[Senate Hearing 109-204]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-204

 
        FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2005

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

                                HEARING

                               before the

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

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                                   ON

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

                               __________

                             JULY 21, 2005

                               __________

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


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html


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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

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

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

               Peggy R. Kuhn, Senior Financial Economist

             Martin J. Gruenberg, Democratic Senior Counsel

                  Aaron D. Klein, Democratic Economist

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                        THURSDAY, JULY 21, 2005

                                                                   Page

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

Opening statements, comments, or prepared statements of:
    Senator Schumer..............................................     2
    Senator Allard...............................................     2
    Senator Reed.................................................     3
    Senator Bunning..............................................     3
    Senator Bennett..............................................     5
    Senator Dole.................................................     5
    Senator Crapo................................................     6
    Senator Sarbanes.............................................    15
    Senator Corzine..............................................    25

                                WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal 
  Reserve System, Washington, DC.................................     6
    Prepared statement...........................................    31
    Response to written questions of:
        Senator Reed.............................................    36
        Senator Bennett..........................................    36
        Senator Corzine..........................................    38

              Additional Material Supplied for the Record

Various charts submitted to the Committee........................    40
Letter to Senator Bennett from Alan Greenspan dated September 2, 
  2005...........................................................    53
Monetary Policy Report to the Congress, July 21, 2005............    59

                                 (iii)


                   FEDERAL RESERVE'S SECOND MONETARY
                         POLICY REPORT FOR 2005

                              ----------                              


                        THURSDAY, JULY 21, 2005

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

    The Committee met at 10:07 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    We are very pleased this morning to welcome Chairman 
Greenspan once again before the Committee on Banking, Housing, 
and Urban Affairs to testify on the Federal Reserve's Semi-
Annual Monetary Policy Report to the Congress.
    The June meeting of the Federal Open Market Committee 
marked the 1 year anniversary of incremental increases in the 
Federal funds rate from a low of 1 percent. These measured 
changes appear to have been accommodated pretty well by the 
economy. GDP has sustained a strong rate of growth, increases 
in core inflation have been moderate, and we have seen a 
continued decline in unemployment. The country is also 
fortunate to have enjoyed an unexpected increase in tax 
revenues and subsequent reduction in the Federal deficit for 
this fiscal year. But as your report highlights, Mr. Chairman, 
there are also some cautionary factors that we need to be 
mindful of in the months ahead.
    This morning we will have ample opportunity to discuss in 
greater detail the Federal Reserve's performance in carrying 
out monetary policy and its views on the future direction of 
our Nation's economy. I look forward, as others will, to raise 
a number of issues during our discussion.
    Chairman Greenspan, I am told that today marks the 18th 
anniversary of your first appearance before the Congress for 
the nomination to be Federal Reserve Chairman. Since that time, 
you have made 34 appearances before this Committee to discuss 
monetary policy and conditions alone. While this morning may be 
your last appearance--I hope it will not be, but it could be--
as Federal Reserve Chairman testifying on the Federal Reserve's 
Semi-Annual Monetary Policy Report, the Committee would 
certainly extend a warm welcome to you at any time should we 
end up hosting you again in February of 2006.
    But on behalf of the Committee, I want to thank you for 
your many years of service and your respected counsel. I 
suspect that this Committee may still be interested in hosting 
you as a witness on other topics in the months ahead. Beyond 
your tenure, Mr. Chairman, your voice will undoubtedly continue 
to be valued after your departure from the Fed. We hope you 
will continue to accept our invitation in the years ahead.
    Senator Schumer.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman. I just ask to 
make a brief statement.
    First, I want to join you, Mr. Chairman, in thanking 
Chairman Greenspan for his amazing service to this country and 
his willingness. I only served under two Fed Chairmen, both of 
whom have been very accessible, but your accessibility and 
interest in things that we ask you about is just incredible, 
and we appreciate that. And one of the things that we have 
worked together on, of course, is the Chinese currency, and as 
you know, this morning the Chinese made their first step to 
revalue their currency. So, I just wanted to read a brief 
statement on that.
    And what I believe, Mr. Chairman, is that this is a good 
first step, albeit a baby step. It is smaller than we had 
hoped. But to paraphrase the Chinese philosophers, a trip of a 
thousand miles can well begin with the first baby step.
    The most significant thing about this move is that the 
Chinese, in effect, have conceded that pegging their currency 
is bad for China, for the world economy, and for the United 
States. And we are glad they have come to this understanding. 
If there are not larger steps in the future we will not have 
accomplished very much. But after years of inaction, this step 
is welcome.
    Again, I want to thank Chairman Greenspan. I want to thank 
Senator Graham as well as Senator Bunning and Senator Dole on 
this Committee, and Senator Bayh, Senator Reed, and some others 
who were part of our effort, and we are beginning to bear some 
fruit.
    So, I thank you, Mr. Chairman.
    Chairman Shelby. Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Thank you, Mr. Chairman, for holding this 
hearing, and I would like to join my colleagues in welcoming 
Federal Reserve Board Chairman Greenspan to the Committee today 
to discuss monetary policy and the state of the U.S. economy.
    I also look forward to the opportunity to hear from 
Chairman Greenspan. His expertise and insight is always helpful 
to the Committee.
    Chairman Greenspan, I was pleased to hear in your testimony 
before the House yesterday that the outlook for the U.S. 
economy is positive and one of sustained growth. Under your 
leadership, the Federal Reserve Board has done a good job 
monitoring the U.S. economy and managing monetary policy, as 
appropriate. Since this will be the last time you will be 
delivering the Fed's monetary policy report in your current 
term--and I hope you continue to serve--I want to take this 
opportunity to congratulate you on a job well done. I also want 
to thank you on behalf of the American people for your years of 
public service. We have all been the beneficiaries of your 
careful approach, and your service has set a high standard.
    Thank you for taking the time out of your busy schedule to 
be here, and I look forward to hearing your testimony.
    Chairman Shelby. Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman. And let me 
commend you, Chairman Greenspan, for your extraordinary service 
over 18 years, and I think you will continue to be invited back 
to the Committee for many years to come.
    We have a challenging economy before us. Last June, 
employment added about 146,000 jobs, which might be appropriate 
at the end of an expansion, but we are coming out of a long, 
protracted job slump. And this is far from the numbers we saw 
in the Clinton Administration of 200,000 to 300,000 jobs a 
month. So we have essentially a jobless recovery, and the 
unemployment rate, although it edged down to 5 percent, the 
Boston Fed points out there is still considerable evidence of 
hidden unemployment that does not show up. Labor force 
participation has not rebounded in this recovery. A study finds 
that the labor force shortfall is between 1.6 million and 5.1 
million people. Employers are not hiring as though they believe 
the economy is strong, and potential workers are staying out of 
the labor force.
    We have discussed many times, Mr. Chairman, the fact that 
there are disturbing trends in the distribution of earnings. 
Things seem to be getting worse in this recover, with most of 
the gains from productivity going into profits, not wages, and 
overall real earnings remaining stagnant. And the only group 
that seems to be doing exceptionally well are those at the top 
of the distribution of earnings and wages. People in the middle 
and further down are seeing their purchasing power fall because 
of rising costs of gasoline, food, medical care, housing, 
really eating into their ability to maintain their families.
    And then we have seen some news that the deficit--progress 
has been made, but if you look behind the numbers, it looks 
like a one-time situation where certain tax advantages came to 
pass in this particular period but are not sustainable over a 
longer time. The deficit still is extraordinarily burdensome on 
our economy as we go forward. Low national savings rates and 
the widening trade deficit are problems that we have to deal 
with, an we are not dealing with them effectively and 
permanently.
    I hope at the hearing today, Mr. Chairman, that you will 
touch on these issues, and once again let me commend you for 
your service and judgment in so many different ways. We have 
disagreed, but it has been a productive exchange, and I thank 
you for that.
    Chairman Shelby. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman, particularly for 
holding this meeting today. I would especially like to thank 
Chairman Greenspan for delivering what will probably be your 
last monetary policy report to Congress.
    According to the Congressional Research Service, this is 
the 35th time that you have appeared before a Committee on 
which I sit. I think I am finally starting to understand your 
statements and answers----
    [Laughter.]
    Which probably means it is time for one of us to go.
    [Laughter.]
    Seriously, I will miss our sparring, and I thank you for 
your service. I am sure you would be disappointed if I gave you 
a speech full of flowery tributes, and I would hate for you to 
be disappointed in what could be your last appearance before 
this Committee. So, I will point out my differences with the 
FMOC latest monetary policy decision. As my good friend and 
fellow Hall of Famer Yogi Berra once said, it is deja vu all 
over.
    Once again, I believe the FMOC is taking us down the 
economic path that is fraught with peril by unnecessarily 
raising interest rates. Surveys show that Americans are much 
more worried about filling their gas tanks than they are about 
fitting into their swimsuits this summer, which may be a first. 
But, nonetheless, despite record high energy prices, the FMOC 
continues to raises rates. I believe that you are fighting an 
inflationary bogeyman that does not exist.
    This reminds me of the summer of 2000 when all signs 
pointed toward a recession, but the FMOC refused to cut 
interest rates. When you finally did cut rates on January 3, 
2001, in an emergency meeting after refusing to cut them at the 
FMOC's regular meeting on December 19, 2000, the damage was 
done and the recession then took place. That was greatly 
exacerbated by September 11, and it was already underway before 
that took place.
    I am very concerned with the Federal Reserve's continuing 
raising interest rates. The FMOC, it seems to me, continues to 
fix an economy that just is not broken. It is almost as if the 
Fed is frightened by success. The FMOC is once again throwing a 
wet blanket on the inflationary fire that does not exist.
    As I have said before, I do not believe the Federal Reserve 
economic models are factoring in the impact of new technologies 
on the economy. I also do not believe they take into account 
the psychological effect of higher energy prices and economic 
worries in general. People in my State get nervous about our 
economy's future every time they fill up their gas tank. I also 
know that despite very good economic numbers, many Americans 
are worried about the future. They are worried that if they 
lose their current job, they will be unable to find another. I 
believe we are coming to a critical point in our economy--a 
point where it cannot sustain higher and higher interest rates. 
We almost have an inverted curve, as you know. There are only 
20 basis points between the 5-year note and the 10-year note 
right now.
    As our interest rates rise, our economy will suffer. 
Housing starts will be down, and we will lose the economic 
momentum that we have enjoyed. We just got good news about 
increased tax revenues helping reduce our deficits. I know you 
are a deficit hawk, Mr. Chairman. I hope you will do what you 
can to sustain our growth and help reduce the deficit.
    Once again, thank you, Mr. Chairman, for coming before this 
Committee today and for your long and distinguished service to 
our country.
    Chairman Shelby. Senator Bennett.

             STATEMENT OF SENATOR ROBERT F. BENNETT

    Senator Bennett. Thank you very much, Mr. Chairman.
    Chairman Greenspan, listening to all of the comments about 
your service and your performance here reminds me of the story 
of Henry Kissinger, who was in a group and the person presiding 
over that particular event said, ``We have with us today Henry 
Kissinger, who needs no introduction.'' And Henry Kissinger 
said, ``While it is true that I need no introduction, no one 
enjoys an introduction more than I do.'' And you do not need 
the kind of praise that is being heaped upon you, but I hope 
you enjoy it because it is certainly deserved. And I want to 
join in it.
    We appreciate your testimony here today. I have looked 
through it, and I look forward to asking you some questions 
about it. But I would hope that the tradition that when 
Greenspan speaks the entire country listens will hold true for 
your testimony today, because the recovery that we are in could 
be labeled ``the Rodney Dangerfield recovery'': It don't get no 
respect. And your comments about where we are and how robust 
the recovery is I think should get a lot of respect and a lot 
of currency.
    So, I appreciate your testimony and look forward to having 
the opportunity to question you here today.
    Chairman Shelby. Senator Dole.

