Testimony of Chairman Alan Greenspan
Federal Reserve Board's semiannual monetary policy report to the Congress
Before the Committee on Financial Services, U.S. House of Representatives
February 27, 2002
" ... the typical dynamics of the business cycle ... are prompting a firming in economic activity. An array of influences unique to this business cycle, however, seems likely to moderate the speed of the anticipated recovery."
"A coincident deceleration in activity among the world economies was evident over the past year, owing, at least in part, to the retrenchment in the high-technology sector and the global reach of the capital markets in which the firms in that sector are valued and funded. ... The simultaneous further slowing in activity raised concerns that a self-reinforcing cycle of contraction, fed by perceptions of greater economic risk, could develop."
"One key consideration in the assessment that the economy is close to a turning point is the behavior of inventories. Stocks in many industries have been drawn down to levels at which firms will soon need to taper off their rate of liquidation ... with production running well below sales, the lift to income and spending from the inevitable cessation of inventory liquidation could be significant."
"Through much of last year's slowdown, however, spending by the household sector held up well and proved to be a major stabilizing force. As a consequence, although household spending should continue to trend up, the potential for significant acceleration in activity in this sector is likely to be more limited than in past cycles. ... Drawing on home equity in this manner is a significant source of funding for consumption and home modernization. The pace of such extractions likely dropped along with the decline in refinancing activity that followed the backup in mortgage rates that began in early November."
"Changes in household financial positions in recent years are probably damping consumer spending ... Overall household wealth relative to income has dropped from a peak multiple of about 6.3 at the end of 1999 to around 5.3 currently. Moreover, the aggregate household debt service burden, defined as the ratio of households' required debt payments to their disposable personal income, rose considerably in recent years, returning last year to its previous cyclical peak of the mid-1980s. ... repayment difficulties have already increased, particularly in the subprime markets for consumer loans and mortgages. Delinquency rates may well worsen as a delayed result of the strains on household finances over the past two years."
"Perhaps most central to the outlook for consumer spending will be developments in the labor market. ... layoffs diminished noticeably in January ... initial claims for unemployment insurance have decreased markedly ... a soft labor market could put something of a damper on consumer spending."
"The dynamics of inventory investment and the balance of factors influencing consumer demand will have important consequences for the economic outlook in coming months. But the broad contours of the present cycle have been, and will continue to be, driven by the evolution of corporate profits and capital investment. The retrenchment in capital spending over the past year and a half was central to the sharp slowing we experienced in overall activity. ... Uncertainty about economic prospects boosted risk premiums significantly, and this rise, in turn, propelled required, or hurdle, rates of return to markedly elevated levels. ... reductions in capital outlays were broad-based. These cutbacks in capital spending interacted with, and were reinforced by, falling profits and equity prices. ... a marked decline in profit margins."
" ... slack in labor markets and further increases in productivity should hold labor costs in check and result in rising profit margins even with inflation remaining low. ... Improved profit margins and more assured prospects for rising final demand would likely be accompanied by a decline in risk premiums from their current elevated levels toward a more normal range. ... On balance ... if the recent more-favorable economic developments gather momentum, uncertainties will diminish, risk premiums will fall, and the pace of capital investment embodying new technologies will increase."
"Both deregulation and innovation in the financial sector have been especially important in enhancing overall economic resilience. New financial products--including derivatives, asset-backed securities, collateralized loan obligations, and collateralized mortgage obligations, among others--have enabled risk to be dispersed more effectively to those willing to, and presumably capable of, bearing it. Shocks to the overall economic system are accordingly less likely to create cascading credit failure. Lenders have the opportunity to be considerably more diversified, and borrowers are far less dependent on specific institutions for funds."
"As a consequence of ... extensive deregulation in financial and product markets and the unbundling of risk, imbalances are more likely to be readily contained, and cyclical episodes overall should be less severe than would be the case otherwise. ... the implied reduction in volatility, other things equal, would lower risk and equity premiums. ... the ever-increasing proportion of our GDP that represents conceptual as distinct from physical value added may actually have lessened cyclical volatility. ... But an economy in which concepts form an important share of valuation has its own vulnerabilities. ... a firm is inherently fragile if its value added emanates more from conceptual as distinct from physical assets. ... the vulnerability of a firm whose market value largely rests on capitalized reputation. The physical assets of such a firm comprise a small proportion of its asset base. Trust and reputation can vanish overnight. A factory cannot."
"A sophisticated financial system, with its substantial array of instruments to unbundle risks, will tend toward a higher degree of leverage at any given level of underlying economic risk. But, the greater the degree of leverage in any economy, the greater its vulnerability to unexpected shortfalls in demand and mistakes. ... The ratio of interest payments to cash flow, one indicator of the consequence of leverage, has crept up in recent years, reflecting growth in debt. ... Although the fears of business leverage have been mostly confined to specific sectors in recent years, concerns over potential systemic problems resulting from the vast expansion of derivatives have reemerged ... Derivatives have provided greater flexibility to our financial system. But their very complexity could leave counterparties vulnerable to significant risk that they do not currently recognize, and hence these instruments potentially expose the overall system if mistakes are large. "
"Certain factors, such as the lack of pent-up demand in the consumer sector, significant levels of excess capacity in a number of industries, weakness and financial fragility in some key international trading partners, and persistent caution in financial markets at home, seem likely to restrain the near-term performance of the economy. ... the Federal Open Market Committee at its meeting on January 30 saw the risks nonetheless as continuing to be weighted mainly toward conditions that may generate economic weakness in the foreseeable future." ... [more]
8:10:13 AM 
|
