[Senate Hearing 108-769]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-769


        FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2004

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                                   ON

      OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- 
       ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978

                               __________

                             JULY 20, 2004

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

               Peggy R. Kuhn, Senior Financial Economist

             Martin J. Gruenberg, Democratic Senior Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                         TUESDAY, JULY 20, 2004

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Dole.................................................     2
    Senator Bunning..............................................     2
    Senator Carper...............................................     3
    Senator Reed.................................................     4
    Senator Crapo................................................     4
    Senator Bayh.................................................     4
    Senator Sununu...............................................     5
    Senator Sarbanes.............................................     5
    Senator Hagel................................................     6
    Senator Dodd.................................................     6
    Senator Allard...............................................     6
        Prepared statement.......................................    36
    Senator Schumer..............................................     7
    Senator Corzine..............................................     7
    Senator Bennett..............................................    26

                                WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal 
  Reserve System, Washington, DC.................................     7
    Prepared statement...........................................    36
    Response to written questions of:
        Senator Shelby...........................................    40
        Senator Bunning..........................................    42
        Senator Crapo............................................    43
        Senator Sununu...........................................    44
        Senator Stabenow.........................................    46

              Additional Material Supplied for the Record

Foreign Official Assets in the United States chart, submitted by 
  Senator Paul S. Sarbanes.......................................    48
Monetary Policy Report to the Congress, July 20, 2004............    49

                                 (iii)

 
                   FEDERAL RESERVE'S SECOND MONETARY
                         POLICY REPORT FOR 2004

                              ----------                              


                         TUESDAY, JULY 20, 2004

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met, at 2:31 p.m., in room SH-216 of the Hart 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order. I am very 
pleased this afternoon to welcome Chairman Greenspan before the 
Committee on Banking, Housing, and Urban Affairs, to testify on 
the Federal Reserve's Semi-Annual Monetary Policy Report to the 
Congress.
    Chairman Greenspan, the U.S. economy is continuing its 
expansion with real GDP increasing 3.9 percent in the first 
quarter of 2004. I hope we can now also point to strong job 
growth with payroll employment increasing for 10 straight 
months with an average of 200,000 jobs per month in the first 
half of this year. I think overall this is good news for the 
American worker and we hope to see even better numbers on jobs 
and wages in the months ahead.
    When this Committee heard from you in February of this 
year, the Federal Open Market Committee had just stated that 
the Committee could be ``patient'' in changing its 
accommodative monetary policy. The FOMC then indicated in May 
that changes in its policy were ``likely to be measured.'' At 
its June meeting, the Federal Open Market Committee raised its 
target for the Federal funds rate by 25 basis points to 1\1/4\ 
percent--the first increase since May 2000. This move was 
widely anticipated by financial markets, and I think overall it 
has helped ease inflationary fears.
    Some Fed watchers have expressed the concern that the FOMC 
waited too long to increase its target Federal funds rate 
target. However, last week's report on retail sales and 
industrial production seemed to indicate that the Fed's actions 
have been prudent. Also, since the FOMC's June action, the 
markets have responded by a reduction, as you well know, in the 
long-term interest rate.
    This afternoon, I think we will have ample opportunity to 
discuss the Federal Reserve's views on the economy and how we 
might interpret the FOMC statement on changes in monetary 
policy which are ``likely to be measured.'' And, perhaps we 
will even garner some insight as to the FOMC's consideration at 
its upcoming August meeting.
    Mr. Chairman, as I had indicated to you a minute ago, there 
is a vote going on. Some of us voted early, and we will have a 
lot of Members to join us. We look forward to your remarks, but 
first, Senator Dole, any statement?

              STATEMENT OF SENATOR ELIZABETH DOLE

    Senator Dole. Thank you, Chairman Shelby.
    Today, we welcome Chairman Greenspan back to this Committee 
for our fourth and final Semi-Annual Monetary Policy Report of 
the Federal Reserve for this Congress. I appreciate the 
Chairman's willingness to visit with us so often, and explore 
areas of concerns with regard to our economy and monetary 
policy.
    Last month, Chairman Greenspan assured us that he has 
observed real wages increasing for Americans in the past 4 
months. This, in turn, has helped increase disposable income, a 
trend that I understand Chairman Greenspan expects to continue 
as the natural course of the recovery and growing strength of 
our economy. I cannot overstate the importance of this trend 
for our men and women in the workforce, and appreciate Chairman 
Greenspan's continued optimism in the American economy. I was 
very pleased with the release last week of the June industrial 
production data, indicating the growing strength in the 
manufacture of durable capital goods. North Carolina has been 
hit very hard by the loss of manufacturing jobs over the past 
years. Any reversal of this trend is indeed welcome news.
    There have been some excellent numbers for North Carolina--
according to figures released today from the Bureau of Labor 
Statistics--North Carolina has created 35,400 new jobs in the 
month of June. This positive news highlights the transition 
which is occurring in North Carolina with the loss of low-
skilled manufacturing jobs and the creation of jobs in service 
sectors which require a good education with a demand on 
computer skills. Continuing education must continue to be a top 
priority for us to respond to this demand.
    I have spoken before about the work that Senators Enzi, 
Alexander, and I are undertaking to write the Higher Education 
Access, Affordability, and Opportunity Act of 2004. It will 
provide additional assistance to our community colleges and 
other institutions of higher learning for training and 
retraining students in high-growth job markets. We hope to 
introduce this bill shortly.
    In addition, I remain concerned about a number of factors 
such as high energy prices, the rise in steel prices, and the 
size of our trade deficit. Despite these concerns though, I am 
confident that through increased trade, hard work, global 
communications, and continuing education of our workforce, we 
will achieve new levels of opportunity for all Americans and 
global security.
    I, again, thank Chairman Greenspan for joining us here 
today, and I will look forward to his testimony.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman.
    I am glad that we get you first this time, Chairman 
Greenspan--the House usually shares that opportunity with us--
because given the June economic figures, especially the housing 
figures that came out today, I know many want to know what you 
make of these figures, and that is especially true of this 
Committee.
    When the FOMC raised rates 25 basis points on June 30, it 
was a move that was largely expected. Many in the economic 
talking heads class said the market had already built in this 
rate adjustment. However, since that raise, as of last night's 
close, the Nasdaq market has lost 164 points, and the Dow has 
lost 341 points. It has not been a very good 3 weeks for our 
stock markets. I am not sure the June economic figures were 
what the FOMC had in mind when it made its decision to raise 
rates. I do not think any of us like the figures we have seen. 
We can do better on all fronts. We did have another jobs 
increase, but I still think we can do better. We need to make 
sure those who want a job can find one.
    I am also concerned with some of the recent corporate 
earnings that have been reported, especially in the airlines 
industry. Delta Airlines has been a major presence in Northern 
Kentucky and in Kentucky in general. Their Northern Kentucky 
hub has been an economic engine for all of Kentucky. It is a 
major reason why companies such as Toyota, Fidelity, Citigroup, 
to name a few, have built facilities in Kentucky. Delta also 
has a great many employees in my State, about 8,000 in the 
Northern Kentucky area. Delta's health is a very large concern 
to my State.
    I do not know what the answer is, but I know other Members 
of this Committee have similar concerns about airlines with 
major operations in their States. I also think many are 
concerned about the new housing starts figures that were 
released today. As you know, the housing sector helped carry 
our economy during the last recession. Obviously, at some point 
this would have to cool down, just a little I hope, but it was 
a pretty dramatic drop both in May and in June. That came as a 
surprise to me. I would like to hear your take on this. Is this 
so-called housing bubble bursting? Is it something we need to 
be concerned with, or was it inevitable that the housing market 
would have to slow some?
    I am concerned with how our economy is faring right now, 
especially with the June figures coming in. Energy prices were 
falling, but they are back on the rise. The stock market is 
down and housing is down. It seems that our recovery had a 
definite hiccup in June. I guess the $64,000 question, was it a 
hiccup or something that we should be more concerned about?
    Also, as I mentioned earlier, most of the economic talking 
heads stated that the FOMC rate raise was built into the 
market. They seem to have been proven wrong. They also stated 
that a second rate increase was pretty much a done deal for 
August. I hope the Fed is not on automatic pilot. I would like 
you to look closely at the June figures, and I know you will, 
before a decision is made in August. I do not want a hiccup to 
turn into the flu.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Carper.

              COMMENT OF SENATOR THOMAS R. CARPER

    Senator Carper. I have no prepared remarks, Mr. Chairman.
    Chairman Greenspan, welcome. I look forward to hearing your 
testimony.
    Chairman Shelby. Senator Reed.

                 COMMENTS OF SENATOR JACK REED

    Senator Reed. Thank you, Mr. Chairman.
    Thank you, Chairman Greenspan, for attending.
    It does look like we are recovering jobs, but those jobs 
seem to not have the same wages and earnings of previous jobs 
that were lost, and that is a significant issue. We have had a 
chance to talk about this before, but until we can really 
establish wage and earning growth among a broad sector of 
American workers, I do not think we are going to see a robust 
economic recovery, and we are going to continue to have 
families that are trying to make ends meet by borrowing. And as 
interest rates go up--and you have already raised them and you 
might contemplate raising again--that will put additional 
pressure on families. So there is perhaps some encouraging 
news, but there is also a very different reality we have to 
cope with, and I am looking forward to your testimony.
    Thank you.
    Chairman Shelby. Senator Crapo.

                 COMMENTS OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman.
    Chairman Greenspan, it is a pleasure to welcome you back 
here.
    I am going to say at the outset my duty is to preside over 
the floor in about 18 minutes, so I will not be here too far 
into your testimony. In fact, I may miss your testimony. I am 
going to read it very carefully, however, and I do share some 
of the questions that you have already heard. The main 
question, of course, that we want to see, is whether the 
expansion that we are now seeing is capable of sustaining 
itself, what the numbers from June meant, and how we can look 
forward now in terms of gauging the strength of the expansion 
and what is going to happen with inflation. I do appreciate 
your careful attention to the inflation in our economy.
    I do want to pose one question for you to consider either 
during your testimony or perhaps in follow up if it does not 
come up there. That is, as you know, a divided SEC voted 3 to 2 
last Wednesday to seek comments on a proposal for mandatory 
registration of hedge funds advisers with the SEC. My question 
is whether you are concerned with this SEC proposal for 
mandatory registration of hedge fund advisers with the SEC, and 
whether you think it would be advisable for the President's 
Working Group on Financial Markets to become involved in issues 
relating to the regulation of the hedge fund industry.
    With that, again, I welcome you here, and I look forward to 
your testimony.
    Chairman Shelby. Senator Bayh.

                  COMMENT OF SENATOR EVAN BAYH

    Senator Bayh. Thank you, Mr. Chairman. I look forward to 
hearing from Chairman Greenspan, and I will reserve other 
comments until the question period.
    Chairman Shelby. Senator Sununu.

               COMMENT OF SENATOR JOHN E. SUNUNU

    Senator Sununu. I have no opening statement. Welcome, Mr. 
Chairman.
    Chairman Shelby. Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Mr. Chairman, thank you very much. I am 
pleased to welcome Chairman Greenspan back before our Committee 
to testify on the Federal Reserve's Semi-Annual Monetary Policy 
Report to Congress.
    This was a requirement put into law by this Committee with 
actually the support of the Fed, and I think it has worked very 
well over the years.
    As we all know, of course, at the last meeting of the 
Federal Open Market Committee, they decided to raise the target 
for the Federal funds rate by 25 basis points to 1\1/4\ 
percent, the first change in interest rates by the Fed in about 
a year's time.
    In a statement released after the meeting--and I want to 
commend Chairman Greenspan and his colleagues for this shift in 
practice, whereby after the FOMC makes decisions, they seek to 
explain them, however briefly, to the public. The FOMC said 
they ``perceive the upside and downside risks to the attainment 
of both sustainable growth and price stability for the next few 
quarters are roughly equal. With underlying inflation still 
expected to be relatively low, the Committee believes that 
policy accommodation can be removed at a pace that is likely to 
be measured. Nonetheless, the Committee will respond to changes 
in economic prospects as needed to fulfill its obligation to 
maintain price stability.''
    The final sentence of that paragraph has generally been 
read to suggest that the FOMC will take a more aggressive 
stance toward monetary policy if economic conditions warrant. 
But, I would just like to note, in light of the recent economic 
indicators that have been released, that the sentence could 
also be read to suggest that the FOMC may tilt in the other 
direction if, in fact, it is necessary.
    While the outlook for economic growth remains positive, 
most forecasts are being revised downward. GDP growth for the 
first quarter of the year was revised downward to 3.9 percent. 
Last week, the Commerce Department reported an unexpectedly 
large decline in retail sales for June of 1.1 percent. The Fed 
reported a 0.3 percent decline in industrial production. And 
just this morning, the Commerce Department reported that 
housing construction fell 8\1/2\ percent in June, the sharpest 
drop since February 2003.
    While these are all just monthly numbers, they raise 
questions about the strength of the economic outlook. That is 
particularly true when taken together with a continuing 
weakness in the labor market.
    Job growth in May declined from the 300,000 figure of March 
and April to 250,000, and in June was cut in half to 112,000. 
As a result of the prolonged labor market weakness, the economy 
remains 1.2 million jobs below the level when the recession 
began 39 months ago. Compared to the average economic recovery 
of the post-war era, today's economy is nearly 6 million jobs 
short.
    Further, in June, 1.7 million of the unemployed, 21.6 
percent of the total, had been unemployed an average duration 
of 20 weeks. The long-term unemployed have made up over 20 
percent of the unemployed for the past 21 months, surpassing 
the record set from 1982 to 1984.
    As The New York Times reported on Sunday, the slack labor 
market is resulting in the failure of hourly pay in the United 
States to keep pace with inflation. The article points out that 
the Bureau of Labor Statistics reported last Friday, that 
hourly earnings of production workers fell 1.1 percent over the 
past 12 months, after accounting for inflation. The decline is 
the steepest since the recession of 1991.
    And only this morning, The Wall Street Journal had an 
article entitled, ``So Far, Economic Recovery Tilts to Highest-
Income Americans,'' and goes on to note that, ``The recovery's 
primary beneficiaries have been upper-income households.''
    Finally, Mr. Chairman, in closing I simply want to take 
note that Virgil Mattingly, who had served as General Counsel 
for the Federal Reserve Board and the Federal Open Market 
Committee for the past 15 years, and who served a total of 30 
years at the Federal Reserve, just retired on June 30.
    Virgil Mattingly worked closely with the Members and staff 
of this Committee on every major piece of banking legislation 
enacted over the past 20 years. He always provided not only 
exceptionally intelligent and competent technical assistance to 
the work of this Committee, but also wise counsel and wise 
advice. He was, in my view, an extraordinarily able and 
dedicated public servant, and upheld, and indeed in some 
measure helped to define, the tradition at the Federal Reserve 
of an outstanding career of service. He made very significant 
contributions to our Nation and to the formulation of public 
policy. I simply wanted to take this opportunity to wish him 
well in his retirement, and to express appreciation for the 
fine work he did over the years.
    I also want to take this opportunity to congratulate Scott 
Alvarez, who has been Associate General Counsel for the Federal 
Reserve, and has been appointed to succeed Virgil Mattingly as 
the Fed's General Counsel. Scott Alvarez is also well known and 
highly regarded by the Members and staff of this Committee, and 
we look forward to continuing to work closely with him in his 
new capacity.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Hagel.

