CONDUCT OF MONETARY POLICY Report of the Federal Reserve pursuant to the Full Employment and Balanced Growth Act of 1978, PJL. 95-523, and The State of the Economy HEARING BEFORE THE SUBCOMMITTEE ON ECONOMIC GROWTH AND CREDIT FORMATION OF THE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS HOUSE OF REPRESENTATIVES ONE HUNDRED THIRD CONGRESS SECOND SESSION FEBRUARY 22, 1994 Printed for the use of the Committee on Banking, Finance and Urban Affairs Serial No. 103-118 U.S. GOVERNMENT PRINTING OFFICE 76-S94 CC WASHINGTON : 1994 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS HENRY B. GONZALEZ, Texas, Chairman STEPHEN L. NEAL, North Carolina JAMES A. LEACH, Iowa JOHN J. LAFALCE, New York BILL MCCOLLUM, Florida BRUCE F. VENTO, Minnesota MARGE ROUKEMA, New Jersey CHARLES E. SCHUMER, New York DOUG BEREUTER, Nebraska BARNEY FRANK, Massachusetts THOMAS J. RIDGE, Pennsylvania PAUL E. KANJORSKI, Pennsylvania TOBY ROTH, Wisconsin JOSEPH P. KENNEDY II, Massachusetts ALFRED A. (AL) McCANDLESS, California FLOYD H. FLAKE, New York RICHARD H. BAKER, Louisiana KWEISI MFUME, Maryland JIM NUSSLE, Iowa MAXINE WATERS, California CRAIG THOMAS, Wyoming LARRY LAROCCO, Idaho SAM JOHNSON, Texas BILL ORTON, Utah DEBORAH PRYCE, Ohio JIM BACCHUS, Florida JOHN LINDER, Georgia HERBERT C. KLEIN, New Jersey JOE KNOLLENBERG, Michigan CAROLYN B. MALONEY, New York RICK LAZIO, New York PETER DEUTSCH, Florida ROD GRAMS, Minnesota LUIS V. GUTIERREZ, Illinois SPENCER BACKUS, Alabama BOBBY L. RUSH, Illinois MIKE HUFFINGTON, California LUCILLE ROYBAL-ALLARD, California MICHAEL CASTLE, Delaware THOMAS M. BARRETT, Wisconsin PETER KING, New York ELIZABETH FURSE, Oregon NYDIA M. VELAZQUEZ, New York BERNARD SANDERS, Vermont ALBERT R. WYNN, Maryland CLEO FIELDS, Louisiana MELVIN WATT, North Carolina MAURICE HINCHEY, New York CALVIN M. DOOLEY, California RON KLINK, Pennsylvania ERIC FINGERHUT, Ohio SUBCOMMITTEE ON ECONOMIC GROWTH AND CREDIT FORMATION PAUL E. KANJORSKI, Pennsylvania, Chairman STEPHEN L. NEAL, North Carolina THOMAS J. RIDGE, Pennsylvania JOHN J. LAFALCE, New York BILL McCOLLUM, Florida BILL ORTON, Utah TOBY ROTH, Wisconsin HERBERT C. KLEIN, New Jersey JIM NUSSLE, Iowa NYDIA M. VELAZQUEZ, New York MARGE ROUKEMA, New Jersey CALVIN M. DOOLEY, California PETER KING, New York RON KLINK, Pennsylvania ERIC FINGERHUT, Ohio (ID Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONTENTS Page Hearing held on: February 22, 1994 1 Appendix: February 22, 1994 37 WITNESSES TUESDAY, FEBRUARY 22, 1994 Greenspan, Hon. Alan, Chairman, Federal Reserve System APPENDIX Prepared statements: Kanjorski, Hon. Paul E 38 Greenspan, Hon. Alan 42 ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD Greenspan, Hon. Alan: Board of Governors of the Federal Reserve System "Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978," February 22, 1994 58 Letter to Congressman John J. LaFalce, dated February 25, 1994, enclos- ing material recfuested at the hearing 89 National summary of the January 1994 Senior Loan Officer Opinion Survey on Bank Lending Practices 90 Credit Availability for Small Businesses and Small Farms 118 Letter to Congressman Stephen L. Neal, dated April 1, 1994, enclosing excerpts from Hon. Greenspan's statement before the Senate Commit- tee on Banking, Housing and Urban Affairs on March 2, 1994 158 (III) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE CONDUCT OF MONETARY POLICY TUESDAY, FEBRUARY 22, 1994 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON ECONOMIC GROWTH AND CREDIT FORMATION, COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS, Washington, DC. The subcommittee met, pursuant to notice, at 10:03 a.m., in room 2128, Rayburn House Office Building, Hon. Paul E. Kanjorski [chairman of the subcommittee] presiding. Present: Chairman Kanjorski, Representatives Neal, LaFalce, Klein, Dooley, Fingerhut, Roth, and Nussle. Also present: Representatives Bachus and Thomas. Chairman KANJORSKI. The subcommittee will come to order. The subcommittee meets today to receive the semiannual report of the Federal Reserve System on economic and monetary policy as mandated under the Full Employment Balanced Growth Act of 1978. I want to welcome Chairman Greenspan back before the sub- committee today. Since we last met to discuss monetary policy in July, there have been major developments in our Nation, the econ- omy, and the Federal Reserve and the Federal Open Market Committee. Much of the economic news of the last 6 months has been encour- aging: Inflation remains low. In January the Consumer Price Index was unchanged. In the fourth quarter of 1993 it increased at an annual rate of only 1.9 percent; and for the last 2 years it has increased only 3 percent per year, the lowest rate in many years. Labor costs, which are a major predictor of future inflation, re- main stable. Unemployment continues to decline. The Gross Domestic Product