.S. Productivity Growth," paper presented at the OECD Workshop on the Impact of Multinational Enterprises on Productivity Growth, Paris, November 5. See Robert Z. Lawrence (1996), Single World, Divided Nations? International Trade and OECD Labor Markets (Washington: Brookings Institution), and Per Krusell, Lee E. Ohanian, Jose-Victor Rios-Rull, and Giovanni L. Violante (2000), "Capital-Skill Complementarity and Inequality: A Macroeconomic Analysis," Econometrica, vol. 68 (September), pp. 1029-53. See Edward E. Leamer and Peter K. Schott (2005), "The Rich (and Poor) Keep Getting Richer," Harvard Business Review, vol. 83 (April), p. 20. some major recessions in emerging-market nations appear to have been associated with boom-and-bust cycles in capital flows. But barriers to capital flows are not a realistic choice for emerging-market nations in the long run because these nations are unlikely to join the ranks of advanced economies without open capital markets. Globalization also presents challenges for corporate treasurers and for other corporate decisionmakers. The importance of managing risk related to foreign exchange rate fluctuations usually grows with the size of a firm's foreign sales and production. And operational risks have also become more important at many firms. Examples include political risks - such as disruptions to operations or sales associated with political upheaval in a given nation or with changes in law - and reputational risks flowing from the challenges of conforming to a broader array of legal and cultural norms. I would encourage you to consider the degree to which each of your institutions has accurately measured and effectively managed these and other risks associated with global operations. Implications for public policy Policymakers should and do pay attention to globalization. To some extent, they have helped to promote it by removing or lowering barriers to cross-border investment, migration, and trade. I hope policymakers continue to take steps to facilitate globalization. But progress probably will also depend on other factors, like further advances in information, communication, and transportation technology, as well as changes in the habits of individuals and firms, all of which are largely out of the hands of policymakers. Besides broad efforts to facilitate it, how should public policy respond to globalization? As I noted earlier, some are concerned that financial globalization leads to boom-and-bust patterns in capital flows and investment, especially in emerging-market nations. A return to capital controls is probably not the best choice here. More likely to be helpful is attention to the institutional environment, which encompasses the supervision of financial institutions, policy transparency, legal systems, control of corruption, incentives for good corporate governance, and macroeconomic stability. A recent International Monetary Fund study argues that countries that have benefited the most from globalization have been those with the strongest institutions.25 We are currently experiencing a net outflow of capital from the developing world toward the industrial countries, a movement contrary to the prediction of simple economic theory. One important factor in this movement is that, on average, the institutional framework in industrial countries is perceived as being more favorable to investors in terms of allocating capital efficiently and protecting investors from fraud, waste, and expropriation. There is every reason to believe that capital flows will resume to those emerging markets that demonstrate a commitment to sustained improvements in their domestic institutions. The dislocation that can be caused by changing trade patterns poses another challenge to policymakers. This dislocation is not different in any meaningful way from the dislocation caused by technological progress. Just as our economy would be a lot poorer if we had protected horses and buggies by outlawing automobiles, so it will be poorer if we protect specific industries that cannot compete with cheaper foreign products. But we should also acknowledge the hardships imposed on those who must be retrained and relocated into new careers. As society as a whole benefits from trade, so it is only fair that society assist the few who pay a price for our progress. Given that the most severely affected jobs have been and are likely to continue to be those requiring the least education, it is clear that improving education for all of our children is an important part of our national response to globalization. Is globalization making the job of macroeconomic policymakers either easier or harder? One reason to answer "easier" is based on the view, which I share, that globalization makes the economy more flexible and adaptable. A more flexible economy ought to be inherently more stable and more resilient to shocks, and thus present less need for activist policy to stabilize output and inflation. Another positive consideration is that globalization helps to discipline policymakers by punishing them promptly when their policy actions are perceived to have harmful consequences. Globalization has progressed in conjunction with a substantial narrowing of inflation differentials across countries over the past See Eswar Prasad, Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Kose (2003), "Effects of Financial Globalization on Developing Countries," IMF Occasional Paper 220 (Washington: International Monetary Fund, September). twenty years, as the number of countries with high inflation has declined.26 It may be that globalized financial markets are more effective at punishing inflationary policies and that increased competition in goods markets helps to tame inflationary pressure. But another explanation is simply that central banks around the world learned about the costs of inflationary policies after the experience of the 1970s. A more pessimistic view focuses on recent cases in which countries that opened up to global financial flows experienced massive borrowing and subsequent financial crises. On this view, financial globalization may destabilize a country's economy in some circumstances and thereby make macroeconomic policy more difficult. However, I tend to believe that these financial crises often arise from macroeconomic policies that are inherently unstable and from private-sector participants who fail to recognize and price risk appropriately. As such, globalization may have increased the penalties for bad public and private policies, but the correct response is to get policy right, not to turn the clock back on globalization. Globalization has increased the spillovers of economic events across countries. For example, during the Asian financial crises of the late 1990s, investors downgraded their expectations for the future profitability of investments in emerging Asia. The resulting financial flows drove up the prices of U.S. bonds and equities at the same time that Asian demand for U.S. exports fell and the U.S. current account deficit widened. Globalization and the technological and regulatory changes that helped engender it may also be increasing the international spillovers of macroeconomic policy. In a simple macroeconomic model (IS/LM), globalization enhances the exchange rate channel of monetary policy.27 For example, stimulative monetary policy has a greater tendency to weaken a country's currency in a globalized world. This, in turn, has a contractionary effect on trading partners by reducing their exports. On the other hand, globalization implies that, say, a tax cut at home has a greater expansionary effect on trading partners, as consumers spend more of the tax savings on foreign goods. Of course this model makes some strong simplifying assumptions about expectations and price adjustment. In more-general models, a broader range of outcomes is possible. Thus, the degree to which globalization has these effects remains open to question. Does globalization imply a greater need for the international coordination of macroeconomic policies? Let me begin my answer by asserting that explicit coordination of policy setting across countries is not likely to happen in the foreseeable future, and I would argue that such explicit policy coordination would not be desirable. Policymakers have to be able to react quickly in many circumstances, and it makes no sense to delay needed actions in order to achieve international consensus, particularly when the potential benefits from coordinated action are small relative to the potential costs of delay.28 Experience has shown that the best outcomes are achieved when each country's policy focuses on domestic stabilization. Nevertheless, in our interconnected world, it is important for policymakers in different countries to maintain an ongoing conversation. This conversation involves the exchange of information about economic conditions and policy options as well as an opportunity to debate the merits of alternative policies that can lead to improved understanding of the practice of macroeconomic policy. International conversation promotes trust and understanding. It enables us to understand and respond appropriately to developments in each other's economies. Clearly, if globalization is changing the nature of policy spillovers across countries, that effect would be an important topic for an international conversation. In closing, I want to thank you again for inviting me to speak. I suspect that you will be among the first to experience and appreciate new developments in globalization. I continue to look forward to those new developments. I believe they will be positive on the whole and hope you believe so as well. See Irina Tytell and Shang-Jin Wei (2005), "Does Financial Globalization Induce Better Macroeconomic Policies?" unpublished paper (Washington: International Monetary Fund, January). Tytell and Wei find significant evidence that globalization has led to improved monetary outcomes but no evidence that it improves fiscal outcomes. See Rudiger Dornbusch and Stanley Fischer (1978), Macroeconomics (New York: McGraw-Hill) p. 638, or Jeffrey D. Sachs and Felipe B. Larrain (1993), Macroeconomics in the Global Economy (Englewood Cliffs, N.J.: Prentice Hall), p. 429. For a comparison of the gains from coordination versus the costs of domestic policy mistakes, see Laurence H. Meyer, Brian M. Doyle, Joseph E. Gagnon, and Dale W. Henderson (2004), "International Coordination of Macroeconomic Policies: Still Alive in the New Millennium?" in David Vines and Christopher L. Gilbert, eds., The IMF and Its Critics: Reform of Global Financial Architecture (Cambridge, United Kingdom: Cambridge University Press).
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Testimony of Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Domestic and International Monetary Policy, Trade, and Technology and the Subcommittee on Financial Institutions and Consumer Credit, Committee on Financial Services, US House of Representatives, Washington, 11 May 2005.
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Susan Schmidt Bies: The Basel II Accord and House Resolution 1226 Testimony of Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Domestic and International Monetary Policy, Trade, and Technology and the Subcommittee on Financial Institutions and Consumer Credit, Committee on Financial Services, US House of Representatives, Washington, 11 May 2005. * * * Chairman Bachus, Chairman Pryce, and members of the Subcommittee on Financial Institutions and Consumer Credit and the Subcommittee on Domestic and International Monetary Policy, Trade, and Technology: It is a pleasure to join my colleagues from the other banking agencies to discuss the current status of Basel II in this country, as well as the Federal Reserve's views on H.R. 1226. The continued discussion among the Congress and the regulators - and, of course, the banking industry and other members of the public - is critical to the final implementation of the new capital accord. The focus of recent attention has been the agencies' announcement that they will delay the notice of proposed rulemaking (NPR) for Basel II, originally scheduled for midyear 2005. In my remarks today, I will discuss the reasons for the delay and the Board's views regarding the timetable for implementation of Basel II in this country. But, first, I believe it may be useful to remind the members of the subcommittees why the agencies thought it wise to explore and then develop a modernization of the current capital accord; those factors have become, if anything, more important than they were when we began the process. Our banking system is becoming more concentrated, with a number of very large entities operating across multiple business lines and national boundaries, each entity with positions and exposures that are both complicated and difficult for third parties to understand. These entities have outgrown the current regulatory capital regime, which is still adequate for most banks. But the current rules simply cannot keep up with the complex business of the global banking organizations toward which Basel II and its infrastructure prerequisites are directed. These organizations represent significant risks to the financial system should they develop substantial problems in a period of stress. Basel II offers the opportunity to work with these large entities to develop quantitative risk-measurement and risk-management systems that can both measure their risk more accurately and become the basis for more risk-focused capital requirements and prudential supervision. We would also require, as part of the Basel II approach, more public disclosures to improve market discipline and supplement supervisory efforts. Many internationally active U.S. banks apparently agree that we should work toward Basel II. Indeed, we and the industry have already seen some benefits from work on Basel II implementation in that market participants and bank supervisors have developed a common language for inputs into risk-management processes. Earlier this year, twenty-six banking organizations provided us with internal measures of credit risk as part of the fourth quantitative impact study, or QIS4. The agencies have now reviewed the risk parameter estimates provided and are discussing with individual participants their approaches to developing the required inputs. These discussions, which are ongoing, have significantly changed some of the data provided, and some modifications are still coming in. Nonetheless, even with these revisions, two conclusions are already clear. First, the dispersion among the banks in their estimates of the key parameters that would be used to calculate Basel II capital requirements was quite wide - much wider than expected. Second, the implied reductions in minimum regulatory capital were often substantial - far more than previous quantitative impact studies, both here and abroad, had suggested. As responsible and prudent regulators, we believe it is appropriate to improve our understanding of these results and to see whether changes might be needed in our proposals. From the outset of our participation in the development of Basel II, the U.S. agencies have clearly and consistently stated that the final adoption of the new capital rules in the United States would occur only after (1) we had reviewed all public comments and incorporated any needed adjustments to address legitimate concerns, and (2) we were satisfied that Basel II was consistent with safe and sound banking in this country. Throughout this process we have stressed that, should we become concerned about the level of overall capital in the banking system or the capital results for individual portfolios, we would seek to modify the framework, including possibly recalibrating the regulatory capital formulas that translate an individual bank's risk parameters into required capital. The agencies' current review and study is consistent with our historical position at Basel. All of the agencies want to have a better understanding of QIS4 data and results. Does the dispersion reflect different risk profiles? Different model assumptions? Different estimates of risk for the same kind of asset? Different kinds of internal rating systems with some looking "through the cycle" and others being "point in time"? Different stages of institutions' implementation efforts? Limitations of current data bases? Some other factor? We hope that further analysis and discussion with respondents can provide some answers to such questions. All the agencies believed that the prudent approach was to delay the NPR to gain better understanding of the reasons for the unexpected results. Still, this decision presents the U.S. banking agencies with a dilemma. There is good reason to delay the NPR and related supervisory guidance, but those very documents are needed to provide more complete blueprints for what banks will need in terms of the databases and systems to implement Basel II. We are not saying that these large entities today have inadequate risk-management systems. Rather, they do not yet have the systems for producing Basel II inputs that meet the standards set forth in the Basel II proposal. Until the banking organizations have the NPR, many just will not be able to provide us the inputs we need to assess how banks would operate under Basel II. The dilemma can be solved only by first issuing the NPR. But, we must then have a prudent and flexible way to make adjustments should the resultant data produce results that we, as supervisors, are not comfortable with. The plans developed before the delay in the NPR offer just such an opportunity. Under those plans, institutions required or planning to move to Basel II would, after the adoption of a final rule, decide when to start their parallel run - with the first opportunity in January 2007. During the required parallel run, each bank would continue to calculate its required capital under the current capital regime and simultaneously calculate its Basel II capital statistics for review by its primary supervisor. When the supervisor believes that the bank has produced four quarters of credible Basel II estimates, the bank would be able to enter a minimum two-year transition run, the earliest in 2008 under these plans. During this transition run, the bank would be under Basel II capital rules, but it could not reduce its capital below 90 percent of what the current capital rules would require in the first year or below 80 percent in the second year. The length of either the parallel run or the transition run could be extended if the primary supervisor had doubts about the bank's Basel II system or the prudence of the resulting minimum regulatory capital level. Only after a minimum two-year transition run and only if its primary supervisor had no objection could a U.S. bank operate fully under Basel II capital rules. This phase-in plan has been designed to ensure that bank inputs are reasonable and consistent with sound risk-management practices and that supervisors are comfortable with the safety and soundness of Basel II before it goes fully "live" in the United States. Please note that only when we get into the parallel run period will the agencies be able to accurately assess the aggregate capital effects as well as the effects on individual institutions from the new accord. Only then will banks' systems provide risk-parameter inputs that comport with the operational requirements of Basel II, and only then can the U.S. authorities be confident that the resultant capital calculations are reliable estimates of what will happen when Basel II is fully implemented. Such data would be far superior to those obtained through the four QIS exercises that we have conducted to date, which, as I have noted, have been carried out by banks on a best-efforts basis using systems that do not yet meet the standards required under Basel II. Once we have data from the parallel run period, the agencies can then consider the need, if any, for a recalibration of the Basel II parameters or other actions to ensure more-accurate risk sensitivity and a prudent level of overall capital. This deliberate process provides multiple safeguards to help the agencies move to the final adoption of the new framework in the United States only when doing so is clearly appropriate. In other words, our implementation strategy has been designed to be both prudent and flexible enough to move banks from Basel I to Basel II as their own systems mature and they can provide reasonably accurate assessments of their credit and operational risks. The agencies' analysis of and reaction to QIS4 results show how those safeguards work: We saw results that gave us concern, and so we are investigating further before we go to the next stage. Additional, future safeguards - such as the NPR process and the minimum one-year parallel run and the minimum two-year transition period, with options to extend either - will also ensure ample opportunity to recalibrate or seek other adjustments if necessary. But, for now, we believe that after a certain point, further analysis of QIS4 is likely to reap little or no additional benefit. We should, of course, try to learn what we can from these data and particularly look for indications of the need to modify the Basel II proposal where necessary. However, as soon as we have learned what we can, we should promptly return to the development of the joint NPR and related supervisory guidance. These documents are essential so that core and opt-in banks can continue to develop the databases and systems that they would need to operate under the Basel II capital rules and that would provide more-accurate risk parameter estimates than those in QIS4. Recall that there have already been three rounds of U.S. public comments on the Basel II consultative papers between 1999 and 2004; an advance notice of proposed rulemaking (ANPR) in 2003; and numerous agency discussions with congressional committees, banking groups, and individual banks. All have resulted in significant modifications to the proposal. Once published, the NPR and the supervisory guidance will once more elicit comments that could result in further revisions. Particularly given its delayed issuance, the NPR must solicit feedback from core and potential opt-in banks as to whether the current timeline for implementing Basel II in this country needs to be delayed or can be retained. Looking forward, I agree with my colleagues at this table that it is prudent to delay the NPR in order to see what we can learn from further review of QIS4 data, recognizing at the outset that final answers will not be forthcoming because the requisite databases and risk-management systems are not yet in place. I hope that we can return to the NPR before midyear, present it to the Office of Management and Budget for its review, as our OCC and OTS colleagues must do, and release the NPR in the fall. With such a schedule, one might hope that the parallel running period, currently scheduled for 2007, need not be delayed. But, as I noted earlier, it is important for the agencies to get feedback on this issue during the NPR comment period. The views of banking organizations will provide critical insights into the feasibility of the scheduled 2008 start date for the transition run. Once we have the views of the banking organizations, the agencies will be in a better position to reach a consensus on the timeline. Basel II has the potential to be an important supervisory step forward. The Basel I framework is being arbitraged aggressively and provides us with less and less reliable measures on which to base a regulatory capital requirement for our largest and most complex banking organizations. Moreover, banks have spent tens of millions of dollars preparing for the U.S. implementation of Basel II and have contracts for further investment. They are awaiting the NPR, the guidance, and the final rules. Their global competitors are proceeding, and U.S. banks will be eager to avoid being placed at a competitive disadvantage. I might add that, as supervisors, we believe that the core risk-measurement and risk-management improvements contained in Basel II are appropriate, regardless of how the future accord is finally structured and calibrated. So it is, in our view, a good idea for banks to continue their current trajectory of making risk-management investments. While the regulatory capital requirements ultimately produced by Basel II would be, we believe, considerably more risk sensitive than the current capital regime, importantly this is not the only capital regulation under which U.S. institutions would operate. Over a decade ago, the Congress, as part of the Federal Deposit Insurance Corporation Improvement Act's Prompt Corrective Action (PCA) regime, defined a critically undercapitalized insured depository institution by reference to a minimum tangible-equity-to-asset requirement, a leverage ratio. The agencies have also used other leverage ratios to define other PCA capital categories because experience has suggested that there is no substitute for an adequate equity-to-asset ratio, especially for entities that face the moral hazard that accompanies the safety net. The Federal Deposit Insurance Corporation (FDIC), responsible to the Congress for the management of the critical deposit insurance portion of the safety net, has underlined the importance of that minimum leverage ratio and PCA as part of a prudent supervisory regime. The Federal Reserve concurs in the FDIC's view. We need, for reasons I have given, the risk-measurement and risk-management infrastructure and risk sensitivity of Basel II; but we also need the supplementary assurance of a minimum equity base. The market and the rating agencies will continue to require exactly that kind of base, and a regulatory minimum is prudentially desirable. Even though the market and the rating agencies, not to mention bank management, will still require banking organizations to carry capital considerably above regulatory minimums, many of the thousands of depository institutions that will remain under the current capital rules are concerned about the impact of Basel II on their businesses. This concern is often voiced as a general disquiet about broad competitive feedbacks but also about competitive implications in specific markets. The Federal Reserve has published a series of research papers investigating such concerns voiced in public comments on the previous ANPR on Basel II. These studies have indeed suggested that there are potential effects that should be addressed in the small business and residential mortgage markets. For this reason, as well as to continue to modernize the current capital regime, the agencies are developing, simultaneously with the Basel II proposal, a proposal to revise the current capital rules for non-Basel II banks to make those rules more risk sensitive and to blunt any unintended harm that Basel II might impose on non-adopters. Our intention is to keep these proposed changes simple to minimize any costs imposed on the many non-adopters. We plan to issue these proposals for public comment concurrently with or soon after the NPR on Basel II, to allow the banking community to comment on a combined package of proposed changes. However, these revised Basel I rules would not be an adequate substitute for the necessary capital reforms for the large, complex, global banks operating in this country because they would not provide the incentives for banks to adopt the more-sophisticated risk-measurement and risk-management techniques envisioned by the Basel II proposal. Chairman Bachus and Chairman Pryce, I would also like to present the Federal Reserve's views on H.R. 1226, a bill setting up a committee of the four banking and thrift regulators to reach a common U.S. position on Basel issues and authorizing the Secretary of the Treasury, as its chairman, to determine a common position on any issue about which the regulators could not agree. The Federal Reserve believes that the bill does not fully reflect the existing process used by the four agencies to develop and modify Basel II and we would counsel that Congress not enact it. Staff members of the four agencies have held frequent and comprehensive discussions about Basel II throughout the process. Certainly, the agencies have sometimes disagreed on specific issues, and we will sometimes disagree in the future. But we have in the past been able to find a common position that we can all support at Basel, and we will do so in the future. The salient fact is that any one of us has a veto over the entire proposal because we all realize that different rules cannot be applied to similarly situated insured depository institutions. That fact forces us to develop consensus positions on which all of us can agree. We have done so in the past because we understand that if the agencies cannot reach a collective agreement at Basel, the Basel II reforms will not be implemented in the United States while they go forward in the rest of the world. Communication, compromise, and comity are the prerequisites for agreement among the agencies. Further, the ability of the U.S. agencies to negotiate effectively at Basel would be severely constrained if our foreign counterparties knew that we had to return to a committee before we could agree. The formalized "decision by committee" approach of H.R. 1226 would not advance U.S. interests in the complex and dynamic Basel negotiation process. The U.S. banking agencies need to preserve our current flexibility to respond to Basel issues if we are to develop a set of capital rules that are useful and productive for U.S. banks and thrifts. Moreover, it is possible that the agencies are more likely to implement effectively an agreement that they helped shape than they would be one that was imposed on them and for which they did not understand fully the rationale. While we urge the Congress not to move forward on this bill, we look forward to keeping Congress fully informed as the Basel process continues. I will be pleased to answer your questions.
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Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Annual Washington Briefing Conference of the Financial Women¿s Association, Washington, DC, 16 May 2005.
