Alan Greenspan

Since I've become a central banker, I've learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.

I must say that before I attended FOMC meetings, I had a different view of what constitutes the nature of policy, because I used to read the directives and I couldn’t for the life of me figure out what in the world they were talking about. But now, given the few FOMC meetings I’ve attended, I’m realizing what it is.

In his half-yearly Humphrey-Hawkins report, Mr Greenspan confirmed that the Fed has eased its monetary policy - dealers believe that the target rate for Federal funds was cut by 1/4 of a point to 8 per cent last week - but said this was designed to increase credit availability and not simply to lower interest rates. 'Credit tightening is something we would not like to see happening,' Mr Greenspan told the committee.

As reported by Financial Times

Mr. Alan Greenspan, the Fed chairman, was at pains to stress in his congressional testimony on July 18th that this was a response to recent credit tightening, not to concern about a possible recession.

As reported by The Economist

Mr. Greenspan declined to characterize last week's action as easing, instead describing it as a move to offset credit tightening by banks.

As reported by The Washington Times

Now, what is interesting here is that there has been extensive literature on Operation Twist, and my recollection is that it's pretty mixed. No one has been able to confirm that there is a significant supply-side effect occurring in that particular context. On the other hand, there is also evidence, mainly in the recent period, that the Treasury rate is higher relative to private instruments than it otherwise would be, from which one assumes that there is a supply-side effect. So, I would say that there is no really strong analytical evidence that confirms this one way or the other. And what I find a little surprising is how strongly the market responded to Brady's initial [remarks on reducing Treasury long-bond issuance]; I think rates moved down 5 basis points at the long end of the market.

The 50-mile-an-hour headwinds which troubled greater growth several years ago have now come down to perhaps 20 or 25 miles an hour. 

As reported by Reuters News

There may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see signs that underlying forces are acting ultimately to reduce inflation pressures.

If I say something which you understand fully in this regard, I probably made a mistake.

I'm trying to think of a way to answer that question by putting more words into fewer ideas than I usually do.

For now, Mr. Greenspan told the National Italian American Foundation, the economy looks to be in balance -- a remark that suggested the Federal Reserve is in no rush to cut interest rates again.

  "For the moment, we have a relatively balanced set of forces," he said, adding, "It's difficult to read and I'm sure they're not going to stay that way terribly long."

As reported by Reuters

My own observation of business practices over the years suggests that the inability to pass cost increases through to higher prices provides a powerful incentive to firms to increase profit margins through innovation and greater efficiency, which boosts productivity and ultimately standards of living over time. Holding the line on inflation, thus, does not impose a speed limit on economic growth. On the contrary, it induces the private sector to focus more on efforts that yield faster long-term economic growth.

At different times in our history a varying set of simple indicators seemed successfully to summarize the state of monetary policy and its relationship to the economy. Thus, during the decades of the 1970s and 1980s, trends in money supply, first M1, then M2, were useful guides. We could convey the thrust of our policy with money supply targets, though we felt free to deviate from those targets for good reason. This presumably helped the Congress, after the fact, to monitor our contribution to the performance of the economy. I should add that during this period we maintained a fully detailed analysis of the economy, in part, to make sure that money supply was still emitting reliable signals about the state of the economy.

Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy. Thus, to keep the Congress informed on what we are doing, we have been required to explain the full complexity of the substance of our deliberations, and how we see economic relationships and evolving trends.

There are some indications that the money demand relationships to interest rates and income may be coming back on track. It is too soon to tell, and in any event we can not in the future expect to rely a great deal on money supply in making monetary policy. Still, if money growth is better behaved, it would be helpful in the conduct of policy and in our communications with the Congress and the public. In the absence of simple, summary indicators, we will continue our detailed evaluation of economic developments. As we seek price stability and maximum sustainable growth, the changing economic structures constantly present more analytic challenges.

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?

In other words, there is almost a 100 percent probability that we are overcompensating the average social security recipient for increases in the cost of living, and almost a 100 percent probability that we are causing the inflation-adjusted burden of the income tax system to decline more rapidly than I presume the Congress intends.  A major reason for this is that consumers respond to changes in relative prices by changing the composition of their actual marketbasket. At present, however, the marketbasket used in constructing the CPI changes only once every decade or so. Moreover, new goods and services deliver value to consumers even at the relatively elevated prices that often prevail early in their life cycles; currently, that value is not reflected in the CPI.

Significant innovations, such as the personal computer, the cellular telephone, and the heart bypass operation create value for consumers, even at their typically high initial prices; moreover, this value is even greater at the much lower prices that often prevail when new products are, in fact, introduced into the CPI. A true cost-of-living index would reflect this value and its implication for the true rate of growth of the cost of living. The CPI does not reflect it, and accordingly fails to capture a significant offset to price rises in other products.

I think we are getting to the point ... when we will have to move unless very clear evidence emerges that the expansion is easing significantly.  I don't mean evidence that GDP growth is moderating to 1-3/4 percent or whatever the forecast is.  The GDP is a nice number and it does have some relationship to the real world.  I'm not terribly certain what it is, though everyone tells me it does.

But the rate of pay increase still was markedly less than historical relationships with labor market conditions would have predicted. Atypical restraint on compensation increases has been evident for a few years now and appears to be mainly the consequence of greater worker insecurity. In 1991, at the bottom of the recession, a survey of workers at large firms by International Survey Research Corporation indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff.

Given the lags with which monetary policy affects the economy, however, we cannot rule out a situation in which a preemptive policy tightening may become appropriate before any sign of actual higher inflation becomes evident. If the FOMC were to implement such an action, it would be judging that the risks to the economic expansion of waiting longer had increased unduly and had begun to outweigh the advantages of waiting for uncertainties to be reduced by the accumulation of more information about economic trends.

History demonstrates that participants in financial markets are susceptible to waves of optimism, which can in turn foster a general process of asset-price inflation that can feed through into markets for goods and services. Excessive optimism sows the seeds of its own reversal in the form of imbalances that tend to grow over time. When unwarranted expectations ultimately are not realized, the unwinding of these financial excesses can act to amplify a downturn in economic activity, much as they can amplify the upswing.

Nonetheless, the trends in the core CPI and in broader price measures are likely to come under pressure from a continued tight labor market, whose influence on costs will be augmented by the scheduled increase in the minimum wage later in the year.

To be sure, the effects of the banking crisis, as well as the ongoing pace of consolidation within the industry, have reduced the total number of banking organizations by more than a third since 1980...The new firms come into existence often to replace old firms that were not willing or able to take on the risks associated with high-growth strategies. This replacement of stagnating firms with dynamic new firms--what the economist Joseph Schumpeter called the "perennial gale of creative destruction"--is at the heart of our robust, growth-oriented economy. It is this freedom to take on risk that characterizes our economy and, by extension, our banking system. Legislation and regulation of banks, in turn, generally should not aim to curtail the predilection of businesses and their banks to take on risk--so long as the general safety and soundness of our banking system is maintained.

Is price stability really what we are after or are we after financial stability? Even more generally, going back over time we have tended to argue, I think correctly, that the objective of monetary policy is to create maximum sustainable economic growth, and we have argued, again I think quite correctly, that price stability is a necessary condition to reach that goal. But price stability may indeed be a proxy for something else, which I suspect is financial stability...It is by no means clear exactly how we should measure price stability, given the prospect that it will become increasingly difficult over time to define what constitutes output and prices...When we move into the 21st century, what we will try to stabilize may in effect be the purchasing power of money, however that is measured...While I am not saying that these involve issues that we need to  resolve today, I suspect that we will start to confront them in 5 years or certainly within 10 years, and they may very well affect our projections going out to, say, the year 2006. I also suspect that by around the year 2006, this very tricky question may involve what we are endeavoring to stabilize and may be the focus of our policy actions. My own guess is that we are going to be dealing with asset prices, the question of nominal long-term interest rates, and probably the outlook for nominal GDP as well.

Many observers, including us, have been puzzled about how an economy, operating at high levels and drawing into employment increasingly less experienced workers, can still produce subdued and, by some measures even falling, inflation rates.

As I pointed out here last February, polls indicated that despite the significant fall in the unemployment rate, the proportion of workers in larger establishments fearful of being laid off rose from 25 percent in 1991 to 46 percent by 1996. It should not have been surprising then that strike activity in the 1990s has been lower than it has been in decades and that new labor union contracts have been longer and have given greater emphasis to job security. Nor should it have been unexpected that the number of workers voluntarily leaving their jobs to seek other employment has not risen in this period of tight labor markets.

To be sure, since last year, surveys have indicated that the proportion of workers fearful of layoff has stabilized and the number of voluntary job leavers has edged up. And, indeed, perhaps as a consequence, wage gains have accelerated some. But increases in the Employment Cost Index still trail behind what previous relationships to tight labor markets would have suggested, and a lingering sense of fear or uncertainty seems still to pervade the job market, though to a somewhat lesser extent.

As Taylor himself has pointed out, these types of formulations are at best "guideposts" to help central banks, not inflexible rules that eliminate discretion. One reason is that their formulation depends on the values of certain key variables--most crucially the equilibrium real federal funds rate and the production potential of the economy. In practice these have been obtained by observation of past macroeconomic behavior--either through informal inspection of the data, or more formally as embedded in models. In that sense, like all rules, as I noted earlier, they embody a forecast that the future will be like the past. Unfortunately, however, history is not an infallible guide to the future, and the levels of these two variables are currently under active debate.

The drive to stretch traditional underwriting criteria is intensifying. Recently, there has been a boom in so-called "subprime" lending, offering a variety of types of mortgage and other loans to borrowers who have less than good credit; such lending is priced for risk and the favorable pricing of securities backed by subprime loans have found acceptance with investors...

Improved access to credit for consumers, and especially these more recent developments, reflects a good news/bad news story. The good news is that market specialization, competition, and innovation have vastly expanded credit availability to virtually all income classes. Access to credit is essential to help families purchase homes, deal with emergencies, and obtain goods and services that have become staples of our daily lives. Home ownership is at an all-time high, and the number of home mortgage loans to low- and moderate-income families has risen at a rapid rate over the last 5 years. Credit cards and installment loans are available to the vast majority of households.

The bad news is that under certain circumstances this may not be entirely good news, either for consumers in general or for lower-income communities. Along with unprecedented credit access, some problems are occurring that should alert us all to potential dangers. While every potential problem doesn't result in disaster, it's important to recognize the risks and take protective steps.

Some loans to low- and moderate-income families with multiple underwriting flexibilities, layered subsidies, and high loan-to-value ratios have been showing unfavorable delinquency and default trends. Large mortgage lenders, secondary market agencies, and private mortgage insurers are conducting studies of their portfolios to determine how more-relaxed underwriting standards are affecting delinquencies and defaults. Although more study is required to determine which risk factors are most important in particular lending situations, the results of these portfolio studies bear watching.

Although legitimate lenders may be able to manage the risks associated with the overall expansion of lending, the same may not be true of many consumers, especially those with limited means to weather a storm or who have been encouraged to borrow improvidently. Should economic or personal difficulties occur, such as the temporary loss of a job, illness, or unexpected car or house repairs, those with limited incomes and without significant savings may easily find themselves in financial trouble.

Centrally planned economies are frozen in time.  They cannot readily accommodate innovation, new ideas, new products and altered specifications. In sharp contrast, capitalist market economies are driven by what Professor Joseph Schumpeter a number of decades ago called "creative destruction."

As we move closer to price stability, the necessity of measuring prices accurately has become an especial challenge. Biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, a debate has emerged over whether our economies are moving toward price deflation...

In thinking about the problems of price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level, on the other. The notion of what we mean by a general price level--or more relevantly, its change--is never unambiguously defined. ...

It is the measurement of individual prices, not the aggregation of those prices, that is so difficult conceptually. At first glance, observing and measuring prices might not appear especially daunting. After all, prices are at the center of virtually all economic transactions. But, in fact, the problem is extraordinarily complex. To be sure, the nominal value--in dollars or deutsche marks, for example--of most transactions is unambiguously exact and, at least in principle, is amenable to highly accurate estimation by our statistical agencies. ...

But when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult. These problems are becoming pervasive in modern economies as service prices, which are generally more difficult to measure, become more prominent in aggregate price measures. One does not have to look to the most advanced technology to recognize the difficulties that are faced. To take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago.

The Boskin commission, along with most other estimates of bias in the U.S. CPI, have taken a microstatistical approach, estimating separately the magnitude of each category of potential bias. Recent work by staff economists at the Federal Reserve Board has added corroborating evidence of price mismeasurement, using a macroeconomic approach that is essentially independent of the microstatistical exercises. Specifically, employing disaggregated data from the national income and product accounts, this research finds that the measured growth of real output and productivity in the service sector is implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Indeed, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. It is simply not credible that firms in these industries have been becoming less and less efficient for more than twenty years. Much more reasonable is the view that prices have been mismeasured and that the true quality-adjusted prices have been rising more slowly than the published price indexes. Properly measured, output and productivity trends in these service industries might be considerably stronger than suggested by the published data. Assuming, for example, no change in productivity for these industries would imply a price bias consistent with the Boskin commission findings.

But we must be concerned about becoming too complacent about evaluating repayment risks. All too often at this stage of the business cycle, the loans that banks extend later make up a disproportionate share of total nonperforming loans. In addition, quite possibly, twelve or eighteen months hence, some of the securities purchased on the market could be looked upon with some regret by investors.

The key question going forward is whether the restraint building from the turmoil in Asia will be sufficient to check inflationary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. The depth of the adjustment abroad will depend on the extent of weakness in the financial sectors of Asian economies and the speed with which structural inefficiencies in the financial and nonfinancial sectors of those economies are corrected.

Confident households, enjoying gains in income and wealth and benefitting from the reductions in intermediate- and longer-term interest rates to date, should continue to increase their spending. Firms should find financing available on relatively attractive terms to fund profitable opportunities to enhance efficiency by investing in new capital equipment. By itself, this strength in spending would seem to presage intensifying pressures in labor markets and on prices. Yet, the outlook for total spending on goods and services produced in the United States is less assured of late because of storm clouds massing over the Western Pacific and heading our way.

Should the situation abroad remain unsettled, these factors would probably continue to contribute to good price performance in the United States in the period ahead. But it is important to recognize that the damping influence of these factors on inflation is mostly temporary. At some point, the dollar will stop rising, foreign demand will begin to recover, and oil and other commodity prices will stop falling and could even back up some. Indeed, a brisk snap-back in foreign economic activity, should that occur, would add, at least temporarily, to price pressures in the United States.

In the current circumstances, we need to be aware that monetary policy tightening actions in the United States could have outsized effects on very sensitive financial markets in Asia, a development that could have substantial adverse repercussions on U.S. financial markets and, over time, on our own economy. But while we must take account of such foreign interactions, we must be careful that our responses ultimately are consistent with a monetary policy aimed at optimal performance of the U.S. economy.

Our goal as central bankers should be clear: We must pursue monetary conditions in which stable prices contribute to maximizing sustainable long-run growth. Such disciplined policies will offer the best underpinnings for identifying opportunities to channel growing knowledge, innovation, and capital investment into the creation of wealth that, in turn, will lift living standards as broadly as possible.

You may remember that in Jackson Hole a number of us got together and expressed the hope that we would be able to wait until today’s meeting to take whatever action was consistent with developments in our domestic economy. We did not want to be seen as rushed into action by events external to the United States and associated market forces. We felt that having to move earlier than today would clearly be seen evidence of a central bank that was scurrying to catch up. We have succeeded in staying on schedule, if I may use that term, and hopefully we will continue to do so.