continues to grow. Gross Domestic Product grew 2.9 percent in 1993, and preliminary data suggests it grew between 5.9 percent and 7 percent in the fourth quarter of 1993. Until the Federal Reserve's action on February 4, interest rates remained low. At the end of 1993 interest rates for virtually all ma- turities hovered at or below the rates of 6 months or 1 year earlier. Bank and thrift profits are up, and the costs of S&L cleanup is dropping. And, finally, but no less importantly, the Federal deficit is being significantly reduced. Passage of President Clinton's Deficit Reduc- (l) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis tion bill has substantially reduced both current and future Federal deficits. While there has been progress on many fronts, areas of concern remain. Commercial industrial lending by banks remains stagnant. Even with orders and new home construction up, total commercial lend- ing by banks remains virtually unchanged. The California earthquake and unusual snow storms and cold weather in the East may depress first quarter economic activity. The Fed increased the Federal funds rate by one-fourth of 1 per- cent on February 4, triggering an increase in short-term interest rates and a 96-point drop in the Dow Jones industrial average. The Dow's drop was the largest 1-day drop in 2 years and was not tem- porary. More than 2 weeks later, the Dow is still 80 points, or 2 percent, below the level it closed on February 3. It is clear that stock and bond traders are very unsettled by re- cent developments. In the words of one news report, "It appears that, rather than reassuring traders and investors, the Federal Re- serve has managed to leave them with a worse case of jitters." What concerns me most, and what I hope Chairman Greenspan will explain today, is why did the Fed raise short-term interest rates when there has been no evidence that inflation is increasing? In addition to the fact that most recent CPI figures indicate that inflation is frozen in its tracks, inflation data is no worse today than it was when Chairman Greenspan last reported to us in July. In fact, actual inflation performance is at the absolute low end of the range Chairman Greenspan predicted last July. Why did the Federal Reserve increase the Federal funds rate when inflation is at or below the rate you predicted? How are eco- nomic conditions today different from last July? And if the inflation rate was not a problem in 1993, why is it suddenly a problem in 1994 when the basic rate remains unchanged? Like many Americans, I am concerned that the Federal Reserve's action may impede or even end our slow economic recovery. I know that Federal Reserve economists have models which predict the economic consequences of the Fed's February 4 action. I hope that Chairman Greenspan will describe for us today what the Fed's model projects and what he will—and that he will provide a de- tailed description of that model for the record. Since the Federal Reserve has tightened monetary policy in the absence of data suggesting that inflation is increasing, it is incum- bent on the Chairman to advise us what types of circumstances in the future would warrant similar action by the Fed. If inflation re- mains at the 3 percent level, can we expect the Fed to raise the Federal funds rate again or take other action to contract the money supply? Another area that concerns me is the Federal Open Market Com- mittee's continued inability to meet its projections for M2 and M3 growth. Leaving aside the arguments over whether the Federal Open Market Committee's targets for M2 and M3 are too high, too low or too broadly defined, it sounds to me that the FOMC consist- ently fails in any meaningful way to keep M2 and M3 in the ranges they predict. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis This inability to meaningfully meet broad targets that the Fed- eral Reserve itself selects does not inspire confidence in the Fed. Chairman Greenspan, why isn't the Fed doing a better job meet- ing its monetary targets? If, as Chairman Greenspan has reported to us on several occa- sions, the Fed has less confidence than in the past in the value of M2 and M3 as economic indicators, I hope he will also report to us today what steps the Fed is taking to identify or define an accept- able substitute. We need to know what measuring sticks the Fed is using so we can evaluate the performance of the economy as well as the performance of the Fed. Finally, the Federal Reserve has been very vocal in recent months in suggesting that it is imperative that the Fed continue in its role as a regulator of financial institutions and that banks should be able to choose not only whether they have a Federal or a State charter but also whether their primary Federal regulator should be the Federal Reserve or the administration's proposed Federal Banking Commission.