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Mark W Olson: Basel II Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Annual Washington Briefing Conference of the Financial Women’s Association, Washington, DC, 16 May 2005. * * * Thank you for the opportunity to speak to you today about current status of the Basel II capital revisions. As most of you know, the U.S. banking agencies are working with their counterparts on the Basel Committee on Banking Supervision to develop and implement revisions to the original Basel Capital Accord - also known as Basel I - which was adopted in 1988. As we earnestly work to develop those revisions, it is instructive to recall the environment in which Basel I was created. If we look back at the state of the banking and financial markets in 1988, it is clear that Basel I was a major accomplishment. Many countries had distinct, and considerably different, capital adequacy requirements. Indeed, as banks conducted more and more business across borders, these differences raised significant competitive, if not safety-and-soundness, issues. It soon became clear that supervisors in the industrial countries would benefit from agreement on certain common definitions and minimum standards for regulatory capital. Thus was born the first Basel Capital Accord. Two factors made Basel I particularly noteworthy. First, it contained some common definitions of capital and risk-weighted assets that could be applied across countries. This was no small feat, since, as you know, different jurisdictions often apply a variety of definitions. By agreeing on common definitions, supervisors around the world were more readily able to depend on one another's assessment of capital adequacy without having to determine what the terms meant. Second, Basel I reflected agreement on what constituted a reasonable minimum ratio of capital to risk-weighted assets - the now-famous 8 percent. Although some empirical work went into the derivation of this 8 percent, we should not pretend that this ratio was determined with scientific precision. It did, however, reflect the combined experience and knowledge of all the supervisors around the table. The four risk-weighting brackets, while equally imprecise, were the first efforts to differentiate risk exposures among categories of loan and investment assets. Reasons for developing Basel II In looking back, I believe Basel I, with its common definitions, common agreement on capital minimums, and the initial risk-weighting categories, has served the banking and financial community well. Indeed, there is no reason to replace Basel I for the vast majority of banks here in the United States. But our largest and most complex global banking organizations have, in a sense, outgrown Basel I. On the one hand, the need for Basel II reflects the increased sophistication of risk-management practices and the ways they can be applied to the measurement of capital. At the same time, it also reflects the increased complexity of banking in general, especially at larger institutions. Although many in this audience are very familiar with the provisions of Basel II, let me briefly review them for those who are not. In a general sense, Basel II represents an improved and broadly comparable way to look at risk taking across organizations and over time. It is composed of the now-familiar three pillars: Pillar 1, minimum capital requirements; Pillar 2, supervisory review; and Pillar 3, market discipline. The framework is structured to be much more risk-sensitive than its predecessor; for example, all commercial loans are not lumped into one risk bucket but are differentiated according to certain indicators of risk. Basel II is designed to address the concern that Basel I regulatory capital ratios are no longer good indicators of risk for our largest institutions. Indeed, at our largest institutions, calculating Basel I ratios is sometimes viewed as nothing more than a compliance exercise. The development of sophisticated secondary markets in recent years has allowed banks to make strategic decisions to either retain or sell virtually every category of loan and investment asset. This market advance has had significant implications for the initial Basel effort. Basel I presents an opportunity for banks to retain balance-sheet positions that are of higher risk than their regulatory capital charge and to shed those of lower risk. Using this type of capital arbitrage, banks can game the system in such a way that the resultant Basel I ratio does not have substantial meaning for the public, bank management, or the supervisor. Basel II is intended to close this gap by more directly linking riskiness of assets to their corresponding regulatory capital charge and to reduce, if not eliminate, the incentives to engage in capital arbitrage. Basel II also creates a link between regulatory capital and risk management, especially under the advanced approaches, which are the only ones expected to be applied in the United States. Under these approaches, banks will be required to adopt more-formal, quantitative risk-measurement and management procedures and processes. And, to implement this framework, both bank management and supervisors will need to focus on the integrity and soundness of these procedures and processes, including comprehensive assessments of capital adequacy in relation to the bank's overall risk taking. It is helpful to recall that the quantitative risk-measurement and management procedures and processes that will be required by Basel II are based on practices already in use at today's most sophisticated institutions. In other words, the practices in Basel II were not devised by regulators on their own. Admittedly, a certain degree of standardization in these practices was required because Basel II is a minimum regulatory capital framework intended to apply fairly consistently to a wide range of institutions. The new framework should improve supervisors' ability to understand and monitor the risk taking and capital adequacy of large complex banks, thereby allowing regulators to address emerging problems more proactively. The new framework should also enable supervisors to have much more informed and timely conversations with bank management about their risk profiles, based on the new information flows generated. Our hope is that conversations around this common analytical framework will create a common language for risk management. In the United States, we intend to use the framework to determine whether bankers are indeed able to monitor their own risk-taking and capital positions, and we will be placing the onus on bankers to show that they are able to measure, understand, and effectively manage their consolidated risks. It is important to remember that Pillar 1 is supposed to produce a minimum level of regulatory capital and that each institution's actual capital held will vary according to its own risk profile and business mix. Explicit assumptions are built into Pillar 1, such as the idea that portfolios are well diversified and do not contain geographic or sectoral concentrations. Supervisors must remind institutions that it is initially the bank's job to address any deviations from Pillar 1 assumptions, as well as any additional factors that affect the risk of the individual bank, and to adjust their minimum regulatory capital accordingly. Under Pillar 2, supervisory authorities, in turn, will review these adjustments by banks and could ask them to take additional steps to ensure that all risks have been addressed. We should also remember that beyond minimum regulatory capital requirements, Pillar 2 requires banks to develop a viable internal process for assessing capital adequacy that contributes to the determination of the amount of capital actually held. Banks should take this requirement seriously. Supervisors will carefully review banks' compliance with this requirement. Basel II also adds a new element of market discipline, as described in Pillar 3. In the case of our larger organizations, which have become so varied and complex, supervisors have the choice of either using more invasive procedures or relying on market discipline. And market discipline is impossible if counterparties (and rating agencies) do not have better information about banks' risk positions. Markets need accurate information to function effectively. The objective is not to supplant supervision of our larger organizations but to provide information that will enable market participants to serve as an effective complement to supervisors. I would also like to underscore that Basel II is indeed a seminal step in the development of regulatory capital requirements. It is not necessarily the endpoint, but it does represent a substantial step forward - one that we believe will remain in place for many years to come. Implementation efforts in the United States I would now like to address some of the practical aspects of the implementation of Basel II in the United States. I assume that most of you either heard, or read about the testimony and discussion at last week's hearing before two subcommittees of the House Committee on Financial Services. I will not attempt to paraphrase my colleagues' statements, but I will point out that throughout this process the agencies have stressed the importance of comments from the Congress, the banking industry, and other interested parties. The agencies' reaction to the results of the fourth Quantitative Impact Study - known as QIS4 - shows how seriously we are taking Basel II implementation. The interagency statement issued on April 29 indicated clearly, I believe, that results from QIS4 were more widely dispersed and showed a larger overall drop in capital than the agencies had expected. This was the impetus for deciding to delay the notice of proposed rulemaking for Basel II. We now have to determine whether these results arose from actual differences in risk among respondents, differences in stages of preparation (including data limitations) among respondents, limits of the QIS4 exercise, or a possible need for adjustments to the Basel framework itself. Staff at the agencies are working together to analyze the QIS4 results and in some cases are talking to banks about their submissions. Analyzing the data used in QIS4 is vitally important, because ultimately the success of Basel II will depend on the quantity and quality of data that banks have to use as inputs to the framework. From the Federal Reserve's perspective, delving into the results of QIS4 is an appropriate response by the agencies. But we should also acknowledge that this follow-up work has its limits. We can go only so far with the data given to us. We must recognize that banks - understandably - might not yet have their data systems ready to develop Basel II risk parameters and that it might take more time before we see Basel II parameters based on truly credible systems. But, in our view, that is not a reason to stop working. Indeed, one of the most important aspects of Basel II pertains to improved risk management, and having banks move forward in that area can only bring benefits. Of course, we support the established protocols and procedures for implementing domestic rules in the United States, which will include additional comment periods and opportunity for the banking industry, Congress, and others to express their views, and we are in favor of starting that part of the process as soon as possible. The information we now have points to the need to keep working; however, if new information indicates that changes need to be made or that additional pauses would be prudent, we will of course respond appropriately. Since the agencies remain committed to Basel II, we must give institutions as much information as possible to help them with their preparations. The agencies have sought to provide helpful information to institutions as soon as it becomes available - for example the draft supervisory guidance documents that are now under development. So far, the agencies have issued draft guidance for the advanced measurement approaches for operational risk and certain parts of the internal ratings-based approach for credit risk. Additional draft guidance is expected to be issued for public comment either along with or soon after the notice of proposed rulemaking is released. From the beginning, we intended this guidance to further clarify supervisory expectations for implementation of Basel II in the United States, and it is directed at bankers as well as at supervisors. We believe that by outlining what supervisors would expect, the proposed guidance gives banks a far better understanding of how to upgrade their systems, modify their procedures, and strengthen their controls in anticipation of eventual adoption of Basel II. Our hope is that, by clearly communicating expectations, we are giving both bankers and our own examiners sufficient time to prepare for the new framework. One vital element of our preparation for implementation has been our dialogue with the banking industry. At many stages along the way, banking organizations - both internationally and domestically have expressed their concerns about certain aspects of Basel II. When credible evidence and compelling arguments have shown that those concerns are well founded, the agencies and the Basel Committee have modified the proposal. For example, global regulators heard the industry's call for addressing only unexpected loss in the framework, and the approach to securitization was substantially altered on the basis of comments received. Supervisors and the industry need to maintain an ongoing dialogue about Basel II, since it is such a complex and multifaceted project. Issues range from very technical questions about parameter values to broad concerns about how the framework will be implemented across countries. We hope it is clear that we are being attentive to the full range of these concerns and will continue to be as the industry raises additional concerns along the way. The continued emphasis on dialogue is even more important because a few important elements of the framework are still considered works in process. For example, the Basel framework issued last June did not define the exact manner in which institutions should calculate their estimates of loss given default (LGD) based on periods of economic downturn. The Basel member countries have commissioned a subgroup to study this issue, recommend a way to add clarity to the concept of downturn or "stress" LGDs, and provide guidance to the industry. The Basel Committee has also recently issued a consultative paper on certain trading-related exposures and double-default effects, stemming from the work of a joint group formed by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions. We are acutely aware that our continuing work on these issues is complicating banks' preparations somewhat. But since these issues are so critical, we have to take the extra time to find the right solutions. And we need the help of the industry to do so. Competitive effects of Basel II Before I close, I would like to say a few words about the potential competitive effects of Basel II. At the Federal Reserve, we are particularly interested in effects that Basel II could have on banking markets, particularly ones that could distort existing markets that work well. In that vein, we have published several white papers analyzing the potential impact on specific aspects of banking, such as small-business lending, mortgage lending, and mergers and acquisitions. A paper on credit cards is forthcoming. While the conclusions of the papers published so far do not point to broad disruptions in existing banking markets as a result of Basel II, we do acknowledge that certain participants could be affected, especially in the small-business and residential-mortgage credit markets. In part to address these concerns, but also to conduct overdue routine updates to existing regulatory capital rules, the agencies also plan to propose several modifications to the current rules that most banks in the United States will continue to follow, since Basel II is expected to apply to only a handful of institutions. The agencies understand that outside parties will likely want to see the notice of proposed rulemaking for Basel II and the relevant proposals for amending current rules alongside one another for comparison's sake. Conclusion Broadly speaking, in developing Basel II we are striving to establish higher standards for internal risk management at banking organizations, including capital adequacy, and to improve both the supervisors' and the public's understanding of banks' risk taking and risk management. Over the past two decades, major banking organizations have become ever larger and more complex, while some national financial systems have become more concentrated. Against this backdrop, assessing the overall risk and capital adequacy of the largest banks has become not only increasingly difficult for supervisors, the public, and bank management, but also critical for national authorities. If you believe, as I do, that Basel I was one of the most important advances in international bank supervision, then I hope you also accept that market changes and increased sophistication in risk-management techniques require that we now update that initial framework. A fundamental premise of Basel II is that, for these major banks, neither supervisory nor market discipline can be effective unless banks' own systems can be depended on to measure and manage risk taking and capital adequacy. Basel II is intended to provide both a framework and incentives for achieving these ends. It is useful to keep in mind that as supervisors we are seeking to apply a new set of rules to private, profit-seeking businesses and are trying to achieve the goals of Basel II in a manner consistent with achieving safety and soundness in a market economy. For example, we want to be relatively certain that the required capital levels for business lines (and, of course, for the bank as a whole) are in line with the underlying risks, and we need to have a certain degree of confidence in the capital numbers for each bank. We also want banks to target their investments where they can have the greatest positive impact on risk measurement and management. In other words, we are not looking for large expenditures in areas for which the benefits will not be material. Finally, we would like to see some comparability across banks, at least in their estimation of the inputs for Basel II, but at the same time offer a certain degree of flexibility to reduce burden on the banks and allow them to retain their own styles of risk management. Admittedly, navigating between consistency and flexibility is an art, but our experience tells us that it is achievable when all parties work together.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Central Bank of the Republic of Turkey¿s International Conference on Financial Stability and Implications of Basel II, Istanbul, 17 May 2005.
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Susan Schmidt Bies: Financial stability benefits and implementation challenges of Basel II Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Central Bank of the Republic of Turkey’s International Conference on Financial Stability and Implications of Basel II, Istanbul, 17 May 2005. * * * I want to thank the Governor and the Central Bank of Turkey for the invitation to speak at this prestigious conference. The sharing of ideas among policymakers, academics, and bankers at venues such as this benefits all involved and, I believe, helps us assess important issues relating to the strength and stability of banking and financial markets. I hope that my remarks today will contribute to that overall objective. This conference on financial stability and implications of Basel II is certainly timely. As you know, members of the Basel Committee on Banking Supervision are working diligently to implement the framework issued last June. At the same time, we are all dedicated to maintaining financial stability in our respective jurisdictions, and in global banking and financial markets as a whole. In this light, Basel II should not be seen as an end in itself, but a means to promote broad stability and enhance safety and soundness of financial institutions. Today I want to address three issues. First, I will describe the challenges facing bank regulators as they strive to improve financial stability. Then I will briefly describe some of the Basel II issues in the United States that were covered in the recent interagency press release and in last week's congressional hearing. Finally, I want to describe the challenges bank supervisors face in effectively implementing Basel II. Financial stability As a central banker, I realize how vital it is to have a strong, stable financial system to support effective monetary policy. Excessive volatility in financial markets can significantly raise the cost of capital for business investment and adversely affect real economic expansion. History has demonstrated that a weak financial sector can significantly impede the monetary transmission mechanism when the central bank is trying to stimulate the economy. Since banks are the core of the financial system, efforts to improve their risk management can help mitigate the impact of shocks on financial markets and real economic performance. With effective risk management, banks are better able to plan alternatives to mitigate risks when they exceed predetermined risk exposure levels. It is important to emphasize that the normal fluctuations in asset prices that result from dynamic demand and supply conditions, and even some increase in uncertainty, do not usually generate financial instability. Put differently, financial stability implies that key institutions in the financial system are operating without significant difficulty and markets are generally functioning well. Bankers implicitly accept risk as a consequence of providing services to customers and also take explicit risk positions that offer profitable returns relative to their risk appetites. The job of bank supervisors is to ensure that bank capital represents an adequate cushion against losses, especially during times of financial instability or stress. Basel II is yet another step to minimize the negative consequences of risk-taking by financial institutions, particularly those institutions that could contribute to financial instability. This is reflected in the use of unexpected loss to calibrate capital. The assumption is that normal volatility should be covered by normal operating earnings. For losses beyond the normal range of expectations, capital should be in place to absorb the loss and leave the financial institution stable and able to continue operating effectively. Thus, financial institutions with weaker profit margins, or with customers with more varied ability to meet their obligations, should have more capital. It is important here to distinguish between higher expected losses, for which bankers raise prices to cover risk, and greater volatility of results, which requires additional capital. Greater sensitivity of regulatory capital to risk has taken on increased significance as virtually all banking markets have become considerably more concentrated, with some companies - by their very size alone - posing the potential for systemic risk. Also, the advanced approaches of Basel II better align regulatory capital to the risks presented by sophisticated financial instruments and to the complexity of large, internationally active financial institutions. The current Basel I framework is more focused on credit risk for balance sheet assets. But sophisticated financial institutions carry fewer of their potential exposures on their books. Rather, after credit- and market-risk mitigation, it is often the process of managing risks or laying off exposures that has created earnings surprises in recent years. Basel II is intended to mitigate potential disruptions in banking markets by improving risk measurement and management; establishing a better link between risk and minimum capital ratios; and providing more information to bankers, supervisors, and other market participants. But we should also remember that the increased sensitivity to risk in Basel II carries with it the possibility that minimum capital ratios could actually be more volatile than they are today. As my colleague Bill Rutledge pointed out yesterday, that is what we expect, since those ratios will be more responsive to changes in risk. The Basel Committee has attempted to reduce procyclicality effects in the new framework, incorporating factors such as estimates of loss severities that focus on downturns. These are wise decisions intended to obviate the need for institutions to raise large amounts of capital at the trough of a downturn - something that can be quite difficult and add to financial market instability. But I think we could all agree that Basel II should not be unresponsive to changes in risk, for example when the obligor rating distribution at an institution shifts to poorer-quality borrowers. In my view, we want these signals of changes in risk reflected in regulatory capital levels. But by being careful about the extent that capital levels respond to cyclicality, we are trying to make sure that risk signals do not on their own generate added instability. This requires some balancing. Greater responsiveness of regulatory capital ratios to risk is something that institutions will have to learn to manage under Basel II. Given the potential for increased volatility in their capital ratios, I expect that institutions operating under Basel II will maintain a certain cushion above their minimum ratios since they must have the capital in place before the date of measurement of risk. Indeed, Pillar 2 of the Basel framework (supervisory review) requires banks to develop a viable internal process for assessing capital adequacy that helps determine the amount of capital actually needed for their particular business mixes and risk profiles. Explicit assumptions are built into Pillar 1 (minimum capital requirements), such as the idea that portfolios are well-diversified and do not contain geographic or sectoral concentrations - assumptions that are not true in the case of many institutions. Supervisors must remind institutions that it is initially the banks' job to address any deviations from Pillar 1 assumptions, as well as any additional factors that affect the risk of the individual bank, and adjust their capital accordingly. Under Pillar 2, supervisory authorities, in turn, will review these adjustments by banks and could ask them to take additional steps to ensure that all risks have been addressed. There are additional reasons why I expect that well-run financial institutions will maintain capital ratios above the regulatory minimums, as they have under the existing Basel I framework. Some markets and customers will require their banks to have a stronger credit rating than that implied by the Basel I or II minimum capital frameworks. Banks will also continue to be opportunistic in pursuing mergers and new business expansion, and this requires capital above the regulatory minimum to be able to respond promptly to new initiatives. Finally, bankers who are using economic capital models such as RAROC (risk-adjusted return on capital) recognize that Basel II does not take into consideration some forms of unexpected losses, for example, higher charge-offs that occur when new products are introduced, information technology systems change, merger integrations occur, and internal control processes occasionally prove ineffective. Implementation efforts in the United States The U.S. banking agencies' reaction to the results of the fourth Quantitative Impact Study - known as QIS4 - shows how seriously we are taking Basel II implementation. In a statement issued on April 29, the U.S. banking agencies indicated that the minimum regulatory capital changes resulting from QIS4 were more variable across institutions and capital dropped more in the aggregate than the agencies had expected. This was the impetus for deciding to delay issuance of our next round of proposals for Basel II. These unexpected results show the continued benefit of conducting periodic quantitative impact studies. They serve as a milestone to help us calibrate the progress of the framework and the bankers as we move to Basel II. We now must determine the reasons for the unexpected results from QIS4. Do they reflect actual differences in risk among respondents when prior supervisory information suggested more similarity in credit quality? None of the participating banks has completed their databases and models for all of their risk areas. In some cases, this created results that would not be reliable for implementing Basel II. For example, for some portfolios, expected losses reflected only the last year or two of results. Thus, the strong credit performance of recent experience was not balanced by higher losses at other points of the credit cycle. Were there limits of the QIS4 exercise itself? Is there a possible need for adjustments to the Basel framework itself? Analyzing the data used in QIS4 is vitally important, because ultimately the success of Basel II will depend on the quantity and quality of data that banks have to use as inputs to the framework. I am sure that those of you working on Basel II - particularly the advanced approaches - are facing the same types of issues in your own countries. For those of you who will be conducting QIS5 or similar exercises, I strongly suggest that you include qualitative responses from the participants as well as quantitative data. We are finding this very useful as we review the results and have follow-on discussions with bankers. U.S. regulators expect to provide additional information on the lessons we learn from the QIS4 review in the near future. The notice of proposed rulemaking for Basel II will incorporate what we learn from this exercise. But we really are caught in a process dilemma. Bankers cannot complete their models and collect the necessary data until they know what the specific requirements will be. Regulators, on the other hand, will have to develop these requirements before seeing the actual results of these models and robust databases. The process we have for vetting Basel II in the United States is probably similar to those followed in many other countries. We are putting forward proposals and seeking comment from the industry, our legislature, and other interested parties. Given what a vast undertaking Basel II is, this seems entirely appropriate and beneficial. In addition to what we learn from the work on QIS4 results, we will also assess the trading and banking book comments of the Basel Committee on Banking Supervision and the International Organization of Securities Commissions. We will incorporate the latest proposal into the notice of proposed rulemaking and hope to complete our efforts in a timely manner. Challenges for supervisors In preparing for Basel II, supervisors realize that they must address their own capital needs - that is, human capital. Throughout Basel II implementation in the United States, it has become strikingly apparent that supervisors will need a higher degree of knowledge, skill, and experience. Even just our preliminary work on Basel II, which includes writing regulations, drafting guidance, and evaluating preliminary estimates from banks, has consumed substantial resources within the Federal Reserve System. We are in the process of training existing staff members and recruiting new ones, and that itself takes time and resources. We are aware that to implement a framework of the complexity and scope of the advanced approaches of Basel II, we need highly qualified supervisors. As we have learned over the past few years, many aspects of Basel II will require a considerable amount of judgment and experience. That is, as supervisors engage in the qualification of institutions for Basel II and then conduct ongoing monitoring, they will need to become intimately familiar with many technical aspects of the framework and have the ability to assess each institution in context. We want to ensure that in all Basel II discussions, bankers will sit across the table from supervisory staff who understand the framework and how it applies to individual institutions. This does not pertain just to Basel II, specifically, but also to supervision of evolving risk-measurement and -management practices more generally. As they have in the past, supervisors must keep pace with the latest developments in the industry and be able to differentiate among them in terms of appropriateness. One of the many attractive characteristics of the Basel II framework is its flexibility for incorporating new best practices without having to be fundamentally restructured. It provides a useful and credible basis for improving bank practice today and allowing for future improvements - which could include actual modifications to the framework. We consider this vitally important because banking will remain a highly dynamic industry. Supervisors will have to be especially attentive to changing best practices and ensure that Basel II does not inhibit adoption of new banking practices and financial instruments. Conclusion Maintaining financial stability in global banking and financial markets continues to be an important objective of regulators, bankers, and other market participants, particularly because of the negative impact that financial instability has on economies as a whole. Basel II, in my view, will help improve financial stability. The new framework will enable bank regulatory capital ratios to be more responsive to changes in risk and will foster additional disclosures by banks about their risk-measurement and management systems. And even though minimum regulatory capital ratios are likely to be more volatile under Basel II, this reflects greater risk sensitivity. Perhaps most important, Basel II will encourage banks to develop their systems to measure and manage risk as part of the investment needed to support strategic initiatives. The greater volatility in measured risk, coupled with strategic capital planning, should encourage bankers to continue to maintain actual capital levels above regulatory minimums. In the United States, we are working very hard on Basel II implementation and are taking the appropriate, measured steps to ensure that we get it right. I expect that those in other Basel member countries are doing the same, and facing similar challenges. Of course, certain non-Group of Ten countries are looking to see if adapting Basel II is the best choice for them in the near term. For all of us engaged in Basel II work, it is helpful to remember that certain prerequisites have to be met particularly for the advanced approaches - including the development of qualified and experienced staff to oversee banks' adoption of the new framework.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Economic Club of New York, New York, 20 May 2005.