Fifth, how much weight should concerns about moral hazard be given when designing mechanisms for governmental regulation of markets? By way of example, we should note that were banks required by the market, or their regulator, to hold 40 percent capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidely lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged financial institutions, has been a conscious choice of the American people since the 1930s. We do not have the choice of accepting the benefits of the current system without its costs.

Let me take a minute to explain this issue of the Humphrey-Hawkins reauthorization. Unbeknownst to 104 percent of the world, [laughter] a piece of legislation went through the Congress a few years ago which effectively sunset virtually every report required to be issued by various governmental agencies. One reason it happened that way was because the legislation said that all reports listed in some obscure source would be "included under this Act," and that list included absolutely everything. Nobody here caught it except Don Winn, who does that sort of thing for a living. It came as a great puzzlement to everybody. So it turns out that under law the reporting requirements in the Humphrey-Hawkins Act--not the Act itself but the reporting aspect of it, I gather, Don--will expire at year-end.

How is it possible, first, for hourly compensation growth to be flat or falling in an ever-tightening labor market? Let me begin by suggesting what does not explain it. You may recall that two or three years ago I was arguing that fear of job obsolescence was a major factor suppressing the nominal increase in compensation per hour. That factor clearly has not gotten worse; if anything, it has eased. The International Survey Research Company is the source of the data that I was quoting back in 1995 and 1996, as you may remember. When workers were asked whether they frequently were concerned about being laid off, 46 percent responded “yes” in 1995 and 1996 compared with figures in the teens or in the twenties throughout the 1980s. The 46 percent number is now down to 37 percent. Statistics on job leavers, another indicator I would use, likewise do not indicate any significant change. So an increase in uncertainty and the fear of job loss amongst workers cannot account for this extraordinary combination of low unemployment and no acceleration in hourly compensation.

But, after eight years of economic expansion, the economy appears stretched in a number of dimensions, implying considerable upside and downside risks to the economic outlook. The robust increase of production has been using up our nation's spare labor resources, suggesting that recent strong growth in spending cannot continue without a pickup in inflation unless labor productivity growth increases significantly further. Equity prices are high enough to raise questions about whether shares are overvalued. The debt of the household and business sectors has mounted, as has the external debt of the country as a whole, reflecting the deepening current account deficit. We remain vulnerable to rapidly changing conditions overseas, which, as we saw last summer, can be transmitted to U.S. markets quickly and traumatically.

Recent experience does seem to suggest that the economy has become less inflation prone than in the past, so that the chances of an inflationary breakout arguably are, at least for now, less than they would have been under similar conditions in earlier cycles.

The American economy, clearly more than most, is in the grip of what the eminent Harvard professor Joseph Schumpeter many years ago called "creative destruction," the continuous process by which emerging technologies push out the old. Standards of living rise when incomes created by the productive facilities employing older, increasingly obsolescent, technologies are marshaled to finance the newly produced capital assets that embody cutting-edge technologies.

Despite the ever shrinking pool of available labor, recent readings on year-over-year increases in labor compensation have held steady or, by some measures, even eased. This seems to have resulted in part from falling inflation, which has implied that relatively modest nominal wage gains have provided healthy increases in purchasing power. Also, a residual fear of job skill obsolescence, which has induced a preference for job security over wage gains, probably is still holding down wage levels.

For the period immediately ahead, inflationary pressures still seem well contained. To be sure, oil prices have nearly doubled and some other commodity prices have firmed, but large productivity gains have held unit cost increases to negligible levels. Pricing power is still generally reported to be virtually nonexistent. Moreover, the re-emergence of rising profit margins, after severe problems last fall, indicates cost pressures on prices remain small.

The failure of economic models based on history to anticipate the acceleration in productivity contributed to the recent persistent underprediction of economic growth and overprediction of inflation. Guiding policy by those models doubtless would have unduly inhibited what has been a remarkable run of economic prosperity.

If new data suggest it is likely that the pace of cost and price increases will be picking up, the Federal Reserve will have to act promptly and forcefully so as to preclude imbalances from arising that would only require a more disruptive adjustment later--one that could impair the expansion and bring into question whether the many gains already made can be sustained.

For monetary policy to foster maximum sustainable economic growth, it is useful to preempt forces of imbalance before they threaten economic stability. But this may not always be possible--the future at times can be too opaque to penetrate. When we can be preemptive, we should be, because modest preemptive actions can obviate more drastic actions at a later date that could destabilize the economy.

The already shrunken pool of job-seekers and considerable strength of aggregate demand suggest that the Federal Reserve will need to be especially alert to inflation risks. Should productivity fail to continue to accelerate and demand growth persist or strengthen, the economy could overheat. That would engender inflationary pressures and put the sustainability of this unprecedented period of remarkable growth in jeopardy.

I would be remiss in this overview of near-term economic developments if I did not relay the ongoing efforts of the Federal Reserve, other financial regulators, and the private sector to come to grips with the rollover of their computer systems at the start of the upcoming century. While I have been in this business too long to promise that 2000 will open on an entirely trouble-free note, the efforts to address potential problems in the banking and financial system have been exhaustive. For our part, the Federal Reserve System has now completed remediation and testing of all its mission-critical applications, including testing its securities and funds-transfer systems with our thousands of financial institution customers.

As we have said previously, while we do not believe consumers need to hold excess cash because we expect the full array of payment options to work, we have taken precautions to ensure that ample currency is available. Further, the Federal Reserve established a special liquidity facility at which sound depository institutions with good collateral can readily borrow at a slight penalty rate in the months surrounding the rollover. The availability of this back-stop funding should make depository institutions more willing to provide loans and lines of credit to other financial institutions and businesses and to meet any deposit withdrawals as this century closes.

[T]he central bank cannot effectively directly target stock or other asset prices. Should an asset bubble arise, or even if one is already in train, monetary policy properly calibrated can doubtless mitigate at least part of the impact on the economy. And, obviously, if we could find a way to prevent or deflate emerging bubbles, we would be better off. But identifying a bubble in the process of inflating may be among the most formidable challenges confronting a central bank, pitting its own assessment of fundamentals against the combined judgment of millions of investors.

...The danger is that in these circumstances, an unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to levels that are unsupportable even if risks in the future become relatively small. Such straying above fundamentals could create problems for our economy when the inevitable adjustment occurs. It is the job of economic policymakers to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.

I just wanted to make a very simple point that should be obvious but that I suspect is not--that there is a form of asymmetry in response to asset rises and asset declines but not if the rate of change is similar.  In other words, central banks do not respond to gradually declining asset prices.  We do not respond to gradually rising asset prices.  We do respond to sharply reduced asset prices, which will create a seizing up of liquidity in the system.  But you almost never have the type of 180-degree version of the seizing up on the up side. If, indeed, such an event occurred, I think we would respond to it.  The actuality is that it almost never occurs, so it appears as though we are asymmetric when, indeed, we are not. The markets are asymmetric; we are not.

Probability distributions estimated largely, or exclusively, over cycles that do not include periods of panic will underestimate the likelihood of extreme price movements because they fail to capture a secondary peak at the extreme negative tail that reflects the probability of occurrence of a panic. Furthermore, joint distributions estimated over periods that do not include panics will underestimate correlations between asset returns during panics. Under these circumstances, fear and disengagement on the part of investors holding net long positions often lead to simultaneous declines in the values of private obligations, as investors no longer realistically differentiate among degrees of risk and liquidity, and to increases in the values of riskless government securities. Consequently, the benefits of portfolio diversification will tend to be overestimated when the rare panic periods are not taken into account.

That equity premiums have generally declined during the past decade is not in dispute. What is at issue is how much of the decline reflects new, irreversible technologies, and what part is a consequence of a prolonged business expansion without a significant period of adjustment. The business expansion is, of course, reversible, whereas the technological advancements presumably are not.

Some analysts have offered an entirely different interpretation of the drop in equity premiums. They assert that a long history of a rate of return on equity persistently exceeding the riskless rate of interest is bound to induce a learning-curve response that will eventually close the gap. According to this argument, much, possibly all, of the decline in equity premiums over the past five years reflects this learning response. It would be a mistake to dismiss such notions out of hand. We have learned to no longer cower at an eclipse of the sun or to run for cover at the sight of a newfangled automobile.

But are we really observing in today's low equity premiums a permanent move up the learning curve in response to decades of data? Or are other factors at play?

This is a testament to the extraordinary efforts of thousands of far-sighted technicians and business planners who, confronted with an intangible and abstract problem, have been able to convince businesses and governments to marshal vast resources for remedial actions. This has been a truly impressive feat. If we avoid fear-induced, significant economic responses in the months ahead, the Century Date Change will hopefully replicate the saga of "the dog that did not bark."

I think we ought to set aside the consumer price index. The reason I say that is that the PCE deflator is far more usable for analyzing what is really going on. The owners' equivalent rent component in the CPI is 20 percent of the total index. Now, owners' equivalent rent is going to start to accelerate unless I misread how asset prices interact with consumer prices. The reason is that the ratio of owners' equivalent rent to the value of housing has been going down continuously, and the implicit rate of return that that is suggesting cannot credibly be expected to continue on a prolonged basis. So the little "pop" we saw in owners' equivalent rent in the most recent CPI is probably a harbinger of a slightly stronger number there.

The reason the PCE deflator is a better indicator in my view is that it incorporates a far more accurate estimate of the weight of housing in total consumer prices than the CPI. The latter is based upon a survey of consumer expenditures, which as we all know very dramatically underestimates the consumption of alcohol and tobacco, just to name a couple of its components. It also depends on people's recollections of what they spent, and we have much harder evidence of that in retail sales data, which is where the PCE deflator comes from. Why we should look at data based on a distorted sample when we have a universe whose data are more accurate is beyond me. The reasons that are given theoretically are that we want to measure urban or suburban consumer prices and that's not what gets picked up in the total. It would be so easy to make a simple adjustment in the aggregate data to cover only the urban component by using appropriate ratios if we want to do that. That is, we could use the base universe of what is consumed to give us our weights, but that is not what the CPI does. So if I had my way, the CPI would be abolished for all uses other than labor union contracts, Social Security benefits, and all the other uses that would create an undue amount of political noise if we tried to change them.  It's not statistical noise that I am talking about at the moment.  In sum, I think we have to be careful about any reading of inflation trends from the CPI.

With foreign economies strengthening and labor markets already tight, how the current wealth effect is finally contained will determine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process.

With the welcome recovery of foreign economies and with the leveling out of the dollar, these factors holding down demand and prices in the United States started to unwind. Strong growth in foreign economic activity is expected to continue this year, and, other things equal, the effect of the previous appreciation of the dollar should wane, augmenting demand on U.S. resources and lessening one source of downward pressure on our prices.

Competitive and open markets, the rule of law, fiscal discipline, and a culture of enterprise and entrepreneurship should continue to undergird rapid innovation and enhanced productivity that in turn should foster a sustained further rise in living standards. It would be imprudent, however, to presume that the business cycle has been purged from market economies so long as human expectations are subject to bouts of euphoria and disillusionment. We can only anticipate that we will readily take such diversions in stride and trust that beneficent fundamentals will provide the framework for continued economic progress well into the new millennium.

The marked move of capital from failing technologies to those at the cutting edge has quickened the pace at which job skills become obsolete. The completion of high school used to equip the average worker with sufficient skills to last a lifetime. That is no longer true, as evidenced by community colleges being inundated with workers returning to school to acquire new skills and on-the-job training being expanded and upgraded by a large proportion of American business.

{Central banks} have all chosen implicitly, if not in a more overt fashion, to set our capital and other reserve standards for banks to guard against outcomes that exclude those once or twice in a century crises that threaten the stability of our domestic and international financial systems.

I do not believe any central bank explicitly makes this calculation. But we have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes. There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks. At the same time, society on the whole should require that we set this bar very high. Hundred-year floods come only once every hundred years. Financial institutions should expect to look to the central bank only in extremely rare situations.

I am obviously referring to far more adverse outcomes than I was alluding to in my earlier remarks on the need for private risk-management systems to adjust for crises in their estimates of risk distributions. However, where that dividing line rests is an issue that has not yet been addressed by the international banking community. Clearly, to choose the distribution of risk-bearing between private finance and government is to choose the degree of moral hazard. I believe we recognize and accept it. Indeed, making that choice may be the essence of central banking.

 At a conference honoring Anna Schwartz

All the new financial products that have been created in recent years contribute economic value by unbundling risks and reallocating them in a highly calibrated manner. The rising share of finance in the business output of the United States and other countries is a measure of the economic value added by the ability of these new instruments and techniques to enhance the process of wealth creation.

...This redistribution of risk induces more investment in real assets, presumably engendering a higher standard of living. This occurs because financial intermediation facilitates diversification of risk and its redistribution among people with different attitudes toward risk. Any mechanism that shifts risk from those who choose to withdraw from it to those more willing to take it on increases investment without significantly raising the perceived degree of discomfort from risk borne by the public.

But, as I have noted previously, while time preference may appear to be relatively stable over history, perceptions of risk and uncertainty, which couple with time preference to create discount factors, obviously vary widely, as does liquidity preference, itself a function of uncertainty.

During a financial crisis, risk aversion rises dramatically, and deliberate trading strategies are replaced by rising fear-induced disengagement from market activity. It is the general human experience that when confronted with uncertainty, whether in financial markets or in any other aspect of life, disengagement is the normal protective reaction. In markets that are net long, the most general case, disengagement brings falling prices. In the more extreme manifestation, the inability or unwillingness to differentiate among degrees of risk drives trading strategies to seek ever-more-liquid instruments that presumably would permit investors immediately to reverse decisions at minimum cost should that be required. As a consequence, even among riskless assets, such as U.S. Treasury securities, liquidity premiums rise sharply as investors seek the heavily traded "on-the-run" issues--a behavior that was so evident in the fall of 1998.

Furthermore, joint distributions estimated over periods that do not include panics will underestimate correlations between asset returns during panics. Under these circumstances, fear and hence disengagement on the part of investors holding net long positions often lead to simultaneous declines in the values of private obligations, as investors no longer materially differentiate among degrees of risk and liquidity, and to increases in the values of riskless government securities. Consequently, the benefits of portfolio diversification will tend to be overestimated when the rare panic periods are not taken into account.

... At a minimum, risk managers need to stress test the assumptions underlying their models and consider portfolio dynamics under a variety of alternative scenarios. The outcome of this process may well be the recommendation to set aside somewhat higher contingency resources--reserves or capital--to cover the losses that will inevitably emerge from time to time when investors suffer a loss of confidence. These reserves will appear almost all the time to be a suboptimal use of capital, but so do fire insurance premiums--until there is a fire.

[A] decline in uncertainty resulting from a substantial increase in real-time information implies a reduction in what might be called "knowledge float"--the ability to maintain proprietary information and earn a rate of return from that information with no cost. As you know, financial intermediaries historically have been successful not only because they diversified to manage risk but also because they possessed information that others did not have. This asymmetry of information was capitalized at a fairly significant rate. But that advantage now is rapidly dissipating. We are going to real-time systems, not only with transactions but with knowledge as well.

It is certainly premature to make a definitive assessment of either the recent trends in household spending or what they mean. But it is clear that, for the time being at least, the increase in spending on consumer goods and houses has come down several notches, albeit from very high levels.

We cannot yet be sure that the slower expansion of domestic final demand, at a pace more in line with potential supply, will persist. Even if the growth rates of demand and potential supply move into better balance, there is still uncertainty about whether the current level of labor resource utilization can be maintained without generating increased cost and price pressures. As I have already noted, to date costs have been held in check by productivity gains. But at the same time, inflation has picked up--even the core measures that do not include energy prices directly. Higher rates of core inflation may mostly reflect the indirect effects of energy prices, but the Federal Reserve will need to be alert to the risks that high levels of resource utilization may put upward pressure on inflation.

