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03/01/2002

Greenspan on the Economy

The other day Federal Reserve Chairman Alan Greenspan
appeared before the House Committee on Financial Services for
his semiannual update on the health of the U.S. economy.

Greenspan gets a lot of grief, much of it deserved, for his
reporting style, better known as “Greenspeak,” to some an often
indecipherable way of putting things. But if you read his
statements, they actually represent a good lesson on the economy
and the markets. His opinions and forecasts are not always right
(whose are), but since this link, in particular, is designed to
educate, I thought I would take some of his thoughts from his
7/18/01 and 2/27/02 appearances.

There are a few overriding themes in the following; a focus on
demand, inventories, consumer spending, innovation /
productivity, the overall strength of the economy, and, of more
import in his latter take, a renewed focus on debt and risk. Keep
these ideas in mind as you read his statements.

Finally, while he refuses to admit it, Greenspan was far too
optimistic on productivity in his 7/01 speech and he continues to
wrestle with the idea that there must be a better way to forecast
future demand in the economy. Well, there isn’t. There are
simply too many variables, 9/11 just being one example. And I
would also urge you to read his 2/02 conclusions on what to me
is a huge issue going forward, derivatives. He is as blunt as he
has ever been on this topic.

What follows are the chairman’s exact words. Again, these are
excerpts.

July 18, 2001

By aggressively easing the stance of monetary policy, the
Federal Reserve has moved to support demand and, we trust,
help lay the groundwork for the economy to achieve maximum
sustainable growth. Our accelerated action reflected the
pronounced downshift in economic activity, which was
accentuated by the especially prompt and synchronous
adjustment of production by businesses utilizing the faster flow
of information coming from the adoption of new technologies. A
rapid and sizable easing was made possible by reasonably well-
anchored inflation expectations, which helped to keep underlying
inflation at a modest rate, and by the prospect that inflation
would remain contained as resource utilization eased and energy
prices backed down.

In addition to the more accomodative stance of monetary policy,
demand should be assisted going forward by the effects of the tax
cut, by falling energy costs, by the spur to production once
businesses work down their inventories to more comfortable
levels, and, most important, by the inducement to resume
increases in capital spending. That inducement should be
provided by the continuation of cost-saving opportunities
associated with rapid technological innovation. Such innovation
has been the driving force raising the growth of structural
productivity over the last half-dozen years. To be sure, measured
productivity has softened in recent quarters, but by no more than
one would anticipate from cyclical influences layered on top of a
faster long-term trend.

But 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.

Because the extent of the slowdown was not anticipated by
businesses, some backup in inventories occurred, especially in
the United States. Innovations, such as more advanced supply-
chain management, and flexible manufacturing technologies,
have enabled firms to adjust production levels more rapidly to
changes in sales. But these improvements apparently have not
solved the thornier problem of correctly anticipating demand.

At some point, inventory liquidation will come to an end, and
its termination will spur production and incomes. Of course, the
timing and force with which that process of recovery plays out
will depend on the behavior of final demand. In that regard, the
demand for capital equipment, particularly in the near term,
could pose a continuing problem. Despite evidence that
expected long-term rates of return on the newer technologies
remain high, growth of investment in equipment and software
has turned decidedly negative. Sharp increases in uncertainties
about the short-term outlook have significantly foreshortened the
time frame over which business are requiring new capital
projects to pay off. The consequent heavier discounts applied to
those long-term expectations have induced a major scaling back
of new capital spending initiatives, though one that presumably
is not long-lasting given the continuing inducements to embody
improving technologies in new capital equipment.

But there are also downside risks to consumer spending over
the next few quarters. Importantly, the same pressure on profits
and the heightened sense of risk that have held down investment
have also lowered equity prices and reduced household wealth
despite the rise in home equity. We can expect the decline in
stock market wealth that has occurred over the past year to
restrain the growth of household spending relative to income,
just as the previous increase gave an extra spur to household
demand. Furthermore, while most survey measures suggest
consumer sentiment has stabilized recently, softer job markets
could induce a further deterioration in confidence and spending
intentions.

