[Joint House and Senate Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
S. Hrg. 109-392
THE ECONOMIC OUTLOOK
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HEARING
BEFORE THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
__________
OCTOBER 20, 2005
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Printed for the use of the Joint Economic Committee
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JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]
HOUSE OF REPRESENTATIVES SENATE
Jim Saxton, New Jersey, Chairman Robert F. Bennett, Utah, Vice
Paul Ryan, Wisconsin Chairman
Phil English, Pennsylvania Sam Brownback, Kansas
Ron Paul, Texas John Sununu, New Hampshire
Kevin Brady, Texas Jim DeMint, South Carolina
Thaddeus G. McCotter, Michigan Jeff Sessions, Alabama
Carolyn B. Maloney, New York John Cornyn, Texas
Maurice D. Hinchey, New York Jack Reed, Rhode Island
Loretta Sanchez, California Edward M. Kennedy, Massachusetts
Elijah E. Cummings, Maryland Paul S. Sarbanes, Maryland
Jeff Bingaman, New Mexico
Christopher J. Frenze, Executive Director
Chad Stone, Minority Staff Director
C O N T E N T S
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Opening Statement of Members
Statement of Hon. Jim Saxton, Chairman, a U.S. Representative
from New Jersey................................................ 1
Statement of Hon. Jack Reed, Ranking Minority Member, a U.S.
Senator from Rhode Island...................................... 2
Witnesses
Statement of Hon. Ben Bernanke, Chairman, Council of Economic
Advisers, Washington, DC....................................... 4
Statement of Dr. Mickey D. Levy, Chief Economist, Bank of
America, New York, NY.......................................... 23
Statement of Dr. David F. Seiders, Chief Economist, National
Association of Home Builders, Washington, DC................... 26
Statement of Dr. Brad Setser, Senior Economist and Director of
Global Research, Roubini Global Economics, LLC, New York, NY... 28
Submissions for the Record
Prepared statement of Representative Jim Saxton, Chairman........ 37
Civilian Unemployment Rate Chart............................. 38
International Unemployment Chart............................. 39
Core PCE Inflation Chart..................................... 40
Personal Consumption Expenditures (PCE) Chart................ 41
Economic Effects of Inflation Targeting, Study............... 42
Prepared statement of Senator Jack Reed, Ranking Minority Member. 49
Chart submitted by Representative Carolyn B. Maloney showing the
growing trend of inequality between the ``haves'' and the
``have-nots''.................................................. 51
Prepared statement of Hon. Ben Bernanke, Chairman, Council of
Economic Advisers, Washington, DC.............................. 52
Prepared statement of Dr. Mickey D. Levy, Chief Economist, Bank
of America, New York, NY....................................... 55
Prepared statement of Dr. David F. Seiders, Chief Economist,
National Association of Home Builders, Washington, DC.......... 60
Prepared statement of Dr. Brad Setser, Senior Economist and
Director of Global Research, Roubini Global Economics, LLC, New
York, NY....................................................... 67
THE ECONOMIC OUTLOOK
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THURSDAY, OCTOBER 20, 2005
Congress of the United States,
Joint Economic Committee,
Washington, DC
The Committee met, pursuant to notice, at 10 a.m., in room
311, Cannon House Office Building, the Honorable Jim Saxton,
Chairman of the Committee, presiding.
Representatives Present: Saxton, Ryan, English, Paul,
Maloney, Hinchey, and Sanchez.
Senators present: Bennett and Reed.
Staff present: Chris Frenze, Robert Keleher, Brian
Higginbotham, Colleen Healy, John Kachtik, Suzanne Stewart,
Jeff Schlagenhauf, Emily Gigena, Chad Stone, Matt Salomon, Nan
Gibson, and Daphne Federing.
OPENING STATEMENT OF HON. JIM SAXTON, CHAIRMAN, A U.S.
REPRESENTATIVE FROM NEW JERSEY
Representative Saxton. Good morning. I am pleased to have
the opportunity to welcome Chairman Bernanke and the members of
our second panel as well before the Joint Economic Committee
this morning.
The Committee values its long history of cooperation with
the Council of Economic Advisers. The testimony today will
provide a solid foundation for understanding the forces that
are shaping current economic conditions, as well as the
economic outlook.
The recent hurricanes have caused a tragic loss of life and
property on the Gulf Coast and also have had temporary effects
on the U.S. economy as a whole. One reason for this national
impact is that a significant portion of U.S. oil and gas
production is concentrated in the Gulf, and much of it is still
damaged. Thus, it is reasonable to expect that the economic
impact of the hurricanes will slow GDP growth during the second
half of 2005.
In 2006, as recovery efforts proceed, many economists
expect growth to be a bit higher than previously forecast.
Despite the hurricane damage, a broad array of standard
economic data indicates that the economic expansion has built
up a strong momentum. The U.S. economy grew at 4 percent during
2004 and advanced at a rate of about 3.5 percent in the first
half of 2005. A rebound in business investment has played an
important role in explaining the pickup of the economy since
2003. Equipment and software investment has been strong over
this period.
The improvement in economic growth is reflected in other
economic figures as well. For example, since May of 2003,
business payrolls have increased by 4.2 million jobs. The
unemployment rate stands at 5.1 percent. Consumer spending
continues to grow. Home ownership has hit record highs.
Household net worth is also at a record level, and productivity
growth continues at a healthy pace.
Long-run inflation pressures appear to be contained, and
that is good news. Long-term interest rates, including mortgage
rates, are still relatively low, in spite of the fact that the
Fed has increased short-term rates. It is clear that the Fed
remains poised to keep inflation under control.
In summary, overall economic conditions remain positive.
The U.S. economy has displayed remarkable flexibility and
resilience in dealing with many shocks.
It is clear that monetary policy and tax incentives for
investment have made important contributions to the improvement
of the economy in recent years. Recently released minutes from
the Federal Reserve suggest that the central bank expects this
economic strength to continue. The Administration forecast for
economic growth in 2006 is compatible with those of the Blue
Chip consensus and Federal Reserve.
With growth expected to exceed 3 percent next year, the
current economic situation is solid, and the outlook remains
favorable.
At this time, we will go to Ranking Member Senator Reed for
his opening statement.
[The prepared statement of Representative Saxton appears in
the Submissions for the Record on page 37.]
OPENING STATEMENT OF HON. JACK REED, RANKING MINORITY MEMBER, A
U.S. SENATOR FROM RHODE ISLAND
Senator Reed. Thank you very much, Mr. Chairman.
I want to welcome Chairman Bernanke to the hearing today. I
hope he will give us some important insights into current
economic conditions and the President's policies and the
direction of these policies.
I am also pleased that we will have a second panel of
witnesses to provide additional perspectives on the current
economic conditions and outlook.
Like many Americans, my concerns about the economic outlook
and the Administration's stewardship of the economy have grown
in the wake of Hurricane Katrina and Hurricane Rita and the new
hurricane in the Gulf. Economic insecurity for workers is
widespread as energy prices are soaring. Employer-provided
health insurance coverage is falling, private pensions are in
jeopardy, and American workers are still waiting to see the
benefits of the economic recovery reflected in their paychecks.
President Bush's tax cuts were poorly designed to stimulate
broadly shared prosperity, and it produced a legacy of large
budget deficits that leaves us increasingly hampered in our
ability to deal with the host of challenges that we face. The
devastating impact of Hurricanes Rita and Katrina will put
short-term strains on the Federal budget, strains that would be
fairly easy to absorb if our budget and economic policies were
sound, but they are not.
The President's goals of making his tax cuts permanent and
cutting the deficit in half are simply incompatible. Large and
persistent budget deficits have also contributed to an ever-
widening trade deficit that forces us to borrow vast amounts
from abroad and puts us at risk of a major financial collapse
if foreign lenders suddenly stop accepting our IOUs. The trade
deficit of $59 billion in August is close to the record for a
single month of more than $60 billion set in February.
The broader current account deficit, which measures how
much we are borrowing from the rest of the world, is running at
a record annual rate of nearly $800 billion, or well over 6
percent of GDP. I will be interested in the Chairman's views on
whether the budget deficit and trade deficit are dangerous
imbalances that pose a risk to the economic outlook. I am also
pleased that we will be able to hear Dr. Setser's views, which
may be somewhat different.
I hope that we would all agree that raising our future
standard of living and preparing adequately for the retirement
of the baby boom generation require that we have a high level
of investment and that a high fraction of that investment be
financed by our own national savings, not by foreign borrowing.
We followed such prosperity enhancing policies under President
Clinton, but that legacy of fiscal discipline has been
squandered under President Bush.
Sound policies are clearly important for the long run, but
I am also deeply concerned about what continues to be a
disappointing economic recovery for the typical American
worker. Strong productivity gains have turned up in the bottom
line for the shareholders, but not in the paychecks of workers.
The typical worker's earnings are not keeping up with their
rising living expenses, and both earnings and economic
inequality are increasing.
It is certainly hard to take seriously the President's
rhetoric about wanting to lift families out of poverty when he
has refused to support an increase in the minimum wage and has
lifted the Davis-Bacon Act, thereby legitimizing subpar wages
for workers rebuilding the communities in the hurricane-
stricken gulf coast region.
Even though home heating costs are expected to skyrocket
this winter, President Bush said he will not request additional
funds for the Low Income Home Energy Assistance Program known
as LIHEAP. Together with my colleagues, Senators Snowe and
Collins, we have been trying to reverse that by providing
additional funds, and I hope we succeed, but I think the
Administration should be supportive, not antagonistic to that
approach.
I look forward to your testimony, Chairman Bernanke, about
the economic outlook; and thank you again, Mr. Chairman, for
this hearing.
[The prepared statement of Senator Reed appears in the
Submissions for the Record on page 49.]
Representative Saxton. Thank you.
Thank you for being with us this morning, Dr. Bernanke. Let
me just say, for purposes of introduction, Dr. Bernanke was
sworn in June of 2005 as chairman of the President's Council of
Economic Advisers. Prior to his appointment to the Council, Dr.
Bernanke served as a member of the Board of Governors of the
Federal Reserve.
We are pleased to have you here today.
I might also note, as a New Jerseyan, that Dr. Bernanke has
served as professor of economic and public affairs at Princeton
University.
Dr. Bernanke.
STATEMENT OF HON. BEN BERNANKE, CHAIRMAN, COUNCIL OF ECONOMIC
ADVISERS, WASHINGTON, DC
Dr. Bernanke. Thank you.
Chairman Saxton, Vice Chairman Bennett, Ranking Member Reed
and Members of the Committee, thank you for the opportunity to
testify before the Joint Economic Committee. We appreciate the
long-standing and mutually beneficial relationship between the
Committee and the Council of Economic Advisers. My remarks
today will focus on the current state of the economy, but of
course, such an overview would be incomplete without an eye to
the human and economic impacts of Hurricanes Katrina and Rita
in the U.S. Gulf Coast.
While it has been nearly two months since Hurricane Katrina
made landfall, its devastation will have a protracted impact on
the Gulf region. As you know, Hurricane Katrina wreaked
unprecedented losses on the people of Louisiana, Mississippi,
and the Alabama coasts. Katrina took many lives, destroyed
communities and shook a vital portion of our nation and our
economy. The Gulf region was then hit by Hurricane Rita, which
did significant damage, but in most areas less than was feared.
In response to the disasters, the President has directed
all agencies of the Federal Government to devote their maximum
effort to helping the victims of the hurricanes and to begin
the process of cleaning up and rebuilding the region. The
President has also proposed a series of measures to restore the
Gulf's communities and economy.
One of the greatest assets we have in rebuilding after a
hurricane is the overall strength of the national economy. The
resiliency of the economy--the product of flexible labor
markets, a culture of entrepreneurship, liquid and efficient
capital markets and intense market competition--is helping it
to absorb the shocks to energy and transportation from the
hurricanes. The ability of our economy to grow and create jobs
will act as a lifeline to the regions and people most affected.
Thus, these recent events make it all the more important that
we keep the fundamentals of the national economy strong and
continue to promote economic policies that will encourage
growth and job creation.
When thinking about where the economy is now and where it
is heading, it is useful to keep in mind just how far the U.S.
economy has come in recent years. The economy's resilience was
put to severe test in the past 5 years, even prior to Katrina.
A remarkable range of shocks hit the U.S. economy, beginning
with a sharp decline in stock prices in 2000 and the recession
that followed in 2001. The economy was further buffeted by the
terrorist attacks of September 11, 2001, and the subsequent
geopolitical uncertainty. Business and investor confidence was
shaken by a series of corporate scandals in 2002. By early
2003, uncertainty about economic prospects was pervasive and
the economy appeared to be sputtering.
Yet, in the face of all these shocks, together with new
challenges such as the recent sharp rise in energy prices, the
American economy has rebounded strongly. Policy actions taken
by the President and the Congress were important in getting the
economy back on track. Notably, beginning with the President's
2001 tax cuts, multiple rounds of tax relief increased
disposable income for all taxpayers, supporting consumer
confidence and spending, while increasing incentives for work
and entrepreneurship. Additional tax legislation passed in 2002
and 2003 provided incentives for businesses to expand their
capital investments and reduce the cost of capital by lowering
tax rates on dividends and capital gains.
Together with appropriate monetary policies, these policy
actions helped spur economic growth in both the short run and
the long run. Today, the U.S. economy is in the midst of a
strong and sustainable economic expansion. Over the past four
quarters real GDP has grown at a 3.6 percent rate and over the
past eight quarters real growth has been at a 4.1 percent
annual rate.
Prior to Katrina, the near-term forecast of both CEA and
private-sector economists had called for continued solid
growth. The destruction wrought by Katrina and Rita may reduce
growth somewhat in the short run, but the longer-term growth
trajectory remains in place. I will return to economic
prospects in a moment.
An important reason for the recovery has been improved
business confidence. To an extent unusual in the post-War
period, the slowdown at the beginning of this decade was
business-led rather than consumer-led. Home building and
purchases of consumer durables did not decline as they
typically do in a cyclical downturn. Instead, the primary
source of weakness was the reluctance of businesses to hire and
to invest. Supported by appropriate fiscal and monetary
policies and by the economy's innate strengths, business
confidence has risen markedly in the past few years. The
effects are evident in the investment and employment data. From
its trough in the first quarter of 2003, business fixed
investment has increased over 21 percent, with the biggest
gains coming in equipment and software.
Since the labor market bottomed out in May 2003, more than
four million net new payroll jobs have been added. Currently,
the unemployment rate stands at 5.1 percent, up from 4.9 in
August prior to the job losses that followed Katrina.
Although growth and GDP and jobs capture the headlines, one
of the biggest macroeconomic stories of the past few years is
what has been happening to productivity. Productivity growth is
the fundamental source of improvements in living standards and
the primary determinant of the long-run growth potential of the
economy. Over the past four years, labor productivity in the
non-farm business sector has grown at a 3.4 percent annual
rate, and productivity in manufacturing has risen at a 5.7
percent annual rate. Productivity growth has slowed recently as
businesses have absorbed millions of new workers--a normal
development for this stage of an economic expansion--but it
remains--in the four quarters ending in the second quarter this
year--at the quite respectful level of 2.2 percent and 6.3
percent in the non-financial corporate sector. Thus, on each of
the three key indicators of the real economy--GDP growth, job
creation, and productivity growth--the United States in recent
years has the best record of any major industrial economy and
by a fairly wide margin.
Finally, while there has been a notable rise in overall
inflation this year, prices on nonenergy products have
continued to increase at moderate rates. In particular, soaring
energy prices have played the largest role in boosting the
overall consumer price index to an increase of 4.7 percent in
the past year, up from a 2.5 increase over the year-earlier
period.
In contrast, core consumer prices--as measured by the
consumer price index, excluding volatile food and energy
prices--rose only 2 percent the past 12 months, unchanged from
the year-earlier pace. Long-term expectations also remain low
and stable, based on measures of inflation compensation derived
from inflation-indexed Treasury securities.
To be clear, the focus on core inflation by no means
implies the rise in energy prices is inconsequential. Sharply
higher energy costs place a heavy burden on household budgets
and increase firms' costs of production. I will discuss the
energy situation in more detail in a moment. However, the
stability in core inflation and inflation expectations does
suggest that overall inflation is likely to return to levels
consistent with price stability in coming quarters.
Let me turn now to the outlook. In the shorter term, the
devastation wrought by the hurricanes has already had palpable
effects on the national rates of job creation and output
growth. Payroll employment declined by 35,000 in September, its
first decline since May of 2003, and industrial production fell
1.3 percent, its largest monthly decline in over two decades.
Both of these declines appear to be entirely accounted for as
the effects of the hurricanes. The Bureau of Labor Statistics
estimates employment growth would have been roughly 200,000 in
the absence of the hurricanes, and the Federal Reserve
estimates that industrial production would have increased about
.04 percent. Consumer confidence also dropped in September,
although growth in consumer spending has continued to be solid.
While the effects of the storm certainly reduced growth in
the third quarter relative to what it would have been
otherwise, most private-sector economists expect healthy growth
for the remainder of this year and in 2006. For example, the
Blue Chip panel of forecasters now projects growth at 3.2
percent in the second half of 2005 and 3.3 percent growth in
2006. Recovery and rebuilding will contribute to job creation
and growth by the latter part of this year and in 2006.
The economic impact of the hurricanes included significant
damage to the country's energy infrastructure. As you know,
Katrina shuttered a substantial portion of U.S. refining and
pipeline capacity, which led to a spike in gasoline prices in
the weeks after the storm. Rita caused further damage. The
Federal Government has assisted in, among other ways, by
lending or selling oil from the Strategic Petroleum Reserve,
arranging for additional shipment of oil and refined products
from abroad to the United States, and providing appropriate
regulatory waivers to increase the flexibility of the energy
supply chain. In part because of these efforts and a vigorous
private-sector response, oil prices have returned to roughly
their pre-Katrina levels. Wholesale gasoline prices have also
retreated to the levels of mid-August, suggesting the recent
declines in prices at the pump is likely to continue. National
gas prices may remain elevated somewhat longer, however,
because of lost production in the Gulf, the difficulty of
increasing natural gas imports, and damage to plants that
process natural gas for final use.
Even as the energy sector continues to recover, it remains
true that the prices of oil and natural gas have risen sharply
in the past two years, reflecting a tight balance of supply and
demand. High energy prices are burdening household budgets and
raising production costs, and continued increases would at some
point restrain economic growth. Thus far, at least, the growth
effects of energy price increases appear relatively modest. The
economy is much more energy efficient today than it was in the
1970s when energy shocks contributed to sharp slowdowns.
Well-controlled inflation and inflation expectations have
also moderated the effects of energy price increases since
those increases no longer set off an inflation spiral and the
associated increases in interest rates as they did three
decades ago. In addition, allowing prices to adjust, rather
than rationing gasoline, is helping to minimize the overall
impact on the economy.
House prices have risen by nearly 25 percent over the past
two years. Although speculative activity has increased in some
areas, at a national level these price increases largely
reflect strong economic fundamentals, including robust growth
in jobs and income, low mortgage rates, steady rates of
household formation, and factors that limit the expansion of
housing supply in some areas.
House prices are unlikely to continue rising at current
rates. However, as reflected in many private-sector forecasts
such as the Blue Chip forecast mentioned earlier, a moderate
cooling in the housing market, should one occur, would not be
inconsistent with the economy continuing to grow at or near its
potential next year.
The current account deficit presents some economic
challenges. At 6.3 percent, the ratio of the current account
deficit to GDP is now at its highest recorded level. Gradually
reducing the account deficit over a period of time would be
desirable. While the current account imbalance partly reflects
the strong growth of the U.S. economy and its attractiveness to
foreign investors, low U.S. national saving also contributes to
the deficit. The United States should work to increase its
national saving rate over time by encouraging private saving
and by controlling federal spending to reduce the federal
budget deficit. Our trading partners must also play a role in
reducing imbalances by becoming less reliant on export-led
growth and increasing domestic spending and by allowing their
exchange rates to move flexibly as determined by the market.
The economic challenges posed by Hurricanes Katrina and
Rita reinforce, once again, the importance of economic policies
that promote growth and increase the resilience of the economy.
Energy issues, in particular, have come to the fore recently.
The energy bill recently passed by Congress and signed by the
President should help address the nation's energy needs in the
longer term. As an additional step, the Administration will
continue to work with Congress to take measures that permit
needed increases in refinery capacity. The Administration has
made a number of other proposals to increase economic growth,
including proposals to reduce the economic cost of litigation,
to increase quality and reduce costs in the health care sector,
and to address national needs in education and job training.
The Administration is currently engaged in several
international negotiations, including the Doha round at the
World Trade Organization, as well as talks with China on a
number of matters involving trade, exchange rates and needed
financial reforms. Liberalized trade and capital flows promote
economic growth, and we should strive to achieve those
objectives in the context of a gradual reduction of current
account imbalances. It is important that we persist in these
efforts and not retreat to economic isolationism, which would
negatively affect the long-run growth potential of the economy.
Fiscal discipline, always important, has become
increasingly so in the face of the likely costs of assisting
the victims of the hurricanes and of helping in the rebuilding.
Before the impact of the hurricanes, strong economic growth was
helping to reduce the budget deficit and the government
finished fiscal year 2005 with a much lower-than-expected
deficit.
The President remains committed to controlling spending and
cutting the budget deficit in half by 2009. His 2006 budget
made numerous proposals to save more than $200 billion over the
next 10 years from both discretionary and mandatory programs.
In the budget resolution earlier this year, Congress laid
plans to pass $35 billion out of the President's $70 billion in
savings for mandatory programs over the next 5 years. Congress
should now make good on that plan by passing at least $35
billion in mandatory savings in reconciliation legislation.
Further savings beyond $35 billion would be highly
desirable. The President continues to seek a decrease in non-
security discretionary spending in fiscal year 2006
appropriation bills, and the Administration is working on
options for spending rescissions. The President also remains
committed to reforms to address fiscal challenges in the longer
term, such as Social Security.
Finally, I note that the Tax Reform Advisory Panel, whose
official report will go to the Secretary of the Treasury on
November 1st, has kicked off a much-needed debate on how to
make the Federal Tax Code simpler, fairer, and more pro-growth.
We thank them for their hard work and look forward to reviewing
their recommendations.
Thank you very much for the opportunity to be here today,
and I would be happy to take any questions.
[The prepared statement of Dr. Bernanke appears in the
Submissions for the Record on page 52.]
Representative Saxton. Thank you very much, Dr. Bernanke.
We appreciate your being here.
Thank you.
Let me begin with a question on business investment. As
most of us know, in recent economic analysis a lot of credit
has been given to business investment that has spurred economic
growth. However, when the recovery started in the last quarter
of 2001, business investment was not great. In fact, it was not
good in 2002, and it didn't begin to click in until the second
quarter of 2003.
Coincidentally, Congress passed some tax legislation that
was recommended by the President in 2003 which appears to have
stimulated investment. Dr. Bernanke, do you believe that the
tax legislation that was passed in 2003 had this effect; and,
if so, how important do you think it was?
Dr. Bernanke. As I agreed, it was very important. As your
chart shows, investment was quite weak until the middle of
2003. The President's tax proposals which were passed by
Congress included, first, measures to reduce the cost of
capital, including reductions in dividends and capital gains
taxes; second, bonus depreciation provisions which increased
the incentives for firms to make capital investment.
Of your private nonresidential investment, there were two
components. There are both equipment and structures. Structures
investment has remained somewhat moderate in terms of its
recovery, reflecting overbuilding in the late 1990s and
relatively high vacancy rates in office buildings, for example.
So investment in the structure side, while we expect it to
recover, has not yet fully recovered to earlier rates. However,
the recovery in equipment investment has been quite strong; and
I believe that the tax measures that you mentioned were an
important component in that recovery.
Representative Saxton. Thank you, sir.
Let me turn quickly to another question. I would like to
show you another chart that shows the history of inflation
during the past several years; and it is fairly obvious by
looking at the chart that inflation has remained in check since
the early 1990s.
[The chart appears in the Submissions for the Record on
page 40.]
As an advocate of inflation targeting, it appears to me
that the Fed has successfully kept the measure of inflation in
the range, as the chart shows, between 1 and 2 percent, which
some refer to as the Fed's, quote, comfort zone. This appears
to be similar to informal inflation and targeting, inflation
targeting. By keeping inflation low and in this narrow range,
hasn't the Fed reduced risk and helped keep long-term interest
rates lower than they would otherwise be, in spite of the fact
the Fed has increased short-term rates in recent times?
Dr. Bernanke. Indeed, sir, you are correct. Bringing
inflation down has been an important accomplishment. It has
been often noted that, since about 1986, that the U.S. economy
has been more stable. This is referred to by economists as a
so-called grade moderation. In my belief, one of the major
contributors to the increased stability of the economy, the
fact the recessions are less frequent and severe than they were
earlier, is the fact that inflation remains low and stable.
As you point out, inflation, core inflation has remained
within the 1 point to 2 percent range, which I believe is
consistent with overall price stability. Looking forward, I
hope the Fed will continue to maintain its commitment to keep
inflation low and stable. I believe that is the best way to
achieve its overall objectives of economic stability, price
stability and low interest rates, as you point out.
Representative Saxton. Thank you.
Senator Reed.
Senator Reed. Thank you very much, Mr. Chairman. Thank you,
Chairman Bernanke.