              STATEMENT OF SENATOR ELIZABETH DOLE

    Senator Dole. Thank you, Chairman Shelby.
    I want to join with Senator Schumer in recognizing the 
importance of China's removal of their peg of their currency to 
the dollar. This is significant and an important first step 
toward our long-term goal of having the yuan freely float. 
Welcome, Chairman Greenspan, for what appears to be your final 
semi-annual report to the Congress. Your service as Chairman of 
the Federal Reserve has been truly admirable and deeply 
appreciated. While some may worry if the overall economy will 
continue to improve without you in the Chairman's seat, I know 
that your efforts have put us on the track to find long-term 
sustainable growth.
    The times during which you have served, Mr. Chairman, have 
been filled with extraordinary events and personalities. Over 
your 18 years as the Chairman of the Federal Reserve, the 
American people's understanding of the markets has dramatically 
improved, as has our understanding of the role of the Federal 
Reserve Board. I believe the relatively new measured pace that 
the Federal Reserve has adopted in its adjustments to the rates 
is part of this progress, and this predictability has benefited 
our economy.
    Three weeks ago, the Federal Open Market Committee again 
raised its target for the Federal funds rate and the discount 
rate by 25 basis points. This was the ninth straight increase 
in the 
Federal funds rate. The release noted robust underlying growth 
in productivity and a gradually improving labor market. These 
observations appear to indicate a positive track for economic 
expansion in the coming years. While these trends certainly are 
encouraging, I continue to be concerned about the slower pace 
of job creation.
    As you well know, the State of North Carolina continues to 
experience dramatic losses in employment, especially in textile 
and furniture manufacturing. While the national economy may be 
trending positively, we continue to focus special attention on 
those who have lost their jobs as their companies struggled to 
compete with foreign firms that operate with dramatically lower 
cost structures. Congress continues to debate the positives and 
negatives of free trade, and I continue to believe we must work 
on agreements that bring new benefits to American workers and 
consumers while minimizing the negative effects.
    In this changing economic environment, there are fewer and 
fewer opportunities for lower-skilled workers. The opportunity 
gap is widening. We must do everything in our power to make 
sure that these people do not fall through the cracks. We must 
educate our less-skilled workers so they take advantage of new 
jobs created by the expanding economy. To this end, I believe 
we should take steps to improve trade adjustment assistance and 
continue to make the goal of strenghtening our community 
colleges a top priority.
    In addition to the President's $125 million proposal to 
establish a new community college access grant program, which 
is included in this year's Labor-HHS-Education appropriations 
bill, Senator Baucus and I have introduced legislation, S. 
1068, which provides better links between our higher education 
institutions and the business community. This will help prepare 
a new generation of skilled workers so our workforce will 
remain strong and competitive in years to come. The bill is 
currently in the Senate HELP Committee, and I look forward to 
working with Chairman Enzi to see that it becomes law.
    And, of course, I also remain concerned about high energy 
prices, the rise in steel prices, and the growing size of our 
trade deficit. But in spite of these concerns, I am confident 
that through increased trade, hard work, global communications, 
and improved education of our workforce, we will achieve new 
levels of opportunity for the people of North Carolina and for 
all Americans.
    I look forward to hearing from you on these and other 
matters, Chairman Greenspan. Thank you very much for joining us 
today.
    Chairman Shelby. Senator Crapo.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman. I came to 
listen to Chairman Greenspan, so I will save everybody from 
having to listen to my opening statement.
    Chairman Shelby. Thank you.
    Chairman Greenspan, your written statement will be made 
part of the record today. You proceed as you wish. Welcome 
again to the Committee.