As we learned from previous episodes, rising energy prices could engender risks to both inflation and economic activity. If accommodated by monetary policy, the jump in energy prices could spill over into general inflation and inflationary expectations, as was so evident in the 1970s. At the same time, the hike in the price of imported energy has acted, in effect, as a tax equivalent of roughly one percent of national income. Although there is as yet little evidence of the type of destabilizing inflationary pressures observed in the aftermath of previous oil price spikes or of exceptionally large restraint on consumer spending, Middle East tensions have heightened such risks.

That said, a growing dependence on wholesale funding is becoming an established trend for large and small institutions alike. As loan growth has greatly exceeded that of deposits, liquidity benchmark ratios such as loans-to-deposits have reached historic peaks.

Nonetheless, in the face of the energy price spike and the erosion of optimism in financial markets, consumer confidence, or sentiment, appears to be holding up reasonably well to date, though there have been some mixed signals of late...

...[I]n an economy that already has lost some momentum, one must remain alert to the possibility that greater caution and weakening asset values in financial markets could signal or precipitate an excessive softening in household and business spending.

[W]hat we're seeing in the implications for inflation expectations in the TIPS spreads is that irrespective of the price level from which we start, inflation expectations have clearly come down about 0.3 percentage point. How much of that truly represents an underlying decline in inflation expectations is an arguable issue because the TIPS implicit price deflator is fundamentally an arguable issue to begin with.

GOVERNOR KELLEY.   ...That ability to micro control is going to lead, I think, to more little saw tooth type variations in inventories rather than the large waves that we saw earlier. And I would submit that the likelihood is that the inventory recessions that we remember historically are a thing of the past.

CHAIRMAN GREENSPAN. One would almost assume that, on the grounds that in fully automated retail establishments the bar codes check out what is being sold and items are automatically reordered. So the long lag in bookkeeping, where inventories could build up before one knew it, no longer exists. Adjustments occur very quickly. If sales go down, boom! Suddenly there’s a big shift in the purchasing pattern. The question, however, is how prevalent is this totally automated system.

MS. FOX{of the FOMC secretariat}.  Thank you both for saying that. I think everybody already has said the right thing, which is to refer monotonously to this public statement--to use those words over and over.  They become a mantra and then everyone gets the same story all the time.

....

CHAIRMAN GREENSPAN. Let me make one comment about the mantra issue. Bob Rubin used the mantra about the strong dollar to a point where all of us who had to sit and listen invariably cringed more and more as the weeks and months went on. It turned out to be exactly the right policy approach because what happened was that by not varying the statement, an issue never arose about whether a comment involved a subtle change or not in the policy toward the dollar. It was boring, it was dull, it was repetitive, it was nonintellectual, and it worked like a charm. So I would suggest to you that your inclinations to be thoughtful, conceptual, and interesting be suppressed.

The hastening of the adjustment to emerging imbalances is generally beneficial. It means that those imbalances are not allowed to build until they require very large corrections. But the faster adjustment process does raise some warning flags. Although the newer technologies have clearly allowed firms to make more informed decisions, business managers throughout the economy also are likely responding to much of the same enhanced body of information. As a consequence, firms appear to be acting in far closer alignment with one another than in decades past. The result is not only a faster adjustment, but one that is potentially more synchronized, compressing changes into an even shorter time frame.

While technology has quickened production adjustments, human nature remains unaltered. We respond to a heightened pace of change and its associated uncertainty in the same way we always have. We withdraw from action, postpone decisions, and generally hunker down until a renewed, more comprehensible basis for acting emerges. In its extreme manifestation, many economic decisionmakers not only become risk averse but attempt to disengage from all risk...But even when decisionmakers are only somewhat more risk averse, a process of retrenchment can occur. Thus, although prospective long-term returns on new high-tech investment may change little, increased uncertainty can induce a higher discount of those returns and, hence, a reduced willingness to commit liquid resources to illiquid fixed investments.

Although the sources of long-term strength of our economy remain in place, excesses built up in 1999 and early 2000 have engendered a retrenchment that has yet to run its full course. This retrenchment has been prompt, in part because new technologies have enabled businesses to respond more rapidly to emerging excesses. Accordingly, to foster financial conditions conducive to the economy's realizing its long-term strengths, the Federal Reserve has quickened the pace of adjustment of its policy.

I indicated earlier that I would counsel against moving today, for if we do, in my judgment we will break whatever developing pattern for equity price stability may be currently emerging, at least temporarily. Were we to cut rates, there doubtless would be an initial sharp rise in stock prices as less sophisticated buyers enter the market.  However, a move today would remove the constructive ambiguity about monetary policy from the markets. As a consequence, after the initial price surge the more sophisticated traders could well be selling, with a distinct possibility that stock prices would fall markedly, essentially undercutting the nascent stabilization that may be in the process of forming. We would have used up some significant monetary policy ammunition without realizing any short-term stabilizing benefits. Long term, of course, it doesn’t matter much unless the failure of achieving short-term stability sets us on a path with long-term consequences.

To repeat, we have a credible intermeeting window over the next 10 days. Let us employ the time to monitor markets, but especially to look for evidence of emerging stability in capital goods orders. I might say in closing that I know all of you in the Reserve Banks will be working on Beige Book commentary shortly. And I would request that you make a special endeavor to see if you can gain some insights on what is going on in capital spending within your Districts and what the prospects are for a stabilization and hopefully an upturn.

Movements in asset prices most often reflect changing underlying fundamentals. Forecasts that an increase in an asset price is a bubble would likely run counter to the conventional wisdom of a large segment of the investment community, or asset prices would not be so high.

Banks that have not understood the subprime market have had significant difficulties. To ensure that banks entering this business properly understand these risks, the agencies have encouraged banks to adopt strong risk management systems tailored to the challenges posed by these loan segments. Beyond poor risk management, there have also been instances in which certain lenders have charged fees and structured loans designed not to protect against risk, but rather to deceptively extract a borrower's net worth. Such predatory lending practices, though rare, are a cause for concern and examiners are watchful for programs that would violate the law in this regard.

From staff appendix to the Chairman's testimony

We do know that as the rate of growth has slowed down, unit labor costs have gone up as they invariably do in such a period. But we've seen no evidence that those costs are being passed through into final prices in any material way. Similarly, we see a fairly extraordinary increase in energy costs. And here again, separating corporations into non-energy, non-financial, we've tried to trace the movement of energy costs into prices, and we've found that almost all does not going to final goods prices, but is squeezing profit margins, which is the same thing as unit labor costs.

From Q&A session, as reported by Bloomberg News

As our economy expanded, business and household financing needs increased and projections of future outcomes turned increasingly optimistic. In such a context, the loan officers whose experience counsels that the vast majority of bad loans are made in the latter stages of a business expansion, have had the choice of (1) restraining lending, and presumably losing market share or (2) hoping for repayment of new loans before conditions turn adverse. Given the limited ability to foresee turning points, the competitive pressures led, as has usually been the case, to a deterioration of underlying loan quality as the peak in the economy approached.

The period of sub-par economic performance, however, is not yet over, and we are not free of the risk that economic weakness will be greater than currently anticipated, and require further policy response. That weakness could arise from softer demand abroad as well as from domestic developments. But we need also to be aware that our front-loaded policy actions this year coupled with the tax cuts under way should be increasingly affecting economic activity as the year progresses.

Some moderation in the pace of spending was necessary and expected if the economy was to progress along a more balanced growth path..The adjustment occurred much faster than most businesses anticipated, with the slowdown likely intensified by the rise in the cost of energy that until quite recently had drained businesses and households of purchasing power.

Most long-term interest rates, however, have barely budged despite the appreciable reductions in short-term rates since the beginning of the year. This has led many commentators to ask whether inflation expectations have risen. Surely, one reason long-term rates have held up is changed expectations in the Treasury market, as forecasts of the unified budget surplus were revised down, indicating that the supplies of outstanding marketable Treasury debt are unlikely to shrink as rapidly as previously anticipated. Beyond that, it is difficult to judge whether long-term rates have held up because of firming inflation expectations or a belief that economic growth is likely to strengthen, spurring a rise in real long-term rates.

The uncertainties surrounding the current economic situation are considerable, and, until we see more concrete evidence that the adjustments of inventories and capital spending are well along, the risks would seem to remain mostly tilted toward weakness in the economy. Still, the FOMC opted for a smaller policy move at our last meeting because we recognized that the effects of policy actions are felt with a lag, and, with our cumulative 2-3/4 percentage points of easing this year, we have moved a considerable distance in the direction of monetary stimulus. Certainly, should conditions warrant, we may need to ease further, but we must not lose sight of the prerequisite of longer-run price stability for realizing the economy's full growth potential over time.

Eventually, the high-tech correction will abate, and these industries will reestablish themselves as a solidly expanding, though less frenetic, part of our economy. When they do, growth in that sector presumably will not return to the outsized 50 percent annual growth rates of last year, but rather to a more sustainable pace.

Nobody has the capacity to fathom fully how the effects of the tragedy of September 11 will play out in our economy. But in the weeks ahead, as the initial shock continues to wear off, we should be able to better gauge how the ongoing dynamics of these events are shaping the immediate economic outlook.

For the longer term, prospects for ongoing rapid technological advance and associated faster productivity growth are scarcely diminished. Those prospects, born of the ingenuity of our people and the strength of our system, fortify a promising future for our free nation.

Fear of terrorist acts, however, has the potential to induce disengagement from activities, both domestic and cross border. If we allow terrorism to undermine our freedom of action, we could reverse at least part of the palpable gains achieved by postwar globalization. It is incumbent upon us not to allow that to happen.

We are left with the question of how the international role of the euro will unfold. The attraction of investing in dollar-denominated assets depends upon relative rates of return. To the extent that the capital flows we have observed from Europe to the United States are a critical piece of the story, the future will be determined, at least in part, by the success in Europe of matching the expected rates of return on U.S. assets. But market pressures toward portfolio diversification are clearly also going to play a major role in the future relative positions of the dollar and the euro.

Before we go into a discussion on that, let me note that I have recently had conversations with the Secretary of the Treasury in which he reiterated the Treasury’s position with regard to foreign currency intervention. It is about as close to ours as you can get. The general view at Treasury is that the history of intervention shows clearly that it has not been effective. And except under extraordinary circumstances, which would be less economic and perhaps more political in an international sense, there is no inclination on their part to do any intervention.

Reports from businesses around the country suggest that the exploitation of available networking and other information technologies was only partially completed when the cyclical retrenchment of the past year began. Many business managers are still of the view, according to a recent survey of purchasing managers, that less than half of currently available new, and presumably profitable, supply-chain technologies have been put into use.

Despite the disruptions engendered by the terrorist attacks of September 11, the typical dynamics of the business cycle have re-emerged and are prompting a firming in economic activity. The recent evidence increasingly suggests that an economic expansion is already well under way, although an array of influences unique to this business cycle seems likely to moderate its speed.

When industrial product was the centerpiece of the economy during the first two-thirds of the twentieth century, our overall price indexes served us well. Pricing a pound of electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel sheet, or a linear yard of cotton broad-woven fabrics, could be reasonably compared over a period of years. But in our new century, the simple notion of price has turned decidedly ambiguous. What is the price of a unit of software or a legal opinion? How does one evaluate change in the price of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient has changed so radically? Indeed, how will we measure inflation, and the associated financial and real implications, in the twenty-first century when our data—using current techniques—could become increasingly less adequate for tracing price trends over time?

For all these conceptual uncertainties and measurement problems, a specific numerical inflation target would represent an unhelpful and false precision. Rather, price stability is best thought of as an environment in which inflation is so low and stable over time that it does not materially enter into the decisions of households and firms.

Manifestations of lax corporate governance, in my judgment, are largely a symptom of a failed CEO.
...
If a CEO countenances managing reported earnings, that attitude will drive the entire accounting regime of the firm. If he or she instead insists on an objective representation of a company's business dealings, that standard will govern recordkeeping and due diligence. It has been my experience on numerous corporate boards that CEOs who insist that their auditors render objective accounts get them. And CEOs who discourage corner-cutting by subordinates are rarely exposed to it.

I recognize that I am saying that the state of corporate governance to a very large extent reflects the character of the CEO, and that this is a very difficult issue to address. Although we may not be able to change the character of corporate officers, we can change behavior through incentives and penalties. That, in my judgment, could dramatically improve the state of corporate governance.

Considerable uncertainties--about the progress of the adjustment of capital spending and the rebound in profitability, about the potential for additional revelations of corporate malfeasance, and about possible risks from global political events and terrorism--still confront us.

If equity premiums were redefined to include both the unrealistic part of profit projections and the unsustainably low segment of discount factors, and if we had associated measures of these concepts, we could employ this measure to infer emerging bubbles. That is, if we could substitute realistic projections of earnings and dividend growth, perhaps based on structural productivity growth and the behavior of the payout ratio, the residual equity premium might afford some evidence of a developing bubble. Of course, if the central bank had access to this information, so would private agents, rendering the development of bubbles highly unlikely.

From mid-1999 through May 2000, the federal funds rate was raised 150 basis points. However, equity price increases were largely undeterred during that period despite what now, in retrospect, was the exhausted tail of a bull market. Such data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion. Instead, we noted in the previously cited mid-1999 congressional testimony the need to focus on policies "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."

We at the Federal Reserve considered a number of issues related to asset bubbles--that is, surges in prices of assets to unsustainable levels. As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact--that is, when its bursting confirmed its existence.

Derivatives, by construction, are highly leveraged, a condition that is both a large benefit and an Achilles’ heel. The benefits of risk dispersion are accomplished without holding massive positions in the underlying financial instruments. Yet, too often in our financially checkered past, the access to such leverage has induced speculative excesses that have led to financial grief. We are scarcely likely to reform the underlying human traits that lead to excess, but we do need to buttress our risk management capabilities as best we can to delimit such detours from the path of balanced growth.

More fundamentally, we should recognize that if we choose to enjoy the advantages of a system of leveraged financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. Leveraging always carries with it the remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks have, of necessity, been drawn into becoming lenders of last resort.

Most standard macroeconomic models fitted to the experience of recent decades imply that a distortion in valuation ratios induced by a bubble can be offset by adopting a sufficiently restrictive monetary policy...  But that conclusion is a consequence of the model's construction. It is not based on evidence drawn from history. In fact, history indicates that bubbles tend to deflate not gradually and linearly but suddenly, unpredictably, and often violently. In addition, the degree of monetary tightening that would be required to contain or offset a bubble of any substantial dimension appears to be so great as to risk an unacceptable amount of collateral damage to the wider economy...

...Among our realistically limited alternatives, dealing aggressively with the aftermath of a bubble appears the most likely to avert long-term damage to the economy. 

If the bursting of an asset bubble creates economic dislocation, then preventing bubbles might seem an attractive goal. But whether incipient bubbles can be detected in real time and whether, once detected, they can be defused without inadvertently precipitating still greater adverse consequences for the economy remain in doubt.

It may be useful, as a first step, to consider both the economic circumstances most likely to impede the development of bubbles and the circumstances most conducive to their formation. Destabilizing macroeconomic policies and poor economic performance are not likely to provide fertile ground for the optimism that usually accompanies surging asset prices.

Ironically, low inflation, economic stability, and low risk premiums may provide tinder for asset price speculation that could be sparked should technological innovations open up new opportunities for profitable investment. ...