Much has happened since the President's tax cuts were first
advocated or passed here--9/11, huge costs for homeland
security, the war in Iraq--which has consumed over $200
billion. In fact, I think one of your predecessors, NEC
Director Lindsey, accurately predicted that, much to the
chagrin of the Administration.
We have hurricanes that we are going to spend billions of
dollars in the Gulf, and yet the President seems to still be
solely stuck on permanent tax cuts. Some people suggest that he
is not paying attention to the reality of what has been
happening in the last several years about the expenditures that
we just can't avoid and the need, as you also suggested, to
balance the budget, bring down the deficit. So what is more
important, reducing the deficit or continued tax cuts?
Dr. Bernanke. Thank you.
First, as you point out, a good bit of the costs that have
occurred are related to security expenditures, the global war
on terror; second, the disasters in the Gulf. I think most
economists would agree that, to the extent that deficit
spending is appropriate for large expenditures of this type,
using deficit spending as a partial way of funding it is not an
unreasonable approach.
With respect to taxes, it is my belief, and I think many
economists would agree, that low marginal tax rates are
supportive of economic growth, particularly in the long run,
and that keeping them low, therefore, is an important priority.
The question one would ask is, ``Before we begin raising taxes,
have we really satisfied ourselves that we have reduced
government spending as much as possible and that the existing
programs that we are funding meet rigorous cost-benefit
tests?'' I would submit that we would want to look very hard at
government spending, make sure it is controlled before we raise
taxes, which, in turn, would have negative impacts on the
economy.
Looking in the future, first in the near term, I do believe
the President will be successful in his promise to bring the
deficit down half by 2009. If that is accomplished, then, as a
share of GDP, it will be significantly lower than the long-term
average.
Looking further out, we face very substantial increased
costs in terms of entitlement programs. I would submit that
there is simply no way that tax increases could ever cover the
projected costs of those entitlement programs because they, on
current plans, over the next few decades will rise, will
increase government spending by 50 percent or more. Therefore,
both in the short run as we look at current government programs
and in the long run at entitlement programs, we need to think
how hard we are going to maintain discipline in fiscal
spending.
Senator Reed. We have gone from a surplus in the Clinton
administration, when tax policies seemed to be not adversely
affecting the economy, to a situation now where we have no
surplus, we have deficits, cumulative deficits going forward
many years, a position of economic weakness rather than
strength. Everyone is sympathetic about programs that don't
seem to be working efficiently, but we are talking about
cutting deeply into programs that are necessary for many
Americans: those entitlement programs, et cetera. As we
approach the baby boom generation, we seem to have squandered
the flexibility and strength which we had several years ago
with a surplus.
Again, in the short run, what is more important, to deal
with this deficit or to have permanent tax cuts?
Dr. Bernanke. With respect to the arrival of deficits in
the early part of this decade, I believe that the tax revenues
that were received in the late 1990s were well above normal
levels and I think I attribute that to the stock boom and the
unsustainable state of the economy in the late 1990s. The
deficits that arose early this decade primarily, in my opinion,
arose because of the decline in the stock market, the end of
the Internet bubble and then, on the spending side, from the
increased costs of the War on Terror in particular.
So I think----
Senator Reed. Well, I have just 30 seconds. Can you give us
your estimate of how much we will be spending on homeland
security and the war in Iraq over the next 5 years? Because I
presume you would not want to cut those funds.
Dr. Bernanke. I think efficiency should be applied
throughout the budget. Wherever we can find savings, it is
important to do so. I do not know, however, what the spending
will be on those items you are referring to.
Senator Reed. So you would urge us to look closely at the
military budget, Iraq, everything.
Dr. Bernanke. I think the cost-benefit analysis should be
applied wherever it is appropriate. However, the President has
set forward proposals for savings that would double, for
example, the current proposed savings under the budget
resolution. So there certainly are many proposals that have
been put forth by the White House, and I think we should look
throughout the entire budget and see where we can find programs
that are not providing value for money.
Senator Reed. Thank you.
Representative Saxton. Thank you very much, Senator Reed.
We are going now to Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman.
The longer I sit on this Committee, the more I realize the
debate just keeps being recycled. I remember the first time I
came to the JEC as the Committee's very junior, very green,
newest Member. One of your predecessors, Dr. Tyson, was the
witness and her comment was, ``Compared to other industrial
nations in the world, we are seriously undertaxed; and this
Administration is going to fix that.''
Now, with the benefit of a dozen years of hindsight,
looking back at the U.S. economic position vis-a-vis that of
other industrialized nations, to pick a few--Germany, France,
Japan, Great Britain--would you say that our tax policies have
been more conducive to growth than theirs and that the level of
taxation, which in my opinion should be measured as a
percentage of GDP rather than in numbers of tax rates and tax
brackets, but the amount, whatever the method, by which the
Government takes money out of the economy relative to the GDP
is the number that I think makes the most sense. Do you think
our present band of GDP tax revenues is too high or too low
compared to other industrialized nations, their rate of growth?
Just get into this whole question of the American economy and
tax policy and growth vis-a-vis other countries.
Dr. Bernanke. Thank you, Senator.
There have been three important long-term trends in tax
policy in the United States. They encompass both Democratic and
Republican administrations.
Since President Kennedy, there has been generally declines
in the marginal tax rates both at the highest level, but
throughout the distribution. My view, and I think that this has
become broadly accepted, is that lower marginal tax rates
improve incentives for work and promote growth. The differences
in marginal tax rates here and abroad, I think, account for a
significant part of the difference in U.S. economic performance
in terms of growth and productivity relative to other
countries.
The other two trends are, first, that the share of taxes,
the share of GDP collected in taxes has not in fact changed
very much despite the declines in marginal tax rates,
suggesting that growth and other measures have been sufficient
to keep revenues strong.
The ultimate way to determine the appropriate level of
revenue collection--I think, again, the first place to look is
to ask the question, what does the Government need to spend; we
need to look at spending programs in terms of whether they are
providing value for money.
So my approach is to think first about government spending.
It is, in fact, the share of GDP that goes to government
spending which is the true measure of the burden of the
government on the national economy, and that is where we have
to make sure that we are getting full value for money.
Let me just add that although I think the U.S. tax system
on the whole has been positive in terms of promoting growth,
investment, entrepreneurship, and productivity, relative to
other industrial countries, there is still a lot of improvement
that can be had in the U.S. Tax Code. The President's tax panel
is reporting and the objectives of tax reform would be to make
the system simpler--it is incredibly complex--to make it more
fair and to increase still further its tendency to increase and
support economic growth. I think there is progress that can be
made, but this bipartisan consensus over 40 years of reducing
tax rates and improving incentives I think has paid off in
terms of U.S. economic performance.
Senator Bennett. Let me just comment, my reaction to the
Mack-Breaux Commission is that I am sorry they weren't more
bold. The present tax system is a disaster in terms of
simplicity and efficiency, and we continue to nibble around the
edges as we have done ever since we created the tax in the
1930s. I would have preferred something much more dramatic than
they have proposed. I would endorse the direction they are
proposing, but I would like to move in another direction. Thank
you very much.
Chairman Saxton has given us a chart that shows the
relative unemployment in various countries. Maybe we are not
doing so badly when we compare American unemployment with some
of that of the other industrial nations. Thank you.
[The chart appears in the Submissions for the Record on
page 39.]
Representative Saxton. Chairman Bernanke, if I may refer to
the chart to my right, your left. The unemployment rate in the
so-called Euro zone is shown on this chart to be about 8.6
percent; in Canada, 6.7 percent; and here in the United States
at 5.1 percent. Your comments relative to and Senator Bennett's
comments relative to the tax situation I suspect you would
agree has something to do with this in various economies.
Dr. Bernanke. Yes, sir. In addition, another dimension of
this labor market performance is job creation where over the
past two or three years total job creation in the United States
is greater than that of Germany and Japan and the UK combined.
Our tax system makes a constructive contribution to this
performance. In addition, we have flexible and diverse labor
markets which also can adapt to shocks and have allowed us
remarkably to deal with high energy prices, hurricanes and many
other shocks to the economy and still continue to have growth
and job creation.
Representative Saxton. Thank you, sir.
Mrs. Maloney.
Representative Maloney. Thank you very much and welcome.
Congratulations on your appointment.
You testified that productivity growth is absolutely
fundamental to the improvement of the standard of living for
Americans and for our long-term growth, but in order to have
productivity we have to have jobs.
At a recent forum that we had, Professor Blinder testified
and said some interesting and, for me, some rather disturbing
things about outsourcing for the future of this country. He
argued that we can expect a dramatic increase in the amount of
outsourcing because there is a huge educated population in
China, India and other countries, and any job that can be
remotely subject to outsourcing or can be done in another
country, he says is in jeopardy. He predicts that outsourcing
will be an incredible drain on American jobs in the future. I
would like to hear your comments on what he has put forward,
and does the Administration have policies that would address
the fact that a huge number of American jobs may be at risk in
the future.
Dr. Bernanke. Thank you.
First of all, we certainly don't want to see any American
lose their job. If someone loses a job, we hope to have ways of
helping them retrain and relocate as needed to find good new
work. We want to support American workers in every way that we
can.
There is certainly some outsourcing in terms of purchases
of services abroad. There is also insourcing. For example, the
United States, although we have a very large overall current
account deficit, we have a surplus on services. Americans
provide financial, educational, tourism, and other services to
people the world over. So it is a source of prosperity in
markets for us as well.
In addition, we benefit from foreign direct investment.
Many Americans are employed by foreign companies with plants in
the United States, for example, in the automobile industry. So
trade is a two-way street. I think it is important to protect
Americans who lose their jobs or whose jobs come under pressure
from international trade, but I think we need to be careful not
to embrace economic isolationism.
With respect to overall jobs, I dispute the conclusion that
either trade or even current account deficits destroy jobs. As
was just shown on the diagram, the unemployment rate here is
lower than Germany, which has a larger current account surplus,
lower than Japan or other countries which have large current
account surpluses. The job creation is better here. I believe
that the U.S. economy will prosper in an international global
economy and that jobs will be created, as many as needed, to
employ all those who want to work.
Representative Maloney. So, you do not see outsourcing as a
challenge to American jobs. How much do you believe the United
States will have to borrow from the rest of the world this year
to support our swollen trade deficit? Some people have said it
will be as much as 600, 700, 800 billion dollars. What is your
estimate?
Dr. Bernanke. As I mentioned in my testimony, the current
account deficit is currently 6.3 percent of GDP, so that would
be roughly the amount of foreign acquisition of U.S. assets
associated with the current account deficit. I agree that we
need to bring the current account deficit down, and I believe
we can do so over a period of time. Doing so requires more
savings of the United States, including a reduction in the U.S.
budget deficit.
Representative Maloney. That is roughly $800 billion. What
would happen, Professor, if the rest of the world decided that
it was too risky to hold this large amount of our debt? Would
we see a collapse of the dollar, high interest rates, and
possibly an international crisis if countries decided not to
continue holding our debt?
Dr. Bernanke. I don't anticipate any such development. U.S.
bonds are well regarded as safe and liquid investments. They
are the primary source of international reserves.
Representative Maloney. Finally, what are your comments on
the growing trend of inequality between the haves and have-nots
that has been displayed? We have a chart. This also was a theme
at our hearing with Professor Blinder, and I believe that
leaders on both sides of the aisle are concerned about this
trend. It is not good for our country, it is not good for our
people, and what policies does the Administration have to
address this growing trend of inequality between the haves and
have-nots?
[The chart appears in the Submissions for the Record on
page 51.]
Dr. Bernanke. Ma'am, that is a very complex question. I
won't have time to answer in full detail. But I would point to
one trend which is over the last 25 years or so the returns to
education have risen. Therefore, people who are more educated,
have college degrees or advanced degrees, the differential in
their earnings to those who have high school or less has
increased. This is reflective of the change in our economy
toward a more technologically dynamic economy, one where higher
skills are valued.
The fact that we have become more technologically dynamic
is a positive thing, but the increased inequality and earnings
associated with this is a concern. I think certainly one
approach is to try and spread the benefits of education, skills
and training more broadly to make sure everyone is equipped to
deal with the demands of our current economy.
Representative Saxton. Thank you very much.
Mr. Paul.
Representative Paul. Thank you, Mr. Chairman.
On page 8, you talk about the current account deficit which
you expressed concern about and you discussed, as well as
expressing concern about spending and deficits. You talked
about a $35 billion cut, which to me seems like a drop in the
bucket and will turn out to be irrelevant. We can't even get it
passed here. It is over 5 years, and the national debt is going
up nearly $600 billion a year. I don't think we are addressing
the real problem, and the real problem is the Government is out
of control and spending is out of control.
But I think some of the problems you discuss here are
probably related to monetary policy, and we never seem to
connect the two. Yet in a speech a few years ago, I thought you
did make a connection, and I want to just quote from that 2002
speech.
He says, ``We conclude that under a paper money system, a
determined Government can always generate higher spending and
hence positive inflation. While there are some who are less
enthusiastic about paper money than that, I don't see inflation
ever as a positive because it caused some of these problems
that we are concerned about.'' But also increased spending
naturally is going to lower savings. You would like to see
higher savings. So we have a system of money where free market
people supposedly have total monopoly control of the money
supply and interest rates so we manipulate interest rates down
to 2 percent on savings and then we want people to save. These
are artificially low interest rates. So people on fixed incomes
aren't going to save. There is really no incentive. Then we tax
them on the interest they earn.
To me, that is reflection of a very flawed monetary policy,
and it does confirm Nixon's contention in 1971 that we are all
Keynesians now, and we are resorting to the liquidation of debt
through the debasement of currency, and it also invites concern
about deflation which you have had concern about. But, since
1971, we have had a 1,300 percent increase in the money supply
and we have the privilege of being the reserve currency of the
world, so we are encouraged to spend.
But I think it is so unfair. It is not, as far as I am
concerned, good economics, and it is unfair to the people who
want to save. Then we get concerned about savings and then we
create a monetary system that does increase spending not only
in the private sector, but in the Government sector. As long as
the Fed is there waiting ready to monetize anything we spend
on, I think we are going to continue guns and butter, endless
war spending, endless domestic spending.
So I would like to suggest why can't we make a better
connection to monetary policy, and I think you would be the
expert on this that might be able to do that, and how can we
justify this as being a fair system to the elderly who would
like to earn a decent interest on their savings?
Dr. Bernanke. Related back to an earlier question from Mr.
Saxton, I think the best thing the Federal Reserve can do to
avoid the problems you are referring to and make sure people
get a fair return on their savings is to keep inflation low and
stable. That has been the objective, and success has been
increased over a period of time. You keep inflation low and
stable. Then the cost of living for the retirees, for example,
doesn't go up as fast. The real returns to savings are not
eroded by inflation.
So I think the appropriate approach is to focus on keeping
inflation in the medium term low and stable. I believe that
supports the Fed's other objectives of low interest rates and
stable employment growth. So that would be the central part of
my prescription for making monetary policy constructive in
terms of economic growth and stability.
Representative Paul. But for the elderly, the cost of
living is not 2 percent, so I think it is a fiction to tell the
people there is no inflation. If most of their money is being
spent on medical care and on energy and keeping their house
warm, these people are having an inflation rate of 10, 12 or 15
percent and we deny this. So at the same time the Government
says there is no inflation, therefore it is justified to have
low interest rates. My contention is, why should we assume that
we know what the interest rates ought to be? Why as free market
people do we not resort to the marketplace to determine
interest rates?
Dr. Bernanke. There have been many proposals along those
lines, and some of them are quite interesting. Under our
current system, the central bank has been required by Congress
to manage the monetary system, and I think the best way to do
that in a stable manner is again, to focus on making sure that
we have price stability.
You point out correctly we do have inflation now. We have
4.7 percent inflation in the last year. The biggest contributor
to that is higher energy prices, which in turn depends on a
variety of factors, including the supply and demand for energy
around the world. That is a real phenomenon, one that is
affecting people's budgets. It is hitting a lot of people, a
lot of firms. There is no question that is a negative influence
on our economy.
Representative Saxton. Thank you very much. The gentleman's
time has expired.
Mr. Hinchey.
Representative Hinchey. Thank you very much, Mr. Chairman.
Chairman Bernanke, it is nice to see you, and thank you for
being here.
We are talking about economic growth; and it strikes me
that growth, somewhat like beauty, is in the eye of the
beholder. Looking at the chart over here on unemployment rates,
I think that those figures in many respects do not reflect
aspects of our culture that, if they were taken into
consideration, would cause some dramatic differences in the
levels of those charts.
For example, we have two million people in prison in the
United States, more than in any other country in the world,
with the possible exception of China. We don't know how many
they have, but if that were reflected in that chart number it
would go up considerably.
We have the highest level of homeless people of any
advanced industrial country in the world. If that number were
considered in there, the unemployment rate would go up
substantially.
There are a great number of people who have dropped out of
the economy. That number of people is not reflected in that
chart over there as well.
So you have a situation where we are not just facing up to
the truth. We are not addressing the real needs of people in
this country, and one of the ways that we are avoiding that is
pretending that the situation is rosy, rosy where for a lot of
people it really isn't. One of the reasons why we have had the
kind of growth that you described in your testimony over the
last several years is that we have experienced an extraordinary
amount of economic stimulation, both fiscal and monetary; and
the fiscal stimulation, of course, has resulted in huge budget
deficits, in fact, record budget deficits for the last 3 years
and a record and growing national debt.
The question arises, I think, in the minds of anyone
looking at this objectively, how much longer can we sustain
that kind of so-called economic stimulation, which is the
source of whatever growth we are experiencing? And, of course,
going back to the idea of the inequality of that growth, we are
seeing more and more inequality in this country.
The tax cuts that were passed by this Congress have had
extraordinary economic benefits for the wealthiest people in
America, but, at the same time, they are causing economic
hardship for millions and millions of other people. We have 37
million people in America now living below poverty. That is an
increase of more than one million in the last couple of years.
We have 45 million people now without health insurance, most of
them working people making incomes of above $50,000 a year.
Nevertheless, 45 million Americans are without health
insurance. That number has gone up by nearly 8 million in the
last 5 years.
So the inequality that we are experiencing is very, very
dramatic. Anyone sitting here at this table or as a member of
the President's Council of Economic Advisers pretending that
everything is just fine in America, that everybody is
benefiting from this growth in the economy isn't really being
honest about the situation.
What is it that we ought to be doing to address the real
economic needs of the average America?
With another example, the median income of the average
American family has been flat for the last 5 years. They are
experiencing no growth whatsoever. That is the first time that
that has happened in recorded history in our nation. So, what
can we do, what can this Congress do and what can you recommend
as the sole member of the President's Council of Economic
Advisers that we can do to address the real needs of the real
people of America?
Dr. Bernanke. Thank you. That was a very lengthy question.
First of all, with respect to the labor market, it is true
that the unemployment rate is calculated relative to the labor
force, and that in turn depends on how many people are actively
seeking work and would include, for example, prisoners. If you
look at other measures of the labor force, the share of the
total population that is working or the number of jobs that are
created, both of those also suggest a very strong labor force,
so I don't think incarceration rates, for example, are the
issue here.
Also, in terms of sustainability, ultimately what allows us
to continue to grow is the rate of productivity growth. As I
mentioned in my testimony, we have had remarkable productivity
growth going back to the mid-1990s.
Representative Hinchey. That productivity growth is not
being shared equitably. We have lost 3 million manufacturing
jobs in the last several years here in this country. The kind
of growth that you are talking about is not being shared
equitably. If we are going to put up a chart reflecting the
unemployment rates between Europe and another country that I
can't see or another place that I can't see and the United
States, we need to take into consideration the cultural aspects
of those countries. The things that you are talking about are
not reflected there. The number of people that are in the
employment arena in Europe is reflected in those numbers.
Representative Saxton. I am sorry, but the gentleman's time
has expired.
Representative Hinchey. They are not reflected here in this
chart.
Representative Saxton. Let me just remind everybody, we
have this room for just 2 hours. We started right on time. We
are now 55 minutes into the first hour, and we haven't finished
the first round of questions. So we are going to go to Mr.
Ryan.
Representative Ryan. I will try to keep under the 5
minutes.
First, I want to make a clarification and ask a quick
question. I think it was Senator Reed who talked about the tax
cuts, how they supposedly balloon the deficits and how we
should not extend these tax cuts. Mr. English and I serve on
the Ways and Means Committee that wrote that tax cut, so I
looked up the spreadsheet from the Joint Committee on Taxation
that we used in 2003 to estimate what they would cost.
In 2003, our official scorekeeper estimated that in the
next year, 2004, the individual income tax cuts would cost this
country $106 billion in revenue loss and that the corporate tax
revenue loss would cost us $35 billion. So, we thought in 2003
individual receipts would go down by $106 billion. What
happened? They went up 14 percent. We thought corporate
receipts would go down, because of the tax cuts, $35 billion.
What happened, they went up 33.4 percent. In total, in light of
our scorekeeping, our estimate, we thought that in 2004 we
would lose $148 billion in revenues from those tax cuts. We
thought we would increase the budget deficit by $148 billion.
What actually ended up happening in 2004 was revenues went up
$116 billion.
Look at what is happening in 2005. In 2005, so far this
year, individual income tax receipts are up 15 percent and
corporate income tax receipts are up 47 percent. We have had
the largest year-to-year increase in revenues in this country
since 1981 and, in particular, in our budget deficit in the
first quarter of this year, we have the largest drop, an
unprecedented first quarter drop of $94 billion. The budget
deficit is now down $94 billion pre-Katrina, and we are
preparing a package to pay for that one as well.
So, I think it is very important as we talk about tax
policy and what to do in the future, and what not to do in the
future, not look at estimates that were done a few years ago
that we already know for a fact are not only incorrect, but are
way off. Let's look at reality, and let's look at actual
performance, and let's look at the fact that these tax cuts not
only help produce jobs and economic growth, lower the
retirement or lower the unemployment rates, but these tax cuts
actually increased revenue to the Federal Government, which is
helping us get this budget deficit down. So it is a very
important dose of reality.
Here is my quick question. Two important tax cuts expire in
2008, dividends and capital gains; they are off the track with
respect to the rest of the tax cuts which expire in 2010.
I want your opinion, Dr. Bernanke, on how the economy views
this; how do the markets look at this? I am very concerned that
the longer we delay in extending those two provisions that
expire in 2008, the more it will produce more uncertainty in
the capital markets, will make capital less attractive in the
United States and more attractive in foreign countries, will
depress our savings rate even more, and would be harmful to our
economy. But that is just my own personal concern. Could you
address what the economic ramifications, in your opinion, are
of not extending the capital gains and dividend tax cuts; and
are we hurting ourselves with respect to the economy by
delaying extending those cuts? Is it wrong to wait until the
last minute to extend those cuts, and should we do this now or
should we not be concerned about that?
Dr. Bernanke. Thank you. First of all, I agree about your
comments about 2005, that tax receipts have been about $100
billion more than expected, and the deficit correspondingly
lower.
With respect to taxes on capital gains and dividends, the
President, as you know, is in strong support of continuing
those tax measures. I do think that uncertainty and delay,
although sequel, would be costly in the sense that investors
would not know exactly what to anticipate in making their
decisions. So there is, I think, some validity to that concern.
Representative Ryan. So we will forego economic growth that
we would have otherwise been able to achieve in this economy if
we delay in extending those two provisions from 2008 to, say,
2010 or permanently.
Dr. Bernanke. There will be an increase in uncertainty and
there may be some effect on growth, yes.
Representative Ryan. Thank you.
Representative Saxton. Thank you.
Ms. Sanchez.
Representative Sanchez. Thank you, Mr. Chairman. And I have
to tell you that as a trained economist, I feel like I am in--
and I am used to sitting in a room with lots of economists and
everybody having different opinions--but I really feel like I
am in the twilight zone here. It is just amazing to hear some
of the things that are being said here.
I find it interesting that this Administration would pat
itself on its back by comparing the European Union's
unemployment to the United States', for example. Europe has
been vigorously incorporating poor countries into its economy,
cold war economies that were totally devastated by communism,
and cold war workers who have had a very hard time
accommodating to the market economy. So to compare their
unemployment rate to the United States, I mean, I think this
Administration has been terrible about accommodating poor
people, about educating poor people, about bringing people who
are underemployed or unemployed into the realm. And we see it
basically with the differences between the gap, income gap. And
certainly Chairman Greenspan spoke about this when he was
before us most recently.
I have a couple of questions. I hope I get to them. The
first one would be, I am interested in the comments that were
just made about the revenue levels with respect to the tax cut,
because when I look at the numbers, I see that the revenue
levels in the Bush administration have been actually lower as a
share of GDP than at any time since 1959. So with increased
spending priorities--I mean, this Administration is spending
like crazy, it is just unbelievable--why is it better to have
deficits than to pay for them on a pay-as-you-go basis, Mr.
Chairman?
Dr. Bernanke. There was a decline in tax revenues in 2001,
I believe, which I think was justified, first of all, by the
recession and the appropriate fiscal response to that. And in
addition, it has been the case in the past that in a short
period following cuts in marginal tax rates, which, as I
mentioned, occurred under both Democratic and Republican
administrations, there was a period of reduced tax revenues
associated in the short run with that reduction. However, over
a longer period, there is a tendency to return to a more normal
level, and currently income tax revenues, for example, as a
share of GDP, are very close to their long-run average and they
are projected to go above the long-run average by 2009.
