Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, May 27, 1994 - interest rates - Statements to the Congress - Transcript

Federal Reserve Bulletin, July, 1994

I appreciate the opportunity to appear before you to discuss recent monetary policy.

The Federal Reserve's moves to increase short-term interest rates this year are most appropriately understood in a historical context.

In the spring of 1989, we began to ease monetary conditions as we observed the consequence of balance sheet strains resulting from increased debt, along with significant weakness in the collateral underlying that debt. Households and businesses became much more reluctant to borrow and spend, and lenders to extend credit--a phenomenon often referred to as the "credit crunch." In an endeavor to defuse these financial strains, we moved short-term rates lower in a long series of steps through the summer of 1992, and we held them at unusually low levels through the end of 1993--both absolutely and, importantly, relative to inflation. These actions, together with those to reduce budget deficits, facilitated a significant decline in long-term rates as well.

Lower interest rates fostered a dramatic improvement in the financial condition of borrowers and lenders. Households rolled outstanding mortgage and consumer loans into much-lower-rate debt. Business firms were able to pay down high-cost debt by issuing bonds and stocks on very favorable terms. And banks, which had cut back on credit availability partly because of their own balance sheet problems, were able to strengthen their capital positions by issuing a substantial volume of equity shares and other capital instruments and by retaining much of their improved flow of earnings. Moreover, the lower interest rates, together with expanding economic activity, recently have bolstered the commercial real estate market, stemming losses on the collateral underlying some of the largest problem credits of banks and other intermediaries and, in some cases, permitting them to find purchasers for these assets.

The sharp, sustained decline in debt-service charges and the restructuring of balance sheets alleviated the financial distress, enabling the economy to begin to move again in a normal expansionary pattern. When I last testified before you on monetary policy, in July 1993, the likelihood that the economy would soon respond more vigorously to these financial developments already was evident both to the Federal Reserve and to outside analysts. Indeed, I mentioned that, with short-term real rates not far from zero, ". . . market participants anticipate that short-term real interest rates will have to rise as the headwinds diminish if substantial inflationary imbalances are to be avoided." But lingering questions into the second half of 1993 about whether the economy had fully recuperated made the appropriate timing of such action unclear.

Since the latter part of 1993, however, the expansionary effects of the monetary policy of the past few years have become increasingly apparent. Although quarter-to-quarter developments are subject to considerable statistical noise, in an underlying sense real gross domestic product clearly has accelerated. Strength has been particularly evident in interest-sensitive sectors. Business investment has been quite robust, and order books for producers of durable equipment have expanded appreciably. Housing starts rose in the last three months of 1993 to their highest level in more than four years; although they have dropped back some more recently, they remain 18 percent above a year ago. Demand for motor vehicles has been strong, lifting production of many types of automobiles and light trucks to capacity. Moreover, as economic conditions have improved in other industrial countries, the growth of our merchandise exports has picked up markedly. Overall industrial capacity utilization has increased to 83 1/2 percent, its highest level since the late 1980s. In excess of 2 million jobs have been created over the past twelve months, and the unemployment rate has fallen substantially.

In this more robust financial and economic climate, expansion of money and credit has picked up. Business loans--which had contracted over the 1990-93 period--grew at a 9 1/2 percent annual rate in the first four months of 1994. Bank lending to consumers also has been quite brisk. The pickup in loan growth seems to reflect both stepped-up short-term credit demands and a greater willingness on the part of banks to extend credit. Our surveys as well as anecdotal reports indicate that banks have been easing standards and terms on business loans for more than a year, and they have become more aggressive in seeking to extend consumer and residential mortgage loans. The total debt of private borrowers and state and local governments, which had risen at only a 2 1/2 percent annual rate over the first half of 1993, accelerated to more than a 4 1/2 percent rate over the second half and has maintained the stronger pace during recent months. Although ongoing portfolio adjustments have kept growth of M2 relatively sluggish, it has been increasing a little more quickly this year than last.