                 COMMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. I have no statement, Mr. Chairman.
    Chairman Shelby. Senator Dodd.

             COMMENT OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Mr. Chairman, I will wait, and I will just 
ask unanimous consent that my statement be included in the 
record.
    Chairman Shelby. Without objection, so ordered.
    Chairman Shelby. Senator Allard.

                COMMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, I would like to thank you for 
holding this hearing, and I always look forward to hearing from 
the Chairman, and I will submit my full statement to the 
record.
    Chairman Shelby. Without objection, it will be made part of 
the record.
    Chairman Shelby. Senator Schumer.

             COMMENTS OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman. I would ask that 
my full statement be submitted to the record.
    Chairman Shelby. Without objection, so ordered.
    Senator Schumer. The only observation I would make is there 
are two wings to our economic policy here. There is fiscal 
policy and monetary policy. The thing you are here to report on 
and the thing you are in charge of, monetary policy, I think 
you are doing a superb job. I think the quarter-inch steps that 
you have made is just about perfect for our situation. But I do 
worry about our fiscal policy, and sometimes, as you well know, 
much of the time, lower interest rates are better for the 
economy than lower taxes, and that will be the line of my 
questions.
    Chairman Shelby. Thank you, Senator Schumer.
    Senator Corzine.

               COMMENTS OF SENATOR JON S. CORZINE

    Senator Corzine. I will submit a statement for the record.
    Chairman Shelby. Without objection, your opening statement 
will be made part of the record.
    Chairman Greenspan, if you will abide us a few minutes, we 
have established a quorum and would like to move the Committee 
to Executive Session and ask for a vote on our nomination for 
the Department of the Treasury and the Department of Housing 
and Urban Development.
    Chairman Greenspan, you proceed as you wish. Thank you.