             STATEMENT OF ALAN GREENSPAN, CHAIRMAN,

        BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Chairman Greenspan. Thank you, Mr. Chairman. I have 
excerpted only part of that rather extended statement.
    Mr. Chairman and Members of the Committee, I am pleased to 
be here to present the Federal Reserve's Monetary Policy Report 
to the Congress.
    In recent weeks, employment has remained on an upward 
trend, retail spending has posted appreciable gains, inventory 
levels have been modest, and business investment appears to 
have firmed. At the same time, low long-term interest rates 
have continued to provide a lift to housing activity. Although 
both overall and core consumer price inflation have eased of 
late, the prices of oil and natural gas have moved up again on 
balance since May and are likely to place some upward pressure 
on consumer prices, at least over the near term.
    Should the prices of crude oil and natural gas flatten out 
after their recent run-up--the forecast currently embedded in 
futures markets, incidentally--the prospects for aggregate 
demand appear favorable, and upward pressures on inflation 
would be reduced.
    Thus, our baseline outlook for the U.S. economy is one of 
sustained economic growth and contained inflation pressures. In 
our view, realizing this outcome will require the Federal 
Reserve to continue to remove monetary accommodation. This 
generally favorable outlook, however, is attended by some 
significant uncertainties that warrant careful scrutiny.
    With regard to the outlook for inflation, future price 
performance will be influenced importantly by the trend in unit 
labor costs, or its equivalent, the ratio of hourly labor 
compensation to output per hour. Over most of the past several 
years, the behavior of unit labor costs has been quite subdued. 
But those costs have turned up of late, and whether the 
favorable trends of the past few years will be maintained is 
unclear. Hourly labor compensation as measured from the 
national income and product accounts increased sharply near the 
end of 2004. However, that measure appears to have been boosted 
significantly by temporary factors.
    Over the past 2 years, growth in output per hour seems to 
have moved off the peak that it reached in 2003. However, the 
cause, extent, and duration of that slowdown are not yet clear.
    Energy prices represent a second major uncertainty in the 
economic outlook. A further rise could materially cut into 
private spending and thus damp the rate of economic expansion.
    More favorably, the current and prospective expansion of 
U.S. capability to import liquefied natural gas will help ease 
long-term natural gas stringencies and perhaps bring natural 
gas prices in the United States down to world levels.
    The third major uncertainty in the economic outlook relates 
to the behavior of long-term interest rates. The yield on 10-
year Treasury notes, currently near 4\1/4\ percent, is about 50 
basis points below its level of late spring 2004.
    Two distinct but overlapping developments appear to be at 
work: A longer-term trend decline in bond yields and an 
acceleration of that trend of late.
    Some, but not all, of the decade-long trend decline in bond 
yield can be ascribed to expectations of lower inflation, a 
reduced risk premium resulting from less inflation volatility, 
and a smaller real term premium that seems due to a moderation 
of the business cycle over the past few decades.
    In addition to these factors, the trend reduction worldwide 
in long-term rates surely reflects an excess of intended saving 
over intended investment. What is unclear is whether the excess 
is due to a glut of savings or a shortfall of investment. 
Because intended capital investment is to some extent driven by 
forces independent of those governing intended saving, the gap 
between intended saving and investment can be quite wide and 
variable. It is real interest rates that bring actual capital 
investment worldwide and its means of financing, global 
savings, into equality. As best we can judge, both high levels 
of intended saving and low levels of intended investment have 
combined to lower real long-term interest rates over the past 
decade.
    Since the mid-1990's, a significant increase in the share 
of world gross domestic product produced by economies with 
persistently above average saving--predominantly the emerging 
economies of Asia--has put upward pressure on world saving. 
These pressures have been supplemented by shifts in income 
toward the oil-exporting countries, which more recently have 
built surpluses because of steep increases in oil prices.
    Softness in intended investment is also evidence. Although 
corporate capital investment in the major industrial countries 
rose in recent years, it apparently failed to match increases 
in corporate cashflow.
    Whether the excess of global intended saving over intended 
investment has been caused by weak investment or excessive 
saving--that is, weak consumption--or, more likely, a 
combination of both does not much affect the intermediate-term 
outlook for world GDP or, for that matter, U.S. monetary 
policy. What have mattered in recent years are the sign and the 
size of the gap of intentions and the implications for interest 
rates, not whether the gap results from a saving glut or an 
investment shortfall. That said, saving and investment 
propensities do matter over the longer-run. Higher levels of 
investment relative to consumption build up the capital stock 
and thus add to the productive potential of an economy.
    The economic forces driving the global saving-investment 
balance have been unfolding over the course of the past decade, 
so the steepness of the recent decline in long-term dollar 
yields and the associated distant forward rates suggests that 
something more may have been at work over the past year. 
Inflation premiums in forward rates 10 years ahead have 
apparently continued to decline, but real yields have also 
fallen markedly over the past year.
    Risk takers apparently have been encouraged by a perceived 
increase in economic stability to reach out to more distant 
time horizons. These actions have been accompanied by 
significant declines in measures of expected volatility and 
equity in credit markets. History cautions that long periods of 
relative stability often engender unrealistic expectations of 
its permanence and, at times, may lead to financial excess and 
economic stress.
    Such perceptions, many observers believe, are contributing 
to the boom in home prices and creating some associated risks. 
And, certainly, the exceptionally low interest rates on 10-year 
Treasury notes and hence on home mortgages have been a major 
factor in the recent surge of homebuilding, home turnover, and 
particularly in the steep climb in home prices. Whether home 
prices on average for the Nation as a whole are overvalued 
relative to underlying determinants is difficult to ascertain, 
but there do appear to be, at a minimum, signs of froth in some 
local markets where home prices seem to have risen to 
unsustainable levels. Among other indicators, the significant 
rise in purchases of homes for investment since 2001 seems to 
have charged some regional markets with speculative fervor.
    The U.S. economy has weathered such episodes before without 
experiencing significant declines in the national average level 
of home prices. Nevertheless, we certainly cannot rule out 
declines in home prices, especially in some local markets. If 
declines were to occur, they likely would be accompanied by 
some economic stress, though the macroeconomic implications 
need not be substantial.
    Historically, it has been rising real long-term interest 
rates that have restrained the pace of residential building and 
have suppressed existing home sales.
    The trend of mortgage rates, or long-term interest rates 
more generally, is likely to be influenced importantly by the 
worldwide evolution of intended saving and intended investment. 
We are the Federal Reserve will be closely monitoring the path 
of this global development few, if any, have previously 
experienced.
    We collectively confront many risks beyond those I have 
just mentioned. As was tragically evidenced again by the 
bombings in London earlier this month--and, I might add, some 
questions about what is going on in London today--terrorism and 
geopolitical risk have become enduring features of the global 
landscape. Another prominent concern is the growing evidence of 
anti-
globalization sentiment and protectionist initiatives, which, 
if implemented, would significantly threaten the flexibility 
and resilience of many economies. This situation is especially 
troubling for the United States, where openness and flexibility 
have allowed us to absorb a succession of large shocks in 
recent years with only minimal economic disruption. That 
flexibility is, in large measure, a testament to the industry 
and resourcefulness of our workers and businesses. But our 
success in this dimension has also been aided importantly by 
more than two and a half decades of bipartisan effort aimed at 
reducing unnecessary regulation and promoting the openness of 
our market economy. Going forward, policymakers will need to be 
vigilant to preserve this flexibility, which has contributed so 
constructively to our economic performance in recent years.
    In conclusion, Mr. Chairman, despite the challenges I have 
highlighted and the many I have not, the U.S. economy has 
remained on a firm footing, and inflation continues to be well 
contained. Moreover, the prospects are favorable for a 
continuation of those trends. Accordingly, the Federal Open 
Market Committee in its June meeting reaffirmed that it ``. . . 
believes that policy accommodation can be removed at a pace 
that is likely to be measured. Nonetheless, the committee will 
respond to changes in economic prospects as needed to fulfill 
its obligation to maintain price stability.''
    Thank you very much. I look forward to your questions.
    Chairman Shelby. Thank you, Mr. Chairman.
    Mr. Chairman, some Fed watchers speculate that the Federal 
Open Market Committee may halt its incremental increases after 
reaching a Federal funds rate of 4 percent in November, which 
assumes three additional quarter-point increases in upcoming 
FOMC meetings. Mr. Chairman, to what extent does the Federal 
Open Market Committee consider the long-term interest rate in 
pursuing changes to the Federal funds rate? For example, would 
the Federal Open Market Committee continue raising the Federal 
funds rate even if the yield curve, which Senator Bunning 
alluded to, becomes inverted in the months ahead?
    Chairman Greenspan. First of all, I cannot comment for the 
Federal Open Market Committee's actions in the future because 
we have not taken them, and we will obviously engage in ongoing 
deliberations to make judgments at each of our meetings. But I 
think there is a misconception relevant not to what we may do 
but to the importance of an inverted yield curve.
    It is certainly the case that if you go back historically, 
an inverted yield curve has actually been a reasonably good 
measure of potential recession in front of us. The quality of 
that signal has been declining in the last decade, in fact, 
quite measurably, and the reason basically is that it was a 
good measure in the early period when commercial banks were the 
major financial intermediaries, and when you had long-term 
interest rates rise. I should say that when short-term interest 
rates--rise relative to long-term interest rates, it usually 
implied a squeeze on the profitability of commercial banks 
because they tend to hold somewhat longer maturities on the 
asset side of their balance sheet than on the liability side. 
As a consequence, that squeeze was usually associated with an 
economy running into some trouble.
    But extraordinary new avenues of financial intermediation 
have developed over the last decade and a half, and, therefore, 
there are innumerable other ways in which savings can move into 
investment without going through the commercial banks. As a 
result, a straightforward statistical analysis of the efficacy 
of the yield curve inversion as a forecasting tool has 
diminished very dramatically because of economic events.
    So, yes, we do look at the structure of long-term rates and 
the inversion of yields as well as a whole panoply of 
everything else, before we make judgments as to the Federal 
funds rate. Our basic goal, as I have indicated many times 
here, is essentially to create an environment which sustains 
maximum sustainable growth, and we have always argued--because 
the data are so persuasive that inflation stability is a 
necessary condition to achieve that goal. In that context, we 
make our judgments meeting by meeting.
    Chairman Shelby. But is the possibility of an inverted 
yield curve still relevant to your thinking along with other 
factors?
    Chairman Greenspan. Yes, it is, and even though its 
forecasting or anticipatory capability is greatly diminished, 
it is not zero.
    Chairman Shelby. I want to touch on something else that you 
have spoken on many times here, and that is the GSE's. You 
stress the need for any GSE reform, Mr. Chairman, to provide 
clear guidance over the GSE's portfolio. You have also 
indicated that you do not believe that focusing GSE's on their 
core mission and securitization mission would not adversely 
impact liquidity in the mortgage markets.
    As this Committee moves forward hopefully toward a markup 
next week, I would ask you to elaborate again for the record on 
the issue of the GSE's' role of providing liquidity in the 
mortgage markets and how you see the GSE's' securitization and 
portfolio business affecting the GSE's' ability to carry out a 
liquidity role. In other words, how important is the portfolio? 
And I know you have spoken of the risk for the GSE's being in a 
portfolio and so forth.
    Chairman Greenspan. First of all, Mr. Chairman, let me 
stipulate that the secondary mortgage market functions of the 
GSE's are critical to our evolving economy. And indeed, I might 
say that is one of the means of improved intermediation which I 
was referring to previously. So let me just say that the actual 
actions taken by the GSE's to purchase mortgages, securitize 
them, and sell them into the market has been an extraordinarily 
valuable addition to American finance.
    Chairman Shelby. It brought liquidity to the housing 
market.
    Chairman Greenspan. It brought very significant liquidity 
to the housing market and indeed has offered the mortgage 
instrument in a securitized form to a much broader segment of 
American investors, and that has been very helpful to them as 
well.
    That particular function is unaffected, in our judgment, 
whether purchases of mortgages by the GSE's are securitized and 
sold off in the market, held as mortgages on the balance sheet 
of the GSE, or securitized and held on the balance sheet. So, 
in effect, the composition of the secondary market purchases--
which is what their charter is all about--as best we can judge, 
between portfolio accumulation and securitization, has very 
little effect on market liquidity, interest rates, or anything 
else except the profitability of the GSE's.
    It is strikingly obvious to those of us who have looked at 
this in some detail that the motive for accumulating portfolios 
is solely, essentially in all respects, profitmaking.
    Now, I have no objection to that. Indeed, they are 
profitmaking organizations. They are chartered as such. And 
indeed their shareholders could very well presumably sue if 
they did not pursue those goals. But accumulating portfolios is 
not adding liquidity to the housing market, nor in our judgment 
is it assisting the market generally. In addition, because it 
is a highly leveraged operation, and one which requires very 
sophisticated hedging of interest rate risk, it is imparting a 
significant potential systemic risk to the American financial 
system.
    Chairman Shelby. Thank you.
    Senator Sarbanes.
    Senator Sarbanes. Senator Reed.
    Chairman Shelby. You want to defer to him? Go ahead, 
Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman.
    Just to follow up with respect to the GSE's, there are 
several issues here. One is liquidity to the market, which you 
talked about. Another is systemic risk. It strikes me, though, 
that many institutions that you regulate have very large 
portfolios, and they maintain them to increase their profits, 
which is not something bad. Would you urge that we enact 
legislation to set limits on these portfolios?
    Chairman Greenspan. No, we do not, and the major reason is 
that these are not leveraged in anywhere near the extent to 
which the GSE's are.
    A critical aspect here of the problem is the fact that the 
GSE's have relatively small amounts of capital relative to the 
assets they hold. Indeed, they hold 1 to 2 percent of assets. 
The commercial banks, as you know, are several multiples above 
that. And indeed interest rate risk originally was not even 
hedged at all by commercial banks and savings and loans in the 
very early years, largely because their capital was adequate to 
self-insure.
    The GSE's cannot self-insure. Their capital segment in 
their balance sheet is too small. They cannot risk not fully 
hedging their position.
    Senator Reed. You raise, I think, an interesting point 
because the typical way risk is managed in a regulatory process 
is to increase capital rather than to put limits on growth 
portfolios. That is essentially what the Federal Reserve does. 
If you are concerned about the ability to manage risk in an 
institution, your first response, your first authority is to 
increase capital, which to me, frankly, is probably an 
appropriate response to some of the risk that has been 
illustrated in GSE's.
    Let me change the subject slightly, and that is, I presume 
that the current portfolio does not engender great risk since 
many of your institutions hold a great deal of the paper of 
these GSE's. They must find that these investments are prudent.
    Chairman Greenspan. They hold them wholly because there is 
a perception they are guaranteed by the full faith and credit 
of the U.S. Government, despite the fact that the debentures 
which they buy literally say, as required by law, that this 
instrument is not backed by the full faith and credit.
    The problem basically is if you ask anybody on Wall Street, 
they do not care about the status of the GSE's, the financial 
state. It goes up and it goes down. The stock prices of these 
companies move all over the place, but the yield spread against 
U.S. Treasuries locks, and the reason is that they do not 
envisage their holdings of GSE's to have anything to do with 
the GSE's.
    Senator Reed. Are there some investors that buy the debt 
and equity of companies you regulate because they feel that you 
could never let them go out of business, the ``too big to 
fail'' phenomenon?
    Chairman Greenspan. If, in fact, we found that the 
debentures that they issued had very narrow spreads against 
U.S. Treasuries, I would say yes. But they do not. There are 
very substantial spreads. The only way you can tell whether 
they believe it is to watch the spreads. The spreads of 
comparable debentures for large commercial banks or even large 
mortgage holding commercial banks is very substantially higher.
    Senator Reed. Let me change the subject. I mentioned in my 
opening remarks the study by the Boston Federal Reserve with 
respect to labor participation, which suggests there is a 
significant and growing lack of participation in the labor 