While this litany of risks should not be downplayed, it is notable
how well the U.S. economy has withstood the many negative
forces weighing on it. Economic activity has held up remarkably
in the face of a difficult adjustment toward a more sustainable
pattern of expansion.

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.

-----

February 27, 2002

Since July, when I last reported to you on the conduct of
monetary policy, the U.S. economy has gone through a period of
considerable strain, with output contracting for a time and
unemployment rising. We in the Federal Reserve System acted
vigorously to adjust monetary policy in an endeavor both to limit
the extent of the downturn and to hasten its completion. 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. An array of
influences unique to this business cycle, however, seems likely to
moderate the speed of the anticipated recovery.

If ever a situation existed in which the fabric of business and
consumer confidence, both here and abroad, was vulnerable to
being torn, the shock of September 11 was surely it. In addition
to the horrific loss of life, enormous uncertainties accompanied
the unfolding events and their implications for the economy.
Indeed, for a period of weeks, U.S. economic activity did drop
dramatically in response to that shock.

As the fourth quarter progressed, business and consumer
confidence recovered, no doubt buoyed by successes in the war
on terrorism. The improved sentiment seemed to buffer the
decline in economic activity.

Indeed, in the past several months, increasing signs have
emerged that some of the forces that have been restraining the
economy over the past year are starting to diminish and that
activity is beginning to firm. The appearance of these signs, in
circumstances in which the level of the real federal funds rate
was at a very low level, led the Federal Open Market Committee
to keep policy unchanged at its meeting in late January, although
it retained its assessment that the risks were tilted toward
economic weakness.

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, if they have
not already done so. Any slowing in the rate of inventory
liquidation will induce a rise in industrial production if demand
for those products is stable or is falling only moderately. That
rise in production will, other things being equal, increase
household income and spending. The runoff of inventories, even
apart from the large reduction in motor vehicle stocks, remained
sizable in the fourth quarter. Hence, with production running
well below sales, the lift to income and spending from the
inevitable cessation of inventory liquidation could be significant.

But that impetus to the growth of activity will be short-lived
unless sustained increases in final demand kick in before the
positive effects of the swing from inventory liquidation dissipate.
Most recoveries in the post-World War II period received a boost
from a rebound in demand for consumer durables and housing
from recession-depressed levels in addition to an abatement of
inventory liquidation. 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.

In fact, there are a number of cross currents in the outlook for
household spending. In recent months, low mortgage interest
rates and favorable weather have provided considerable support
to homebuilding. Moreover, attractive mortgage rates have
bolstered the sales of existing homes and the extraction of capital
gains embedded in home equity that those sales engender. Low
rates have also encouraged households to take on larger
mortgages when refinancing their homes. 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. But mortgage rates remain at low levels and
should continue to underpin activity in this sector.

Changes in household financial positions in recent years are
probably damping consumer spending, at least to a degree.
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.

Although the macroeconomic effects of debt burdens may be
limited, we have already seen significant spending restraint
among the top fifth of income earners, presumably owing to the
drop in equity prices. The effect of the stock market on other
households’ spending has been less evident. Moderate-income
households have a much larger proportion of their assets in
homes, and the continuing rise in the value of houses has
provided greater support for their net worth. Reflecting these
differences in portfolio composition, the net worth of the top fifth
of income earners has dropped far more than it did for the bottom
80 percent.

Perhaps most central to the outlook for consumer spending
will be developments in the labor market. The pace of layoffs
quickened last fall, especially after September 11, and the
unemployment rate rose sharply . Even if the economy is on
the road to recovery, the unemployment rate, in typical fashion,
may resume its increase for a time, and a soft labor market could
put something of a damper on consumer spending.