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Alan Greenspan: Energy Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Economic Club of New York, New York, 20 May 2005. * * * Over the past twenty years, the American economy has absorbed the major shocks of two stock market slumps, the terrorist attacks of September 11, and debilitating corporate scandals. But we have also been subjected to other shocks, the most immediately prominent ones being the oil and gas price surges of the past two years. Indeed, most analysts attribute the economic soft spots of the past two years to energy shocks. Accordingly, I will devote the rest of my formal remarks to developments in oil and gas markets, and I will endeavor to address broader issues of the world economy in the question and answer period. *** World markets for oil and natural gas have been subject to a degree of strain over the past year not experienced for a generation. Increased demand and lagging additions to productive capacity have combined to eliminate a significant amount of the slack in energy markets that was essential in containing energy prices between 1985 and 2000. Reflecting a low short-term elasticity of demand, higher prices in recent months have slowed the growth of oil demand, but only modestly. That slowdown, coupled with expanded production also induced by the price firmness, required markets to absorb an unexpected pickup in the pace of inventory accumulation. The initial response was a marked drop in spot prices for light, sweet crude oil. But that drop left forward prices sufficiently above spot prices to create an above-normal rate of return for oil bought for inventory and hedged, even after storage and interest costs are accounted for. As I indicated in early April, this emerging condition could encourage the buildup of enough of an inventory buffer to damp the price frenzy. Indeed, since early April, private crude oil inventories in the United States have been accumulated at a seasonally adjusted rate of around 250,000 barrels a day, rising as of last week to the highest seasonally adjusted level in three years. A somewhat lesser, but still important, accumulation of crude oil is evident in other major countries. Inventory accumulation is likely to continue unless demand rises, output declines, or we run out of storage capacity. In the United States, natural gas prices in recent weeks, seasonally adjusted, have come off their peak of early April, but those prices still remain significantly above the average level of 2004. Working levels of gas inventories are seasonally moderate, but domestic dry gas production plus net imports has not expanded sufficiently over the past few years to have prevented a marked rise in price. The inexorable rise in residential and utility use has priced the more marginal industrial gas users partially out of the market and has induced significant gains in gas efficiency among a number of gas users, such as petroleum refineries, steel mills, and paper and board mills. Industrial gas use overall in the United States has declined 12 percent since 1998. *** For both oil and natural gas, the inventory, production, and price outlook beyond the current episode will doubtless continue to reflect longer-term concerns. Much will depend on the response of demand to price over the longer run. Prices of spot crude oil and natural gas have risen sharply over the past year in response to constrained supply and the firming of overall demand. But if history is any guide, should higher prices persist, energy use over time will continue to decline relative to gross domestic product (GDP). In the wake of sharply higher prices, the energy intensity of the United States economy has been reduced about half since the early 1970s. Much of that displacement was achieved by 1985. Progress in reducing energy intensity has continued since then, but at a lessened pace. This more-modest rate of decline in energy intensity should not be surprising, given the generally lower level of real oil prices that prevailed between 1985 and 2000. With real energy prices again on the rise, more-rapid decreases in the intensity of use in the years ahead seem virtually inevitable. As would be expected, long-term demand elasticities have proved noticeably higher than those evident in the short term. *** Altering the magnitude and manner of U.S. energy consumption will significantly affect the path of the U.S. economy over the long term. For years, long-term prospects for oil and gas prices appeared benign. When choosing capital projects, businesses in the past could mostly look through short-run fluctuations in oil and natural gas prices, with an anticipation that moderate prices would prevail over the longer haul. The recent shift in expectations, however, has been substantial enough and persistent enough to direct business-investment decisions in favor of energy-cost reduction. Of critical importance will be the extent to which the more than 200 million light vehicles on U.S. highways, which consume 11 percent of total world oil production, become more fuel efficient as vehicle buyers choose the lower fuel costs of lighter or hybrid vehicles. We can expect similar increases in oil and energy efficiency in the rapidly growing economies of East Asia as they respond to the same set of market incentives. But at present, China consumes roughly twice as much oil per dollar of GDP as the United States, and if, as projected, its share of world oil consumption continues to increase, the average improvements in world oil-intensity will be less pronounced than the improvements in individual countries viewed separately would suggest. *** Aside from uncertain demand, the resolution of current major geopolitical uncertainties will materially affect oil prices in the years ahead. The effect on oil prices, in turn, will significantly influence the levels of investment over the next decade in crude oil productive capacity and, only slightly less importantly, investment in refining facilities. Because of the geographic concentration of proved reserves, much of the investment in crude oil productive capacity will need to be made in countries where foreign investment is prohibited or restricted or faces considerable political risk. Unless those policies and political institutions and attitudes change, a greater proportion of the cash flow of producing countries will be needed for oil re-investment to ensure that capacity keeps up with projected world demand. Concerns about potential shortfalls in investment certainly have contributed to recent record-high long-term futures prices. To be sure, world oil supplies and productive capacity continue to expand. Major advances in recovery rates from existing reservoirs have enhanced proved reserves despite ever-fewer discoveries of major oil fields. But investment to convert reserves to productive capacity has fallen short of the levels required to match unexpected recent gains in demand, especially gains in China. Besides feared shortfalls in crude oil capacity, the status of world refining capacity has become worrisome as well. Of special concern is the need to add adequate coking and desulphurization capacity to convert the average gravity and sulphur content of much of the world's crude oil to the lighter and sweeter needs of product markets, which are increasingly dominated by transportation fuels that must meet ever-more stringent environmental requirements. *** The extraordinary uncertainties about oil prices of late are reminiscent of the early years of oil development. Over the past few decades, crude oil prices have been determined largely by international market participants, especially OPEC. But such was not always the case. In the early twentieth century, pricing power was firmly in the hands of Americans, predominately John D. Rockefeller and Standard Oil. Reportedly appalled by the volatility of crude oil prices in the early years of the petroleum industry, Rockefeller endeavored with some success to control those prices. After the breakup of Standard Oil in 1911, pricing power remained with the United States - first with the U.S. oil companies and later with the Texas Railroad Commission, which raised allowable output to suppress price spikes and cut output to prevent sharp price declines. Indeed, as late as 1952, U.S. crude oil production (44 percent of which was in Texas) still accounted for more than half of the world total. However, that historical role came to an end in 1971, when excess crude oil capacity in the United States was finally absorbed by rising demand. At that point, the marginal pricing of oil, which for so long had been resident on the Gulf Coast of Texas, moved to the Persian Gulf. To capitalize on their newly acquired pricing power, many producing nations in the Middle East nationalized their oil companies. But the full magnitude of their pricing power became evident only in the aftermath of the oil embargo of 1973. During that period, posted crude oil prices at Ras Tanura, Saudi Arabia, rose to more than $11 per barrel, significantly above the $1.80 per barrel that had been unchanged from 1961 to 1970. A further surge in oil prices accompanied the Iranian Revolution in 1979. The higher prices of the 1970s brought to an abrupt end the extraordinary period of growth in U.S. consumption of oil and the increased intensity of its use that was so evident in the decades immediately following World War II. Between 1945 and 1973, consumption of petroleum products rose at a startling average annual rate of 4-1/2 percent, well in excess of growth of real GDP. However, between 1973 and 2004, oil consumption grew, on average, only 1/2 percent per year, far short of the rise in real GDP. Although OPEC production quotas have been a significant factor in price determination for a third of a century, the story since 1973 has been as much about the power of markets as it has been about power over markets. The signals provided by market prices have eventually resolved even the most seemingly insurmountable difficulties of inadequate domestic supply in the United States. The gap projected between supply and demand in the immediate post-1973 period was feared by many to be so large that rationing would be the only practical solution. But the resolution did not occur quite that way. To be sure, mandated fuel-efficiency standards for cars and light trucks induced slower growth of gasoline demand. Some observers argue, however, that, even without government-enforced standards, market forces would have produced increased fuel efficiency. Indeed, the number of small, fuel-efficient Japanese cars that were imported into the United States markets rose throughout the 1970s as the price of oil moved higher. Moreover, at that time, prices were expected to go still higher. Our Department of Energy, for example, had baseline projections showing prices reaching $60 per barrel - the equivalent of about twice that amount in today's prices. The failure of oil prices to rise as projected in the late 1970s is a testament to the power of markets and the technologies they foster. Today, despite its recent surge, the average price of crude oil in real terms is still only three-quarters of the price peak of February 1981. Moreover, the effect of the current surge in oil prices, though noticeable, is likely to prove less consequential to economic growth and inflation than in the 1970s. Since the end of 2003, the rise in the value of imported oil - essentially a tax on U.S. residents - has amounted to about 3/4 percent of GDP. The effects were far larger in the crises of the 1970s. But, obviously, the risk of more-serious negative consequences would intensify if oil prices were to move materially higher. *** U.S. natural gas prices have historically displayed greater volatility than prices of crude oil, doubtless reflecting, in part, the less-advanced development of price-damping global trade in natural gas. Over the past few years, notwithstanding markedly higher drilling activity, the U.S. natural gas industry has been unable to noticeably expand production or to increase imports from Canada. Significant upward pressure on prices has ensued. North America's limited capacity to import liquefied natural gas (LNG) has effectively restricted our access to the world's abundant supplies of gas. Because international trade in natural gas has been insufficient to equalize prices across markets, U.S. natural gas prices since late 2002 have been notably higher, on average, than prices abroad. As a result, significant segments of the North American gas-using industry are in a weakened competitive position. Indeed, ammonia and fertilizer plants in the United States have been particularly hard hit as the costs of domestic feedstocks have risen relative to those abroad. The difficulties associated with inadequate domestic supplies will eventually be resolved as consumers and producers react to the signals provided by market prices. Indeed, the process is already under way. As a result of substantial cost reductions for liquefaction and transportation of LNG, significant global trade in natural gas is developing. This activity has accelerated sharply over the past few years as profitable arbitrage has emerged in natural gas prices across international markets. At the liquefaction end of the process, new investments are in the works across the globe. Enormous tankers to transport LNG are being constructed, even though they are not dedicated to specific long-term delivery contracts. The increasing availability of LNG around the world should lead to much greater flexibility and efficiency in the allocation of energy resources. According to tabulations of BP, worldwide imports of natural gas in 2003 were only 24 percent of world consumption, compared with 59 percent for oil. Clearly, the gas trade has significant margin to exercise its price-damping opportunities. In the United States, import terminals in Georgia and in Maryland have reopened after having been mothballed for more than two decades. The added capacity led to a noticeable increase in imports of LNG last year, but LNG imports still accounted for less than 3 percent of U.S. consumption. Additional import facilities, both onshore and offshore, are being developed. A new offshore facility in the Gulf of Mexico received its first delivery of liquefied natural gas a little more than a month ago. According to the Federal Energy Regulatory Commission, the number of approved and proposed new or expanded LNG import terminals in the United States stood at thirty-three earlier this month. Together they have capacity for 15 trillion cubic feet of imports annually, far in excess of any pending consumption needs, which in 2004 amounted to 22 trillion cubic feet. Clearly, not all of these projects will come to fruition. Some will be abandoned for economic and business considerations, and others will fail because of local opposition, motivated by environmental, safety, and other concerns. The larger question, of course, is what will increased world trade in LNG and expanded U.S. import capacity do to natural gas prices in the United States? During the past couple of years, when U.S. prices of natural gas hovered around $6 per million Btu, import prices of LNG in Europe have ranged between $2 and $4, and those in Japan and Korea have generally been between $3 and $5. Estimates of production and delivery costs of LNG to North America appear to hover around $3. In the short run, exporters to the United States are likely to receive our domestic price, currently above $6 per million Btu. But unless world gas markets tighten aggressively, competitive pressures will arbitrage the U.S. natural gas price down, possibly significantly, through increased imports. In addition to expanded supplies from abroad, North America still has numerous unexploited sources of gas production. Significant quantities of recoverable gas reserves are located in Alaska and the northern territories of Canada. Negotiations over the construction of pipelines connecting these northern supplies to existing delivery infrastructure are currently under way. *** The dramatic changes in technology in recent years have made existing oil and natural gas reserves stretch further while keeping energy costs lower than they otherwise would have been. Seismic imaging and advanced drilling techniques are facilitating the discovery of promising new reservoirs and are enabling the continued development of mature fields. But because of inexorably rising demand, these improved technologies have been unable to prevent the underlying long-term prices of oil and natural gas in the United States from rising. Conversion of the vast Athabasca oil sands reserves in Alberta to productive capacity has been slow. But at current market prices they have become competitive. Moreover, new technologies are facilitating U.S. production of so-called unconventional gas reserves, such as tight sands gas, shale gas, and coalbed methane. Production from unconventional sources has more than doubled since 1990 and currently accounts for roughly one-third of U.S. dry gas production. According to projections from the Energy Information Administration, most of the growth in the domestic supply of natural gas over the next twenty years will come from unconventional sources. In many respects, the unconventional is increasingly becoming the conventional. In the more distant future, perhaps a generation or more, lies the potential to develop productive capacity from natural gas hydrates. Located in marine sediments and the Arctic, these ice-like structures store immense quantities of methane. Although the size of these potential resources is not well measured, mean estimates from the U.S. Geological Survey indicate that the United States alone may possess 200 quadrillion cubic feet of natural gas in the form of hydrates. To put this figure in perspective, the world's proved reserves of natural gas are on the order of 6 quadrillion cubic feet. *** In the decades ahead, natural gas and oil will compete in the United States with coal, nuclear power, and renewable sources of energy. As the manner in which energy is produced and consumed evolves, it is not unreasonable to expect that, in the long run, the prices per unit of energy from various sources would tend to converge. At present, long-term futures prices for natural gas are, on a Btu-equivalent basis, notably less expensive than those for crude oil. Clearly, limited substitution possibilities across fuels have resulted in persistent cost differentials, but those very differentials inspire the technologies that, over time, reduce such limitations. A clear example is gas-to-liquids (GTL) technology, which converts natural gas to high-quality naphtha and diesel fuel. Given the large-scale production facilities that are currently being contemplated, GTL is poised to become an increasingly important component of the world's energy supply. Current projections of production however remain modest. GTL promises to add a good measure of flexibility in the way that natural gas resources are utilized. In addition, given the concerns over the long-term adequacy of liquid production capacity from conventional oil reserves, gas to liquids may provide an attractive, competitively priced, option for making use of stranded gas, which, for lack of access to transportation infrastructure, cannot be brought to market. *** In summary, improving technology and ongoing shifts in the structure of economic activity are reducing the energy intensity of industrial countries, and presumably recent oil price increases will accelerate the pace of displacement of energy-intensive production facilities. If history is any guide, oil will eventually be overtaken by less-costly alternatives well before conventional oil reserves run out. Indeed, oil displaced coal despite still vast untapped reserves of coal, and coal displaced wood without denuding our forest lands. Innovation is already altering the power source of motor vehicles, and much research is directed at reducing gasoline requirements. Moreover, new technologies to preserve existing conventional oil reserves will emerge in the years ahead. We will begin the transition to the next major sources of energy perhaps before midcentury as production from conventional oil reservoirs, according to central tendency scenarios of the Energy Information Administration, is projected to peak. In fact, the development and application of new sources of energy, especially nonconventional oil, is already in train. Nonetheless, the transition will take time. We, and the rest of the world, doubtless will have to live with the geopolitical and other uncertainties of the oil markets for some time to come. *** We are unable to judge with certainty how technological possibilities will play out in the future, but we can say with some assurance that developments in energy markets will remain central in determining the longer-run health of our nation's economy. The experience of the past fifty years - and indeed much longer than that - affirms that market forces play the key role in conserving scarce energy resources, directing those resources to their most highly valued uses. The availability of adequate productive capacity, of course, will also be driven by nonmarket influences and by other policy considerations. To be sure, energy issues present policymakers and citizens with difficult tradeoffs to consider and decisions to make outside the market process. The concentration of oil reserves in politically volatile areas of the world is an ongoing concern. But that concern and others, one hopes, will be addressed in a manner that, to the greatest extent possible, does not distort or stifle the meaningful functioning of our markets. We must remember that the same price signals that are so critical for balancing energy supply and demand in the short run also signal profit opportunities for long-term supply expansion. Moreover, they stimulate the research and development that will unlock new approaches to energy production and use that we can now only barely envision.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, to the Conference on Housing, Mortgage Finance, and the Macroeconomy, Federal Reserve Bank of Atlanta, Atlanta, (via satellite), 19 May 2005.
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Alan Greenspan: Government-sponsored enterprises Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, to the Conference on Housing, Mortgage Finance, and the Macroeconomy, Federal Reserve Bank of Atlanta, Atlanta, (via satellite), 19 May 2005. * * * Let me begin by thanking the Federal Reserve Bank of Atlanta and President Guynn for hosting this conference - "Housing, Mortgage Finance, and the Macroeconomy." Clearly, housing and the financing of housing purchases have been critical components of economic activity in recent years. Understanding better how the financial structure of housing transactions influences households' economic decisions is crucial both for academics and for policymakers. In the United States, few financial innovations in recent decades have had so widespread an impact as the development of the secondary home-mortgage market and the attendant diversification of funding sources for depository institutions and other mortgage originators. Critical to the success of this innovation has been the role of Fannie Mae and Freddie Mac in promoting mortgage securitization - the key to the development of secondary mortgage markets in the United States.1 Their efforts spawned the vast asset-backed securities market that, along with credit derivatives, has contributed to the transfer of credit risk from highly leveraged originators of credit - especially banks and thrifts - to less-leveraged insurance companies and pension and mutual funds, among other investors. The stated intent of the Congress is to use the housing-related government-sponsored enterprises (GSEs) to provide a well-established channel between housing credit and the capital markets and, through this channel, to promote homeownership, particularly among lower-income families. Although prospectuses for GSE debt are required by law to stipulate that such instruments are not backed by the full faith and credit of the U.S. government, investors worldwide have concluded that our government will not allow GSEs to default. As a consequence, market participants offer to purchase GSE debt at interest rates substantially lower than those required of comparably situated financial institutions without direct ties to government.2 Given this advantage, which private competitors have been unable to fully overcome, the housing-related GSEs have grown rapidly in recent years. Fannie and Freddie essentially dominate the market for purchasing conforming home mortgage loans.3 The strong belief of investors in the implicit government backing of the GSEs does not by itself create problems of safety and soundness for the GSEs, but it does create systemic risks for the U.S. financial system as the GSEs become very large. As I have recently testified before the Banking Committee of the U.S. Senate, systemic risks are difficult to address through the normal course of financial institution regulation alone. But in the case of the GSEs, these risks can be effectively handled by limiting their investment portfolios, which are funded by implicitly subsidized debt. The government guarantee for GSE debt inferred by investors enables Fannie and Freddie to profitably expand their portfolios of assets essentially without limit.4 Private investors have granted them a market subsidy in the form of lower borrowing rates, which staff at the Federal Reserve Board has estimated at 40 basis points in recent years. This market subsidy is a formidable advantage in our Under securitization, mortgages are bundled into pools and then turned into securities that can be easily bought and sold alongside other debt securities. Combining a diversified pool of home mortgages into a single package in this way reduces the sum of the risks associated with the individual mortgages and enables the packager to sell claims against the package that pay interest rates below the average yield of the package as a whole. For example, the government provides the housing-related GSEs with a line of credit from the Department of the Treasury, fiscal agency services through the Federal Reserve, exemptions from securities registration requirements, exemptions from bank regulations on security holdings, and tax exemptions. Fannie and Freddie can buy a single-family home mortgage only if the principal balance is below the "conforming loan limit." For 2005, that limit for most loans is $359,650. The boards of directors of Fannie and Freddie are allowed to invest in almost anything so long as there is some link, direct or indirect, to their mission of supporting conforming mortgage markets. As demonstrated by recent innovations in the home equity lending and asset-backed securities markets, much of the $9 trillion in household credit can potentially be secured by real estate and thus appears to be available to the GSEs as investments. Moreover, the GSEs have been allowed to invest in many forms of non-mortgage debt, such as corporate bonds and commercial paper, to the degree that the GSEs can argue such investments support their liquidity goals and thus indirectly support mortgage markets. highly competitive Aaa market, where a few basis points are often competitively determinant. Unlike subsidies explicitly mandated by the Congress, the implicit subsidies to the GSEs are initiated wholly at the discretion of the GSEs. They choose when to borrow and gain the advantage of the subsidy, and because markets perceive such debt as government guaranteed, GSEs can effectively borrow without limit. Investors have provided Fannie and Freddie with a powerful vehicle for achieving profits that are virtually guaranteed through the rapid growth of their balance sheets, and the resultant scale has given them an advantage that their potential private-sector competitors cannot meet. As a result, their annual return on equity, which has often exceeded 30 percent, is far in excess of the average annual return of approximately 15 percent that has been earned by other large financial competitors holding substantially similar assets. Virtually none of the GSE excess return reflects higher yields on assets; it is almost wholly attributable to subsidized borrowing costs. In a market system, lenders and investors typically monitor and discipline the activities, including leverage, of their counterparties to assure themselves that these entities are financially sound. Because the many counterparties in GSE transactions assess risk based mainly on the GSE's perceived special relationship to the government, rather than on the underlying soundness of the institutions, regulators cannot rely on market discipline to contain systemic risk. *** The profit potential created by subsidized debt has been available to the GSEs for decades. However, the management of Fannie and Freddie chose to abstain from making profit-centers out of their portfolios in earlier years, and only during the mid-1990s did they begin rapidly enlarging their portfolios. At the end of 1990, for example, Fannie's and Freddie's combined portfolios amounted to $132 billion, or only 5.6 percent of the single-family home-mortgage market. Indeed, in 1989, before the rapid expansion of its portfolio, Freddie testified before the Congress that the need for safe and sound operation and the need to provide affordable mortgages to homebuyers were inconsistent with holding a substantial portfolio. As Freddie's CEO argued at that time, by financing mortgages with mortgage-backed securities sold to investors rather than with a portfolio, Freddie avoided interest rate risks and thus could keep mortgages flowing when depository institutions were suffering an interest rate squeeze.5 Moreover, Freddie's 1990 annual report stated that Freddie could provide ample liquidity to mortgage markets and make profits by financing mortgages with mortgage-backed securities sold to investors rather than by holding a mortgage portfolio. To quote, "Freddie Mac maintains a presence in the secondary market each and every day - regardless of economic conditions - by buying mortgages from lenders, pooling and packaging them into securities, and selling these securities to investors"(emphasis added). When Freddie Mac became owned by private shareholders and began to realize the potential for exploiting the risk-adjusted profit-making of a larger portfolio, the message changed. Freddie stated in its 1993 annual report that "in short, to achieve our earnings objective, we are striving to increase our total portfolio at a rate faster than residential mortgage debt growth ... [and] generate earnings growth in excess of revenue growth through focused management of credit and operating expenses." By 2003, Freddie's portfolio had grown tenfold, and Fannie and Freddie together held $1.5 trillion in assets, or 23 percent of the home-mortgage market. Today, the interest rate and prepayment risks inherent in mortgages with a low-cost refinancing option is concentrated in the large portfolios at Fannie and Freddie. These concentrations cannot be readily handled by private-market forces because there are no meaningful limits to the expansion of portfolios created with debt that the market believes to be federally guaranteed. As Fannie and Freddie increase in size relative to the counterparties to their hedging transactions, the ability of these GSEs to quickly correct a misjudgment in their complex hedging strategies becomes more difficult, especially when vast reversal transactions are required to rebalance portfolio risks. We are thus highly dependent on the risk-managers at Fannie and Freddie to do everything right. Moreover, the success of interest-rate-risk management, especially the exceptionally rapid timing required by dynamic risk adjustments, requires that the ultimate counterparties to the GSEs' transactions provide sufficient liquidity to finance an interest-rate-risk transfer that counters the risk. Leland C. Brendsel, "Government-Sponsored Enterprises," Hearing before the Subcommittee on Oversight of the Committee on Ways and Means, House of Representatives, the 101st Congress, September 28, 1989. Otherwise, large and rapid dynamic adjustments will result in sharp changes in the prices for rebalancing and hedging a mortgage portfolio. The consequence would be added to interest rate volatility. In the end, we cannot eliminate the risk inherent in mortgages with refinancing options. But we can markedly contain the accompanying risks to systemic stability by diversifying the concentration of risk away from large, highly leveraged portfolios for which misjudgments can have quick and devastating consequences. A system of diversified and less-leveraged interest-rate-risk management would be far more resilient to the inevitable mistakes and shocks of individual risk-mitigating strategies. Such diversification would thus pose much less systemic risk, largely because of lowered leverage, which in turn is the consequence of the private-market discipline imposed on commercial and investment banks, mutual funds, insurance companies, and other current or potential holders of mortgage-backed securities. Some argue correctly that, although the borrowing rates of the GSEs are subsidized, so are those of commercial banks because of deposit insurance and access to the Federal Reserve's discount window and payments system. But interest rates on the long-term debentures of banks exceed the rate of interest required on GSE debt, suggesting that market participants perceive banks as far less subsidized than GSEs. Banks accordingly have access to significantly less-subsidized credit than do GSEs. To be sure, banks do have access to insured deposits at low rates. But large banks find it difficult to grow using only insured deposits. Interest rates on banks' insured deposits, while usually less than those on GSE debentures, do not account for the substantial costs that banks incur to collect, and provide services for, core and small time deposits. If larger banks could rely on low-cost insured deposits as their effective marginal source of funds, why would they pay higher interest rates to holders of their debentures? The borrowing edge of the GSEs prevails even though the biggest banks must maintain at least twice the capital ratio of Fannie and Freddie and smaller banks hold even more. Moreover, with the additional capital available at banks to absorb the inevitable hedging misjudgments, reversals of fortune are likely to create less disruption to the banking system relative to the disruption possible at Fannie and Freddie. *** The Federal Reserve Board has been unable to find any credible purpose for the huge balance sheets built by Fannie and Freddie other than the creation of profit through the exploitation of the marketgranted subsidy. Fannie's and Freddie's purchases of their own or each other's mortgage-backed securities with their market-subsidized debt do not contribute usefully to mortgage market liquidity, to the enhancement of capital markets in the United States, or to the lowering of mortgage rates for homeowners. The key activity of the GSEs - the provision of liquidity to the primary mortgage market - can be accomplished exclusively through the securitization of mortgages; GSE portfolios of mortgage-related assets cannot serve this function. Indeed, during a crisis, the GSEs' portfolios of mortgage-backed securities (MBS), in contrast to portfolios of liquid assets such as Treasury bills or cash, cannot provide liquidity to either the primary or the secondary mortgage market. To sell mortgaged-backed securities to purchase other mortgage-backed securities clearly adds no net support to the mortgage markets. GSE portfolios could act as a source of strength to the mortgage markets only if they contained highly liquid, non-mortgage assets such as Treasury bills, which can be readily turned into cash under all possible scenarios without importantly affecting the prices of home mortgages. Indeed, only such highly liquid portfolios would be consistent with the GSEs' mission of providing primary mortgage market liquidity during a crisis, particularly during a financial crisis. Fannie and Freddie do need to hold in portfolio some mortgage-related assets to achieve their mission. In the normal course of securitization, timing differences between purchases of home mortgages and sales of MBS imply an inventory of home loans, although most such transactions are simultaneous swaps of packages of home mortgages for MBS. Moreover, there may be some affordable housing mortgages unsuitable for securitization that serve the chartered mission of the GSE. But in total, the assets required for Fannie and Freddie to achieve their mission are but a small fraction of the current level of their assets. Thus, if the Congress legislates a mission-only need for GSE portfolio assets, a substantial liquidation of MBS over time, coupled with an equivalent redemption of GSE debt, will doubtless be required. Such liquidation would entail not solely a removal of demand but an equal removal of both supply and demand for MBS. Accordingly, the implementation of portfolio limits should pose no significant difficulties: The amassing of GSE portfolio assets is a simple grossing-up of mortgage assets, which can be initiated and reversed in quite large volumes with relative ease. *** The average paydown rate of the GSEs' portfolios from 1997 to 2004 was about 25 percent. Even if outright sales of MBS were required to shrink portfolios, the proceeds would presumably be employed to redeem GSE debt. In effect, a private investor whose holding of GSE debt has been redeemed receives, in exchange, either the mortgage-backed security sold by the GSE or other assets sold by those who acquire the mortgage-backed security. In either case, the grossing-up or its reversal does not affect the net demand for high-quality securities.6 The concern of some observers that large sales of MBS will be difficult to absorb runs counter to the evidence that GSE-backed MBS, being Aaa-rated securities, already trade as part of the large worldwide market for high-quality corporate debt and U.S. Treasury issues. GSE sales of MBS, matched with redemptions of debt, will be readily absorbed in the vast market without a significant change in the relative interest rate spreads of such investments. At the most, the grossing-up and liquidation of MBS and the corresponding GSE debt might conceivably affect the MBS-GSE interest rate spread at the margin. Moreover, unwinding MBS financed by GSE debt does not affect the level of home mortgage debt outstanding or of mortgage interest rates. Indeed, we have found little, if any, evidence that the spread of home-mortgage interest rates over comparable-maturity U.S. Treasuries are affected at all by variations in the size of GSE portfolios.7 In fact, contrary to the expectations that MBS portfolio accumulation lowers home mortgage interest rates, the spreads apparently widened as the portfolios grew from 1995 to 2003. In any event, since the development of the MBS market, the determinants of interest rates that finance home purchase have exhibited little, if any, response to the size of GSE portfolios. The past year provides yet more evidence of this independence, with GSE portfolios not growing and mortgage spreads, as well as the spread between yields on GSE debentures and Treasury securities, declining further. Despite the turmoil at Fannie and Freddie during the past two years, home mortgage markets have functioned well. Indeed, as an indication that the yield on debt owed by GSEs is wholly a function of the yield's perceived status as government guaranteed, the credit default swaps of both Fannie and Freddie have barely budged as the disruption in the markets for GSE equities has deepened. The MBS-GSE or GSE-Treasury interest rate spreads seem to be insensitive to changes in the degree of intermediation because of the extraordinary substitutability of Aaa mortgages and their financing vehicles for high-quality corporate debt and Treasuries. The method of GSEs' intermediation may be another reason that we find so little effect of the size of the GSEs' MBS portfolio on home-mortgage interest rates. The decision by a GSE to purchase and securitize a mortgage is made independently of the decision to place the mortgage or mortgage-backed security in the GSEs own portfolio. Thus, whatever effect the GSEs have on primary home-mortgage rates appears to flow from the decision to purchase and securitize the mortgage, not from the decision of whether to put the mortgage-backed security into the GSEs' portfolios or sell the MBS in the private market.8 In effect, investors who purchase MBS use their own savings or the savings of others to fund the asset. But purchasers of GSE debt fund in the same manner. Thus, if Fannie securitizes and sells an MBS, it has no need to fund it. But if Fannie does fund it, the private investor, of course, does not. In effect, the same amount of the nation's saving is drawn upon whether a purchased origination is sold as MBS to investors or Fannie funds the mortgage or MBS. See Wayne Passmore (2005), "The GSE Implicit Subsidy and the Value of Government Ambiguity," Finance and Economic Discussion Series 2005-5 (Washington: Board of Governors of the Federal Reserve System, January) (forthcoming in Real Estate Economics); Wayne Passmore, Shane M. Sherlund, and Gillian Burgess (2005), "The Effect of Government Sponsored Enterprises on Mortgage Rates," Finance and Economic Discussion Series 2005-6 (January) (forthcoming in Real Estate Economics); and Andreas Lehnert, Wayne Passmore, and Shane M. Sherlund (2005), "GSEs, Mortgage Rates, and Secondary Market Activities," Finance and Economic Discussion Series 2005-7 (January). One issue that has been raised in the debate about the size of GSE portfolios is the following: In the event of a shrinkage of GSE debt, would the reduction of foreign holdings of GSE debt deprive the U.S. housing market of a net source of savings not otherwise available? Foreign holders whose GSE debt is redeemed will reinvest the proceeds in U.S. Treasury issues, *** Some observers have suggested that the availability of fixed-rate mortgages is tied to the size of GSE portfolios. We see little empirical support for this notion. For example, we have found no evidence that fixed-rate mortgages were difficult to obtain during the early 1990s, when GSE portfolios were small. Indeed, the share of fixed-rate mortgage originations averaged slightly less than 80 percent in 1992, when GSE portfolios were small, and averaged 66 percent in 2004, when GSE portfolios were large. Clearly, these data do not support the proposition that the size of the GSEs' portfolios positively contributes to the availability or popularity of fixed-rate mortgages. It is, of course, mortgage securitization, and not GSE portfolios, that is the more likely reason for the continued market support for the popular thirty-year fixed-rate mortgage. *** Without a notable direct or indirect effect on primary home-mortgage rates, it is difficult to see how the GSEs' portfolios can influence homeownership. The evident de minimis to small changes in home mortgage interest rates owing to GSE mortgage market intermediation suggested by recent studies would have little effect on homeownership. Indeed, a comprehensive survey by Ron Feldman finds that a change in mortgage rates would have to be at least 200 basis points before it would have more than a trivial effect on homeownership.9 Most analysts conclude that the primary determinants of homeownership appear to be the loan-to-value, debt-to-income, and payment-to-income ratios associated with the mortgagor and the mortgage. Over the 1990s, homeownership rates in the United States increased from about 64 percent to about 67 percent. Much of this increase seems to be due to growing incomes of households, a generally lower level of interest rates, and an increased ability to extend loans to borrowers who require higher loan-to-value ratios. The generally declining level of mortgage rates that occurred in the 1990s reflects the fact that worldwide interest rates have been generally lower and that worldwide development cannot be a consequence of GSE portfolio growth. Even with smaller portfolios, Fannie and Freddie would remain formidable institutions and their profits would provide more than sufficient support for their special affordable-housing programs. GSE mortgage securitization is a profitable activity and, with its modestly subsidized guarantee, earns above-normal rates of returns. *** As I testified before the Congress both this year and in 2004, the GSEs need a regulator with authority on par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear and credible process sanctioned by the Congress for placing a GSE in receivership, where the conditions under which debt holders take losses are made clear. However, if legislation takes only these actions and does not limit GSE portfolios, we run the risk of solidifying investors' perceptions that the GSEs are instruments of the government and that their debt is equivalent to government debt. The GSEs will have an increased facility to continue to grow faster than the overall home-mortgage market; indeed because their portfolios are not constrained, by law, to exclusively home mortgages, GSEs can grow virtually without limit. GSE's mortgage securitization, in contrast to their portfolio holdings, is the key to maintaining and enhancing the benefits of Fannie and Freddie to homebuyers and secondary mortgage markets. And mortgage securitization, unlike the GSE portfolio holdings, does not create substantial systemic risks. Thus, one way to limit the GSE portfolios is to create a strong presumption that almost all mortgage-related assets can be securitized. The GSEs would need to establish, with their regulator, that any asset held in their portfolio could not be securitized. In other words, the method of GSE financing most consistent with their missions is to securitize assets first and to hold in their portfolios only those assets that are very difficult or unduly expensive to securitize. as GSE debt was perceived, in effect, as higher-yielding Treasury debt. Accordingly, the effect on the financing of our current account deficit would likely be nil. Moreover, there is no reason to believe that the effect on interest rates for MBS and home mortgages from reduced foreign holdings of GSE debt would be any different from the evident quite small change owing to reduced domestic holdings of GSE debt. Ron J. Feldman (2001), "Mortgage Rates, Homeownership Rates, and Government-Sponsored Enterprises," Federal Reserve Bank of Minneapolis Annual Report, pp. 3-23. Without the needed restrictions on the size of the GSE balance sheets, we put at risk our ability to preserve safe and sound financial markets in the United States, a key ingredient of support for housing. Financial instability coupled with the higher interest rates it creates is the most formidable barrier to the growth, if not the level, of homeownership. Huge, highly leveraged GSEs subject to significant interest rate risk are not conducive to the long-term financial stability that a nation of homeowners requires.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve System¿s Conference on Implementing an Advanced Measurement Approach for Operational Risk, Boston, 19 May 2005.