The conditions of extended low inflation and low risk were combined with breakthrough technologies to produce the bubble of recent years. But do such conditions always produce a bubble? It seems improbable that a surge in innovation in the near future would generate a new bubble of substantial proportions. Investors are likely to be sensitive to the need for asset prices to be backed ultimately by an ongoing stream of earnings. Hence, a further necessary condition for the emergence of a bubble is the passage of sufficient time to erode the traumatic memories of earlier post-bubble experiences.

Although the U.S. economy has largely escaped any deflation since World War II, there are some well-founded reasons to presume that deflation is more of a threat to economic growth than is inflation. For one, the lower bound on nominal interest rates at zero threatens ever-rising real rates if deflation intensifies. A related consequence is that even if debtors are able to refinance loans at zero nominal interest rates, they may still face high and rising real rates that cause their balance sheets to deteriorate.

Another concern about deflation resides in labor markets. Some studies have suggested that nominal wages do not easily adjust downward. If lower price inflation is accompanied by lower average wage inflation, then the prevalence of nominal wages being constrained from falling could increase as price inflation moves toward or below zero. In these circumstances, the effective clearing of labor markets would be inhibited, with the consequence being higher rates of unemployment.

Taken together, these considerations suggest that deflation could well be more damaging than inflation to economic growth. While this asymmetry should not be overlooked, several factors limit its significance. In particular, more rapid advances in productivity can make this asymmetry less severe. Fast growth of productivity, by buoying expectations of future advances of wages and earnings and thus aggregate demand, enables real interest rates to be higher than would otherwise be the case without restricting economic growth. Moreover, to the extent that more-rapid growth of productivity shows through to faster gains in nominal wages, there will be fewer instances in which nominal wages will be pressured to fall.

One also should not overstate the difficulties posed for monetary policy by the zero bound on interest rates and nominal wage inflexibility even in the absence of faster productivity growth. The expansion of the monetary base can proceed even if overnight rates are driven to their zero lower bound. The Federal Reserve has authority to purchase Treasury securities of any maturity and indeed already purchases such securities as part of its procedures to keep the overnight rate at its desired level. This authority could be used to lower interest rates at longer maturities. Such actions have precedent: Between 1942 and 1951, the Federal Reserve put a ceiling on longer-term Treasury yields at 2-1/2 percent. With respect to potential difficulties in labor markets, results from research remain ambiguous on the extent and persistence of downward rigidity in nominal compensation.

Clearly, it would be desirable to avoid deflation. But if deflation were to develop, options for an aggressive monetary policy response are available.

The limited evidence since the November easing has supported our view that the U.S. economy has been working its way through a soft patch. And the patch has certainly been soft. The labor market has remained subdued, as businesses apparently have been reluctant to add to payrolls. The manufacturing sector remains especially damped, and nonresidential construction has trended lower. By all reports, state and local governments continue to struggle with deterioration in their fiscal conditions. Oil prices have recently risen and, not least, the economies of most of our major trading partners have shown little vigor.

Some argue that bubbles can be prevented or defused by financial regulatory initiatives. It is observed that asset bubbles have often been associated with rapid credit expansion, and hence it is claimed that restraining credit growth could quash nascent bubbles. A bubble could conceivably be defused by restrictive credit regulations that stifle economic growth. It is by no means clear, however, that such a regime would be more conducive to wealth creation over time than our current regulatory system. Also of relevance, in a vibrant financial system, such as exists in the United States, there will always be many avenues available to investors for financing a bubble. Furthermore, many analysts maintain that stocks are priced at the margin by institutions with little or no financing needs.

Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.

But the adverse consequences of excessive money growth for financial stability and economic performance provoked a backlash. Central banks were finally pressed to rein in overissuance of money even at the cost of considerable temporary economic disruption.

A budget framework along the lines of the one that provided significant and effective discipline in the past needs, in my judgment, to be reinstated without delay. I am concerned that, should the enforcement mechanisms governing the budget process not be restored, the resulting lack of clear direction and constructive goals would allow the inbuilt political bias in favor of growing budget deficits to again become entrenched.

This is not a technical matter, nor a simple matter of fairness that affects only a small number of grandfathered companies.  There is no restriction that prevents grandfathered states from chartering new ILCs for corporations seeking banks, as they have continued to do since 1987.  Moreover, competitive pressures could encourage existing bank holding companies seeking commercial affiliations or to avoid prudential supervision to relocate their insured banks to grandfathered states that charter ILCs to take advantage of the ILC loophole.  Consequently, taking this step would alter the structure of banking in the United States and be contrary to two important national policies that Congress reaffirmed recently in the GLB Act: one prohibiting the mixing of banking and commerce, and the other establishing a federal prudential framework to assue that companies that own insured banks operate in a safe and sound manner.

The intensification of geopolitical risks makes discerning the economic path ahead especially difficult. If these uncertainties diminish considerably in the near term, we should be able to tell far better whether we are dealing with a business sector and an economy poised to grow more rapidly--our more probable expectation--or one that is still laboring under persisting strains and imbalances that have been misidentified as transitory.

Recent studies suggest that differing disclosure and corporate governance standards preserve home bias. Researchers have shown that, in most countries, holding a controlling interest in a firm yields significant benefits that do not accrue to minority shareholders, and that a substantial portion of home bias in those countries can be attributed to local holdings of closely held firms.7 Additionally, staff at the Federal Reserve Board and International Monetary Fund have shown that, for firms from emerging-market economies that meet U.S. standards for disclosure and protection of minority shareholder rights, U.S. residents hold the theoretically predicted proportion of company shares in their portfolios.8 Thus, it appears that an improvement in global reporting and corporate governance standards could significantly reduce global home bias.

A clear benefit of financial globalization is that, to the extent that it reduces home bias, savings will be better directed to the most promising investments in the world, increasing global economic growth and prosperity. However, so long as risk aversion exists and trust is enhanced by local familiarity, we cannot expect that home bias will fully dissipate.

Of the various savings concepts, it is national saving that is most important for determining our future national standard of living.  Thus, it is critical that any effort to raise personal saving be judged in terms of its efficacy in raising national saving.

I believe that our current tax system is overly complex, burdensome, and inefficient.  It creates larger disincentives for work, saving, and investment than need be to raise the revenue required to finance government operations.  Moreover, the complexity leads to substantial commitment of resources on the part of the private sector for the sole purpose of complying with the tax code.  The nation would be well served by moving to a more straightforward structure that would engender greater economic flexibility and efficiency and lower the compliance burden.  A successful round of tax reform, particularly with regard to the taxation of capital income, could significantly improve the working of our economy.

I support the elimination of double taxation of dividends because it is good long-term policy that reduces distortions and adds to the flexibility of the economy in responding to shocks that otherwise might result in recession.  While I do not suport elimination of double taxation because of short-term stimulus, it likely would provide some near-term boost to the economy.  This is primarily because the plan would likely boost the level of stock prices that, in turn, would generate a positive wealth effect; there also could be some small income effects owing to short-run multiplier effects on aggregate demand.

Some may see government regulation of OTC derivatives dealers as essential to ensuring efficacious risk management. This view presumes that government regulation can address the challenges these types of markets engender and that it can do so without lessening the effectiveness of market discipline supplied by counterparties. Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties. In essence, prudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities. Such private prudential regulation can be impaired--indeed, even displaced--if some counterparties assume that government regulations obviate private prudence.

We regulators are often perceived as constraining excessive risk-taking more effectively than is demonstrably possible in practice. Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation.

We need a much wider fire break, in logging and forestry terms, because we know so little about [deflation]. So we lean over backwards to make certain that we contain deflationary forces.

The FOMC stands prepared to maintain a highly accommodative stance of policy for as long as needed to promote satisfactory economic performance. In the judgment of the Committee, policy accommodation aimed at raising the growth of output, boosting the utilization of resources, and warding off unwelcome disinflation can be maintained for a considerable period without ultimately stoking inflationary pressures.

The FOMC stands ready to maintain a highly accommodative stance of policy for as long as it takes to achieve a return to satisfactory economic performance.

Allowing for known measurement biases, these inflation indexes have been in a neighborhood that corresponds to effective price stability--a long-held goal assigned to the Federal Reserve by the Congress. But we can pause at this achievement only for a moment, mindful that we face new challenges in maintaining price stability, specifically to prevent inflation from falling too low. This is one reason the FOMC has adopted a quite accommodative stance of policy. A very low inflation rate increases the risk that an adverse shock to the economy would be more difficult to counter effectively. Indeed, there is an especially pernicious, albeit remote, scenario in which inflation turns negative against a backdrop of weak aggregate demand, engendering a corrosive deflationary spiral.

Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape.

And you {Jean-Claude Trichet} have been an extraordinary force for strength amongst those who have argued essentially against our finance ministers, and you must remember that when we have - and I assume Ben now becomes aware of this at every peculiarity - when you go into a G-7 meeting, you would think that it would be France against the United States and Britain against Germany. No. It's the finance ministers against the central bankers.

Central bankers take the right view, obviously, and the finance ministers are in perpetual catch-up. But the reason, incidentally, is the fact that finance ministers can't seem to hold their jobs very long. They don't have the chance to learn very much, whereas we central bankers learn from each other.

At a dinner honoring Jean-Claude Trichet, as reported in a Bloomberg News transcript

In recent years, competition from abroad has risen to a point at which our lowest skilled workers are being priced out of the global labor market. This diminishing of opportunities for such workers is why retraining for new job skills that meet the evolving opportunities created by our economy has become so urgent in this country. A major source of such retraining has been our community colleges, which have proliferated over the past two decades.

Though economic activity hesitated in early 1995, it soon steadied, confirming the achievement of a historically elusive soft landing. The success of that period set up two powerful expectations that were to influence developments over the subsequent decade. One was the expectation that inflation could be controlled over the business cycle and that price stability was an achievable objective. The second expectation, in part a consequence of more stable inflation, was that overall economic volatility had been reduced and would likely remain lower than it had previously.

As yet unresolved is whether the mere announcement that a central bank intends to engage in inflation targeting increases the credibility of the central bank's inclination to maintain price stability and, hence, assists in the anchoring of inflation expectations. The Bank of England's recent experiences may be encouraging in this regard. But, presumably, we will not know for sure the significance of formal inflation targeting as a tool until the world economy is subjected to shocks of sufficient magnitude to assess the differential performance of those who do not employ formally announced inflation targets. To date, inflation has fallen for formal targeters, but it has fallen for others as well.

The economic world in which we function is best described by a structure whose parameters are continuously changing. The channels of monetary policy, consequently, are changing in tandem. An ongoing challenge for the Federal Reserve--indeed, for any central bank--is to operate in a way that does not depend on a fixed economic structure based on historically average coefficients...

Moreover, we recognize that the simple linear functions underlying most of our econometric structures may not hold outside the range in which adequate economic observations exist. For example, it is difficult to have much confidence in the ability of models fit to the data of the moderate inflations of the postwar period to accurately predict what the behavior of the economy would be in an environment of aggregate price deflation.

However, the {early 1990s} recovery also was more modest than usual, in large measure because of the notable financial "headwinds" that confronted businesses. Those headwinds were primarily generated by the constriction of credit in response to major losses at banks, associated with real-estate and foreign lending, coupled with a crisis in the savings and loan industry that had its origins in a serious maturity mismatch as interest rates rose. With their access to managed funds threatened and the quality of their loan portfolio--and hence their capital--uncertain, these depositories were most reluctant to lend....

By early 1994, as the headwinds of financial restraint abated, it became clear that underlying price pressures were again building.

We were motivated, in part, by the view that the evident structural economic changes rendered suspect, at best, the prevailing notion in the early 1990s of an elevated and reasonably stable NAIRU. Those views were reinforced as inflation continued to fall in the context of a declining unemployment rate that by 2000 had dipped below 4 percent in the United States for the first time in three decades.

Perhaps the greatest irony of the past decade is that the gradually unfolding success against inflation may well have contributed to the stock price bubble of the latter part of the 1990s.  Looking back on those years, it is evident that technology-driven increases in productivity growth imparted significant upward momentum to expectations of earnings growth and, accordingly, to stock prices.  At the same time, an environment of increasing macroeconomic stability reduced perceptions of risk. In any event, Fed policymakers were confronted with forces that none of us had previously encountered. Aside from the then-recent experience of Japan, only remote historical episodes gave us clues to the appropriate stance for policy under such conditions. The sharp rise in stock prices and their subsequent fall were, thus, an especial challenge to the Federal Reserve.

It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization--the very outcomes we would be seeking to avoid.

In fact, our experience over the past two decades suggests that a moderate monetary tightening that deflates stock prices without substantial effect on economic activity has often been associated with subsequent increases in the level of stock prices.6 Arguably, markets that pass that type of stress test are presumed particularly resilient. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion.

Some have asserted that the Federal Reserve can deflate a stock-price bubble--rather painlessly--by boosting margin requirements. The evidence suggests otherwise. First, the amount of margin debt is small, having never amounted to more than about 1-3/4 percent of the market value of equities; moreover, even this figure overstates the amount of margin debt used to purchase stock, as such debt also finances short sales of equity and transactions in non-equity securities. Second, investors need not rely on margin debt to take a leveraged position in equities. They can borrow from other sources to buy stock. Or, they can purchase options, which will affect stock prices given the linkages across markets.

Thus, not surprisingly, the preponderance of research suggests that changes in margins are not an effective tool for reducing stock market volatility. It is possible that margin requirements inhibit very small investors whose access to other forms of credit is limited. If so, the only effect of increasing margin requirements is to price out of the market the very small investor without addressing the broader issue of stock price bubbles.

If a change in margin requirements were taken by investors as a signal that the central bank would soon tighten monetary policy enough to burst a bubble, then there might be the appearance of a causal effect. But it is the prospect of monetary policy action, not the margin increase, that should be viewed as the trigger. In a similar manner, history tells us that "jawboning" asset markets will be ineffective unless backed by action.

Under the rubric of risk management are a number of specific issues that we at the Fed had to address over the past decade and a half and that will likely resurface to confront future monetary policymakers.

Most prominent is the appropriate role of asset prices in policy. In addition to the narrower issue of product price stability, asset prices will remain high on the research agenda of central banks for years to come. As the ratios of gross liabilities and gross assets to GDP continue to rise, owing to expanding domestic and international financial intermediation, the visibility of asset prices relative to product prices will itself rise. There is little dispute that the prices of stocks, bonds, homes, real estate, and exchange rates affect GDP. But most central banks have chosen, at least to date, not to view asset prices as targets of policy, but as economic variables to be considered through the prism of the policy's ultimate objective.

As I indicated earlier, policy has worked off a risk-management paradigm in which the risk and cost-benefit analyses depend on forecasts of probabilities developed from large macromodels, numerous submodels, and judgments based on less mathematically precise regimens. Such judgments, by their nature, are based on bits and pieces of history that cannot formally be associated with an analysis of variance.

Should globalization be allowed to proceed and thereby create an ever more flexible international financial system, history suggests that current imbalances will be defused with little disruption. And if other currencies, such as the euro, emerge to share the dollar's role as a global reserve currency, that process, too, is likely to be benign.

I have stressed the importance of redressing the apparent imbalances between the supply and demand for labor across the spectrum of skills. Those imbalances have the potential to hamper the adjustment flexibility of our economy overall. But these growing imbalances are also aggravating the inequality of incomes in this country. The single central action necessary to ameliorate these imbalances and their accompanying consequences for income inequality is to boost the skills, and thus earning potential, of those workers lower on the skill ladder.

The greatest current threat to that flexibility is protectionism, a danger that has become increasingly visible on today's landscape. Over the years, protected interests have often endeavored to stop in its tracks the process of unsettling economic change. Pitted against the powerful forces of market competition, virtually all such efforts have failed. The costs of any new protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy. Consequently, creeping protectionism must be thwarted and reversed.