The retrenchment in capital spending over the past year and a
half was central to the sharp slowing we experienced in overall
activity. The steep rise in high-tech spending that occurred in the
early post-Y2K months was clearly not sustainable. The demand
for many of the newer technologies was growing rapidly, but
capacity was expanding even faster, and that imbalance exerted
significant downward pressure on prices and the profits of
producers of high-tech goods and services.

Recent evidence suggests that a recovery in at least some
forms of high-tech investment could already be under way.
Production of semiconductors, which in the past has been a
leading indicator of computer production, turned up last fall.
Expenditures on computers rose at a double-digit annual rate in
real terms last quarter. But the contraction of investment
expenditures in the communications sector, where the amount of
overcapacity was substantial, as yet shows few signs of abating,
and business investment in some other sectors, such as aircraft,
hit by the drop in air travel, will presumably remain weak this
year.

On balance, the recovery in overall spending on business fixed
investment is likely to be only gradual; in particular, its growth
will doubtless be less frenetic than in 1999 and early 2000 – a
period during which outlays were boosted by the dislocations of
Y2K and the extraordinarily low cost of equity capital available
to many firms.

[Following is an extremely important statement on financial
derivatives, at least in my opinion.]

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 with the difficulties of Enron. To be
sure, firms like Enron, and Long-Term Capital Management
before it, were major players in the derivatives markets. But
their problems were readily traceable to an old fashioned excess
of debt, however acquired, as well as to opaque accounting of
that leverage and lax counterparty scrutiny. Swaps and other
derivatives throughout their short history, including over the past
eighteen months, have been remarkably free of default. Of
course, there can be latent problems in any market that expands
as rapidly as these markets have. Regulators and supervisors are
particularly sensitive to this possibility. 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.

(Concluding) The U.S. economy has experienced a
substantial shock, and, no doubt, we continue to face risks in the
period ahead. But the response thus far of our citizens to these
new economic challenges provides reason for encouragement.

Source: The Federal Reserve Board

Next week: the 1830s.

Brian Trumbore



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-03/01/2002-      
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Wall Street History

03/01/2002

Greenspan on the Economy

The other day Federal Reserve Chairman Alan Greenspan
appeared before the House Committee on Financial Services for
his semiannual update on the health of the U.S. economy.

Greenspan gets a lot of grief, much of it deserved, for his
reporting style, better known as “Greenspeak,” to some an often
indecipherable way of putting things. But if you read his
statements, they actually represent a good lesson on the economy
and the markets. His opinions and forecasts are not always right
(whose are), but since this link, in particular, is designed to
educate, I thought I would take some of his thoughts from his
7/18/01 and 2/27/02 appearances.

There are a few overriding themes in the following; a focus on
demand, inventories, consumer spending, innovation /
productivity, the overall strength of the economy, and, of more
import in his latter take, a renewed focus on debt and risk. Keep
these ideas in mind as you read his statements.

Finally, while he refuses to admit it, Greenspan was far too
optimistic on productivity in his 7/01 speech and he continues to
wrestle with the idea that there must be a better way to forecast
future demand in the economy. Well, there isn’t. There are
simply too many variables, 9/11 just being one example. And I
would also urge you to read his 2/02 conclusions on what to me
is a huge issue going forward, derivatives. He is as blunt as he
has ever been on this topic.

What follows are the chairman’s exact words. Again, these are
excerpts.

July 18, 2001

By aggressively easing the stance of monetary policy, the
Federal Reserve has moved to support demand and, we trust,
help lay the groundwork for the economy to achieve maximum
sustainable growth. Our accelerated action reflected the
pronounced downshift in economic activity, which was
accentuated by the especially prompt and synchronous
adjustment of production by businesses utilizing the faster flow
of information coming from the adoption of new technologies. A
rapid and sizable easing was made possible by reasonably well-
anchored inflation expectations, which helped to keep underlying
inflation at a modest rate, and by the prospect that inflation
would remain contained as resource utilization eased and energy
prices backed down.