Representative Sanchez. But over the time, they have been
lower than at any time since 1959. Are you saying that all of a
sudden, the next couple of years, we are just going to do such
incredible things that that is not going to be true? I mean,
given the fact that I have got two Louisiana Senators asking
for $250 billion for Louisiana, for example, that I am sure
most people here are going to try to put in a supplemental
spending.
Dr. Bernanke. Well, as I mentioned earlier, I think that
some deficit spending is appropriate when you are facing a
global war on terror and natural disasters. It certainly would
not have been--a balanced budget policy in 2001 would not have
been a constructive economic policy, in my view. I think that
the President is going to meet his objective of reducing the
deficit in half by 2009, and if he does so as a share of GDP,
we will be actually well below----
Representative Sanchez. And how do you think he is going to
do that? I mean, I don't know where you got this figure from,
but you just said that you thought that entitlements were going
to be increasing by 50 percent, and I don't know over what time
period you gave us. I mean, when I think of entitlements, I
think of veterans health care, Social Security, disability
benefits, a death benefit to survivors of people who have put
into Social Security, Medicare. Are you trying to tell me that
the President is going to cut health care to the elderly,
retirement to the elderly, cut moneys to those who are
disabled, cut money to orphans, cut health care to veterans,
cut the retirement of our people who have served in the
military? Is that what his intentions are to bring down the
deficit, if you are looking at a 50 percent increase over this
time period?
Dr. Bernanke. No, ma'am. I have two different time frames
in mind. The President's 2009 commitment obviously is over the
next few years, and over the next few years I believe that--not
cutting, but simply slowing the very rapid rate of growth of
some programs will be sufficient to restore the deficit to a
lower level.
However, the real challenges for America are not in the
next five years, they are over the next 20 and 30 and 40 years;
and that is what my figures about 50 percent were referring to,
around 2030 and 2035. If you make no changes in current
programs such as Social Security and Medicare and Medicaid, and
they continue to grow at recent pace, reflecting the graying of
America, the retirement of the baby boomers and the like, there
is going to be an enormous increase in the share of national
resources absorbed by Government programs, much greater than we
could conceivably cover by tax increases. We will need to
consider how to modify those programs so that they serve their
purposes without busting the budget.
Representative Sanchez. It sounds to me, Mr. Chairman, like
you are expecting the President to cut those programs----
Representative Saxton. The time of the gentlelady has
expired.
Representative Sanchez. Thank you, Mr. Chairman.
Representative Saxton. Mr. English.
Representative English. I would like to move this debate a
little bit, Doctor, out of the twilight zone and maybe focus on
a couple of things where we are comparing apples to apples. You
have been criticized, I see, for pointing out what I think is a
useful point: that our unemployment rate in this country,
although it is not very good in parts of my district, overall
is significantly lower than that of many of our European
trading partners.
I wonder if you could briefly, maybe provide a perspective
of comparing the growth rate within the United States--which I
think is very much affected by our tax policy, and Chairman
Greenspan has conceded that point up front--would you compare
our growth rate with that of our trading partners in Europe?
Dr. Bernanke. I don't immediately recall the recent growth
rates in the major countries, but I am quite certain that the
U.S. growth rate in recent years, and also over the last
decade, for that matter, is higher by a significant margin than
other major industrial countries such as Germany, U.K., France,
and Japan. And job creation is significantly greater in the
United States than in those countries.
Representative English. And that growth rate has a direct
bearing on our ability to grow our tax base and generate
revenues that in turn will move us away from a deficit
position. Has that not been the experience over the last year--
as Mr. Ryan was careful to point out--with, in effect, a
reduction in the overall deficit picture beyond estimates of
about $95 billion. That $95 billion drop--which I realize
didn't take into account Katrina and some other factors--that
was largely driven, as I understand it, by a growth in revenues
that are directly attributable to economic growth. Am I
mistaken on that point?
Dr. Bernanke. No, sir, you are correct. GDP growth in the
United States has been 4.1 percent annually over the past two
years. I believe that tax policy had a significant role to play
in creating that growth. Revenues have grown accordingly with
economic growth, and indeed in 2005 they appear to be
significantly higher than we expected, even given the amount of
economic growth that we observed.
Representative English. Then I think the issue here is what
do we need to do to continue that growth path despite price
shocks in the energy sector. And here I want to go back to Mr.
Ryan's point with regard to current tax rates on dividends and
long-term capital gains. I am concerned about the message we
might send to markets if we don't move now to extend the
current rates.
And this week I noticed that the chief economist at
Wachovia, John Silvia, published a research note in which he
said, and I quote, ``Policy makers can enhance employment and
growth by providing a stable tax environment for capital by
extending the 15 percent tax rate.''
Now, opportunities lost may be difficult to quantify in the
short run, but the competitive nature of a global marketplace
suggests that other nations will attract the capital necessary
to improve their competitiveness and long-term employment if we
fail to extend the current 15 percent rate.
Now, do you think this concern is an immediate one? You
have already testified that it would make sense for us to move
sooner rather than later, but at what point will markets start
to make the judgment that Congress may lack the political will
to extend its current pro-growth policies?
Dr. Bernanke. Well, as I indicated, I think it is important
that we make the tax cuts permanent. The markets will have to
make their own assessment about the probabilities and the risks
associated with that. And I really don't have much to add on
that side, other than the more we can assure markets that we
continue to favor pro-growth policies and a low cost to
capital, the better off we are going to be.
I realize it is a very complex budget negotiation going on,
and I want to say, in addition, that we do need to look at the
spending side and make sure that spending is under control and
we are eliminating programs that are not providing good value.
Ultimately, if the spending grows beyond reasonable ranges,
then it will be extremely difficult to maintain the low tax
rate.
So part of keeping taxes low is also keeping spending low,
and I think that is equally important as we look at the budget
process.
Representative English. And ultimately, economic growth is
critical to us in meeting our social needs, which the
gentlelady from California was kind enough to catalog for us.
I yield back the balance of my time, Mr. Chairman.
Representative Saxton. Thank you very much, Mr. English.
Chairman Bernanke, thank you very much for being with us
this morning. I wish we had more time; however, we are pressed,
and so we thank you for being here with us. And you can be sure
that we will invite you back again.
Dr. Bernanke. Thank you very much for having me.
Representative Saxton. We are now going to move to our
second panel: Dr. Mickey D. Levy, who is the Chief Economist at
the Bank of America in New York City; Dr. David F. Seiders,
Chief Economist, National Association of Home Builders here in
Washington, DC; and Dr. Brad Setser, Senior Economist and
Director of Global Research at the Roubini Global Economics in
New York City. If you would be so kind as to take your places.
Representative Saxton. And, Dr. Levy, when you are ready,
sir, we would appreciate hearing from you.
STATEMENT OF DR. MICKEY D. LEVY, CHIEF ECONOMIST, BANK OF
AMERICA, NEW YORK, NY
Dr. Levy. Yes. Mr. Chairman, and Members of the Committee,
I am very pleased to discuss the economy and associated
economic policies, particularly in regard to following Ben
Bernanke's comments. I think it is extraordinarily important to
point out the underlying fundamentals in the U.S. economy, how
strong they are. And here I refer to the flexible and efficient
production processes, labor markets, the low inflation, the
relatively favorable taxes and regulatory policies, and this
leads to the U.S. economy growing much faster than every other
industrialized nation.
This has been true, the United States has grown at least a
percentage point faster than Europe every year since 1990, with
the exception of 2002. Capital spending is multiples higher.
And I would say U.S. potential growth is 3\1/2\ percent plus,
to the plus side. And we have an $11 trillion economy. And so
3\1/2\ percent growth adds an extra output of $375 billion,
which creates jobs and the like. And I think it is incumbent
for policymakers to maintain policies that are consistent with
sustained healthy economic growth, not just for raising
standards of living, but for the best environment for budget
policymaking.
There was sound economic growth prior to Katrina, showing
some signs of moderation, but healthy increases in employment,
modest increases in wages, healthy increases in personal
income, business investment was rising, and corporate profits
had reached an all-time high. And, I might note, exports had
reaccelerated significantly.
The impact of Katrina will cause a temporary--and I
underline the word temporary--impact on employment,
consumption, trade, and inflation. And the data we have seen
for September, post-Katrina, suggests that the impacts are
identifiable and local, meaning that in the rest of the Nation
there continues to be healthy growth. And I might note that the
healthy economic expansion and the Fed's accommodation so far
will help absorb displaced workers, and that is already
occurring.
I expect in the next quarter and this quarter, and perhaps
into early 2006, moderation in the rate of consumption growth;
but then you are starting to see, as we speak, increased
Government purchases, increased Government spending and fiscal
policy multipliers are really going to kick in. And you can
have that occur just at the same time consumption is bouncing
back next year. So next we could have very strong economic
growth.
I might note here that the higher headline inflation due to
higher energy prices is reducing real purchasing power and is
having a temporary negative impact on real wages. I do not
expect that to continue. I do expect sustained productivity
gains to generate increases in wages.
I would like to clarify two misperceptions I read about--I
see about characteristics in the economy that are commonly
viewed as flaws. And the first is the low rate of personal
saving. And I would like to point out here that the rate of
personal saving, which is close to zero, is a flow variable; it
does not include any appreciation of stocks or bonds, it does
not include any appreciation of real estate. Therefore, this
rate of personal saving is so low it excludes every avenue
through which most households save. Meanwhile, total household
wealth, even excluding all debt, is at an all-time high. So I
say the rate of personal saving, in an odd sense, reflects
confidence in the U.S. economy. People, even if they feel like
they might lose their job, they can find another one, so they
spend their cash flow and wealth continues to rise.
The other misperception about the economy is the trade
deficit which is very, very large. Many people perceive that
the high trade deficit is due to U.S. consumers, which is
borrow to the hilt and spend their money on imported goods. But
in fact if you look at a composition of what we import, it is
amazing, because 40 percent of all imported goods to the United
States are industrial materials and capital goods, even
excluding oil and excluding autos. That is as much as total
imports of all consumer goods.
Now, if you look at the way the United States has
consistently grown faster than any other industrialized nation
and its capital spending is multiples faster, the wide trade
deficit, the fact that we are importing more than we are
exporting, is a natural consequence of that. And it may just
last a long time, and it may just be sustainable. That is, if
we had a recession, and capital spending fell and consumption
slowed, then, sure, the trade deficit is going to come in. What
should your objective be?
But I would also point out so far this year, the trade
deficit has come in, for some reason import growth is slow, the
exports are accelerating nicely. And when I look around the
world I see very strong economic growth in Asia, and Japan is
really coming back to stronger growth. The Latin countries are
doing fairly well now. All of our major trading partners,
except for Europe, are doing poorly; so I think we can look
forward to continued growth in exports, but the trade deficit
is going to stay wide.
In this regard, the extraordinarily large current account,
it has widened. I do not perceive it is an immediate problem.
When we think about--when we ask the question, will foreign
central banks and foreign portfolio managers continue to buy
dollar-denominated assets, the answer is yes; they are doing so
because it is economically rational for them to do so. Put
yourself in their shoes. They see stronger economic growth in
the United States, higher interest rates, higher inflation-
adjusted interest rates, a credible central bank, credible
policymakers, predictable policymakers. If you were in their
shoes, you would allocate your resources to the United States.
And I don't see any dramatic shift in global asset allocation
that would lead to either a dramatic decline in the dollar or a
sharp rise in interest rates.
Having said that, the character of the current account
deficit has changed. In the 1990s we had an investment boom and
saving was OK, but insufficient relative to investment. Now the
problem we have is investments bouncing back, but saving is
low, OK. So you have insufficient saving relative to national
investment, just like Japan has excess saving relative to
investment, so the exports are capital here. The culprit of the
lack of saving is not as much the low rate of personal saving
as it is the budget deficit, and this needs to be addressed.
And so the problem, I see, is we have this issue that, when
I look at it, both the current trade account deficits--we
should expect them to be wide--it is a natural consequence of
differences.
Let me just put it as a question. If you see such large
differences in economic growth across nations and large
differences in rates of saving and investment and you believe
in international trade and capital flows, why would you ever
expect current accounts and trade accounts to be in balance?
You shouldn't. But we have this problem.
Now, what is the solution? I would love to see the solution
be the United States, Europe, and Asian policymakers sit around
the table and say, OK, United States says we will lower our
budget deficit by 2 percent GDP, Europe says we will lower
taxes, reduce our burdensome regulations, increase our
potential growth from 2 to 3, and Asia--China would come along
and say if you do that, we will float our currency. That is a
pro-growth solution. But the point here--the reason I am
bringing that out is when you look at these imbalances, think
about pro-growth solutions rather than just reducing imbalances
just to reduce them. My expectation is that consumption growth
in the United States will bounce back post-Katrina, but it will
slow--it will bounce back to a more moderate level than we had.
I mean, if you look at the average annualized growth of
consumption, really the last 45 years it has averaged 3.6
percent, we are not much higher than that now. I think it is
going to bounce back to a slower rate of growth, exports are
going to surprise to the upside, and the trade deficit will
decline, and that imbalance will decline a bit, but we still
have this long-run budget problem.
And on the budget issue I would just note, trying to be as
absolutely nonpartisan as possible, if you look at what has
happened to the composition of spending in the budget and the
composition of the growth in spending, in the last 3--in the
1990s, the vast majority of the move toward budget surpluses on
a cash flow basis was due to the decline in defense spending.
In the last 3-4 years, both sides of the political aisle have
voted for increase in defense spending. Neither party has come
up with a great long-run solution for Medicaid or Medicare,
both of which are rising fast as a share of the budget and the
GDP, and we all know the Social Security issue.
So basically, given the short-run intractability of the
spending side of the budget--I am being a realist here--what
fiscal policymakers should be addressing now is to address the
larger budgets on an accrual basis; that is, look at the large
entitlement and retirement programs, which is the larger source
of the increase of the budget over the last 15 years, and have
a rational debate and say--and ask the question, how can we put
together programmatic changes that are fair to current
participants, that put in place the right incentives----
Representative Saxton. Doctor, if I may ask you to cut it--
--
Dr. Levy [continuing.] And for the long run, just make the
benefit structures rational. Thank you.
[The prepared statement of Dr. Levy appears in the
Submissions for the Record on page 55.]
Representative Saxton. Thank you very much.
Dr. Seiders.
STATEMENT OF DR. DAVID F. SEIDERS, CHIEF ECONOMIST,
NATIONAL ASSOCIATION OF HOME BUILDERS,
WASHINGTON, DC
Dr. Seiders. Well, thank you, Mr. Chairman. It is genuinely
an honor to be here today. I appreciate the opportunity to
testify, and will certainly take any questions you may have.
My name is David Seiders. I am Chief Economist with the
National Association of Home Builders. My written statement
contains detailed forecasts for the economy and the housing
sector, on a quarterly basis, through 2007.
Today, I would just like to concentrate on what the role of
housing has been in the economic expansion so far, and how I
view the evolving role of housing in the near-term outlook.
Let me say at the beginning, that my forecasts assume that
the current economic and housing policy structure remains very
much intact. Housing certainly has some beneficial provisions
in both the Tax Code and the housing finance system, and I'm
assuming in the forecast that they are unchanged in the near
term.
There has been a lot of talk about imbalances here this
morning, and you may be aware that Chairman Greenspan recently
described the current ``housing boom,'' as he called it, as one
of America's great economic imbalances. I certainly don't share
that opinion, and I will tell you why as we go along.
As you know, the housing sector has been a real pillar of
strength for the economy, even in the recession of 2001, and
certainly in the economic expansion since then. The housing
production component of gross domestic product has been growing
rapidly and delivering solid contributions to GDP growth. The
housing stock itself produces housing services that are
consumed by households, a big piece of consumer spending in the
GDP accounts that also has been showing solid growth.
When housing is moving well in terms of sales and
production, we are pulling other industries with us, like
furniture and appliances and those sorts of things. And as
Chairman Greenspan has been talking a lot about recently, the
strong house price appreciation that we have seen in recent
years has created huge capital gains and equity benefits for
America's homeowners, about 70 percent of all households. And
that equity generation has supported a lot of consumer
spending. When you add all this up, we estimate, I think
conservatively, that housing has been accounting for at least a
full percentage point of GDP growth in recent times. That is at
least a quarter of the total, so it has been quite a story.
I mentioned that this kind of performance, particularly the
behavior of house prices, has generated widespread speculation
that the housing ``boom'' is overdone, and that it is likely to
``bust'' and possibly cause not only serious damage to our
sector, the housing sector, but also to the economy overall.
And we have been seeing a lot of analogies drawn between the
current housing boom, if I can use the term, and the stock
market bubble that preceded the recession of 2001. I think
those analogies are really off base.
My own view is that the housing market will inevitably cool
down to some degree before long, but a destructive housing bust
is not in the cards. Furthermore, rebuilding in the wake of
this year's hurricane season will add to housing production for
years to come. Everything considered, I think that the housing
sector should transition away from being this strong GDP
engine--fairly soon probably--but continue to play a vital role
in the economy going forward.
Recent housing market indicators, on balance, have been
suggesting that the housing market may be plateauing in terms
of the volume of sales and starts and so forth. We got some
very strong numbers yesterday on permit issuance and housing
starts in September, a little stronger than I expected.
However, my surveys of builders and some other indicators
suggest that there is kind of a flattening going on out there
in terms of volume, certainly not yet in terms of pricing. And
so I think that the housing market, in terms of sales and
production, if not topping out now, is close to it.
Going forward, my forecast does recognize emerging
affordability issues that have been created, first of all, by
the succession of rapid house price gains in many parts of the
country. We are seeing that affordability factor putting a bind
on home buying now. And we expect the affordability issue to be
more complicated as we go ahead, as the interest rate
structure, both short and long rates, gravitates up further;
and that process certainly has begun.
I am also looking for less support to the housing market
from two special factors that probably are temporary. One is
heavy use of what Chairman Greenspan has called ``exotic''
forms of adjustable-rate mortgages, including deeply discounted
interest-only adjustable-rate loans and various structures like
that. Certainly the financial regulators are taking a very hard
look at that right now. I expect to see these types of loans
recede in the market, in terms of their importance.
The other special factor we have seen is a lot of investors
out there, and a lot of them probably just short-term
speculators in the housing market. As the market situation
evolves and housing demand does fade to some degree, because of
the affordability issue, I think we will see a lot of those
speculators go to the sidelines as well.
So, what does my forecast show? It says that we are going
to see the housing numbers, in terms of home sales and housing
starts, move off in 2006. The decline probably will be only
about 5 percent from 2005, which will easily be a record for
the single-family market, in particular, and also a very strong
year for the condo market.
In terms of pricing, we are still seeing double-digit
increases in house values nationally, 20 percent or more in 50
to 60 metro areas in recent times. As housing demand fades as I
have described, and volume comes off, I think that the rate of
appreciation in house values will recede. To what rate next
year, I am not exactly sure. If I had to make a guess, probably
10 to 12 percent this year, next year something like half that
pace.
Don't expect to be worrying about a national house price
decline over the next couple of years. We may see some declines
develop in some of the hottest areas where the prices have
risen the most. But even in those areas, unless the economy
falters, I think price declines are a low probability. One of
the key things in those areas has been serious supply
constraints, mainly land-use controls which prevent the
builders from meeting the housing demand that is there. As we
go forward, more supply will keep coming on those markets, and
I think that the price rebalancing will be an orderly process.
Mr. Chairman, that concludes my remarks.
[The prepared statement of Dr. Seiders appears in the
Submissions for the Record on page 60.]
Representative Saxton. Thank you very much, Dr. Seiders.
Before we go to Dr. Setser, let me just say that we have a
series of votes currently on the House floor, and House Members
will be scampering out to make those votes, and then we will
try to get back for the question and answer period. In the
meantime, Senator Bennett is going to take the Chair. Thank
you.
Dr. Setser.
STATEMENT OF DR. BRAD SETSER, SENIOR ECONOMIST
AND DIRECTOR OF GLOBAL RESEARCH, ROUBINI GLOBAL
ECONOMICS, LLC, NEW YORK, NY
Dr. Setser. I want to thank Chairman Saxton and the Members
of the Joint Economic Committee for the opportunity to testify
here today.
My remarks will focus on one particular aspect of the
economic outlook, the payments deficit that the United States
is running with the rest of the world. I want to make five
points.
First, the U.S. current account deficit has reached an
unprecedented size for a major economy. Barring a sharp fall in
oil prices, that deficit is likely to rise next year.
Second, the U.S. external deficit reflects policy decisions
both here in the United States and abroad, not simply private
savings and investment decisions. Both the large U.S. fiscal
deficit and the unwillingness of many economies elsewhere in
the world to allow their currencies to appreciate against the
dollar are contributing to this deficit.
Third, trade deficits at nearly 6 percent of U.S. GDP are
simply not sustainable over time.
Fourth, large current account deficits reflect borrowing
that is needed to finance consumption in excess of income. The
availability of sufficient financing to sustain deficits of the
current-size--borrowing that may reach $900 billion next year--
should not be taken for granted. Consequently, these large
ongoing deficits will be a risk to the U.S. economic outlook
for many years to come.
Finally, policy actions both here and abroad can help,
first to stabilize and then to reduce the U.S. external
deficit. The needed policy steps by now, I think, are well
known, but no less urgent.
First, the U.S. current account deficit is now quite large.
The current account deficit is, by definition, the sum of the
trade deficit, the deficit on transfer payments--U.S. foreign
aid, and private gifts of U.S. citizens abroad--and the balance
on income. The income balance reflects the difference between
what the United States earns on its foreign assets and what the
United States must pay on its liabilities. The United States
pays both dividends on foreign investments here in the United
States and the interest on our rising external debt.
In the second quarter, that balance--the balance on
income--turned negative for the first time in some time, and
over time the balance on investment income will contribute
increasingly to the U.S. current account deficit.
In 2005, I expect the current account deficit to rise to a
bit over $800 billion. That will reflect a trade deficit that
will increase to about $720 billion, largely on the back of
higher oil prices, continued transfer deficits, and for the
first time in several years, an income deficit.
That $800 billion deficit is a significant increase from
the $520 billion deficit of 2003 and the roughly $670 billion
deficit of 2004. I expect the trend of wider deficits to
continue in 2006 for three reasons:
First, the pace of growth of non-oil imports, as has been
noted, has been relatively subdued this year. That reflects a
lag after very strong growth at the end of 2004. As the U.S.
economy continues to grow, I expect some resumption in the
growth of non-oil imports.
Second, I expect the current strong export growth to slow.
Why? Because the dollar has been strengthening this year, and
that will impact the trade balance.
I disagree somewhat with Dr. Levy in his emphasis on strong
growth in Asia and low growth in Europe. If you look at the
composition of U.S. export growth this year, U.S. exports to
Europe have been growing faster than U.S. exports to the Asia
Pacific region for the simple reason the dollar felt
substantially against the euro in 2003 and 2004.
Finally, the balance on investment income, the amount of
interest that the United States has to pay on the external
debt, is set to rise substantially. The roughly $800 billion
that we have to borrow this year, assuming an interest rate at
around 5 percent, translates into a $40 billion increase in our
net payments abroad.
Second point, this rising external deficit is a function of
policy choices both here and abroad--policy choices that have
reduced savings relative to investment in the United States and
increased savings relative to investment in the rest of the
world. The key policy decision that we in the United States
made is to increase our structural fiscal deficit. That deficit
went up during the recession, as Dr. Bernanke noted. It has not
come down commensurately as the economy has recovered. As
investment has picked up from its low levels, that has
correspondingly widened the gap between savings and investment
here in the United States.
Abroad, savings and investment have evolved in different
ways in different countries, but I think it is important to
recognize the main counterparts to the U.S. current account
deficit--or to the rise in the U.S. account deficit--has not
been an increase in Europe's current account surplus. Europe's
current account surplus, broadly speaking, has been falling.
Japan's surplus has been rising, but the rise, roughly $60
billion since 1997, is in no way on the same scale as the
increase in the U.S. current account deficit. The main
counterpart to the increase in the U.S. current account deficit
has been the enormous increase in the surpluses that have been
run by so-called emerging and developing economies. That
reflects rises in savings in China and in the oil-exporting
countries, and falls in investment in many other emerging Asian
economies.
The vector that has carried these surplus savings to the
United States, by and large, has not been the private flow of
capital; rather, it has been the unprecedented increase in the
accumulation of hard currency reserves by emerging economies.
The increase in true reserves, the annual increase, has gone
from about $116 billion in 2001 to about $500 billion last
year, and I expect around $600 billion this year just in the
world's emerging economies.
Third point. These deficits are not sustainable over time.
Particularly trade deficits of this magnitude are not
sustainable over time. Why? Because a constant trade deficit,
according to basic external debt sustainability analysis,
implies a rising external debt-to-GDP ratio over time, and a
rising external debt-to-GDP ratio implies a rising current
account deficit as the amount of interest that we have to pay
on our external debt rises over time.
Indeed, should the trade deficit gradually fall to roughly
zero over the next 10 years, something that would imply
substantial changes, the U.S. national external debt would
still rise to about 50 percent of U.S. GDP, and at the end of
that adjustment period the United States would still be running
a significant current account deficit.