             STATEMENT OF ALAN GREENSPAN, CHAIRMAN

        BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Chairman Greenspan. Mr. Chairman, if I may before I start, 
I would like to thank the Senator for his very thoughtful 
remarks with respect to Virgil Mattingly's tenure at the 
Federal Reserve. We will miss him, and we certainly concur in 
how you evaluated his service and his contributions, I must 
say, to this Committee, and assisting in innumerable pieces of 
legislation, for which, for some reason or other, he always had 
the right balanced insight.
    We know Scott Alvarez, who worked closely with him over the 
years, will not become a Virgil clone, but we would not mind if 
he did.
    Mr. Chairman, with respect to Federal Reserve's Monetary 
Policy Report to the Congress, I cannot remember how many times 
I have been here, but it is always a fascinating experience 
because it gives us a chance, in this requirement, to review 
every 6 months what is going on in the economy and our 
interfacing with it. As Senator Sarbanes said, it has probably 
been a major element in our generalized communications policy, 
and I know that we always look forward to meeting with this 
Committee.
    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 also 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 1990's. Indeed, over much of the 
previous 3 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 cashflow. 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 
6 months, up sharply from the pace of roughly 60,000 per month 
registered over the fourth quarter of 2003.
    The improvements 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 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-term 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 12-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 companies.
    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 profit share occurred between the first quarter of 2003 and 
the first quarter of 2004, a period during which costs were 
unusually subdued. In fact, consolidated unit costs of business 
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 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.
    The profit share in the first quarter of this year, at 
about 12 percent, was well above normal. The gap suggested that 
the growth of unit profits would eventually slow relative to 
increased unit costs. This outlook had accorded with analysts' 
expectations for earnings growth over the next year, which are 
substantially below the realized profit growth of profit 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. And, although advances in productivity are 
continuing at a rate above the long-term 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.
    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 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.
    If economic developments are such that monetary policy 
neutrality can be restored at a measured pace, as the FOMC 
expects, 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 an 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.
    Financial intermediaries are profitable, well-capitalized, 
and appear to be well-positioned to manage in a rising rate 
environment. In short, Mr. Chairman, 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 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 25 
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.
    Thank you very much, Mr. Chairman. I have excerpted from my 
prepared remarks and request that they be included in the 
record in full, and I look forward to your questions.
    Chairman Shelby. Without objection, it will be. Thank you, 
Mr. Chairman.
    Chairman Greenspan, your testimony, among other things, 
indicates that the economic expansion is self-sustaining, and 
that it has become broad based with strengthened demand and 
employment gains. You also indicate that financial markets, 
along with households and businesses, seem to be reasonably 
well prepared to cope with a transition to a more neutral sense 
of monetary policy.
    Can we interpret those comments as indicating that the 
Federal Open Market Committee, FOMC, will be inclined to raise 
the Federal funds target by an additional 25 basis points in 
August, and would this be a measured pace?
    Chairman Greenspan. I think we have very purposely 
refrained from defining what we mean by that term. Obviously, I 
try to raise two general scenarios as to how we would 
ultimately restore the Federal funds rate to neutrality, where 
we believe it will need to go. One is measured, which I guess 
the dictionary says means gradual; and the other is one which 
we do not perceive is the most likely, but still we are 
prepared for if necessary, if the economy shows signs of 
exhibiting significant inflationary pressures, in order to 
maintain the mandate which the Congress has given us to create 
price stability mainly for the purpose of maintaining and 
fostering maximum, sustainable long-term growth. Because that 
is our objective, we will do what is required to achieve that 
objective.
    Chairman Shelby. In February, the Fed's forecast for growth 
was between 4.5 and 5 percent for 2004. Today's forecast gives 
a range of 4.5 to 4.75 percent, or a slight reduction. It is 
close. At the same time we have seen evidence of higher 
inflation in recent months.
    Others argue that the economy does not have as much excess 
capacity as utilization data would imply, with the implication 
there that the inflation threat may be stronger in the Fed's 
view.
    What is your assessment, Mr. Chairman, of whether the 
economy is in any danger of moving into a slowdown 
characterized by higher inflation?
    Chairman Greenspan. Mr. Chairman, this is always our 
concern. I should say most of us lived through the stagflation 
of the 1970's, and it was a very, I would say, disconcerting 
experience.
    Chairman Shelby. A bad situation.
    Chairman Greenspan. And the concern that we have, 
obviously, in this context, is something that obviously 
occurred in that period, namely a sharp rise in oil prices. 
Now, obviously, the levels of oil prices in real terms are 
nowhere near today where they were back then. But we will 
always be confronted with issues of trying to maintain an 
economy in which low inflation exists in the context of strong 
growth in the economy and in employment.
    We try to calibrate our policies to achieve that end as 
best we can. Sometimes the real world does not offer us the 
opportunities that we would like, but we work as expeditiously 
as we can to calibrate policy to achieve those ends.
    Chairman Shelby. Chairman, how comfortable are you with the 
data being gathered on production capacity, which seems to 
imply that there is still room to absorb additional production 
without generating significant inflation? You alluded to that 
earlier.
    Chairman Greenspan. Mr. Chairman, these data are collected 
through surveys of plant managers who were asked at what level 
in their judgment at a certain period of time their plant is 
operating. And what we do is essentially collect, reweigh, and 
process those data and make a judgment as to what the 
facility's capacity and excess capacity is, recognizing that 
this is not necessarily the same thing as saying, what is the 
capability of these plants, because there may be shortages of 
skilled workers or surpluses of skilled workers, and obviously, 
capacity in any meaningful sense is an integration of the 
physical facilities and a workforce capable of effectively 
operating those facilities.
    Chairman Shelby. Chairman Greenspan, the House has been 
considering a bill that effectively blocks FASB from requiring 
the expensing of all employee stock options. Some of us here 
have grave concerns about the Congress becoming involved in 
such technical accounting issues. What message would the 
Congress send by intervening in FASB's rulemaking process? What 
would the implications have for the current standard-setting 
process?
    Chairman Greenspan. I would be most concerned if the 
Congress intervened. Accounting, remember, is for the purpose 
of trying to get records which tell companies whether their 
strategies for success are succeeding or not. Accounting is 
difficult because a lot of it requires forecasts. FASB 
endeavors to obtain all of the various differing views on the 
way certain particular accounting procedures should be 
implemented, and I think that they do a good job. It is a tough 
job. And if the Congress dictates what they can do or should 
do, I think it undercuts the ability of the business community 
to effectively measure what it is doing.
    Chairman Shelby. Thank you.
    Senator Carper.
    Senator Carper. Thank you, Mr. Chairman.
    Chairman Greenspan, this past weekend I flew out to 
Kentucky to visit my mother. Senator Bunning, she lives over in 
Ashland, Kentucky, real close to Huntington, West Virginia. 
While traveling there and back to Delaware I had some down time 
because our planes were delayed, and I had a chance to catch up 
on some of my reading.
    Among the things that I read about were the competitive 
disadvantage that a lot of our manufacturers face because of 
the rising, still-high cost of natural gas compared with 
natural gas costs for a lot of our competitors around the 
world. I read about the competitive disadvantage that a number 
of our employers face in this county--I will call them legacy 
costs--which relate to pension costs for pensions that you are 
attempting to fund, and pension costs for those that are 
already retired. I read about the health care cost that we face 
in this country, double digit increases again in health care 
costs for employees and for those who are retired. And I read 
about the disadvantages that we face with respect to legal 
costs. We tried mightily earlier this month to pass class 
action reform legislation in the Senate, have not yet been 
successful, although I certainly hope we are not giving up. And 
another is with respect to costs growing out of asbestos, and 
the question whether or not we are going to be able to come to 
grips with a more rational approach for compensating those who 
have been damaged by exposure to asbestos.
    I am going to ask you to maybe address a couple of those. 
First of all, if you will, just maybe a minute or two with 
respect to natural gas prices. I did not fully appreciate 
earlier how much higher our natural gas prices are to those in 
other parts of the world and how regionalized the prices are 
and what that means to us. If you could just dwell on that a 
little bit. As you know, we are supposed to be in conference 
with the House on a FISC ETI bill, so-called the Jobs Bill or 
Tax Bill. There are provisions in that legislation for energy 
conservation and production. Just a thought, if you will, to 
start off on natural gas prices and what these are doing to our 
competitiveness.
    Chairman Greenspan. Senator, I think you are raising a very 
critical issue which I have addressed before this Committee in 
the past, and regrettably, things have not changed or improved 
much.
    Our basic problem is that natural gas is essentially unlike 
crude oil or all of the oil products, where because we have a 
significant world trade, when we run into shortages here as we 
do, and indeed we are always short in the sense we are 
importing a very significant amount of our oil in this country, 
we have the capability from almost any part of the world to 
draw in additional supplies of crude oil and petroleum 
products. As a consequence, our prices tend to be, at least 
domestically, fairly close to those amongst our competitors 
around the world.
    That is not true, as you point out, with natural gas. The 
basic reason is that as our demand for natural gas in this 
country has increased year-by-year in part because it is 
obviously the preferred fuel in so many applications, we have 
begun to run out of the ability to supply that from domestic 
sources or from Canada, which has historically supplied us with 
about a sixth of our needs. Because trade in natural gas is 
about half the size, relative to total consumption worldwide 
that oil is, we have very considerable difficulty importing. 
One of the reasons is that while we do import from Canada, we 
can no longer expand Canadian imports. What we have to do is 
very markedly increase our supplies of liquified natural gas, 
which means what we have to do is get gas which is put in 
liquified form for transport in a cryogenic state, and bring it 
in to terminals in the United States. Our terminal capacity is 
not at this stage large enough to fill our import needs, and I 
trust we will be moving fairly rapidly to increase our capacity 
to bring in foreign gas, but until that occurs, I am fearful, 
as I suspect you are from the remarks you were making, that we 
are going to erode our competitive advantage where natural gas 
is a key input into the production process.
    And I trust we can expedite our ability to raise our import 
capabilities and bring gas prices, which now are close to $6 
per million BTU, well above the world competitive level, back 
to levels which enable our companies to be far more 
competitive.
    Senator Carper. Mr. Chairman, I mentioned earlier that we 
have been unsuccessful, at least this month, in passing class 
action reform legislation. Later today or maybe tomorrow 
Senator Frist is expected to meet with Senator Daschle and make 
a counter-proposal, if you will, to the offer Senator Daschle 
made maybe 4 weeks ago on asbestos litigation reform. We have 
about 70 to 75 companies that have gone bankrupt in this 
country. A number of others are threatened at this point in 
time. Could you take a minute and share with us your views of 
the importance of our trying to reach an accommodation in this 
area?
    Chairman Greenspan. I am not someone who has looked at the 
details of the legislation, or in fact, the depth of the 
problem. In my early years, asbestos was something that was 
considered an exceptionally valuable product and----
    Senator Carper. Times have changed.
    Chairman Greenspan. Times have definitely changed. And I 
cannot add terribly much to this, but hope that the obvious 
business uncertainty which the lack of a resolution of this 
question is creating can be expeditiously resolved.
    Senator Carper. Thank you, sir.
    Chairman Shelby. Senator Dole.
    Senator Dole. Mr. Chairman, I am concerned about how 
movement in the Chinese economy could affect us, and I would 
like to ask you about this. The Chinese, of course, have a very 
weak banking sector. Half of their loans are bad. There are 
signs of a growing bubble in their commercial real estate 
sector, a growing U.S. currency reserve at $415 billion as of 
January.
    Chairman Greenspan, while the Chinese economy is small 
compared to ours, how concerned are you about these and other 
potential problems in the Chinese economy? Recently, China 
appeared to have realized that their growth is not sustainable, 
and have taken steps to slow down their rapid growth. One of 
the areas where they have pulled back is with steel production. 
Recently, I have been contacted by our transit authorities, 
both in Charlotte and Raleigh, North Carolina, because they are 
going to be starting soon on construction, and they have 
expressed deep concern on how this rise in steel prices is 
presenting real problems to their cost projections. I have to 
imagine that commercial real estate and other industries will 
be impacted and will suffer because of these cost increases.
    Could these steps by the Chinese Government to slow down 
their economy potentially trigger inflation in the United 
States with continued globalization? Can China, in combination 
with other countries with high growth, export inflation to the 
United States, and if so, do we have any monetary tools to 
combat such a problem?
    Chairman Greenspan. Senator, the Chinese economy is slowing 
down, and it is a deliberate effort on the part of what is a 
partial, centrally planned economy with an ever-growing market 
segment, and it is a very tricky policy that they have to 
implement to get it right.
    The rate of increase in investment has gone down very 
materially on a year over year basis, and clearly through the 
second quarter, where their quarter-by-quarter rate of growth 
really slowed virtually to a halt, they exhibited considerable 
removal of very major elements of growth. However, they do not 
seem to be sinking much further. In fact, their exports look, 
frankly, a little bit better in June, and overall, it is very 
likely that, largely because of the nature of the central 
planning, they will try to calibrate it in a way which improves 
the outlook. But their economy, as you point out, is still 
relatively small in the areas which impact directly on us. I 
find it most unlikely that their contraction of steel product, 
as large a producer as they are, will induce any significant 
rise in steel prices.
    There has been, as you know, some significant decline in 
steel prices in the United States, but judging from the scrap 
prices in recent weeks, it has come back a bit in part because 
the demand is still reasonably strong. I do not believe that 
the Chinese can export inflation to us. It is extremely 
difficult to do that, and they are not the type of economy 
which so interfaces with us that would create such a problem.
    It is important that they move as quickly as they can to a 
market economy, and I think that they are trying to move in 
that direction. But until they have succeeded, they will still 
have the types of problems that you suggest.
    Senator Dole. The Bureau of Labor Statistics reported that 
in June that the U.S. economy created about 112,000 new jobs 
nationwide. I have been amazed that some have stated that since 