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Susan Schmidt Bies: Observations on measuring and managing operational risk under Basel II Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve System’s Conference on Implementing an Advanced Measurement Approach for Operational Risk, Boston, 19 May 2005. * * * Good morning and welcome to the Federal Reserve's conference - "Implementing an Advanced Measurement Approach for Operational Risk." It gives me great pleasure to open this conference. I would like to thank the Federal Reserve Bank of Boston and Board staff for organizing this important event and all the speakers for the time and effort they have devoted to making this conference worthwhile. Indeed, judging from the impressive lineup of speakers, this conference should be a highly useful forum for an exchange of ideas. I also want to extend a special welcome to the international supervisors and bankers who are in attendance. I know that some of you have spent the earlier part of this week sharing your views about and experiences with the implementation of the Basel II operational risk framework and working to achieve an appropriate level of consistency in implementation across countries. Our hope is that this conference will broaden and deepen the understanding within the banking and regulatory community of operational-risk measurement techniques, both quantitative and qualitative, particularly as they relate to the development of the advanced measurement approaches, or AMAs. I think you have an interesting two days ahead of you, with an opportunity to hear the current state of implementation from banks and regulators. Specifically, this morning you will hear supervisors describe the range of practices they observed during the "interagency AMA benchmarking exercise" conducted last year at institutions that will likely be required to adopt Basel II. They will also summarize the results of the operational-risk-loss data-collection exercise and Fourth Quantitative Impact Study - known as QIS4. This afternoon you will hear from academics and practitioners who are experts in measuring operational risk, and tomorrow you will hear from financial institutions who will share their practical experiences in designing and implementing operational-risk measurement systems and then from regulators on the outstanding policy issues. Today, I would like to address some of the practical aspects of implementing Basel II in the United States, including some observations on progress being made in the management and measurement of operational risk as well as some observations on the challenges associated with implementing an AMA. Implementation of Basel II in the United States The agencies' reaction to the results of QIS4 shows how seriously we are taking Basel II implementation. As you probably know, the agencies issued a statement on April 29 indicating that results from QIS4 were more widely dispersed and showed a larger overall drop in capital than we had expected. This was the impetus for deciding to delay issuance of our next round of proposals for Basel II. These unexpected results show the continued benefit of conducting periodic quantitative impact studies. They serve as a milestone to help us calibrate the progress of the framework and the bankers as we move to Basel II. We now must determine the reasons for the unexpected results from QIS4. Do they reflect actual differences in risk among respondents when prior supervisory information suggested more similarity in credit quality? None of the participating banks has completed their databases and models for all of their risk areas. In some cases, this created results that would not be reliable for implementing Basel II. For example, for some portfolios, expected losses reflected only the last year or two of results. Thus, the strong credit performance of recent experience was not balanced by higher losses at other points of the credit cycle. Were there limits of the QIS4 exercise itself? Is there a possible need for adjustments to the Basel framework? Analyzing the data used in QIS4 is vitally important, because ultimately the success of Basel II will depend on the quantity and quality of data that banks have to use as inputs to the framework. U.S. regulators expect to provide additional information on the lessons we learn from the QIS4 review in the near future. The notice of proposed rulemaking (NPR) for Basel II will incorporate what we learn from this exercise. But we really are caught in a process dilemma. Bankers cannot complete their models and collect the necessary data until they know what the specific requirements will be. Regulators, on the other hand, will have to develop these requirements before seeing the actual results of these models and robust databases. Given what a vast undertaking Basel II is, this seems entirely appropriate and beneficial. In addition to what we learn from the work on QIS4 results, we will also assess the trading and banking book comments of the Basel Committee on Banking Supervision and the International Organization of Securities Commissions. We will incorporate the latest proposal into the notice of proposed rulemaking and hope to complete our efforts in a timely manner. In addition, under our current plans, we also will be delaying issuance of an advance notice of proposed rulemaking to revise current capital rules for non-Basel II banks. U.S. banking regulators have longed recognized that the existing capital rules need to be updated. These modifications are needed to reflect changing products and risk exposures and also to address potential competitive impacts from Basel II. We plan to issue these proposals for public comment concurrently with, or soon after, the NPR on Basel II to allow the banking community to comment on a combined package. I will now turn to some observations about operational risk. Observations related to implementing an AMA As you may know, I have spent much of my career in the field of risk management, and of course the Federal Reserve has a keen interest in this topic. For those of us who have spent more than a few years in the business, it is easy to see the recent progress in the quantitative aspects of risk management brought about by improved databases and technological advances. Indeed, the development of techniques for the measurement and management of operational risk is very dynamic, with much progress being made relatively recently. Evidence of this dynamic development process can be seen in the results of an interagency AMA benchmarking exercise conducted last year, as well as the results of the operational-risk-loss data-collection exercise and QIS4. In fact, one very encouraging sign of progress in measuring operational risk is the broad participation we saw in the loss data-collection exercise and on the operational-risk portions of QIS4. As you will hear in more detail later this morning, twenty-seven institutions participated in these exercises; and it appears that, based on our preliminary analysis of the submissions, significant progress has been made in the collection of operational-risk data and the quantification of operational risk. A review of the loss data submitted by you and your colleagues shows a substantial increase in the number of institutions collecting operational-risk data over the past five years. In addition, the QIS4 responses suggest that although significant quantification challenges remain, many institutions are developing sophisticated approaches for measuring their operational-risk exposure. It has often been argued that measuring operational risk is much more difficult than measuring market or credit risk. The lack of a consistent definition of operational risk (until recently); the central role of the internal control environment; the relatively short time span of historical loss data; and the important role of infrequent, but very large, loss events are just some of the challenges that operational-risk measurement systems have had to confront. Coming up with credible ways of capturing the tail of the loss distribution and, just as important, of verifying that it has been captured in a reasonably accurate and consistent way, have presented interesting challenges to those developing operational-risk measurement frameworks. But, in a very real sense, these challenges have become the true strengths of the operational-risk measurement discipline. As will be very evident from the presentations over the next two days, tremendous creativity and insight have been brought to bear on the issue of operational-risk measurement. To address the difficulties presented by the very nature of the risk, the designers of operational-risk measurement frameworks have had to be more innovative, take bigger steps into new territory, and be more willing to step away from traditional - and comfortably familiar - techniques than their counterparts in the market- and credit-risk arenas. Designers of operational-risk measurement systems have had to do some really fundamental thinking about the goals of risk measurement and about the tools used to achieve those goals. As a result, we have seen innovation in the use of "soft" data derived from scenario analysis, risk self-assessments, and the judgment of senior business managers. We have seen creativity in the melding of internal and external loss data to guide thinking about internal loss exposures. Perhaps most significantly, we have seen some truly innovative thinking about ways to integrate operational-risk measurement into the broader framework of operational-risk management. I commend you on all that you have accomplished to date, but substantial work remains to be accomplished before Basel II can "go live." I strongly encourage both bankers and supervisors to continue their efforts to support the evolution of operational-risk measurement and management practices. One of the major challenges bankers face in implementing an AMA is creating a credible database of internal loss-event data on which to base the AMA capital charge. Another, and no less important, challenge is ensuring that operational-risk measurement and management systems are integrated into the day-to-day decisionmaking processes of your institution. The focus on enhanced risk management in Basel II means that banks should not view Basel II preparations with a checklist mentality. Rather, they should be moving ahead on many fronts, looking at how to make the fundamental changes needed for better risk identification, measurement, management, and control. By doing so, banks can position themselves to succeed in implementing an operational risk-management and -measurement system on a timely basis. We do, however, recognize that a certain time constraint exists for institutions wishing to implement the new framework. On the one hand, banks are encouraged to start preparations as soon as possible; on the other hand, we leave open the possibility that elements of the framework are subject to change. This is not a trivial matter. As a former banker, I sympathize with the challenges you face in deciding on investments and upgrades to your systems and personnel. When it comes to Basel II, we recognize that certain details relating to systems and processes will depend on what the final U.S. rule and guidance contain. Accordingly, your primary supervisor is available to discuss your implementation efforts and we want to hear specifics about which elements of the proposal, from your perspective, will demand the greatest investments or appear to generate the greatest uncertainty. Using that information, the agencies can then understand where to target resources to assist banks during the transition to Basel II. We certainly hope that many upgrades made for Basel II are those that would have been made anyway to strengthen enterprise-risk management. An additional challenge that you face in implementing an AMA is that operational risk has only relatively recently risen to management and regulatory attention - not because it was previously unimportant, but because it has been so difficult to measure. As QIS4 has demonstrated, we are still in the early stages of measuring this risk, and the challenges in gathering the relevant data and developing the models are still great. The main reason for the lack of data, as I am sure many of you know firsthand, is simply the fact that most banks have only recently started systematically collecting operational-loss data. While the importance of models and loss data in quantifying operational risk may be quite apparent at least to practitioners of the art - the importance of the qualitative aspects may be less so. In practice, though, these qualitative aspects are no less important to the successful operation of a business - as events continue to demonstrate. Some qualitative factors, such as experience and judgment, affect what one does with model results. It is important that we not let models make the decisions, that we keep in mind that they are just tools, because in many cases it is management experience - aided by models to be sure - that helps to limit losses. Some qualitative factors affect what the models and risk measures say, including the parameters and modeling assumptions used and the choices that relate to the characteristics of the underlying data and the historical period from which the data are drawn. I think you will hear a common theme today and tomorrow: Value is added to the firm when operational-risk measurement is integrated with the business-unit management processes. In other words, the business-line staff should be in the process of developing the firm-wide operational-risk measurement framework. While firms generally are developing corporate-level operational-risk management functions and firm-wide policies and procedures to bring greater consistency to how operational risk is measured throughout the institution, business-line staff can add significant value to this effort through their understanding of inherent risks and controls in their areas. And finally, the more business- line staff is involved in the development of the measurement framework and the more transparent the framework is, the more credible will be the process of allocating the total capital number back to the business lines - an effort in which many of the banks represented here today are now engaged. To be meaningful, the quantification of operational risk must be forward-looking. This means that a mechanical focus on historic loss data series will not work. We must recognize the roles of qualitative factors and a well-reasoned assessment of what we will call stress events or scenario analysis. In this regard, the burden is on management to exercise judgment. Clearly, this judgment must include consideration not only of a soundness standard but also of contingencies and actions taken to reduce the risks posed by those contingencies. A self-assessment of the internal control structure and overall risk-management process is crucial. Clearly, this is not a simple process if the results are to be relevant to the specific risk profile of the firm. But based on the progress we have seen to date in this area, I think you are up to the challenge and I encourage you to keep moving forward. Before I wrap up, I would like to say a few words directly to the potential "opt-in" institutions. An institution that does not meet the mandatory criteria in the framework will be under no obligation to adopt Basel II. Some potential opt-in institutions have complex and varied operations and are developing enhanced enterprise-wide risk-management processes and systems to strengthen their internal control environments. These institutions understand that complex operations receive a more structured and well-defined risk-management framework to monitor the effectiveness of internal control processes and risk exposures. For these organizations, the incremental cost to opt into Basel II advanced approaches will be a relatively moderate incremental cost. For other financial institutions, with a simpler organizational structure and less-complex processes and services, a less-sophisticated enterprise-wide risk-management and -measurement is entirely appropriate. For these organizations, the incremental cost to develop advanced Basel II systems can be substantial. These organizations may appropriately choose not to adopt Basel II, especially at the earliest possible date. If they choose to opt in, they may want to implement Basel II later when they can take advantage of third-party models and databases to assist in the development of their systems at much lower costs. Also, I would like to quell any concerns that potential opt-in institutions may have about being viewed as having inferior risk-management systems if they decide not to adopt Basel II. It is important for you to know that, as supervisors, we will not look upon institutions that decide not to adopt Basel II as having deficient risk-management systems simply because they choose to stay under the Basel I capital framework. As supervisors, our focus will continue to be on ensuring that risk-management processes are appropriate for operations of each institution and that those risk systems operate effectively. Thus, we expect that non-Basel II banks will continue to have CAMELS 1 and 2 ratings as they operate in a safe and sound manner. As Basel II implementation continues, customers, credit rating agencies, and analysts should also understand these fundamental concepts of effective risk management and internal controls. Conclusion In my remarks today, I have encouraged you to continue your efforts to support the evolution of operational-risk measurement and management practices. I want to end by reminding all of you not to become so caught up in the latest technical developments that you lose sight of the qualitative aspects of your responsibilities. Models alone do not guarantee an effective risk-management process. You should encourage continuous improvement in all aspects, including data integrity and internal controls, to name just a few. For the risk managers at this conference, I hope the message you have heard is that you should be actively engaged with managers throughout the organization, talking about the merits of a consistent, sound enterprise-wide risk-management culture. In doing so, you can help managers see that the risk-management process will allow them to better understand the inherent risks of their activities so that they in turn can more effectively mitigate these risks and achieve their profit goals in a safe and sound manner. The agencies will continue to provide as much information as possible to help potential opt-in institutions make their decisions. Our supervisory teams continue to stand ready to discuss Basel II issues with all institutions and answer any questions that arise.
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board of governors of the federal reserve system
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Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, to the International Research Forum on Monetary Policy Conference, Frankfurt am Main, 20 May 2005.