In addition to the more accomodative stance of monetary policy,
demand should be assisted going forward by the effects of the tax
cut, by falling energy costs, by the spur to production once
businesses work down their inventories to more comfortable
levels, and, most important, by the inducement to resume
increases in capital spending. That inducement should be
provided by the continuation of cost-saving opportunities
associated with rapid technological innovation. Such innovation
has been the driving force raising the growth of structural
productivity over the last half-dozen years. To be sure, measured
productivity has softened in recent quarters, but by no more than
one would anticipate from cyclical influences layered on top of a
faster long-term trend.

But 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.

Because the extent of the slowdown was not anticipated by
businesses, some backup in inventories occurred, especially in
the United States. Innovations, such as more advanced supply-
chain management, and flexible manufacturing technologies,
have enabled firms to adjust production levels more rapidly to
changes in sales. But these improvements apparently have not
solved the thornier problem of correctly anticipating demand.

At some point, inventory liquidation will come to an end, and
its termination will spur production and incomes. Of course, the
timing and force with which that process of recovery plays out
will depend on the behavior of final demand. In that regard, the
demand for capital equipment, particularly in the near term,
could pose a continuing problem. Despite evidence that
expected long-term rates of return on the newer technologies
remain high, growth of investment in equipment and software
has turned decidedly negative. Sharp increases in uncertainties
about the short-term outlook have significantly foreshortened the
time frame over which business are requiring new capital
projects to pay off. The consequent heavier discounts applied to
those long-term expectations have induced a major scaling back
of new capital spending initiatives, though one that presumably
is not long-lasting given the continuing inducements to embody
improving technologies in new capital equipment.

But there are also downside risks to consumer spending over
the next few quarters. Importantly, the same pressure on profits
and the heightened sense of risk that have held down investment
have also lowered equity prices and reduced household wealth
despite the rise in home equity. We can expect the decline in
stock market wealth that has occurred over the past year to
restrain the growth of household spending relative to income,
just as the previous increase gave an extra spur to household
demand. Furthermore, while most survey measures suggest
consumer sentiment has stabilized recently, softer job markets
could induce a further deterioration in confidence and spending
intentions.

While this litany of risks should not be downplayed, it is notable
how well the U.S. economy has withstood the many negative
forces weighing on it. Economic activity has held up remarkably
in the face of a difficult adjustment toward a more sustainable
pattern of expansion.

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.

-----

February 27, 2002

Since July, when I last reported to you on the conduct of
monetary policy, the U.S. economy has gone through a period of
considerable strain, with output contracting for a time and
unemployment rising. We in the Federal Reserve System acted
vigorously to adjust monetary policy in an endeavor both to limit
the extent of the downturn and to hasten its completion. 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. An array of
influences unique to this business cycle, however, seems likely to
moderate the speed of the anticipated recovery.

If ever a situation existed in which the fabric of business and
consumer confidence, both here and abroad, was vulnerable to
being torn, the shock of September 11 was surely it. In addition
to the horrific loss of life, enormous uncertainties accompanied
the unfolding events and their implications for the economy.
Indeed, for a period of weeks, U.S. economic activity did drop
dramatically in response to that shock.

As the fourth quarter progressed, business and consumer
confidence recovered, no doubt buoyed by successes in the war
on terrorism. The improved sentiment seemed to buffer the
decline in economic activity.

Indeed, in the past several months, increasing signs have
emerged that some of the forces that have been restraining the
economy over the past year are starting to diminish and that
activity is beginning to firm. The appearance of these signs, in
circumstances in which the level of the real federal funds rate
was at a very low level, led the Federal Open Market Committee
to keep policy unchanged at its meeting in late January, although
it retained its assessment that the risks were tilted toward
economic weakness.