force which distorts our ability to see how well we are doing 
with respect to recoveries. In fact, one thing that I found 
interesting was the ratio of employment to population, 62.7 
percent, is below the level at the start of the economic 
recovery in November 2001. And this is the first time the ratio 
has failed to surpass its trial level so far into a recovery.
    The reality is--this is not just statistics--there could be 
millions of people who have been discouraged by the workforce 
not working, and we have to respond to that.
    Can you comment?
    Chairman Greenspan. Yes. We have looked at the Boston 
report, and I must say Board staff does not come up with 
numbers anywhere near what they have. We have, as I think it 
is, less than half a percentage point.
    Senator Reed. Could you share those numbers with us, Mr. 
Chairman?
    Chairman Greenspan. Certainly we can. But let me express to 
you very succinctly why that is the case.
    Labor force participation over the longer-run has been 
driven by two factors here of importance. One is, as you know, 
a very marked increase in the participation of adult women in 
the labor force, which has been going up very dramatically for 
decades; it finally reached a level which is about as high as 
apparently it is going to go, and it has flattened out.
    At the same time, the demographics are moving closer to 
retirement ages where the ordinary early retirement begins to 
occur. So those two structural factors are very dominant forces 
as to why we have not gotten that pickup that you were 
mentioning. And the result is that there is some evidence that 
the participation rate is down partly because of economic 
forces, but our numbers are nowhere near the dimensions that 
the Boston Fed is showing.
    Senator Reed. Just if I may make a final point, if, in 
fact, there is this type of employment slack in the economy, it 
would argue against precipitously increasing the interest rates 
because you still have some capacity, I would suspect.
    Chairman Greenspan. Well, it would certainly be arguing 
against concerns with respect to rising unit labor costs and 
the elements underlying the economic outlook, which we 
obviously appraise, of course.
    Senator Reed. Thank you.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Chairman Greenspan, I have been in some other hearings on 
the Pension Guaranty Corporation, and they face a deficit of 
over $20 billion presently. With a large number of pension 
plans appearing to be teetering, we appear to be facing a very 
serious situation in that Pension Benefit Guaranty Corporation.
    What impact do you think would the dumping of a few more 
large pension plans on the PBGC have on the economy, if any?
    Chairman Greenspan. It is difficult to judge. It has 
similar effects of other types of deficits in the Federal 
system. It clearly is negative, and I think it is a worrisome 
thing for American taxpayers, needless to say. But it is hard 
to see at this stage any spillover effects yet on economic 
forces.
    As large as the numbers are, relative to a $12 trillion 
economy obviously they are not yet critical. My main concern is 
that it ultimately will require U.S. Treasury bonds to fill in 
the gap, which is another way of saying increasing the deficit 
and increasing the Federal debt.
    Senator Bunning. Do you have any comment on this morning's 
report that the Chinese are moving away from the dollar peg 
toward a currency basket?
    Chairman Greenspan. I have not had a chance to look at the 
full detail of what is going on, but I must say I associate 
myself with Senator Schumer. This is certainly a good first 
step. It is the type of step that you would want to take when 
you have a decade-long fixed structure. And so they have been 
cautious, and I think admirably so. But I look at it as the 
first step in a number of further adjustments as they 
invariably increase their participation in the world trading 
markets. And so I believe it is a good start.
    Senator Bunning. Yesterday, in response to a question from 
Congressman Royce of California regarding moving the goalpost 
on this legislation, you claimed that the Federal Reserve had 
no concerns regarding the portfolios of Fannie Mae and Freddie 
Mac until recently. These companies have been around in one 
form or another since 1938.
    How is it that the portfolios of the two largest financial 
services companies in the country, which you claim pose a 
systemic risk to the Nation's financial security, went 
unnoticed until the past year by the Federal Reserve?
    Chairman Greenspan. Well, that is a good question. First of 
all, the portfolios did not exist in any substantial form prior 
to, say, 1990.
    Yesterday, I was asked why I have not previously raised the 
issue. Let me answer this very simply. It has taken me quite a 
good deal of time to disentangle the very complex structure of 
these institutions to really understand how they work, what 
motivates them, and where the sensitive points are.
    When I first looked at this situation, I knew what the 
stock of the debt was and the types of risks that held. But I 
was not aware of how sensitive their profitability was between 
securitizing and selling mortgages that they purchased and the 
amount that they accumulated in their portfolio.
    It is only fairly recently that it finally became clear to 
me that that was basically how the system works, and I must say 
that it was a revelation in certain respects. The more I have 
looked at it since, I am impressed at how quickly, once they 
realized in the early 1990's how important a vehicle this was 
to profitability, how aggressively they pursued it.
    Senator Bunning. Last question. Do you believe energy 
prices have stabilized, or do you believe consumers and 
businesses can expect lower or higher energy prices?
    Chairman Greenspan. Senator, I cannot answer that question, 
and I tried to express some of the reasons in the formal 
remarks which I put in the record. The big problem is that 
demand has picked up and has been going forward now, especially 
because of increased pickup in oil demand in emerging Asia, 
and, incidentally, also in the United States, the consequence 
of which has been, after a very gradual rise over the years, 
the rate of increase has picked up enough that it has eaten 
into the excess capacity of the system.
    As I point out in my prepared remarks, the geographic 
location of proved reserves is relatively concentrated in the 
Middle East, and most of the oil-producing countries who 
perceive they had poor results when private international oil 
companies were extracting their oil have essentially restricted 
the entrance of either the majors who have significant 
financing capabilities. The result of this is that they have 
found, because of their growing population needs, they require 
a goodly chunk of the revenues from oil to finance their 
domestic needs. Therefore, there has been, as best we can 
judge, an inadequate amount of investment to convert the proved 
reserves into actual productive oil capacity, that is, oil 
wells and the infrastructure in which you can actually extract 
it. The markets, as far as long-term futures are concerned, 
have expressed real concern about the balance of supply and 
demand.
    But let me just say this to you: It is a very narrow 
balance, and it can go either way. So we have had a very 
significant run-up, and it is perfectly credible that it could 
go down for a while. But I do think that we are in a position 
where forecasting the direction of oil is a particularly tricky 
issue short term, but longer term, unless we address the issue 
of getting adequate investment to convert the proved reserves 
into productive oil capacity, we are going to have trouble 
meeting long-term demands of the world a decade forward or 
thereabouts.
    Senator Bunning. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman.
    First of all, Mr. Chairman, I am pleased to welcome you 
back before the Committee. I think, if I am correct, this will 
be your last opportunity to come before us to submit a report 
on the conduct of monetary policy by the Fed pursuant to the 
changes that were made to the Federal Reserve Act to require 
the semiannual report to the Congress. I know we worked 
together on bringing about that change. My recollection is you 
were supportive of it at the time.
    Chairman Greenspan. I was.
    Senator Sarbanes. And I hope you feel that it has proven 
out. I think it has been very beneficial to have these two set 
periods for an open report by the Fed with respect to the 
development of monetary policy. And before, we were on a kind 
of ad hoc, hit-or-miss basis. I do not think that was really 
very satisfactory, and my perception is that it has worked very 
well, and I hope you feel the same.
    Chairman Greenspan. I certainly agree with you, Senator.
    Senator Sarbanes. Thank you. Now, first, I have a few 
questions I want to put to you. There is a vote on, so we will 
try to do the best we can within its constraints.
    I want to address minimum capital standards for the banks 
to begin with in the context of the efforts to negotiate the 
Basel Capital Accords. Congress has expressed concern 
repeatedly that the minimal capital requirements on federally 
insured banks should be preserved in hearing after hearing. And 
we have been regularly assured by the bank regulators that that 
would happen.
    Therefore, it was with some concern that we read the 
comments by Federal Reserve Governor Bies back in March when 
she spoke to the Institute of International Bankers Annual 
Washington Conference, and I will just quote the article 
reporting on that speech. ``Ms. Bies made it clear the Fed 
still intends to jettison the straight capital assets leverage 
ratio eventually. It is a position some other regulators, 
particularly Mr. Powell at the FDIC, oppose. Executives at the 
largest banks, however, have argued it makes no sense to 
implement Basel II without also lifting the leverage minimums. 
`The leverage ratio down the road has got to disappear,' Ms. 
Bies said. `I would say to the industry, if you work with us 
and be patient, we understand the concerns about leverage 
ratios, and as we get more confidence in the new risk-based 
approach, it will be easier for us to move away from the 
leverage ratio.' ''
    And at a hearing before this Committee, you were asked 
about the minimum capital issue, and you responded as follows, 
and this was to Senator Bunning: ``I think the issue that is 
raised with respect to the leverage ratio is that it duplicates 
numbers of other types of measures of capital. As you move into 
the Basel II framework, which is a far more sophisticated 
capital ratio, the need to get the old-fashioned leverage 
ratio, which has worked for many generations--we basically 
employed as a sole measure of capital--the need for that is 
significantly diminished.''
    So we had that indication of the attitude at the Fed on 
this issue. Recently, at the end of May, Governor Bies gave 
another speech. She said, ``While the regulatory capital 
requirements ultimately produced by Basel II would be, we 
believe, considerably more risk-sensitive than the current 
capital regime, this is not the only capital regulation under 
which U.S. institutions would operate.''
    More than a decade ago, the Congress, as part of the FDIC 
Improvement Acts, prompt corrective action to find a critically 
undercapitalized insured deposit institution by reference to a 
minimum tangible equity to asset requirement, a leverage ratio. 
The agencies have also used other leverage ratios because 
experience has suggested there is no substitute for an adequate 
equity to asset ratio.
    Federal Deposit Insurance Corporation, which was 
responsible to the Congress for the management of the critical 
deposit insurance portion of the safety net, has underlined the 
importance of that minimum leverage ratio. The Federal Reserve 
concurs with the FDIC's view.
    Just to be clear, what is the Fed's view on the minimum 
capital issue, and does the Fed take the position that the 
leverage ratio down the road has to disappear?
    Chairman Greenspan. The general view that we are 
endeavoring to express is that when you have a Basel type 
capital accord down the road, which is essentially fully 
sensitive to the various different capital needs of an 
institution, that there is no further need for other measures 
because, by definition, the system is fully controlled.
    We are not yet there with respect to Basel II. As I have 
often said, there will be a Basel III and there will be a Basel 
IV because the technologies are changing, commercial banking is 
evolving, and supervision and regulation should not be fixed, 
it should actually endeavor to adjust to the changing structure 
of a financial or commercial banking system.
    So when we get to the point--and I do not think we are 
there yet--that the various structures defining what capital 
should be address everybody's concerns about supervision and 
control, then there is no longer a need for a minimum capital 
requirement. It would be merely duplicative, and indeed, if the 
system is working well, it is actually inoperative. We are not 
there yet, and I think what Governor Bies is trying to say is 
that we recognize that that not yet being there, there is still 
a role for minimum capital and a leverage ratio.
    But that does not change the fact that when we get a 
sufficiently sophisticated structure of capital supervision, 
that issue will become moot. So it is really a question of, as 
you quoted earlier, the word is ``eventually,'' and where that 
is, I do not yet know. But I do know, as indicated by both 
Governor Bies and Chairman Powell, that we are not there yet.
    Senator Sarbanes. One quick question and then I will----
    Chairman Shelby. Proceed.
    Senator Sarbanes. Every statistical study shows a marked 
growing inequality in the distribution of income and wealth in 
the country. The disparities are actually the largest of any of 
the advanced industrial countries, and they also loom out at 
you when you look at the United States in historical terms 
unless you go way back into----
    Chairman Greenspan. The ``Gilded Age'' as they like to say.
    Senator Sarbanes. --the Roaring 1920's or the Roaring 
1890's or something. What is your view of that development?
    Chairman Greenspan. I think it is a very disturbing trend, 
Senator, and the reason I say that is twofold. One, it is a 
reflection, as best I can judge, of a faulty educational system 
in the United States. As you know, we receive relatively poor 
marks internationally, especially as our students move from the 
4th grade to the 12th grade. That, as I think I have testified 
here before, creates a inadequate movement of students through 
high school, into college, and into skilled jobs, so that the 
total supply of skilled workers is sufficiently large relative 
to the increasing demand for skills because of technology to 
keep the skilled wage level down.
    We have been unable to do that, and indeed, we end up with 
too many people who are lesser skilled, vying for jobs which 
are declining in number, so that the wage rates there are 
constricted, and it is causing this rather major dispersion.
    A free market democratic society is ill-served by an 
economy in which the rewards of that economy distributed in a 
way which too many of our population do not feel is 
appropriate. More importantly, they do not feel the advantages 
and benefits coming from the system that a smaller but still 
significant group have experienced. So, I am concerned about 
this. I think it is a major issue in this country.
    Senator Sarbanes. Thank you very much.
    Thank you, Mr. Chairman.
    Senator Allard. [Presiding.] Thank you, Senator Sarbanes. 
The Chairman has stepped out. My turn is next, so I will go 
ahead and resume questioning.
    As Chairman of the Housing Subcommittee, I would like to 
discuss a number of issues related to housing. Your testimony 
mentioned exotic loan products, and that caught my attention 
because I believe that Colorado is probably one of the higher 
States as far as foreclosures are concerned. Many in Congress I 
think have shared your concerns about those certain loan 
products such as interest-only loans, and also what we call 
negative advertising loans.
    My question is, do these loan products create new 
sustainable homeownership? In other words, these new products, 
are they replacing the conventional loan, and are there some 
negative results as a result of that?
    Chairman Greenspan. Well, Senator, actually all of these 
loans, properly used, are not bad instruments. In other words, 
they give the consumers, the mortgagors, indeed the mortgagees 
as well, a broader set of instruments which can be employed, so 
there is greater consumer choice.
    Our concern is that a number of these instruments are being 
used to enable people to purchase homes who would otherwise not 
have been able to do so. In other words, they are stretching to 
make the payments, and that is not good lending practice for 
banks or other purveyors of mortgages, and certainly it is not 
good practice on the part of pending homeowners.
    It is a concern to us. Fortunately, it is not a large 
enough part of the market to create serious systemic problems, 
but it is an issue, and we at the Federal Reserve and other 
banking supervisors are looking at that. We are examining these 
issues, and we are making decisions as to what, if any, 
guidance to the banking system we would endeavor to convey.
    Senator Allard. So just to follow up on that, you do not 
see any need for any kind of legislative remedy or anything at 
this point in time?
    Chairman Greenspan. We do not need any legislative remedy. 
It is wholly under the regulatory authorities of the banking 
agencies.
    Senator Allard. Do you think the banks are utilizing proper 
underwriting standards for these type of products, and are we 
having more of a problem in certain States than in other 
States?
    Chairman Greenspan. I do not know that. That is factually 
capable of being ascertained, and I assume some of my 
colleagues do know the answer to that question. It is not, in 
my judgment, at least what I have heard, an issue that is 
critical or something that requires immediate response. But it 
is enough of an issue that I think we have to look at it, and 
that is what we are doing, we are looking very closely.
    Senator Allard. I appreciate your response on that.
    Now, on various occasions you have downplayed the idea of a 
national housing bubble, and have instead pointed to a 
situation which some regions of the country are exhibiting 
signs of, I quote, ``froth'' I guess. And I am pleased to hear 
comments that while housing prices may well decline, such a 
decline would not necessarily derail the economy. Would you not 
agree though that while this may be true for the Nation as a 
whole, a correction could have a significant impact within a 
specific community or region? Could you please elaborate what 
the future could hold for such a city or region, and what can 
or should be done to mitigate the damage such a correction 
could cause?
    Chairman Greenspan. We have had such experiences in the 
past, and quite correctly, there have been regional problems 
associated with unwinding of frothy local housing markets.
    One thing that obviously is an issue with respect to the 
overall economy of these metropolitan areas, is that unlike 
earlier history, we have developed a mortgage instrument to a 
point, and the ability to extract equity from homes to such an 
extent, that now a surprisingly large proportion of consumer 
expenditures and home modernization outlays are financed by 