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Donald L Kohn: Modelling inflation - a policymaker’s perspective Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, to the International Research Forum on Monetary Policy Conference, Frankfurt am Main, 20 May 2005. * * * Nothing is more important to the conduct of monetary policy than understanding and predicting inflation. Price stability is our responsibility as central banks - it is how, in the long run, we contribute to society's welfare. Achieving and maintaining price stability will be more efficient and effective the better we understand the causes of inflation and the dynamics of how it evolves.1 I think central bankers are asking more of inflation analysis these days. In the United States, our attention was focused for many years on containing and then reducing inflation. The risks and rewards were one-sided, and policymakers were mostly interested in whether inflation would rise. Now that we are in the neighborhood of price stability, we can be faced with looking at the possibility that inflation will fall too low as well as rise too high. Moreover, so long as inflation expectations are well anchored, we can tolerate limited changes in inflation, but we need to know that a rise or fall is not the beginning of a more extended trend. Consequently, we focus closely on the reasons for any changes in inflation and their implications for the outlook. Of course, I have always known how important the analysis and forecasting of inflation was for monetary policy, but I must admit that as someone who now has to go on record with a vote on the basis of some notion of the future course of inflation, the exercise has taken on added meaning. I thought I might take advantage of this captive audience of researchers on central bank policies to ruminate a bit on the evolution of inflation modeling and suggest areas for further research. I know that European central banks have been in the forefront of recent efforts to improve our understanding of some key issues in this area, but I will focus on our practices in the United States. The stability of the basic framework I find it remarkable how fundamentally stable our basic framework for analyzing inflation has remained over the past thirty-five years or so: That basic framework is essentially the expectations-augmented Phillips curve introduced by Milton Friedman and Edmund Phelps in the late 1960s.2 One of the key assumptions underlying this basic framework is the temporary rigidity of wages and prices. It is because of these nominal rigidities that monetary shocks have real effects: In the well-known litany, wages and prices do not change immediately in response to a positive monetary surprise, so real interest rates fall, and spending is stimulated. But higher demand cannot be met without pushing firms up their marginal cost curves as they compete for scarce labor and other resources. As opportunities to raise prices present themselves, firms take them to better align prices with costs. That process may be gradual, because firms' competitors may not be raising their prices at the same time. It is easy to see in this tale the central mechanism of the Phillips curve. What is missing from the story, though, is that seminal feature of Friedman and Phelps's framework, namely, expectations. Expectations are a key part of the framework because wages and prices will be set for some time, and so it is important for workers and firms to consider the economic conditions expected to prevail during the period that the wages and prices are fixed. If inflation is anticipated over the period ahead, wages and prices will be set commensurately higher as workers and firms strive to protect themselves against the erosion of their purchasing power. The views I am expressing today are my own and not necessarily those of my colleagues on the Federal Open Market Committee. John Roberts, of the Board's staff, helped with the preparation of these remarks. Milton Friedman (1968), "The Role of Monetary Policy," American Economic Review, vol. 58 (March), pp. 1-17; Edmund S. Phelps (1968), "Money-Wage Dynamics and Labor-Market Equilibrium," Journal of Political Economy, vol. 76 (July-August, part 2: Issues in Monetary Research), pp. 678-711. As Friedman and Phelps emphasized, these efforts to protect against the erosion of purchasing power by inflation will mean that an ongoing and fully anticipated inflation will, to a first approximation, have no effect on the level of resource utilization; the outcome of the economy will be whatever the real forces at work dictate. Friedman called the unemployment rate determined by such real factors the natural rate of unemployment. An important implication of the expectations-augmented Phillips curve is that any attempt to use monetary policy to lower the unemployment rate below the natural rate on a sustained basis will end in failure. Initially, expansionary monetary policy would lower unemployment as well as raise inflation. As the stimulus continued, however, firms and workers would increasingly protect themselves against the higher inflation, giving an additional boost to inflation. Eventually, there would be no additional employment; only a (self-reinforcing) higher rate of inflation. In 1970, the Federal Reserve held a conference that addressed this then-new framework; the conference encompassed both theoretical extensions, including Lucas' first exposition of rational expectations, and empirical implementation.3 In its essentials, the way we forecast inflation today is not all that different from what came out of that conference. That is, inflation is importantly a function of an output or employment gap relative to a natural rate, plus some measure of inflation expectations. Advances within the basic framework One of the first challenges that the new framework had to face was the supply shocks of the early 1970s. The framework was extended to allow for the effects of shifts in relative prices, such as crude oil and import prices. Such shifts can feed through fairly directly to the measures of core inflation through their effect on business costs, though their influence on inflation should be temporary unless they get built into labor costs or inflation expectations. We include these types of price terms today in our forecasting equations, and they are important to forming our views of the inflation outlook and thus to the policy process. Another early development within the framework was the buttressing of its microeconomic foundations, in particular by paying more careful attention to the modeling of nominal rigidities. John Taylor's staggered-contracts framework remains a touchstone because of its intuitive appeal - annual wage reviews are a familiar experience for most people who work. Much subsequent work - including, recently, among economists at the European Central Bank and the euro-area national central banks has confirmed the key assumption underlying this model, which is that wages and prices are changed infrequently. A key objective of Taylor's staggered-contracts model was to show that, in an economy with nominal rigidities, monetary policy can have important effects even when expectations are perfectly rational. However, about a decade ago, Jeff Fuhrer and George Moore pointed out that inflation was more persistent than was predicted by the model with sticky prices and rational expectations.4 Since their work, a number of researchers have suggested that "sticky information" or rules of thumb can account for this excess persistence. Such departures of expectations from perfect rationality can be an important source of observed inflation dynamics. At the Fed, the staff takes a number of different approaches to the modeling of expectations. The staff's large, formal model (FRB/US) assumes rational expectations - but with a twist. In particular, the model addresses the Fuhrer-Moore critique by making inflation itself, as well as the levels of wages and prices, costly to adjust. The implications of these additional frictions are very similar to those of the departures of expectations from perfect rationality used by other modelers. An advantage of a model with expectations that are, at least in part, rational is that we can address questions related to how the behavior of the economy may change when the systematic implementation of monetary policy changes. We also look at models that assume that inflation expectations are well modeled by lagged inflation the original proposal of Friedman and of Phelps. Such models may not be as useful in addressing policy questions. However, they have a good forecasting track record. The Econometrics of Price Determination (1972), proceedings of a conference sponsored by the Board of Governors of the Federal Reserve System and the Social Science Research Council, October 30-31, 1970 (Washington: Board of Governors of the Federal Reserve System). Jeff Fuhrer and George Moore (1995), "Inflation Persistence," Quarterly Journal of Economics, vol. 110 (February), pp. 127-59. The performance of the board staff's inflation forecast The Board staff forecasts distributed to the Federal Open Market Committee (FOMC) are judgmental: Although the staff consults a variety of models in coming up with its forecasts, no one model can be said to summarize the staff view. Also, the staff forecasts are not necessarily its best guess on how inflation will evolve; the forecasts are conditioned on an assumed path for monetary policy and, during some periods, at the behest of policymakers, the staff did not assume what it would have viewed as the most likely policy path. I have distributed a figure that shows the Board staff's four-quarter-ahead forecasts for inflation as measured by the core Consumer Price Index along with the actual outcomes. The period shown is 1984 to 2000; I chose those years because the current definition of the core CPI did not come into use until 1983, and the staff's forecasts remain confidential for five years. As shown in the inset box, the root-mean-squared error of the staff projections has been smaller than that of a naïve benchmark model, in which inflation is assumed to continue at its pace over the preceding four quarters. Nonetheless, the one-year-ahead root-mean-squared error of the staff forecast is about 1/2 percentage point. That is to say, almost one-third of the time, inflation has been either more than 1/2 percentage point higher, or more than 1/2 percentage point lower, than the staff has predicted. Moreover, over the period shown, there was, on average, some bias in the staff's inflation forecasts; inflation has tended to come in lower than the staff anticipated, by about 0.2 percentage point per year. No single explanation suggests itself for either the extent of the misses or the bias. Rather, a variety of factors has caused inflation to deviate from expectations.5 At times, demand was not as robust as anticipated, and unexpected but persistent changes in the foreign exchange value of the dollar and oil prices fed through to core CPI inflation on several occasions. But I will concentrate on one general phenomenon and two episodes that help illustrate how our understanding has evolved and some of the more general challenges for inflation forecasting over the past twenty years. One factor that may account for some of the upward bias over this entire period was a gradual reduction in the natural rate of unemployment. With hindsight, I believe we can point to a number of developments in labor markets that are consistent with such a reduction. For example, disability insurance rolls rose steadily over this period, which allowed many people who likely would have had above-average unemployment rates to withdraw from the labor force. Also, in the early 1990s, many public opinion surveys indicated a sharp increase in worker insecurity - and workers who are anxious about losing their jobs will be less willing to risk unemployment. These examples illustrate the need to be alert to the possibility of the natural rate shifting. As Friedman emphasized, the natural rate is not a rigid data point, but rather the reflection of many developments in the economy. In the 1988-90 period, the behavior of crude oil prices, unemployment, and the exchange rate were not especially surprising or anomalous. However, the models the staff was consulting in preparing its forecasts may have been miscalibrated. In particular, inflation expectations perhaps were becoming better anchored, so that an unemployment rate below the natural rate was putting less pressure on inflation than it would have over the preceding twenty years. Likewise, the staff may have overestimated the ongoing effects of the dollar decline on inflation, as the models in use at that time inevitably gave considerable weight to the experience of the 1970s. Empirical estimates unavoidably lag these sorts of endogenous changes in inflation dynamics. For the period from 1996 to 1998, inflation also came in consistently lower than the staff forecast. Here, the pick up in structural productivity growth was the likely cause: The historical record suggests that a sustained acceleration in productivity affects prices before it affects wages. Thus, the pickup in productivity growth has a direct, depressing effect on costs - and thus ultimately on prices. It took Fed forecasters - and others - a while to discern the acceleration in productivity and its implications for inflation. Interestingly, by the time of the forecasts made in 1998 and 1999 - the 1999 and 2000 observations on the chart - the string of forecasting errors had ended. This improved performance likely reflected the eventual recognition that productivity growth had increased on a sustained basis. The discussion of the forecasting record that follows is largely a matter of conjecture and guesswork. It is hard to pinpoint the cause of any particular forecast error. I am drawing on my own memories of events, as well as those of current members of the Board's staff. An agenda for further research As I noted at the beginning of my remarks, research aimed at improving our understanding of and ability to predict inflation is essential to the central banker's mission. The better the forecasts, the better the odds that policy choices will contribute to economic stability and efficient resource allocation. Needless to say, more work remains to be done - and always will. My chart stops at 2000, but it is no secret that forecasters everywhere did not anticipate the extent of disinflation in the U.S. economy in 2003 and, even after the fact, have had trouble explaining what happened. Moreover, the degree to which core inflation picked up in 2004 and 2005 also caught many economists, including this one on the FOMC, by surprise. Surprises are inevitable; aggregate supply and demand curves shift for reasons that cannot be anticipated. But improvement should be possible in several dimensions. We could identify shocks sooner and get a better understanding of their likely effects on inflation. And we could attempt to narrow the definition of "shock." I suspect that much of what we consider to be exogenous is the working out of endogenous events that we do not understand very well. Better predictions inevitably begin with improved understanding - both theoretical and empirical. In reviewing some of the advances of the past thirty-five years for this talk, I was struck by the degree to which so much of the work on rigidities and expectations seemed to be trying to find an elegant rationale at the level of the firm and the worker for the observed dynamic properties of aggregate price measures. This work, while illuminating in many respects, does not seem to have greatly advanced the empirical forecasting of inflation. And, the microeconomic behaviors we describe to justify the empirical specifications of our macroeconomic models often do not coincide very well with what we find when we directly observe the decisionmaking of workers and firms. I think we need to push forward along these microeconomic lines. I have a lengthy list of macroeconomic inflation puzzles whose answers would make me a better policymaker, but, for the most part, the solutions to the puzzles rest on a better understanding of how workers and firms set wages and prices. Researchers at the ECB and at the euro-area national central banks have made an important contribution in their recent work. I agree with one of the conclusions I understand many of them came to - that is, we especially need to improve our understanding of the determinants of labor compensation. The reduced-form price equations we so often use for inflation prediction bypass direct contact with labor compensation issues. But the labor market is at the foundation of the FriedmanPhelps analysis. Labor is the major element of business cost and as such often occupies a prominent role in policy discussions of inflation prospects, and the unemployment rate often proxies for resource slack more generally. As I have already discussed, unanticipated changes in the natural rate have contributed to forecasting errors over the past two decades. In the past few years, we have had some experience with wage setting under conditions of price stability, and nominal compensation showed greater flexibility than some observers had anticipated. Too often, discussions of wage and compensation determination rely on descriptions of worker demands and expectations that seem drawn from an era of strong unions rather than from the more atomistic labor markets that dominate the U.S. economy these days. A better understanding of the motivation and dynamics of how compensation is determined between firms and individuals or small groups of workers would help unravel a number of the inflation puzzles I think we face, including those involving productivity growth, globalization, markups, and expectations formation. Changes in productivity growth An important aspect of this story has been that productivity affects prices before it affects wages - that is why we were able to experience low and stable inflation in the latter part of the 1990s with the unemployment rate well below any estimates of its natural level. But is it really true that prices are more responsive to productivity than wages? Why? Should the effects be symmetrical when productivity growth slows? How can we better estimate structural productivity and determine changes in its pace of growth more promptly? Globalization and the iInflation process Several observers have argued that increased trade has been an important factor in the downtrend in inflation over the past two decades.6 One channel is said to be through greater competitive pressures and another through increased support for price stability engendered by the competitive environment. Globalization might restrain prices and wages in those sectors in which imports play an increasing role, but how does it hold back the average wage and price level? And, how do we reconcile the sense of greater competitive pressures with record levels of profits - and capital income more generally - in the United States? The behavior of profit margins or markups The Federal Reserve's 1970 conference and much of the work since then has approached the determination of inflation as a two-step process: model both labor costs and the price markup over labor costs. Yet, we find that this approach does not work very well in practice. Years of experience suggest that although profit margins tend to return to their mean, deviations can increase for a time and the eventual return can be slow and very difficult to predict. In the United States, markups have remained unusually elevated of late, absorbing little of the rise in the cost of energy, import, and materials. Does it matter whether the shock to margins comes from a change in potential supply or aggregate demand? What type of pricing behavior reconciles these outcomes? How are they consistent with the expectation that margins return to means? Inflation expectations Measures of inflation expectations are among the variables I watch most closely as I formulate my policy recommendations because I recognize that changing expectations are a principal avenue by which short-term perturbations in price levels are propagated into more persistent changes in inflation rates. Yet our knowledge of the expectations that businesses and workers bring to the process of setting wages and prices is extremely limited. We use proxies - most often surveys of economists, whose projections may be influenced by their knowledge of other economists' projections, and of households, who may or may not understand the question or have a realistic view of what to expect. Readings from the financial markets are helpful, but they are also muddied by changing premiums for inflation risk and liquidity, and they are not necessarily representative of the attitudes of households or businesses. Moreover, how expectations are formed remains an area that would benefit from further research. How much do people rely on the immediate past in forming expectations about the future? To what extent are projections from the past modified by what they know about the goals of the central bank or the stage and characteristics of the current economic cycle? How often do expectations get updated, and what types of information are used in the process? *** This is a daunting research agenda, but it should be given a high priority. I appreciate the opportunity to spell it out before an audience that has the skills and the opportunity to address some of these pressing questions. Kenneth S. Rogoff (2003), "Globalization and Global Disinflation," in Monetary Policy and Uncertainty: Adapting to a Changing Economy, proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, August 28-30 (Kansas City: Federal Reserve Bank of Kansas City), pp. 77-112; Alan Greenspan (2005), "Globalization," speech presented to the Council on Foreign Relations, March 10.
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Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the 2005 Payments Conference, Federal Reserve Bank of Chicago, Chicago, 19 May 2005.
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Mark W Olson: The Federal Reserve in an electronic world Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the 2005 Payments Conference, Federal Reserve Bank of Chicago, Chicago, 19 May 2005. * * * Michael, thank you for your kind introduction and for the opportunity to share with you my perspective on the forces shaping today's payments landscape. We have heard a great deal during this conference about various innovations within the payments system and how payments providers can take advantage of them. What I would like to focus on this morning are some of the effects that these innovations, and market changes, in general are having on the payments industry and to address the role of the Federal Reserve in this time of rapid market change. Let me begin with a review of marketplace changes. It is clear that a market-driven change is under way within the payments system. Overall, users of the payments system are moving away from the use of paper checks and toward much greater use of electronic payments. A recent Federal Reserve study shows that in 2003, for the first time ever, the number of electronic payments in the United States exceeded the number made by check. Although checks are likely to remain an important part of the payments system for some time to come, a long-term decline in the use of the check appears, finally, to be taking hold. Still, it is important to remember that this changeover has been a long time in coming. After all, electronic wire transfers have been around for most of our lives and debit cards and the automated clearinghouse (ACH) system were developed three decades ago. There is, of course, more to the story of increased use of - and confidence in - electronic payments by consumers, businesses, and governments. The payments industry itself is taking innovative steps to collect more payments electronically. Let me highlight two of the most significant innovations. The first one, which was discussed earlier at this conference, is electronic check conversion. Simply put, electronic check conversion amounts to using the bank account and routing information printed on a check to debit a consumer's bank account electronically via the ACH system or a debit card network. In 2004, more than 1 billion checks were converted to electronic payments using the ACH system, reducing the number of checks that would otherwise have entered the paper collection system. Electronic check conversion is sometimes confused with innovations associated with the Check Clearing for the 21st Century Act (commonly known as Check 21). This very important law will ultimately bring about fundamental changes to the check-collection system, because it facilitates the adoption of check truncation and electronic collection of checks through the action of market forces. I would note, however, that even before Check 21 became law, one out of every five checks collected through the Federal Reserve Banks was being presented electronically. Check 21 contains consumer protection provisions that differ from those provided under electronic check conversion. But the substantive rights of consumers are very similar whether they are derived from check or electronic fund transfer law. To date, little has changed within our national check collection system since Check 21 came into effect a little more than six months ago. However, as banks make the investments necessary to take advantage of Check 21 and modify their operations to make the best use of the new technologies, the acceptance of digital check images for presentment and return of checks will accelerate. And costly substitute checks, though they are critical to the change allowed by Check 21, will eventually be looked back on as a transitional vehicle that helped achieve greater electronification of payments. Overall, a more electronic payments system will benefit society and will help improve payments system efficiency. The need for physical transportation of paper checks will decrease. With more channels for processing payments, the payments system infrastructure will become more diverse and more resilient. At the same time, however, the payments industry will have to rely more heavily on key telecommunications networks and computing systems. Mitigating the risk associated with greater reliance on electronic processing is vital and should be a top priority for the payments industry. There are other challenges arising from the ongoing transition to a more electronic system. Many payments providers are trying to determine how best to manage investments in paper check processing as check volumes decline. Many are also trying to decide what, if any, investments to make to take advantage of the authority provided by Check 21 to convert checks to electronic funds transfers. Changes within the payments system are also presenting challenges to the Federal Reserve System. Since 1999, the number of checks collected through the Reserve Banks has fallen nearly 20 percent, and the pace of decline is accelerating. The Reserve Banks have undertaken a range of cost-reduction initiatives to keep pace with the declining volumes, including an ongoing realignment of their check collection operations. Among their restructuring efforts is a reduction of the number of offices at which checks are processed from forty-five as of 2003 to twenty-three by early 2006. As the check market continues to shrink beyond 2006, the number of check processing centers will almost certainly decrease further. The Reserve Banks are also increasing their use of technology as part of a longer-term business strategy to facilitate the greater use of electronics in check processing. That strategy includes providing products and services that help banks take advantage of Check 21. To date, the adoption of those services has been slow, however. On average, only 400,000 of the 50 million checks the Reserve Banks collect each business day involve the deposit of digital check images or the printing of substitute checks. Using Internet technology, the Reserve Banks are improving customers' access to such core clearance and settlement systems as ACH and Fedwire. They are also offering new services consistent with heightened customer account activity and risk management capability. Any discussion of the Federal Reserve's evolving role in payments would be incomplete without a review of the Fed's role vis-Ã -vis its private-sector competitors. From its inception, the Federal Reserve considered its role in payments to be an important component of its central bank responsibility. The Fed's check and ACH services, in addition to Fedwire for commercial transactions, have provided a consistent, reliable, and efficient payment capability that has enhanced the performance of the U.S. economy. While the Fed has had a significant role in payments, it has not been the only player. The Monetary Control Act of 1980 (MCA), by requiring that the Fed explicitly price all the fee services it offers to banks, establishes, as a matter of public policy, a competition between the Reserve Banks and the private sector in the provision of payment services, to ensure that the efficiencies of market competition are realized fully. Other legal and policy limitations on the Reserve Banks also affect the Fed's competition within the private sector in the provision of payments services. First, the Reserve Banks, as directed by the MCA, must make their payments services available to all depository institutions - in contrast to private-sector competitors, which may offer their services to a limited, more profitable market segment. Second, the Reserve Banks, again as directed by the MCA, must recover, over the long run, the full direct and imputed costs of providing payments services to depository institutions. While the Reserve Banks' competitors also must recover their costs, they may, in addition, offer non-payment-related services that the Reserve Banks may not offer, thereby giving competitors greater flexibility in recovering payment service costs. This mix of competition and statutory obligation is highly beneficial to consumers and businesses alike and is an important source of efficiency and innovation within the payments system. The Reserve Banks' direct involvement in the payments system and ability to facilitate the adoption of standards and practices through their operating circulars also helps the Federal Reserve achieve its broader public policy goals, such as improving the efficiency and smooth functioning of the payments system. Unlike the Federal Reserve Bank obligations under the MCA, private-sector payment providers have a single-sided option. That is, they can compete in any segment of payments without the requirement to offer a full range of payment alternatives. As will be discussed later, this competitive option for private-sector firms is good for the consumer. There are many examples of private-sector payment providers making strategic decisions on payments that affect competition. One example involves check-clearing services. Many large banks with significant correspondent banking networks have historically offered check-clearing services to downstream correspondents as a core component of their product mix. Through consolidation, some of those banks have discontinued all or parts of their correspondent banking services. Others have promoted their check-clearing services, as the incremental cost of clearing checks is small relative to their existing fixed-cost structure. As this example suggests, banks have a wide range of strategic reasons for either discontinuing or expanding their check-clearing operations, and their pricing strategies can be as varied as their strategic reasons for participating in the business. Other examples of strong private-sector competition provided by the Clearing House Interbank Payments System (CHIPS) and the Electronic Payments Network (EPN), are the large-value funds transfers and ACH processing services to an increasing number of large banks that originate many of these payments. A diverse mix of banks, corporate credit unions, third-party processors, and other service providers also provide competitive payment services in markets across the country. An important question raised by the ongoing innovation and change in the payments system is whether regulatory response is necessary. At this conference we have heard a variety of opinions on this topic. Some believe that as payments are made and collected in new ways, certain laws and regulations need to be clarified. Others suggest that the change offers a unique opportunity to reconsider the relationships among legal and regulatory regimes that support the payments system. When considering the need for regulatory response, it is instructive to recall efforts by committees of both the House and the Senate in the very tech-conscious environment surrounding Y2K. After extensive hearings, committees concluded that caution should be exercised in changing laws and regulations to accommodate technological innovations. This sensible conclusion was based in part on two important realizations - first, that however well intended, efforts to alter current laws and regulations may assume that today's technological state of the art will also be tomorrow's and, second, that any changes based on that assumption could have the unintended consequence of stifling innovation. Rather than attempting to address specific technological changes, a starting point might be to identify certain principles. One principle, for example, might be that regulation in general (not just regulation within the payments system) should be effective and as clear as possible, and should support marketled innovation. Another principle might be that payments laws and regulations should be viewed holistically. As the distinctions between paper and electronic payments become increasingly blurred, there may be opportunities to simplify existing laws and regulations to achieve greater consistency among them. But I would be wary of making fundamental changes to the existing regulatory regimes without substantial study and careful consideration of the potential implications. Careful consideration would argue for a gradual, cooperative approach to identifying regulatory concerns and impediments to innovation and to address those concerns in a way that meets the needs of our economy for flexibility and growth. Of course, government organizations must carry out their specific mandates and act according to the public interest. The development and enactment of Check 21 offers a good example of this approach. As you may recall, the development of Check 21 began as the result of the banking industry identifying legal barriers to clearing checks electronically - specifically, state laws governing check collection that allow banks to demand that the original checks be physically presented for payment. Although these laws typically allow banks to agree to alternative presentment arrangements, the large number of banks in the United States has made the widespread adoption of electronic check collection through agreement extremely difficult. The Federal Reserve worked with the banking industry, consumer groups, and legal experts to analyze these barriers to innovation and determine how best to address them. The resulting legal innovation was the introduction of paper substitute checks that are legally equivalent to original checks, thereby allowing banks that choose to collect checks electronically to create and present substitute checks to paying banks that demand presentment by paper check. The resulting proposal was then presented to Congress and formed the basis of what became known as Check 21. This bit of history leads me to the role of the Federal Reserve in regulating the payments system. While the Federal Reserve has an interest in the smooth and secure functioning of the overall payments system, our regulatory authorities are specific to only certain operational aspects of the system, such as the interbank collection of checks, and specific consumer rights and protections, such as consumer liability for unauthorized electronic funds transfers. These authorities are derived from statute. With regard to the operational aspects of the payments system, the Federal Reserve is responsible for regulating the operations of the Reserve Banks, particularly their check collection and wire transfer activities. The Federal Reserve also has regulatory authority, under the Expedited Funds Availability Act and Check 21, for various aspects of the collection and return of checks by banks. The Federal Reserve's regulatory authority over electronic payment operations is limited to those of the Reserve Banks. Instead, the private sector, through bank associations, card networks, and other cooperative rule-setting bodies, establishes many of the operating rules for electronic payments. For example, NACHA - the National Automated Clearing House Association - sets the operating rules and establishes contractual liabilities and warranties among the banks that participate in the ACH system. Similarly, Visa, MasterCard, various electronic funds transfer networks, and card companies establish the particular operating rules their members must follow in their credit and debit card operations. A potential implication of this distribution of rulemaking authority within the payments system is that as more payments are made by ACH or by debit and credit cards, the relative importance of private-sector rulemaking may increase. At the same time, as checks are increasingly collected electronically, the Federal Reserve may need to use its regulatory authority over the interbank check collection system more actively. In particular, we will be monitoring the banking industry's experience with the Board's regulations implementing Check 21 and will revisit them over the next few years to determine whether any refinements are necessary. With regard to consumer rights and protections, the Board has a more extensive role with both checks and electronic payments. For checks, the Federal Reserve's statutory authorities relate to the obligations of banks to make deposited funds available to their customers and to recredit their customers for losses suffered as a result of receiving a substitute check. We take these responsibilities seriously. For example, we monitor developments in the check-collection system on an ongoing basis to determine if the maximum permissible hold periods in Regulation CC should be shortened. If we find sufficient improvement in check-collection and return times, particularly as more banks make use of Check 21, we will reduce the funds availability schedule accordingly. For electronic payments, specifically debit cards and ACH, the Federal Reserve has equally important responsibilities. They include establishing the rules that help protect consumers from unauthorized transactions and the various reporting and notice requirements associated with electronic funds transfers that must be made to consumers. The card associations and private-sector rulemaking organizations complement these regulatory protections and disclosure requirements by offering additional rights, protections, and notices. For example, the card associations provide consumers with "zero liability" for certain unauthorized credit and debit card transactions that are processed on their networks. While the private sector plays an important supplemental role in the area of consumer protections and notices, the Federal Reserve has become increasingly active in this area. For example, we have clarified that consumers have the same general rights under Regulation E (Electronic Funds Transfers) when their payments are made via electronic check conversion as they do when they pay their mortgage automatically each month. We also are considering how to address concerns about the notices that consumers receive when their checks are converted to electronic payments. We have found that the quality of these notices varies tremendously, creating some confusion among consumers about what they are authorizing. The Board is considering whether to revise the commentary to Regulation E to include model language that could be used in these consumer notices. We are also considering whether to require, along the lines of current industry rules, a written authorization signed by the consumer when the check is converted at a merchant location. I expect that the need for further clarification of regulations by the Federal Reserve will only grow as more innovation occurs within the payments system. An important conclusion from this discussion is that the role of the private sector is growing. This is happening in all segments of the payments system, from providing payments services, to setting industry rules or establishing industry technical and operational standards, to providing consumer rights and protections. Nevertheless, the Federal Reserve will continue to have an important role within a more-electronic payments system. We will continue to monitor developments within the payments system to better understand their implications. As a policymaking body, we will continue to promote the integrity and safety of the payments system while also supporting improvements in efficiency and accessibility. We will facilitate private-sector efforts to improve the payments system through a combination of dialogue and leadership. Where appropriate, we will work cooperatively with the private sector to identify and remove regulatory barriers to innovation and efficiency within the payments system. And, finally, when necessary, the Federal Reserve will act as a catalyst to greater efficiency, safety, and accessibility within the payments system. I would be happy to answer any questions you may have.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Women in Housing and Finance Spring Symposium, Capital Issues for Financial Institutions, Washington, DC, 26 May 2005.