this number was less than half of that projected for new jobs, 
that somehow this is an indication that our economy is headed 
back into recession again.
    For the record, how do you view these lower-than-expected 
job figures?
    Chairman Greenspan. Senator, we have approximately 130 
million people on payrolls in this country, and I am surprised 
that we can estimate the change from month to month as 
accurately as we do. The range is really quite large.
    I know a number of people looked at those data and took it 
as some indication that there is some significant weakness 
developing. If that were the case, I think we would have seen 
it in a marked pickup in initial claims for unemployment 
insurance, which of course we have not, and all of the other 
qualitative indicators we have currently in the third quarter 
suggest that employment is continuing to expand. And indeed, 
while there has been weakness in June, and a number of your 
colleagues mentioned this, I might say that July seems to be 
somewhat better, even though we are going through a soft patch.
    Motor vehicle sales, which for example, were an important 
part of the weakness in the June retail sales data, as least so 
far as the first 10 days were concerned, shows a very 
significant snap-back largely because discounts have been 
expanded again. Our anecdotal data on new orders arriving 
during the month of July showed that the system is holding up. 
There is no real underlying evidence of any cumulative weakness 
here.
    It is nonetheless the case that the little bulge in 
inflationary pressure seems to have created a soft patch here, 
and it is something obviously we are watching very closely.
    Senator Dole. Just one final question. Recently, some have 
suggested that most of the new jobs being created in the last 
year are paying an average $1,500 to $9,000 less than those 
jobs lost over the past few years. Obviously, often an 
unemployed person that finds a new job, they may be at a lower 
salary for a short time. But does your analysis show that the 
current jobs being created are basically lower-wage jobs with 
little or no benefits?
    Chairman Greenspan. The answer is no. But let me say that 
there are several different statistics that I think are 
important. The one that you cite is an important fact, namely, 
that people who do lose their jobs tend to have difficulty 
restoring the level of their original wage for quite a while. 
And that is part of the process which goes on in the very 
significant churning in the labor market.
    We have looked at this question in the broader sense of are 
we essentially downgrading the types of jobs that are being 
created, say, over the past year, and the answer is we find 
very little evidence of that.
    There are essentially two ways to interpret how one should 
evaluate this. One, is to look at the question as to whether 
the growth in jobs is disproportionately in industries where 
the average wage rate is higher than average for the economy as 
a whole. There seems to be a slight indication of a decline in 
that regard, meaning more workers going into industries with 
slightly below nationwide average earnings.
    And two, when we look at it in the context of occupation, 
where clearly one gets a sense of what is happening to 
particular types of job slots, the answer is exactly in the 
opposite direction.
    Now, these are not contradictory. In other words, you can 
have an increasing spread within industries where there is a 
greater skill dispersion while still having the average of the 
industry go down. But the bottom line in all of this is these 
data are so marginal that the conclusion that there is anything 
going on other than just average expectation of changes in jobs 
does not seem, in our judgment, to be supported by the 
underlying data which is broadly available.
    Senator Dole. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    Actually, Senator Dole touched on a couple of issues I 
wanted to address. One is the current account deficit, which is 
now at about 5.5 percent of GDP, the highest level, as I 
understand it, in U.S. economic history, at least according to 
Pete Peterson, who said in an article in The Washington Post on 
Sunday, ``This deficit requires us Americans to borrow about $2 
billion from foreigners every working day. No expert I know 
believes that this is sustainable.'' And, Chairman Greenspan, 
if I recall correctly, you have stated before this Committee in 
the past that a current account deficit of this magnitude is 
not sustainable, as I recall.
    Chairman Greenspan. That is correct, Senator.
    Senator Sarbanes. Now, I am concerned not only about the 
deficit but that the source of the foreign borrowing has 
shifted. In its February report, the Fed found, ``The financing 
counterpart to the current account deficit experienced a 
sizable shift in 2003 as net private inflows fell while foreign 
official inflows increased. Foreign official purchases of U.S. 
assets surged to record levels in 2003, with the accumulation 
of dollar reserves particular high in China and Japan.''
    I have a chart here that I want to show this surge and 
which I think highlights that our dependence on foreign capital 
has increasingly been supplied by foreign governments, 
specifically, according to the Fed, China and Japan. And this 
is the foreign official assets in the United States. This is 
1976. This is 1993. And then we see the steady pace--and then 
it is almost going up at a perpendicular rate now.
    I find this troubling. I guess I find any chart that all of 
a sudden seems to leap out in some different direction from 
what we have generally been experiencing a matter of concern. 
What is happening here and what are its implications? Are China 
and Japan doing this to manipulate the currency in order to 
gain a trade advantage and help their export position? And what 
are the potential consequences for us in this scenario, 
particularly assuming it might continue?
    Chairman Greenspan. Well, let me answer the second part of 
your question first. We have obviously been monitoring these 
flows very closely for precisely the reasons that you indicate. 
It is turning out that the impact on the international markets 
on the value of the dollar and, hence, on the value of the 
United States' internal economic system from these shifts 
between foreign private funding of our current account deficit 
to last year's very significant public funding, it is turning 
out that in 2004 we are beginning to see a reversal of that 
without any serious consequences, meaning that the shift 
between foreign public financing of the deficit and private 
financing is not a significantly large issue. The Japanese, for 
example, stopped intervening to accumulate American dollars in 
March of this year, after very heavy purchases earlier this 
year, and the Chinese purchases have flattened out. We see very 
little evidence that the shift of that official financing to 
private financing is impacting on the economy in general.
    Nonetheless, there is no question that, as I am sure you 
are aware, almost half of Federal marketable debt outstanding 
that we issue, is held abroad. And these trends are 
significant, and they do raise serious questions. But so far, 
the flexibility of our international financial system has been 
such that we have had very little problem in financing these 
very large deficits.
    Now, as I have testified before this Committee on 
innumerable occasions, this cannot go on indefinitely because 
at some point we are going to reach a status where our net debt 
to foreigners--currently a little under a fourth of GDP--will 
get exceptionally large, and the holding of dollar assets as 
reserves for both the private and public sectors abroad will 
become abnormally large relative to their needs and they will 
stop purchasing dollars. That will have an obvious significant 
impact on us when it occurs.
    I do not know when that date is. I know at some point in 
the future something of that nature has to occur, unless there 
are shifts in the world economy such that our trade deficit 
and, therefore, our current account deficit falls measurably. 
If that does not happen, then we are going to see a clear 
indication on the part of foreign investors in the United 
States to start to hold back and diversify, even if the rates 
of return here remain high. Since we are at unprecedented 
levels--and it could conceivably be higher, as I indicated in a 
speech earlier this year--at some point it has to shift.
    Senator Sarbanes. I want to touch on one other subject that 
Senator Dole raised, and that is the weakness of the labor 
market. The participation rate between the first quarter of 
2001 and the second quarter of 2004 dropped to such an extent 
that actually we would have 2.5 percent more people in the 
labor force today if the participation rate was what it was 
just 3 years ago.
    In June, 21.6 percent of the total of unemployed have been 
unemployed over 20 weeks. This is quite a change, as we can see 
here, in terms of having crossed above the 20-percent line and 
staying up there, which actually now it has been there for 21 
months. It surpassed the record set from 1982 to 1984.
    Finally, the job growth, although we have had some job 
growth in recent months, we still remain below where we were in 
the level of jobs 39 months ago when the recession began. In 
every economic recovery since the Depression, the economy has 
recaptured all of the jobs it lost well within the 39 months. 
So this is the longest job loss recovery. And, in fact, there 
is a very marked contrast between the current recovery and the 
average of post-war recessions. If we just match the average, 
we would have about 6 million more jobs currently.
    Now, looking at all of this, and, of course, you know, we 
are getting a lot of comment in the newspapers and in the 
magazines about this very difficult problem, it seems to me we 
have not been able to bring jobs back online in a way that 
gives us encouragement in terms of putting people back to work. 
We still have this job gap, this slack in the labor market. How 
do we explain it? I mean, it is a very marked contrast----
    Chairman Greenspan. It is.
    Senator Sarbanes. --where we are today with previous 
recoveries.
    Chairman Greenspan. Senator, I think there are two basic 
forces at play here. The first is that productivity growth over 
this period has been extraordinarily large, far in excess of 
the rate of increase in output per hour that was experienced 
during other periods that you draw on the average of your 
chart. And so as production picked up, we were not hiring, 
basically for reasons which I indicate in my prepared remarks, 
and that has continued, not to the extent that it existed last 
year, but productivity is still running above the averages of a 
goodly part of the period which you have on your chart.
    Second, we have had an exceptionally shallow recession--in 
fact, the shallowest recession in the post-World War II 
period--so that the normal rebound that we experienced in a lot 
of the recoveries which are part of the average that you show 
on your chart was not possible.
    If, as I suspect is the case, the growth rate of 
productivity will slow down from the extraordinary levels of 
last year, growth will continue in payrolls, and at a fairly 
significant pace. I do not know that I can pinpoint the actual 
number. It will depend crucially on every tenth of a percent in 
the productivity numbers and obviously in the GDP. But it does 
not look as though the growth in employment is stalling, though 
there is no question that it is moving up at a pace far less 
rapid than you point out has been our history.
    Chairman Shelby. Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Chairman Greenspan, how concerned should we be about the 
June housing figures, 8.4-percent reduction following a 3.5-
percent reduction in May?
    Chairman Greenspan. Senator, the figures for June came out 
below where we would have expected them to be, but not 
appreciably. The reason essentially is that as mortgage rates 
began to move up several months ago, we began to see a 
significant pick-up in housing sales, people endeavoring to get 
in under the wire, so to speak. The result was clearly a 
borrowing of housing starts from the future. And that I think 
is part of the June experience.
    If that is the case, then we would expect some short-term 
recovery from the June decline, and, indeed, that is suggested 
in the detail that we get along with housing starts, which 
tries to measure the permit data that go along with the starts 
data, coupled with backlogs of unused permits. And those data 
indicate that a significant part of the drop, almost half, is 
not reflected in the decline in so-called adjusted permits, 
meaning for single-family dwellings it would be permits of 
single-family dwellings plus the number of starts in 
nonpermitted issuing areas. Those numbers are down roughly half 
what the actual starts figure is.
    So the number is weak, there is no question about that, and 
definitely below where our expectations are. But we do not 
believe it is a cause for concern. Our general forecast, as it 
has been for quite a while, is that housing starts which have 
come up at an extraordinary pace in recent years are very 
likely to shade lower over the next couple of years. It is hard 
to maintain the pace that we are maintaining, but we do not 
expect that the fall-off will be abrupt or significant. And as 
a consequence of that, we do not perceive the June figure to be 
a harbinger of worse to come.
    Senator Bunning. Does the June producer price index drop 
make you feel better about inflation or not?
    Chairman Greenspan. Obviously somewhat better, but still, a 
number of the prices that are built into that index were rising 
recently at a somewhat faster pace than we expect in the 
context of maintaining long-term price stability. But it is the 
case that the modest slowdown in the inflation rate was 
welcome.
    Senator Bunning. Let me ask you, you talked productivity 
and how important it was for the job market and other things. 
What is the Fed's view as far as additional productivity gains 
as we look down through the third and fourth quarter of this 
year? Do you see an average gain of productivity? Or where are 
we?
    Chairman Greenspan. It is one of the most difficult 
statistics to forecast, Senator. We can forecast aggregative 
demand reasonably well, plus or minus a half a percentage point 
annual rate, most of the time. We know that when we have profit 
margins at the levels they are now, there are very significant 
incentives on the part of business to expand their workforces 
and in the process be less focused on cost reduction, which is 
the major component of productivity growth.
    So it is difficult for us to make judgments as to the path 
of productivity or exactly how the increase in the GDP will be 
distributed between that produced by increased employment and 
that produced by increased productivity. Our general judgment 
is that it is probably going to be average, but the truth of 
the matter is we have very little experience in dealing with 
productivity numbers as high as they have been, and our 
forecasting success in the last year or two in trying to judge 
where these numbers were likely to go has been one of our 
poorer set of projections.
    Senator Bunning. The last question, and this has to do with 
energy costs, the cost of crude oil, the cost of natural gas, 
and everything. How much more cost increase can this economy 
stand before it becomes a very significant factor in the 
overall well-being of the economy?
    Chairman Greenspan. Senator, that is one of the most 
important questions that we focus on. It depends in part on 
what these oil prices or gas prices are going to rise from 
here. Their impact on the economy will depend on how fast they 
are moving, because what our data show, especially for oil, is 
that over the longer run, say a series of years, the elasticity 
of demand for oil with respect to price is pretty high. In 
other words, if prices stay high, after several years we will 
shift the structure of our economy to less oil-intensive 
structures. The nature of our light motor vehicle stock, for 
example, will shift significantly to types of cars and trucks 
which consume far less motor gasoline. And the same will hold 
true in lots of other areas of the economy.
    If, however, prices spike in the short run, where those 
adjustments are not possible, then history tells us it has 
significant impacts. And, indeed, that is what happened to us 
in the latter part of the 1970's. So it depends very 
critically, if we are to run into a problem, whether it is a 
gradual change in price or whether it is a short-term change. 
But as I indicated earlier, even though we are approaching 
record nominal prices of crude oil in the world, we obviously 
are well below where we were, for example, in 1979 in real 
terms.
    Senator Bunning. Thank you.
    Chairman Shelby. Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    Chairman Greenspan, one of the issues we have talked about 
on several occasions is this lack of growth in wages and 
earnings for workers, and that is a critical issue. Increases 
are necessary to meet increased obligations of housing, 
education, health care, but also there is a distributional 
effect which you have pointed out, where higher-skilled workers 
seem to do okay and lower-skilled workers seem to be falling 
behind, creating social tensions.
    Senator Reed. Looking at the numbers I have, over the last 
year average hourly earnings decline 1.1 percent in real terms. 
Average weekly earnings declined 1.4 percent. This is in a 
situation where the economy is recovering. We are seeing GDP 