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, if they have
not already done so. Any slowing in the rate of inventory
liquidation will induce a rise in industrial production if demand
for those products is stable or is falling only moderately. That
rise in production will, other things being equal, increase
household income and spending. The runoff of inventories, even
apart from the large reduction in motor vehicle stocks, remained
sizable in the fourth quarter. Hence, with production running
well below sales, the lift to income and spending from the
inevitable cessation of inventory liquidation could be significant.

But that impetus to the growth of activity will be short-lived
unless sustained increases in final demand kick in before the
positive effects of the swing from inventory liquidation dissipate.
Most recoveries in the post-World War II period received a boost
from a rebound in demand for consumer durables and housing
from recession-depressed levels in addition to an abatement of
inventory liquidation. 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.

In fact, there are a number of cross currents in the outlook for
household spending. In recent months, low mortgage interest
rates and favorable weather have provided considerable support
to homebuilding. Moreover, attractive mortgage rates have
bolstered the sales of existing homes and the extraction of capital
gains embedded in home equity that those sales engender. Low
rates have also encouraged households to take on larger
mortgages when refinancing their homes. 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. But mortgage rates remain at low levels and
should continue to underpin activity in this sector.

Changes in household financial positions in recent years are
probably damping consumer spending, at least to a degree.
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.

Although the macroeconomic effects of debt burdens may be
limited, we have already seen significant spending restraint
among the top fifth of income earners, presumably owing to the
drop in equity prices. The effect of the stock market on other
households’ spending has been less evident. Moderate-income
households have a much larger proportion of their assets in
homes, and the continuing rise in the value of houses has
provided greater support for their net worth. Reflecting these
differences in portfolio composition, the net worth of the top fifth
of income earners has dropped far more than it did for the bottom
80 percent.

Perhaps most central to the outlook for consumer spending
will be developments in the labor market. The pace of layoffs
quickened last fall, especially after September 11, and the
unemployment rate rose sharply . Even if the economy is on
the road to recovery, the unemployment rate, in typical fashion,
may resume its increase for a time, and a soft labor market could
put something of a damper on consumer spending.

The retrenchment in capital spending over the past year and a
half was central to the sharp slowing we experienced in overall
activity. The steep rise in high-tech spending that occurred in the
early post-Y2K months was clearly not sustainable. The demand
for many of the newer technologies was growing rapidly, but
capacity was expanding even faster, and that imbalance exerted
significant downward pressure on prices and the profits of
producers of high-tech goods and services.

Recent evidence suggests that a recovery in at least some
forms of high-tech investment could already be under way.
Production of semiconductors, which in the past has been a
leading indicator of computer production, turned up last fall.
Expenditures on computers rose at a double-digit annual rate in
real terms last quarter. But the contraction of investment
expenditures in the communications sector, where the amount of
overcapacity was substantial, as yet shows few signs of abating,
and business investment in some other sectors, such as aircraft,
hit by the drop in air travel, will presumably remain weak this
year.

On balance, the recovery in overall spending on business fixed
investment is likely to be only gradual; in particular, its growth
will doubtless be less frenetic than in 1999 and early 2000 – a
period during which outlays were boosted by the dislocations of
Y2K and the extraordinarily low cost of equity capital available
to many firms.

[Following is an extremely important statement on financial
derivatives, at least in my opinion.]

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 with the difficulties of Enron. To be
sure, firms like Enron, and Long-Term Capital Management
before it, were major players in the derivatives markets. But
their problems were readily traceable to an old fashioned excess
of debt, however acquired, as well as to opaque accounting of
that leverage and lax counterparty scrutiny. Swaps and other
derivatives throughout their short history, including over the past
eighteen months, have been remarkably free of default. Of
course, there can be latent problems in any market that expands
as rapidly as these markets have. Regulators and supervisors are
particularly sensitive to this possibility. 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.

(Concluding) The U.S. economy has experienced a
substantial shock, and, no doubt, we continue to face risks in the
period ahead. But the response thus far of our citizens to these
new economic challenges provides reason for encouragement.

Source: The Federal Reserve Board

Next week: the 1830s.

Brian Trumbore