home equity extraction. That is clearly a consequence of one, 
house turnover, largely because, of course, the seller of the 
home extinguishes a mortgage which is less than the mortgage of 
the buyer of the home, which is essentially a reduction or 
extraction of equity from that home of that exact difference. 
Then of course there are cash-outs, which have increased over 
the years, associated with refinancing, and then finally, a 
significant amount of extraction of unrealized capital gains 
essentially from home equity loans.
    These are large enough to be an issue in the overall 
consumption expenditures of a local community, and in the event 
that you begin to get a retrenchment in house turnover, which 
would presumably be associated with unwinding of a frothy 
market, you would probably also have impacts on consumer 
expenditures in that particular area.
    There are obviously national implications of this as well. 
We would expect as the housing boom eventually simmers down, as 
we have long expected it would but find no evidence that it is 
about to, that it would begin to have some impact on 
consumption expenditures, and if not for the fact that we 
perceive capital investment picking up the slack, it would give 
us some pause as to 
economic consequences of the adjustment process.
    Senator Allard. Mr. Chairman, you kind of moved into my 
second question where people were extracting this equity out of 
their home. If the value of these homes should begin drop or 
something, that could create some problems for our national 
economy, or would it not?
    Chairman Greenspan. Well, the run up in prices has been so 
significant, and the accumulated equity has been so large, 
indeed, it has been larger than the debt increase. So that the 
ratio of equity in homes to debt has been rising in the most 
recent period. So there is a fairly significant buffer. But 
there is no question that, if you confronted a situation of 
declining house turnover and even declining house prices, home 
equity extraction would be expected to decrease.
    Senator Allard. Mr. Chairman, I have a few questions, if I 
may proceed.
    Chairman Shelby. [Presiding.] You go ahead, you take your 
time.
    Senator Allard. This has to do with the terrorist attacks 
and the security in our financial industry. Do you believe that 
the financial services industry is prepared to protect people, 
processes, and infrastructure against potential disruptions 
from a terrorist attack, and do you see any further steps that 
need to be taken if not?
    Chairman Greenspan. This is obviously under significant 
discussion now with the question of the expiration of TRIA. It 
gets to the base of a very difficult question: How does a 
civilized society with an economy based on the rule of law deal 
with the losses from violence?
    What we have done over the years is very successfully 
construct an insurance system which basically has picked up a 
lot of different losses from disruption from violence, from 
everything else, and it is a very sophisticated system which 
has evolved over the years and is still evolving.
    We are now confronted with something different, and it is 
different because of the technological changes and the ways in 
which things can be destroyed. There is a potential very large 
scope of damage that can occur, which the existing insurance 
system would have difficulty figuring out how to insure and 
basically cope with the problem.
    This is why I have argued that there should be a fall-back 
position for very large terrorist attacks, where as the 
Government socializes a good deal of potential violence--and 
that is what our military budgets are, that is what our police 
forces are--there is a role if this terrorism level continues 
to pose the potential for very large disasters.
    So, I would perceive that until and unless we get this 
issue of terrorism to a dimension where the private sector can 
fully handle it, there is a role here for Government.
    Senator Allard. So you think that at this particular point, 
it might be appropriate for the Congress to provide some 
subsidy to the terrorist insurance, on the umbrella coverage?
    Chairman Greenspan. Yes. But I think the Administration's 
proposals of delimiting some of it and having very large 
copayments are very sensible. The reason is that to the extent 
you socialize risks, you cause the misallocation of capital in 
a market economy and this reduce the standards of living, and 
so you have a tradeoff here. The more socialization of risk 
that you create, which is what we are talking about, the more 
potential distortion in the private sector's capital account 
allocation. So we have to be very careful about what types of 
things we are trying to insure against, and it should be very 
succinctly limited to very large events. Part of the reason is 
that the technology has never been there for a small number of 
people to create as much damage as they apparently can with 
essentially various different forms of terrorism, which we have 
not really experienced in this country, and hopefully will 
never.
    If we, however, can find ways of diminishing the risk, at 
some point it is conceivable the private sector could handle 
the whole thing.
    Senator Allard. Thank you, Mr. Chairman. You have been very 
tolerant.
    And thank you, Chairman Greenspan.
    Chairman Shelby. Senator Bennett.
    Senator Bennett. Thank you very much.
    Several items, Chairman Greenspan. In your prepared 
testimony, in that portion which you read to us, you made 
reference to--let me read it because I was struck by it as 
important to note--``A prominent concern is the growing 
evidence of antiglobalization sentiment and protectionist 
initiatives, which if implemented, would significantly threaten 
the flexibility and resilience of many economies. The situation 
is especially troubling for the United States, where openness 
and flexibility have allowed us to absorb a succession of large 
shocks in recent years with only minimal economic disruption.''
    I am fishing here for a comment on the importance of CAFTA. 
I think economically CAFTA is a relatively small deal because 
the economies of Central America are not that vital to our $12 
trillion economy, but symbolically I think CAFTA is a very big 
deal, and I get the sense from your testimony that you would 
agree. But I want to give you the opportunity to comment rather 
than just put words in your mouth.
    Chairman Greenspan. I do, Senator, and the reason is it is 
part of the very critical issue of globalization. We in this 
country have embraced globalization over the decades, very much 
to our benefit. The world trading system has expanded 
dramatically. World standards of living have expanded 
dramatically, and it is we in the United States who have 
benefited the most.
    We recognize, however, that the very nature of 
globalization, which creates ever higher standards of living, 
also is a process which we call ``creative destruction,'' which 
essentially means that the depreciation reserves of obsolescent 
capital get employed to finance cutting edge capital, and the 
differential productivity between the obsolescent capital and 
the newer capital creates the 
increase in standards of living. That is the actual thing which 
engenders the result.
    The problem with creative destruction is that it is 
destruction, and there is a very considerable amount of turmoil 
that goes on in the process. As I have mentioned here many 
times, we hire and essentially let go a million workers a week 
in this country. It is a huge churning turnover. What we must 
focus on is that as we gain the benefits of globalization, it 
is important that the problems of those who are on the 
destruction side of the globalization problem be addressed 
appropriately.
    As Senator Dole said earlier today, we have to get focused 
on training, on the issue of various different means to retrain 
workforces which are being altered, or doing what is required 
to recognize the nature of the problems of those people who are 
associated--it is a minority of the people, but it is a large 
enough minority that we have to address the fact that they are 
in serious trouble on occasion.
    Senator Bennett. When you are a member of the minority, it 
is not a small problem.
    Chairman Greenspan. It is 100 percent of the problem.
    Senator Bennett. Let me turn again to the GSE's and the 
issue. One of the facts of life that I have learned here is 
that you can tell how a piece of legislation is going to affect 
the marketplace by seeing who is lined up on which side of the 
issue. And as people have come to see me, pleading that heavy 
restrictions be put on the portfolio size of the GSE's, and 
then others have come to see me pleading that nothing be done 
with respect to the portfolios of the GSE's, aside from the 
GSE's themselves--you know, you kind of set aside their 
statements because their position is fairly clear. A pattern 
has seemed to emerge. The small banks, the mortgage brokers, 
the homebuilders, realtors, are all saying do not mess with the 
portfolios of the GSE's. The big banks, Citibank, Wells Fargo, 
saying yeah, absolutely do this to the GSE's.
    This may be an oversimplification, but as I sort through 
the advocates on either side of this fight, I find it is kind 
of rural on one side and big city on another. It is kind of 
small bank brokerage operations that deal with small 
institutions on one side, big banks on the other. The 
implication being that the independent banks, the community 
banks are benefitted by the present situation and the big banks 
are competing with the present situation; therefore, the one 
would like to see it stay and the other would like to see it 
change.
    Fannie Mae and Freddie Mac do not require anybody to sell 
them a mortgage. The market works. People bring it to them. And 
the only reason that somebody would bring a mortgage to Fannie 
Mae would be if the price were better or if the service were 
better. And as I have talked to people on the anti side, if you 
will, they have indicated that they believe if Fannie Mae and 
Freddie Mac are constrained in their portfolios, that the price 
will go up and they will be forced to deal with other 
institutions where they think the service--if the price goes 
up, they still would rather deal with Fannie Mae because they 
think it is more convenient, they move more rapidly, they are 
much more flexible.
    What would you say to these groups, legitimate groups, who 
are not shareholders of Fannie Mae or Freddie Mac? How would 
you reassure them that if we did what you wanted to do, they 
were going to be just fine?
    Chairman Greenspan. It is a question of fact. See, here is 
what the problem is, to directly relate to your issue. I am a 
community bank and I have been very appreciative of the 
secondary mortgage market to take the mortgages I have and sell 
to them. They are confronted with an issue of uncertainty as to 
what would happen in the event if the portfolio of the GSE's 
went down. The GSE's and a lot of other people say it is going 
to cause interest rates to go up. Nobody says, including the 
Federal Reserve, that will cause interest rates to go down.
    So, they are confronted with an uncertainty of the fact 
that they seem to be better off with the status quo. The truth 
of the matter is they are not. That is, there is no evidence 
that the amount of purchases made by Fannie, Freddie, and 
indeed a very large and increasing private sector, would be 
bidding significantly different prices for their home 
mortgages. And the decision whether those accumulated mortgages 
by, say, Fannie and Freddie, end up in their portfolio or end 
up securitized and sold into the marketplace is essentially 
made after they are purchased from, let us say, a community 
bank.
    So there is an understandable concern if you are not fully 
familiar with how the markets work and there is no potential on 
the other side. In other words, if I am confronted with very 
little knowledge but I know the chances are only that a certain 
thing can go in the wrong direction for me, I will argue for 
the status quo. Now, that is a perfectly understandable and 
reasonable case, and that is true, incidentally, I think, of 
the homebuilders as well. I think they are mistaken. Indeed, I 
know they are mistaken. But I fully understand where they are 
coming from.
    So the concern that I have is that over the longer-run they 
are actually at risk here, as we will all be at risk if indeed 
there is a systemic problem. Then there will be very serious 
problems for the housing market and they will find that they 
are at significant risk. They do not perceive that now because 
they do not perceive what could conceivably be occurring in the 
future, which is what is motivating Federal Reserve. So it is a 
difficult issue of who knows what about what is going on. I do 
not find any difficulty in understanding where these various 
positions are coming from. And I would make the same argument, 
incidentally, in reverse, for the big banks.
    Senator Bennett. If I may, Mr. Chairman, go forward with 
that.
    Chairman Shelby. Go ahead.
    Senator Bennett. You would make the same argument in 
reverse?
    Chairman Greenspan. Yes, in other words----
    Senator Bennett. The big banks presumably will increase 
their market share----
    Chairman Greenspan. Yes, what I am basically saying is I 
think that the amount of market share that they think that will 
occur as a consequence of this is not obvious to me in any 
particular way.
    Senator Bennett. Okay, so you are saying that the big banks 
who are beating on me, you have to do this, this is a terrible 
competitive they are going to be disappointed.
    Chairman Greenspan. Well, unless they are using the 
arguments that I am using. We have to distinguish between the 
mortgage market and the securitized market. In the securitized 
market, yes, the commercial banks will probably pick up some 
advantages because indeed that will be one of the purposes of 
changing the system. I think, however, that the nature of the 
argument misses the really fundamental point, which is that we 
are creating a potential very serious systemic risk. And to 
have arguments that are going on about whose market share or 
whose potential profits will change in somewhat different ways, 
I think, is missing the much larger point.
    Let me respond in writing to you about how I think the 
specific changes might occur in these markets. There are 
changes. I do not want to deny that there will be changes. But 
I think people extraordinarily exaggerate what the implications 
are. And for the self-interest of all parties, in my judgment, 
making certain that we do not have a systemic problem occurring 
because there is a very large accumulation created by 
incentives to hold ever-increasing portfolios to get ever-
increasing incomes, in the long-run will redound to nobody's 
benefit, because we will all lose.
    Chairman Shelby. Mr. Chairman, I would also request a copy 
of that letter, if you would, please.
    Senator Bennett. Yes, that would be very helpful. And my 
time is gone, but I look forward to having additional 
conversations with you about this.
    Thank you very much.
    Chairman Shelby. Chairman Greenspan, since we are talking 
about GSE's, how many companies with $12 billion accounting 
errors--which would be representing a significant portion of 
the capital of that company--see no increase in debt cost in 
the market after that? I am referring to Fannie Mae.
    Chairman Greenspan. It is very simple. Because it has 
nothing to----
    Chairman Shelby. Oh, it is the implicit guaranty.
    Chairman Greenspan. Yes. It has nothing to do with the 
status of Fannie Mae or Freddie Mac.
    Chairman Shelby. Thank you.
    This Committee has previously raised questions with you, 
Mr. Chairman, and Treasury Secretary Snow regarding the large 
Chinese and Japanese official holdings of U.S. Treasuries. Your 
report today indicates that data from Treasury indicates that 
demand for these securities from foreign official investors has 
ebbed during the first 5 months of this year. Obviously, the 
Chinese Government announcement to switch to a currency basket 
in setting its peg could also affect that demand.
    Mr. Chairman, do you anticipate that long-term rates may be 
affected by the changes in foreign official demand, or do you 
expect such changes to unfold slowly over time and thus be 
absorbed into the market?
    Chairman Greenspan. Well, two things happened. We have 
estimated, I think I have testified before, that the 
accumulation on foreign account has probably subtracted 
something under 50 basis from long-term interest rates in the 
United States. Should that unwind, that is about the order of 
magnitude we are talking about. But markets anticipate what is 
likely to occur. As a consequence of that, you could very well 
get changes that are up front in anticipation of things that 
will go on longer term.
    Chairman Shelby. Factored it in, in a sense?
    Chairman Greenspan. Yes. In other words, the markets do not 
wait--they anticipate. So we could get some impact sooner 
rather than later.
    Chairman Shelby. Mr. Chairman, the Chinese Government 
today, as we have been talking about, announced a 2 percent 
reevaluation of its currency and the move to a currency peg 
linked to a basket of currencies rather than just linked to the 
U.S. dollar. Other Asian countries, like Japan and Korea, who 
have extensive trade relationships with China, have grown 
accustomed to China's fixed exchange rate policies. How will 
China's other Asian trading partners manage this transition by 
the Chinese, and won't these countries have to allow more 
flexibility in their currencies in order to see a more level 
playing field for the United States?
    Chairman Greenspan. I think we are already seeing that. I 
mean, Malaysia this morning also moved, as I recall.
    Chairman Shelby. So the market again anticipated this move 
and has reacted to it?
    Chairman Greenspan. Yes. If you look, for example, the 
dollar weakened significantly against the yen this morning, as 
a consequence of this move.
    Chairman Shelby. Mr. Chairman, your testimony also 
discussed at length what others have referred to as the savings 
glut. One factor you note is corporate behavior and the 
softness in capital investment. This is particularly puzzling 
in light of strong profits in the corporate sector and lower 
interest rates. Could you touch further on the potential causes 
of this behavior and whether our Nation's economy has ever 
experienced similar circumstances? Should the situation 
persist, how would this affect the Federal Reserve's growth 
projections?
    Chairman Greenspan. Well, as I indicated in my prepared 
remarks, capital investment in the United States is expanding, 
and indeed we are expecting it to expand a good deal further.
    Chairman Shelby. Do you think it is adequate?
    Chairman Greenspan. It is less than one would have 
expected, given the levels of cashflow and, indeed, other 
measures that usually were associated with capital investment. 
I attribute this in my remarks to the aftermath of the stock 
market liquidation and the corporate scandals, which had a 
fairly profound effect on corporate governance and on the risk 
aversion of corporate managers. I think we are still seeing the 
aftermath of that, although there is some evidence that it is 
beginning to dissipate, and that is one of the reasons we 
perceive that the outlook for capital investment in the United 
States is quite favorable.
    Chairman Shelby. Thank you.
    Oh, excuse me, Senator Corzine. My eyes aren't as good as 
yours.
    Senator Corzine.