growth and, as you point out, where productivity has been 
growing significantly, allowing, one presumes, increases of 
wages.
    Can you explain the apparent contradiction between these 
falling wages and increased productivity and expansion?
    Chairman Greenspan. Senator, I believe--I think it was the 
last time I was here--we had a fairly extensive discussion in 
the question-and-answer period on the issue of education. I 
believe you were participating in that.
    Senator Reed. That is right, and can I say, I think this is 
a slightly different question, because we are not talking about 
people entering the workforce with different skills. We are 
talking about apparently workers that are already employed 
within a year. I would think that factor would not be the most 
critical.
    Chairman Greenspan. In a way it is, and the reason I say 
that is that, as I tried to define the problem back then, what 
has been happening to our labor force is that we have not been 
able to keep up the average skill level in our workforce to 
match the required increases of increasing technology. And what 
that has meant has been that rather than getting an ever 
increasing number of college graduates at a far faster rate 
than we have been getting them and, hence, higher skills, to 
create a surplus or at least a significantly large supply of 
skilled workers relative to the demand in order to keep skilled 
wages down and because you move up people from the lesser 
skilled areas to the skilled, you lower the number of surplus 
workers in those markets for lesser skilled and, hence, remove 
the downside pressure on wages.
    In other words, this is an issue which has been regrettably 
going on for 15 years, or thereabouts, creating an ever 
increasing opening up of the skilled versus lesser-skilled gap. 
And as you point out, if you put the wage changes in nominal 
terms, for the lesser-skilled they have been growing in many 
parts of the last 15 years at less than the increase in the 
Consumer Price Index. That is, of course, not true for wages 
and salaries as a whole. Indeed, the ratio of average hourly 
earnings for supervisory workers that one can infer from the 
data systems that we have, have been rising relative to average 
hourly earnings, which you cite, for quite a considerable 
period of time, and they account for 40 percent of the 
aggregate wage and salary totals. So we are getting a problem 
here which I think has got to be addressed, and as I had 
indicated last month, I think the effective increase in the 
concentration of incomes here, which is implicit in this, is 
not desirable in a democratic society.
    Senator Reed. We have several problems. One problem is 
training and retraining individuals and, you know, if you are 
starting off with high school or elementary children, you maybe 
can have an effect. That is 5 or 10 years out. The situation 
is: What do we do in this year, next year, and the following 
years to raise the wages of people whose skills cannot be----
    Chairman Greenspan. I think the way you raise those wages 
is you remove the large number of younger people whose skills 
should be upgraded significantly from being an overhang on the 
job markets in which we have got, from as best I can see, an 
excess of supply over demand, and that has got to be changed.
    Senator Reed. I do not see a ready policy there, but I see 
a concept.
    Chairman Greenspan. Whether you have a policy or not, I 
think it is right to get the analysis right. Because if we do 
not understand what is causing this, our policies are not going 
to address what is a significant problem.
    Senator Reed. What specific policies should we adopt today?
    Chairman Greenspan. Well, I mean, if we can move----
    Senator Reed. Because that helps us understand.
    Chairman Greenspan. First of all, we know that from the 
fourth grade to the twelth grade, our children somehow are 
falling behind international standards.
    Senator Reed. Mr. Chairman, I accept that, but policies 
that are applied to people currently in the workforce today, 
adults who are working hard, they are seeing corporate profits 
go up dramatically. They are getting very little share of those 
corporate profits as the data indicates.
    Chairman Greenspan. I think what you are going to find is 
that that share will now start to increase.
    Senator Reed. Now, one of the places that this share 
increases is labor costs, because employers will spend more for 
health care and for other benefits, which workers appreciate. 
That still does not increase the take-home.
    Chairman Greenspan. I agree with that, and what I am saying 
is that, as I indicated I think the last time I was here, 
virtually all of the increase in productivity during the year 
starting in the first quarter of 2003 shows up not as real 
wages, but as increased profitability. That stopped some time 
in the last several months, and what history tells us is that 
the shift now goes in the other direction, and you get, with a 
delayed effect, the increased productivity showing up as real 
wages overall, and I would think that while certainly 
supervisory workers are going to contribute or share 
significantly, it will also be true of the 80 percent of 
payrolls which are nonsupervisory workers as well.
    Senator Reed. My time has expired. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Allard.
    Senator Allard. Thank you, Mr. Chairman. I want to pose a 
housing question to Chairman Greenspan.
    Low mortgage rates I think for the last year have probably 
contributed substantially to increased sales of existing 
residences, helping to boost the national homeownership rate to 
the highest level ever. Could you please discuss your views on 
what lies in store for housing, particularly in terms of other 
factors such as consumer confidence, unemployment rates, as 
well as wage rate? And what trends do you see for the 
homeownership rate?
    Chairman Greenspan. Senator, as you know, the homeownership 
rate in the United States has risen quite materially in the 
last decade. We went from about 64 percent to probably around 
69 percent now. We are seeing that household growth is holding 
up reasonably, and indeed a significant part of that is 
actually the result of immigration. And with household growth 
holding up, and the inclination of renters to move into an 
owner-occupied status, we still seem to be getting a fairly 
pronounced growth in homeownership, and indeed the broad 
policies and effectiveness of our mortgage markets are clearly 
working in that direction.
    To the extent, obviously, that homeownership becomes a 
critical continuing factor, it creates big demand for single-
family dwellings, and that is the reason why we have had 
approximately a million and a half plus single-family dwellings 
annually for a number of years as homeownership has moved 
forward.
    Now, obviously, as we get into ever higher numbers, there 
is some amount of desire to be a renter, not an owner. So at 
some point we will slow down, but I see no evidence at this 
stage that slowdown is occurring, and as a consequence I think 
the underlying demand for housing is going to remain reasonably 
solid, although presumably less than the peaks that we have 
seen in recent months.
    Senator Allard. I also understand that the number of jobs 
coming from--to change the subject--other countries to the 
United States is growing at a faster rate than jobs lost 
overseas. According to the Organization for International 
Investment over the last 15 years, the numbers of manufactured 
jobs insourced, coming into the United States, have grown by 82 
percent, while the number outsourced overseas grew by only 23 
percent. This study indicated that these insourced jobs are 
offering higher pay than those outsourced. Furthermore, last 
month the Labor Department released the first official 
Government study that revealed only 2.5 percent of the 182,456 
workers who lost their jobs in the first quarter of this year 
were due to jobs being sent abroad.
    Would you please share your thoughts on these numbers, and 
is outsourcing really taking away as many American jobs as 
people are claiming it is?
    Chairman Greenspan. Senator, I have not checked the 
specific numbers, but it does not seem different from what I am 
generally aware of, depending on how you define a lot of these 
categories.
    We are in a global economy, and increasingly so, and it has 
been to the advantage of the United States to be in this global 
economy, and indeed in the position of leadership, which we 
have been in, and it has contributed, in my judgment, to a very 
significant increase in standards of living of the average 
American.
    As the world becomes ever more complex and as we find we go 
to ever increasingly more sophisticated levels of 
specialization in the division of labor, it necessarily means 
that we reach out to engage in trade with the rest of the world 
at an increasing rate, and indeed, the aggregate amount of 
trade worldwide has been growing almost every year relative to 
world GDP for the last half century. This means that you are 
getting imports as a share of domestic GNP's, on average, 
rising. And as a consequence of this, we are engaged in ever 
more insourcing and outsourcing, depending how you want to 
define it, and while it is certainly the case that outsourcing 
as estimated for the current period is quite small, I think it 
is going to be rising, and I do not think that is bad. I think 
that is going to be part of a broader expansion which will lead 
to higher standards of living in this country and an ability 
for our expertise to be most effectively applied in 
international markets.
    Senator Allard. Mr. Chairman, may I follow with a question 
on protectionism?
    Chairman Shelby. Go ahead.
    Senator Allard. You have cautioned repeatedly about the 
danger of protectionism, and that it could provide a barrier to 
the economic growth that has picked up in recent months. Could 
you elaborate on that for us, please?
    Chairman Greenspan. Looking back at the post-World War II 
period, this very expansion of globalization which I have 
referred to is also capable of being viewed as an ever wider 
degree of international stimulus to the United States, and 
indeed, I think that our ability to engage the international 
community has significantly enhanced our standard of living, as 
I just indicated. But it depends on that expansion continuing, 
because it is the rate of change in expansion which creates the 
level of economic growth here, and I think that what one 
requires to recognize is that if the Doha Round, for example, 
fails to be completed--and there is some concern, as you know, 
about how that is evolving, especially this month--I would have 
a concern that we would find that losing this stimulus from the 
international system will work negatively on economic growth in 
the United States, and I, accordingly therefore, hope that we 
can continue our efforts to make sure that globalization 
continues if we are to reap the benefits of it.
    Senator Allard. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bayh.
    Senator Bayh. Thank you, Mr. Chairman.
    Chairman Greenspan, I would like to follow up on Senator 
Sarbanes first line of questioning with regard to our growing 
dependence upon foreign borrowing and the consequences for our 
domestic economy. I think you indicated that at some point we 
will reach a position where the rest of the world's appetite 
for U.S. denominated assets has been satiated. We do not know 
when that point will arrive. Are there any studies under way to 
try and determine, using portfolio theory or other types of 
analysis, when that point might be reached?
    Chairman Greenspan. Senator, it is very interesting because 
there has been a very considerable amount of work endeavoring 
to unearth where those points are. We do know that in 
developing countries in the past, as individual countries have 
gotten up to ever higher current account deficits, they turned 
around. In some cases they got to double digits before they 
turned around. But they usually, if the economies were 
flexible, adjusted without any real crisis occurring. But a 
number of us have been trying to figure out whether there are 
leading indicators as to when this type of thing turns. What 
has been examined are all the various different types of flows, 
private flows, equity flows, debt flows, flows of governments. 
What we find is that none of them work.
    What that says is that the markets internationally are so 
efficient that the substitutability of various different 
instruments to finance, for example, our current account 
deficit, is extraordinarily high, and while it clearly affects 
prices of bonds and stocks and exchange rates in the process, 
the adjustments continue in a way which it is very difficult to 
determine when certain types of flows are occurring and when 
the aggregate deficit is about to turn around.
    Senator Bayh. Let me follow up. I was concerned about part 
of your response to Senator Sarbanes, where I believe you 
indicated that when the satiation point arrives, that even a 
higher rate of return on U.S. denominated assets would not lead 
them to acquire more of our assets, which means that if the 
deficit has to be financed entirely domestically, the increase 
in interest rates and other adjustments that might flow from 
that would have to be even more severe. I find that potential 
to be rather alarming.
    Chairman Greenspan. I think the way I put it, I said that 
even if rates of return stay high. I did not say necessarily 
``increase.'' The reason I put it that way, Senator, is that if 
you think about rates of retutn being high in the United 
States, and people therefore continually wish to invest here, 
you can conceive of a situation in which even though the rate 
of return does not change, they will eventually say, ``I am 
over committed. I have too much. I want to diversify, even 
though I will get a lower rate of return.''
    Senator Bayh. Does that not imply more adverse consequences 
for us domestically?
    Chairman Greenspan. If we get to the point where there is a 
cliff effect, obviously, it would, but I think we are so 
flexible and the markets are so flexible, and I assume we will 
keep them flexible, that the international system does not work 
that way. It works incrementally. But you are quite right. I 
mean ultimately if we cannot continue to attract investment at 
current interest rates or current rates of return, and we still 
are running very large trade, and therefore capital account 
deficits, all economic theory says that rates have to rise.
    I am a little suspicious of that conclusion largely because 
of a lot of those conclusions are based on the way the markets 
functioned 30, 40, 50 years ago, when remember, they were not 
flexible. We had all sorts of capital controls and all sorts of 
rigidities. But I do not think we can readily dismiss it out of 
hand as a possibility.
    Senator Bayh. Our focus as policymakers, when we are 
concerned about this issue, should be on maintaining the 
flexibility of the international financial system and hoping 
there is not an exogenous shock of some kind that would lead to 
a rapid readjustment.
    Chairman Greenspan. Senator, I would generalize that. I say 
the experience we have had in the last decade has indicated 
that the most important thing we can do with respect to policy, 
both domestically and internationally, is to create 
flexibility, because it obviously is a factor in the resilience 
of an economy to respond to shocks, and indeed, I do not think 
that we could have successfully gotten through September 11, 
for example, unless we had an exceptionally flexible financial 
and economic system domestically.
    Senator Bayh. My final question, Mr. Chairman, and thank 
you for this discussion, it is something I am concerned about. 
I hope that the flexible nature of the markets will enable us 
to make a gradual adjustment but I am somewhat concerned.
    I would like to just change the topic and ask my final 
question. A recent Fed study entitled ``The Price and Quantity 
of Residential Land in the United States'' was just completed, 
and concluded that over the next 3 years in the aggregate, 
housing prices on a cumulative basis, will go up, they predict, 
2.6 percent, which is the lowest increase on record according 
to the report. Given the role that real estate values played in 
getting us through the recent softness and sustaining consumer 
demand, is that not the source of some concern?
    Chairman Greenspan. It would be if it were an abrupt 
change. Remember that we have had a fairly significant rise in 
real residential prices in recent years, and historically if 
you look back, that is not unusual. But what does tend to 
happen is that we go up for quite a while, and then we flatten 
out, and I do not know what the actual number is. I have not 
read the details of the study, nor do I know whether the data 
are accurate in that regard, but I certainly do not----
    Senator Bayh. If you are having a restless night and have 
trouble nodding off, I recommend it.
    Chairman Greenspan. I find the best thing to do if I run 
into that occasion is to read some of my speeches.
    [Laughter.]
    Senator Bayh. Thank you, Mr. Chairman. The reason for my 
question was simply--by the way, that has been said about mine 
as well--is your sanguine view about the sustainability of the 
recovery, and it seems one of the legs that we have relied upon 
recently is--I may perhaps be ameliorating a little bit here 
going forward, but you think that will be more than offset by 
other things.
    Chairman Greenspan. Yes, that is our forecast.
    Senator Bayh. Thank you.
    Chairman Shelby. Senator Bennett.