To be sure, the Federal Open Market Committee's current judgment is that its accommodative posture is appropriate to foster sustainable expansion of economic activity. But the evidence indicates clearly that such a policy stance will not be compatible indefinitely with price stability and sustainable growth; the real federal funds rate will eventually need to rise toward a more neutral level. However, with inflation very low and substantial slack in the economy, the Federal Reserve can be patient in removing its current policy accommodation.

The profitability of the business sector was again propelled by stunning increases in productivity...The vigorous advance in efficiency represents a notable extension of the pickup that started around the mid-1990s. Apparently, businesses are still reaping the benefits of the marked acceleration in technology. The strong gains in productivity, however, have obviated robust increases in business payrolls. To date, the expansion of employment has significantly lagged increases in output...In all likelihood, employment will begin to grow more quickly before long as output continues to expand.

In retrospect, last year appears to have marked a transition from an extended period of subpar economic performance to one of more vigorous expansion.

The imbalance in the federal budgetary situation, unless addressed soon, will pose serious longer-term fiscal difficulties...The longer we wait before addressing these imbalances, the more wrenching the fiscal adjustment ultimately will be.

One effective tool that we have developed to facilitate the transition to a new job or profession has been our community colleges. These two-year institutions have been in the forefront of teaching the types of skills that build on workers' previous experiences to create new job skills. Currently almost one in three of their enrollees are aged thirty or older, a statistic that suggests that these individuals have previous job experience.

The unease [generated by Fannie and Freddie] relates mainly to the scale and growth of the mortgage-related asset portfolios held on their balance sheets. That growth has been facilitated, as least in part, by a perceived special advantage of these institutions that keeps normal market restraints from being fully effective.

Most of the concerns associated with systemic risks flow from the size of the balance sheets that these GSEs maintain.

Congress needs to create a GSE regulator with authority on a par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear process sanctioned by the Congress for placing a GSE in receivership...[Furthermore,] GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and nonmortgages, that they hold. Fannie and Freddie should be encouraged to continue to expand mortgage securitization, keeping mortgage markets deep and liquid while limiting the size of their portfolios. 

[Fannie and Freddie] are important organizations that, because of their implicit subsidy, are expanding at a pace beyond that consistent with systematic safety. They have made, and should--with less reliance on subsidies--continue to make, major contributions to the financial system of the United States.

I should emphasize that Fannie and Freddie, to date, appear to have managed [their] risks well and that we see nothing on the immediate horizon that is likely to create a systemic problem. But to fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later.

The currency depreciation that we have experienced of late should eventually help to contain our current account deficit as foreigners export less to the United States.  On the other side of the ledger, the current account should improve as U.S. firms find the export market more receptive.

Although the recent data suggest that the worrisome trend of disinflation presumably has come to an end, still-significant productivity growth and a sizable margin of underutilized resources, to date, have checked any sustained acceleration of the general price level and should continue to do so for a time. Moreover, the initial effect of a slowing of productivity growth is more likely to be an easing of profit margins than an acceleration of prices.

With the ever-increasing pace of economic change, the old notion of getting out of high school or even college and having a job for the rest of your life is no longer a realistic expectation.  In today's world, education has to be viewed as a process of lifetime learning.  As a consequence, the nature of education is of necessity changing.  As I have often noted, community colleges, which largely tend to be focused on providing the education and training needed to move from one occupation to another, play an important role in this process.

This hesitancy on the part of businesses to expand risk-taking, as I have noted in the past, is an apparent consequence of scandals surrounding corporate accounting and governance, an aftermath of the stock market surge. Although there is no compelling evidence that corporate governance risk has fully subsided, with time, it should. An increased willingness to borrow, and ample liquid assets, should provide a further lift to capital investment and, with it, economic activity.

At some point, however, investors will have achieved the level of claims on oil that they seek. When that occurs, their demand will presumably stop rising, thus removing some of the current upward pressure on prices. Nonetheless, the increased value of oil imports has been a net drain on purchasing power, spending, and production in the United States. Moreover, higher oil prices, if they persist, are likely to boost core consumer prices, as well as the total price level, in this country. The recent modest declines in oil and natural gas prices may or may not signal a trend but are nonetheless welcome.

In an endeavor to exploit current high margins, businesses are being driven to expand their use of capital and labor resources. If history is any guide, this will tend to increase both real wages and interest rates. Fears of losing market share should dissuade businesses from passing these high costs fully through to prices. Accordingly, the forces of competition should cap the rise in profit margins and ultimately return them to more normal levels.

Going forward, we must remain prepared to deal with a wide range of events. Particularly notable in this regard is the fortunately low, but still deeply disturbing, possibility of another significant terrorist attack in the United States. Our economy was able to absorb the shock of the attacks of September 11 and to recover, though remnants of the effects remain. We at the Federal Reserve learned a good deal from that tragic episode with respect to the impact of policy and, of no less importance, the functioning under stress of the sophisticated payments system that supports our economy.

Following the pattern of recent quarters, corporate investment in fixed capital and inventories apparently continues to fall short of cash flow. The protracted nature of this shortfall is unprecedented over the past three decades. Moreover, the proportion of temporary hires relative to total employment continues to rise, underscoring that business caution remains a feature of the economic landscape.

Both equity prices and capital goods spending have turned up over the past year, and the probability that economic activity might stagnate has receded.

Financial markets along with households and businesses seem to be reasonably well prepared to cope with a transition to a more neutral stance of monetary policy. Some risks necessarily attend this transition, but they are outweighed in our judgment by those that would be associated with maintaining the existing degree of monetary policy accommodation in the current environment.

Inflation also seems to have been boosted by transitory factors such as the surge in energy prices. Those higher prices, by eroding households' disposable income, have accounted for at least some of the observed softness in consumer spending of late, a softness which should prove short-lived.

So far this year, the rise in the value of imported oil--essentially a tax on U.S. residents--has amounted to about 3/4 percent of GDP.

We may be approaching a point, if we are not already there, at which exporters to the United States, should the dollar decline further, would no longer choose to absorb a further reduction in profit margins.

Besides market pressures, which appear poised to stabilize and over the longer run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction.  The voice of fiscal restraint, barely audible a year ago, has at least partially regained volume. If actions are taken to reduce federal government dissaving, pressures to borrow from abroad will presumably diminish.

The dramatic advances over the past decade in virtually all measures of globalization have resulted in an international economic environment with little relevant historical precedent. I have argued elsewhere that the U.S. current account deficit cannot widen forever but that, fortunately, the increased flexibility of the American economy will likely facilitate any adjustment without significant consequences to aggregate economic activity.

Given the dollar's depreciation since 2002, U.S. exporters' profit margins appear to be increasing, which bodes well for future U.S. exports and the adjustment process.

Whether inflation actually rises in the wake of slowing productivity growth, however, will depend on the rate of growth of labor compensation and the ability and willingness of firms to pass on higher costs to their customers. That, in turn, will depend on the degree of utilization of resources and how monetary policymakers respond. To date, with profit margins already high, competitive pressures have tended to limit the extent to which cost pressures have been reflected in higher prices.

It is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.

The recent somewhat quickened pace of increases in US import prices suggests that profit margins of exporters to the United States have contracted to the point where foreign shippers may exhibit only limited tolerance for additional reductions in margins should the dollar decline further.

[The retirement of the Baby Boom generation] creates a very significant slowing in the rate of economic growth because, obviously, the rate of growth of the working-age population relative to total goes down.  And even with productivity going at a reasonably good clip, it, under most scenarios, shows the rate of growth in GDP per capita must slow down.

The sharp rise in oil prices over the past year has no doubt boosted firms' costs and may have weighed on production...However, the share of total business expenses attributable to energy costs has declined appreciably over the past 30 years, which has helped to buffer profits and the economy more generally from the adverse effect of high oil and natural gas prices.

If [the] unified budget deficit is two percent of GDP or less, it stabilizes the ratio of debt to GDP. So, if you are looking at a straightforward numerical type, that's not a bad one. But again, I want to caution you that it's a little simplistic and I wouldn't want to press it too far.

We very purposefully moved the federal funds rate down quite sharply in the context of the financial deflation - the set of financial deflationary pressures which occurred as the stock market came down and capital investment went down, capital goods spending went down. And so we very purposefully decided to drive the federal funds rate well below what we considered a long-term sustainable rate.

[A] critical long-run economic challenge facing the United States is the need to ensure that our workforce is equipped with the requisite skills to compete effectively in an environment of rapid technological progress and global competition...Demand for the least-skilled workers in the United States and other developed countries is diminishing, placing downward pressure on their wages.  These workers will need to acquire the skills required to compete effectively for the new jobs that our economy will create.

[One challenge is to] maintain the flexibility of our economic and financial system.  This will be essential if we are to address our current account deficit without significant disruption.  Central to that adjustment must be an increase in net national saving.  This serves to underscore the imperative to restore fiscal discipline.

Yet history cautions that people experiencing long periods of relative stability are prone to excess.  We must thus remain vigilant against complacency, especially since several important economic challenges confront policymakers in the years ahead.

The economy seems to have entered 2005 expanding at a reasonably good pace, with inflation and inflation expectations well anchored.

This apparent disparity in sentiment between business people and market participants could reflect the heightened additional concerns of business executives about potential legal liabilities rather than a fundamentally different assessment of macroeconomic risks.

I think that...if the deficit as a percent of GDP does not go down, I think we will - going into the 2008 forward period poorly positioned.

In general, I would say flexibility, which is an extraordinarily valuable asset to the world financial system, is clearly advanced by having, essentially, a free floating rate system, which is largely what we have.

At the moment, excluding...U.S. Treasury debt held by the Federal Reserve, half of our debt is owned abroad. And I would assume, at some point, it has consequences, but I'm not sure - I cannot tell you what they are.

The demographics are inexorable and call for action before the leading edge of baby boomer retirement becomes evident in 2008.

Ordinarily, any increase in spending or reduction in taxes which are funded by marketable securities clearly increases the deficit and lowers national savings. The only reason I raise it at the moment is that we are discussing these private accounts, and this is one of the very rare cases in which you can increase the deficit but not - but not decrease the national savings if you have the forced savings accounts which I mentioned earlier.

The degree of flexibility owing to deregulation, owing to technology, owing to lost of innovation has created a degree of flexibility and therefore resilience in this economy that has in the past and is very likely in the future to defuse this large current account balance without undue negative economic effects on the American economy.

Our judgment...at the moment is the economy is moving forward at a reasonably good pace.

I would be very careful about very large increases in debt. But I do believe that relatively small increases are not something that would concern me.

If you're going to move to private accounts, which I approve of, I think you have to do it in a cautious, gradual way and recognize that there is yet another problem involved, which is this. Unlike almost all of the other programs with which we deal, moving to a forced savings account technically does not materially affect net national savings. It merely moves savings from the government account to a private account.

There are basically two models that we're confronting. One is the pay-as-you-go model, which if we can fully fund, will work. But it's shown very considerable difficulty in doing that. The other is the forced savings model, which in the current context is not increasing savings because you're switching from the federal government to a forced savings account. But as a general model, it has in it the seeds of developing full funding by its very nature, and therefore, I've always supported moves to full funding in the context of a private account.

The issue of education is so critical...I would say what makes our country competitive is, in my judgment, two things.  One, it's our Constitution, which creates a rule of law which people want to invest in, and two, it's what's in the heads of our children, because they are the future of the people who will staff our...increasingly complex capital stock.

[We strengthen international exports in manufacturing] by essentially being competitive in that we develop skills that create goods and services which customers in the rest of the world want.

One of the reasons that I think we have to move towards a private individual account system is they, by their nature, tend to be significantly fully funded, even if they are defined contribution plans, because individuals know what they need for the future, and they tend to put monies away adequately to create incomes they will need in retirement.

The structure of essentially a pay-as-you-go system, which is what our Social Security system is, which worked exceptionally well for almost 50, 60 years, that system is not well suited to a period in which you do not any longer have significant overall population growth, and therefore a very high ratio of workers to retirees.

We don't know what the actual [neutral rate] number is, but it is that interest rate which creates a degree of stability in the economy and removes any sense of excess which would create inflationary pressures.

As you know productivity in manufacturing has really been very impressive. The downside, obviously, is it's made - created fewer job opportunities. And we can reasonably assume that the economy is going forward at a fairly good clip and that, therefore, the demand for manufactured goods will continue reasonably significant. But it depends on productivity growth, or I should say the extent to which manufacturing jobs changes one way or the other depends on whether productivity growth goes up or slows down.

The notion...which came out...a couple of weeks ago that there was a significant move towards selling off U.S. dollar instruments by foreign central banks, that actually was not accurate. The extent of holdings remains very heavy for dollars. It's a share of their aggregate holdings.

Our problem with respect to retirement has got nothing to do with finance. It's got to do with real assets, real physical resources, and goods and services that people consume.

Interest rates have a number of different effects but they're rarely critical in the issue of determination of the current account balance.

I think we should maintain the principles of Social Security, but I think the existing structure is not working. And...until we can construct a system which creates the savings that are required to build the real assets so that the retirees can have real goods and services, we don't have a system that's working. We have one that basically moves cash around, and we can guarantee cash benefits as far out and in whatever size you like. But we cannot guarantee the purchasing power.

The way I would reconcile my own position is that I think maintaining the tax cuts on...dividends which essentially partially integrates the individual on corporate taxes and eliminating part of the double taxation on dividends I think is a good thing, but because I hold to the position that we should be adhering to PAYGO I think it's necessary to offset it by other means as is required by the law with PAYGO still in effect.

My own judgment is I think when you have assets which you own which you can bequeath to your children and which have your name on it, I think that is a highly thing [sic] because you give wealth basically to people in the lower and middle income groups who have not had it before. Because remember these private accounts, even though they are a forced savings, are, indeed, owned by the people and they have wealth which they probably would not have had before.

I'm...of the belief that we probably ought not to address the medical issue quite yet until we get very far - much further down the road in the advance in information technology in the medical area...So I think that people who are saying we ought to do Medicare first before Social Security because it's a much bigger problem - I agree, it is a hugely much more difficult problem but I'm not sure I would agree with the issue of the sequence wholly because of the nature of what's now occurring in medicine.

We believe that that so-called normative rate or whatever you want to call it is not...stable. It does move around.

The US economic expansion has firmed, overall inflation has subsided, and core inflation has remained low.

The cumulative removal of policy accommodation to date has significantly raised measures of the real federal funds rate, but by most measures, it remains fairly low.

Raising national saving is an essential step if we are to build a capital stock that by, say, 2030 will be sufficiently large to produce goods and services adequate to meet the needs of retirees without unduly curbing the standard of living of our working-age population.  Unfortunately, the current Social Security system has not proven a reliable vehicle for such saving.

Because the baby boomers have not yet started to retire in force, we have been in a demographic lull. But this state of relative stability will soon end. In 2008--just three years from now--the leading edge of the baby-boom generation will reach 62, the earliest age at which Social Security retirement benefits can be drawn and the age at which about half of those eligible to claim benefits have been doing so in recent years.

Programs can always be expanded in the future should the resources for them become available, but they cannot be easily curtailed if resources later fall short of commitments.

Tax increases of sufficient dimension to deal with our looming fiscal problems arguably pose significant risks to economic growth and the revenue base. The exact magnitude of such risks is very difficult to estimate, but, in my judgment, they are sufficiently worrisome to warrant aiming, if at all possible, to close the fiscal gap primarily, if not wholly, from the outlay side.