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Susan Schmidt Bies: Capital and risk management Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Women in Housing and Finance Spring Symposium, Capital Issues for Financial Institutions, Washington, DC, 26 May 2005. * * * I want to thank Women in Housing and Finance for sponsoring this conference and providing another opportunity for regulators, bankers, legislators, and other interested parties to discuss the evolving approaches to defining appropriate levels of regulatory capital. I also want to thank you for the opportunity to offer some remarks today. In recent speeches, I have focused on the operational-risk aspects of Basel II, as well as the ways that Basel II can contribute to financial stability. Today, I want to review the main reasons for implementing the new framework, offer a brief comment on the recent fourth quantitative impact study (QIS4) exercise, and outline supervisors' efforts to move the process along. Finally, I will discuss where we are in the process of amending Basel I, which will continue to apply to most banks operating in the United States. Reasons for developing Basel II Large, internationally active financial institutions have become more complex in terms of both sophistication of services and business practices, as well as organizational structure. As a result, effective risk management has been evolving to support these innovative financial structures. One often hears that the advanced approaches of Basel II are "too complex" for anyone to understand, and the mathematical formulas in various drafts of the guidance can look like a foreign language to some readers. But I want to emphasize that today, even before Basel II is adopted, we expect banking organizations involved in complex financial instruments already to possess an understanding of advanced risk concepts and to have implemented effective risk-management practices. As prudent supervisors, all the banking agencies require any organization employing sophisticated financial practices or using financial instruments to have a governance structure commensurate with those activities. That is, the bank must have knowledgeable staff to effectively set risk limits and clearly communicate these to executive management and their boards of directors, must have acquired and implemented effective mitigating controls, and must have a robust process for monitoring exposures. That is why in the United States we are proposing to require only the largest financial institutions to adopt the advanced approaches of Basel II. These institutions understand that complex operations require a more structured and well-defined risk-management framework to monitor the effectiveness of internal control processes and risk exposures. For these organizations, the incremental cost of adopting Basel II advanced approaches should be relatively modest compared with the significant risk-management investments they have already made. For financial institutions with a simpler organizational structure and less-complex processes and services, a less-sophisticated enterprise-wide risk-management framework is entirely appropriate. For these organizations, the incremental cost of developing advanced Basel II systems can be substantial. These organizations may appropriately choose not to adopt Basel II, especially at the earliest possible date. If they choose to opt in, they may want to implement Basel II later, when they can take advantage of vendor models and databases to assist in the development of their systems at much lower costs. In a general sense, Basel II expands advanced risk-management techniques from a set of tools used in an operating and control environment into the basis for making minimum regulatory capital reflective of risk exposures. Since individual organizations employ various types of risk-management techniques, moving to Basel II as a minimum regulatory capital framework requires a certain degree of standardization so that risk measures can be compared across organizations and over time. It is composed of the now-familiar three pillars: Pillar 1, minimum capital requirements; Pillar 2, supervisory review; and Pillar 3, market discipline. The framework is structured to be much more risk-sensitive than its predecessor; for example, all commercial loans are not lumped into one risk bucket but are differentiated according to certain indicators of risk. Basel II is designed to address the concern that Basel I regulatory capital ratios are no longer good indicators of risk for our largest institutions. Basel II is intended to close this gap by more directly linking regulatory capital charges to the riskiness of the corresponding assets and thereby reducing the incentives to engage in capital arbitrage. Basel II also creates a link between regulatory capital and risk management, especially under the advanced approaches, which are the only ones expected to be applied in the United States. Under these approaches, banks will be required to adopt more formal, quantitative risk-measurement and risk-management procedures and processes. For instance, Basel II establishes standards for data collection and the systematic use of the information collected. These standards are consistent with broader supervisory expectations that high-quality risk management at large complex organizations depends upon credible data. Enhancements to technological infrastructure - combined with detailed data - will, over time, allow firms to better price exposures and manage risk. The emphasis in the new Accord on improved data standards should not be interpreted solely as a requirement to determine regulatory capital standards, but rather as a foundation for risk-management practices that will strengthen the value of the banking franchise. The new framework should improve supervisors' ability to understand and monitor the risk taking and capital adequacy of large complex banks, thereby allowing regulators to address emerging problems more proactively. The new framework should also enable supervisors to have much more informed and timely conversations with bankers about their risk profiles, based on the new information flows generated. Our hope is that conversations around this common analytical framework will create a common language for risk management. In the United States, we intend to use the framework to determine whether bankers are indeed able to monitor their own risk-taking and capital positions, placing the onus on bankers to show that they are able to measure, understand, and effectively manage their consolidated risks. We expect improved risk management not only through institutions' efforts to calculate minimum regulatory capital in Pillar 1, but also through their development of credible internal capital adequacy processes as required by Pillar 2. Each institution must correct for Pillar 1 assumptions that may not apply to that particular bank, for example if the "well diversified" assumption is not met because of geographic or sectoral concentrations. In essence, the bank should determine whether capital levels are appropriate in light of any deviations from Pillar 1 assumptions. We also hope that the added transparency contained in Pillar 3 of Basel II will generate improved market discipline for these large organizations. Market discipline is not possible if counterparties and rating agencies do not have good information about banks' risk positions and the techniques used to manage those positions. Indeed, market participants play a useful role by requiring banks to hold more capital than implied by minimum regulatory capital requirements, or sometimes their own economic capital models, and by demanding additional disclosures about how risks are being managed. From the outset of our participation in the development of Basel II, the U.S. agencies have clearly and consistently stated that the final adoption of the new capital rules in the United States would occur only after (1) we had reviewed all public comments and incorporated any needed adjustments to address legitimate concerns and (2) we were satisfied that Basel II was consistent with safe and sound banking in this country. Throughout this process we have stressed that, if we become concerned about the level of overall capital in the banking system or the capital results for individual portfolios, we will seek to modify the framework, including possibly recalibrating the regulatory capital formulas that translate an individual bank's risk parameters into required capital. The agencies' current review and study is consistent with our historical position at Basel. Implementation efforts in the United States The U.S. banking agencies are grateful to the institutions that voluntarily participated in the QIS4 exercise, from which we received valuable information. In a statement issued on April 29, 2005, the U.S. banking agencies indicated that the minimum regulatory capital charges resulting from QIS4 were more variable across institutions and these capital charges dropped more in the aggregate than the agencies had expected. This was the impetus for deciding to delay issuance of our next round of proposals for Basel II. The agencies' reaction to the QIS4 results should signal how seriously we are taking the Basel II effort and how we are striving to implement it correctly. These somewhat unexpected results show the continued benefit of conducting periodic quantitative impact studies. They serve as a milestone to help us evaluate progress as we move to Basel II. We now must determine the reasons for the results from QIS4. Were there limits to the QIS4 exercise? Is there a need for adjustments to the Basel framework itself? Do the QIS4 results reflect actual differences in risk among respondents when prior supervisory information suggested more similarity in credit quality? Do the results indicate the various stages of preparedness among participants, especially relating to data availability? None of the participating banks have completed their databases and models for all of their risk areas. In some cases, this created results that could not be relied upon in the implementation of Basel II. For example, for some portfolios, losses reflected only the last year or two of results. Thus, the strong credit performance of recent experience was not balanced by higher losses at other points in the credit cycle. Analysis of the data used in QIS4 is vitally important, because the ultimate success of Basel II will depend on the quantity and quality of data that banks have to use as inputs to the framework. And as I noted before, these data are fundamental to the proper management of risks at large complex institutions, even outside the realm of regulatory capital. Although the agencies have decided to delay the next round of proposals, we remain committed to Basel II. Indeed, we continue to recognize that we must give institutions as much information as possible to help them with their preparations. And we have sought to provide helpful information to institutions as soon as it becomes available - for example, the draft supervisory guidance documents that are now under development. So far, the agencies have issued draft guidance for the advanced measurement approaches for operational risk and certain parts of the internal ratings-based approach for credit risk. Additional draft guidance is expected to be issued for public comment either along with or soon after the notice of proposed rulemaking is released. From the beginning, we intended this guidance to further clarify supervisory expectations for implementation of Basel II in the United States, and it is directed at bankers as well as supervisors. We believe that by outlining what supervisors would expect, the proposed guidance gives banks a far better understanding of how to upgrade their systems, modify their procedures, and strengthen their controls in anticipation of eventual adoption of Basel II. We hope that by clearly communicating expectations, we are giving both bankers and our own examiners sufficient time to prepare for the new framework. One vital element of our preparation for implementation has been our dialogue with the banking industry. At many stages along the way, banking organizations - both internationally and domestically have expressed their concerns about certain aspects of Basel II. When credible evidence and compelling arguments have shown that those concerns are well founded, the agencies and the Basel Committee have modified the proposal. For example, global regulators heard the industry's call for addressing only unexpected loss in the framework; additionally, the approach to securitization was substantially altered on the basis of comments received. We hope it is clear that we are being attentive to the full range of these concerns and will continue to be as the industry raises additional concerns along the way. The deliberate process of issuing proposals and hearing public comment on each proposal provides multiple safeguards, helping the agencies move to the final adoption of the new framework in the United States only when doing so is clearly appropriate. In other words, our implementation strategy has been designed to be prudent but also flexible enough to move banks from Basel I to Basel II as their own systems mature and they become able to provide reasonably accurate assessments of their credit and operational risks. The agencies' analysis of and reaction to the QIS4 results show how those safeguards work: we saw results that gave us concern, so we are investigating further before we go to the next stage. Additional, future safeguards - such as the notice-of-proposed-rulemaking process and the minimum one-year parallel run and the minimum two-year transition period, with options to extend either - will also ensure ample opportunity to recalibrate or make other adjustments if necessary. Current capital framework In looking at the current capital framework, I first want to make clear that I see no reason to replace Basel I for the vast majority of banks here in the United States. Effective risk management and risk-based capital levels must be consistent with the scope and complexity of risk taking in individual organizations. And making appropriate amendments to update the 1988 Accord, as we have been doing periodically over the years, will make the current framework appropriate for most of the banking organizations in the United States. But we remain sensitive to the possibility that proposed Basel II rules could have some unintended competitive effects. Accordingly, when we issue the next Basel II proposals we also plan to issue an advance notice of proposed rulemaking to revise current capital rules. U.S. banking regulators have long recognized that the existing capital rules need to be appropriately updated. Naturally, we need to understand the impact of Basel II on organizations that are adopting the new framework before we propose changes to Basel I. That is why we would like to allow the banking community to comment on a combined package of proposed changes. While the regulatory capital requirements ultimately produced by Basel II would be, we believe, considerably more risk-sensitive than the current capital regime, this is not the only capital regulation under which U.S. institutions would operate. More than a decade ago, the Congress, as part of the Federal Deposit Insurance Corporation Improvement Act's prompt- corrective-action (PCA) regime, defined a critically undercapitalized insured depository institution by reference to a minimum tangible-equity-to-asset requirement - a leverage ratio. The agencies have also used other leverage ratios to define other PCA capital categories because experience has suggested that there is no substitute for an adequate equity-to-asset ratio, especially for entities that face the moral hazard that accompanies the safety net. The Federal Deposit Insurance Corporation, which is responsible to the Congress for the management of the critical deposit-insurance portion of the safety net, has underlined the importance of that minimum leverage ratio and PCA as part of a prudent supervisory regime. The Federal Reserve concurs with the FDIC's view. As I have mentioned, we need the risk-measurement and risk-management infrastructure and the risk sensitivity of Basel II; but we also need the supplementary assurance of a minimum equity base. The market and the rating agencies will continue to require exactly that kind of base, and a regulatory minimum is prudentially desirable. Conclusion In closing, I would like to underscore that Basel II is not just a capital calculation or a minimum regulatory ratio; it is an ongoing process to help banks implement new technologies and risk-management techniques, to align capital with risks, to foster a level playing field internationally especially given the increasing integration of banking and financial markets worldwide - and to ensure a capital cushion that is adequate and promotes financial stability. The Basel II framework and the relationships among supervisors and bankers that have helped to advance capital reform should provide a process to encourage bankers and supervisors to adapt their procedures and techniques over time. The U.S. banking agencies are working diligently on Basel II implementation. The QIS4 results, however, have given us reason to pause before releasing our next round of proposals. The agencies will continue to provide as much information as possible to help institutions make their decisions about implementation - both those institutions that are required to adopt Basel II and those that may opt in. Throughout the process, our supervisory teams stand ready to discuss Basel II issues with all institutions and answer any questions that arise.
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Euromoney Inflation Conference, Paris, 26 May 2005.
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Edward M Gramlich: The politics of inflation targeting Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Euromoney Inflation Conference, Paris, 26 May 2005. * * * While many policymaking innovations have spread around the world from large nations to small, inflation targeting took a reverse course. It was first adopted in New Zealand in 1989, appeared to be successful, and has now spread to more than twenty nations. The regime is now being urged on the laggard countries that have not yet joined the bandwagon, notably the United States. The question of whether a country should adopt inflation targeting raises several issues. At the theoretical level, inflation targeting is alleged to promote central bank transparency, clarify communication, and establish a central bank commitment to price stability. These advantages are offset by the fact that inflation targeting could lead to rigid or formulaic policies that limit flexibility. Given the impossibility of rewriting history - trying to determine either what an inflation-targeting central bank would have done in response to some economic shock had it been a nontargeter or what a nontargeting central bank would have done had it been a targeter - the theoretical debate has never proved conclusive in deciding for or against inflation targeting. Nor is the empirical evidence conclusive. Econometric studies find that, in countries that have adopted inflation targeting, inflation rates have fallen, spreads between nominal and real interest rates have fallen, other measures of expectations of inflation have fallen, and macroeconomic growth numbers have not worsened and have often improved. From this point of view, inflation targeting looks to have been successful. But inflation rates have also fallen, nominal-real spreads have fallen, inflation expectations have fallen, and macroeconomic growth numbers have improved in at least one significant country that has not adopted inflation targeting, the United States. The general verdict of the many comparison studies seems to be in favor of inflation targeting, but something else, most likely the sheer commitment to price stability, has also appeared to have worked just as well in the United States. For countries that have not yet adopted inflation targeting, a key issue then becomes politics. The countries that have adopted inflation targeting report that the regime has helped to clarify the relationship between the central bank and the government, generally giving the government say over the ultimate objectives of monetary policy but the central bank freedom in how it pursues these objectives. But these are usually parliamentary countries where the governmental authorities have strongly endorsed inflation targeting. There is a large question about what a central bank should do in a congressional system, when its government has not endorsed inflation targeting. That is the issue I will discuss today. After reviewing present-day inflation-targeting relationships around the world, I turn my attention to political considerations for the United States. Present inflation-targeting arrangements The first country to adopt inflation targeting, New Zealand, did so with strong support and fairly specific instructions from its legislature. The Reserve Bank of New Zealand Act of 1989 established the basic framework. This act gave the central bank the objective "of achieving and maintaining stability in the general level of prices," with "regard for the efficiency and soundness of the financial system." The act provided that the government and Reserve Bank jointly determine the specific inflation target and other policy objectives through Policy Target Agreements. The first of these target agreements defined price stability as a range of 0 percent to 2 percent in New Zealand's Consumers Price Index (CPI), set a goal of achieving price stability two years hence, and gave conditions that could justify going outside the price stability band. Subsequent agreements have modified the target CPI, widened the tolerance band, and introduced other objectives, such as the stability of output growth. These modifications have generally made New Zealand's inflation-targeting regime much more flexible. Governmental involvement was still very important, though somewhat less explicit, for the next three inflation targeters. Chile's adoption of inflation targeting in 1990 was preceded by new central bank legislation. Canada, which adopted inflation targeting in 1991, used the vehicle of a joint announcement by the Ministry of Finance and the governor of the Bank of Canada. This announcement, and subsequent joint announcements, established a target range for price stability but left the details, and the responsibility for policy, in the hands of the Bank. In Britain, which adopted inflation targeting in 1992, the chancellor of the Exchequer first announced the inflation goal. The Bank of England did not even have operational independence at the time. Though the Bank later gained independence, the chancellor still sets policy goals for the Bank through periodic remits. In the next wave of inflation targeters, there was less-explicit governmental involvement. In Sweden, which adopted inflation targeting in 1993, the government had previously announced that controlling inflation was an overriding goal for the Riksbank. In Australia, the Reserve Bank governor announced its inflation-targeting regime in a speech, using broad, previously delegated authority. In Norway, the Norges Bank operates under a governmental mandate declaring that the long-term objective of monetary policy is to maintain the domestic and international value of its currency. The European Central Bank (ECB) operates its regime under authority delegated by the Treaty Establishing the European Community, with the primary goal of price stability established by the treaty. Lessons are more diffuse from the last wave of countries to adopt inflation targeting. Brazil's adoption of inflation targeting in 1999 was preceded by a presidential decree. Hungary and Poland adopted inflation targeting following parliamentary acts stipulating that price stability was the main objective for the central bank. But in two cases, Mexico and the Czech Republic, the central bank moved to inflation targeting on its own. In the Czech Republic, subsequent legislation enshrined price stability as the main objective of the central bank, but not in Mexico. Although these regimes differ from one another, there is at least some governmental involvement in all but the Mexican case. The level of involvement ranges from New Zealand's explicit governmental guidance to other, much more flexible arrangements that give the central bank fairly wide latitude in establishing target ranges, choosing indexes, and choosing time periods over which to meet the price stability objectives. There may also be a correlation between governmental involvement and the strictness of the inflation-targeting regime. Involvement has been the greatest in the strictest regime, New Zealand, and is noticeably less in the more flexible regimes. The United States The main country that has not adopted inflation targeting is the United States. Although academic economists and many others have for years been urging the Federal Reserve to adopt inflation targeting, legislators have shown very little interest in the issue. Congressman Jim Saxton of New Jersey, chairman of the Joint Economic Committee, has introduced an inflation-targeting bill several times, but the bill currently has no cosponsors and has not been reviewed recently in committee hearings. Previous inflation-targeting bills have fared no better. This lack of congressional momentum could be interpreted as lack of congressional support for inflation targeting, or it could merely reflect a more neutral absence of strong opinions. Given the absence of firmer congressional guidance, the Federal Reserve has continued to operate under the Full Employment and Balanced Growth Act of 1978. This act directs the Fed to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Should these goals be in conflict, it is up to the Fed to resolve the problem. To say the least, the U.S. approach is a rather stark contrast with the approach in New Zealand with its policy agreements and in Canada with its joint announcements. Academics and others urge the Federal Reserve to adopt inflation targeting, but should the Fed do so on its own? If the Fed does something on its own, how strict an inflation-targeting regime should it be? The politics of inflation targeting have never been fully explored. We should first recognize that the form of the U.S. government is different than that of most inflation-targeting countries. These targeting countries typically operate under a parliamentary form of government, under which the Treasury secretary or chancellor of the Exchequer is speaking for the whole government, both the executive and the legislative branches. There would be many more complications in the United States - the Federal Reserve would have to coordinate with the Treasury secretary, representing the executive branch, and members of the Congress. When the Congressional Budget Office deals with the Congress, it coordinates between both parties and both the Senate and the House of Representatives. The Fed might not have to coordinate with both houses of the Congress, but it would certainly have to coordinate with both parties. This problem is not necessarily insuperable; all political actors might recognize the value of price stability and might appreciate inflation targeting, at least in its softer form. But at a minimum, political issues are much more complicated in congressional systems than in parliamentary systems. On a more technical level, there are at least two places to look for guidance. A first place is the Full Employment and Balanced Growth Act itself. As amended, this act requires the Fed to make a semiannual Monetary Policy Report to the Congress, accompanied by testimony from the Chairman of the Federal Reserve. These reports and testimony have been occasions for the Fed to report on concepts and developments, though never one as significant as inflation targeting. It is hard to imagine the Fed's using these hearings to announce a full-blown inflation-targeting regime, though it is conceivable that the Fed could use them to propose soft target bands for price stability, or at least to get more specific about the Fed's commitment to price stability. But in the end, using the Monetary Policy Reports from the Fed as a means of getting the Congress to endorse inflation targeting would be stretching things. A second place to look for legal guidance is the fact that the Fed also has rule-writing responsibility for several statutes in the consumer area, such as the Home Mortgage Disclosure Act, the Home Ownership Equity Protection Act, and the Community Reinvestment Act. In each of these cases, the statute was passed some years ago, and the Fed has responsibility for writing rules to keep the statute up-to-date. Periodically the Fed issues advance notices of proposed rulemaking, solicits comments, revises the rules, puts these revisions out for comment, and then adopts final rules. One could imagine a similar process for inflation targeting. For the Fed to write rules for a strict inflation-targeting regime on its own would presumably be impossible, though one might interpret "maximum employment, stable prices, and moderate long-term interest rates" as an invitation for the Fed to write rules to institute a soft form of inflation targeting. On the whole, this precedential guidance is not very helpful. When it has had opportunities, the Congress has never moved ahead on inflation targeting, possibly because of outright opposition, possibly because of a desire for neutral non-involvement. Nor have various recent Administrations expressed much interest, preferring to leave such matters in the hands of the Fed. A Fed announcement about inflation targeting would be much more significant than the other more-technical and more-data-oriented announcements or pronouncements the Fed normally gives in its Monetary Policy Reports. And for the Fed to interpret the broad language of the Full Employment and Balanced Growth Act as an invitation to write rules instituting a strict form of inflation targeting would be an extreme stretch, though perhaps not for a soft form of inflation targeting. Normative considerations Granted that there is not much legal precedent for going ahead with inflation targeting on its own, would there be any value in having the Fed start a conversation with the Congress? Left to its own devices, the Congress probably will not move ahead on the Saxton bill or anything like it. But what if the Fed were actually to propose a soft form of inflation targeting? Such a proposal might change the dynamics and raise the possibility that the Congress could at least tacitly endorse inflation targeting. The advantages of soliciting congressional support for inflation targeting would be essentially those normally ascribed to inflation targeting in the first place. The Fed's announcements could become clearer and more transparent, its commitment to price stability could become more universally understood, and market participants could have a better idea of what specifically the Fed means by price stability. The present "bias" statement in the Fed's announcement of changes in the federal funds rate target could be supplanted with a statement on whether inflation is tending to the upper or lower bound of the Fed's price stability range. I see no particular need to clarify the relationship between the Treasury and the Federal Reserve in the United States - already there is agreement that the Treasury should be the only agency that comments on currency values, and that the Fed should be the only agency that comments on monetary policy - but added demarcations can never hurt. Another advantage would be that inflation targeting could assist in clarifying roles. When the Chairman testifies on the Monetary Policy Report, most of the questions involve an incredibly broad range of topics - fiscal policy, tax policy, entitlement spending issues, trade issues, and wage distribution questions. Many of these have little to do with the Fed's direct areas of responsibility. I can see a democratic effectiveness argument for rerouting these questions back to the area of direct Federal Reserve responsibility, and discussion of how to implement inflation targeting might well do that. These discussions might also make it clear that price stability - not all these other matters - is the primary economic outcome for which the Fed is responsible. As for the disadvantages, the most significant seems to be explaining why the Fed is specifically delineating only one of its three goals. A modern-day macroeconomist would have no trouble in understanding why the Fed would put a target band on inflation but not on unemployment and not on long-term interest rates. In modern-day macroeconomics, inflation is a policy choice variable - there is essentially no long-run tradeoff between inflation and unemployment, and it is up to monetary policy to choose the long-run rate of inflation. Zero inflation, or close to zero depending on measurement error and other technical details, is as good as any other choice in promoting ultimate macroeconomic goals such as full employment and long-term economic growth. Keeping inflation close to zero has the further advantage of limiting the microeconomic costs and tax distortions caused by inflation. Hence a target zone for price stability fits perfectly into the standard macro model. But that's not true for the other parts of the Fed's mandate. Were the Fed, or the Congress, to set a target bound on the unemployment rate, that bound might not be consistent with the so-called natural, or non-inflationary, rate of unemployment. Were the target band, say, below the natural rate, the Fed would be forced to follow policies likely to lead to accelerating inflation. Similarly, a target band for long-term interest rates below the equilibrium long-term rate could also again force the Fed to pump money out to a highly inflationary degree. The difference is all in the way the macroeconomy works. The straightforward way to resolve this impasse is to try to explain it to politicians who remain skeptical. As evidence, one could use the 1960s and 1970s as dramatic indications of what happens when macro policy violates the natural unemployment rate rule and the equilibrium interest rate rule, with rather dire subsequent inflationary consequences. Or the 1990s could be used as an illustration of how monetary policy could lower inflation, with concomitant gains in terms of full employment and long-term economic growth. Similar conversations might have occurred in all those countries where the government seems to have eagerly adopted inflation targeting. But these attempts to explain inflation targeting still might not work, and the Congress might still delineate specific unemployment and interest rate goals along with inflation goals. Were such to be the case, particularly if the specific goals for unemployment or interest rates were set inappropriately, as was done in the Humphrey-Hawkins Act of the late 1970s, I believe that even die-hard advocates of inflation targeting would consider the costs greater than the benefits. Given the already good inflation performance in the United States, the benefits of adopting inflation targeting are likely to be modest. But in an inappropriately constrained system, the costs could be enormous. Another potential political cost of inflation targeting involves loss of flexibility. As inflation targeting has evolved in other countries, and in the thinking of academic economists, a flexible approach to inflation targeting has proved quite popular. Specific goals for inflation are important, yes, but not under any and all circumstances. Real-world economies are subject to unanticipated shocks and unanticipated financial crises. Sometimes monetary authorities, even under inflation targeting, must respond to these shocks by going outside the price stability band for a short period. For example, the ECB has held its short-term interest rate at a low level for a significant period even though inflation has been slightly above its target ceiling most of that time. Many outside observers believe that economic sluggishness is the real problem in Europe and are quite sympathetic with the ECB strategy, even though it may violate a strict interpretation of inflation targeting. Most experts and others interested in inflation targeting understand this need for flexibility and are quite comfortable with flexible inflation-targeting schemes. In all likelihood, any scheme designed for the United States would feature such flexibility. So far there is no problem, but there could be at least a political awkwardness to such a situation. The Federal Reserve is responsible for many controversial policies - sometimes its approval or disapproval of bank mergers is controversial, sometimes its safety and soundness supervision is controversial, and sometimes its consumer protection regulations are controversial. At any point, some observers and some politicians are likely to be upset at the Fed for one reason or another. Were the inflation rate temporarily outside the target band, even for good economic reasons, the mere existence of inflation targets could be another excuse for tension between the Fed and the Congress. There is almost always at least potential tension between the Fed and the Congress, and both sides have learned how to handle it. But at least some danger lies in introducing new possibilities for tension. None of these supposed political costs of inflation targeting are certain, all could be readily handled, and it is at least possible that only vague congressional support for inflation targeting would ultimately be necessary. But we should recognize that same clarity of inflation targeting that has generally proved advantageous in other countries contains at least the seeds for potential disagreements in the United States. Conclusion All debates about whether the United States should adopt inflation targeting are fairly amorphous, balancing speculative theoretical considerations and imaging hypothetical situations. Given the good inflationary performance of the American economy in the past decade, the question of whether to adopt inflation targeting has never been an all-out do-or-die issue. The most that pro-targeters have been able to claim is some possible benefits; and anti-targeters, some possible costs. In this amorphous debate, the political questions are perhaps the most amorphous of all. But surely it is relevant that, in other countries that have adopted inflation targeting, the parliamentary governments have generally been strong supporters, whereas in the United States Administration and congressional support has ranged from weak to non-existent. This lack of support could well change as the Administration and the Congress became more familiar with inflation targeting and, in particular, the possible flexibility of the regime. But if it does not change, or if it takes the form of inappropriate targets for other macroeconomic objectives, it becomes a definite impediment to the adoption of inflation targeting by the United States.