             STATEMENT OF SENATOR ROBERT F. BENNETT

    Senator Bennett. Thank you very much, Mr. Chairman.
    One of the advantages of coming a little bit late is that 
you get to hear all of your colleagues ask your own brilliant 
questions before you can get to them, but you can also take 
notes on the things that people say.
    You said in response to Senator Shelby, when he was talking 
about where interest rates should be, and you very 
appropriately and predictably did not give us a number. But you 
said you were hoping we could get back to neutrality. So let me 
take one more stab at it and ask what number is neutrality?
    Chairman Greenspan. I knew you were going to ask that 
question, Senator. Actually, we do not know what neutrality is 
until we get there. The reason I say that is the notion of 
stability, or a state where the financial markets are in some 
form of equilibrium, depends on a number of things. You can 
tell whether you are below or above, but until you are there, 
you are not quite sure you are there. We know at this stage 
that at 1\1/4\ percent Federal funds rate, are below neutral. 
When we arrive at neutral, we will know it, and we can take 
whatever actions we consider desirable or not desirable at that 
time, but I think that estimates that people try to make as to 
where that so-called neutrality is, fall in a fairly broad 
range, and I would just choose not to speculate where it is.
    Senator Bennett. You said to Senator Allard that 
outsourcing is rising and that is good.
    Chairman Greenspan. It is very low at this stage, but what 
I was saying is, as part of the globalization process, which I 
think is good for the American economy, and probably an 
inevitable component is increasing trade of all sorts, and 
therefore, outsourcing both into the United States and out is 
likely to rise. And as Senator Allard suggests, a number of 
studies say at this stage that the outsourcing into the United 
States may very well be larger than the outsourcing. I do not 
think this is a critical issue. I am really quite surprised at 
how big an issue this has become. I fully understand the real 
and serious problems that individuals have who lose their jobs 
in this process, and indeed, we should do whatever is required 
to make their lives better, but shutting off international 
trade as a means of doing that is essentially very 
counterproductive to everybody's standard of living.
    Senator Bennett. I happen to feel the same way. When you 
made the statement ``that is good,'' I thought it is a good 
thing he is not Chairman of the Council of Economic Advisers, 
because if you were, tomorrow morning there would be calls for 
his resignation and attempts on the part of the political arm 
of White House to distance themselves from your testimony, 
because that is exactly what Greg Mankiw said to the Joint 
Economic Committee, and that is what happened when he said 
that.
    Chairman Greenspan. I think the response to Greg Mankiw's 
remark was unfortunate.
    Senator Bennett. Yes, and you are not going to be invited 
to Lou Dobbs' show any time soon.
    [Laughter.]
    Let us talk for just a little bit about oil prices. Oil is 
traded in dollars. The dollar is losing its value vis-a-vis the 
euro, the British pound, and some other currencies. Is there a 
temptation therefore on the part of OPEC to get their real 
return back up to what it might have been by raising the 
denomination of a barrel of oil in dollars? In other words, is 
it in their interest to try to take the price of oil in dollars 
up to the point where they are getting as much real income as 
they used to get when the dollar and the euro were in parity?
    Chairman Greenspan. Senator, I do not think that the 
particular denomination in which oil is priced affects the 
overall price. In other words, the way I would put it is we 
could trace oil prices in euros, for example, or in dollars or 
in yen, and while there are certain technical issues which are 
a slight problem here, if we were to officially switch the unit 
in which oil was denominated, I do not think it would change 
the price patterns in dollars, yen or euros in any significant 
manner.
    Senator Bennett. I do not think it would either at the 
moment the switch were made, but if a dollar is seen as 
continuing to depreciate with respect to other world 
currencies, is there an incentive over time for an OPEC 
country----
    Chairman Greenspan. Oh, I see. There obviously is a sense 
in which if a dollar purchases less in other currencies, that 
one could conceive that they might try to raise prices in order 
to offset that.
    Senator Bennett. Offset the declining value of the dollar. 
Do you see that in OPEC strategy?
    Chairman Greenspan. Well, they are certainly not doing it 
now. They essentially have opened up the taps as best one can 
judge. Supply is increasing, but demand overall is increasing 
more, and that is what the difficulty is. I cannot say to you 
that I see any evidence that OPEC is constraining production 
for the purpose of raising price at this particular time.
    Senator Bennett. My observation of the current increase of 
the price of oil has more to do with uncertainty over the 
situation in Russia than it does with OPEC strategy. Do you 
have a reaction to that?
    Chairman Greenspan. Let me say this. I am talking about 
short-term strategy obviously. There is a long-term strategy 
about the 
capacity of crude oil in OPEC producing countries, which is a 
different issue, but clearly, the problems in Russia involve a 
significant concern about a curtailment of crude oil production 
if Yukos went into bankruptcy and it was dismembered or 
something like that. That was clearly in the marketplace.
    But also in the marketplace is something which is 
disturbing in the sense that the very long-term futures, that 
is, those for 2010, for example, have risen very substantially 
in recent years, which is unusual because in years past the so-
called long-term supply price of crude oil in dollars was about 
$20 a barrel, and irrespective of what the spot price was, the 
long-term price stabilized somewhere in that $20 area. In the 
last several years, the long-term price has gone up very 
substantially, and it is not because of cost. It is basically 
fear of long-term supply in a number of the areas of the world 
where geopolitical concerns have risen.
    Senator Bennett. Thank you.
    Chairman Shelby. Senator Dodd.
    Senator Dodd. Thank you very much, Mr. Chairman.
    Thank you, Mr. Chairman, for being here today. I was not 
here for your confirmation hearing, but let me once again say I 
think of how fortunate we are in this country that you are the 
Chairman of the Federal Reserve, and you have done a tremendous 
job over the past 16 years.
    Chairman Greenspan. Thank you very much.
    Senator Dodd. I suspect the next 16 years are going to be 
difficult ones, and in your contribution to this discussion, 
debate is very much appreciated. Let me begin with those 
comments.
    Senator Schumer, when he was speaking a little while ago, 
mentioned that these two wings, like a wonderful physical 
analogy, talking about monetary policy and fiscal policy. I 
know you are here to give a monetary policy report, but I 
cannot resist the opportunity to raise issues with you 
involving fiscal policy. We are policy setters up here. We have 
about 20 working days by my calculations, between now and the 
adjournment of this Congress, which is not a great deal of time 
left. Two issues that I would like to raise with you, both of 
which you have commented on in the past. In fact, you did again 
today in part. One has to do with the growing and dangerous gap 
between those who are more affluent and those who are not in 
the country. The second issue has to do with the Federal 
deficit.
    I recall sitting here, it was about 42 months ago, when you 
were sitting in that very chair in January 2001, and we had 
this incredible conversation, that is, you did with the 
Committee, about the potential effects of eliminating the 
national debt and how we should respond to it, a conversation I 
suspect many of us only a few years earlier never would have 
imagined occurring.
    Chairman Greenspan. Nor I.
    Senator Dodd. All of us have in our minds those clocks, 
whether it was in New York or Washington, that would tick off 
every nanosecond the accumulation of debt, and here we were, 
only 42 months ago, literally talking about the implications of 
eliminating the national debt. You spoke at that time about 
realistically getting to the level of Federal debt that is an 
effective irreducible minimum. I am quoting you from your 
testimony on that day in January 2001.
    Let me begin if I can with the gap question and wealth, 
because some of the things we have heard today and some of the 
statistics you point to, indicate that that is going on. I do 
not know if you had the opportunity this morning to read an 
article in The Wall Street Journal entitled ``So Far Economic 
Recovery Tilts to the Highest-Income Americans.'' The article 
quotes Dan Maki, M-a-k-i, a former member of the staff of the 
Federal Reserve and currently an economist.
    Chairman Greenspan. Dean Maki, I believe.
    Senator Dodd. What is it?
    Chairman Greenspan. Dean.
    Senator Dodd. Dean, yes. He is an economist today with 
JPMorgan. He says, ``Today the recovery's primary beneficiaries 
have been upper-income households.'' Your own testimony of 
course mentions a similar point when you find that increases in 
average hourly earnings of nonsupervisory workers have been 
subdued in recent months and barely budged in June, while also 
find an apparently more robust rate of growth for hourly 
earnings of supervisory workers. I wonder if I can conclude 
from your testimony here today that you would in general agree 
with Dean Maki's findings, that the primary beneficiaries of 
this recovery have been upper-income households?
    He goes on, by the way, in the article, to compare 
purchases that are occurring in some of the high end value 
stores. Nieman Marcus sales are up 13\1/2\ percent, whereas 
Payless Shoe Stores have seen sales fall by 1 percent, of low 
cost product. Putting that together, have we seen the wealthy, 
who were given huge tax cuts over the past 3 years, turn around 
and spend their tax cuts on these luxury items, while average 
workers of course have seen their wages stagnate? What are the 
implications? It worries me deeply. I think it does you as 
well. If these trendlines continue, what happens to the social 
fabric of a country where those kind of gaps exist?
    Chairman Greenspan. I am not concerned about what people 
spend money on. That is not an issue so much. But it is the 
resource issue.
    Senator Dodd. But as an evidentiary piece.
    Chairman Greenspan. Yes. I agree with Dean Maki's 
conclusions. That is what our data show as well. That is the 
reason why I think, as I indicated earlier, that is very 
important to understand the process that is going on here and 
find a way to have public policy address it.
    My own judgment, and I think the data strongly support the 
underlying forces, is that the problem is essentially an 
educational issue, plus I would suspect it may have something 
to do with immigration policy as well. But we have been unable 
to create a level of skills which would enable a significant 
part of our population to earn skilled wages. Unless we can do 
that, I am not sure how we get out of this bind.
    Obviously, we could slow down the growth of the economy, 
stabilize our technology, try not to be innovative, and that 
will actually create a stabilization in the income shares. But 
that is scarcely an acceptable way to come at this. Rather than 
try to essentially curtail economic growth, we should determine 
why it is that the skills of our schoolchildren, which in the 
fourth grade internationally are above average, somehow 
deteriorate by the time they get to the twelfth grade to well 
in the lower echelons of children around the world.
    It cannot be that our children are somehow inferior. The 
fourth graders are not. And if they are not interior in the 
fourth grade, I do not know how they become inferior 
thereafter. So it is not the quality of the students. It is 
something we do wrong. I am not knowledgeable enough to know, 
but this is a crucial issue.
    Senator Dodd. It would be worthwhile to have maybe a longer 
conversation. One of the factors I think is we--I think the 
high rate at one point in the Nixon Administration is we were 
spending something close to 6 percent of the Federal budget on 
secondary and elementary education in this country, the Federal 
Government was. Today, I think the figure is less than 2 
percent. And when you look at disparities that exist within 
school systems, even adjoining ones or neighboring ones where I 
think the average of a noncertified teacher in a poor rural and 
urban school is hovering around 35 percent of the teachers not 
certified to teach the classes they are teaching, class sizes 
being huge, there are factors there that make it difficult for 
students to learn.
    I think we should look at our choices. We can come down to 
where we allocate resources and how we make choices between the 
issue of tax cuts for the top 1 percent of income earners 
versus investing in a No Child Left Behind bill, or special 
education funds and so forth that I think could contribute to 
that. But it is an interesting point and I appreciation your 
observation because I think it does contribute to it.
    Let me jump to the deficit issue, because my colleague from 
New York is here and I suspect he may want to talk about the 
same subject matter. I want you to use a little bit if you can 
here the bully pulpit of this chair have you. Again, we are 
here from monetary policy. We have no budget. Not likely to get 
one. Maybe we will, but I doubt it at this point. We are going 
to be asked later this week to vote for a tax cut which we are 
going to be asked not to pay for. No matter how much you may 
find it attractive politically to be for it, there is no 
provision apparently to accommodate for the cost of it. We may 
be asked to vote for an omnibus appropriations bill, because we 
have only passed one appropriations bills, the Department of 
Defense appropriation bill. Otherwise, 12 appropriations bills 
have not been enacted.
    The House has done more, but nonetheless, not likely to 
reach some common agreement between the two.
    We are going to be asked to increase the debt ceiling by 
some $680 billion, therefore getting near $8 trillion in debt 
figures. That is in 42 months going from a projected, I think 
it was in excess of $3 trillion, surplus over 10 years to now 
$8 trillion in deficit. I know you feel strongly about this and 
it just seems to me we need to hear your voice again on this 
subject matter. That our fiscal policies are out of control 
here and we need some voices of discipline warning members.
    Again, I am not suggesting you come up with a policy 
solution, but I think we need to hear from you as often as we 
can. Along with the trend lines in the gap in wealth in this 
country are disturbing, the trend lines on Federal deficits are 
deeply alarming. And our inability or unwillingness to come to 
terms with them is a growing concern, it should be to all of 
us. I wonder if you might take a few minutes and express your 
views on this subject matter once again.
    Chairman Greenspan. Senator, let me just say that I think 
we are, at the moment, reaping some of the consequence of the 
failure to extend PAYGO and discretionary cap legislation in 
September 2002. You are dealing with long-term budgets, which 
has been something novel in this country in the last 20 years. 
It was not all that long ago, in the 1960's and certainly in 
the 1950's, that there were very few long-term programs. The F-
4, for example, was a project which took a number of years in 
the military, and we had certain agricultural programs which 
extended, but we did not have very long-term commitments as we 
have today.
    The problem is that our ability to forecast what the budget 
will look like 15 years from today is extremely limited. We can 
estimate within a reasonable degree of accuracy where, for 
example, Social Security, a defined-benefit program, will 
ultimately come out because it is a defined benefit and 
forecasting only a limited number of variables will tell us 
where we are going to be. In contrast, we have extraordinarily 
limited understanding of the forces that are going to drive 
Medicare 15 to 20 years from now. We know that the recipient 
population is going to rise very sharply. But if we try to 
determine what benefit outlay per recipient is going to be, we 
would have a long list of things we needed to forecast. But the 
variance in every one of them is very large. As a consequence, 
the product of those variances creates huge uncertainty.
    Unless we have a process which, for example, has a means to 
control the long-term projections, for example, to have 
triggers in the programs, both taxes and outlays, which go off, 
so to speak, when a program is significantly off the originally 
expected path. We clearly should be looking at the issue of 
sunset legislation, automatically requiring reevaluations of 
programs. The vast majority of programs will probably be 
extended by voice vote on the floor. But there would be an 
awfully large number of individual programs which really should 
be looked at. And if you look at them, some of them require 
major change, or elimination.
    We at the Federal Reserve, for example, have a process 
where every 5 years we scrub all of the regulations that we 
have built up over the years to determine which of them still 
are applicable. Had we not done that we would have had a huge 
number of regulations.
    So, I think what is wrong at the moment is that we do not 
have process. It is very difficult to vote on individual bills 
without the context of everything else. And 30, 40 years ago we 
did not need triggers. We did not need PAYGO. We did not need 
sunset legislation, largely because the vast majority of what 
the Congress voted on was relatively short term and you could 
make some reasonably good forecasts and reasonably good 
judgments.
    We can no longer do that. Unless we find that we can 
address process first and get the Budget Committees back in 
play and get the process by which the overall budget is 
constructed in the way we did prior to September 2002, I do not 
know how you figure out how to go forward. I do not think you 
can construct a Medicare program, or any amendments to 
Medicare, without some advertence to what the long-term fiscal 
outlook is, and I do not know how you do it without process.
    Senator Dodd. Thank you for that. I guess I can conclude, 
at least in the short term here, your view would be that on the 
various proposals we have before us in the budget that PAYGO at 
the very least is something the Congress to endorse; is that 
correct?
    Chairman Greenspan. Indeed.
    Senator Dodd. Thank you, Mr. Chairman.
    Chairman Shelby. Thank you, Senator Dodd.
    Senator Schumer.
    Senator Schumer. Thank you, Mr. Chairman. And thank you, 
Chairman Greenspan, as well.
    Hearing the summary of your statement and your answers to 
questions, I guess if I had to summarize it I would say, the 
recovery is sustainable. That seems to be the tone. The 
disparity I think some of us face as we go around our States 
and our country is there does not seem to be a tremendous 
amount of confidence about that. You can look at two measures. 
One, consumer confidence has been relatively flat. We have the 
oil prices, which you mentioned. And for the higher income 
people, since we have talked a lot about disparities, the stock 
market has actually gone down since the good numbers have 
started going up.
    I guess the question I have, the first question I have is, 
why do you think that is? Does it have an effect on the 
economy? You mentioned terrorism in your statement. Obviously, 
that is something that is out there that is hard to quantify. 
Do disparate incomes create that? Does the deficit help create 
lower confidence? And how much effect, if this lower confidence 
that is not as optimistic--it does not seem that average 
people, the consumer end, whether it is higher end or lower end 
seem to have that kind of confidence. Businesses seem to have a 
little more confidence these days. But even they are saying 
that profitability, which was enormously high in the last few 
quarters, is going to decline some.
    Could you just talk a little bit about this phenomenon 
which is confusing in certain ways? Particularly the stock 
market. I am puzzled how the stock market has gone down. The 
Dow Jones has gone down 400 points as all these numbers are 
good.
    Chairman Greenspan. Senator, this is not atypical of a 
recovery. If you go back historically and read the records of 
the time when you know that subsequently things got 
extraordinarily positive, people were glum. You have to put it 
in context. With regard to today's environment, for example, 
the June figures, and this soft patch we are going through, I 
do not recall a recovery in which there were not several soft 
patches. It's the way the markets work.
    There is something different here, in a sense as you point 
out, that the level of confidence is less. The way we know 
that, or the way I would suggest is a indication of it, is we 
have for the first time in a quarter-century, or more than that 
I think, the aggregate of capital investment and inventory 
investment running less than cashflow. The typical pattern is 
that businesses when they are confident are expanding. They are 
borrowing, and capital investment expands way beyond cashflow.
    If you look at the debt markets, the corporate debt 
markets, they are barely moving. In fact, I think in June, the 
preliminary estimate is that corporate debt on balance 
declined. In other words, repayments were greater than new 
extensions because cashflow is so high. I think the reasons for 
that are largely the aftermath of terrorism. I still think 
there are concerns out there. Corporate scandals have created a 
really serious issue of caution on the part of business who are 
terribly fearful of doing things which are perceived to be 
inappropriate. So that there is this sense of general lack of 
charging ahead, which clearly was the case in the latter part 
of the 1990's. It is likely that the mere aftermath of the 
1990's themselves had some effect.
    But it does not appear to be enough to hold back the 
gradual broadening we perceive to be going on. Some things go 
down, some things go up, but the markets and the economy 
continues to grow.
    The stock market does not always respond to good news 
positively, and in fact in most instances where the perception 
is that a rising economy or a booming economy will somehow 
create increased interest rates in the context where long-term 
or short-term profitability no longer has the upside to move as 
fast as it has, markets will go down under those conditions. 
So, I would say that the weakness in the stock market is a 
perfectly typical type of pattern that one sees over the years, 
and more generally that the way this economy is behaving with 
its obvious idiosyncratic characteristics, as all recoveries 
have, is nothing that we perceive at the Fed as particularly 
surprising.
    Senator Schumer. One more question, if I might, Mr. 
Chairman.
    Chairman Shelby. Go ahead.
    Senator Schumer. Although I would just make a comment I 
made in my opening statement, sometimes maybe for the stock 
market and maybe for the economy, lower interest rates are 
better than lower taxes. That is a debate on the fiscal side 
that we have been having here, although it affects you. I take 
it you would not disagree with that necessarily as long as 
underline----
    Chairman Greenspan. I can conceive of situations in which 
you could be accurate.
    Senator Schumer. How about now?
    [Laughter.]
    Here is my other question. This is a bit off the topic but 
I had wanted to ask you this before. Last week, we had a very 
interesting hearing that the Chairman led on hedge funds. It 
was an interesting discussion and I, for one, have not made up 
my mind on this thing. I have a bent that regulation, if it is 
not heavy-handed, has been good for the markets. People 
complain about it, but it works, and it has led people's view 
that our markets are on the level.
    The proposal made by Chairman Donaldson, who I know is your 
friend and whom I know you disagree with on this issue, he made 
a pretty good argument in saying, first of all, that 40 to 50 
percent of the funds register now and there does not seem to be 
too many complaints. In fact, they voluntarily register. That 
he thought registration might increase because pension funds 
and other types of funds that are dealing with consumers and 
others might feel better with the registration. He mentioned 
that the financial cost was quite low. I think he said it would 
cost about $45,000 or $50,000 to do the registration, which for 
a large pension fund is a drop in the bucket, particularly 
given their profitability.
    And he seemed to feel that the act of registering would not 
create any kind of systemic risk--sorry, you said the systemic 
risk. But he felt that the act of registering would not get in 
the way of any kind of thing that a hedge fund wanted to do in 
terms of its entrepreneurial zest, activity, risk taking, et 
cetera.
    I am wrestling with issue and I think some of us on the 
Committee are, could you give us your views on this, 
particularly on the aspect of, does required registration 
cause--oh, one other point he mentioned, which made a 
difference to me since hedge funds are based in New York and I 
try to make sure businesses come to New York and not run away, 
that you would not have people go overseas. I had heard from 
some hedge funds, well, we will just go overseas. He said, it 
does not matter. If they had U.S. investors they would still 
have to be through the same--they would meet the same legal 
requirements and have to register anyway.
    Could you comment on the issue in general, and specifically 
your view about how required registration would affect the 
entrepreneurial zeal and zest, risk-taking of the hedge funds?
    Chairman Greenspan. Senator, I actually was writing down a 
few comments on this particular issue, not sure where I would 
use it, just to get my own thoughts. It will take a couple of 
minutes for me to read it. Let me read it to you, if you do not 
mind.
    Senator Schumer. That would be great.
    Chairman Greenspan. If you do not mind, with the Chairman's 
acceptance.
    Chairman Shelby. Yes, sir, go ahead.
    Chairman Greenspan. Hedge funds have become major 
contributors to the flexibility of our financial system; an 
issue I raised earlier. That development proved essential to 
our ability to absorb so many economic shocks in recent years. 
Hedge funds seek out the abnormal rates of profit often found 
where markets are otherwise inefficient. Taking positions in 
volume, as hedge funds do, tends to eliminate the abnormal 
profits and the inefficiencies by aligning prices across 
markets and provides liquidity to markets. Successful or not, 
when those profit opportunities are perceived to be eliminated, 
individual funds move on to address other inefficiencies.
    But these above-normal profits have attracted a large 
number of new entrants seeking to exploit a possibly narrowing 
field of inefficiencies. Not surprising, the rate of return in 
this activity is reportedly declining. I would not be surprised 
if, with time, many of the new entrants exited, some presumably 
following large losses.
    Chairman Donaldson, who as you mentioned has been a good 
friend of mine for 45 years, is certainly right in wanting to 
eliminate fraud by hedge funds and other financial 
institutions. Fraud undermines markets and the efficient 
functioning of our economy.
    My problem with the SEC's current initiative is that the 
initiative cannot accomplish what it seeks to accomplish. Fraud 
and market manipulation will be very difficult to detect from 
the information provided by registration under the 1940 Act. 
Fraud is almost always uncovered through complaints of 
counterparties or by accident, such as our uncovering millions 
of dollars of the new U.S. currency in Federal Reserve 
wrappings in Iraq.
    This is certainly true, namely the uncovering of fraud, in 
banking as we experience it, and I assume is also true for 
regulated broker-dealers as well. Even should SEC's proposed 
risk evaluation surveillance of hedge funds detect possible 
trading irregularities, which I doubt, those irregularities 
will likely be idiosyncratic and of mainly historic interest 
because by the time of detection hedge funds would have long 
since moved on to different strategies.
    Should the existing proposal fail in achieving its goal, 
pressure will become irresistible to expand SEC's regulatory 
reach in an endeavor to accomplish it set out to do. Hedge fund 
arbitragers are required to move flexibly and expeditiously if 
they are to succeed. If placed under increasing restrictions, 
many will be leave the industry to the significant detriment of 
our economy.
    Senator Schumer. So in other words, if I might, and I 
appreciate your statement. As I said, I am grappling with this 
issue and have not made up my mind, but you are saying 
registration in itself would not be detrimental. It might not 
accomplish what its advocates say, but could leave to other 
things that would become detrimental. Is that a fair summation?
    Chairman Greenspan. That is correct.
    Senator Schumer. Without the erudition that you have.
    Thank you, Mr. Chairman.
    Chairman Shelby. Chairman Greenspan, it has been a long 
afternoon. I have a number of questions I am going to submit 
for the record. We appreciate your candor, your appearance as 
always, and we will be watching you and praying for our 
economy. It is doing well. Thank you.
    Chairman Greenspan. Thank you, sir.
    Chairman Shelby. The hearing is adjourned.
    [Whereupon, at 4:55 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]
               PREPARED STATEMENT OF SENATOR WAYNE ALLARD
    Thank you, Chairman Shelby, for convening this important hearing. I 
always look forward to the opportunity to hear from Chairman Greenspan.
    I believe that the U.S. economy is on the right track. The economy 
is growing, payroll employment is up, and new and existing home sales 
set new record highs in May. This is good news.
    However, we cannot take the positive economic news for granted; 
Congress needs to do more to continue to promote a healthy economy. 
First, we need to address the looming problems in the various 
entitlement programs.
    Second, we need to continue to provide economic incentives through 
tax cuts, including making the previous tax cuts permanent.
    Finally, I believe the most important way that we can ensure the 
long-term economic vitality of our country is to control Government 
growth and spending. Congress will not spend the Nation into 
prosperity. Chairman Greenspan, you and I have discussed this point a 
number of times during your previous appearances before the Banking 
Committee, and I have always appreciated your comments in favor of 
Government restraint.
    Chairman Greenspan, I know that you have a very busy schedule, so I 
appreciate you taking the time to appear before the Committee today. I 
look forward to your report and the opportunity to raise several 
questions with you.