Fourth, as I mentioned earlier, sustaining ongoing deficits
of this magnitude next year requires net inflows of capital
from abroad of between $900 billion and $1 trillion dollars;
that implies that we have to commit some of our future income
to pay for that inflow of debt. And broadly speaking, since we
are relying on foreign savings to finance investment here at
home, some of the benefits of investment here will flow to our
foreign creditors.
More immediately, though, the risk is that the financing
needed to sustain these deficits won't be available at current
relatively low interest rates. Any rise in interest rates might
provoke a slowdown in U.S. economic activity.
The combination of market forces and policy decisions that
will bring about the necessary adjustment in the U.S. trade
deficit is subject to substantial uncertainty, but there is no
doubt that the adjustment, when it comes, implies substantial
changes in the drivers of growth both in the United States and
in our trading partners. Specifically, consumption growth here
in the United States must slow, and consumption growth in our
trading partners needs to rise.
Recent studies by the staff of the Federal Reserve Board
offer hope that the necessary adjustment process will be
relatively smooth. However, caution is in order. The United
States is in many ways operating outside the realm of
historical experience. But I think one lesson from
international experience is pretty clear. As a country's
external debt grows, it becomes more, not less, important to
maintain confidence in a country's fiscal policy choices.
Reducing the fiscal deficit, put simply, is the best way to
raise national savings.
Policy changes are also necessary abroad. China, Malaysia,
and many oil-exporting countries need to unpeg or reduce the
degree to which they peg their currencies to the dollar.
Spending in oil-exporting countries must rise if oil prices
stay high, and China needs to take steps to stimulate
consumption.
As I have argued, the expansion of the U.S. trade deficit
reflects mutually reinforcing policy choices. The stabilization
and the eventual fall in the U.S. deficit will also be far
smoother if that process is supported by appropriate policy
changes. No doubt market forces will eventually demand
adjustment even in the absence of policy change. But as both
the current President of the New York Fed, Tim Geithner, and
former Treasury Secretary Robert Rubin have emphasized, without
supporting policies the needed market moves are bigger and the
risk of disrupted market moves is far higher.
Thank you.
[The prepared statement of Dr. Setser appears in the
Submissions for the Record on page 67.]
Senator Bennett [Presiding.] Thank you very much. This is a
very interesting and worthwhile panel, and it looks like
Senator Reed and I are going to have the next 15 minutes to
ourselves before the lease runs out and we are forced to leave
the room.
I would like Dr. Setser and Dr. Levy to kind of go at each
other here, because they have slightly different views; but
there is also a degree of agreement and common ground from
which to have this exchange.
Let me just make a comment before I ask the two of you to
respond to each other. Everybody agrees that the American
deficit has to come down; that is, the amount of borrowing by
the government, whose percentage of GDP has to be stabilized--I
am of the opinion that if it stays at its present level as a
percentage of GDP that is within historic norms, then it is
completely sustainable. However, if you look ahead at the
demographics, it becomes abundantly clear that it cannot stay
within its present percent of GDP without some fairly
fundamental changes in the spending patterns. And we saw the
peace dividend that occurred in the 1990s that brought the
deficit down, and we all assumed we were responsible. All of us
here in the Congress took full credit for it, and the Clinton
administration took full credit for it, and that is the way
politics works. But the peace dividend is a one-time dividend,
and if we are going to bring the deficit down, we are going to
need to have the courage to address the entitlement problem.
And the entitlement problem is summarized by our friend Ted
Stevens, who, when he went on the Appropriations Committee,
said the Appropriations Committee controlled two-thirds of the
Federal budget and one-third was mandatory spending outside of
the purview of the appropriations process.
Today those numbers are reversed. We have a budget of
roughly $2\1/2\ trillion, and that portion that is subject to
appropriations is roughly $800 billion, a third. And the
percentages keep going in favor of the mandatory spending, to
the detriment of discretionary spending. And the $800 billion--
$840 I think is the actual number--roughly $800 billion that
the appropriations covers includes defense, which is roughly
half.
So if you take away half of the discretionary spending and
say it is off limits because of defense, and you are going to,
quote, ``balance the budget by Congress getting its act in
order and holding down spending, you have a universe of $400
billion that you have to deal with out of a $2\1/2\ trillion
budget, unless you are willing to tackle the mandatory
spending, the entitlement spending, which means Social
Security, Medicare and Medicaid. And if we say those must be
held inviolate, we will see the two-thirds that is currently
mandatory grow to three-fourths, or to 90 percent, or
eventually 100 percent. And if you want to talk about something
that is unsustainable, that is a trend that is unsustainable
and affects everything else we are talking about.
OK. Having made that point, Dr. Setser and Dr. Levy, can
you comment back and forth on each other, and we will try to
hold what you say between the two of you for maybe the next 7
minutes, and then Senator Reed can ask his for the next 7
minutes, and we will have taken the time that is available to
us because I don't think our House colleagues are coming back.
Is that a fair division of time, Senator?
Dr. Levy. Let me take a crack at it. I would note in the
1990s, even as the cash flow government budget went from
deficit to surplus, on an accruable basis the deficit--on an
accrual basis, the budget was deteriorating because of the
continued rising in the unfunded liabilities.
It is imperative to address the long-run budget imbalance
because if we look realistically in the short run, many aspects
of the programs that are growing the fastest are intractable.
So it is now important to address in a very rational, fair way
that doesn't affect current recipients, change the policies
that will affect the long run, grandfather them in.
And I remember when I was working on the Hill in the late
1970s and the Social Security projections were accurate--they
proved to be accurate. And the issues are the same, just the
numbers are bigger. Address them in an appropriate way.
I would like to make two comments on the current account.
Very frequently in my position I have to talk to portfolio
managers that run all of the Asian central bank money. And I
was just over there, and they are very economically rational.
And they are seeking the highest risk-adjusted expected rates
of return. They have no intention at all of dramatically
altering their asset allocation.
Second, if you think about it, in the last year with low
interest rates, when they buy, say, a 2-year debt, we are
borrowing at, say, 3 percent, now it is 4 percent, the issue is
what are we doing with the imported capital? To the extent we
are using it--and as I mentioned it in my testimony--to finance
corporate purchases of industrial materials and capital goods,
I guarantee you the average rate of return on that imported
capital is higher than the cost of financing it. So once again,
the culprit once again is the budget deficit. And not just the
budget deficit per se, but the entitlement programs, the
consumption-oriented ones that increase spending without adding
to the Nation's long-run productive capacity.
Senator Bennett. Dr. Setser.
Dr. Setser. Well, I do think Dr. Levy and I share a common
opinion that the best way that the pace of increase in the
current account deficit can first be reduced and then the
deficit can be brought down is by taking steps to increase
national savings, and the first best way to do so is to reduce
the fiscal deficit.
I am not convinced, however, that the debate about
entitlements is totally relevant here, and I say that for the
following reason, and with complete respect for the opinions of
the Senator.
In my personal opinion, the trade deficit and the trends of
the unsustainability about the trade deficit are likely to
manifest themselves as a problem in a much shorter time frame
than the time frame that is relevant for the debate about
entitlements, and particularly for the debate about Social
Security. And I would note in that context that at this current
point in time, Social Security runs a cash flow surplus, as is
well known, and this reduces the cash flow deficit of the rest
of the government. So my concern would be that in the context
of reforming our entitlements, we increase our near-term fiscal
deficits--cash flow deficits--and increase our near-term
borrowing. That would not increase our own national savings or
decrease our dependence on savings from abroad.
As I have argued, our current dependence on foreign savings
is already quite high. And since I don't think we are talking
about a 40-year problem or a 20-year problem, I think we are
talking about more of a 10-year problem, so I think the time
frames are a little bit different.
The question about the continued availability of financing
to sustain the U.S. current account deficit--which is much
larger than the U.S. fiscal deficit--does hinge, as Dr. Levy
suggested, on the portfolio decisions made by Asian central
banks. I would also note it hinges on the portfolio decisions
made by the Russian central bank and by the central banks of
the major oil-exporting countries. One of the major evolutions
that has occurred this year is that a growing share of our
deficit is indirectly being financed by Saudi Arabia, by
Russia, by the other countries with large oil exporters.
I differ slightly from Dr. Levy in his assessment that it
is rational for these countries, on an investment basis, to be
sending and to be buying U.S. treasuries at the current rate; I
say that for the following reason. Most forecasts for the size
of the dollar depreciation against Asian currencies that would
be needed to bring the trade deficit down over time, are quite
large; therefore, even the interest rates of 4 percent or 5
percent that these countries are getting on your dollar assets
here, is unlikely to compensate them for the future exchange
rate risk. So while I don't think Asian central banks are
likely to shift their portfolio away from dollar assets, I
think there is a risk that over time they may be less willing
to add to their stock of dollar assets. And remember, we do
need $800--or $900 billion every year. We get it 1 year, we
still need it the next year. I also differ slightly in my
assessment of the uses to which this imported savings is being
put.
Senator Bennett. I am sorry to interrupt you, but I would
like Senator Reed to----
Senator Reed. Go ahead, Doctor.
Dr. Setser. My concern is that the external debt that we
are taking on right now is not being, by and large, used to
finance investment in the tradables portion of the U.S.
economy, and external debt is ultimately a claim on our
tradable production of goods and services. So while in the
short run, shifting resources toward the residential housing
sector and toward other sectors can help sustain growth, in the
long run it is not obvious to me that improvement in our
residential housing stock will generate the future export
revenue needed to pay back the interest on that rising external
debt.
Senator Bennett. Thank you.
Senator Reed. Thank you, Senator Bennett.
It strikes me that we all are saying the same thing, just
in different ways. That is that we have to increase national
savings. There are several ways to do that. One is to reduce
the budget deficit, or to increase household personal savings.
And it strikes me with all the discussion particularly around
this room about tax policy, tax policy doesn't seem to produce
a lot of increases in personal savings.
Do you want to comment on that, Dr. Setser?
Dr. Setser. I tend to agree with that. I think the general
studies suggest that tax incentives for savings have offsetting
effects, that on one level they may increase some savings at
the margins, but a lot of the benefits from the tax incentives
go to people who would otherwise have saved, and so are offset
by reductions in tax revenues, and the overall impact on
national savings is small.
Senator Reed. Dr. Levy, I will let you respond, too, but
behind that question is another question. If we can't
effectively--or don't choose to effectively stimulate household
savings, then we are left to close the budget deficit in order
to achieve this goal of increasing national savings and
investment; is that----
Dr. Levy. You want to reduce the budget deficit in any way,
in any case, because how you spend and how you tax determines
the allocation of national resources. And once again, what you
want to do is effect a policy that is best for a sustained,
healthy long-run economic growth.
With regard to tax incentives, I respectfully disagree. I
think they have increased saving.
I would like to embellish on one other point, and it is an
oddity in the following way----
Senator Reed. Excuse me. In your testimony you indicated
that the numbers suggest a close to zero household savings
rate. You made some interesting points about the fact that it
doesn't include residential real estate and stocks, et cetera,
but I just want you to clarify now whether you are saying that
tax policy is actually stimulating savings.
Dr. Levy. Well, the rate of personal savings has come down
because it is a cash flow measure and people are spending their
cash flow because their wealth is going up. Let me juxtapose
that with the double-digit rate of saving, personal saving in
Germany, because people are still pessimistic about the economy
and their prospect for jobs, where there is a 7\1/2\ percent
rate of personal saving in Japan where there is a lot of angst.
Let me add this oddity. In the last year oil prices have
increased significantly. On an annualized basis, the doubling
of oil prices has increased revenues to OPEC just in the United
States by over $200 billion. U.S. consumers have smoothed their
consumption pattern, that lowers their rate of saving; but
because it is all denominated in dollars, a lot of it flows
back into the United States and keeps the real cost of capital
low.
So it is very ironic, like circa 1970s recycling petro
dollars; that is, lowering our rate of personal saving and
widening our current account deficit. That is, the cost of
higher energy crisis is real.
Senator Reed. And both those things are bad in terms of
lowering savings and----
Dr. Levy. Yes.
Senator Reed. Dr. Setser, do you have a final comment?
Dr. Setser. I agree with the mechanism that Dr. Levy
described by which the oil surplus is being recycled back on
the United States. I think the ironic thing, in some sense, is
that the oil surplus that these countries have comes not just
from exporting oil to the United States, but to exporting oil
to Asia. And one of the striking features of the current
situation is while they are earning money from the entire
world, it seems like a disproportionate share of their savings
is flowing back to the United States.
However, I wouldn't assert that is a necessary consequence
of the fact that oil is priced in dollars. In liquid capital
markets, it is quite easy to sell oil for a dollar and trade
that dollar for a euro, and I think over time we shouldn't
assume that current patterns will continue.
Senator Reed. Well, thank you very much, gentlemen. Thank
you, Senator Bennett.
Senator Bennett. This has been a most worthwhile panel.
And, Dr. Seiders, you didn't get into this macro stuff because
you are talking about housing----
Dr. Seiders. The House Members are probably more interested
in that. Just kidding.
Senator Bennett. I found your comments to be very useful.
Let me just make one comment, back to my earlier one about
the mandatory spending and the entitlements. Dr. Setser, the
only reason that I pick on Social Security is that it is the
easy one. Medicare and Medicaid are going to be much more
difficult. And if we cannot in the Congress come together to
solve the Social Security long-term structural problem--I agree
with Dr. Levy, we should hold the present participants
harmless, because I happen to be one of them; but for my
children and grandchildren, if we can't come together to deal
with Social Security in a bipartisan fashion, we will never,
ever get our arms around the Medicare problem.
Social Security is the easy one because it is simply moving
numbers around. We know all the people, we know all the dollars
that can be allocated. Medicare has so many other problems
connected with it.
So I agree with you that Social Security may not be the big
one, but at least I want to take it on because I think it is
the easy one.
And thank you very much for your participation here. The
hearing is adjourned.
[Whereupon, at 12 p.m., the Committee was adjourned.]
Submissions for the Record
=======================================================================
Prepared Statement of Representative Jim Saxton, Chairman
I am pleased to welcome Chairman Bernanke and the members of our
second panel of witnesses before the Joint Economic Committee this
morning. This Committee values its long history of cooperation with the
Council of Economic Advisers. The testimony today will provide a solid
foundation for understanding the forces that are shaping current
economic conditions as well as the economic outlook.
The recent hurricanes have caused a tragic loss of life and
property on the Gulf Coast, and also have had temporary effects on the
U.S. economy as a whole. One reason for this national impact is that a
significant portion of U.S. oil and gas production is concentrated in
the Gulf, and much of it is still damaged. Thus it is reasonable to
expect that the economic impact of the hurricanes will slow GDP growth
in the second half of 2005. In 2006, as recovery efforts proceed, many
economists expect growth to be a bit higher than previously forecast.
Despite the hurricane damage, a broad array of standard economic
data indicates that the economic expansion has built up strong
momentum. The U.S. economy grew 4 percent in 2004, and advanced at a
rate of about 3.5 percent in the first half of 2005. A rebound in
business investment has played an important role in explaining the
pick-up in the economy since early 2003. Equipment and software
investment has been strong over this period.
The improvement in economic growth is reflected in other economic
figures as well. Since May of 2003, business payrolls have increased by
4.2 million jobs. The unemployment rate stands at 5.1 percent. Consumer
spending continues to grow. Homeownership has hit record highs.
Household net worth is also at a record level. Productivity growth
continues at a healthy pace.
Long run inflation pressures appear to be contained. Long-term
interest rates, including mortgage rates, are still relatively low. It
is clear that the Fed remains poised to keep inflation under control.
In summary, overall economic conditions remain positive. The U.S.
economy has displayed remarkable flexibility and resilience in dealing
with many shocks. It is clear that monetary policy and tax incentives
for investment have made important contributions to the improvement in
the economy in recent years. Recently released minutes from the Federal
Reserve suggest that the central bank expects this economic strength to
continue.
The Administration forecast for economic growth in 2006 is
comparable with those of the Blue Chip consensus and the Federal
Reserve. With growth expected to exceed 3 percent next year, the
current economic situation is solid and the outlook remains favorable.
Economic Effects of Inflation Targeting
After decades of debate, the case for inflation targeting is well
established. This paper focuses on one key ingredient of the argument
supporting inflation targeting: The proposition that a credible
implementation of inflation targeting will calm and stabilize various
financial markets, anchor the price system, and limit inflation as well
as its variability and persistence. Other competing views--i.e., (a)
that inflation targeting has no impact on financial markets and (b)
that inflation targeting leads to asset price bubbles and hence to
financial market volatility--are briefly outlined.
These alternative views are presented and briefly contrasted with
existing empirical evidence. Some key findings include the following:
There is little or no evidence that inflation targeting
adversely affects financial markets.
While not unanimous, the weight of the existing empirical
evidence appears to support the view that inflation targeting matters
and will work to calm and limit the variability of financial markets,
as well as the persistence of inflation. As the empirical literature
suggests, this will likely help to foster healthier economic growth.
Although some research findings are consistent with competing
hypotheses, this research has a number of problems.
Since there is little evidence that inflation targeting has adverse
effects on financial markets or the economy, adopting inflation
targeting once price stability is attainted likely will make
maintaining price stability easier. As emphasized by others, adopting
inflation targeting will help future economic performance in that gains
in credibility will be preserved for future Federal Reserve chairmen.
introduction
The theoretical case for inflation targeting (IT) has been spelled
out during the course of the last 15 years in a number of publications,
including several JEC studies. The case for IT is a strong one,
supported by a number of compelling arguments. According to proponents,
adopting IT certainly does make a difference by improving the
performance of the economy, the financial system, and the inflation
rate. The arguments supporting this approach, however, will not be
repeated here; these arguments have been amply described elsewhere.
Instead, one component of the arguments supporting the adoption of IT
will be reviewed and assessed.
In particular, IT proponents contend that its adoption will help to
calm and stabilize financial markets. More precisely, the adoption of
credible IT will provide an anchor to the financial system and to
financial markets. In so doing, financial markets will stabilize as
inflation is driven from the price system. Temporary deviation of
inflation will be ignored. This credibly reduced inflation is
associated with less volatile financial markets, smaller risk premiums,
and lower inflationary expectations. In this view, then, IT is
associated with more stable financial markets.
On the other hand, some economists contend that IT is associated
with asset price bubbles, and thus, asset price volatility. In
particular, as credible IT works to stabilize conventional measured
inflation, to reduce risk premiums, and to tame economic fluctuations,
economies experience more risk taking and more risky investment.
Economies will also experience increased stock price volatility and
associated asset price bubbles. According to this view, there is a kind
of ``moral hazard'' of economic policymaking: The more stable/
predictable the economic environment, the more risk taking and risky
investment take place. Proponents of this view point to several classic
episodes in which asset price bubbles followed periods of price
stability; e.g., the United States during the 1920s, as well as more
recent episodes in Japan and the U.S. In this view, then, IT is
associated with more volatile asset prices and financial markets, the
opposite contention of the above, more conventional view.
This paper briefly describes these alternative views, reviews
relevant empirical evidence, and attempts to reconcile these seemingly
conflicting positions.
an unconventional view: inflation targeting (it) and asset price
volatility
Recently, a few economists have broken rank with the conventional
view supporting IT. These economists contend that low inflation
environments tend not to be associated with asset price stability.
Instead, they argue that IT or low inflation environments tend to be
associated with asset price movements and bubbles (or financial
fragility) and asset price volatility. Fildaro, for example, states
that:
. . . The achievement of a low, stable inflation environment
has not simultaneously brought about a more stable asset price
environment. The record over the last decade, in fact, has
raised the prospect of asset price booms and busts as a
permanent feature of the monetary policy landscape.\1\
---------------------------------------------------------------------------
\1\ Fildaro, Andrew, ``Monetary Policy and Asset Price Bubbles:
Calibrating the Monetary policy tradeoffs,'' BIS Working Paper No. 155,
June (2004), p.
---------------------------------------------------------------------------
Similarly, Borio and Lowe (2002) argue that:
. . . financial imbalances can buildup in a low inflation
environment . . . while low and stable inflation promotes
financial stability, it also increases the likelihood that
excess demand pressures show up first in credit aggregates and
asset prices, rather than in goods and services prices . . . We
stress that financial imbalances can and do buildup in periods
of disinflation or in a low inflation environment,\2\
---------------------------------------------------------------------------
\2\ Borio Claudio, and Philip Lowe, ``Asset Prices Financial and
Monetary Stability: Exploring the Nexis,'' BIS Working Paper No. 114,
(July 2002), Abstract, p. 1.
Furthermore, in reviewing the economic environment of the past 30
years or so, Borio and White (2004) maintain that this environment can
be characterized as improving in price stability while at the same time
experiencing more financial instability.\3\
---------------------------------------------------------------------------
\3\ Borio, Claudio and William White, ``Whither Monetary and
Financial Stability? The Implications of Evolving Policy Regimes,'' BIS
Working Paper No. 147 (February 2004).
---------------------------------------------------------------------------
Some endorsing this alternative view include some economists
sympathetic to the Austrian School and several economists affiliated
with at the Bank for International Settlements (BIS).\4\
---------------------------------------------------------------------------
\4\ These authors, include, for example, Charles Bean, Claudio
Borio, Philip Lowe, William White, Andrew Filadro, Andrew Crockett, and
others.
---------------------------------------------------------------------------
This alternative view embodies some important implications.
Notably, proponents of this view contend that price stability or IT
causes sharp movements in asset prices; i.e., price stability or IT is
associated with asset price bubbles.
According to proponents of this view, IT central banks themselves
increasingly (but unwittingly) work to create the environment conducive
to the formation of asset price bubbles or instabilities. Specifically,
as modern central banks learn to control inflation and tame economic
fluctuation, thereby stabilizing economic activity, these economies
will experience more risk taking, more innovation, more investment and
sometimes stronger advances in productivity. They will experience
increased stock market volatility and associated asset price bubbles.
Credible IT policies, therefore, stabilize conventionally measured
price indices while at the same time create new incentives to take
risk.
In this view, there is a kind of ``moral hazard'' of economic
policymaking: The more stable/predictable the economic environment, the
more risk taking, investment, and innovation take place. In sum, low
inflation environments are increasingly associated with financial
imbalances and asset price volatility.
the conventional view: inflation targeting calms and stabilizes
financial market prices
There are several theoretical explanations of how financial markets
are affected by the existing monetary regime. In particular, different
explanations exist as to how movements in financial market prices are
shaped by the adoption of IT and its associated consequent price
stabilization. One of the direct benefits of IT, for example, is the
calming, stabilizing effect it has on financial market prices and on
the market price system itself. In short, IT stabilizes prices and
serves as an anchor to the price system. According to Levin et.al., for
example:
. . . under an inflation-targeting regime, expectations about
inflation, particularly at longer horizons, should be
``anchored'' by the target, and thus should be less affected by
changes in actual inflation . . . Having inflation expectations
that are well anchored--that is, unresponsive to short-run
changes in inflation--is of significant benefit to a country's
economy . . . Keeping inflation expectations anchored helps to
keep inflation itself low and stable.\5\
---------------------------------------------------------------------------
\5\ Jeremy Piger, ``Does Inflation Targeting Make a Difference?'',
Monetary Trends, Federal Reserve Bank of St. Louis, April 2004, p. 1.
See also Levin, Andrew T., Natalucci, Fabio M. and Piger, Jeremy M.,
``The Macroeconomic Effects of Inflation Targeting,'' Federal Reserve
Bank of St. Louis Review, July/August 2004, 86 (4).
More specifically, as inflation rates are credibly lowered and as
stable prices eventually emerge, inflation and inflationary
expectations will have less of a disturbing effect on price movements.
Price reactions to both economic policy announcements and economic data
releases will be tempered. This reduction in inflation and inflationary
expectations will lower the variability of relative and nominal prices.
And this reduction of inflation and inflationary expectations will also
reduce uncertainty and thereby lower risk spreads.
Furthermore, distorting interactions of inflation with the tax code
will gradually be minimized. In short, the operation and working of the
price system will be improved as adopting IT will reduce market
volatility.
These factors will contribute to calming and stabilizing a number
of important markets including the short-term money market, long-term
bond market, foreign exchange market, sensitive commodity markets, as
well as equity markets. All of these improvements will work to better
enable to function, improve market efficiency, and inevitably to
improve economic growth and performance.
indirect approaches to stabilize markets
There are additional indirect, but important ways in which IT can
work further to calm and stabilize movements in market prices. More
specifically, IT necessarily involves an increase in central bank
transparency, which can work to further stabilize markets.\6\ The
benefits of monetary policy transparency cited in the literature
include a reduction in both the level of and variability of inflation,
as well as output.\7\
---------------------------------------------------------------------------
\6\ Transparency has several dimensions. These involve explicit
identification of policy objectives, issuing inflation reports, policy
announcements, and testimony, i.e., providing much more information to
the market. See for example, Seth B. Carpenter, ``Transparency and
Monetary Policy: What Does the Literature tell policymakers?'' Working
Paper, Board of Governors of the Federal Reserve System, April 2004. p.
1.
\7\ See Carpenter, op. cit., p. 1.
---------------------------------------------------------------------------
IT, after all, involves the announcement of and explicit public
identification of policy goals or policy rules. This involves providing
more information to the market. Markets work better with more
information; more specifically, they absorb new information and use it
to form common, concentrated expectations about the future.\8\ As
markets begin to anticipate policy changes, the initial steps of the
monetary transmission mechanism between policy action and economic
activity begin to work more efficiently.\9\ Policy surprises affecting
markets become smaller and fewer in number. Central bank credibility
begins to build and to anchor inflationary expectations, thereby
helping to stabilize financial markets. As one proponent put it: ``the
strength of inflation targeting, vis-a-vis other monetary regimes lies
precisely in how transparency enhances monetary credibility and anchors
private expectations.'' \10\
---------------------------------------------------------------------------
\8\ See, for example, Gavin, William, ``Inflation Targeting,''
Business Economics, April 2004, pp. 30, 36.