Our current, largely pay-as-you go social insurance system worked well given the demographics of the second half of the twentieth century. But as I have argued previously, the system is ill-suited to address the unprecedented shift of population from the workforce to retirement that will start in 2008.

Favorable productivity developments would help to alleviate the impending budgetary strains. But unless productivity growth far outstrips that embodied in current budget forecasts, it is unlikely to represent more than part of the answer.

So long as health-care costs continue to grow faster than the economy as a whole, the additional resources needed for such programs will exert pressure on the federal budget that seems increasingly likely to make current fiscal policy unsustainable. The likelihood of escalating unified budget deficits is of especially great concern because they would drain an inexorably growing volume of real resources away from private capital formation over time and cast an ever-larger shadow over the growth of living standards.

The combination of an aging population and the soaring costs of its medical care is certain to place enormous demands on our nation's resources and to exert pressure on the budget that economic growth alone is unlikely to eliminate.

The fundamental fiscal issue is the need to make difficult choices among budget priorities, and this need is becoming ever more pressing in light of the unprecedented number of individuals approaching retirement age.

As the latest projections from the Administration and the Congressional Budget Office suggest, our budget position is unlikely to improve substantially in the coming years unless major deficit-reducing actions are taken.  In my judgment, the necessary choices will be especially difficult to implement without the restoration of a set of procedural restraints on the budget-making process.

In my view, a retirement system with a significant personal accounts component would provide a more credible means of ensuring that the program actually adds to overall saving and, in turn, boosts the nation's capital stock. The reason is that money allocated to the personal accounts would no longer be available to fund other government activities and--barring an offsetting reduction in private saving outside the new accounts--would, in effect, be reserved for future consumption needs.

Crafting a budget strategy that meets the nation's longer-run needs will become ever more difficult the more we delay.

The uncertainty about future medical spending is daunting. We know very little about how rapidly medical technology will continue to advance and how those innovations will translate into future spending.

I believe that, as the baby boom generation begins to retire in a few years, it will become increasingly important for the nation to boost resources available in the future through greater national saving and enhanced incentives for participation in the labor force. The tax system has the potential to contribute importantly to those goals, and, at a minimum, tax reform should not hinder the achievement of those objectives.

The U.S. economy is the world's most dynamic and flexible, and the federal government's system for raising revenue must not hinder the processes generating that economic success. However...the tax code has drifted back to be overly complicated and burdened by higher marginal rates and by many special provisions that have undesirably narrowed the tax base.

The pronounced structural shift over the past decade to a far more vigorous and competitive world economy than that which existed in earlier post-World War II decades apparently has been adding significant stimulus to world economic activity. This stimulus, like that which resulted from similar structural changes in the past, is likely a function of the rate of increase of globalization and not its level. If so, such impetus would tend to peter out as we approach the practical limits of globalization.

Although a complete understanding of the reasons remains elusive, globalization and innovation would appear to be essential elements of any paradigm capable of explaining the events of the past ten years. If this is indeed the case, because the extent of globalization and the speed of innovation are limited, the current apparent rapid pace of structural shift cannot continue indefinitely. While the outlook for the next year or two seems reasonably bright, the outlook for the latter part of this decade remains opaque because it is uncertain whether this transitional paradigm, if that is what it is, is already far advanced and about to slow, or whether it remains in an early, still-vibrant stage of evolution.

Full globalization, in which production, trade, and finance are driven solely by risk-adjusted rates of return and in which risk is indifferent to distance and national borders, will likely never be achieved...But because so much of our recent experience has little precedent, as I noted earlier, we cannot fully determine how long the current globalization dynamic will take to play out.

We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis. Should globalization continue unfettered and thereby create an ever-more flexible international financial system, history suggests that current account imbalances will be defused with modest risk of disruption.

Protectionism, some signs of which have emerged in recent years, could significantly erode global flexibility and, hence, undermine the global adjustment process.

Rising debt-to-income ratios can be somewhat misleading as an indicator of stress. Indeed the ratio of household debt to income has been rising sporadically for more than a half-century, a trend that partly reflects the increased capacity of ever-wealthier households to service debt. Moreover, a significant part of the recent rise in the debt-to-income ratio reflects the remarkable gain in homeownership...Thus, short of a period of appreciable overall economic weakness, households, with the exception of some highly leveraged subprime borrowers, do not appear to be faced with significant financial strain.

A number of analysts have conjectured that the extended period of low interest rates is spawning a bubble in housing prices in the United States that will, at some point, implode. Their concern is that, if this were to occur, highly leveraged homeowners would be forced to sharply curtail their spending. To be sure, indexes of house prices based on repeat sales of existing homes have significantly outstripped increases in rents, suggesting at least the possibility of price misalignment in some housing markets. But a destabilizing contraction in nationwide house prices does not seem the most probable outcome...House prices, however, like those of many other assets, are difficult to predict, and movements in those prices can be of macroeconomic significance.

The resolution of our current account deficit and household debt burdens does not strike me as overly worrisome, but that is certainly not the case for our fiscal deficit, which...will rise significantly as the baby boomers start to retire in 2008. Our fiscal prospects are, in my judgment, a significant obstacle to long-term stability because the budget deficit is not readily subject to correction by market forces that stabilize other imbalances.

To avoid any changes in replacement rates, the Social Security tax rate would have to be increased from the current 12.4 percent to about 18 percent at the middle of the century.

I believe that a thorough review of our commitments [in the federal budget]--and at least some adjustments in those commitments--is urgently needed.  The necessary adjustments will become ever more difficult and larger the longer we delay.  No changes will be easy.

Workers near retirement have accumulated many years of valuable experience, so extending labor force participation by just a few years could have a sizable impact on economic output.

We are unable to judge with certainty how technological possibilities will play out in the future, but we can say with some assurance that developments in energy markets will remain central in determining the longer-run health of our nation's economy.

The strong belief of investors in the implicit government backing of the GSEs does not by itself create safety and soundness problems for the GSEs, but it does create systemic risks for the U.S. financial system as the GSEs become very large. Systemic risks are difficult to address through the normal course of financial institution regulation alone and...can be effectively handled in the case of the GSEs by limiting their investment portfolios funded by implicitly subsidized debt.

The GSEs need a regulator with authority on a par with banking regulators, with a free hand to set appropriate capital standards, and with a clear and credible process sanctioned by the Congress for placing a GSE in receivership, where the conditions under which debt holders take losses are made clear. However, if legislation takes only these actions and does not limit GSE portfolios, we run the risk of solidifying investors' perceptions that the GSEs are instruments of the government and that their debt is equivalent to government debt...Without restrictions on the size of GSE balance sheets, we put at risk our ability to preserve safe and sound financial markets in the United States, a key ingredient of support for homeownership.

Beyond strengthening GSE regulation, the Congress will need to clarify the circumstances under which a GSE can become insolvent and, in particular, the resultant position--both during and after insolvency--of the investors that hold GSE debt, as well as other creditors and shareholders.

If we fail to strengthen GSE regulation, we increase the possibility of insolvency and crisis. We at the Federal Reserve believe this dilemma would be resolved by placing limits on the GSEs' portfolios of assets, perhaps as a share of single-family home mortgages outstanding or some other variation of such a ratio. Almost all the concerns associated with systemic risks flow from the size of the balance sheets of the GSEs, not from their purchase of loans from home-mortgage originators and the subsequent securitization of these mortgages.

We at the Federal Reserve remain concerned about the growth and magnitude of the mortgage portfolios of the GSEs, which concentrate interest rate risk and prepayment risk at these two institutions and makes our financial system dependent on their ability to manage these risks. Although Fannie and Freddie have chosen not to expand their portfolios significantly this past year (presumably at least partly in light of their recent difficulties), the potential for rapid growth in the future is not constrained by the existing legislative and regulatory regime.

Our budget position is unlikely to improve substantially in the coming years unless major deficit-reducing actions are taken.

I fear that we may have already committed more physical resources to the baby-boom generation in its retirement years that our economy has the capacity to deliver.  If existing promises need to be changed, those changes should be made sooner rather than later.  We owe future retirees as much time as possible to adjust their plans for work, saving, and retirement spending.

Considerable uncertainty remains about the precise dimensions of the problem and about the extent to which future resources will fall short of our current statutory obligations ot the coming generations of retirees.

The federal budget is on an unsustainable path, in which large deficits result in rising interest rates and ever-growing interest payments that augment deficits in future years.  But most important, deficits as a percentage of GDP in these simulations rise without limit.  Unless that trend is reversed, at some point these deficits would cause the economy to stagnate or worse.

I have more in common with you graduates than people might think. After all, before long, after my term at the Federal Reserve comes to an end, I too will be looking for a job.

Financial instability coupled with the higher interest rates it creates is the most formidable barrier to the growth, if not the level, of homeownership. Huge, highly leveraged GSEs [government-sponsored enterprise] subject to significant interest rate risk are not conducive to the long-term financial stability that a nation of homeowners requires.

As I testified before the Congress both this year and in 2004, the GSEs need a regulator with authority on par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear and credible process sanctioned by the Congress for placing a GSE in receivership, where the conditions under which debt holders take losses are made clear.

However, I continue to believe, as I did in the aftermath of the LTCM episode, that ensuring sound credit-risk management by the regulated banks and securities firms that are hedge funds' counterparties is the most promising approach to addressing concerns that excessive hedge fund leverage could threaten the financial system.  Some may believe that government regulation of hedge fund leverage would be more effective.  But it would be very difficult to design a set of capital requirements for hedge funds that is appropriately sensitive to the diversity and flexibility of investment strategies that different funds employ and to the lack of diversification in the portfolios of individual funds.  More important, government regulation of hedge funds could undermine the effectiveness of market discipline if counterparties incorrectly assume that government regulation is so effective that it obviates private prudence.

The pronounced decline in the US Treasury long-term interest rates over the past year despite a 200-basis-point increase in our federal funds rate is clearly without recent precedent.

Many of the new hedge fund entrepreneurs are embracing a strategy of pinpointing temporary market inefficiencies, the exploitation of which is expected to yield above-average rates of return.  For the time being, most of the low-hanging fruit of readily available profits has already been picked by the managers of the massive influx of hedge fund capital, leaving as a byproduct much-more-efficient markets and normal returns.

The breakup of the Soviet Union and the integration of China and India into the global trading market...have permitted more of the world's lower-cost productive capacity to be tapped to satisfy global demands for goods and services.  Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of cost-reducing investments.  The enlargement of global markets for goods, services, and finance has contributed importantly to the favorable inflation performance that we are witnessing in so many countries.  That improved performance has doubtless contributed to lower inflation-related risk premiums, and the lowering of these premiums is reflected in significant declines in nominal and real-long-term rates.

One prominent hypothesis [to explain the narrowing gap between long- and short-term interest rates] is that the markets are signaling economic weakness.  This is certainly a credible notion.  But periodic signs of bouyancy in some areas of the global economy have not arrested the fall in rates.

The enlargement of global markets for goods, services, and finance has contributed importantly to the favorable inflation performance that we are witnessing in so many countries.

Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications.

Although a "bubble" in home prices for the nation as a whole does not appear likely, 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.

Unlike the behavior of commodity prices, which varies little from place to place, the behavior of home prices varies widely across the nation.  Speculation in homes is largely local, especially for owner-occupied residences.

The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern.

Despite the uneven character of the expansion over the past year, the U.S. economy has done well, on net, by most measures.

The broad tariff on Chinese goods...should it be implemented, would significantly lower US imports from China but would comparably rise US imports from other low-cost sources of supply...Few, if any, American jobs would be protected.

Some observers mistakenly believe that a marked increase in the exchange value of the renminbi relative to the US dollar would significantly increase manufacturing activity and jobs in the United States.  I am aware of no credible evidence that supports such a conclusion.

Any significant elevation of tariffs that substantially reduces our overall imports, by keeping out competitively priced goods, would materially lower our standard of living.  A return to protectionism would threaten the comtinuation of the extraordinary growth in living standards worldwide, but especially in the United States.

A policy to dismantle the global trading system in a misguided effort to protect jobs from competition would redound to the eventual detriment of all U.S. job seekers, as well as of millions of American consumers.  Policy should aim to bolster the well-being of job losers through retraining and unemployment insurance, not to stave off job loss through counterproductive efforts to impede the process of income-enhancing international trade and globalization.

It is in our interest and that of the global economy that China continue to progress toward becoming a more market-based, productive, and dynamic economy in which individual initiative, not government decisionmaking, is the fundamental strength behind economic activity.  For our part, it is essential that we not put that outcome, or our future, at risk with a step back into protectionism.

The sooner the Chinese, in their own self-interest, move to a more flexible currency regime, perhaps leading other Asian currencies to become more flexible as well, the better for all participants in the global trading system.

Based on econometric estimates done by the Board staff, the increase in oil prices since the end of 2003 probably has shaved roughly 1/2 percentage point off of real GDP growth [in 2004] and they look to restrain growth [in 2005] by approximately 3/4 percentage point.  Aside from these "headwinds," the US economy seems to be coping pretty well with the run-up in crude oil prices.

A sharp flattening of the yield curve is not a foolproof indicator of economic weakness.  Indeed, the yield curve narrowed sharply over the period 1992-1994 even as the economy was entering the longest sustained expansion of the postwar period.

With respect to regulatory options or "regulatory substitutes" to address asset price bubbles, some observers have suggested increasing margin requirements to counter perceived speculation in equities markets.  Even if one presumes that a bubble in this market can be identified before it bursts, however, such an approach is unlikely to succeed.  Only a small fraction of equity is purchased using credit.  Moreover, money is fungible, so that if an attempt were made to limit the amount of credit that could be used for a particular purpose...it is highly likely that some investors who would be constrained by such a regulation would find ways to channel credit from other sources to effect the desired purchases.

The recent Interagency Credit Risk Management Guidance for Home Equity Lending was not a regulatory effort to combat a housing price bubble, nor was it an example of regulatory suasion aimed at asset prices.  Rather, it was a response to indications that some banks were not appropriately managing risks in the home equity area.  The regulatory system is not designed to influence or control asset bubbles, but rather to ensure that bubbles, should they develop, do not lead to unsafe lending practices.  Although the guidance was not aimed at affecting asset prices directly, it may nevertheless affect market conditions through changes in the availability of credit for some riskier households.

The significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor.

It is in China's interest to allow its currency to move up, largely because its procedures that it uses to support its currency requires that their central bank accumulate very large quantities of US Treasury securities.  Unless they sterilize that very substantial inflow, they create significant distortions in their financial system and ultimately could be very serious for the Chinese economy.

Output as a ratio to GDP has gone down very gradually, and indeed the reason...that it's going down is that we are an increasingly conceptual economy; that an ever increasing proportion of what we create, values that...other countries want are nonmaterial.  And therefore we are seeing some gradual decline in goods production as a ratio to overall GDP, but the rest of the GDP being ideas.

We do estimate a three-quarters of a percentage point loss in real growth this year as a consequence of these [gasoline] prices.

We are getting a bivariate income distribution...For a democratic society, this is not healthful, to say the least...I believe this is an education problem that requires us to get the balance of skills coming out of our schools to match the skills that our physical facilities require.

Despite the challenges...the US 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.

How does a civilized society with the rule of law deal with losses from violence?...I think we correctly choose to leave the vast majority of risk to be absorbed by the private sector...[However] the type of terrorism that is arising in the context of increasing technologies, which were not available before, has created possibilities of huge losses, and there is no way for a private system to handle that...So long as we have terrorism, which has the capability of a very substantial scope of damage, there is no way you can expect private insurance systems to handle that...To the extent that we socialize risk, we reduce our standard of living.  And so it's a tradeoff.