                               ----------
                  PREPARED STATEMENT OF ALAN GREENSPAN
       Chairman, Board of Governors of the Federal Reserve System
                             July 20, 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 also 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 1990's. Indeed, over much of the previous 3 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 cashflow. 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 6 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 
12-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 long-term 
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 noncommercial have established net short positions in 10-
year Treasury note futures in recent months. Indeed, the swing toward a 
net short position on 10-year Treasury note futures has been the 
largest since the inception of the contract in the 1980's, 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.
    Last, very large fractions of the total outstanding obligations of 
businesses and households are long-term, 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, 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 25 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.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY 
                      FROM ALAN GREENSPAN

The Housing Sector
Q.1. The semi-annual written report refers to activity in the 
housing sector remaining ``torrid'' in the first half of 2004. 
There have been some concerns expressed about a potential 
bubble in housing prices. Your report indicates that house 
price increases have outstripped gains in incomes as well as 
rents in recent years. In a recent speech, one member of the 
Board of Governors, Governor Kohn, indicated that ``the odds 
have risen that these prices could be out of line with 
fundamentals.'' Governor Kohn also indicated that ``we still 
cannot be very confident about whether a significant 
misalignment exists, however.'' What is your assessment of the 
continued rise in housing prices? Are there any particular 
geographic sectors that you are more concerned about than 
others?

A.1. As you note, the most recent Monetary Policy Report to the 
Congress indicated that house price increases have outstripped 
gains in income as well as rents in recent years. This 
observation raises the possibility that real estate prices, at 
least in some markets, could be out of alignment with the 
fundamentals. But as 
Governor Kohn notes, that conclusion cannot be reached with any 
confidence. For example, the rise in house prices relative to 
rents and incomes has, no doubt, been influenced by the low 
level of mortgage interest rates in recent years in ways that 
cannot be gauged precisely. Moreover, the available data are 
not fully adequate for a complete analysis of the issue; house 
prices are difficult to measure given the enormous 
heterogeneity of the U.S. housing stock--both within and across 
geographic regions--and available measures of residential rents 
do not match precisely with the units for which we have prices. 
Although taking a firm stand on the appropriateness of real 
estate prices is not possible, policymakers do need to take 
account of their influence on economic activity. As is the case 
with other asset prices, we monitor real estate prices closely 
in developing our economic outlook.
    The data limitations that prevent a complete analysis of 
housing price developments at the national level are even more 
binding at the local level, making it especially difficult to 
detect asset price misalignments for specific markets.
Improvements in the World Economy
Q.2. The semi-annual report comments on solid gains in U.S. 
exports since mid-2003 due to the strong economic performance 
of many of the major trading partners. What is your view as to 
the continued economic strength of our trading partners? In 
particular, do you believe the improvements in Japan will 
continue?

A.2. Over the past year, the global economic recovery has 
become both stronger and more sustainable. Growth has 
strengthened in every major region compared with the sluggish 
performance during the first half of 2003, and recent 
indicators suggest that the foreign economies continue to put 
in a favorable performance. To be sure, average growth in 
emerging Asia appears to have braked sharply in recent months, 
as policy measures muffled the boom in the Chinese economy. 
However, continued strong export growth and recent signs of an 
acceleration in consumer spending suggest that Chinese GDP 
growth will rebound in the second half of this year. Recovery 
in Canada and in Latin America also appears to be on track, and 
economic expansion in the United Kingdom continues unabated. 
The pace of recovery in the euro area has been sluggish, 
however, with particularly weak activity in Germany.
    In Japan, the rebound that began last year has continued to 
broaden. Japanese exports have grown rapidly over the past 
couple of years, as exports to China and other emerging Asian 
economies have surged. The expansion in exports has contributed 
to a snapback in corporate profits in the export-related 
manufacturing sector, and the revival in profits appears to be 
spreading to the more domestic-oriented nonmanufacturing 
sector. Rising profitability along with improving conditions in 
the corporate sector more generally have allowed investment to 
rebound from its recent trough. Labor markets have also 
revived, with employment rising and the unemployment rate 
declining from a peak of 5.5 percent early last year to 4.6 
percent at present. Against this backdrop of strengthening 
activity, consumer price deflation has eased markedly since 
early 2002.
    These positive developments suggest that Japan may finally 
be on its way to a self-sustaining recovery. However, there are 
several risks to the outlook. In particular, the recent run-up 
in oil prices, if sustained, may exert a significant drag on 
Japanese economic activity. Moreover, Japanese consumption has 
risen sharply over recent quarters, while employee compensation 
has fallen. The result has been a marked decline in the 
household saving rate. Most analysts expect the saving rate to 
move up as economic conditions 
improve. If this happens abruptly, consumption might lag the 
recovery even if compensation begins to rise. Also, the 
possibility of a hard landing in China carries significant 
risks for Japan as well as for other Asian economies. Finally, 
bank lending in Japan continues to contract, and more 
aggressive financial sector restructuring remains important for 
Japan's long-term growth prospects.
The President's Working Group & Hedge Funds
Q.3.a. In 1999, the President's Working Group concluded that 
``requiring hedge fund managers to register as investment 
advisers would not seem to be an appropriate method to monitor 
hedge fund activity.'' In the intervening 5 years, have market 
conditions changed in order to justify a different conclusion?

A.3.a. No. The Working Group's report made two arguments in 
support of this conclusion. First, it argued that the provision 
of the Investment Advisers Act that exempts hedge fund managers 
from registration (Section 203(b)(3)) evidences a Congressional 
determination that clients of an adviser that has relatively 
few clients do not need the substantive protections of the 
Investment Advisers Act. Congress has not repealed Section 
203(b)(3). Second, it argued that the sophisticated investors 
that typically invest in hedge funds are in a position to 
protect their own interests. There is no evidence that 
investors in hedge funds today are less sophisticated than they 
were in 1999. Indeed, institutional investors have accounted 
for a growing share of hedge fund investments, and they can and 
should protect their own interests rather than rely on the 
limited regulatory protections that would be provided as a 
result of a registration requirement.

Q.3.b. What, if any, mechanism would be the appropriate method 
for monitoring hedge fund activity in light of their growth in 
recent years and the increased investor involvement while at 
the same time being mindful of liquidity concerns?

A.3.b. The case for monitoring hedge fund activity has not been 
made. Some have argued that monitoring of hedge funds is 
necessary to detect and deter market manipulation. However, the 
data collected from registered advisers is limited to total 
assets under management, which would provide no insight into 
any manipulative activities. Concerns about market 
manipulation, whether by hedge funds or others, can best be 
addressed by enhanced market surveillance. If there were a 
public policy reason to monitor hedge fund activity, the best 
method of doing so without raising liquidity concerns would be 
indirectly through oversight of those broker-dealers (so-called 
prime brokers) that clear, settle, and finance trades for hedge 
funds. Although the use of multiple prime brokers by the 
largest funds would complicate the monitoring of individual 
funds by this method, such monitoring could provide much useful 
information on the hedge fund sector as a whole.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING 
                      FROM ALAN GREENSPAN

Q.1. The Securities and Exchange Commission (SEC) has recently 
issued a proposed rule on the Gramm-Leach-Bliley push-outs 
provisions governing bank securities activities. It is this 
Senator's recollection that Congress intended to allow banks to 
continue their 
existing, limited securities activities that are part of their 
banking business, such as trust, fiduciary, and custodial 
activities. Do you believe that the SEC proposal accomplishes 
Congressional intent? Also, do you believe that this SEC 
proposal has complied with the intent of Congress not to impose 
unnecessary regulatory burdens on banks?