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board of governors of the federal reserve system
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the Seventh Deutsche Bundesbank Spring Conference, Berlin, 27 May 2005.
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Roger W Ferguson, Jr: Asset prices and monetary liquidity Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, to the Seventh Deutsche Bundesbank Spring Conference, Berlin, 27 May 2005. * * * Over many decades, the Federal Reserve and the Bundesbank have enjoyed a very productive working relationship that has included sharing our concerns and insights about good policy. The sharing has been not only between our two institutions but with the policy and research communities more broadly. This conference is one more such occasion, and I am grateful to the Bundesbank organizers for this opportunity to speak this evening. Several of my recent assignments, both at the Board and in international groups, concerned the continuing effects of financial innovation and liberalization on the scope and scale of financial activity around the globe. In fact, in terms of sheer volume, the expansion of financial activity has greatly outstripped economic growth in recent years. With wider and faster access to information, markets have become more precise, on balance, in pricing value and risk. Innovation and liberalization have also brought more diverse opportunities for investors and borrowers, a wider selection of financial instruments, and generally improved risk management. The overall result has been more-efficient use of financial and real resources and, ultimately, better economic performance. Many observers believe that this result has been a key factor in the strong productivity and growth that the United States has realized in recent years. Many economies have become more resilient and more capable of withstanding shocks, but financial markets themselves seem to have become more sensitive to real-time data. The past decade has been marked by episodes of financial volatility that have had the potential for trouble at a systemic level. Linkages between financial markets and real economic outcomes have become more complex, periodically presenting policymakers with surprises and puzzles. And, paralleling efforts by central banks at improving transparency of the policy process, heightened scrutiny of policy by markets has added both new benefits and new complexities. A particular phenomenon that touches on all these issues is the movement of asset prices, especially the prices of equities and residential real estate. Because these assets are the most widely held by the general public, price changes, even when not exceptional, can significantly affect the macroeconomy. Rising asset prices support household consumption, whereas falling asset prices damp consumption. In a scenario of collapse, the damage to balance sheets and private wealth could go as far as undermining the soundness of the financial system and threatening stability of the real economy. Apart from such outcomes, policymakers might also take special interest in asset price movements because it has been alleged that badly designed or poorly implemented policy (even if well intended) sometimes has helped feed unsustainable movements in asset prices. Accordingly, I would like to highlight some aspects of the link between monetary conditions and asset prices and point to areas in which the policy community could use further insight from researchers, including perhaps from this distinguished group. I should note, my comments this evening reflect only my views and should not be taken to represent the views of my colleagues on the Board of Governors or in the Federal Reserve System. Interaction of asset prices and policy Asset price movements that are discontinuous or extreme can affect the policy process in at least two important ways. First, because they are interest-sensitive, asset prices are primary components of the channels by which monetary policy is transmitted to the real economy. If these transmission channels are disrupted, the reliability and the effectiveness of policy are degraded. In the worst case, policy's room for maneuver may be narrowed or even severely compromised, and risks of a policy blunder are heightened. Second, because asset prices are forward-looking, they should contain information of value for the policy-setting process. If those signals of market participants' expectations are blurred by extreme movements, important information may be misread or lost. Of course, some uncertainty is inevitable and quite manageable in the course of normal policymaking. By virtue of its mandate, the Federal Reserve focuses on price stability, interpreted to mean stability of consumer prices. Monetary policy does not aim at any particular relative price, nor is the mandate thought to refer to prices beyond consumer prices, such as those for assets. Ordinarily, however, asset prices are among the many factors that central bankers assess when we evaluate present economic and financial conditions and the outlook. And when asset prices exhibit large, systematic, and persistent deviations from fundamentals, the implications of those deviations inevitably get more prominence. Clearly central bankers would benefit from a better understanding of asset price movements - particularly more extreme movements - so that we do not mistakenly facilitate in some way potentially harmful outcomes. Liquidity and asset prices Overly rapid monetary expansion, or excessive liquidity, has been named as a leading suspect in some episodes of unsustainable movements in asset prices. Liquidity is not a precise concept, however. Liquidity could be measured narrowly as central bank money, for example, or more broadly to reflect the multiplier effects of the financial system; sometimes it is measured instead by the level of policy interest rates. All these definitions and others have been in play in the economics profession's analysis of the link between monetary conditions and asset prices. What is meant by "excessive" is even less well defined. Some commentators have taken a circular approach: If monetary conditions were comparatively easy when asset prices experienced a significant swing, then liquidity must have been "excessive." A good place to start to unravel some of these issues is to look at the data. The results of research at the Board and that of many others seeking to document a link between liquidity and swings in asset prices has focused on growth rates of broad monetary aggregates and measures of equity and house prices deflated by the price index for personal consumption expenditures.1 Using these measures, the results differ significantly according to the type of asset being studied. For equity prices, under various alternative specifications, the link between the growth rate of liquidity and changes in real equity prices at frequencies beyond very short term appears to be tenuous at best.2 To illustrate, the upper panel of figure 1 shows a scatter plot of contemporaneous four-quarter growth rates of M3 and changes in broad measures of equity prices for sixteen industrial countries during roughly the past twenty-five years.3 As you can see, no obvious sign of a meaningful correlation at this frequency is evident in this pattern. Indeed, the actual correlation is slightly negative. Most other studies - such as the study by Bordo and Wheelock - using a variety of definitions and more-rigorous techniques, support the same conclusion.4 The lack of a strong finding of any positive medium- to longer-run relationship, of course, could be because equity prices are quite volatile, making unconditional correlation difficult to identify. Perhaps, too, more-refined measures of liquidity than those used in studies so far are needed to capture possible effects on equity prices. So the effect of money growth on real equity prices is by no means a closed question, and there certainly would be interest in whatever might come from further research on this topic. In contrast, the link between monetary growth, as measured by M3, and changes in real house prices appears to be more definite. The bottom panel of figure 1 shows a similar scatter plot for the same group of countries and periods as in the upper panel, but for changes in real house prices. The two series exhibit a small positive correlation that is statistically significant. Moreover, various tests have shown that the correlation is not just a recent phenomenon or confined to a few countries; it is evident in varying degrees both over time and across our sample of sixteen countries. Again, this finding is consistent with findings from a number of other academic researchers. (I might add that the correlation with real house prices also holds even if M3 is normalized by prices or gross domestic product. Negative correlation between interest rates and house prices is, of course, not unexpected.) I wish to thank Robert Martin, Alain Chaboud, Jon Faust, and Brian Doyle of the Board staff for research support. Various studies have found that stock prices do exhibit an immediate reaction to monetary policy surprises, not unlike their responses to other macroeconomic surprises, for example, Ben S. Bernanke and Kenneth Kuttner (2005), "What Explains the Stock Market's Reaction to Federal Reserve Policy?," Journal of Finance, vol. 60, 1221-57. Data on residential real estate and equity prices are from the Bank for International Settlements and, for most countries, are quarterly. M3 data are derived from national sources; the length of the series on M3 varies across countries. The list of countries covered and the relevant periods are provided in the appendix. Michael D. Bordo and David C. Wheelock (2004), "Monetary Policy and Asset Prices: A Look Back at Past U.S. Stock Market Booms," NBER Working Paper 10704. To explore this relationship further, figure 2 provides some background on longer-term movements in house prices in the United States, the United Kingdom, and Japan - three countries where house price movements have been prominent.5 As the three panels show, each country's movements in real house prices have experienced two or three cycles during the past thirty-five years, usually with relatively long periods of gains followed by long periods of decline. This suggests that one potentially useful way to explore further the relationship between liquidity and asset prices is to examine movements in those two variables in ten-year windows surrounding house price peaks. The solid line in figure 3 shows the average behavior of the growth rate of M3 from twenty quarters before a peak in real house prices until twenty quarters after the peak, where the average is taken across all the cyclical episodes in our broad sample. The broken line in the chart is the log level of real house prices indexed to zero in the peak year. As can be seen from the chart, on average the growth rate of money increases fairly steadily until around two quarters before the peak in real house prices and then drops fairly steadily for ten quarters afterward before recovering somewhat. Although there are some variations, this pattern tends to occur in most countries' episodes.6 Importantly, the connection between money growth and house prices does not seem to vary much with the rate of macroeconomic expansion. This statement is underlined by figure 4, which shows as an example actual house prices for the United Kingdom (the broken line) and their forecasted values from an equation based on the growth rate of real broad money and real long-term interest rates over more than twenty years (the solid line). The close correspondence is apparent. While these results are suggestive, correlation is by no means causality. Confirming that variations in growth rates of liquidity (especially unusual changes in liquidity growth that could be called excessive) systematically lead to wide swings in real asset prices requires further theoretical investigation and more empirical support. That asset prices rise during a period of monetary easing is not surprising, of course. But why growth of money sometimes might cause housing prices to move more than other asset prices or, for that matter, than goods prices is not clear. Indeed, some elements of causality run in the opposite direction, clouding the underlying relationships. For instance, as the value of collateral rises during a house price boom, the associated expansion of credit typically leads to increases in broad money. The effect can be accentuated by the temporary parking in liquid accounts of the proceeds from the more-frequent turnover and refinancings that often accompany a house price boom. Complicating the analysis further, a substantial list of third factors could drive both housing prices and liquidity measures, producing co-movements that look like causality. A productivity shock or a sharp decrease in energy prices, for example, could lead to general economic expansion and rising asset prices while goods prices are not rising. This situation might allow more liquid monetary conditions than would otherwise be the case. Distinguishing the various forces in play obviously requires tools that are finer than simple observations that both liquidity measures and assets prices are moving together. Identification of unsustainable movements The example cited above also should remind us that not all situations in which asset prices are rising rapidly under seemingly easy monetary conditions are worrisome. Some are quite benign and even signal a healthy economy. Accordingly, for policymakers who have to confront these situations in real time, a fundamental challenge is identification. When asset prices are moving in an unusual manner, is the movement unsustainable; does the pattern arise from excessive liquidity in the market; and will policy be challenged by that combination at some future date? Or are we observing a more complex process, perhaps less aberrant and less prone to a troubling reversal? The answers to these questions depend in part on the link between an asset's price and some estimate of its "fundamental" value. Unfortunately, from the point of view of both the analyst and the policymaker, the link between an asset's price and the structure of its return is hard to pin down, as it typically embodies complex factors that are inherently difficult to measure, such as expected future earnings, riskiness, and risk aversion. Consequently, for evaluating in real time whether prices may be "off track" and, if so, by how much, we have to fall back on more readily observable measures that, in principle at least, should bear some systematic relationship to ideal measures and that can be House prices in other industrial countries have shown similar, but generally more modulated, swings. The correlation between real house prices and money growth in Japan was close to zero during the deflationary 1990s. assessed against historical experience. For equities, a stock's price-earnings ratio is a standard benchmark for assessing valuation. In the late 1990s, the price-earnings ratio for U.S. equities especially in the high-tech area - soared to record levels, and the so-called equity risk premium narrowed to a historical low. There was a strong sense at the time that such elevated price levels were unusual, but there was no uniform consensus regarding whether or not they were sustainable. All agreed, however, that the pricing of assets, given profit expectations, was difficult. And even after we have seen a major correction, our understanding of what drove that process and what the proper level should have been - and should be now - still is unsettled.7 For housing, rent-to-price ratios and income-to-price ratios are commonly used measures to assess valuation. Over the past several years, both measures have decreased sharply in many countries, and they currently are well outside historical ranges in some countries. In 2004, U.S. home prices increased 11.2 percent, their fastest pace since 1979, and right now, housing prices in many markets in the United States are relatively high when judged by conventional valuation measures.8 To know if housing is fairly valued requires assessing whether today's valuations are consistent with unobservable future rents, interest rates, and returns - concepts for which we have only rough proxies. However, in some markets the most prudent judgment is that the growth of house prices will slow from the rapid pace experienced most recently. Interpretation of correlation - other fundamental factors The issue of identification becomes much more difficult in a changing environment. Some patterns of asset price changes that are attributed to excess liquidity may arise, for example, from financial innovation and other structural changes.9 But mapping such changes into asset price movements to control for such factors is difficult. For example, the rise in house prices in the United Kingdom in the late 1980s was thought at the time to relate importantly to the liberalization of U.K. banking laws several years earlier and, therefore, likely to be sustainable. As it turned out, the run-up ended fairly soon and was followed by a steep decline. The inability to more accurately gauge the effects on asset prices conferred (or not) by earlier structural changes likely contributed to the inaccurate expectation that they would last longer. In Sweden, the large and swift increases in property prices in the 1980s also related in part to the earlier liberalization of domestic banking laws and consequent easier lending practices. The tax reform of 1990, which among other things made the tax treatment of mortgage interest rates in Sweden considerably less favorable, contributed to a subsequent drop in property prices that ultimately severely stressed banks' balance sheets, an experience that again highlighted the potential impact of such structural factors on asset price movements. Controlling for cyclical effects on both liquidity and real asset prices is basic, of course, in any empirical assessment of how they may be linked. But some observers have conjectured that, beyond conventional cyclical patterns in a benign environment with low-inflation and strong real growth such as we have had in recent years, investors' preferences and behaviors may change qualitatively in ways that are not captured well by models based on historical patterns. Faced with cumulating wealth and lower nominal returns, investors may develop a distinctly greater tolerance for risk that results in aggressive "search for yield" behavior. This behavior may engender, it is argued, a tendency for unusual run-ups in some asset prices. If so, a concern is that changes in the underlying conditions that fostered this pattern or a policy misstep could cause a quick reversion to the historical norm. The policy community has been on the lookout for such patterns of "search for yield" during the latest cycle of low rates and tightening.10 Others have argued that in certain circumstances, when special factors may be preventing inflationary pressures from showing through to consumer prices, increases in asset prices might serve as an For further details on the difficulty of identifying unsustainable movements in asset prices, see Refet S. Gurkaynak (2005), "Econometric Tests of Asset Price Bubbles: Taking Stock," (Finance and Economic Discussion Series) working paper 2005-04. The source of the data is the Office of Federal Housing Enterprise Oversight. The OFHEO index is based on repeat sales prices derived from mortgage acquisitions on conforming loans. See, for example, Franklin Allen and Douglas Gale (2000), "Bubbles and Crises," Economic Journal, vol. 110, pp. 236-56. For example, see my statement as Chairman of the Financial Stability Forum to the International Monetary and Financial Committee, April 16, 2005, Washington, D.C., and International Monetary Fund Global Financial Stability Report, 2005. early, more visible warning that liquidity is excessive. It has been asserted, for example, that the strength of the yen in the late 1980s stifled Japanese consumer price inflation and contributed to an easier policy stance by the Bank of Japan.11 The fact that resulting liquidity was greater than would have been ideal was most apparent (unfortunately, more so in retrospect) in Japan's booming asset prices. A sharp (but temporary) boost in productivity or disruption of exchange rate pass-through behavior could have similar masking effects. But whether, in general, asset prices could provide reliable signals of suppressed but impending general inflation is a complex matter, and elevating asset prices to a more prominent role in the policy process is not without a number of potential pitfalls. Among other complications is the possibility that financial globalization may be changing the links between liquidity and asset prices. Movements in asset prices across countries now appear to be more synchronized. This synchronization could arise in a number of ways. National business cycles and policy responses may be moving more in tandem just because national economies have become more closely integrated through trade and investment, producing in turn a greater synchronization in asset markets. Global shocks (for example, from oil prices and geopolitical risk factors) that produce broadly similar effects on most economies may have become more prevalent and may tend to dominate idiosyncratic national shocks. But it also is quite possible that greater international diversification of portfolios now allows developments affecting assets in one country to spill over into markets of others - both at the level of particular industries and more broadly. If synchronization of asset price movements comes about mainly in this way, the suggestion is that excess liquidity in one country could move asset prices in another, perhaps significantly, even if liquidity was well contained in the latter.12 In the somewhat longer run, patterns of aggregate saving - influenced, for example, by demographic developments - may also affect the path of real interest rates and, in turn, prices of assets, again complicating interpretation of co-movements. For instance, an increase in savings as a growing share of the population nears retirement may reduce real rates and raise asset prices. Patterns of immigration that affect the population's demographic profile, too, can affect asset prices. In the United States, we have seen some of these effects in certain segments of the housing market. Conclusions In summary, although excess liquidity has been cited as a source of general asset price instability, the support for this conclusion is mixed, at best. We do find a positive correlation between growth rates of real house prices and M3, but the correlation does not seem to hold for real asset prices more generally - including, in particular, equities. In this talk, I have suggested that we are only at the beginning of an understanding of some of these relationships. Even if an underlying causal link exists between some real asset prices and liquidity, many additional factors may be influencing what we see, with potential for misleading us in interpreting simple associations or correlations. The problem obviously is complex. As a start, however, we need a better understanding of how asset prices are determined that can be translated into guidance for a policy process that uses real-time variables. To borrow a turn of phrase cited often in the physical sciences, theory tends to "explain a complex visible, with a simple invisible."13 In the realm of policy, of course, we need to work with simple, but reliable visibles - a requirement that makes this task all the more challenging. For that reason, I have been pleased to join this group of distinguished economists this evening. Appendix Countries in the dataset and the date for the beginning of the broad money series used for each country are as follows: See, for example, Takatoshi Ito and Frederic S. Mishkin (2004), "Two Decades of Japanese Monetary Policy and the Deflation Problem," NBER working paper 10878. This argument obviously applies best to markets such as those for equities where cross-holdings and international diversification are comparatively well developed. An IMF research paper has found evidence of liquidity spillovers and that an increase in aggregate G-7 liquidity is "consistent with" an increase in G-7 real stock returns (Klaas Baks and Charles Kramer (1999), "Global Liquidity and Asset Prices: Measurement, Implications, and Spillovers," IMF working paper 99/168). The origin of the remark is generally attributed to French scientist Jean Baptiste Perrin in his Nobel Lecture, given when accepting the 1926 Nobel Prize in physics. Country First data point for broad money Australia Belgium Canada Denmark Finland France Germany Japan Netherlands New Zealand Norway Spain Sweden Switzerland United Kingdom United States Residential real estate and equity index data cover the period 1970-2004 for all countries except Spain, for which the coverage begins in 1971. Figures
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, to the National Association of Real Estate Editors, Washington DC, 3 June 2005.