Anything [protectionist] that we do with respect to world globalization, at the end of the day, redounds to our disadvantage.

The very most recent data do suggest that there is an increasing return of self-employed to the corporate sector more generally...One of the reasons I suspect it's probably happening is that medical costs being provided by...corporate organizations are attractive to a number who are not doing as well self-employed as they would like.

One thing about Americans is that our cars are critical to our day-to-day existence.  And they do notice when gasoline prices go up.  And it probably does curtail other forms of spending...But what they don't do is drive fewer miles.

The question is, would there be any advantage at this particular stage in going back to the gold standard? And the answer is, I don't think so because we are acting as though we were there.

I don't expect that the personal saving rate will stay down this low indefinitely...There is a very significant amount of extraction of equity from homes in this country, financed by mortgage debt...That is a major factor creating the low level of savings.  And when equity extraction slows down, as it eventually will at some point, I think you will find this personal saving rate starting back up.

The globalization route is by far the superior route, because protection may appear to be helpful in the short run, but over the long run, you cannot protect industries or jobs which are obsolescent.

[Globalization] undoubtedly enhances standards of living worldwide.  And indeed, those economies that engage in international freight have invariably been boosted...But that process is very disruptive, and indeed, it's associated with a very large turnover of the labor force.

We're developing a bivariate labor market...We have an oversupply of high-skill jobs and an undersupply of people to fill them, the effect of which is to create a significant acceleration in average incomes of the highly-skilled segment of our labor force.

Central bankers began to realize in the late 1970s how deleterious a factor inflation was and indeed, since the late 1970s central bankers have behaved as though we were on the gold standard.

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.

A flattening out of the prices of crude oil and natural gas, were it to materialize, would...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.

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...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.

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.

[A] 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...Going forward, policymakers will need to be vigilant to preserve this flexibility, which has contributed so constructively to our economic performance in recent years.

Some recovery in nonresidential contruction appears in the offing, spurred partly by lower vacancy rates and rising prices for commerical properties.

Our baseline outlook for the US 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 srutiny.

A further rise [in energy prices] could cut materially into private spending and thus damp the rate of economic expansion.

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.

This decline in long-term rates has occurred against the backdrop of generally firm US 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.  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.

Experience suggests that such rapid advances are unlikely to be maintained in an economy that has reached the cutting edge of technology.

Some, but not all, of the decade-long trend decline in that forward [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.

The trend reduction worldwide in long-term yields surely reflects an excess of intended saving over intended investment...What is unclear is whether the excess is due to a glut of saving or a shortfall of investment.

Since the mid-1990s, 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.

In the United States...capital expenditures were below the very substantial level of corporate cash flow 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.

Exceptionally low interest rates on ten-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.

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.

Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, the paradigm on which we have settled has come to involve, at its core, crucial elements of risk management. In this approach, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of various possible outcomes under alternative choices for policy.

The risk-management approach has gained greater traction as a consequence of the step-up in globalization and the technological changes of the 1990s, which found us adjusting to events without the comfort of relevant history to guide us. Forecasts of change in the global economic structure--for that is what we are now required to construct--can usefully be described only in probabalistic terms. In other words, point forecasts need to be supplemented by a clear understanding of the nature and magnitude of the risks that surround them.

Debates on the relative merits of asset price targeting also will continue and possibly intensify in the years ahead...But given our current state of knowledge, I find it difficult to envision central banks successfully targeting asset prices any time soon. However, I certainly do not rule out that future work could improve our understanding of asset price behavior, and with it, the conduct of monetary policy.

The housing boom will inevitably simmer down...As a consequence, home equity extraction will ease and with it some of the strength in personal consumption expenditures.

The surprisingly high correlation between increases in home equity extraction and the current account deficit suggests that an end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports, and a corresponding improvement in the current account deficit. Whether those adjustments are wrenching will depend...the degree of economic flexibility that we and our trading partners maintain, and I hope enhance, in the years ahead.

I remain unpersuaded that explicit numerical inflation targets are a key characteristic that distinguishes behavior among the world's central banks.

Although the C-CPI-U [Chained CPI-U] is still subject to other sources of bias--especially those related to changes in the quality of existing products and the introduction of new goods and serives--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.

It is certainly true that when dealing with policies that affect so important an institution as homeownership in this country, caution is always commendable.  However, caution based on concerns without merit can be counterproductive.  Indeed, in the case of GSEs, excessive caution in reducing their portfolios could prove to be destabilizing to our financial system as a whole and in the end could seriously diminish the availability of home mortgage funds.

The costs and the quantity of options (or swaps or other derivatives) needed to sufficiently passively hedge a mortgage portfolio, however, can become substantial, especially when the portfolio is leveraged, is growing rapidly, is large relative to the supply of options and whose outcome, in any event, is not a perfect hedge.  Moreover, thse strategies, which are complex, can be costly when they fail.  Thus, even if Fannie and Freddie were to fully rely on passive hedges (a very expensive approach to managing prepayment risks), the system would again rely on Fannie and Freddie avoiding large errors.

Transactions in second homes, of course, are not restrained to the same degree as sales of primary residences--an individual can sell without having to move. This suggests that speculative activity may have had a greater role in generating the recent price increases than it customarily has had in the past.

It is encouraging to find that, despite the rapid growth of mortgage debt, only a small fraction of households across the country have loan-to-value ratios greater than 90 percent. Thus, the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices. In addition, the LTVs for recent homebuyers appear to be lower in those states that have experienced the most explosive run-up in house prices and that, conceivably, could be at risk for the largest price reversal.

The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other, more-exotic forms of adjustable-rate mortgages, are developments that bear close scrutiny. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is adding to the pressures in the marketplace.

In the United States, signs of froth have clearly emerged in some local markets where home prices seem to have risen to unsustainable levels. It is still too early to judge whether the froth will become evident on a widening geographic scale, or whether recent indications of some easing of speculative pressures signal the onset of a moderating trend.

It is difficult to dismiss the conclusion that a significant amount of consumption is driven by capital gains on some combination of both stocks and residences, with the latter being financed predominantly by home equity extraction. If so, leaving aside the effect of equity prices on consumption, should mortgage interest rates rise or home affordability be further stretched, home turnover and mortgage refinancing cash-outs would decline as would equity extraction and, presumably, consumption expenditure growth. The personal saving rate, accordingly, would rise. Carrying the hypothesis further, imports of consumer goods would surely decline as would those imported intermediate products that support them. And one would assume that the U.S. trade and current account deficits would shrink as well, all else being equal.

The economic forces driving the global saving-investment balance have been becoming manifest over the past decade, so the steepness of the recent decline in long-term yields suggests that something more may have been at work over the past year. According to estimates prepared by the staff of the Federal Reserve Board, a significant portion of the more recent decline appears to have resulted from a fall in term premiums. Such estimates are subject to considerable uncertainty; nevertheless, they suggest that a perceived increase in economic stability in recent years has encouraged risk-takers to reach out to more-distant time horizons.

The FOMC knew [in the 1990s] that tools were available to choke off the stock market boom, but those tools would only have been effective if they undermined market participants' confidence in future stability. Market participants, however, read the resilience of the economy and stock prices in the face of monetary tightening as an indication of undiscounted market strength.

Relying on policymakers to perceive when speculative asset bubbles have developed and then to implement timely policies to address successfully these misalignments in asset prices is simply not realistic.

Flexibility is most readily achieved by fostering an environment of maximum competition.

Most recently, the flexibility of our market-driven economy has allowed us, thus far, to weather reasonably well the steep rise in spot and futures prices for oil and natural gas that we have experienced over the past two years. The consequence has been a far more stable economy.

Being able to rely on markets to do the heavy lifting of adjustment is an exceptionally valuable policy asset. The impressive performance of the U.S. economy over the past couple of decades, despite shocks that in the past would have surely produced marked economic contraction, offers the clearest evidence of the benefits of increased market flexibility.

It is important to remember that most adjustment of a market imbalance is well under way before the imbalance becomes widely identified as a problem. Individual prices, exchange rates, and interest rates, adjust incrementally in real time to restore balance. In contrast, administrative or policy actions that await clear evidence of imbalance are of necessity late.

Protectionism in all its guises, both domestic and international, does not contribute to the welfare of American workers. At best, it is a short-term fix at a cost of lower standards of living for the nation as a whole. We need increased education and training for those displaced by creative destruction, not a stifling of competition.

Even before the devastating hurricanes of August and September 2005, world oil markets had been subject to a degree of strain not experienced for a generation. Increased demand and lagging additions to productive capacity had eliminated a significant amount of the slack in world oil markets that had been essential in containing crude oil and product prices between 1985 and 2000. In such tight markets, the shutdown of oil platforms and refineries last month by Hurricanes Katrina and Rita was an accident waiting to happen.

If history is any guide, oil will eventually be overtaken by less-costly alternatives well before conventional oil reserves run out...We will begin the transition to the next major sources of energy, perhaps before midcentury, as production from conventional oil reservoirs, according to central-tendency scenarios of the U.S. Department of Energy, is projected to peak. In fact, the development and application of new sources of energy, especially nonconventional sources of oil, is already in train. Nonetheless, the transition will take time. 

Today, the average price of crude oil, despite its recent surge, is still in real terms below the price peak of February 1981. Moreover, since oil use, as I noted, is only two-thirds as important an input into world GDP as it was three decades ago, the effect of the current surge in oil prices, though noticeable, is likely to prove significantly less consequential to economic growth and inflation than the surge in the 1970s.

The President has made a distinguished appointment in Ben Bernanke. Ben comes with superb academic credentials and important insights into the ways our economy functions. I have no doubt that he will be a credit to the nation as Chairman of the Federal Reserve Board.

Economic modeling is as much art as science.  Economic policy makers face enormous uncertainty.  Economic models provide a set of useful tools to frame future outcomes; but as we were reminded repeatedly during our efforts to forecast the economy in 1974 and 1975, models can go off track in myriad ways...As hard as this can be to achieve, economic policy should take the long view.

The disruptions to energy production have noticeably affected economic activity. We estimate that the storms held down the increase in industrial production 0.4 percentage point in August and an additional 1.7 percentage point in September. Except for the hurricane effects, readings on the economy indicate a continued solid expansion of aggregate demand and production. If allowance is taken for the effects of Katrina and Rita and for the now-settled machinist strike at Boeing, industrial production rose at an annual rate of 5-1/4 percent in the third quarter. That's up from an annual pace of 1-1/4 percent in the second quarter.

The longer-term prospects for the U.S. economy remain favorable. Structural productivity continues to grow at a firm pace, and rebuilding activity following the hurricanes should boost real GDP growth for a while. More uncertainty, however, surrounds the outlook for inflation.

Contributing to the disinflationary pressures that have been evident in the global economy over the past decade or more has been the integration of in excess of 100 million educated workers from the former Soviet bloc into the world's open trading system. More recently, and of even greater significance, has been the freeing from central planning of large segments of China's 750 million workforce. The gradual addition of these workers plus workers from India...would approximately double the overall supply of labor once all these workers become fully engaged in competitive world markets...Over the past decade or more, the gradual assimilation of these new entrants into the world's free-market trading system has restrained the rise of unit labor costs in much of the world and hence has helped to contain inflation.

The federal budget situation [was]--at least until Hurricanes Katrina and Rita struck the Gulf Coast--...showing signs of modest improvement...Lowering the deficit further in the near term, however, will be difficult in light of the need to pay for post-hurricane reconstruction and relief. But even apart from the hurricanes, our budget position is unlikely to improve substantially further until we restore constraints similar to the Budget Enforcement Act of 1990, which were allowed to lapse in 2002. 

As I have testified on numerous occasions, current entitlement law may have already promised to this next generation of retirees more in real resources than our economy, with its predictably slowing rate of labor force growth, will be able to supply...We owe it to those who will retire over the next couple of decades to promise only what the government can deliver. The present policy path makes current promises, at least in real terms, highly conjectural. If fewer resources will be available per retiree than promised under current law, those in their later working years need sufficient time to adjust their work and retirement decisions.

Although the concept of a "neutral interest rate" is a useful theoretical construct, difficulties in implementing it in practice limit its usefulness as a framework for monetary policymaking.  For one thing, a variety of definitions of a neutral real interest rate are possible.  For another, quantitative estimates of the level of such a rate are subject to considerable uncertainty.  Also, such estimates can vary widely depending on the type of measure and the prevailing and projected economic conditions.  In particular, all variables that contribute to making a macroeconomic forecast are relevant for estimates of neutral interest rates, greatly complicating such assessments.  Thus, it is impossible to know with any certainty when the neutral rate has been reached.

The use of neutral real rates in the formulation of monetary policy is not necessarily straightforward.  For instance, in some circumstances, attaining a "neutral" federal funds rate would in principle be an appropriate objective for monetary policy, but in others -- particularly when inflation is too high or too low -- aiming for a neutral funds rate in the near term would not be appropriate.  These uncertainties and complications suggest that reliance on a single summary measure such as a neutral real interest rate would be unwise as a strategy for formulating monetary policy.  Rather, a full consideration of current and prospective economic developments, and of the risks to the outlook, is essential for the conduct of monetary policy.

Two distinct but overlapping developments appear to be at work in explaining the low level of long-term interest rates: a longer-term trend decline in bond yields and an acceleration of that trend over the period since mid-2004.

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...As best we can judge, both high levels of intended saving and low levels of intended investment combined to lower real long-term interest rates over the past decade.

Greater transparency with regard to Federal Reserve actions encourages public discussion and informed scrutiny, important aspects of accountability in a democratic society.  Transparency also enables financial markets to better predict monetary policy decisions, which can contribute to improved policy outcomes.  However, providing more complete information about policy decisions is not without cost.  Transparency requires careful attention by policymakers, and so constrains the time they have for actually making decisions.  More importantly, excessive transparency could inhibit policymakers, making them less spontaneous in their remarks and less willing to explore new ideas.  Such an outcome would have adverse effects on policy decisions.  The Federal Reserve's current practices strike a reasonable balance between transparency and the degree of confidentiality appropriate to support the policy process.

Although the slope of the yield curve remains an important financial indicator, it needs to be interpreted carefully.  In particular, a flattening of the yield curve is not a foolproof indicator of future economic weakness.  For example, the yield curve narrowed sharply over the period 1992-1994 even as the economy was entering the longest sustained expansion of the postwar period.

Flexibility is most readily achieved by fostering an environment of maximum competition. A key element in creating this environment is flexible labor markets. Many working people equate labor market flexibility with job insecurity. Despite that perception, flexible labor policies appear to promote job creation. An increased capacity of management to discharge workers without excessive cost, for example, apparently increases companies' willingness to hire without fear of unremediable mistakes. The net effect, to the surprise of most, has been what appears to be a decline in the structural unemployment rate in the United States over the past quarter century.  Protectionism in all its guises, both domestic and international, does not contribute to the welfare of workers. At best, it is a short-term fix for a few workers at a cost of lower standards of living for a nation as a whole. Increased education and training for those displaced by creative destruction is the answer, not a stifling of competition.

How much further home bias can decline is obviously conjectural, given the paucity of historical precedent. Federal Reserve staff studies indicate that, despite evidence of recent diversification, U.S. and foreign portfolios still exhibit marked home bias. Funding of our current account deficit likely will become more difficult when home bias approaches its practical minimum. Irrespective of how globalized our economy may become, other things equal, people will still accord nearby investments a lower risk premium.