\9\ See, Charles Freedman, ``Panel Discussion: Transparency in the
Practice of Monetary Policy,'' Review, Federal Reserve Bank of St.
Louis, July/August, 2002, p. 155.
\10\ Klaus Schmidt-Hebbel and Matias Tapia, ``Statement'' (2002),
p. 11)
In short, increased transparency changes behavior so that markets
function better and in a more stable, predictable manner that works to
stabilize markets.
empirical evidence
In sum, alternative views as to the effects IT might have on
financial markets suggest that, the adoption of IT could result in
these markets becoming more volatile, less volatile, or unaffected by
IT. Existing evidence sheds some light on validity of these alternative
views.
Does IT result in more Volatile Financial Markets?
Hard empirical evidence supporting the view that IT causes
financial market volatility appears difficult to muster. Much of the
literature sympathetic to this view is not focused directly on such
empirical evidence. Rather, it often deals with broader issues of
monetary policy and the policy role played by asset price ``bubbles''.
Borio and Lowe, for example, make such a connection:
While low and stable inflation promotes financial stability,
it also increases the likelihood that excess demand pressures
show up first in credit aggregates and asset prices, rather
than in goods and services prices. Accordingly, in some
situations, a monetary response to credit and asset markets may
be appropriate to preserve both financial and monetary
stability.\11\
---------------------------------------------------------------------------
\11\ Borio Claudio and Philip Loew, ``Asset Prices, Financial and
Monetary Stability: Exploring the Nexis,'' BIS Working Paper No. 114,
July 2002, Abstract.
But the argument that price stability or IT itself fosters asset
price bubbles, asset price volatility, or financial instability has
been neither adequately nor convincingly established. And the case that
financial imbalances develop because of stable price environments, has
not been demonstrated; it has not been shown that price stability
causes financial instability. In short, no direct ``hard core'' or
formal statistical or econometric evidence supports this view. Instead,
anecdotal compilations of ``stylized facts'' are used to assess
historical episodes in support of the view. Additionally, only a few
episodes appear to have the characteristics (low inflation, credit
growth, asset price bubbles, etc) consistent with this view. Instead of
such evidence, proponents rely on assumptions relating to the
credibility of policymakers, investment activity, technological
advances, or productivity gains that can serve to constrain the price
increases of goods and services. In sum, little hard empirical evidence
supporting the view that price stability or IT contributes to or causes
volatile financial markets exists.
Empirical Evidence: Does IT matter? Is IT unrelated to economic
performance or to market volatility?
A number of studies have examined whether the adoption of IT
improves economic performance (as measured by movements in inflation,
output, and/or interest rates) or affects the volatility of market
variables. In short, they have tested to see if IT matters.
Several researchers have addressed this question. Despite a good
deal of effort, however, some of their empirical results have been
mixed. As a result, this research in turn has raised a number of
methodological questions. More specifically, in assessing these
questions in recent years, researchers have often used a common
methodology. The reason for this is that recently both IT and non-IT
countries experienced improvement in economic performance as measured,
for example, by inflation or the level of interest rates. Focusing on
any one IT country in isolation might lead researchers to falsely
conclude that IT caused the improvement. But non-IT countries may have
experienced similar affects. Some researchers contend, therefore, that
to test for the effects of IT, improvements in IT countries must be
made relative to improvements in non-IT countries.
Examples of research results: Implying IT doesn't matter include
the following:
Ammer and Freeman (1995) surveyed three IT countries, New
Zealand, Canada, and the United Kingdom. They found that although each
reached its inflation goal, bond yields suggested that long-term
inflationary expectations exceeded targets as did short-term measures
of inflationary expectations. This suggests that these countries did
not attain the credibility necessary to properly anchor other prices
and stabilize the price system. Moreover, there is no evidence that
announcement of an explicit IT policy would reduce inflationary
expectations.\12\
---------------------------------------------------------------------------
\12\ John Ammer and Richard T. Freeman, ``Inflation Targeting in
the 1990s. The Experiences of New Zealand, Canada, and the United
Kingdom,'' Journal of Economies and Business, 1995, 47:165-192, pp.
165,189.
---------------------------------------------------------------------------
Johnson (2002) employed data from 11 countries. He adopted
a methodology which divided up his sample into inflation targeting and
non-inflation targeting countries. His results are mixed. Specifically,
he found that while the level of inflationary expectations falls after
announcing explicit inflation targets, the variability of expected
inflation does not. In describing his results, Johnson contended that
``inflation targets allowed a larger disinflation with smaller forecast
errors to take place in targeting countries.'' \13\
---------------------------------------------------------------------------
\13\ David R. Johnson, ``The Effect of Inflation Targeting on the
Behavior of Expected Inflation: Evidence from an 11 country panel,''
Journal of Monetary Economies, 49 (2002) 1521-1538, p. 1537.
---------------------------------------------------------------------------
Recent research by Ball and Sheridan (2003) is perhaps the
most forceful example of empirical work concluding that IT does not
matter. These authors, for example, conclude that:
. . . on average, there is no evidence that inflation
targeting improves performance as measured by the behavior of
inflation, output, or interest rates . . . overall it appears
that targeting does not matter. Inflation targeting has no
effect on the level of long-term interest rates, contrary to
what one would expect if targeting reduces inflation
expectations . . . targeting does not affect the variability of
the short-term interest rates controlled by policymakers . . .
we find no evidence that inflation targeting improves a
country's economic performance.\14\
---------------------------------------------------------------------------
\14\ Ball, Laurence and Niamh Sheridan, ``Does Inflation Targeting
Matter?,'' Paper presented at NBER Inflation Targeting Conference,
January 2003 (March 2003), pp. 2,3,4,29.
In short, some research clearly concludes that IT does not matter.
some questions and critique
There are, however, a number of fundamental reasons why this
research and its conclusions are both questionable and in conflict with
the results of other research. For example, many economists question
the methodology employed in these studies. The selection and
identification of ``non-IT countries,'' for example, is one of these
issues. Several economists, analysts, and even Federal Reserve
officials have pointed out that a number of key countries, including
the U.S., are identified as non IT countries in the studies because
they do not have explicit inflation targets. But many of these
countries consistently pursued an implicit inflation targeting
strategy. So the label may be misleading and inappropriate for several
countries. This misspecification also applies to countries pegging
their currencies to a currency whose central bank is following ITs;
(i.e., some countries in Europe and Asia). These observations were made
by, Gertler, Mankiw, Federal Reserve officials and others.\15\ These
contentions draw into question the validity of the methodology and
results of these empirical studies.
---------------------------------------------------------------------------
\15\ See Gertler, Mark, ``Comments on Ball and Sheridan,'' Prepared
for the NBER Conference on Inflation Targeting, January 2003. (June
2003), pp 1, 3-5; Mankiw N. Gregory, (2001), ``U.S. Monetary Policy
During the 1990's. NBER Working Paper No. 8471, Cambridge, Mass Sept
2003; and Marvin Goodfriend, ``Inflation Targeting in the United
States?,'' (2003) Paper prepared for the NBER Conference on Inflation
Targeting, January 2003.
---------------------------------------------------------------------------
Furthermore, recent IMF research surveys and delineates the many
dimensions to and ways of classifying and categorizing IT. This
research underscores the large number of variables that can be used to
select and define IT. It is a reminder that there may be no easy,
simple way of neatly identifying an IT central bank.
Because of the multi-dimensional character of IT regimes, it is
difficult to clearly and neatly dichotomize existing central banks into
IT and non-IT categories. Definitions of IT, for example, should be
adjusted to reflect the realities of ``flexible'' IT. The clean
dichotomization maintained by theoretical researchers may not be nearly
as clean as suggested by the authors. Consequently, the empirical
results may not be as clean as suggested by some of the results of
these papers.
Additionally, several statistical or econometric issues and
critiques were identified in much of this literature. In his comments
on Ball and Sheridan, for example, Gertler notes that ``existing
evidence in favor of inflation targeting is open to identification
problems.'' \16\ Ball and Sheridan themselves assert that their
empirical results are often not strictly comparable to the results of
other studies because of unusual techniques that were employed.\17\
---------------------------------------------------------------------------
\16\ Gertler, Mark, ``Comments on Ball and Sheridan,'' June 2003,
Paper prepared for the NBER Conference on Inflation Targeting, January
2003, p. 1.
\17\ Ball and Sheridan, op. cit., p. 28. (The unusual technique was
regression to the mean.)
---------------------------------------------------------------------------
Empirical Evidence: IT is related to macroeconomic performance and
to financial market volatility: IT does make a difference.--Despite the
widespread practical support accorded IT in recent years, not much hard
empirical support was found favoring IT in early, initial research.\18\
As time passed and more historical data has come to the fore, however,
researchers have uncovered a number of important empirical regularities
tending to support IT. Some of the evidence comes from single-country
case studies suggesting that IT tends to stabilize markets. Other
evidence is cross-section support. For example, a number of recent
empirical studies examined the relationship between IT and
macroeconomic performance, as well as between IT and financial market
behavior: i.e., these studies attempted to assess whether IT matters.
While mixed, the bulk of the new evidence indicates that IT matters; IT
has a positive significant impact on economic and financial market
performance.
---------------------------------------------------------------------------
\18\ See Neumann and Von Hagen, p. 127.
---------------------------------------------------------------------------
The following ``bullet points'' supply an abbreviated summary of
the recent key empirical studies relevant to this topic:
In a (1996) report to the FOMC, David Stockton surveyed
existing literature related to price objectives for monetary
policy.\19\ In that survey, Stockton identified several well-known
established empirical relationships pertinent to this topic. They
included the following:
---------------------------------------------------------------------------
\19\ David J. Stockton, ``The Price Objective for Monetary Policy:
An Outline of the Issues,'' A Report to the FOMC Board of Governors,
June 1996.
* Both cross-country and time-series evidence supports the
notion that inflation reduces the growth of real output (or
productivity).
* Inflation is positively related to the variability of
relative prices.
* Inflation is positively related to inflation uncertainty.
* In general, relative price variability and inflation
uncertainty adversely affect real output.
In his recent book Inflation Targeting (2003), Truman
summarizes the principal conclusions of the empirical literature on
inflation targeting.\20\ In particular, IT generally:
---------------------------------------------------------------------------
\20\ Edwin M. Truman, Inflation Targeting in the World Economy,
Institute for International Economics, Washington, D.C. October 2003,
p. 72.
* Has had a favorable effect on inflation, inflation
variability, inflation expectations, and the persistence of
inflation.
* Has not had a negative effect on economic growth, the
variability of growth, or unemployment.
* Has had mixed effects on both the level and variability of
real, nominal, short-term, and long-term interest rates.
* Has had positive effects on exchange rate stability.
* Has affected the reaction functions of the central banks
that have adopted the framework.\21\
---------------------------------------------------------------------------
\21\ Ibid. p. 72. (The points outlined were taken from Truman, p.
72.)
For the most part, economists have established
empirically a negative relationship between inflation uncertainty and
---------------------------------------------------------------------------
real economic activity. Elder (2004), for example, relates that:
Our main empirical result is that uncertainty about inflation
has significantly reduced real economic activity over the post-
1982 period . . . Our findings suggest that . . . macroeconomic
policies that reduce volatility in the inflation process are
likely to contribute to greater overall growth.\22\
---------------------------------------------------------------------------
\22\ John Elder, ``Another Perspective on the Effects of Inflation
Uncertainty.''
In a early study, Ammer and Freeman (AF) (1995) examined
three IT countries. This study provided mixed results for IT. On the
one hand, inflation did not exceed the targets and this result occurred
without sharp increases in short-term rates. These researchers found
that ``inflation fell by more than was predicted by the models in the
early 1990s, an indication of the effect of the new regime.'' \23\
However, ``longer term interest rates suggest that none of these
countries rapidly achieved complete long-term credibility for their
announced long-run inflation intentions.\24\
---------------------------------------------------------------------------
\23\ Neumann and von Hagen, op.cit., p.128.
\24\ John Ammer and Richard T. Freeman, ``Inflation Targeting in
the 1990's: The Experiences of New Zealand, Canada, and the United
Kingdon,'' Journal of Economics and Business, 1995; 47: 165-192, p.
189.
---------------------------------------------------------------------------
Some of the earlier (pre-2000) literature was summarized
by Neuman and von Hagen (NvH) and included the following observations:
* Some authors find that ``IT might . . . serve to lock in
gains from disinflation rather than to facilitate
disinflation.'' \25\ After introducing IT, inflation and
interest rates remained below values predicted by existing
models.
---------------------------------------------------------------------------
\25\ Neumann and von Hagen, op.cit., p.128.
---------------------------------------------------------------------------
* Other authors found that the ``volatility of official
central bank interest rates . . . declined substantially after
the introduction of IT.'' \26\
\26\ Ibid., p. 129.
---------------------------------------------------------------------------
Neumann and von Hagen (NvH) (2002) reviewed earlier
studies of inflation targeting episodes. They presented ``evidence on
the performance of IT central banks.'' \27\ In particular, NvH showed
that ``. . . IT has reduced short-term variability in central bank
interest rates and in headline inflation . . .'' \28\ (The NvH paper)
``suggests that IT has indeed changed central bank behavior . . .''
(NvH) ``looked at different types of evidence in order to validate''
(the claim that inflation targeting) ``is a superior concept for
monetary policy.'' ``Taken together, the evidence confirms that IT
matters. Adopting this policy has permitted IT countries to reduce
inflation to low levels and to curb the volatility of inflation and
interest rates . . .'' \29\ In discussing this paper, Mishkin reminds
us that NvH ``produce several pieces of evidence quite favorable to
inflation targeting.'' \30\
---------------------------------------------------------------------------
\27\ Manfred J.M. Neumann and Jurgen Von Hagen, ``Does Inflation
Targeting Matter?,'' Federal Reserve Bank of St. Louis, Review, July/
August 2002, p. 130.
\28\ Ibid, p.127.
\29\ Ibid, pp. 128, 144 (parenthesis added).
\30\ Frederick Mishkin, ``Commentary,'' FRB St. Louis Review, July/
August, 2002, p.144.
---------------------------------------------------------------------------
Johnson (2002) shows that inflation ``targets reduced the
level of expected inflation in targeting countries'' \31\ . . . ``The
evidence is very strong that the period after the announcement of
inflation targets is associated with a large reduction in the level of
expected inflation . . . that (significant) reduction took place in all
5 countries with inflation targets. This is an important success of
inflation targets.''. . . ``inflation targets allowed a larger
disinflation with smaller forecast errors to take place in targeting
countries.'' \32\ In sum, inflation targeting presumably favorably
affected the bond and other markets by influencing inflationary
expectations and reducing uncertainty premiums.
---------------------------------------------------------------------------
\31\ David R. Johnson, ``The Effect of Inflation Targeting on the
Behavior of Expected Inflation: Evidence from an 11 country panel.''
\32\ Journal of Monetary Economics 49 (202), p. 1522. ibid, pp/
1537. (parenthesis added).
---------------------------------------------------------------------------
Levin, Natalucci and Piger (LNP) (2004) find ``evidence
that IT plays a significant role in anchoring long-term inflationary
expectations and in reducing the . . . persistence of inflation'' \33\
The evidence suggests that IT practitioners can more readily delink
their inflationary expectations from realized inflation.\34\ In short,
IT plays a significant role in anchoring long-term inflation
expectations and long-term interest rates themselves.\35\
---------------------------------------------------------------------------
\33\ Andrew T. Levin, Fabio M. Natalucci, and Jeremy M. Pager,
``The Macroeconomic Effects of Inflation Targeting,'' Federal Reserve
Bank of St. Louis, Jan. 23, 2004. Abstract.
\34\ Op.cit., Abstract.
\35\ Op. cit., p.2.
* LNP find that ``inflation targeting affects the public's
expectations about inflation'' . . . ``under an inflation
targeting regime, expectations about inflation, particularly at
longer horizons, should be `anchored' by the target, and thus
should be less affected by changes in actual inflation.''
``Keeping inflation expectations anchored helps to keep
inflation itself low and stable.'' \36\
---------------------------------------------------------------------------
\36\ Jeremy Piger, ``Does Inflation Targeting Make a Difference?''
Monetary Trends, April, 2004.
---------------------------------------------------------------------------
* In commenting on this paper, Uhlig (2004) . . . ``concludes
that these figures seem to suggest that an environment of low
and stable inflation helps to reduce output volatility and
support economic activity.'' \37\
---------------------------------------------------------------------------
\37\ Jeremy M. Piger and Daniel L. Thornton, ``Editor's
Introduction,'' Federal Reserve of St. Louis Review, July/August 2004,
Volume 86, Number 4, p. 5.
Recent empirical research at the Federal Reserve by
Gurkaynak, Sack and Swanson (GSS) (2003) shows that the Fed could boost
the economy by being more transparent about its long-term inflation
objectives.\38\ GSS ``show that the long-term interest rates (of non-IT
countries) react excessively to macroeconomic data releases and to news
about monetary policy. This overreaction is caused by changes in the
market's long-term inflation expectations.'' \39\
---------------------------------------------------------------------------
\38\ See Refet S. Gurkaynak, Brian Sack, and Eric Swanson, ``The
Excess Sensitivity of Long-Term Interest Rates, Evidence and
Implications for Macroeconomic Models,'' Finance and Economic
Discussion Series, Federal Reserve Board, November 17, 2003; William
Gavin, ``Inflation Targeting, Why It Works and How to Make it Work
Better,'' Business Economics, Vol XXXIX April, 2004, p. 32.
\39\ See Gavin, op cit, pp. 32, 36 (parenthesis added).
---------------------------------------------------------------------------
IT, however, works to anchor (or prevent excess volatility in)
long-term market's. Consequently, in IT countries (like the UK),
markets do not overreact or display over-sensitivity. The empirical
results of the paper suggest ``that the central bank can help stabilize
long-term forward rates and inflation expectations by credibly
committing to an explicit inflation target.'' \40\ Commitment to an
explicit target will help stabilize both long rates and inflation
expectations.
---------------------------------------------------------------------------
\40\ GSS, op.cit. p. 28.
---------------------------------------------------------------------------
Other research conducted at the Federal Reserve also
relates to this evidence. Carpenter (2004), for example, surveyed
empirical studies of transparency.\41\ The summarized results are
mixed, but suggest there is evidence of a relationship between IT and
both transparency and lower inflation. Moreover, it is emphasized by
several authors that there is no evidence that IT causes any harm.
Swanson (2004) showed that increased central bank transparency acts to
reduce financial market surprises and uncertainties. This suggests that
IT--which is tantamount to increased transparency of policy goals--may
aid in reducing financial market volatility and stabilizing financial
markets.\42\
---------------------------------------------------------------------------
\41\ Seth Carpenter, ``Transparency and Monetary Policy: What Does
the Academic Literature Tell Policymakers?, ``Working Paper, Board of
Governors of the Federal Reserve System, April 2004, pp. 11-13.
\42\ Eric T. Swanson, ``Federal Reserve Transparency and Financial
Market Forecasts of Short-Term Interest Rates,'' Working Paper, Board
of Governors of the Federal Reserve System, February 9, 2004.
---------------------------------------------------------------------------
Several studies establish that additional central bank
transparency in the form of announced inflation target, works to lower
inflation and stabilizes output. Recently Fatas, Mihov, and Rose (FMR),
for example, found ``that both having and hitting quantitative targets
(like IT) for monetary policy is systematically and robustly associated
with lower inflation . . . Successfully achieving a quantitative
monetary goal (like ITs) is also associated with less volatile
output.'' \43\ These authors find that ``. . . countries with
transparent targets for monetary policy achieve lower inflation.'' \44\
They found ``that having a quantitative de jure target for the monetary
authority tends to lower inflation and smooth business cycles; hitting
that target de facto has further positive effects. These effects are
economically large, typically statistically significant and reasonably
insensitive to perturbations in (their) econometric methodology.'' \45\
---------------------------------------------------------------------------
\43\ Antonio Fatas, Ilian Mihov, and Andrew K. Rose, ``Quantitative
Goals for Monetary Policy,'' NBER Working Paper No. W 10846, October
2004, Abstract (parenthesis added.)
\44\ Ibid, p. 1.
\45\ Ibid. p. 21. (parenthesis added).
---------------------------------------------------------------------------
Siklos (2004) found that ``inflation-targeting countries
have been able to reduce the nominal interest rate to a greater extent
than have non-inflation targeting countries . . . It is also found that
central banks with the clearest policy objectives have a relatively
lower nominal interest rates.'' \46\
---------------------------------------------------------------------------
\46\ Pierre L. Siklos, ``Central Bank Behavior, The Institutional
Framework, and Policy Regimes: Inflation Versus Non-Inflation Targeting
Countries,'' Contemporary Economic Policy, vol 22, no. 3, July 2004,
331-343, pp 331, 332.
---------------------------------------------------------------------------
This abbreviated review of some of the recent literature suggests
that overall, there is a good deal of evidence supporting the case for
IT. This review suggests that inflation targeting does matter. More
specifically, credible commitment to an explicit IT likely will work to
help lower and stabilize the level and variability of inflation. This
result occurs in part because of the reduction and stabilization of
inflationary expectations. Hence, it will likely lower both the level
and variability of the long bond rate. IT will anchor the price system
and help to stabilize short-term interest rates, long-term interest
rates, the foreign exchange and stock markets. Some research suggests
IT also helps to dampen the business cycle and stabilize movements in
output. Additionally there is a body of evidence indicating that
transparency helps to stabilize markets and fosters central bank
credibility.
summary and conclusions
After decades of debate, the case for inflation targeting is well
established. This paper focuses on one key ingredient of the argument
supporting inflation targeting. Namely, it examines the proposition
that a credible implementation of inflation targeting will calm and
stabilize various financial markets, anchor the price system, and limit
inflation, as well as its variability and persistence. Other competing
views--i.e., (a) that inflation targeting has no impact on financial
markets and (b) that Inflation Targeting leads to asset price bubbles
and hence to financial market volatility--are briefly outlined.
These alternative views are presented and briefly contrasted with
existing empirical evidence. Some key findings include the following:
There is little or no evidence that inflation targeting
has adverse effects on financial markets.
Research finding that inflation targeting does not matter
has problems, in part related to the selection and definition of
inflation targeting countries.
The weight of the existing empirical evidence appears to
support the case for inflation targeting; i.e. overall, it supports the
view that inflation targeting matters and will work to calm and limit
the variability of financial markets as well as the persistence of
inflation. It will serve to anchor the price system. As the empirical
literature suggests, this will likely foster healthier economic growth.
There is little evidence that inflation targeting has adverse
effects on or hurts financial markets or the economy.\47\ Accordingly,
adopting inflation targeting once price stability is attained likely
will make it easier to maintain.\48\ As emphasized by Gertler, ``the
case made for adopting formal targets in the U.S. is not that this
system would have improved past performance, but rather that it would
help future performance by preserving gains in credibility for
Greenspan's successor.'' \49\
---------------------------------------------------------------------------
\47\ Ball and Sheridan, op.cit., p. 29.
\48\ See Anthony M. Santomero, ``Monetary Policy and Inflation
Targeting in the United States,'' Business Review, Federal Reserve Bank
of Philadelphia, Fourth Quarter 2004, p. 1.
\49\ Mark Gertler, ``Comments on Ball and Sheridan.'' A Paper
presented to the NBER conference on Inflation Targeting, January 2003,
p. 5. The point was also made by Ball and Sheridan, op. cit., p. 30
---------------------------------------------------------------------------
______
Prepared Statement of Senator Jack Reed, Ranking Minority Member
Thank you, Chairman Saxton. I want to welcome Chairman Bernanke,
who I hope will give us useful insights on current economic conditions
and where he thinks the President's policies are taking us. I am also
pleased that we will have a second panel of witnesses to give us
further perspectives on the economic outlook.
Like many Americans, my concerns about the economic outlook and the
Administration's stewardship of the economy have grown in the wake of
Hurricane Katrina. Economic insecurity for workers is widespread as
energy prices are soaring, employer-provided health insurance coverage
is falling, private pensions are in jeopardy, and American workers are
still waiting to see the benefits of the economic recovery reflected in
their paychecks.
President Bush's tax cuts were poorly designed to stimulate broadly
shared prosperity and have produced a legacy of large budget deficits
that leave us increasingly hampered in our ability to deal with the
host of challenges we face. The devastating impact of Hurricanes
Katrina and Rita will put short-term strains on the Federal budget--
strains that would be fairly easy to absorb if our budget and economic
policies were sound, but they are not. The President's goals of making
his tax cuts permanent and cutting the deficit in half are simply
incompatible.
Large and persistent budget deficits also have contributed to an
ever-widening trade deficit that forces us to borrow vast amounts from
abroad and puts us at risk of a major financial collapse if foreign
lenders suddenly stop accepting our IOU's. The trade deficit of $59
billion in August is close to the record for a single month of more
than $60 billion set in February. The broader current account deficit,
which measures how much we are borrowing from the rest of the world, is
running at a record annual rate of nearly $800 billion, or well over 6
percent of GDP.