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Edward M Gramlich: HMDA data and their effect on mortgage markets Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, to the National Association of Real Estate Editors, Washington DC, 3 June 2005. * * * Thank you for the invitation to speak today. I am particularly pleased to accept an invitation to address the National Association of Real Estate Editors. Journalists are critical in helping the public understand the economics of the mortgage market, which has become more accessible, yet also more complex than ever. Your ability to demystify the mortgage market and identify trends greatly improves the public’s understanding of the housing market - the market for one of the most important financial transactions an individual will ever undertake. I also note that your readership includes real estate professionals - another group of individuals who play a crucial role in the efficient operation of the housing market. Homeowners often rely on recommendations from their realtors when looking for financing. Realtors must understand the role they play in making credit markets work, and in promoting sustainable homeownership opportunities for individuals. In our society, homeownership is the most common step one can take toward accumulating wealth. Home equity, built over time, has also become an important source of cash for other investments, including educational expenses. Moreover, homeownership strengthens communities by turning residents into investors with an ownership interest in the places they live. Recently, homeownership rates have reached record levels, thanks, in large measure, to technological innovations that allow for risk-based pricing of loans, along with the rapid growth of the subprime mortgage market. This brings me to the topic I want to discuss today: the recent release of pricing information collected under the Home Mortgage Disclosure Act (HMDA). As you are aware, HMDA requires that large mortgage lenders report their lending activities to the Federal Reserve Board and its sister agencies. The Board validates and ultimately compiles the data into a format that is made available to the public. The public can then use this information to evaluate whether lenders are serving their communities, enforcing laws prohibiting discrimination in lending, and providing private investors with information to guide investments in housing. Generally, for-profit lenders that have offices in metropolitan areas and that have more than $34 million in assets, or whose mortgage lending represents 10 percent of their lending originations, must report under HMDA. In my remarks today, I will first review the history of HMDA as a backdrop for the new HMDA pricing data. The Federal Reserve is still editing these data, but I will also provide a preview of what they are likely to show. HMDA history in brief The regulations implementing HMDA require that lenders disclose aspects of their home mortgage application and lending activities, including the applicant’s or borrower’s race, ethnicity, sex, and income. Also reported are characteristics of the loan, such as the amount and purpose, and the location of the property securing the loan. But it was not always this way. When HMDA was originally enacted in the mid-1970s, the only information required to be reported was the number and dollar amount of loans, by census tract. Congress, concerned about the role that financial institutions’ lending policies might play in the deterioration of our cities, designed HMDA to combat the practice known as “redlining,” in which institutions took deposits but did not lend in their local communities. Initially, HMDA data simply helped the public and regulators track where an institution was lending and, more important, where it was not. Not until the late 1980s did the data collection expand to include race, sex, and income levels for each loan application, along with whether the application was approved or denied. By then, the issue was whether minority borrowers were denied mortgage loans more frequently than white borrowers and whether those disparities reflected discrimination in mortgage underwriting. Today, after significant changes in the mortgage market brought on by technological advances, deregulation, and financial innovation, the credit availability question is no longer limited to whether minority borrowers have access to credit but, rather, at what price that credit is available. Moreover, there are new questions about whether the price of credit always reflects the lender’s risk or cost, or whether it is tied in any way to the race or sex of the borrower. The technological changes have led to strong growth in the subprime mortgage market. In general, this growth appears to be a positive development. Homeownership is at record highs among low-income and minority borrowers, many of whom would not have qualified for mortgages several years ago, and most of whom have been able to make their mortgage payments. At the same time, the increase in mortgage lending among lower-income and minority borrowers has been accompanied by reports of abusive, unethical, and, in some cases, illegal lending practices. I am sure you are aware of the concern about whether consumers have the ability to shop for mortgages and to avoid unfair or deceptive lending arrangements. Taking these concerns and public comments into consideration, the Federal Reserve determined that information on loan prices was critical to gaining insight into the functioning of the higher-cost mortgage market. In the Board’s amendments to the regulation that implements HMDA, Regulation C, we attempted to expand the HMDA data to permit evaluation of this market. The same amendments also required recording of information about the lien status of the loan, whether it was for manufactured housing, and whether it was subject to the Home Ownership Equity Protection Act. The new data were first reported for loans originated in 2004. Although the edited aggregate HMDA data will not be available until September 2005, lenders, as of March 31, are required to make their individual data available to anyone who submits a request. Some community organizations have already obtained and analyzed the data of some large lenders and have published reports indicating they believe that the data reveal discrimination in pricing. Simultaneously, the Federal Reserve, together with the other agencies that make up the Federal Financial Institutions Examination Council and the Department of Housing and Urban Development, has been explaining to financial institutions and to the public the uses and limitations of the pricing data and how these data will be used by bank examiners. General data issues The collection of HMDA data is premised on two distinct assumptions. The first is that the mortgage markets work more efficiently when information is publicly available. HMDA data have been used to identify credit demand that might otherwise have been overlooked. The analysis and conclusions drawn from the data have also encouraged the establishment of partnerships between lenders and community organizations to meet credit needs. The other assumption is that data improve compliance with, and enforcement of, fair lending and consumer protection laws. The HMDA data are the first point of reference for fair lending examinations conducted by the Federal Reserve and the other banking regulators. Government agencies use HMDA data to assist in evaluating lender compliance with anti-discrimination laws - particularly the Equal Credit Opportunity Act (ECOA) and the Fair Housing Act (FHA) - as well as other consumer protection laws. The data help examiners identify institutions, loan products, or geographic markets that show disparities in the disposition of loan applications by race, ethnicity, or other characteristics that require investigation under the fair lending laws. With the addition of price data for higher-priced loans, the agencies will be able to more easily identify price disparities that require investigation. If disparities are found to violate the ECOA or FHA, certain federal agencies are authorized to compel lenders to cease discriminatory practices and, among other remedies, obtain monetary relief for victims. The public disclosure of price information under HMDA - in the form of spreads between the annual percentage rate (APR) on a loan and the rate on Treasury securities of comparable maturity - is designed to ensure that the data continue to be useful in improving market efficiency and legal compliance. The APR represents the cost of credit to the consumer and captures the contract-based interest rate on a loan as well as the points and fees that consumers pay up front, converted to a percentage rate. But since these fees have to be amortized over the term of the loan to calculate the APR, and since interest rates vary over time, even the APR can be difficult to use as a basis of comparison across loans. Because of interest-rate fluctuations, the HMDA rules require lenders to report the difference between the APR and the rate on Treasury securities of comparable maturity for any loans with rate spreads that exceed prescribed thresholds. For first-and second-lien loans, the thresholds are 3 percentage points and 5 percentage points above the Treasury security of comparable maturity, respectively. These particular thresholds were chosen to exclude the reporting of the vast majority of prime-rate loans and include the vast majority of the subprime-rate loans, minimizing the burden of the data collection on lenders while providing information on that portion of the market where concern about consumer abuse is most prevalent. Although the addition of the price data significantly increases the robustness of HMDA data, the data alone do not prove discrimination. Instead, the data will be used as a screen to identify any aspects of the higher-priced end of the mortgage market that warrant closer scrutiny. The new HMDA data are clearly limited: they do not include credit scores, loan-to-value ratio, or consumer debt-to-income ratio - all factors relevant to the cost of credit. Because these important determinants of price are missing, one cannot draw definitive conclusions about whether particular lenders discriminate unlawfully or take unfair advantage of consumers based solely on a review of the HMDA data. The new data will be useful to examiners in identifying particular loan products or geographic areas with significant pricing disparities and establishing one or more focal points for a pricing analysis that would include a review of all the factors relevant to a particular institution’s pricing decisions. The Board did consider adding other data elements relevant to pricing to the HMDA collection. For each possible new data item, we weighed the potential benefits and costs. On the basis of that analysis and careful consideration of public comments, we decided not to add more factors. In addition to the cost to lenders of collecting additional data, more data being made publicly available would create very real privacy concerns. As it stands, many of the HMDA data fields are unique and can be matched with other information to determine the identity of individual borrowers. Given the costs and limitations of collecting additional data, we felt that the potential for further privacy losses outweighed the usefulness of the additional data. It is always possible that banks could disclose additional information on their own, but even this is questionable from a legal standpoint. The recent Fair Credit Reporting Act limits financial institutions’ ability to share consumer reports (such as credit scores) with third parties. Regardless, the new data still offer the public and supervisory agencies charged with enforcement of the fair lending laws a better screening tool than was previously available. Until now, in determining whether a lender is discriminating in its pricing decisions, examiners have relied on several factors: the relationship between loan pricing and compensation of loan officers or brokers; lender policies giving loan officers broad pricing discretion; the use of empirically based and statistically sound risk-based pricing systems; disparities among prices quoted or charged to applicants who differ in their protected characteristics (such as race); and consumer complaints alleging price discrimination. These data will still be used, but the APRs will make the high-cost loan assessments much more precise. Although discussions of the new HMDA pricing data have just begun, some outcomes should be anticipated. First, a debate will continue about what the HMDA data say about the lending practices of individual institutions. Some community groups have already publicized their analysis of the data provided by individual institutions, and those institutions have responded. The attorney general for New York is also reviewing the data of several institutions. I anticipate that these inquiries and the conclusions drawn from them will continue for several months. Second, lenders can gain an increased awareness of the lending and pricing practices of their organizations, and of their competitors, through analysis of HMDA data. As a result, lenders may take opportunities to compete in areas where the data show concentrations of high-priced lending. Competitive pressures in such markets should increase efficiency in pricing, ensuring that prices for mortgages are commensurate with risk and do not just reflect an absence of competition. Third, new and strengthened collaborations should emerge among lenders, community groups, realtors, and other participants in the real estate market. As lenders seek to enter new markets, or to better serve their existing markets, the groups that have an intimate knowledge of their communities will be viewed as valuable partners. Finally, increased importance will be placed on the value of financial education to help consumers shop for and obtain the mortgage loan that represents the best price and terms for their financial situation and needs. The broad array of mortgage loan products makes choosing difficult, even for those with financial savvy. The choices are substantially more confusing for those with credit-impaired histories or those who are unfamiliar with the different types of financial service providers and products. Consumers are often bewildered by the mortgage credit process, and the consequences of poor choices or misunderstanding or misinformation can have lasting effects on their financial wellbeing. An early look at the data As I said earlier, as of March 31, lenders have been required to make their individual HMDA data available. Many press reports have discussed these data and there is already a vigorous debate about what the data do, and will, show. The Federal Reserve is now editing the data, and its reports will not be complete until September. Until then, we can only provide a broad preview of the overall picture. In 2004, some 8,800 lenders reported 37 million loan applications, compared with 8,100 lenders with 42 million loan applications in 2003. The drop in the number of loan applications reflects the slowing of the refinance market last year. The increase in the number of lenders is partly the result of the expanded coverage of the Board’s amendments, but it could also suggest increasing competition in the home mortgage industry. Regarding subprime lending, back in 1994 the subprime market, defined as high-cost mortgage loans, amounted to $35 billion, or 5 percent of total mortgage originations. By 2004, the subprime market had exploded to $530 billion, or 19 percent of total mortgage originations. The annual subprime market growth rate over this time was a whopping 27 percent. The initial data also suggest that prevalence of higher-priced loans differs notably across racial and ethnic groups. As some press accounts have implied, the data indicate that blacks and Hispanics are more likely to take out higher-priced loans than non-Hispanic whites, and that Asians are the least likely to have higher-priced loans. These preliminary data also seem to indicate that the actual prices paid by those taking out higher-priced loans are about the same for different racial groups. Until the editing process is complete, more details cannot be provided. Needless to say, everyone will have an opportunity to review the final data when they are released in September. Conclusion In closing, I cannot emphasize enough the importance of your role. By understanding the potential usefulness and limitations of the data, and conveying those messages clearly, we can promote a more efficient market and compliance with anti-discrimination laws without unfairly tarnishing the reputations of particular lenders. No one will be served if lenders are unwilling to enter, or remain in, certain higher-priced segments of the market. The most effective way to lower the cost of credit to higher-risk borrowers is to promote a competitive marketplace. And one of the most effective ways of ensuring competition is to make data available.
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Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Annual Meeting of the Conference of State Banking Supervisors, San Antonio, Texas, 3 June 2005.
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Mark W Olson: The health of the banking industry Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Annual Meeting of the Conference of State Banking Supervisors, San Antonio, Texas, 3 June 2005. * * * Let me congratulate the Conference of State Banking Supervisors on another successful and informative annual meeting. The dual banking system is critical to the remarkable diversity and flexibility of our financial system. This system encourages innovation and responsiveness, while serving as a bulwark against regulatory excesses. It supports a dynamic and competitive financial services market that yields tangible benefits for consumers, businesses, and the economy as a whole. The dual banking system could not function without close cooperation and understanding between federal and state supervisors. As you know, the Federal Reserve has consistently been a strong supporter of the dual banking system, and I have every reason to believe that support will continue. We understand, as you do, the importance of a safe and sound banking system to the proper functioning of the economy. We also understand the role of effective supervision in ensuring that our banks are sound. At the conclusion of your three days here, let me offer some perspectives on the financial performance of the banking industry and share my thoughts on what that performance might imply for supervisors. Performance of the banking industry The banking industry began this year with a lot of momentum: In 2004, bank profits exceeded $100 billion for the second consecutive year and indeed the second time ever. The industry delivered this excellent performance as it adapted to rising interest rates and more-rapid economic growth, including a gradual improvement in business loan demand. First-quarter earnings announcements by the major banks were generally quite positive, highlighting further acceleration in loan growth, continuing improvement in credit quality, and robust trading revenues. Call Report information tells the same story. Insured commercial banks reported record earnings of $29 billion in the first quarter, an increase of 10.7 percent from the fourth quarter of 2004. These earnings represent an attractive return on assets of 1.38 percent. Overall return on common equity came in at 13.76 percent, damped a little by the significant increases in reported shareholders’ equity associated with last year’s banking mergers. Loan growth was solid at about 2 percent, including a pickup in the growth of commercial and industrial (C&I), construction, and mortgage loans. Bankers have been pleased to report that C&I loans have shown greater strength, consistent with loan officer surveys and market reports that indicate loan demand has returned. That said, the rate of increase in loans was much lower at community banks than for the industry as a whole. Increases in home equity lines of credit remained rapid at nearly 4 percent but were below the remarkable 10 percent increases seen in the second and third quarters of last year. We understand that much of the construction lending has been for residential construction, consistent with the very strong housing market. Banks were not able to fully enjoy the benefits of growth in loans and securities, however, because banks’ net interest margins narrowed further to 3.61 percent. Rising short-term interest rates, a flattening yield curve, competitive pressure on spreads, and rapid growth in assets funded with purchased money each played a role in the margin compression. The net result was that, despite solid asset growth, the industry’s net interest income barely rose in the first quarter. This narrowing trend in margins bears watching, including the extent to which competitive pressures are playing a significant role. Banks have been managing their core deposits carefully as one means to limit the narrowing of their margins. As market interest rates fell in 2000 and 2001, banks reduced the rates on their nonmaturity deposits more slowly than rates on comparable nondeposit instruments had declined. This strategy helped banks to retain their deposit customers and attract new balances; money market and savings accounts now fund 30.8 percent of bank assets. In addition, this approach allowed banks to reclaim some of the market share they had lost to nondeposit products. As short-term interest rates have risen, banks have repriced these deposits more slowly. Steady improvement in already-strong asset quality has supported earnings growth by allowing for lower provisions. Many in the industry still expect provisioning to increase over the course of 2005, although that did not happen in the first quarter. At this point, it appears that such increases will primarily reflect growth in loan portfolios because asset quality has not yet shown signs of impending deterioration. For example, by the end of the first quarter, problem assets had fallen to 0.59 percent of loans, down considerably from 1.27 percent in September 2002, the peak level for this credit cycle. Improvement in economic conditions is a key reason for this sustained decline in problem assets, along with the liquidity and depth of secondary markets for troubled loans and, we believe, better risk management. Fees in some market-sensitive businesses, especially trading, showed renewed strength in the first quarter. Service charges on deposits weakened as a result of fewer retail overdrafts and the indirect effects of increases in compensating balances - as higher market interest rates boosted internal earnings credit rates on such balances - that damped direct-fee revenue received from commercial depositors. Mortgage banking revenues from servicing activities have been robust, although those from originations are tailing off. Despite frequent reports from bankers that their compliance costs have increased significantly and that they have incurred some significant nonrecurring charges, expense control in the industry has been good. At this point, the available indicators suggest that banks’ earnings prospects remain favorable. Nevertheless, bankers would probably admit they would like to see a greater share of their earnings growth come from improved lending and margins rather than lower provisions. Bank capital ratios remain very strong. Some 99 percent of banks in the United States are well capitalized, matching the highest proportion we have ever seen. Regulatory capital ratios are not affected by merger-related increases in nominal capital, of course, because intangible goodwill assets are deducted from regulatory capital. Community banks The aggregate performance measures I have just described are quite significantly influenced by the largest banks. However, most commercial banks are community banks - banks with assets of less than $1 billion. In 2004, community banks once again demonstrated their value to their shareholders and the marketplace, earning $13.4 billion for a respectable return on assets (ROA) of 1.21 percent and a return on shareholders’ equity of 11.72 percent. Community banks also reported strong results in the first quarter of 2005. Profits of $3.6 billion reflected mixed developments in key businesses, a significant and favorable seasonal influence, and many of the same factors that affected the industry as a whole. Compared with the prior year, community bank profitability improved somewhat with a ROA of 1.27 percent, up 5 basis points from the same quarter of 2004, and a return on equity (ROE) of 12.33 percent, an improvement of about 50 basis points. On this year-over-year basis, improved asset quality allowed for lower provisions, but margins were tighter. Only about 5 percent of community banks lost money for the year - and those institutions represented only about 2 percent of total community bank assets. Community bank loans grew less than 1 percent in the first quarter compared with the fourth quarter of 2004, a rate that was about half the pace for the industry as a whole. Increases in C&I and one- to four-family mortgage loans were more subdued for community banks than they were for other banks. Commercial real estate loans continued to grow smartly, however, and I’ll have a bit more to say about that in a minute. Consolidation is continuing among community banks, and the data tell the story. There were 7,146 community banks at the end of March 2005, about 140 fewer (2 percent) than a year earlier and about 770 fewer (9.7 percent) than at year-end 2000. Consolidation can also be seen at bank holding companies (BHCs), which own 97 percent of commercial banking assets. The number of BHCs has fallen slightly - about 4 percent - over the past decade, but this figure has increased a bit in three of the past four years. The number of multibank BHCs has decreased about one-third over the past decade, reflecting the tendency of banks to consolidate subsidiary charters in this era of nationwide banking. Although bank consolidation largely reflects the search for efficiency and scope, it does not signal a threat to the banking charter or the community banking franchise. Consolidation and the growth of large banking organizations do not alter the fundamental competitive advantages that banks enjoy, namely, deposit insurance, reputation and public confidence, branch networks and other delivery systems, and technology. The market for new bank charters makes this point clear. Some 124 new commercial bank charters were issued in 2004, and another 32 in the first quarter of 2005. Counting these charters, 718 charters have been issued since the beginning of 2000. Over that same period, for every three banks that disappeared through consolidation, another two new charters were granted. In total, the new charters represent about $5.4 billion in new equity capital invested in community bank charters. Issues that bear watching As in the past, the continued vitality of the banking charter calls for strong and prudent management, something that can be a challenge in this dynamic environment. A key issue for management’s attention at this time is the sustained rapid growth in commercial real estate lending - that is, construction loans as well as loans secured by nonfarm nonresidential and multifamily properties. Let me take a moment to put that growth in perspective. At community banks, growth in commercial real estate lending (CRE) - nearly $32 billion in 2004 alone - has accounted for at least two-thirds of total asset growth every year since 2001; CRE lending accounted essentially for all of the asset growth at these institutions in 2003 and 2004. By March of this year, CRE lending had reached 28 percent of aggregate community bank assets, a new record for community banks that exceeded the previous record set in the early 1990s. The bulk of CRE lending is in the form of commercial mortgages, which themselves have risen by an average of 10 percent annually since 1998. However, construction lending has also been assuming a larger share of the pie. Among community banks, construction loans increased at a compounded growth rate of 17.4 percent annually over the same period. This is a remarkable pace of growth - and a growing concentration for community banks. CRE lending is a traditional and natural part of the community banking franchise. Underwriting practices continue to be much better than they were in the troubled days of the 1980s. There is no indication at this time that the overall credit quality of CRE exposures at community banks has deteriorated, although there are signs that some underwriting standards have been under assault from competitive pressures. Nonetheless, credit risk concentrations are a critical “franchise” risk for bankers, especially community bankers, and they can assume even greater importance when they involve high-growth lines of business. Successful identification and management of these concentrations requires adherence to good credit fundamentals. Strong capital ratios - ratios that are well in excess of regulatory minimums have been a key factor in managing credit concentrations and a striking attribute of the most profitable community banks. More generally, the competitive drive to win borrowers should not be allowed to overcome the disciplines of prudent lending practice. As economic conditions and business loan demand have improved, we have expected and seen some degree of easing in commercial lending standards. Competitive pressures and the natural desire to generate loan volume, however, can provide ample temptation to make lending decisions that bankers and their supervisors will live to regret. In a similar vein, supervisors have been attentive to indications that home equity lending standards and risk-management practices may not have kept up with the very rapid growth in this form of lending. Last month, the federal banking agencies issued guidance to the industry that was aimed at reinforcing sound practices for lending and credit risk management. I encourage bankers to review that guidance and consider its recommendations carefully. Let me conclude with a few thoughts on managing interest rate risk. In the low-rate period that ended last summer, bankers faced a natural temptation to extend maturities in search of more-attractive rates of return. From 2000 to early 2004, the share of community bank assets maturing beyond five years had grown steadily from 16.9 percent to 18.4 percent, respectively. Since then, the share of these assets has been pared back to 16.3 percent, as short-term interest rates have increased. Bankers continue to rely significantly on the interest rate protection provided by their stable and reliable core deposit base. If recent deposit growth has been fueled by low interest rates and weakness in the equity markets, unexpected liquidity and interest rate pressures may develop if deposit customers shift funds to other investment vehicles. We need to remember that depositor behavior can change, as it did in the high-interest-rate environment of the late 1970s and early 1980s. Conclusions The U.S. banking industry is healthy, strong, profitable, and well positioned to support economic growth and prosperity. Banks have been able to adapt to changing circumstances and still generate record profits. The outlook for performance in the coming year is good. Community banks continue to demonstrate their value to the marketplace and to occupy a prominent position in the economy. New challenges, and perhaps some new opportunities, will arise as we move ahead. Adapting to change is an important aspect of the banking business and an important strength of bank charters, and the ability to respond well to changing circumstances has been a key to sustained profitability. The continued vibrancy of the bank charter depends on prudent management and a recognition of both the risks and rewards of aggressive growth.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, to the International Monetary Conference, People¿s Republic of China, Beijing, (via satellite), 6 June 2005.
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Alan Greenspan: Central bank panel discussion Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, to the International Monetary Conference, People’s Republic of China, Beijing, (via satellite), 6 June 2005. * * * The pronounced decline in U.S. Treasury long-term interest rates over the past year despite a 200-basis-point increase in our federal funds rate is clearly without recent precedent. The yield on ten-year Treasury notes currently is at about 4 percent, 80 basis points less than its level of a year ago. Moreover, despite the recent backup in credit risk spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasuries over the same period. The unusual behavior of long-term rates first became apparent almost a year ago. In May and June of last year, market participants were behaving as expected. With a firming of monetary policy by the Federal Reserve widely expected, they built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with a rising federal funds rate. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In March of this year, market participants once again bid up long-term rates, but as occurred last year, forces came into play to make those increases short lived. But what are those forces? Clearly, they are not operating solely in the United States. Long-term rates have moved lower virtually everywhere. Except in Japan, rates among the other foreign Group of Seven countries have declined notably more than have rates in the United States. Even in emerging economies, whose history has been too often marked by inflationary imbalances and unstable exchange rates, access to longer-term finance has improved. For many years, emerging-market long-term debt denominated in domestic currencies had generally been unsalable. But in 2003, Mexico, for example, was able to issue a twenty-year maturity, peso-denominated bond, the first such instrument ever. In recent months, Colombia issued domestic-currency-denominated global bonds. As rates came down worldwide, dollar-denominated EMBI+ spreads over U.S. Treasuries receded to historically low levels, before widening modestly of late. *** A number of hypotheses have been offered as explanations of this remarkable worldwide environment of low long-term interest rates. One prominent hypothesis is that the markets are signaling economic weakness. This is certainly a credible notion. But periodic signs of buoyancy in some areas of the global economy have not arrested the fall in rates. A second hypothesis involves the behavior of pension funds. As the inevitable increases in retirement populations approach, especially among developed countries, the underfunding of retirement plans has become a growing concern. Pension funds and insurance companies, are being pressed to make significant additions to longer-term bond portfolios. This demand for increasingly longer-term obligations is evident in the favorable reception given the fifty-year-maturity bonds recently issued by France and the United Kingdom. But world demographic trends are hardly news, and recent adjustments to funding shortfalls do not seem large enough to be more than a small part of a complete explanation. The heavy accumulation of U.S. Treasury obligations by foreign monetary authorities is yet another hypothesis that has been offered. And, doubtless, those purchases have lowered long-term U.S. Treasury rates. But, given the depth of the market for long-term Treasury instruments, the Federal Reserve Board staff estimates that the effect of foreign official purchases has been modest. Furthermore, such purchases seem an implausible explanation of why yields on long-term non-U.S. sovereign debt instruments are so low. A final hypothesis takes as its starting point the breakup of the Soviet Union and the integration of China and India into the global trading market, developments that have permitted more of the world's lower-cost productive capacity to be tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of cost-reducing investments. The enlargement of global markets for goods, services, and finance has contributed importantly to the favorable inflation performance that we are witnessing in so many countries. That improved performance has doubtless contributed to lower inflation-related risk premiums, and the lowering of these premiums is reflected in significant declines in nominal and real long-term rates. Although this explanation contributes to an understanding of the past decade, I do not believe it explains the decline of long-term interest rates over the past year despite rising short-term rates. *** Whatever the underlying causes, low risk-free long-term rates worldwide seem to be one factor driving investors to reach for higher returns, thereby lowering the compensation for bearing credit risk and many other financial risks over recent years. The search for yield is particularly manifest in the massive inflows of funds to private equity firms and hedge funds. These entities have been able to raise significant resources from investors who are apparently seeking above-average risk-adjusted rates of return, which, of course, can be achieved by only a minority of investors. To meet this demand, hedge fund managers are devising increasingly more complex trading strategies to exploit perceived arbitrage opportunities, which are judged - in many cases erroneously - to offer excess rates of return. This effort is particularly evident in the pronounced growth and increasing complexity of collateralized debt obligations. Although collateralized debt obligations are a powerful tool for enhancing risk management by separating idiosyncratic risks from systematic risks, the models used to price and hedge these instruments are just beginning to be tested. I have no doubt that many of the new hedge fund entrepreneurs are embracing a strategy of pinpointing temporary market inefficiencies, the exploitation of which is expected to yield aboveaverage rates of return. For the time being, most of the low-hanging fruit of readily available profits has already been picked by the managers of the massive influx of hedge fund capital, leaving as a byproduct much-more-efficient markets and normal returns. But continuing efforts to seek above-average returns could create risks for which compensation is inadequate. Significant numbers of trading strategies are already destined to prove disappointing, a point that recent data on the distribution of hedge fund returns seem to be confirming. Consequently, after its recent very rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy. But so long as banks and other lenders to these ventures are managing their credit risks effectively, this necessary adjustment should not pose a threat to financial stability. I trust such an episode would not induce us to lose sight of the very important contributions hedge funds and new financial products have made to financial stability by increasing market liquidity and spreading financial risk, and thereby enhancing economic flexibility and resilience. *** The economic and financial world is changing in ways that we still do not fully comprehend. Policymakers accordingly cannot always count on an ability to anticipate potentially adverse developments sufficiently in advance to effectively address them. Thus our economies require, in my judgment, as high a degree of flexibility and resilience to unanticipated shocks as is feasible to achieve. Policymakers need to be able to rely more on the markets' self-adjusting process and less on officials' uncertain forecasting capabilities. The U.S. economy's response to the terrorist attacks of September 11, 2001, is a case in point. That shock was absorbed by a recently enhanced, highly flexible set of institutions and markets without significantly disabling our economy overall. But that flexibility should not be taken for granted, and every effort should be made to preserve and extend it. In this regard, the recent emergence of protectionism and the continued structural rigidities in many parts of the world are truly worrisome. In the end, I trust that we will all recognize our common interest in fostering global and domestic arrangements that promote the prosperity of our citizens.
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board of governors of the federal reserve system
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