Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on the Budget, U.S. Senate, January 26, 1995

Federal Reserve Bulletin, March, 1995

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on the Budget, US. Senate, January 26, 1995

I am pleased to be able to appear here today to offer my thoughts on the economic and fiscal backdrop for your policy discussions.

The US. economy has recorded some notable achievements over the past few years, but there is nonetheless much left to be accomplished. The fiscal decisions made by the Congress in the next several months will play a critical role in determining the economic welfare of our citizens over the years--indeed, the decades--to come.

I perhaps should begin with a brief review of the current condition of the economy. In 1994, we had a difficult reversal in monetary policy to navigate. The overhang of debt and the strains that emerged among our financial intermediaries, especially out of the commercial real estate collapse of the late 1980s, required a heavy dose of monetary ease beginning in 1989 to alleviate a significant credit crunch. The danger of overstaying that policy of ease was clear, particularly as we moved through 1993, but the right time to change course was difficult to determine. Judging from the developments of the past year, it appears that our policy reversal last February was timely--but we will not know for sure except in retrospect.

There is no question that the past year was one of remarkable progress along many dimensions of macroeconomic performance. The official estimates for the fourth quarter are not yet available, but it is clear that real gross domestic product expanded 4 percent over the course of 1994-the best gain in some time and one that surpassed most expectations. Importantly, we saw an accelerated expansion of employment as well. Cumulatively, payrolls have now increased roughly 6 million over the past couple of years, belying in dramatic fashion the notion that had developed earlier in this decade that our economy had lost its job-generating ability. With the rapid growth of employment, the national unemployment rate has fallen sharply, to less than 5 1/2 percent this past month.

Of crucial importance to the sustainability of these gains, they have been achieved without a deterioration in the overall inflation rate. The consumer price index (CPI) rose 2.7 percent last year, the same as in 1993. Inflation at the retail level, as measured by the CPI, has been a bit less than 3 percent for three years running now--the first time that has occurred since the early 1960s. This is a signal accomplishment, for it marks a move toward a more stable economic environment in which households, businesses, and governmental units can plan with greater confidence and operate with greater efficiency. When we consider the probable upward bias of the CPI, it would appear that we have made considerable progress toward achieving price stability.

I have stated many times in congressional testimony that I believe firmly that a key ingredient in achieving the highest possible levels of productivity, real incomes, and living standards is the achievement of price stability. Thus, I see it as crucial that we extend the recent trend of low and, hopefully, declining inflation in the years ahead. The prospects in this regard are fundamentally good, but there are reasons for some concern, at least with respect to the nearer term. Those concerns relate primarily to the fact that resource utilization rates already have risen to high levels by recent historical standards. The current unemployment rate, for example, is comparable to the average of the late 1980s, when wages and prices accelerated appreciably. The same is true of the capacity utilization rate in the industrial sector. It may be that these pressures will lead to some deterioration in the price picture in the near term, but any such deterioration should be contained if the Federal Reserve remains vigilant.

The actions of the Congress and the Administration in the fiscal sphere will also be important to the outlook for prices and the economy. There can be no doubt that the persistence of large federal budget deficits represents in the minds of many individuals a potential risk. Although we clearly have avoided it in recent years, history is replete with examples of fiscal pressures leading to monetary excesses and then to greater inflation. Currently, I strongly suspect that investors here and abroad are exacting from issuers of dollar-denominated debt an extra inflation risk premium that reflects not their estimate of the most likely rate of price level increase over the life of the obligation but the possibility that it could prove to be significantly greater. This inflation risk premium is costly because it raises the hurdle that must be surpassed when looking at the expected returns on possible investment projects.

But the influence of the fiscal imbalance of the federal government on capital formation is broader than that. The federal deficit drains off a large share of a regrettably small pool of domestic private saving, thus contributing further--and perhaps to an even greater degree--to the elevation of real rates of interest in the economy. Admittedly, there is some uncertainty about the causes of what seem to be relatively high real long-term rates around the world, as was noted by leaders of the largest industrial nations at their summit meeting last year. But the vast majority of analysts would agree that in the United States the current sizable federal deficits, and the projected growth of those deficits over the decades ahead, are a significant element in the story.