I will be interested in Chairman Bernanke's views on whether the
budget and trade deficits are dangerous imbalances that pose a risk to
the economic outlook. But I am also pleased that we will be able to
hear Dr. Setser's views, which may be somewhat different.
I hope that we would all agree that raising our future standard of
living and preparing adequately for the retirement of the baby boom
generation require that we have a high evel of national investment and
that a high fraction of that investment be financed by our own national
saving--not by foreign borrowing. We followed such prosperity-enhancing
policies under President Clinton, but that legacy of fiscal discipline
has been squandered under President Bush.
Sound policies for the long run are clearly very important, but I
am also deeply concerned about what continues to be a disappointing
economic recovery for the typical American worker. Strong productivity
gains have shown up in the bottom lines of shareholders but not in the
paychecks of workers. The typical worker's earnings are not keeping up
with their rising living expenses. And both earnings and income
inequality are increasing.
Instead of addressing these problems, the President's policies seem
to be piling on. It's certainly hard to take seriously the President's
rhetoric about wanting to lift families out of poverty when he has
refused to support an increase in the minimum wage and he has lifted
the Davis-Bacon Act, thereby legitimizing sub-par wages for workers
rebuilding their communities in the hurricane-stricken Gulf Coast
region.
And even though home heating costs are expected to skyrocket this
winter, President Bush has said he will not request additional funds
for the Low Income Home Energy Assistance Program, known as LIHEAP.
Together with Republican Senators Susan Collins and Olympia Snowe, I
have offered an amendment to increase LIHEAP by $3.1 billion, so that
low-income Americans won't be left out in the cold this winter. I would
like to know if the Administration is willing to reconsider its
position on providing additional LIHEAP funds and if not, why not?
It seems to me that the President's compassionate words hardly
match his Administration's actions. Now is not the time to cut funding
for important programs such as LIHEAP and Medicaid that support working
families and seniors, while the President continues to push for
irresponsible tax breaks for those who are already well-off.
I look forward to Chairman Bernanke's testimony about the economic
outlook, and I will listen with interest to anything the Chairman and
our witnesses can tell me that will allay my concerns about that
outlook.
Prepared Statement of Hon. Ben Bernanke, Chairman, Council of
Economic Advisers, Washington, DC
Chairman Saxton, Vice-Chairman Bennett, Ranking Member Reed, and
Members of the Committee, thank you for the opportunity to testify
before the Joint Economic Committee. We appreciate the long-standing
and mutually beneficial relationship between the Committee and the
Council of Economic Advisers. My remarks today will focus on the
current state of the economy, but of course such an overview would be
incomplete without an eye to the human and economic impacts of
hurricanes Katrina and Rita in the U.S. Gulf Coast.
While it has been nearly 2 months since Hurricane Katrina made
landfall, its devastation will have a protracted impact on the Gulf
region. As you know, Hurricane Katrina wreaked unprecedented losses on
the people of the Louisiana, Mississippi, and Alabama coasts. Katrina
took many lives, destroyed communities, and shook a vital portion of
our Nation and our economy. The Gulf region was then hit by Hurricane
Rita, which did significant damage but, in most areas, less than was
feared. In response to the disasters, the President has directed all
agencies of the Federal Government to devote their maximum effort to
helping the victims of the hurricanes and to begin the process of
cleaning up and rebuilding the region. The President has also proposed
a series of measures to restore the Gulf's communities and economy.
One of the greatest assets we have in rebuilding after a hurricane
is the overall strength of the national economy. The resiliency of the
economy--the product of flexible labor markets, a culture of
entrepreneurship, liquid and efficient capital markets, and intense
market competition--is helping it to absorb the shocks to energy and
transportation from the hurricanes. The ability of our economy to grow
and create jobs will act as a lifeline to the regions and people that
have been most affected. Thus these recent events make it all the more
important that we keep the fundamentals of the national economy strong
and continue to promote economic policies that will encourage growth
and job creation.
the economic expansion
When thinking about where the economy is now and where it is
heading, it is useful to keep in mind just how far the U.S. economy has
come in recent years. The economy's resilience was put to severe test
during the past 5 years, even prior to Katrina. A remarkable range of
shocks hit the U.S. economy, beginning with the sharp decline in stock
prices in 2000 and the recession that followed in 2001. The economy was
further buffeted by the terrorist attacks of September 11, 2001, and
the subsequent geopolitical uncertainty. Business and investor
confidence was shaken by a series of corporate scandals in 2002. By
early 2003, uncertainty about economic prospects was pervasive and the
economy appeared to be sputtering.
Yet, in the face of all these shocks, together with new challenges
such as the recent sharp rise in energy prices, the American economy
has rebounded strongly. Policy actions taken by the President and the
Congress were important in helping to get the economy back on track.
Notably, beginning with the President's 2001 tax cuts, multiple rounds
of tax relief increased disposable income for all taxpayers, supporting
consumer confidence and spending while increasing incentives for work
and entrepreneurship. Additional tax legislation passed in 2002 and
2003 provided incentives for businesses to expand their capital
investments and reduced the cost of capital by lowering tax rates on
dividends and capital gains.
Together with appropriate monetary policies, these policy actions
helped spur economic growth in both the short run and the long run.
Today the U.S. economy is in the midst of a strong and sustainable
economic expansion. Over the past four quarters real GDP has grown at a
3.6 percent rate, and over the past eight quarters real growth has been
at a 4.1 percent annual rate. Prior to Katrina, the near-term forecasts
of both CEA and private-sector economists had called for continued
solid growth. The destruction wrought by Katrina and Rita may reduce
growth somewhat in the short run, but the longer-term growth trajectory
remains in place. I'll return to economic prospects in a moment.
An important reason for the recovery has been improved business
confidence. To an extent unusual in the postwar period, the slowdown at
the beginning of this decade was business-led rather than consumer-led.
Homebuilding and purchases of consumer durables did not decline as they
typically do in cyclical downturns; instead the primary source of
weakness was the reluctance of businesses to hire and to invest.
Supported by appropriate fiscal and monetary policies and by the
economy's innate strengths, business confidence has risen markedly in
the past few years. The effects are evident in the investment and
employment data. From its trough in the first quarter of 2003, business
fixed investment has increased over 21 percent, with the biggest gains
coming in equipment and software. Since the labor market bottomed out
in May 2003, more than 4 million net new payroll jobs have been added.
Currently, the unemployment rate stands at 5.1 percent, up from 4.9
percent in August, prior to the job losses that followed Katrina.
Although growth in GDP and jobs capture the headlines, one of the
biggest macroeconomic stories of the past few years is what has been
happening to productivity. Productivity growth is the fundamental
source of improvements in living standards and the primary determinant
of the long-run growth potential of the economy. Over the past 4 years,
labor productivity in the nonfarm business sector has grown at a 3.4
percent annual rate, and productivity in manufacturing has risen at a
5.7 percent annual rate. Productivity growth has slowed recently as
businesses have absorbed millions of new workers--a normal development
for this stage of an economic expansion--but it remains (in the four
quarters ending 2005:Q2) at the quite respectable level of 2.2 percent
(and 6.3 percent in the nonfinancial corporate sector). Thus, on each
of three key indicators of the real economy--GDP growth, job creation,
and productivity growth--the United States in recent years has the best
record of any major industrial economy, and by a fairly wide margin.
Finally, while there has been a notable rise in overall inflation
this year, prices on nonenergy products have continued to increase at
moderate rates. In particular, soaring energy prices have played the
largest role in boosting the overall consumer price index to an
increase of 4.7 percent over the past year, up from a 2.5 percent
increase over the year-earlier period. In contrast, core consumer
prices (as measured by the consumer price index excluding volatile food
and energy prices) rose only 2.0 percent over the past 12 months,
unchanged from its year-earlier pace. Long-term-inflation expectations
also remain low and stable, based on measures of inflation compensation
derived from inflation-indexed Treasury securities. To be clear, the
focus on core inflation by no means implies that the rise in energy
prices is inconsequential; sharply higher energy costs place a heavy
burden on household budgets and increase firms' costs of production. I
will discuss the energy situation in more detail in a moment. However,
the stability in core inflation and inflation expectations does suggest
that overall inflation is likely to return to levels consistent with
price stability in coming quarters.
the economic outlook
Let me turn now to the outlook. In the shorter term, the
devastation wrought by the hurricanes has already had palpable effects
on the national rates of job creation and output growth. Payroll
employment declined by 35,000 in September, its first decline since May
2003, and industrial production fell 1.3 percent, its largest monthly
decline in over two decades. Both of these declines appear to be
entirely accounted for as the effects of the hurricanes. The Bureau of
Labor Statistics estimates that employment growth would have been
roughly 200,000 in the absence of the hurricanes, and the Federal
Reserve estimates that industrial production would have increased about
0.4 percent. Consumer confidence also dropped in September, although
growth in consumer spending has continued to be solid. While the
effects of the storms certainly reduced growth in the third quarter
relative to what it would have been otherwise, most private-sector
economists expect healthy growth for the remainder of this year and in
2006. For example, the Blue Chip panel of forecasters now projects
growth at 3.2 percent in the second half of 2005 and 3.3 percent growth
in 2006. Recovery and rebuilding will contribute to job creation and
growth by the latter part of this year and in 2006.
The economic impact of the hurricanes included significant damage
to the country's energy infrastructure. As you know, Katrina shuttered
a substantial portion of U.S. refining and pipeline capacity, which led
to a spike in gasoline prices in the weeks after that storm. Rita
caused further damage. The Federal Government has assisted, in among
other ways, by lending or selling oil from the Strategic Petroleum
Reserve, arranging for additional shipments of oil and refined products
from abroad to the United States, and providing appropriate regulatory
waivers to increase the flexibility of the energy supply chain. In part
because of these efforts and a vigorous private-sector response, oil
prices have returned to roughly their pre-Katrina levels. Wholesale
gasoline prices have also retreated to levels of mid-August, suggesting
that the recent decline in prices at the pump is likely to continue.
Natural gas prices may remain elevated somewhat longer, however,
because of lost production in the Gulf, the difficulty of increasing
natural gas imports, and damage to plants that process natural gas for
final use.
Even as the energy sector continues to recover, it remains true
that the prices of oil and natural gas have risen sharply in the past 2
years, reflecting a tight balance of supply and demand. High energy
prices are burdening household budgets and raising production costs,
and continued increases would at some point restrain economic growth.
Thus far at least, the growth effects of energy price increases appear
relatively modest. The economy is much more energy-efficient today than
it was in the 1970s, when energy shocks contributed to sharp slowdowns.
Well-controlled inflation and inflation expectations have also
moderated the effects of energy price increases, since those increases
no longer set off an inflation spiral and the associated increases in
interest rates, as they did three decades ago. In addition, allowing
prices to adjust, rather than rationing gasoline, is helping to
minimize the overall impact on the economy.
House prices have risen by nearly 25 percent over the past 2 years.
Although speculative activity has increased in some areas, at a
national level these price increases largely reflect strong economic
fundamentals, including robust growth in jobs and incomes, low mortgage
rates, steady rates of household formation, and factors that limit the
expansion of housing supply in some areas. House prices are unlikely to
continue rising at current rates. However, as reflected in many
private-sector forecasts such as the Blue Chip forecast mentioned
earlier, a moderate cooling in the housing market, should one occur,
would not be inconsistent with the economy continuing to grow at or
near its potential next year.
The current account deficit presents some economic challenges. At
6.3 percent, the ratio of the current account deficit to GDP is now at
its highest recorded level. Gradually reducing the current account
deficit over a period of time would be desirable. While the current-
account imbalance partly reflects the strong growth of the U.S. economy
and its attractiveness to foreign investors, low U.S. national saving
also contributes to the deficit. The United States should work to
increase its national saving rate over time, by encouraging private
saving and by controlling Federal spending to reduce the budget
deficit. Our trading partners must also play a role in reducing
imbalances, by becoming less reliant on export-led growth and
increasing domestic spending, and by allowing their exchange rates to
move flexibly as determined by the market.
conclusion
The economic challenges posed by hurricanes Katrina and Rita
reinforce once again the importance of economic policies that promote
growth and increase the resilience of the economy. Energy issues in
particular have come to the fore recently. The energy bill recently
passed by Congress and signed by the President should help address the
Nation's energy needs in the longer term. As an additional step, the
Administration will continue to work with Congress to take measures
that will permit needed increases in refinery capacity. The
Administration has made a number of other proposals to increase
economic growth, including proposals to reduce the economic costs of
litigation, to increase quality and reduce costs in the health-care
sector, and to address national needs in education and job training.
The Administration is currently engaged in several international
negotiations, including the Doha round of the World Trade Organization,
as well as talks with China on a number of matters involving trade,
exchange rates, and needed financial reforms. Liberalized trade and
capital flows promote economic growth, and we should strive to achieve
those objectives in the context of a gradual reduction of current
account imbalances. It is important that we persist in these efforts
and not retreat to economic isolationism, which would negatively affect
the long-run growth potential of the economy.
Fiscal discipline, always important, has become increasingly so in
the face of the likely costs of assisting the victims of the hurricanes
and of helping in the rebuilding. Before the impact of the hurricanes,
strong economic growth was helping to reduce the budget deficit and the
Government finished fiscal year 2005 with a much lower-than-expected
deficit. The President remains committed to controlling spending and
cutting the budget deficit in half by 2009. His 2006 budget made
numerous proposals to save more than $200 billion over the next 10
years from both discretionary and mandatory programs. In the budget
resolution earlier this year, Congress laid plans to pass $35 billion
out of the President's $70 billion in savings from mandatory programs
over the next 5 years. Congress should now make good on that plan by
passing at least $35 billion in mandatory savings in reconciliation
legislation. Further savings beyond $35 billion would be highly
desirable. The President continues to seek a decrease in non-security
discretionary spending in FY2006 appropriations bills, and the
Administration is working on options for spending rescissions. The
President also remains committed to reforms to address fiscal
challenges in the longer term, such as Social Security.
Finally, I note that the tax reform advisory panel, whose official
report will go to the Secretary of the Treasury on November 1, has
kicked off a much-needed debate on how to make the Federal tax code
simpler, fairer, and more pro-growth. We thank them for their hard work
and look forward to reviewing their recommendations.
Thank you for the opportunity to be here today. I would be happy to
answer your questions.
______
Prepared Statement of Dr. Mickey D. Levy, Chief Economist, Bank of
America, New York, NY
My outlook for U.S. economic performance is upbeat, based on sound
fundamentals that underlie high potential growth and a history of
resilience to shocks. The negative effects of Katrina on employment,
consumer spending, trade and inflation will be temporary, and growth
will bounce back in 2006, aided by a significant jump in Government
purchases. Increases in wages and personal incomes will continue to
support consumption. Housing activity is slowing, and prices are
beginning to recede, but it is very unlikely that average values will
decline sharply and unhinge the economic expansion. As always, the
economy faces risks: present concerns include higher energy prices and
further aggressive monetary tightening, a negative shock or a global
slump. The Federal Reserve is expected to raise rates to 4.5-4.75
percent, but this would not be considered excessive. The probability of
recession in 2006 is very low. Sustained long-run economic health
requires fiscal reform involving programmatic changes to the
Government's retirement and health care policies that are fair to
current participants, incorporate the right incentives, and slow the
growth of future benefits.
(1) Solid fundamentals provide a favorable long-run outlook for
U.S. economic growth, and the efficiency and flexibility of the economy
and capital markets provide resilience to external shocks. Potential
growth is 3.5+ percent.
Long-run annualized growth has averaged 3.4 percent, and recent
positive trends in productivity point to sustained healthy economic
growth and rising standards of living. Favorable foundations, often
overlooked in short-term assessments of economic conditions, include
the efficiency and flexibility of U.S. production processes and labor
markets, favorable tax and regulatory environment facilitating the
entrepreneurship and business investment that support technological
innovation, extraordinarily efficient capital markets and a well-
capitalized banking system, and low inflation and the inflation-
fighting credibility of the Federal Reserve. Following an elongated
early expansion spurt in productivity, labor productivity gains have
moderated but are expected to remain healthy, which combined with
labor-force growth points to sustained economic growth over 3.5
percent.
Growth of U.S. GDP and capital spending has exceeded all other
large industrialized nations, and its potential growth is higher.
Moreover, combined with the responsiveness of economic policymakers,
sound fundamentals provide significant resilience to external shocks.
All recent economic expansions, including the current one that began in
2001Q4, have experienced external shocks that potentially could have
sidetracked performance: Latin American debt crises in the early 1980s
and mid-1990s, the Russian default and Asian financial crisis in 1997,
the collapse of LTCM in 1998, 9-11, and most recently, Hurricane
Katrina. In each case, adjustment processes unfolded more quickly than
widely anticipated and, following temporary slowdowns, economic growth
quickly snapped back. The resilience provided by these built-in
stabilizers and smoothed cycles have reinforced confidence in U.S.
economic performance.
(2) Economic growth, which was solid prior to Katrina, will
moderate for several quarters, followed by a reacceleration to
trendline in 2006. Risks to the outlook are slower growth as a
consequence of tighter monetary policy and higher energy prices, or a
negative shock or global slump.
The economy grew at an estimated 3.8 percent annualized pace in the
first three quarters of 2005, and displayed healthy characteristics and
surprising vigor prior to Katrina. In particular, consumer and business
investment spending was quite resilient to the negative impact of
higher energy prices. This reflected several factors: energy
consumption per unit of GDP has declined significantly in recent
decades in response to higher energy prices, and nominal spending
growth has exceeded 6 percent, reflecting the Federal Reserve's
monetary accommodation, so that the higher outlays for energy have not
significantly ``crowded out'' real spending on non energy goods and
services. Employment gains averaged 177,000 per month, and the
unemployment rate dipped to 4.9 percent. Wages were increasing
modestly, contributing to healthy increases in disposable income.
Businesses were very disciplined, and inventories were very low
relative to sales. Corporate profits and cash-flows rose to all-time
highs.
Katrina generated huge declines in national wealth (by some
estimates, up to $150 billion), caused unprecedented displacement of
households and workers, involved large uninsured business losses, and
impaired and disrupted oil and gas refining facilities as well as the
port of New Orleans. Although large, these losses in wealth must be
judged relative to the $11 trillion U.S. economy and its high growth
potential, and household net worth of nearly $50 trillion. The loss in
wealth has little direct impact on measured GDP, while the clean up and
rebuilding, however financed, count as production and adds to GDP.
As a result of Katrina, U.S. economic growth will temporarily slow
and its composition will change. Consumption growth is projected to
slow sharply from its estimated 3.8 percent pace over the past 4
quarters, to approximately 1 percent annualized in Q4, followed by a
modest rebound in 2006Q1. Business investment is unlikely to be
significantly affected, while both imports and exports may be
temporarily delayed, which may temporarily slow production. Aided by a
sharp boost in Government purchases and associated ``fiscal policy
multipliers,'' real GDP is projected to rebound significantly in the
first half of 2006, just when the growth of private consumption is
rebounding.
Certainly, the economy faces risks. Domestic demand would slump in
the second half of 2006 if the Fed inadvertently hikes rates too much
and energy prices rise further. With the Federal funds rate at 3.75
percent, monetary policy remains accommodative, and the inflation-
adjusted funds rate is below its long-run average. It is likely the Fed
will raise interest rates to 4.5-4.75 percent by mid-2006, which I
consider toward the higher end of the range of a ``neutral'' funds
rate. Monetary tightening far beyond ``neutral'' would accentuate the
impacts of higher energy prices. Internationally, a negative global
shock, sharply lower global growth that generated declining U.S.
exports, or a sharp fall in the demand for U.S. dollar-denominated
assets that led to global financial turmoil would harm the U.S.
economy. However, such international events are unlikely, and the risks
of an economic downturn in 2006 remain modest.
(3) Consumer spending growth is projected to slow significantly
through year-end 2005 and rebound to a moderate pace in 2006, while
business investment spending is expected to continue rising at a
healthy pace.
The expected temporary sharp slowdown in consumption growth in Q4
stems from several factors: The disruptions to economic activity in the
hurricane/flood-affected region, including the negative impact on
consumption and provision of services (business, personal, health and
education services, etc.); the depressing impacts of higher energy
prices and the temporary rise in unemployment on real disposable
personal income; and the decline in motor vehicle sales from earlier
unsustainable incentive-driven levels. Through August, increases in
employment and wages had more than offset the higher energy prices,
with real disposable personal income averaging 2.3 percent year-over-
year growth in the first half of 2005. Consumer spending will find
additional support from low real-interest rates and household net
worth-which measures the total value of stocks, bonds and real estate
held by households net of all household debt--that reached an all-time
record in its last reading. Noteworthy, however, the sustained rapid
growth of consumer spending in the face of higher energy prices has
lowered the rate of personal saving even further.
In the near term, the combination of temporary declines in
employment and higher energy prices will dent real purchasing power,
but the impact must be put into perspective: Even displaced households
will continue to consume (shelter, food and clothing) regardless of how
the purchases are financed, and declines in consumer activities in the
Gulf Coast region will be partially offset by increases in other
regions. Look for consumer spending to rebound, but to a slower pace of
growth.
Business investment spending is projected to continue to grow at a
healthy pace, and is unlikely to be materially affected in the near
term. Factors underlying investment, including product demand,
corporate profits and cashflows, and low real costs of capital, remain
positive. The rebuilding of structures and the reconstruction of
damaged infrastructures in the Gulf Coast, including oil and gas
refining facilities, will boost investment spending.
(4) Employment has fallen modestly and the unemployment rate has
risen in the aftermath of Katrina, but these are temporary effects, and
labor markets remain generally healthy. Wages are rising to reflect
sustained productivity gains, but the sharp increases in energy prices
have temporarily suppressed real wage gains.
Katrina's displacement of businesses and households will
temporarily disrupt otherwise healthy labor markets. Employment fell
modestly in September and the unemployment rate rose to 5.1 percent. A
hallmark of the current expansion has been the slow return to health of
the U.S. labor market, following the 2001 recession and severe equity
market declines in 2000-2002. Business caution was unusually high and
slow to recede, contributing to the above-trend pace of productivity
gains. However, prior to Katrina, the pace of layoffs, measured with
initial unemployment claims, had receded to very low levels, and
businesses were both hiring and expanding the hours worked of existing
employees.
This slow cyclical rebound in employment and business caution and
discipline will serve to mitigate the impact of Katrina on net
payrolls. Importantly, outside the affected Gulf Coast region, economic
conditions and business hiring have remained strong. These conditions
provide a positive backdrop for facilitating the re-absorption into the
workforce of many displaced workers. In addition, labor shortages and
temporarily high wages have begun to attract workers back into the
affected region. Following temporary weakness, employment is projected
to resume its growth, and the unemployment rate should again recede
below 5 percent.
Until recently, real wages had been rising, although not as fast as
gains in labor productivity. Rapid increases in nonwage costs,
including employer contributions for worker health care, partially
explain the gap. The recent sharp rise in energy prices has pushed
headline inflation above wage gains, reducing real wages. This too is
likely to be temporary, as the rising demand for labor lifts wages
while headline inflation recedes.
(5) The jump in Government spending for the Katrina cleanup and
rebuilding and the expected fiscal policy multipliers will support
economic growth in Q4 and boost it in 2006, but will contribute to a
renewed spike in budget deficits.
Prior to Katrina, rapid growth in tax receipts (a whopping 14.6
percent in the just completed FY2005) had contributed to a faster-than-
expected decline in the budget deficit. The deficit for FY2005 fell to
less than $320 billion or 2.6 percent of GDP, a significant reduction
from 3.5 percent in 2003 and 3.6 percent in 2004. Fiscal responses to
Katrina may raise the deficit by as much as 1 percent of GDP, as tax
receipts temporarily slump and outlays surge. So far, Congress has
authorized more than $60 billion in Katrina-related spending, and the
total Federal fiscal response almost certainly will be higher.
To date, the financial market reaction to Katrina and the
anticipated fiscal response has been modest: The U.S. dollar has been
virtually unchanged and bond yields have drifted up, reflecting both
related and unrelated concerns. Inflationary expectations have risen,
the underlying economy has shown strength and resilience, and markets
fear a letdown by fiscal policymakers in the wake of the hurricanes.
The longer-run costs are not trivial. The higher deficit will add to
the stock of Government debt, raising net interest costs. The net costs
to sustainable economic growth depend on a host of factors, including
how the Government funds are spent, the returns on such spending and
investments and how they influence private incentives, and how the
outlays are financed--through offsetting spending reductions, tax
increases or higher debt. All of these factors have important
implications for the allocation of national resources. I urge fiscal
policymakers to consider these issues in all of their dimensions, and
encourage a rational debate about how to allocate the Government funds
in the most economically efficient manner.
(6) Corporate profits, which have grown to record levels, are
projected to continue increasing through 2006, although higher energy
prices will adversely affect profits in select industries.
Operating profits--after-tax profits with inventory valuation and
capital consumption allowance adjustments--have risen 9.9 percent in
the last year and almost 59 percent cumulatively since the 2001Q4
recession trough, modestly faster than profits gains during prior
economic expansions. Profits have benefited from healthy growth in
product demand, firm margins generated by modest pricing power and
strong productivity gains that have constrained unit labor costs, low
interest rates that have allowed businesses to restructure their
financial balance sheets and the low U.S. dollar that has boosted
repatriated profits from overseas activities. Higher energy prices have
depressed profits unevenly, with outsized impacts on the airline,
automobile and other select industries.