              STATEMENT OF SENATOR JON S. CORZINE

    Senator Corzine. Your eyes are pretty good, particularly 
when we are looking at legislation, Mr. Chairman.
    I appreciate the Chairman being here. Let me ask, have you 
commented today, with respect to the House bill, with regard to 
GSE's?
    Chairman Greenspan. I have not, Senator.
    Senator Corzine. Do you have views with regard to the House 
bill?
    Chairman Greenspan. You are talking about what the House 
Financial Services Committee voted on?
    Senator Corzine. Yes.
    Chairman Greenspan. That question was asked me yesterday at 
that Committee, and I said it did not address the problems that 
I thought were extant with respect to the GSE's, and indeed, 
went further and said that we would probably be better off with 
no bill than a bill of that nature.
    Senator Corzine. And your major problems?
    Chairman Greenspan. Largely the issue of portfolio to what 
we have been discussing with----
    Senator Corzine. And I know you have spoken often about 
this, but have you narrowed or become more precise on how you 
believe those portfolios restrictions should----
    Chairman Greenspan. I thought that the particular 
formulation by the Secretary of the Treasury with respect to 
what he thought would be an appropriate bill struck us as 
pretty much where we thought it should be. That is essentially, 
as you may recall, stipulating that the level of portfolio 
should reflect, aside from obvious liquidity needs and the 
turnover of very vast amounts of mortgages, the charter 
requirements of the GSE's, but that strictly for the purpose of 
creating increased earnings would not be a justification for 
building up portfolios.
    Senator Corzine. But are you suggesting, and is the 
Treasury Secretary suggesting, in your view, that would be 
based on risk-based modeling with respect to what was an 
appropriate----
    Chairman Greenspan. You mean for the GSE's?
    Senator Corzine. Yes.
    Chairman Greenspan. No. We are not raising the question 
with respect to the portfolios as a risk to the GSE's; on the 
contrary. It is expanding their profitability and everything 
else that goes with it. Our concern is the systemic risk, not 
safety and soundness risk. The House bill specifically puts the 
capability of a regulator to adjust portfolios on the basis of 
safety and soundness, which I read refers to the safety and 
soundness of the GSE's, not the systemic questions that we 
raise.
    Senator Corzine. Is that consistent with bank regulation?
    Chairman Greenspan. No, it is a different standard.
    Senator Corzine. It is a different standard for GSE's?
    Chairman Greenspan. Yes, indeed. At least in my judgment.
    Senator Corzine. And could you explain to me why that 
systemic risk is so much different in an institution of a 
trillion dollars in one format versus a trillion dollars in 
another format?
    Chairman Greenspan. Let me be very explicit. It has to do 
with the extent of leverage. In commercial banks, for example, 
I should say capital is several multiples, many multiples 
higher than what the GSE's are holding. As a consequence, banks 
do not, in our judgment, raise the level of systemic risk that 
the GSE's raise. It is a different order of magnitude largely 
because of, one, the size of the leverage and two, the extent 
to which the financial markets grant the GSE's effective U.S. 
Treasury status with respect to their bond issuance, when they 
do not do for commercial banks.
    Senator Corzine. Okay, so if it were capital, then risk 
capital associated with the underlying assets should put them 
on an equal playing field, I would think. If their regulator 
chose risk capital measures----
    Chairman Greenspan. There would be two issues here. 
Unquestionably, if their risk-based capital were raised to the 
level of where the commercial banks are, that would assuage a 
good deal of the problem. It would still leave the issue, 
however, of the ability of the part of these institutions to 
raise any amount of capital at very low interest rates, 
irrespective of the status of the institution. Indeed as the 
Chairman pointed out, how is it possible I do not know whether 
that was just before you came in or not----
    Senator Corzine. I apologize. I had other things----
    Chairman Greenspan. --how is it possible to have these huge 
accounting losses and serious questions about what the earnings 
of these institutions are and have virtually no effect on the 
rates at which they can sell debentures. The reason, 
essentially, is that the financial state of Fannie and Freddie 
has almost nothing to do with what the interest rate is on 
their debentures or their ability to actually sell them.
    Senator Corzine. Supply and demand, at some point, has 
impact on rates.
    Chairman Greenspan. It does, and it will eventually occur 
with U.S. Treasury issues, and I presume at that time it will 
affect the GSE's.
    Senator Corzine. May I ask one other question?
    Chairman Shelby. Go ahead.
    Senator Corzine. Have you been asked about TRIA?
    Chairman Greenspan. Yes, I have.
    Senator Corzine. I will check the record, then, unless you 
want to repeat.
    Chairman Greenspan. I will be glad to respond in writing to 
you if there are other things that you would like.
    Senator Corzine. Please. Thank you.
    Chairman Shelby. I will get Senator Bennett first. I think 
he has a question.
    Senator Bennett. Yes, one quick additional issue that I 
would like to raise with you again just to get this on the 
record.
    As we grapple with the Social Security problem, and I am 
trying to craft a solution that deals with the solvency 
challenge, I think the political situation says that the 
personal accounts will be a fight we will have at some future 
point. I think there are good enough idea that they will stay 
around and I think eventually the Congress will adopt them. But 
in this Congress, there does not seem to be an appetite to do 
that and the solvency issue is still very much with us. So, I 
have tried to craft a bill to deal with that, as my colleagues 
know.
    But in this process, I come back to an issue that you have 
commented on in the past and I would like to get a fresh 
response from you so that I am not guilty of using outdated 
information. This has to do with the professional consensus 
among economists which says that the CPI overstates changes in 
the cost of living, and the Bureau of Labor Statistics in 2002, 
perhaps in response to that consensus, began publishing a new 
index called the Chain CPI. I had a little trouble 
understanding what that meant. But it takes into account the 
fact that consumers will make substitutions in their purchases. 
If the price of X goes so high, they will switch to Y, and so 
their standard of living presumably has not changed that much, 
but the cost of living is better measured by the chain CPI.
    My staff on the Joint Economic Committee has come up with 
information that the implications of using the chain CPI as 
opposed to the CPI are huge. Over 10 years, the Boskin 
Commission says, quoting CBO, that if CPI overstated the cost 
of living by 1.1 percent per year, the standard programs that 
we have in place would increase the national debt by a trillion 
dollars over a 10-year period. And Congress may want, as a 
matter of policy, to say let's increase the national debt by a 
trillion dollars in order to increase these programs by more 
than the cost of living, but at least the stated position of 
Congress in the current law is that we simply want to have the 
actual cost of living taken care of.
    Another side of it is that CPI is tied to the taxation 
bracket, which means that people get a massive tax cut over 
time with respect to the issue of bracket creep. Bracket creep 
is dampened by using the CPI. So you get less revenues and more 
expenditures by doing this, which means that the trillion-
dollar number may be exacerbated by the impact on the tax side. 
I do not think they took the tax side into consideration when 
they looked at the expenditure side.
    Could you comment on all of this and where you think we as 
policymakers should go on this issue?
    Chairman Greenspan. We at the Federal Reserve Board have 
been looking at this for a number of years. I think our most 
recent estimate is that the Consumer Price Index itself is 
biased upward by a little under 1 percent at this stage.
    Senator Bennett. That is a little less than the Boskin 
thing, so it would not be quite a trillion dollars.
    Chairman Greenspan. Yes. The reason for that is, remember 
that the Bureau of Labor Statistics has made a number of 
changes addressing the problems of the Boskin Commission, which 
in retrospect probably underestimated the extent of what the 
issue of the bias was. Because if you take our current 
evaluation and add back the BLS adjustments, I think we go 
higher than the Boskin Commission data would suggest.
    What we also find is that the CPI chain index takes off 
roughly half of that bias. It does not take the whole bias out, 
and indeed, if the Congress literally wanted to have an index 
which was the optimum estimate of what the cost-of-living 
change really was, you would need to find a mechanism that 
actually made the adjustment for the full bias. And that, you 
know, is close to the 1.1 percent number to which you were 
referring.
    I think that is very difficult to do unless you get, as I 
suggested many years ago, a commission which would sit there 
each year, reevaluate what the nature of the bias was, and set 
what the adjustment for all Federal programs would be. Short of 
that, switching to the chain index, which is just a reweighting 
in a fully mechanical, understandable way by the BLS, would 
give us a far superior, less biased measure of what the cost of 
living is. It will not go all the way, but it will take a good 
deal out of both, obviously, the tax side and the spending 
side.
    Senator Bennett. Thank you very much.
    Chairman Shelby. Mr. Chairman, just for the record again, I 
would like to know what size portfolio, in your judgment, 
roughly, should the GSE's maintain?
    Chairman Greenspan. I do not have a specific number. It is 
significantly below where it is now. They still have very 
significant needs for liquidity, but incidentally, that 
liquidity should be in Treasury bills. But they do not want to 
hold Treasury bills, because to sell debentures and invest in 
Treasury bills does not make any money; in fact, you would 
probably lose something. It is the selling of debentures to 
invest in mortgage-backed securities which gives you a nice big 
fat yield.
    So the presumption that is often stated--that they need 
this whole stock of mortgage-backed securities for liquidity 
purposes--raises a very interesting point: How in the world 
does holding mortgage-backed securities in your portfolio give 
you the capability of buying other mortgage-backed securities? 
In other words, the only thing that will do that----
    Chairman Shelby. That is a bogus argument, really.
    Chairman Greenspan. Yes. The only thing that will do that 
is if they built up either cash balances or Treasury bills or 
something which they could liquidate quickly and employ. The 
presumption that you have a large portfolio of mortgage-backed 
securities for the purposes of liquidity presupposes that you 
sell a mortgage-backed security to get the cash to support 
another mortgage-backed security. That obviously is a zero-sum 
game.
    So the amount of liquidity that is involved and required, 
strikes me as something that the regulator has to make a 
judgment on. But I do think that what should be specified is 
what that portfolio could be held for. There are liquidity 
purposes; there are a significant number of mortgages which 
cannot be securitized, a lot of them basically under affordable 
housing programs, and we would say they should be held in the 
portfolio; and a number of other things. But essentially 
restrict it to the purposes of the charter.
    Chairman Shelby. The mission, huh?
    Chairman Greenspan. Yes.
    Chairman Shelby. Thank you.
    Senator Schumer.
    Senator Schumer. Well, thank you, Mr. Chairman. I apologize 
for being away for a long, busy day in many ways.
    I know you have talked a little bit about the Chinese 
currency, so I will not have you repeat that. You were asked 
about terrorism insurance, so I will not have you repeat that. 
And I could not agree with you more, the private market cannot 
handle this alone.
    I have one topic I would like to ask about, and I thank the 
Chairman.
    As you know, Mr. Chairman, there are ongoing discussions as 
to whether we should fully repeal the estate tax--this is a tax 
that affects about one American in 100--or whether there can be 
some reasonable or permanent compromise that can garner the 
necessary 60 votes, because it breaks the Budget Act, as you 
know.
    The Federal deficit this year, excluding Social Security, 
will be huge, more than half a trillion this year alone. You 
also know, of course, that full repeal would cost $300 billion 
in the next 10 years and $750 billion if you go between 2011 
and 2020--you know, the years that the present law is not in 
effect. And that would be if the costs are not offset.
    So my question is, given these deficits and the cost of 
repeal, if there are no offsets, can we afford to repeal the 
estate tax and increase the deficit by another $750 billion, if 
there are no offsets?
    Chairman Greenspan. I think that is the critical question 
because, as I have testified on numerous occasions, I am 
strongly in favor of reducing taxes on capital, but under 
PAYGO. As a consequence, I would say if there are no offsets, 
obviously PAYGO is operative in that respect and the issue is 
moot.
    Senator Schumer. The issue is not moot.
    Chairman Greenspan. Well, the issue--in other words, if 
you--the issue----
    Senator Schumer. Not everyone has your view.
    Chairman Greenspan. Okay. Well, that is a----
    Senator Schumer. But I just--if we could just translate----
    Chairman Greenspan. I will rephrase.
    Senator Schumer. If we could just translate that into a 
straight--you know, into----
    Chairman Greenspan. I am trying not to translate.
    Senator Schumer. Oh, c'mon. This is your last time here. We 
have a big, big deficit.
    Chairman Greenspan. You mean I am going to become perfectly 
clear the last time I come here?
    Senator Schumer. Yeah, exactly.
    [Laughter.]
    But is it unfair to say you would advise not to repeal the 
estate tax if there are not offsets, if there is no PAYGO?
    Chairman Greenspan. That is correct. I think that PAYGO is 
an essential ingredient going forward and that all programs, 
both the spending and revenue programs, come under that.
    Senator Schumer. I take it there is a proposal for a 
compromise, which would cost about 80 to 90 percent of the full 
cost. In other words, some have proposed going to a capital 
gains rate rather than the 55 percent--that would be 15--and 
raising the floor to about $7.5 million. It is now, I do not 
know, it was originally 1. I think it is 1.5 now. It is one and 
a half now; it goes up and then it goes back down.
    I take it that would cost, instead of $750 billion over the 
next 10 full years, v2011 to 2020, that would cost $600, $625, 
$630 billion. I take it, again, without PAYGO, without an 
offset, you would think we should not do that at this point.
    Chairman Greenspan. That is correct.
    Senator Schumer. Thank you, Mr. Chairman.
    Chairman Shelby. Chairman Greenspan, thank you for your 
appearance today and all the other appearances and your service 
to the country.
    The hearing is adjourned.
    [Whereupon, at 12:10 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]

                  PREPARED STATEMENT OF ALAN GREENSPAN

       Chairman, Board of Governors of the Federal Reserve System
                             July 21, 2005