To date, despite a current account deficit exceeding 6 percent of our gross domestic product (GDP), we--or more exactly, the economic entities that comprise the U.S. economy--are experiencing few difficulties in attracting the foreign saving required to finance it, as evidenced by the recent upward pressure on the dollar. The markets are not behaving in the way that some, if not most, analysts anticipated as the U.S. current account deficit rose above its previous high of 3-1/2 percent of GDP recorded in 1986.  Of course, deficits that cumulate to ever-increasing net external debt, with its attendant rise in servicing costs, cannot persist indefinitely. At some point investors will balk at further financing. Such a development would be particularly likely should risk-adjusted rates of return on assets outside the United States rise relative to investment opportunities in the United States. Even if such returns on U.S. assets stay high, the rise of concentration risks in foreign official and private portfolios could still induce investors to slow their accumulation of dollar claims and thereby delimit the size of the financeable U.S. current account deficit.

Transparency requires careful attention by policymakers, and so constrains the time they have for actually making decisions.  More importantly, excessive transparency could inhibit policymakers, making them less spontaneous in their remarks and less willing to explore new ideas.  Such an outcome would have adverse effects on policy decisions.  The Federal Reserve's current practices strike a reasonable balance between transparency and the degree of confidentiality appropriate to support the policy process.

If the currently disturbing drifit toward protectionism is contained and markets remain sufficiently flexible, changing terms of trade, interest rates, asset prices, and exchange rates will cause US saving to rise, reducing the need for foreign finance and reversing the trend of the apst decade toward increasing reliance on it.  If, however, the perncicious drift toward fiscal instability in the United States and elsewhere is not arrested and is compounded by a protectionist reversal of globalization, the adjustment process could be quite painful for the world economy.

Although the business cycle has not disappeared, flexibility has made the United States and the United Kingdom, and much of the remainder of the global economy more resilient to shocks and more stable during the past couple of decades.  Nonetheless, the piling up of dollar claims against US residents is already leading to concerns about concentration risk.  Although foreign investors have not as yet significantly slowed their financing of US capital investments, since 2002, we have observed a decline in the value of the dollar and a reduction in the share of dollars in global cross-border portfolios

Whatever the significance and possible negative implications of the current account deficit, maintaining economic flexibility, as I have stressed before, may be the most effective initiative to counter such risks.

Anecdotal, circumstantial, and some statistical evidence is suggestice that the historically large current account deficit of the United States may be part of a broader set of rising unconsolidated deficits and accumulated debt that is arguably more secular than cyclical.  The secualr updrift in deficits and debt doubtless has been gradual...The acceleration of US productivity, which dates from the mid-1990s, was an important factor in the process.

I should like to raise the hypothesis that the reason the historically large US current account deficit has not been placing pressure on the exchange rate of the US dollar, at least to date, is that the deficit is a reflection of a far broader and long-standing financial development in the United States and elsewhere.  An ever-growing proportion of US households, nonfinancial busineses, and governments, both national and local, fund their capital investments from external sources...What is special about the past decade is that the decline in home bias, along with the rise in IT productivity growth and the rise in the dollar, has engendered a large increase by US residents in purchases of goods and services from foreign producers.  The increased purchases have been willingly financed by foreign investors with implications that are not as yet clear.

In the 1990s, home bias began to decline discernibly, the consequence of a dismantling of restrictions on capital flows and the advance of information and communication technologies that has effectively shrunk the time and distance that separate markets around the world.  The vast improvements in these technologies have broadened investors' vision to the point that foreign investment appears less risky than it did in earlier times.

The rise of the US current account deficit over the past decade appears to have coincided with a pronounced new phase of globalization that is characterized by a major acceleration in US productivity growth and the decline in what economists call home bias.

The U.S. economy has delivered a solid performance thus far in 2005. And, despite the disruptions of Hurricanes Katrina, Rita, and Wilma, economic activity appears to be expanding at a reasonably good pace as we head into 2006. However, the positive short-term economic outlook is playing out against a backdrop of concern about the prospects for the federal budget over the longer run. To be sure, the current pace of the ramp-up in spending on defense and homeland security is not expected to continue indefinitely. But, as the latest projections from the Administration and the Congressional Budget Office suggest, our budget position will substantially worsen in the coming years unless major deficit-reducing actions are taken.

Reinstating a structure like the one formerly provided by the Budget Enforcement Act of 1990 would signal a renewed commitment to fiscal restraint and help restore discipline to the annual budgeting process. Such a step would be even more meaningful if it were coupled with the adoption of provisions for dealing with unanticipated budget outcomes.

Currently, 3-1/4 workers contribute to the Social Security system for each beneficiary. Under the intermediate assumptions of the program's trustees, the number of beneficiaries will have roughly doubled by 2030, and the ratio of covered workers to beneficiaries will be down to about 2. The pressures on the budget from this dramatic demographic change will be exacerbated by the anticipated steep upward trend in spending per Medicare beneficiary. The soaring cost of medical care for an aging population is certain to place enormous demands on our nation's resources and to exert pressure on the budget that economic growth alone is unlikely to eliminate.

Addressing the government's own imbalances will require scrutiny of both spending and taxes. However, tax increases of sufficient dimension to deal with our looming fiscal problems arguably pose significant risks to economic growth and the revenue base. The exact magnitude of such risks is very difficult to estimate, but, in my judgment, they are sufficiently worrisome to warrant aiming, if at all possible, to close the fiscal gap primarily, if not wholly, from the outlay side. In the end, I suspect that, unless we attain unprecedented increases in productivity, we will have to make significant structural adjustments in the nation's major retirement and health programs.

Our current, largely pay-as-you-go social insurance system...is ill-suited to address the unprecedented shift of population from the workforce to retirement that will start in 2008. 

Crafting a budget strategy that meets the nation's longer-run needs will become more difficult the more we delay. The one certainty is that the resolution of the nation's unprecedented demographic challenge will require hard choices that will determine the future performance of the economy. No changes will be easy, as they all will involve setting priorities and, in the main, lowering claims on resources.

Most policy makers marvel at the seeming ease with which the United States continues to finance its current account deficit.

Despite worrisome pockets of violence and destruction, commerce and wealth-building continues apace. On average, world standards of living are rising, in large part because of the widening embrace of competitive free markets, especially by populous and growing China and India. Since the autumn of 2001, global gross domestic product per capita has grown more than 8 percent. And growth in developing Asia, where so many of the world’s poor reside, has been considerably faster.

Aside from Saudi-Aramco, few, if any, of national oil companies which own most of the world’s proved oil reserves are investing enough of their surging cash flow to convert the reserves into crude oil productive capacity. Only Saudi-Aramco appears sufficiently concerned, at least publicly, that high oil prices will reduce the long term demand for oil, which could significantly diminish the value of Saudi Arabia’s – or indeed, any country’s –oil reserves.

The new participants, investors and speculators, to the world’s two trillion dollar-a-year oil market are hastening the adjustment process that has become so urgent with the virtual elimination of the world supply buffer. With the demand from the investment community, oil prices have moved up sooner than they would have otherwise.

Hypothetically, if we still had the 10 million barrels a day of spare capacity that existed two decades ago, neither surges in demand nor temporary shutdowns of output from violence, hurricanes or unscheduled maintenance would be having much, if any, impact on price. Returning to such a level of spare capacity appears wholly out of reach for the foreseeable future, however.

To date, it is difficult to find serious erosion in world economic activity as a consequence of sharply higher oil prices. Indeed, we have just experienced one of the strongest global economic expansions since the end of World War II. The United States, especially, has been able to absorb the huge implicit tax of rising oil prices so far. However, recent data indicate we may finally be experiencing some impact.

We look down the vector of inflation rates and with the exception of Venezuela and a couple of other countries, they're all single digit, indeed clustered in the area of 1% to 7%, annual rate. I don't recall ever seeing that. I'm too much aware of the fact that we always had some two or three economies which were verging on hyper inflation or were in very serious difficulty. We don't have that at this particular stage. And similarly because of that we have nominal long-term interest rates all in single digits. What this essentially tells us is there's an integration in the world economy, which I've argued elsewhere is a consequence of the very dramatic impact of the fall of the Soviet Union and its economic consequences in creating a very large increase in the number of previously low cost, somewhat educated workers insulated behind central planning being opened to the competitive markets, the effects of which have been extraordinary. In a sense we are on the way to, over the longer run, doubling the size of the labor force which is working in international, competitive markets. That has brought world unit labor costs down, brought inflation down and interest rates down.

Well, when you've been through a cycle of expansion as we have since, really 2001, the recovery is, as what people like to say, long at the tooth, and that when you get this far away from a recession, invariably, forces build up for the next recession. And indeed we are beginning to see signs of, for example in the United States, profit margins, after extraordinary upward-side moves, have begun to stabilize. Which is an early sign that we are in the later stages of a cycle.

But I think, having said that, the probabilities of forecasting a recession are probably more in the area of a third than they are more than a half. And while yes, it is possible that we could get a recession in the latter months of 2007, most forecasters are not making that judgment and indeed they are projecting forward into 2008 at a reasonably good level with some slowdown. Is George Soros correct? I frankly don't know. I do know that it is very precarious to try to forecast that far in the future. And I mean six months, eight months in the future is a very long forecast. So I'm not concerned as he apparently is, but I can't obviously rule out the possibility.

We look down the vector of inflation rates and with the exception of Venezuela and a couple of other countries, they're all single digit, indeed clustered in the area of 1% to 7%, annual rate. I don't recall ever seeing that. I'm too much aware of the fact that we always had some two or three economies which were verging on hyper inflation or were in very serious difficulty. We don't have that at this particular stage. And similarly because of that we have nominal long-term interest rates all in single digits. What this essentially tells us is there's an integration in the world economy, which I've argued elsewhere is a consequence of the very dramatic impact of the fall of the Soviet Union and its economic consequences in creating a very large increase in the number of previously low cost, somewhat educated workers insulated behind central planning being opened to the competitive markets, the effects of which have been extraordinary. In a sense we are on the way to, over the longer run, doubling the size of the labor force which is working in international, competitive markets. That has brought world unit labor costs down, brought inflation down and interest rates down.

There's a general view out there that I have more influence than I know I have.  I get accused of inducing market changes, really because I was standing next to the market when something else happens.

As reported by the Washington Post

The crisis will leave many casualties. Particularly hard hit will be much of today’s financial risk-valuation system, significant parts of which failed under stress. Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief. But I hope that one of the casualties will not be reliance on counterparty surveillance, and more generally financial self-regulation, as the fundamental balance mechanism for global finance.

The problems, at least in the early stages of this crisis, were most pronounced among banks whose regulatory oversight has been elaborate for years. To be sure, the systems of setting bank capital requirements, both economic and regulatory, which have developed over the past two decades will be overhauled substantially in light of recent experience. Indeed, private investors are already demanding larger capital buffers and collateral, and the mavens convened under the auspices of the Bank for International Settlements will surely amend the newly minted Basel II international regulatory accord. Also being questioned, tangentially, are the mathematically elegant economic forecasting models that once again have been unable to anticipate a financial crisis or the onset of recession.

Credit market systems and their degree of leverage and liquidity are rooted in trust in the solvency of counterparties. That trust was badly shaken on August 9 2007 when BNP Paribas revealed large unanticipated losses on US subprime securities. Risk management systems – and the models at their core – were supposed to guard against outsized losses. How did we go so wrong?

The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality.

We will never be able to anticipate all discontinuities in financial markets. Discontinuities are, of necessity, a surprise. Anticipated events are arbitraged away. But if, as I strongly suspect, periods of euphoria are very difficult to suppress as they build, they will not collapse until the speculative fever breaks on its own. Paradoxically, to the extent risk management succeeds in identifying such episodes, it can prolong and enlarge the period of euphoria. But risk management can never reach perfection. It will eventually fail and a disturbing reality will be laid bare, prompting an unexpected and sharp discontinuous response.

In the current crisis, as in past crises, we can learn much, and policy in the future will be informed by these lessons. But we cannot hope to anticipate the specifics of future crises with any degree of confidence. Thus it is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

Those who argue that you can incrementally increase interest rates to defuse bubbles ought to try it some time. I don't know of a single example of when interest rate policy has been successful in suppressing gains in asset prices.

Regarding the mounting levels of debt, encouraged in part by the low cost of borrowing, Greenspan said that he was "reluctant to underestimate the ability of most households and companies to manage their financial affairs."

If I am guilty of encouraging people to take out adjustable-rate mortgages, I am guilty for 30 days.

On his speech of Feb. 23, 2004, in which he encouraged homeowners to take out adjustable-rate mortgages, or ARMs, saying he tried to correct those comments on March 2, 2004,

There was a real serious concern about deflation. If you look at the notes of the Open Market Committee, the pressures were to go lower than 1 percent. There were no dissents. The only dissents were that we should go lower. People don't remember that period. [People thought there was] a threat to American stability because it looked as though we were replicating much of what Japan had done when it had fallen into a corrosive deflation.

Our forecast at the time said the chances were low, but the consequences to the country would have been so great that taking out insurance was by far the most sensible policy. I still believe that today.

On the decision to keep the federal funds rate at 1 percent from mid-2003 to mid-2004
 

I was convinced at the time and am convinced now that the level of adjustable-rate mortgages . . . wasn't a serious problem for attracting people into the market who then got caught [by higher rates]. People who had taken out loans in June 2003 at adjustable rates could have converted those to long-term fixed-rate mortgages at a profit over the next 18 months. And people didn't. And the reason they didn't. . . . Put it this way: They should have. I don't know frankly why they didn't. Long-term rates were low. Refinancing would have been a good decision.

The very sophisticated financial community basically decided that this was a steal. They put very significant pressure on the securitizers to produce more paper. I was aware of it at the time. Then the securitizers began to pressure the lenders and underwriting standards became egregious. It wasn't that the Federal Reserve wasn't aware of the problem. What we didn't realize was the order of magnitude of the subprime lending, which started as a niche with no macroeconomic implications to something that became excessive, a huge part of the market that . . . was sold around the world.

Everyone agrees that it is long-term interest rates and mortgages that ultimately determine the demand for homes and hence the price. What became clear in the early part of this decade is that central banks, not only the Fed, . . . began to lose control over long-term interest rates. That was a major issue in 2004. The Federal Reserve started to raise short-term rates very significantly and found that instead of long-term rates rising with them in unison, it failed . . . I call it the conundrum. What the conundrum was was evidence that long-term interest rates were being dominated by long-term forces.

On the power of the Fed

"I was praised for things I didn't do," Mr. Greenspan said during one of three interviews at his sun-drenched office in downtown Washington, D.C. "I am now being blamed for things that I didn't do."

Now 82 years old, Mr. Greenspan wants to set the record straight before the ink dries on the first draft of the financial crisis' history. The former Fed chief doesn't deny that he cares about his reputation. But the larger issue at stake, he says, is getting the lessons of the crisis right.

"The [wrong] evaluation of this period -- and how to avoid the problems associated with it -- will give you the wrong answers and the wrong policies," he says.

Former Federal Reserve Chairman Alan Greenspan said the U.S. has slipped into an ``awfully pale recession'' and may continue to languish for the rest of the year.

As reported by Bloomberg News

Former Federal Reserve Chairman Alan Greenspan said in an interview that taking bold action as a central bank looks easier than it is. Central banks are creatures of legislatures, which can be suspicious of extraordinary actions, and financial markets can react in unexpected ways, he said.

Greenspan said there is an unspoken consensus about keeping in the bounds of orthodox policy that is difficult for any central banker to violate.

“If we are right, but the consensus is wrong, we are tolerated,” Greenspan said. “If we are wrong, and the consensus is right, we get pilloried. So there is an acute bias to staying with short-term policy and that is what limits the range of action.”

As reported by Bloomberg News.

“Monetary policy should not have the whole load of getting us out of this phenomenon,” Mr. Greenspan said. “It’s fundamentally a fiscal problem.”