I project profits to rise at a moderating pace in 2006, reflecting
ongoing business discipline, enhanced production efficiencies and
global demand for U.S. products. The Fed rate hikes will slow growth in
nominal spending, which will dampen business top-line revenue growth.
Business pricing power will be limited, but sustained productivity
gains should largely offset upward pressures on wage compensation and
help constrain increases in unit labor costs. Nonlabor costs may rise
however, largely reflecting, among other influences, higher insurance
costs.
(7) Housing activity is expected to soften and average prices
decline modestly, but the probability of sharp declines that would
unhinge consumer spending and the economy is low.
Following the unprecedented rise in residential sales, housing
construction and home prices, the real estate market is showing signs
of cooling. In select regions in which prices had soared, inventories
of unsold homes have jumped up--presumably in response to the high
prices--and the volume of sales transactions has begun to slow. In
response to the Fed's rate hikes and flattening yield curve, there has
been a clear shift in mortgage applications toward longer-term
mortgages and away from short-term variable mortgages that had
contributed to real estate price speculation.
Clearly, the rate of real estate appreciation in recent years is
unsustainable. A crucial issue is how and why the market will adjust,
and whether any fall in real estate prices will harm overall economic
performance. My assessment is that housing values will decline from
lofty levels in select ``speculative-driven'' regions, but average
housing prices will dip only modestly, and as long as the economy
continues to expand at a healthy pace and inflation and bond yields
remain reasonably low, the adjustment in housing activity and prices
will not unduly harm the macro economy.
Concerns that the sharp appreciation of real estate has been the
primary factor driving consumer spending are overstated; while housing
appreciation has contributed positively to net worth and the propensity
to spend, real disposable income, which has continued to rise, remains
the crucial variable underlying consumer spending. A slump in overall
economic activity, employment and incomes would generate sharp declines
in housing; however, a flattening in housing, including significant
price declines in speculative markets in response to the Fed rate hikes
and modestly higher mortgage rates, may slow the rate of consumption
growth, but is very unlikely to unhinge the economic expansion.
(8) Exports are projected to continue rising rapidly, reflecting
improving global economic trends; but recently slower import growth has
begun to narrow the trade deficit.
Real exports, which rose very sluggishly early this expansion, but
accelerated to a rapid 9.1 percent average annualized growth pace in
the last 2 years, are projected to grow strongly through 2006, as
global economic conditions continue to improve. Imports have been much
more volatile: After declining during the 2001 recession, they have
increased at a 7.5 percent average annual pace, faster than exports,
and the trade deficit has widened. However, so far in 2005, import
growth has slowed significantly to a 3.5 percent pace-contributing to a
narrowing trade deficit.
With the exception of economic weakness in core European nations,
the economies of major U.S. export markets are healthy. Asia,
destination for approximately 26 percent of U.S. exports, continues to
grow significantly faster than the global average. Importantly, Japan,
the world's second largest economy, is rebounding to sustainable
healthy growth following prolonged stagnation and deflation. I expect
Japan will grow significantly faster than consensus estimates through
2006. China's economy shows no signs of slowing from its long-run 9+
percent rate of expansion. U.S. exports to China have grown 46 percent
in the last year, reaching $39 billion, and should continue to increase
rapidly. India's economy and trade with the U.S. are also expanding
rapidly. Growth in Canada remains healthy, Mexico is growing on the
coattails of the U.S. expansion, and Brazil, Argentina and Chile are
expanding and enjoying relative stability. Europe's economic
performance will remain uneven. Misguided tax and regulatory policies
constrain potential growth in core European nations, while other
European nations, including some that will be joining the European
Union, are growing rapidly.
The substantial widening of the U.S. net export deficit in recent
years implies that foreign producers have supplied a growing share of
domestic demand. Moreover, fueling concerns about the trade deficit,
the common perception is that ``excessive consumer spending'' is the
primary culprit of rapid import growth. In fact, nearly 40 percent of
total U.S. imported goods are industrial supplies and capital goods
(excluding automobiles and petroleum), which directly contribute to
business production and expansion. The growth and composition of
imports suggest strongly that the wide trade deficit is to some extent
a reflection of the U.S.'s economic strength, and is not as bothersome
as is commonly perceived.
As long as the U.S. continues to grow faster than other industrial
nations, and its investment growth is stronger, its trade deficit will
tend to remain wide. However, the strength in exports and recent
slowing in import growth, which must be interpreted cautiously, have
reduced the trade gap. As economic growth improves in other regions of
the world, investment in these nations will expand, and real interest
rates will rise. Slower growth in U.S. consumption, higher household
savings rates, a greater reliance on exports to spur domestic economic
growth and a gradual narrowing in the U.S. trade gap are natural and
necessary consequences of an improved balance in world economies. The
best contribution for U.S. economic policy is to encourage the positive
trends abroad while sustaining healthy domestic economic fundamentals.
(9) Headline inflation has risen due to higher energy prices, but
core measures of inflation, excluding food and energy, have remained
low. Core inflation may rise modestly in response to Katrina, but I
expect that any rise will be temporary, and project inflation to remain
low in 2006.
Following the energy price spike that accompanied Katrina, the CPI
has now risen 4.7 percent in the past 12 months, highest since mid-1991
and a substantial jump from 2.5 percent only a year ago. Core measures
of inflation that exclude food and energy have drifted up very
modestly: both the core PCE deflator and core CPI have risen 2.0
percent in the past 12 months, ending in August and September
respectively. Presently, the core PCE deflator is at the top end of the
Fed's central tendency forecast of 1.75-2.0 percent through 2006. The
Fed and most macroeconomists generally focus on core measures of
inflation because historically, the food and energy components have
been very volatile, and have tended to regress to their long-run
averages, while core measures of inflation have provided the most
reliable forecasts of future inflation.
Core inflation may rise gently through year-end 2005 as a
consequence of Katrina-related price increases of materials and
commodities, but I expect that will prove to be temporary, and core
inflation will remain relatively low in 2006. I am very impressed with
the Fed's inflation-fighting resolve. The Fed rate hikes will slow
nominal spending growth, which will constrain excess domestic demand
relative to productive capacity (the Fed's central tendency forecast
for nominal GDP is 5.25-5.5 percent for 2006, a meaningful deceleration
from its 6.1 percent year-over-year pace). Moreover, the rapid
expansion of the economies of low-cost producers China and India has
lifted global productive capacity, and should continue to put downward
pressure on the prices of traded goods. A widening array of services is
also traded, helping to lower accompanying cost structures. These
trends increase real output globally while constraining inflation.
(10) The Federal Reserve's primary focus remains low inflation, and
it will continue to hike short-term rates into 2006. Bond yields are
projected to rise, but not as much as short-term rates, contributing to
a flatter yield curve.
Even though the Fed has raised its Federal funds rate target from 1
percent to 3.75 percent, it perceives that monetary policy remains
accommodative, and it will continue to raise rates in order to
constrain core inflation. The Fed does not have a ``formal'' numeric
inflation target like many central banks, but it has clearly signaled
that low inflation is its primary goal. Beyond the typical issues of
forecasting inflation and the economy amid uncertainty, the difficulty
the Fed faces is that there is no reliable measure of monetary thrust
that provides a clear, forward-looking guideline for conducting policy,
and there are many crosscurrents in various monetary indicators. The
``neutral'' Federal funds rate is uncertain. At present, the funds rate
remains below its long-run average in inflation-adjusted terms, nominal
spending growth remains too fast to be consistent with stable low long-
run inflation, and the unemployment rate is low. However, growth of the
monetary aggregates has not provided reliable estimates of nominal
spending; although their recent moderate growth points to slower
nominal GDP growth, the seemingly excess liquidity in financial markets
in recent years has not been reflected in money supply measures. The
sharp flattening of the yield curve historically has implied monetary
restrictiveness, but the real costs of capital remain low. The lags
between monetary policy and economic activity always add a degree of
difficulty to Fed decisionmaking.
I expect that the Fed will raise rates through mid-2006, to
approximately 4.5 to 4.75 percent. Core inflation is unlikely to recede
appreciably, and the Fed will remain concerned about inflation in light
of sustained economic growth, low unemployment and scattered production
bottlenecks. Although a ``neutral'' funds rate is unobservable, my
assessment is these anticipated rate hikes would lift rates to a level
consistent with a neutral monetary policy, and would slow nominal
spending and help constrain inflation. Following several years of very
low rates and monetary stimulus, the Fed will perceive it necessary to
hike rates to the high end of estimated range of neutrality. Rising
world real interest rates also imply a higher equilibrium funds rate
target.
Bond yields, which have drifted up recently reflecting concerns
about inflation, are projected to rise to 5 percent by mid-2006. This
would involve a further flattening of the yield curve; I do not expect
the Federal funds rate to rise above 10-year Treasury bond yields. Low
core inflation and the Fed's credibility anchor bond yields. With
inflation expectations around 2 percent, a rise to 5 percent bond yield
would provide an ex ante 3 percent real interest rate, in line with the
long-run average of inflation-adjusted bond yields.
(11) The high U.S. trade deficit has resulted largely from the
U.S.'s relative economic strength, while the unprecedented U.S. current
account deficit reflects global differences in growth, saving and
investment, and is not likely to be the primary source of economic
destabilization.
Since 1990, U.S. economic and investment growth has been
persistently and significantly stronger than Europe, Japan and other
industrialized nations, and its future potential growth is estimated to
be higher. The rising U.S. trade deficit reflects and is consistent
with its relative economic strength, as its strong domestic demand and
investment spending support rapid growth in imports. As long as the
U.S. maintains this growth advantage, which boosts the demand for
imports, and the demand for U.S. dollar-denominated assets remains
high, the trade deficit will remain large.
In general, the large current account imbalances of many nations
and international capital flows reflect the large difference in rates
of economic growth, investment and saving. The unprecedented U.S.
current account deficit--now exceeding 6 percent of GDP--reflects the
U.S.'s insufficient saving relative to investment, other nations'
excess saving, and the strong demand for U.S. dollar-denominated assets
as global portfolio managers seek the highest risk-adjusted rates of
return on investment. While U.S. investment remains strong, its large
budget deficit and low rate of personal saving drag down national
saving.
In contrast, Asian nations tend to be large savers. Japan exports
capital, as its weak investment and high saving have generated current
account surpluses (Japan has been running a large government deficit,
but its private sector saving has been very high, reflecting the
prolonged deflation and long-run concerns about government finances and
pensions). Barring a sharp change in global economic fundamentals, I do
not expect a dramatic shift in asset allocations away from U.S. dollars
that would generate a sharp fall in the U.S. dollar and/or rise in
interest rates that would damage U.S. economic performance. That said,
there are initiatives that international policymakers could agree on
that would reduce global imbalances and boost growth at the same time.
A coordinated package that would reduce U.S. budget deficits, institute
pro-growth tax cuts and regulatory reforms in Europe, and involve
agreement by select Asian nations, including China, to float their
currencies, is such a package.
(12) The largest risks to the medium-term U.S. economic outlook are
excessive monetary tightening and higher energy prices or an
unanticipated slump in global economies. The U.S. economic expansion is
not likely to be sidetracked by large global imbalances or falling
housing prices. Addressing the U.S.'s large Government budget
imbalances remains crucially important to long-run economic health.
Beyond the widely anticipated temporary economic slowdown following
Katrina, the largest risks to U.S. macro performance in 2006 are not
the negative ripple effects of a collapsing housing market or financial
turmoil resulting from a dramatic withdrawal of foreign capital from
U.S. dollar-denominated assets. Rather, my concerns center on the
lagged impacts of significant monetary tightening coupled with
sustained high energy prices, or some unforeseen global slump. So far,
the economy has been very resilient to higher energy prices and Fed
rate hikes, but consumer and business investment spending could be hurt
by further energy price increases and rate hikes beyond the neutral
range. The Fed's top priority should be constraining inflation, but it
must mind its lagged policy impacts, particularly in light of leveraged
household balance sheets. However, the low real costs of capital and
lean business inventories provide important buffers and substantially
reduce the probability of economic downturn.
Although the Government's long-run budget imbalance is unlikely to
hamper near-term economic performance, addressing future rapid growth
in projected outlays and the Government's unfunded liabilities is
crucially important to the Nation's long-run economic health. Delays in
policy changes only raise future economic costs. The estimated
difference between projected spending and taxes under current law is so
large that raising taxes to ``close the gap'' on paper would damage
economic performance and adversely affect the financing gap.
Successfully achieving fiscal responsibility requires programmatic
changes to the major entitlement programs, the sources of the recent
and projected future spending increases, that are fair to current
program participants, provide the right incentives, and are financially
viable for the long run.
______
Prepared Statement of Dr. David F. Seiders, Chief Economist, National
Association of Home Builders, Washington, DC
Thank you Chairman Saxton and Members of the Joint Economic
Committee, I appreciate the opportunity to testify before you today on
behalf of the National Association of Home Builders (NAHB). NAHB
represents more than 220,000 members involved in home building,
remodeling, multifamily construction, property management,
subcontracting, and light commercial construction. NAHB is affiliated
with more than 800 State and local home builder associations around the
country. Our builder members will construct approximately 80 percent of
the more than 1.84 million new housing units projected for construction
in 2005.
The home building industry has been one of the strongest
contributors to the national economy in recent years. We have had
record years of production that have led to the highest homeownership
rate in U.S. history--69 percent. It is in America's interest to assure
that the home building industry maintains its leadership role in the
economy, not only because housing and related industries account for 16
percent of the gross national product (GDP), but most importantly
because of the benefits of home ownership to our country.
introduction
The current U.S. economic expansion began almost 4 years ago,
payroll employment has been growing for about 2 years, and the
unemployment rate has come down substantially in the process.
The housing sector has been a pillar of strength throughout this
economic expansion. The housing production component of GDP
(residential fixed investment) has delivered major contributions to
growth, particularly since early last year, and surging home sales and
residential construction have pulled related components of GDP ahead as
well--including the furniture and household equipment component of
consumer spending. The volume of services produced by the housing stock
and consumed by households also has been a large and growing component
of GDP. Finally, surging house prices have generated massive amounts of
wealth for America's homeowners, and debt-financed ``extraction'' of
housing equity has supported spending on residential remodeling and a
variety of consumer goods and services. Everything considered, it's
safe to say that the housing sector has contributed at least a full
percentage point to overall GDP growth in recent times, conservatively
accounting for between one-fourth and one-third of the total.
The extraordinarily strong performance of housing, including the
large cumulative increase in house prices, has prompted widespread
charges of an unsustainable housing boom, as well as projections of a
bust that could wreck not only the housing market, but also the entire
economy. Indeed, analogies have been drawn between the current housing
market and the stock market bubble that preceded the recession of 2001.
The housing market inevitably will cool down to some degree before
long, but a destructive housing bust is not in the cards; furthermore,
rebuilding in the wake of this year's hurricane season will add to
housing production for years to come. Everything considered, the
housing sector should transition from a strong engine of economic
growth to a more neutral factor in the GDP growth equation, but housing
will continue to play a vital role in U.S. economic activity going
forward.
It should be noted that the housing forecasts presented below
(attachment) assume that the current U.S. housing policy structure
remains essentially intact, with some temporary enhancements to deal
with the extraordinary housing issues created by hurricanes Katrina and
Rita and with maintenance of current benefits to housing in the tax
code and the housing finance system.
forecast highlights
The U.S. economy was performing quite well prior to
hurricanes Katrina and Rita and has enough fundamental strength to
easily weather the storms.
The hurricanes took an immediate toll on growth of
economic output and employment and may shift energy costs upward for an
extended period of time. But the recovery and reconstruction process
will soon provide enough economic stimulus to outweigh the negatives,
thanks largely to the Federal Government response.
The higher energy costs provoked by the hurricanes are
putting upward pressures on headline inflation numbers, but that effect
will diminish with time. Core inflation (excluding prices of food and
energy) promises to accelerate modestly during the next year or so as
labor markets tighten further and high energy prices inevitably leak
into the core.
The Federal Reserve tightened monetary policy another
notch on September 20, judging that the longer-term inflationary
implications of Katrina outweigh the short-term economic negatives.
Additional quarter-point hikes are likely at the next three FOMC
meetings, taking monetary policy to an approximately ``neutral''
position as Chairman Greenspan's term runs out at the end of January
2006.
Long-term interest rates have firmed up from their post-
Katrina lows as the bond markets have judged that the economy will
weather both storms and generate an inflation issue in line with the
Fed's concerns. Long-term rates should move up somewhat further in
coming quarters, lessening the risk of yield curve inversion as the
central bank raises short-term rates.
Katrina and Rita destroyed more than 350,000 housing units
and significantly damaged another 330,000, creating the potential for a
huge repair and rebuilding process with major implications for
residential remodeling, manufactured home shipments and conventional
housing starts--both inside and outside the impacted areas.
NAHB's housing forecasts incorporate tentative assumptions
regarding the timing and the patterns of repair and rebuilding in the
wake of the hurricanes. We're assuming that existing rental vacancies
and available subsidized housing units in the Gulf region and elsewhere
will meet some of the current need. We've also bolstered our outlook
for residential remodeling and manufactured home shipments through 2007
while phasing in increases in conventional housing starts (single-
family and multifamily) over an even longer period of time.
Recent housing market indicators, on balance, suggest that
home sales and housing starts were toying with cyclical peaks prior to
Katrina, and surveys of builders and lenders conducted since then seem
consistent with that judgment. However, the housing market still has a
lot of fundamental strength and home prices still are trending upward--
at least according to most measures we have in hand.
NAHB's housing outlook recognizes declines in housing
affordability measures that so far have been caused by sustained rapid
increases in house prices and that figure to be further eroded down the
line by a persistent upshift in the interest rate structure. We're also
anticipating less support to the single-family and condo markets from
``exotic'' forms of adjustable-rate mortgages and from investors/
speculators that have been relying on short-term capital gains--two
factors that undoubtedly have contributed to the recent housing boom in
some areas.
NAHB's housing forecast through 2007 shows a definite
cooling down of the single-family and condo markets, with relatively
strong performances turned in by rental housing, manufactured homes and
remodeling--owing in part to Katrina and Rita. Everything considered,
the housing production component of GDP (residential fixed investment)
should soon fall out of the economic ``growth engine'' category and
exert a slight drag on GDP growth in both 2006 and 2007.
The anticipated fade in demand for single-family houses
and condo units will result in some deceleration of price gains in
2006-2007, but national average prices will not actually fall in the
type of economic and financial market environment portrayed in our
forecast. Prices could fall in some local markets that have experienced
particularly strong increases in recent times, although persistent
supply constraints in such areas should continue to support home prices
for some time.
Homeowner finances currently are quite healthy, despite a
huge volume of borrowing against accumulated housing equity in recent
years, and the Fed's Financial Obligations Ratio for homeowners still
is in a manageable range. Furthermore, the vast majority of homeowners
will not be disadvantaged by perspective increases in market interest
rates and most have equity positions that could easily absorb declines
in house values--should they occur in some local markets.
economic growth
Incoming data suggest that annualized growth of real gross domestic
product (GDP) was heading toward a robust pace of about 4.5 percent in
the third quarter before Hurricane Katrina hit the Gulf Coast on August
29. We estimate that Katrina took nearly a percentage point out of
third-quarter GDP growth (dropping it to an estimated 3.6 percent) and
that the one-two punch from Katrina and Rita will hold fourth-quarter
growth to 3.2 percent--still a trend-like performance that displays the
resilience of the U.S. economy to serious shocks.
GDP growth should accelerate in the first half of 2006 as
rebuilding activities gear up in the wake of this year's unprecedented
hurricane damage. A bit further out, GDP growth should settle down to a
sustainable trend pace (around 3.25 percent), reflecting minimal
remaining slack in labor markets and maintenance of solid growth in
labor productivity.
labor markets
The employment report for September contained upward revisions to
payroll employment for both July and August, bringing the average
monthly gain to a robust 244,000. The preliminary estimate of net job
losses in September came to only 35,000, much less than the consensus
expectations, although data collection problems in the Gulf region
definitely created a wide range of uncertainty.
For now, the Labor Department suggests that, in the absence of
Katrina, employment growth probably would have followed its recent
trend (an average gain of 194,000 for the previous 12 months), meaning
that Katrina probably subtracted around 230,000 jobs from the national
numbers in September. It's also worth noting that strikes subtracted
22,000 from the September payroll employment numbers, implying that,
ex-Katrina and ex-strikes, payroll employment increased by about
225,000--in line with the strong July-August performance.
The labor market report for October will have to cope with
hurricanes Katrina and Rita, both because more Katrina casualties will
drop off payrolls and because Rita destroyed additional jobs of her
own. However, the September-October disruption to job markets will be
temporary, and national net job growth should regain a solid trend
before long. Indeed, we're looking for resumption of strong payroll
employment growth in 2006, aided by rebuilding activities, followed by
a slowdown in 2007 as GDP growth recedes to around trend. The
unemployment rate should sag a bit next year from the current
hurricane-related level (5.1 percent) but then edge up a bit in 2007.
energy costs and inflation
The hurricanes have seriously complicated the inflation picture,
boosting energy prices and headline inflation in the near term and
putting some upward pressure on core inflation down the line as energy
prices inevitably seep into the business cost structure.
The disruptions to energy production and transmission in the Gulf
region caused energy prices to spike sharply after Katrina, but prices
subsided within a few weeks as the supply situation improved. However,
the arrival of Rita caused energy prices to surge again, particularly
for gasoline and natural gas, and prices for these products are likely
to remain elevated for quite a while.
We're currently assuming that the spot price of WTI crude oil
averages a record $65/barrel in the fourth quarter and gradually
recedes to about $45/barrel by late 2007. We expect the retail price of
gasoline to continue to recede gradually from the post-Katrina peak
(above $3.00/gallon) but remain historically high across the forecast
horizon. We also assume that persistently higher prices for natural gas
will make their way into the prices for residential gas and electric
service as utilities gain regulatory approval to raise their rates.
We expect core inflation to firm up to some degree, particularly in
2006, reflecting tight labor markets and stronger growth of hourly
compensation, as well as some pass-through of high energy prices. Core
consumer price inflation is likely to rise from year-over-year rates of
slightly below 2 percent in the third quarter of this year to about 2.5
percent by 2007. That pace may be around the upper end of the Federal
Reserves ``comfort zone.''
interest rate structure
The apparent strong forward momentum of the U.S. economy, along
with the prospects for higher headline and core inflation, apparently
have steeled Federal Reserve resolve to keep the inflation situation
under control and have sent long-term rates upward.
The Fed enacted another quarter-point increase in short-term
interest rates at the September 20 meeting of the Federal Open Market
Committee (FOMC), raising the Federal funds rate to 3.75 percent (the
bank prime rate went to 6.75 percent in the process). While
acknowledging the negative economic effects of Hurricane Katrina, the
FOMC characterized these negatives as temporary and focused heavily on
the evolving threats to core inflation. And while continuing to say
that remaining monetary policy accommodation can be removed at a
``measured'' pace, the FOMC held open the possibility of a more
aggressive approach in the event that inflation concerns become more
serious than expected.
In recent weeks, various Fed spokespersons have stressed the
evolving inflation threat, and another quarter-point rate hike at the
next FOMC meeting on November 1 seems a foregone conclusion.
Furthermore, we're assuming additional rate hikes at the December 13
and January 31 meetings, as Chairman Greenspan's term runs out. We're
assuming the 4.5 percent funds rate will be considered ``neutral'' and
that monetary policy will hold steady for some time.
The bond markets apparently share the Fed's perspectives on
economic growth and inflation, and market expectations for monetary
policy are essentially the same as ours. As a result, long-term
interest rates have backed up considerably from their post-Katrina lows
and the long-term home mortgage rate edged over 6.0 percent in the
second week of October. Our forecast shows some additional increase in
long-term rates in coming quarters, with the home mortgage rate
reaching 6.6 percent by the fourth quarter of 2006.
hurricane housing damage
According to the October 3 Red Cross ``disaster assessment'' for
hurricanes Katrina and Rita, the two storms destroyed an estimated
356,000 housing units, with 353,000 attributed to Katrina. This was
more than 12 times the number destroyed in any previous natural
disaster (or series of disasters) in the Nation's history.
Furthermore, 146,000 units suffered ``major'' damage (not currently
habitable), 184,000 had ``minor'' damage (could be occupied), and an
additional 206,000 had ``extremely minor'' or ``nuisance'' damage such
as a few missing shingles or broken windows. Four-fifths of the
``destroyed'' housing units (uninhabitable and beyond repair) are in
Louisiana and nearly one-fifth are in Mississippi, while Alabama and
Texas got off quite lightly in this regard. Total damaged housing units
(needing major, minor or extremely minor repairs) amounted to 329,000
in Louisiana, 173,000 in Mississippi, 33,000 in Texas, and about 1,000
in Alabama.
The Red Cross has been trying to categorize destroyed or damaged
homes by type of unit. Current estimates say 88 percent of destroyed
units are single-family homes, 11 percent are apartment units and less
than 1 percent are manufactured homes. Census Bureau numbers, on the
other hand, show that about 15 percent of the housing stock in
Louisiana, Mississippi, and Alabama consisted of manufactured homes in
2000. Thus, it's likely that the Red Cross has been categorizing many
destroyed or damaged HUD-code housing units as conventionally built
single-family homes.