A.1. Prior to the Gramm-Leach-Bliley Act of 1999 (GLB Act), 
banks enjoyed a blanket exception from the definitions of 
``broker'' and ``dealer'' in the Securities Exchange Act of 
1934 (1934 Act). As part of the GLB Act, Congress replaced this 
blanket exception for banks with a series of 15 exceptions 
designed to allow banks to continue to conduct securities 
activities that are part of normal bank activities. When these 
activity-focused exceptions go into effect, a bank may avoid 
registration as a broker-dealer under the 1934 Act only if the 
bank limits its securities activities to those covered by one 
or more of the new activity-focused exceptions. Because banks 
cannot as a practical matter register as a broker-dealer, 
securities brokerage and dealer activities that do not fit 
within one of these 
activity-focused exceptions would have to be ``pushed-out'' of 
the bank to an SEC-registered broker-dealer.
    The activity-focused exceptions that Congress adopted for 
banks in the GLB Act are broad and were intended to allow banks 
to continue to provide their customers securities services in 
connection with their normal banking activities without 
significant disruption. For example, Congress adopted important 
statutory exceptions for the trust, fiduciary, and custodial 
activities of banks. In adopting these exceptions, Congress 
recognized that banks have long provided their customers 
securities services in connection with their trust, fiduciary, 
and custodial activities. Furthermore, Congress recognized that 
banks had provided these services for decades prior to the GLB 
Act without significant securities-related problems and under 
the effective supervision of the Federal and State banking 
agencies. The new activity focused exceptions were designed to 
complement the new authority granted by the GLB Act, which 
allowed banks to affiliate with full-service securities firms 
without the restrictions embodied in the Glass-Steagall Act, by 
restricting the ability of banks to significantly expand their 
securities services. In particular, these targeted exceptions 
were intended to prevent banks from operating a distinct retail 
brokerage business within the bank.
    The Board and the other Federal banking agencies previously 

expressed concern that earlier SEC proposals to implement the 
securities provisions of the GLB Act were not consistent with 
the express terms or the Congressional purpose of the GLB Act. 
In June, the SEC requested comment on new rules to implement 
the ``broker'' exceptions for banks in the GLB Act, including 
the important exceptions for bank trust, fiduciary, and 
custodial activities. The public comment period on these rules 
currently is scheduled to expire on September 1, 2004. Board 
staff, in conjunction with the staffs of the other Federal 
banking agencies, currently is reviewing and analyzing the 
SEC's proposed rules to determine whether these rules, 
consistent with Congress's intent, would permit banks to 
continue to effect securities transactions in connection with 
their traditional bank activities and without significant 
disruption. The Board will provide you a copy of any comment 
letter that the Board decides to file with the SEC on the 
proposed rules.

        RESPONSE TO A WRITTEN QUESTION OF SENATOR CRAPO 
                      FROM ALAN GREENSPAN

Q.1. A divided SEC voted 3-2 last Wednesday to seek comments on 
a proposal for mandatory registration of hedge fund advisers 
with the SEC. Are you concerned with the divided SEC's proposal 
for mandatory registration of hedge fund advisers with the SEC? 
Do you think the President's Working Group on Financial Markets 
should be involved in issues related to regulation of the hedge 
fund industry?

A.1. I am concerned with the proposal. The proposal seeks to 
deter fraud and market manipulation, but it is unlikely to 
accomplish those objectives. The information reported to the 
SEC by registered advisers is very limited and would be of 
little value for these purposes. Nor are examinations of 
advisers likely to uncover much fraud. Our experience with bank 
examinations indicates that examiners have great difficulty 
uncovering fraud. Most often it is uncovered through complaints 
by customers or disaffected employees rather than through 
exams. I believe this was also the case with the recent 
scandals in the regulated mutual fund industry. Should 
registration fail to achieve the intended objectives, pressure 
may well become irresistible to expand the SEC's regulatory 
reach from hedge fund advisers to hedge funds themselves. The 
application of the Investment Company Act to hedge funds would 
greatly impede their important contributions to the flexibility 
and resiliency of our financial system.
    Because of the critical role that hedge funds have come to 
play in our financial system, all of the members of the 
President's Working Group have an interest in what regulations, 
if any, apply to their activities. It was this shared interest 
that motivated the Working Group's April 1999 report on Hedge 
Funds, Leverage, and the Lessons of Long-Term Capital 
Management. More recently, it has motivated discussions within 
the Working Group of the SEC's adviser registration proposal. 
In that sense, the Working Group should be and has been 
involved in issues related to the regulation of the hedge fund 
industry. But decisions about the application of the Investment 
Advisers Act to hedge fund advisers fall squarely within the 
SEC's jurisdiction and must be made by the SEC.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SUNUNU 
                      FROM ALAN GREENSPAN

Q.1. I understand that in August 2003, the Federal Reserve 
proposed a rule to loosen the tying restrictions on bank 
holding companies--the proposal and the subsequent supervisory 
guidance would entail an interpretation of Section 106 of the 
Bank Holding Company Act Amendments of 1970. Can you describe 
the intent of the Fed proposal and comment on the status of the 
rule? Also, does the Federal Reserve Board view tying as a 
problem in large financial institutions?

A.1. The special antitying restrictions established by Section 
106 of the Bank Holding Company Act Amendments of 1970 are 
quite complex. For example, these restrictions apply only to 
banks and do not apply to the nonbank affiliates of a bank or 
other nonbank entities. In addition, while Section 106 
prohibits banks from imposing certain types of tying 
arrangements on their customers, there are several important 
exceptions to the statute. These exceptions, among other 
things, expressly allow a bank to condition the availability or 
price of a product on a requirement that the customer also 
obtain a ``loan, discount, deposit, or trust service'' from the 
bank or an affiliate.
    These exceptions and the statute's complex structure can 
make applying the statute a challenging and fact-intensive 
process. In 
recent years, the Board has received a number of inquiries 
concerning the antitying prohibitions in Section 106 and the 
compliance of banking organizations with these restrictions. 
These inquiries indicated that there was some uncertainty, both 
among bankers and their customers, as to what types of bank 
actions are prohibited by Section 106.
    To help address this uncertainty, the Board in 2003 
requested public comment on a formal interpretation of the 
statute and 
related supervisory guidance. The interpretation was intended 
to provide banks and their customers a comprehensive guide to 
the statute and, thus, improve the public's understanding of 
the statute's restrictions. The proposed interpretation, for 
example, discusses the necessary elements of a prohibited tying 
arrangement, describes the statutory and regulatory exceptions 
to the statute's prohibitions, and provides examples of the 
types of bank actions that are prohibited and permissible under 
the statute. The related supervisory guidance describes the 
types of internal controls that should help banks comply with 
the antitying restrictions in Section 106. The Board has 
received approximately 40 comments on the proposed 
interpretation and related supervisory guidance and we hope to 
finalize these documents in the near future.
    Federal Reserve examiners review the antitying programs of 
bank holding companies and State member banks as part of the 
regular compliance reviews of these organizations. In 2002, 
examiners from the Federal Reserve and the Office of the 
Comptroller of the Currency also conducted targeted antitying 
examinations at several large banking organizations. The 
targeted exams indicated that the banking organizations 
reviewed generally have adequate policies and procedures to 
ensure compliance with the antitying restrictions of Section 
106, and the agencies generally did not uncover unlawful tying 
arrangements in these examinations. The Government 
Accountability Office also recently conducted a review of bank 
compliance with Section 106 and found that the available 
evidence does not substantiate claims that banks are tying the 
availability or price of credit to the purchase of debt 
underwriting services from a securities affiliate of the bank.
    Based on our supervisory experience, it appears that 
banking 
organizations generally have adequate internal controls to help 
prevent illegal tying. The Board, however, will take 
appropriate supervisory action against a bank within our 
supervisory jurisdiction if information developed through the 
supervisory process or provided by a customer indicates that 
the bank has imposed a tie on a customer in violation of 
Section 106. For example, in 2003, the Board took enforcement 
action against a foreign bank for violations of Section 106 
after investigating a tying complaint received from one of the 
bank's customers.

Q.2. In November 2003, the DOJ's Antitrust Division submitted a 
comment letter to the Fed on its proposal to address tying. The 
letter stated that the prohibitions on tying within Section 106 
are much broader than those found in Federal antitrust laws and 
that the Fed's proposed interpretation and supervisory guidance 
might continue to prohibit some pro-competitive practices, such 
as multiproduct discounting. The DOJ expressed concern that 
Section 106 disadvantages banks as competitors in markets in 
which banks and nonbanks compete--lessening competition and 
ultimately harming consumers. The DOJ recommended that the 
Fed's interpretation of Section 106 be consistent with, and not 
broader than, the Federal antitrust laws.
    It would appear that Section 106 was designed to protect 
small business customers or individual consumers from being 
forced to buy products they do not wish to purchase. The 
Division's letter further recommends that, at a minimum, 
Section 106 should be limited to ties involving small 
businesses and individual consumers.
    What are your views regarding the DOJ's Antitrust 
Division's recommendations that Section 106 not be interpreted 
to prohibit conduct that is not found to be anticompetitive 
under the Federal antitrust laws? Also, what are your views on 
applying general antitrust standards when banks are dealing 
with large, sophisticated customers?

A.2. As you note, the Antitrust Division of the Department of 
Justice has submitted a comment letter to the Board concerning 
the Board's proposed interpretation of Section 106. In the 
letter, the Antitrust Division supported the Board's efforts to 
clarify that 
Section 106 does not prohibit banks from entering into tying 
arrangements with their customers when these arrangements are 
voluntarily entered into or sought by the bank's customer (so-
called ``voluntary ties'').
    The Division's letter also expressed concern that Section 
106 may itself harm competition and consumers by limiting the 
ability of banks to provide their customers discounts on 
packaged offerings and by placing banks at a disadvantage in 
markets where both banks and nonbank entities compete. 
Accordingly, the Division recommended that the Board seek to 
interpret the antitying restrictions in Section 106 in a manner 
that is consistent with the tying restrictions that apply to 
all companies, including banks, under the Sherman and Clayton 
Acts. However, the Antitrust Division's letter also recognizes 
that the courts historically have interpreted Section 106 as 
imposing significantly more stringent antitying prohibitions on 
banks than apply to companies generally under the Sherman and 
Clayton Acts and that these precedents may constrain the 
ability of the Board to interpret Section 106 to be coterminous 
with the general antitrust laws.
    The Board will carefully consider the views of the 
Antitrust Division as the Board moves forward with the proposed 
interpretation and related matters.

      RESPONSE TO A WRITTEN QUESTION OF SENATOR STABENOW 
                      FROM ALAN GREENSPAN

Currency Manipulation
Q.1. As you are aware, there has been a lot of concern in the 
Senate with both China and Japan's monetary policy actions, 
particularly related to Japan's huge interventions in 
international 
currency markets to maintain an artificially weak yen, as well 
as China's dollar peg. The last time you and I discussed this, 
you referred to it as a ``problem''--something the Bush 
Administration has been unwilling to do. I would argue that it 
has been an on-going problem and requires Government action to 
end this unfair currency manipulation tax placed on American 
products.
    I believe that Japan's long-standing and successful efforts 
in maintaining an artificially weak yen have been a major 
factor in the ongoing weakness of our manufacturing sector. It 
also has a very negative impact on the automotive sector.
    Although, as you and I discussed recently, Japan had 
stopped its interventions in the last several months after 
spending over $138 billion in the first quarter of this year 
and over $330 billion since 2003, I would note that significant 
sums of money, perhaps as much as $50 billion per month, have 
been budgeted for such future actions in Japan's current fiscal 
year budget. Financial markets are also clearly wary of 
statements from senior officials from Japan's Ministry of 
Finance that the government is not ruling out intervening again 
in massive amounts again if they so choose. And this threat 
alone seems to be putting an artificial ceiling on the yen's 
move toward its appropriate value.
    Given on-going concerns over Japan's currency actions in 
our last hearing and the ever-present threat of further massive 
interventions, should the United States and the G-7 make very 
clear to Japan that a resumption of such interventions would be 
unwelcome and disruptive to the global economy?
    Also, can you provide an analysis of the impact to our 
economy of Japan's successful efforts to weaken its yen? Has it 
undermined the Federal Reserve's efforts to stimulate U.S. 
economic growth and create jobs, particularly in the 
manufacturing sector?

A.1. U.S. policy regarding the foreign exchange value of the 
dollar--against the yen or any other currency--is the province 
of the Secretary of the Treasury, who is also the chief 
spokesperson for the U.S. Government on these matters. I defer 
to the Secretary on any official U.S. response to the concerns 
you raise about Japanese policy operations with respect to the 
dollar's exchange value against the yen. G-7 finance ministers, 
central bank governors, and their respective deputies meet 
frequently to discuss exchange rates and related foreign 
exchange operations, such as those conducted earlier this year 
by Japan.
    Japan's official intervention operations, in which the 
Japanese government purchased dollars in foreign exchange 
markets and sold yen, may have influenced some U.S. asset 
prices. One effect could have been on the foreign exchange 
value of the dollar against the yen. In principle, the Japanese 
operations would have weakened the yen against the dollar, and 
it is possible that the operations did so, although the size 
and persistence of any effects are difficult to judge. However, 
one should keep in mind that, despite the large scale of the 
Japanese operations in 2003 and 2004, the yen has strengthened 
against the dollar on balance, rising roughly 20 percent from 
its low point against the dollar in early 2002.
    Because the Japanese authorities invested the proceeds of 
their dollar purchases in interest-earning, dollar-denominated 
assets, another effect of their operations on U.S. asset prices 
could have come through the potential effect of these 
operations on U.S. interest rates. In principle, the operations 
would have resulted in increased demand for U.S. securities and 
somewhat lower U.S. interest rates. While it is possible that 
these operations did have such an effect, the magnitude of any 
effect is likely to have been quite small. U.S. securities 
markets are the deepest and most liquid of any in the world, 
and the scale of the Japanese operations, while large by some 
standards, was arguably too small to have had a substantial 
effect on the general level of U.S. interest rates.
    In any event, the operations of the Japanese have not 
hampered the Federal Reserve in its efforts to conduct monetary 
policy to achieve price stability and maximum sustainable 
growth for the U.S. economy.



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