    Mr. Chairman and Members of the Committee, I am pleased to be here 
to present the Federal Reserve's Monetary Policy Report to the 
Congress.
    In mid-February, when I presented our last report to the Congress, 
the economy, supported by strong underlying fundamentals, appeared to 
be on a solid growth path, and those circumstances prevailed through 
March. Accordingly, the Federal Open Market Committee (FOMC) continued 
the process of a measured removal of monetary accommodation, which it 
had begun in June 2004, by raising the Federal funds rate 1/4 
percentage point at both the February and the March meetings.
    The upbeat picture became cloudier this spring, when data on 
economic activity proved to be weaker than most market participants had 
anticipated and inflation moved up in response to the jump in world oil 
prices. By the time of the May FOMC meeting, some evidence suggested 
that the economy might have been entering a soft patch reminiscent of 
the middle of last year, perhaps as a result of higher energy costs 
worldwide. In particular, employment gains had slowed from the strong 
pace of the end of 2004, consumer sentiment had weakened, and the 
momentum in household and business spending appeared to have dissipated 
somewhat.
    At the May meeting, the Committee had to weigh the extent to which 
this weakness was likely to be temporary--perhaps simply the product of 
the normal ebb and flow of a business expansion--and the extent to 
which it reflected some influence that might prove more persistent, 
such as the further run-up in crude oil prices. While the incoming data 
highlighted some downside risks to the outlook for economic growth, the 
FOMC judged the balance of information as suggesting that the economy 
had not weakened fundamentally.
    Moreover, core inflation had moved higher again through the first 
quarter. The rising prices of energy and other commodities continued to 
place upward pressures on costs, and reports of greater pricing power 
of firms indicated that they might be more able to pass those higher 
costs on to their customers. Given these considerations, the Committee 
continued the process of gradually removing monetary accommodation in 
May.
    The data released over the past 2 months or so accord with the view 
that the earlier soft readings on the economy were not presaging a more 
serious slowdown in the pace of activity. Employment has remained on an 
upward trend, retail spending has posted appreciable gains, inventory 
levels are modest, and business investment appears to have firmed. At 
the same time, low long-term interest rates have continued to provide a 
lift to housing activity. Although both overall and core consumer price 
inflation have eased of late, the prices of oil and natural gas have 
moved up again on balance since May and are likely to place some upward 
pressure on consumer prices, at least over the near-term. Slack in 
labor and product markets has continued to decline. In light of these 
developments, the FOMC raised the Federal funds rate at its June 
meeting to further reduce monetary policy accommodation. That action 
brought the cumulative increase in the funds rate over the past year to 
2\1/4\ percentage points.
    Should the prices of crude oil and natural gas flatten out after 
their recent run-up--the forecast currently embedded in futures 
markets--the prospects for aggregate demand appear favorable. Household 
spending--buoyed by past gains in wealth, ongoing increases in 
employment and income, and relatively low interest rates--is likely to 
continue to expand. Business investment in equipment and software seems 
to be on a solid upward trajectory in response to supportive conditions 
in financial markets and the ongoing need to replace or upgrade aging 
high-tech and other equipment. Moreover, some recovery in 
nonresidential construction appears in the offing, spurred partly by 
lower vacancy rates and rising prices for commercial properties. 
However, given the comparatively less buoyant growth of many foreign 
economies and the recent increase in the foreign exchange value of the 
dollar, our external sector does not yet seem poised to contribute 
steadily to U.S. growth.
    A flattening out of the prices of crude oil and natural gas, were 
it to materialize, would also lessen upward pressures on inflation. 
Overall inflation would probably drop back noticeably from the rates 
experienced in 2004 and early 2005, and core inflation could hold 
steady or edge lower. Prices of crude materials and intermediate goods 
have softened of late, and the slower rise in import prices that should 
result from the recent strength in the foreign exchange value of the 
dollar could also relieve some pressure on inflation.
    Thus, our baseline outlook for the U.S. economy is one of sustained 
economic growth and contained inflation pressures. In our view, 
realizing this outcome will require the Federal Reserve to continue to 
remove monetary accommodation. This generally favorable outlook, 
however, is attended by some significant uncertainties that warrant 
careful scrutiny.
    With regard to the outlook for inflation, future price performance 
will be influenced importantly by the trend in unit labor costs, or its 
equivalent, the ratio of hourly labor compensation to output per hour. 
Over most of the past several years, the behavior of unit labor costs 
has been quite subdued. But those costs have turned up of late, and 
whether the favorable trends of the past few years will be maintained 
is unclear. Hourly labor compensation as measured from the national 
income and product accounts increased sharply near the end of 2004. 
However, that measure appears to have been boosted significantly by 
temporary factors. Other broad measures suggest hourly labor 
compensation continues to rise at a moderate rate.
    The evolution of unit labor costs will also reflect the growth of 
output per hour. Over the past decade, the U.S. economy has benefited 
from a remarkable acceleration of productivity: Strong gains in 
efficiency have buoyed real incomes and restrained inflation. But 
experience suggests that such rapid advances are unlikely to be 
maintained in an economy that has reached the cutting edge of 
technology. Over the past 2 years, growth in output per hour seems to 
have moved off the peak that it reached in 2003. However, the cause, 
extent, and duration of that slowdown are not yet clear. The 
traditional measure of the growth in output per hour, which is based on 
output as measured from the product side of the national accounts, has 
slowed sharply in recent quarters. But a conceptually equivalent 
measure that uses output measured from the income side has slowed far 
less. Given the divergence between these two readings, a reasonably 
accurate determination of the extent of the recent slowing in 
productivity growth and its parsing into cyclical and secular 
influences will require the accumulation of more evidence.
    Energy prices represent a second major uncertainty in the economic 
outlook. A further rise could cut materially into private spending and 
thus damp the rate of economic expansion. In recent weeks, spot prices 
for crude oil and natural gas have been both high and volatile. Prices 
for far-future delivery of oil and gas have risen even more markedly 
than spot prices over the past year. Apparently, market participants 
now see little prospect of appreciable relief from elevated energy 
prices for years to come. Global demand for energy apparently is 
expected to remain strong, and market participants are evidencing 
increased concerns about the potential for supply disruptions in 
various oil-producing regions.
    To be sure, the capacity to tap and utilize the world's supply of 
oil continues to expand. Major advances in recovery rates from existing 
reservoirs have enhanced proved reserves despite ever fewer discoveries 
of major oil fields. But, going forward, because of the geographic 
location of proved reserves, the great majority of the investment 
required to convert reserves into new crude oil productive capacity 
will need to be made in countries where foreign investment is currently 
prohibited or restricted or faces considerable political risk. 
Moreover, the preponderance of oil and gas revenues of the dominant 
national oil companies is perceived as necessary to meet the domestic 
needs of growing populations. These factors have the potential to 
constrain the ability of producers to expand capacity to keep up with 
the projected growth of world demand, which has been propelled to an 
unexpected extent by burgeoning demand in emerging Asia.
    More favorably, the current and prospective expansion of U.S. 
capability to import liquefied natural gas will help ease longer-term 
natural gas stringencies and perhaps bring natural gas prices in the 
United States down to world levels.
    The third major uncertainty in the economic outlook relates to the 
behavior of long-term interest rates. The yield on 10-year Treasury 
notes, currently near 4\1/4\ percent, is about 50 basis points below 
its level of late spring 2004. Moreover, even after the recent widening 
of credit risk spreads, yields for both investment-grade and less-than-
investment-grade corporate bonds have declined even more than those on 
Treasury notes over the same period.
    This decline in long-term rates has occurred against the backdrop 
of generally firm U.S. economic growth, a continued boost to inflation 
from higher energy prices, and fiscal pressures associated with the 
fast approaching retirement of the baby-boom generation.\1\ The drop in 
long-term rates is especially surprising given the increase in the 
Federal funds rate over the same period. Such a pattern is clearly 
without precedent in our recent experience.
---------------------------------------------------------------------------
    \1\ Under current law, those longer-run pressures on the Federal 
budget threaten to place the economy on an unsustainable path. Large 
deficits could result in rising interest rates and ever-growing 
interest payments on the accumulating stock of debt, which in turn 
would further augment deficits in future years. That process could 
result in deficits as a percentage of gross 
domestic product rising without limit. Unless such a development were 
headed off, these deficits could cause the economy to stagnate or worse 
at some point over the next couple of decades.
---------------------------------------------------------------------------
    The unusual behavior of long-term interest rates first became 
apparent last year. In May and June 2004, with a tightening of monetary 
policy by the Federal Reserve widely expected, market participants 
built large short positions in long-term debt instruments in 
anticipation of the increase in bond yields that has been historically 
associated with an initial rise in the Federal funds rate. Accordingly, 
yields on 10-year Treasury notes rose during the spring of last year 
about 1 percentage point. But by summer, pressures emerged in the 
marketplace that drove long-term rates back down. In March of this 
year, long-term rates once again began to rise, but like last year, 
market forces came into play to make those increases short lived.
    Considerable debate remains among analysts as to the nature of 
those market forces. Whatever those forces are, they are surely global, 
because the decline in long-term interest rates in the past year is 
even more pronounced in major foreign financial markets than in the 
United States.
    Two distinct but overlapping developments appear to be at work: A 
longer-term trend decline in bond yields and an acceleration of that 
trend of late. Both developments are particularly evident in the 
interest rate applying to the 1 year period ending 10 years from today 
that can be inferred from the U.S. Treasury yield curve. In 1994, that 
so-called forward rate exceeded 8 percent. By mid-2004, it had declined 
to about 6\1/2\ percent--an easing of about 15 basis points per year on 
average.\2\ Over the past year, that drop steepened, and the forward 
rate fell 130 basis points to less than 5 percent.
---------------------------------------------------------------------------
    \2\ Dollar interest rate swaps 5 years forward and maturing in 10 
years declined 19 basis points per year on average over the same 
period. Comparable euro (pre-1999, Deutschemark) swaps declined 27 
basis points, sterling swaps 35 basis points, and yen swaps 23 basis 
points.
---------------------------------------------------------------------------
    Some, but not all, of the decade-long trend decline in that forward 
yield can be ascribed to expectations of lower inflation, a reduced 
risk premium resulting from less inflation volatility, and a smaller 
real term premium that seems due to a moderation of the business cycle 
over the past few decades.\3\ This decline in inflation expectations 
and risk premiums is a signal development. As I noted in my testimony 
before this Committee in February, the effective productive capacity of 
the global economy has substantially increased, in part because of the 
breakup of the Soviet Union and the integration of China and India into 
the global marketplace. And this increase in capacity, in turn, has 
doubtless contributed to expectations of lower inflation and lower 
inflation-risk premiums.
---------------------------------------------------------------------------
    \3\ Term premiums measure the extent to which current prices of 
bonds discount future uncertainties.
---------------------------------------------------------------------------
    In addition to these factors, the trend reduction worldwide in 
long-term yields surely reflects an excess of intended saving over 
intended investment. This configuration is equivalent to an excess of 
the supply of funds relative to the demand for investment. What is 
unclear is whether the excess is due to a glut of saving or a shortfall 
of investment. Because intended capital investment is to some extent 
driven by forces independent of those governing intended saving, the 
gap between intended saving and investment can be quite wide and 
variable. It is real interest rates that bring actual capital 
investment worldwide and its means of financing, global saving, into 
equality. We can directly observe only the actual flows, not the saving 
and investment tendencies. Nonetheless, as best we can judge, both high 
levels of intended saving and low levels of intended investment have 
combined to lower real long-term interest rates over the past decade.
    Since the mid-1990's, a significant increase in the share of world 
gross domestic product (GDP) produced by economies with persistently 
above-average saving--prominently the emerging economies of Asia--has 
put upward pressure on world saving. These pressures have been 
supplemented by shifts in income toward the oil-exporting countries, 
which more recently have built surpluses because of steep increases in 
oil prices. The changes in shares of world GDP, however, have had 
little effect on actual world capital investment as a percentage of 
GDP. The fact that investment as a percentage of GDP apparently changed 
little when real interest rates were falling, even adjusting for the 
shift in the shares of world GDP, suggests that, on average, countries' 
investment propensities had been declining.\4\
---------------------------------------------------------------------------
    \4\ Nominal GDP figures by country are estimated in dollars by the 
International Monetary Fund using purchasing power parities (PPP) of 
currencies. These GDP figures are used to calculate weights applied to 
national saving and investment rates to form global measures. When the 
GDP figures are instead measured at market exchange rates, the results 
are similar. The PPP estimates emphasize the economic factors 
generating investment and the use of saving. Exchange rates emphasize 
the financial forces governing the financing of investment across 
borders. Both approaches are useful.
---------------------------------------------------------------------------
    Softness in intended investment is also evident in corporate 
behavior. Although corporate capital investment in the major industrial 
countries rose in recent years, it apparently failed to match increases 
in corporate cashflow.\5\ In the United States, for example, capital 
expenditures were below the very substantial level of corporate 
cashflow in 2003, the first shortfall since the severe recession of 
1975. That development was likely a result of the business caution that 
was apparent in the wake of the stock market decline and the corporate 
scandals early this decade. (Capital investment in the United States 
has only recently shown signs of shedding at least some of that 
caution.) Japanese investment exhibited prolonged restraint following 
the bursting of their speculative bubble in the early 1990's. And 
investment in emerging Asia excluding China fell appreciably after the 
Asian financial crisis in the late 1990's. Moreover, only a modest part 
of the large revenue surpluses of oil-producing nations has been 
reinvested in physical assets. In fact, capital investment in the 
Middle East in 2004, at 25 percent of the region's GDP, was the same as 
in 1998. National saving, however, rose from 21 percent to 32 percent 
of GDP. The unused saving of this region was invested in world markets.
---------------------------------------------------------------------------
    \5\ A significant part of the surge in cashflow of U.S. 
corporations was accrued by those financial intermediaries that invest 
only a small part in capital assets. It appears that the value added of 
intermediation has increased materially over the past decade because of 
major advances in financial product innovation.
---------------------------------------------------------------------------
    Whether the excess of global intended saving over intended 
investment has been caused by weak investment or excessive saving--that 
is, by weak consumption--or, more likely, a combination of both does 
not much affect the intermediate-term outlook for world GDP or, for 
that matter, U.S. monetary policy. What have mattered in recent years 
are the sign and the size of the gap of intentions and the implications 
for interest rates, not whether the gap results from a saving glut or 
an investment shortfall. That said, saving and investment propensities 
do matter over the longer-run. Higher levels of investment relative to 
consumption build up the capital stock and thus add to the productive 
potential of an economy.
    The economic forces driving the global saving-investment balance 
have been unfolding over the course of the past decade, so the 
steepness of the recent decline in long-term dollar yields and the 
associated distant forward rates suggests that something more may have 
been at work over the past year.\6\ Inflation premiums in forward rates 
10 years ahead have apparently continued to decline, but real yields 
have also fallen markedly over the past year. It is possible that the 
factors that have tended to depress real yields over the past decade 
have accelerated recently, though that notion seems implausible.
---------------------------------------------------------------------------
    \6\ The decline of euro, sterling, and yen forward swap rates also 
steepened.
---------------------------------------------------------------------------
    According to estimates prepared by the Federal Reserve Board staff, 
a significant portion of the sharp decline in the 10-year forward 1 
year rate over the past year appears to have resulted from a fall in 
term premiums. Such estimates are subject to considerable uncertainty. 
Nevertheless, they suggest that risk takers have been encouraged by a 
perceived increase in economic stability to reach out to more distant 
time horizons. These actions have been accompanied by significant 
declines in measures of expected volatility in equity and credit 
markets inferred from prices of stock and bond options and narrow 
credit risk premiums. History cautions that long periods of relative 
stability often engender unrealistic expectations of its permanence 
and, at times, may lead to financial excess and economic stress.
    Such perceptions, many observers believe, are contributing to the 
boom in home prices and creating some associated risks. And, certainly, 
the exceptionally low interest rates on 10-year Treasury notes, and 
hence on home mortgages, have been a major factor in the recent surge 
of homebuilding, home turnover, and particularly in the steep climb in 
home prices. Whether home prices on average for the Nation as a whole 
are overvalued relative to underlying determinants is difficult to 
ascertain, but there do appear to be, at a minimum, signs of froth in 
some local markets where home prices seem to have risen to 
unsustainable levels. Among other indicators, the significant rise in 
purchases of homes for investment since 2001 seems to have charged some 
regional markets with speculative fervor.
    The apparent froth in housing markets appears to have interacted 
with evolving practices in mortgage markets. The increase in the 
prevalence of interest-only loans and the introduction of more-exotic 
forms of adjustable-rate mortgages are developments of particular 
concern. To be sure, these financing vehicles have their appropriate 
uses. But some households may be employing these instruments to 
purchase homes that would otherwise be unaffordable, and consequently 
their use could be adding to pressures in the housing market. Moreover, 
these contracts may leave some mortgagors vulnerable to adverse events. 
It is important that lenders fully appreciate the risk that some 
households may have trouble meeting monthly payments as interest rates 
and the macroeconomic climate change.
    The U.S. economy has weathered such episodes before without 
experiencing significant declines in the national average level of home 
prices. Nevertheless, we certainly cannot rule out declines in home 
prices, especially in some local markets. If declines were to occur, 
they likely would be accompanied by some economic stress, though the 
macroeconomic implications need not be substantial. Nationwide banking 
and widespread securitization of mortgages make financial 
intermediation less likely to be impaired than it was in some previous 
episodes of regional house-price correction. Moreover, a decline in the 
national housing price level would need to be substantial to trigger a 
significant rise in foreclosures, because the vast majority of 
homeowners have built up substantial equity in their homes despite 
large mortgage-market-financed withdrawals of home equity in recent 
years.
    Historically, it has been rising real long-term interest rates that 
have restrained the pace of residential building and have suppressed 
existing home sales, high levels of which have been the major 
contributor to the home equity extraction that arguably has financed a 
noticeable share of personal consumption expenditures and home 
modernization outlays.
    The trend of mortgage rates, or long-term interest rates more 
generally, is likely to be influenced importantly by the worldwide 
evolution of intended saving and intended investment. We at the Federal 
Reserve will be closely monitoring the path of this global development 
few, if any, have previously experienced. As I indicated earlier, the 
capital investment climate in the United States appears to be improving 
following significant headwinds since late 2000, as is that in Japan. 
Capital investment in Europe, however, remains tepid. A broad worldwide 
expansion of capital investment not offset by a rising worldwide 
propensity to save would presumably move real long-term interest rates 
higher. Moreover, with term premiums at historical lows, further 
downward pressure on long-term rates from this source is unlikely.
    We collectively confront many risks beyond those that I have just 
mentioned. As was tragically evidenced again by the bombings in London 
earlier this month, terrorism and geopolitical risk have become 
enduring features of the global landscape. Another prominent concern is 
the growing evidence of antiglobalization sentiment and protectionist 
initiatives, which, if implemented, would significantly threaten the 
flexibility and resilience of many economies. This situation is 
especially troubling for the United States, where openness and 
flexibility have allowed us to absorb a succession of large shocks in 
recent years with only minimal economic disruption. That flexibility 
is, in large measure, a testament to the industry and resourcefulness 
of our workers and businesses. But our success in this dimension has 
also been aided importantly by more than two and a half decades of 
bipartisan effort aimed at reducing unnecessary regulation and 
promoting the openness of our market economy. Going forward, 
policymakers will need to be vigilant to preserve this flexibility, 
which has contributed so constructively to our economic performance in 
recent years.
    In conclusion, Mr. Chairman, despite the challenges that I have 
highlighted and the many I have not, the U.S. economy has remained on a 
firm footing, and inflation continues to be well contained. Moreover, 
the prospects are favorable for a continuation of those trends. 
Accordingly, the Federal Open Market Committee in its June meeting 
reaffirmed that it ``. . . believes that policy accommodation can be 
removed at a pace that is likely to be measured. Nonetheless, the 
Committee will respond to changes in economic prospects as needed to 
fulfill its obligation to maintain price stability.''

