Statements to Congress - Statements by Alan Greenspan to the Senate Committee on the Budget and the Senate Committee on Finance

Federal Reserve Bulletin, March, 1997

The question is, of course, where do we go from here? Can we continue to achieve significant gains in real activity while avoiding inflationary excesses? Because monetary policy works with a lag, it is not the conditions prevailing today that are critical but rather those likely to prevail six to twelve months, or even longer, from now. Hence, as difficult as it is, we must arrive at some judgment about the most probable direction of the economy and the distribution of risks around that expectation.

Fortunately, economic events are not wholly random and unforecastable. There are certain principles, and certain empirical regularities in behavioral relations, that we can follow with some degree of confidence. For example, capital investment responds in a predictable way to the rate of growth of the economy, expected profitability, and the cost of capital. Similarly, housing activity, with some qualifications, moves inversely with mortgage rates. And the largest component of final demand, personal consumption expenditures, generally follows income over time. Many of these relationships are embedded in the traditional notion of the business cycle developed by Wesley Clair Mitchell three-quarters of a century ago and worked out with Arthur F. Burns, one of my predecessors, in the definitive tome Measuring Business Cycles. Their insights remain relevant today.

Even so, each cycle tends to have its own identifying characteristic. For example, in the late 1980s and the recessionary period of the early 1990s, the economy was dominated by the sharp fall in the market value of commercial real estate; because such real estate served as a major source of loan collateral, the drop in its value had a profoundly restrictive influence on the willingness and ability of commercial banks to lend. As you may recall, at that time, I characterized the economy as trying to advance in the face of fifty-mile-an-hour headwinds. The severe credit restraint was only grudgingly responsive to the extended efforts of the Federal Reserve to ease monetary conditions.

Similarly, the dramatic rise of inflation and of inflation expectations in the 1970s was key in shaping the cyclical patterns of that period. One manifestation was the impetus to spending on houses, cars, and other consumer durables from buyers' efforts to beat future price increases. Countering this inflation required a major monetary tightening, which moved both nominal and real interest rates up sharply and led to substantial contractions in housing and other interest-sensitive sectors in the early 1980s.

In contrast, as I have mentioned several times to the Congress over the past few years, perhaps the dominant characteristic of the current expansion is low inflation and quiescent inflation expectations, which have helped create a financial environment conducive to strong capital spending and longer-range planning generally. I emphasized this point in our Humphrey-Hawkins testimony of a year ago. Since then, increases in hourly compensation as measured by the employment cost index have continued to fall far short of what they would have been if historical relationships between compensation gains and the degree of labor market tightness had held.