Whatever the exact numbers, it's perfectly clear that the cleanup,
repair and rebuilding process in the wake of Katrina and Rita will be
immense and that the implications for residential maintenance and
repair, spending on improvements (including replacements of major
systems), manufactured home shipments and conventional housing starts
are profound. The timing and composition of the process will depend
heavily on the pattern of Government responses.
repair/reconstruction assumptions
It's extremely difficult to estimate the patterns of repair and
reconstruction of the housing stock that was destroyed or damaged by
hurricanes Katrina and Rita. Experience with previous natural
disasters, along with evolving patterns of Federal Government
assistance in the wake of Katrina-Rita, have led us to the following
working assumptions for the 9-quarter period extending through the end
of 2007:
$1.8 billion for outlays on residential maintenance and
repair.
$4.7 billion for improvements to residential structures
(including replacements of major systems such as roofs and heating
systems).
38,000 manufactured home shipments (HUD-code units).
90,000 conventional housing starts (80 percent single-
family units), including units built on existing foundations in the
Gulf region.
recent housing performance
Housing market indicators painted a fundamentally positive picture
through the pre-Katrina period (essentially through August). Single-
family starts and permits for August held in the record range
established during other recent months, sales of existing homes (based
on closings) displayed a similar pattern, and ``pending'' sales of
existing homes (based on contracts signed) actually moved up to a new
record in August. Sales of new homes (contract basis) fell off in
August following a record pace in July, but statistical problems
definitely contributed to volatility in those months (hardly a new
problem with this series).
For the post-Katrina period, NAHB's single-family Housing Market
Index fell by two points in September, but regained that loss in
October, leaving the index slightly below the cyclical peak in June.
The weekly index of applications for mortgages to buy homes (Mortgage
Bankers Association series) was essentially flat throughout August,
September, and early October (4-week moving average basis).
Everything considered, it seems fair to say that single-family
housing activity has been toying with a cyclical peak and is poised to
show some fade before long. Measures of home-buying affordability have
been eroding in the face of ongoing rapid increases in house prices in
many areas, and the recent upshift in short- and long-term interest
rates figures to take some toll as well. Furthermore, there's a good
chance that those ``exotic'' forms of adjustable-rate mortgages are
losing some luster under the public scrutiny of Federal financial
regulators and the rating agencies. Finally, there's some tentative
evidence of decline in the investor shares of purchases of single-
family homes and condo units, and this component of demand can be quite
fragile.
the housing forecasts
NAHB's forecast shows a slight decline in total housing starts in
the fourth quarter of this year, partly because of hurricane effects in
the Gulf region, and we expect total starts to be down moderately in
both 2006 and 2007, despite hurricane-related additions.
Our forecast for 2006-2007 shows a cumulative decline of 9 percent
in single-family starts from the 2005 record. The multifamily sector is
essentially flat in this forecast, thanks primarily to a good
performance by the rental sector. We expect manufactured home shipments
to pick up significantly in coming quarters, reaching 150,000 units in
2006 before settling back toward a pre-Katrina pace. Residential
remodeling should post solid growth (in both nominal and real terms)
throughout the forecast period, supported by a massive amount of
homeowner equity and swollen repair/improvement needs in the wake of
the hurricanes.
Everything included, the residential fixed investment component of
GDP should soon move out of the strong ``growth engine'' category
occupied since the 2001 recession, although the real value of RFI
should remain within a few percentage points of the record high reached
in the third quarter of this year.
homeowner finances
Various media reports have been insisting that heavy borrowing
against housing equity has been pushing homeowner finances to the brink
of disaster. Indeed, Federal Reserve Chairman Alan Greenspan recently
unveiled Fed research showing net home equity ``extraction'' of $600
billion in 2004 (6.92 percent of disposable income), and borrowing
against equity could be even bigger this year.
These are staggering numbers, of course, but they don't actually
mean that something has gone wrong. Indeed, the Fed's own national
balance sheets show that homeowner equity grew to $10.5 trillion by
mid-2005, up by 18 percent from a year earlier. Furthermore, the
aggregate housing debt-to-value ratio stood at 43 percent at mid-year,
lower than at any time in recent years.
It's also clear that mortgage debt repayment is not placing an
undue burden on the income of America's homeowners--partly because
mortgage debt has been substituting for a lot of shorter-term, higher-
cost, consumer debt. Indeed, the Fed's Financial Obligations Ratio for
homeowners was only 16.37 percent in the second quarter, compared with
28.87 percent for renter households.
While it's possible to find debt-strapped homeowners, the overall
picture shows remarkably healthy homeowner finances and a housing
equity nest egg that could withstand sizable shocks. Indeed Chairman
Greenspan recently pointed out that ``only a small fraction of
households across the country have loan-to-value ratios greater than 90
percent'' and that ``the vast majority of homeowners have a sizable
equity cushion with which to absorb a potential decline in house
prices.'' *
---------------------------------------------------------------------------
* Alan Greenspan, remarks on ``Mortgage Banking'' to the American
Bankers Association Annual Convention, September 26, 2005
---------------------------------------------------------------------------
Mr. Chairman, that concludes my remarks. Again, thank you for the
opportunity to appear before you today. I look forward to answering any
questions you or the Members of the Committee may have for me.
Prepared Statement of Dr. Brad Setser, Senior Economist and Director of
Global Research, Roubini Global Economics, LLC, New York, NY
I want to thank Chairman Saxton and the Joint Economic Committee
for the opportunity to testify. My remarks will focus on one particular
aspect of the economic outlook--but a very important one--the payments
deficit the United States is running with the rest of the world. I will
make five key points:
The U.S. current account deficit has reached an
unprecedented size for a major economy. Barring a sharp fall in oil
prices, this deficit is likely to continue to increase in the next
year, in part because of rising interest payments on the United States
growing external debt.
The U.S. external deficit is a reflection of policy
decisions, both here in the U.S. and abroad, not just private saving
and investment decisions. Both the large U.S. fiscal deficit and the
unwillingness of many economies to allow their currencies to appreciate
against the dollar have contributed to the United States large deficit.
Net private flows have not been large enough to finance the United
States current account deficit.
Trade deficits of nearly 6 percent of U.S. GDP are not
sustainable over time. They imply a rapid increase in the U.S. external
debt to GDP ratio and a growing current account deficit.
The availability of sufficient financing to sustain
deficits of this size at current U.S. interest rates should not be
taken for granted. The larger the deficit, and the longer adjustment is
delayed, the greater the associated risks.
Policy actions, both at here and abroad, can help first to
stabilize and then to reduce the U.S. external deficit. The needed
policy steps are by now well known, but no less urgent. A reduction in
the U.S. fiscal deficit would increase national savings, and thus
reduce the United States' need to draw on the world's savings. Our
trading partners need to show greater willingness to allow their
currencies to appreciate and to take policy steps to encourage domestic
consumption growth.
The current account deficit looks likely to continue to grow in
2006.--The current account deficit is the sum of the trade deficit, the
balance on transfer payments, and the balance on labor and investment
income. This deficit totaled $395 billion in the first half of the
year, largely because of the $346 billion trade deficit. The trade
deficit is set to widen further in the second half of the year on the
back of higher oil prices and the disruption to U.S. oil production and
refining created by Katrina and Rita. The current account deficit has,
until now, largely tracked the U.S. trade deficit, but this is likely
to change going forward. The balance on investment income turned
negative in the second quarter, and further deterioration is to be
expected as higher short-term rates work their way through the U.S.
external debt stock. A surge in incoming transfer payments as European
re-insurers make Katrina-related claims may offset some of this
increase.
The 2005 trade deficit is likely to approach $720 billion and, in
conjunction with a transfers deficit of $85 billion and a negative
income balance, push the current deficit to around $815 billion, or
about 6.6 percent of U.S. GDP--up substantially from the $520 billion
(4.6 percent of GDP) deficit of 2003 and the $668 billion deficit of
2004 (5.7 percent of GDP). In dollar terms, the 2005 deficit will be
about twice as large as the $413 billion deficit of 2000, the peak
deficit of the .com investment boom.
If both the U.S. and the world continue to grow at close to their
current rates in 2006, the current account deficit is likely to
continue to widen in 2006. The recent increase in the trade deficit has
been driven almost exclusively higher oil prices; monthly non-oil
imports have been roughly constant since January. Subdued non-oil
imports combined with strong export growth to lead the non-oil trade
deficit to fall ever so slightly in the second quarter. However, this
improvement in the non-oil balance is likely to be difficult to sustain
in 2006. Strong export growth in 2005 reflects the lagged impact of
falls in dollar/euro in 2003 and 2004, plus a cyclical recovery in
demand for civil aircraft. By 2006, the recent rise in the dollar is
likely to begin to slow export growth. The slowdown in the growth of
non-oil imports is therefore partially a reaction to the exceptionally
rapid growth of these imports at the tail end of 2004. So long as the
U.S. economy continues to grow as expected, it is reasonable to expect
growth in non-oil imports to resume, though at a lower rate than 2004.
The balance on investment income is likely to continue to
deteriorate. Remember, the U.S. will take on $800 billion in new
external debt over the course of 2005 to finance its ongoing external
deficit. If that debt only carries an average interest rate of 5
percent, it implies an additional $40 billion in external payments. The
full impact of the Fed's recent tightening on short-term rates will
also begin to manifest itself in 2006, as existing short-term debt is
refinanced at a higher rate. The resulting 2006 current account deficit
is likely to top $900 billion, and exceed 7 percent of GDP.
The current account deficit essentially measures of how much we
have to borrow from the rest of the world to support the amount we
consume in excess of our income. It consequently is equal to the gap
between what the U.S. saving and U.S. investment. The U.S. budget
deficit--a drain on national savings--is likely to increase in 2006 on
the back of Katrina. Barring a fall in investment or rise in household
savings, so the overall gap between overall national savings and
investment is likely to continue to widen. Put differently, savings
imported from the rest of the world will finance an increasing share of
domestic U.S. investment.
----------------------------------------------------------------------------------------------------------------
2003 2004 2005 (f) 2006 (f)
----------------------------------------------------------------------------------------------------------------
Trade balance................................................... -495 -618 -720 -780
o/w oil......................................................... -130 -175 -241 -260
Non-oil trade balance........................................... -365 -443 -479 -520
Transfers balance............................................... -71 -81 -85 -90
Income balance.................................................. 46 30 -10 -65
Current account................................................. $520 $668 $815 $935
(% of GDP)...................................................... (4.7%) (5.6%) (6.6%) (7.1%)
----------------------------------------------------------------------------------------------------------------
Policy choices in the U.S. and abroad have contributed to the
increase in the deficit.--Current account deficits of this magnitude
are without precedent for a major economy. As Dr. Bernanke has
emphasized, these deficits have, to date, been financed at remarkably
low interest rates. Indeed, current U.S. interest rates seem, on their
face, insufficient to compensate the central banks of the emerging
market economies now financing the United States for the risk of
further dollar depreciation. Consequently, it is interesting to review
the forces that have led to the emergence of such a large U.S. external
deficit.
The U.S. current account deficit, by definition, has to be matched
by a current account surplus in rest of the world. The fall in savings
relative to investment in USA necessarily has been matched by a rise in
savings relative to investment in rest of world. The U.S. external
deficit started to widen in the late 90s, as investment in the U.S.
surged and investment in certain Asian economies fell sharply. The U.S.
external deficit, surprisingly, did not fall when U.S. investment fell
sharply in 2001 and 2002, largely because changes in tax policy--along
with an upturn in expenditure growth--turned a small structural fiscal
surplus to a structural fiscal deficit of around 3 percent of GDP.\1\
Since the fiscal deficit peaked as a share of GDP in 2004, the recent
deterioration in the U.S. current account deficit has been driven by a
fall in household savings and a rebound in investment. This reflects a
surge in investment in residential property, and, as Chairman Greenspan
has emphasized, rising house prices also seem to be closely linked to
the fall in U.S. household savings.
---------------------------------------------------------------------------
\1\ IMF, 2005. See Table of 14 of the statistical appendix of the
WEO. William Gale and Peter Orzag have reached a similar conclusion;
see http://www.brookings.edu/views/articles/20050214galeorszag.pdf.
---------------------------------------------------------------------------
Dr. Bernanke has noted that the main counterpart to the recent rise
in the U.S. current account deficit is not found in either Japan or
Europe.\2\ The eurozone's current account surplus fell between 1997 and
2005.\3\ The roughly $60 billion rise in Japan's current account
surplus between 1997 and 2005 is far too small to account for the much
larger rise in the U.S. current account deficit. Rather, rising U.S.
deficits have been matched by rising surpluses in emerging and
developing economies.
---------------------------------------------------------------------------
\2\ Ben Bernanke, ``The Global Savings Glut and the U.S. Current
Account Deficit,'' The Homer Jones Lecture, April 14, 2005. http://
www.federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm.
\3\ The eurozone's surplus fell from $96 billion in 1997 to an
estimated $24 billion in 2005; Japan's surplus rose from $97 billion to
an estimated $153 billion in 2005. The surplus of the Asian NICs rose
from $6 to $80 billion, and a $85 billion deficit in ``other emerging
markets and developing economies'' turned into a $410 billion surplus
in 2005. IMF data and estimates.
---------------------------------------------------------------------------
These surpluses have different causes. Emerging Asia's surplus has
increased since 1997, driven first by the Asian crisis and, more
recently, by the surge in China's current account surplus. Setting
China aside, the savings rates in most Asian emerging economies have
been constant. Their surpluses reflect a fall in investment, which fell
(from quite high levels) during the crisis and have yet to recover.
China is a different story: its national savings rate has soared to
over 50 percent of its GDP, with most of the increase occurring
recently. It is hard to find evidence of a global savings glut, but it
is hard to deny the presence of savings glut in China. Latin America
has shifted from a deficit to a surplus, largely because improvements
in the fiscal position of most Latin governments have pushed national
savings rates up. Finally, rising oil prices have led to higher savings
in the world's oil exporters.
It is important to note that private capital flows have not carried
the savings surplus of emerging economies to the U.S. Rather the large
scale flow of capital from emerging economies to the U.S. is a function
of policy decisions on the part of many emerging economies to resist
pressures for currency appreciation--pressures stemming, in some cases,
from rising current account surpluses and, in other cases, from private
capital flows. In 2004, IMF data shows that private investors put $150
billion more into the emerging world than they took out. Such private
flows potentially could have financed a substantial current account
deficit, or at least allowed emerging economies to reduce their large
current account surpluses. However, in aggregate, these economies
maintained current account surpluses, in some cases, quite large
surpluses even as private flows picked up. Consequently, private flows
to emerging economies generally have financed faster reserve growth,
and thus have been recycled back to the U.S. and Europe.
IMF data indicates that reserve accumulation by emerging economies
has gone from $116 billion in 2001 to $517 billion in 2004.\4\ In 2003
and early 2004, Japan also intervened heavily to prevent the dollar
from depreciating against the yen. According to official U.S. data,
central bank financing of the U.S. rose from $116 billion in 2002 to
$278 billion in 2003 and $395 billion in 2004--and U.S. data almost
certainly understates total dollar reserve growth, and thus foreign
central bank's indirect role in the financing of U.S. deficits.
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\4\ The 2004 increase was inflated by perhaps $60 billion as a
result of the rising dollar value of euro reserves.
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U.S. data shows a substantial reduction of central bank flows so
far in 2005. This data needs to be interpreted with some caution.
Reserve accumulation, once adjustments are made for the falling dollar
value of euro reserves, is still running at a roughly $600 billion
annual pace. Overall, global growth has not fallen, but the composition
of countries adding to their reserves certainly has changed. Japan has
stopped intervening, while reserve growth in both China and the world's
oil exporters has picked. Almost all of Japan's increase in reserves
showed up in the U.S. data. However, recorded Chinese purchases of U.S.
debt in both 2004 and 2005 have equaled only about 40 percent of
China's reserve increase. OPEC and Russia combined to run a current
account surplus of perhaps $200 billion in the first half of 2005,
but--at least according to U.S. data--they only purchased only $5
billion in U.S. long-term debt (and $1.5 billion in U.S. stocks). There
are several ways to reconcile this data: China and the oil exporters
may account for some of the increase in ``onshore'' central bank dollar
deposits in the second quarter; they may have added to their offshore
dollar deposits; they may have purchased U.S. securities via
intermediaries (inflows from the UK have been strong); or they may have
built up their holdings of euros--driving down yields on European bonds
and thus encouraging private capital to flow to the U.S.
Consequently, in my view, rapid reserve growth my emerging
economies continues to be a key reason why the U.S. has been able to
finance its current account deficit without difficulty.
Large trade deficits are not sustainable over time.--The current
U.S. position differs from the U.S. position in the 1980s in two key
ways: The underlying deficit now is substantially larger, and U.S. is
by now a substantial net debtor. The 2005 current account deficit,
combined with the reduced dollar value of American assets in Europe, is
likely to lead the U.S. net external debt\5\ to increase to around 30
percent of U.S. GDP at end of 2005.
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\5\ I am using net external debt as shorthand for the United States
Net International Investment position. The international investment
position includes U.S. equity investment abroad, and foreign equity
investment in the U.S. Since U.S. equity (FDI and portfolio equity)
investment abroad is worth more than foreign equity investment in the
U.S., the negative U.S. Net International Investment position is
entirely the product of a large negative net debt position.
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Basic external debt sustainability analysis implies that sustained
trade deficits of the current level will lead to the United States net
external debt to rise relative to GDP. Sustained trade deficits also
imply a rising current account deficit, as the current account deficit
includes interest payments on external debt. Stabilizing the U.S. net
external debt-to-GDP ratio at between 50-60 percent of U.S. GDP (a
relatively high level) requires the elimination of the trade deficit
over the next 10 years. Even in that scenario, the U.S. current account
deficit is likely to remain close to 3 percent of U.S. GDP. If this
adjustment is delayed, U.S. external debt-to-GDP will stabilize at
higher levels, net interest payments will be higher, and the U.S. could
eventually need to run substantial trade surpluses to avoid ongoing
increases in its external debt-to-GDP ratio.
Relying on foreign savings to finance a substantial share of
investment in the U.S. implies that, over time, more and more of the
income earned on investment in the U.S. will need to be sent abroad.
Here is one way to think about it: A Chinese company believed that the
future income of Unocal, a U.S. oil company, was worth about $20
billion. Financing this year's current account deficit would therefore
require selling off the future income of 40 Unocals. Since next year's
deficit is larger, it would require selling off the future income of
another 50 Unocals. The U.S. has been financing its external deficits
by selling debt not equity, but the basic principle is the same.
International experience also suggests that deficits associated
with fiscal deficits and low levels of national savings are of greater
concern than deficits associated with high levels of investment. The
recent shift in composition of investment toward residential property
is not particularly encouraging either: Housing is not an obvious
source of future export income.
Short-term risks can be reduced with coordinated policy action.--
Even if the trade deficit stabilizes in 2006 and beings to fall in
2007, the U.S. is likely to still need between $900 billion and a
trillion in financing from the rest of the world in each of the next 2
years. In the long-run, failing to make the adjustments needed to raise
national savings and bring the U.S. trade deficit down over time poses
real risks to the U.S. economy. In the short-run, though, the biggest
risk is that market conditions will change suddenly. Should the
market's demand for adjustment would exceed the capacity of the U.S.
economy to adjust smoothly, U.S. growth could slow--perhaps
significantly. The dollar would fall and interest rates would rise, and
the drag on the economy from higher interest rates would exceed the
stimulus to the U.S. export sector from a falling dollar. U.S. trade
and current account deficits have built over time; we do not want to be
forced to get rid of those deficits over night.
The combination of market forces and policy decisions that will
bring about the necessary adjustment in the U.S. trade deficit is
subject to substantial uncertainty. But there is no doubt that the
adjustment, when it comes, will require substantial changes in the
drivers of growth, both in the U.S. and among our trading partners. In
the U.S., consumption must grow more slowly than overall income,
generating an increase in savings. Some sectors of the economy that
currently are doing well may do less well, and resources will likely
shift into the production of tradable goods and services. As former
Treasury Assistant Secretary and long-term Director of the Federal
Reserve's international staff, Edwin Truman has emphasized, overall
U.S. growth could slow even during a relatively orderly adjustment
process. Conversely, countries that until now have relied heavily on
U.S. demand growth to spur their own economies will have to find new
motors to propel their own growth. Just as the composition of growth
must change here in the U.S., so too must it change abroad. After a
period of time when U.S. imports have grown faster than U.S. exports,
the world is likely looking at an extended period when U.S. exports
will grow faster than U.S. imports.
Recent studies by the staff of the Federal Reserve Board offers
hope that the adjustment process will prove to be relatively smooth,
and need not involve either a sharp rise in interest rates or a large
slowdown in growth. However, caution is still in order. The U.S. is in
many ways operating outside realm of historical experience. The U.S.
current account deficit now is far bigger than the deficit of the
1980s. The U.S. trade deficit is exceptionally large relative to the
U.S. export sector. In 2004, the U.S. exported more ``debt'' than
``goods.'' The U.S. is starting the adjustment process with very low
long-term interest rates. The U.S. has significant assets abroad, which
can help ease the adjustment process, but also very large gross
external debts. Any sustained increase in U.S. interest rates could
have a significant impact on the size of U.S. external interest
payments. The adjustment process in the world's largest economy will
have far larger impacts on the rest of the world than past adjustments
in smaller economies.
International experience certainly suggests one clear lesson: As a
country's external debt grows, it becomes more, not less, important to
maintain fiscal policy credibility. Reducing the U.S. fiscal deficits
is the easiest and most certain way to bring about the needed increase
in U.S. national savings; it is likely to prove central to maintaining
the confidence of the United States external creditors during what
could be a long period of adjustment. Work by the IMF and OECD suggest
that a $1 reduction in the fiscal deficit would lead to a 40 to 50 cent
reduction in the U.S. current account deficit.
Just as policy changes here in the U.S. can help to increase U.S.
savings relative to investment, policy changes in the rest of the world
can raise their consumption growth relative to their income growth,
raise their imports relative to their exports and reduce their savings
relative to their investment. China, Malaysia and many oil exporting
countries need to be willing to allow their currencies to appreciate
against the dollar. All these countries are now running large current
account surpluses, and countries with big surpluses cannot peg, or
otherwise tie their currencies tightly to dollar, without impeding
effective adjustment in the global balance of payments. If higher oil
prices are sustained, oil exporters will need to spend more and save
less. The low level of consumption in China relative to Chinese GDP
suggests that there is substantial scope, with appropriate policies,
for strong consumption growth in China to replace strong consumption
growth in the U.S. as the driver of global demand growth. Continental
Europe needs to direct its domestic macroeconomic policies toward
supporting domestic demand during the adjustment process.
The expansion of the U.S. trade deficit reflects mutually
reinforcing policy choices, both here in the U.S. and abroad. The
stabilization and eventual fall of the U.S. deficit will also be far
smoother if this process is supported by appropriate policy changes. No
doubt, market forces will eventually demand adjustment even in the
absence of policy changes. But, as both New York Federal Reserve
President Timothy Geithner and former Treasury Secretary Robert Rubin
have emphasized, without supportive policies, the needed market moves
are bigger and the risks of disruptive market moves are substantially
higher.
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\6\ Includes the increase in central banks ``offshore'' dollar
deposits reported in the international banking system. See Robert
McCauley, ``Distinguishing global dollar reserves from official
holdings in the United States,'' BIS Quarterly Review, September 2005.
For more on different measures of central bank financing of the U.S.,
see Matthew Higgins and Thomas Klitgaard, ``Reserve accumulation:
implications for global capital flows and financial markets,'' Current
Issues in Economics and Finance, Volume 10 No. 10. Federal Reserve Bank
of New York. September-October 2004.
Central bank financing of the U.S. current account deficit
----------------------------------------------------------------------------------------------------------------
2002 2003 2004 2005 (f)
----------------------------------------------------------------------------------------------------------------
U.S. current account deficit...................................... 475 520 668 815
Central bank financing (BEA data)................................. 116 278 395 205
As percent of deficit............................................. 24% 53% 59% 25%
BIS estimate for increase in dollar reserves \6\.................. 187 423 498 ?
As percent of U.S. deficit........................................ 39% 81% 75% ?
Memo: Global reserve increase, all currencies (Setser estimates, 285 510 640 600
based on IMF data with adjustments for valuation changes)........
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Recorded Chinese Purchases of U.S. Assets v. Chinese Reserve Accumulation
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Estimated
change in
Corp. Total in reserves
T-bills Treasuries Agencies Bonds Foreign U.S. (adjusted %
data for
valuation)
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2002............................................................. 0.2 24.1 29.3 6.1 3.5 63.1 74.5 85%
2003............................................................. 0.3 30.1 29.4 4.5 4.0 68.4 157 43%
2004............................................................. 17.3 18.9 16.4 12.1 3.0 67.4 194 34%
Jan-June 2005.................................................... 2.5 17.3 11.3 13.2 14.3 48.7 137 35%
2005 f........................................................... ......... .......... ......... ....... ........ 110 275 40%
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From: Derived from Prasad and Wei (2005), updated to reflect 2005 TIC data. See http://www.hbs.edu/units/bgie/seminarpdfs/Prasad%20IFC%20Supplement.pdf