        RESPONSE TO A WRITTEN QUESTION OF SENATOR REED 
                      FROM ALAN GREENSPAN

Q.1. I mentioned in my opening remarks the study by the Boston 
Federal Reserve with respect to labor participation, which 
suggests there is a significant and growing lack of 
participation in the labor force which distorts our ability to 
see how well we are doing with respect to recoveries. In fact, 
one thing that I found interesting was the ratio of employment 
to population, 62.7 percent, is below the level at the start of 
the economic recovery in November 2001. And this is the first 
time the ratio has failed to surpass its trial level so far 
into a recovery. Can you comment?

A.1. At my July 21 testimony before the Senate Banking 
Committee, you asked if I could provide additional detail 
concerning the Board staff's assessment of recent developments 
in labor force participation and their implications for the 
interpretation of the unemployment rate as a measure of slack 
in the labor market. As I noted in my response at the hearing, 
while cyclical factors likely have contributed to the weak 
recovery in labor force participation, our staff estimates that 
part of that weak performance in recent years can also be 
traced to a downtrend in the underlying rate of participation. 
The change in the overall trend has occurred both because the 
trend in the participation of adult women appears to have 
flattened out and because the large baby boom cohorts are 
moving into the age range in which their labor force 
participation will likely drop off sharply as many workers in 
these cohorts retire. More specifically, we estimate that the 
underlying trend in the participation rate has fallen from a 
little more than 66\1/2\ percent of the civilian working-age 
population in 2001 to about 66\1/4\ percent this year. Because 
the participation rate in recent months has averaged just over 
66 percent, we estimate that the implied cyclical shortfall in 
participation equates to a few tenths of a percentage point on 
the unemployment rate.
    Our estimates are broadly similar to those of the 
Congressional Budget Office. Differences between our estimates 
and those reported in the Boston Fed study that we discussed at 
my hearing primarily reflect different views about the 
evolution of trends in participation for various demographic 
groups and different ways to measure the size of the current 
participation shortfall. In particular, the Boston Fed study 
examines a range of alternative trajectories for participation 
rates for women and older workers and calibrates the size of 
the estimated current shortfall as a percentage of the labor 
force. Of course, all such estimates are subject to 
considerable uncertainty, and our understanding of the 
relationship between labor force participation and labor market 
slack will undoubtedly benefit from additional research on this 
topic.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR BENNETT 
                      FROM ALAN GREENSPAN

Q.1. What guidance could you offer for selection of an index to 
use for maintaining purchasing power over time in Federal 
programs with cost-of-living adjustments?

A.1. As you know, I have long advocated improvements in the 
price indexes published by the Bureau of Labor Statistics 
(BLS). As you have indicated, this issue is important for 
several reasons. In addition to the need for accurate measures 
of inflation, price indexes are used for the automatic 
inflation adjustments of many Federal tax and spending 
programs, and inaccurate price measures can lead to adjustments 
that are inconsistent with true changes in the cost of living.
    In recent years, the BLS has taken important steps to 
improve the quality of the price indexes. However, reviews of 
the academic literature on price measurement suggest that 
frequently cited consumer price indexes published by the BLS 
still tend to overstate 
increases in the cost of living. This evidence indicates that, 
if Congress intends the inflation adjustments to compensate for 
changes in the cost of living, adjustments based on the CPI-U 
or CPI-W will be too large, perhaps by a significant amount.

Q.2. Do you believe that replacing the CPI-U with the C-CPI-U 
in indexing Federal programs would be truer to the original 
intent of Congress in making cost-of-living adjustments?

A.2. As indicated, research suggests that the CPI-U and CPI-W 
overstate increases in the cost of living. A portion of this 
measurement error owes to substitution bias, and, to address 
this problem, the BLS recently developed the Chained CPI-U (C-
CPI-U).
    Although the C-CPI-U is still subject to other sources of 
bias--especially those related to changes in the quality of 
existing products and introduction of new goods and services--
basing inflation indexation of Federal programs on the C-CPI-U 
would, in my view, give us a less biased measure of changes in 
the cost of living.

Q.3. Because construction of the C-CPI-U requires data on the 
changing expenditure patterns of consumers as relative prices 
shift, the index is subject to revision as better data on 
expenditures become available. However, this presents a problem 
because retroactive adjustments may become necessary as 
revisions are made if the C-CPI-U were to be used for 
indexation purposes in Federal programs.
    One possible way to overcome such a problem would be to use 
``true up'' factors as revisions are made. For example, if last 
year's C-CPI-U growth was revised down by 0.2 percent and this 
year's C-CPI-U growth was 1.4 percent, then we could actually 
increase whatever is being indexed by only 1.2 percent (this 
year's 1.4 percent less a ``true up'' factor of 0.2 percent to 
reflect the revision). Assuming that errors are unbiased 
(essentially, that revisions have mean zero), such a procedure 
should average out correctly over time. However, in the short-
run, revision issues could be significant.
    If you believe that the C-CPI-U represents a truer measure 
of the cost of living than the CPI-U, how would you address the 
problem of data revisions?

A.3. As you noted, the indexation of Federal programs to a 
price index that is subject to revision, such as the C-CPI-U, 
does lead to certain complications. If the index is 
subsequently revised, then programs tied to that index will 
have been set at levels learned, ex post, to have been 
inappropriate. (Of course, use of a price index that is not 
subject to revision also may generate inappropriate adjustments 
to Federal programs, and the absence of revision may mean that 
any such errors are never corrected.) The complications 
introduced by such revisions are readily surmountable, however. 
Indexation formulas may be structured in ways that take such 
revisions into account and ensure that, in the period following 
the revision, the programs are set back at appropriate levels. 
The use of ``true up'' factors, as you suggest, is one way to 
achieve this goal.

Q.4. If you were to change the price measure used in indexing 
Federal programs, how would you respond to a criticism that 
such a change is merely a sneaky way of cutting benefits and 
increasing taxes?

A.4. As indicated above, I believe that it would be desirable, 
insofar as possible, to index Federal programs in a way that 
captures actual changes in the cost of living.

Q.5. In remarks on price measurement at the Center for 
Financial Studies in Frankfurt, Germany on November 7, 1997, 
you advocated establishment of an objective, nonpartisan, and 
independent national commission to set annual cost-of-living 
adjustment factors for Federal programs. Do you still feel that 
it would be beneficial to establish such a commission? How 
would you constitute such a commission? Would you be willing to 
coordinate research efforts of Federal Reserve staff with those 
of my staff on the Joint Economic Committee to help explore the 
possibility of formalizing such a commission?

A.5. Further improvements in our price indexes would be a 
welcome development. In the meantime, it is important to 
consider how best to index Government programs, given price 
measures still appear to suffer from significant biases. Many 
approaches to this latter problem have the potential to yield 
progress, including the establishment of an independent 
commission.

       RESPONSE TO A WRITTEN QUESTION OF SENATOR CORZINE 
                      FROM ALAN GREENSPAN

Q.1. This morning, the Senate Agriculture Committee is marking 
up legislation reauthorizing the Commodities Futures Trading 
Commission. The proposed legislation would modify the Commodity 
Futures Modernization Act (CFMA) of 2000, which, as you know, 
this Committee and Agriculture jointly worked on to develop. 
That effort was based on recommendations from the President's 
Working Group (the Federal Reserve, Treasury, SEC, and CFTC) on 
Financial Markets.
    Yesterday, you expressed concerns to Agriculture Committee 
Chairman Chambliss about the legislation in response to a 
letter from Senator Crapo. Those concerns seem to revolve 
around the fact that the President's Working Group has not had 
the opportunity to review or deliberate key proposals contained 
in the draft reauthorization legislation. SEC Acting Chairman 
Glassman has expressed a similar concern, and Chairman Shelby 
and Ranking Member Sarbanes have done so as well.
    As you know, of major concern with the draft legislation 
are the provisions that would modify portions of the CFMA that 
were painstakingly crafted to balance the differing interests 
of all Federal financial regulators. I wonder if you could 
discuss more in depth the nature of the concerns you expressed 
in your letter and what specific harm could come from 
Congressional action that, done in haste, could disrupt the 
balance and legal certainty the CFMA struck which has aided the 
development of important financial markets and reaped 
significant benefits for the broader economy?

A.1. The Federal Reserve Board believes the CFMA has 
unquestionably been a successful piece of legislation. It 
enacted provisions that excluded transactions between 
institutions and other eligible counterparties in over-the-
counter financial derivatives and foreign currency from 
regulation under the Commodity Exchange Act (CEA). This 
exclusion resolved long-standing concerns that a court might 
find that the CEA applied to these transactions, thereby making 
them legally unenforceable.
    Another important part of the CFMA addressed problems 
associated with ``bucket shops'' that were marketing foreign 
currency futures to retail customers (that is, an individual or 
business that does not meet the definition of eligible 
counterparty). The legislation marked up by the Senate 
Agriculture Committee in July 2005 would apply the CEA as a 
whole to certain retail foreign currency contracts, regardless 
of whether they are futures contracts. We seriously question 
whether it is necessary to apply all the provisions of the CEA 
to these transactions in order to enable the CFTC to address 
fraud, and believe that a broad application of the Act could 
have unintended consequences.



