Greenspan Highlight Reel

Here’s the highlight reel from Greenspan’s testimony before Congress today.

First, some comments about the state of the economy thus far in 2005:

In mid-February, when I presented our last report to the Congress, the economy, supported by strong underlying fundamentals, appeared to be on a solid growth path, and those circumstances prevailed through March.

…The upbeat picture became cloudier this spring, when data on economic activity proved to be weaker than most market participants had anticipated and inflation moved up in response to the jump in world oil prices. By the time of the May FOMC meeting, some evidence suggested that the economy might have been entering a soft patch reminiscent of the middle of last year, perhaps as a result of higher energy costs worldwide.

…[However,] The data released over the past two months or so accord with the view that the earlier soft readings on the economy were not presaging a more serious slowdown in the pace of activity.

Next, comments about the prospects for the rest of this year:

Should the prices of crude oil and natural gas flatten out after their recent run-up–the forecast currently embedded in futures markets–the prospects for aggregate demand appear favorable. Household spending–buoyed by past gains in wealth, ongoing increases in employment and income, and relatively low interest rates–is likely to continue to expand. Business investment in equipment and software seems to be on a solid upward trajectory… However, given the comparatively less buoyant growth of many foreign economies and the recent increase in the foreign exchange value of the dollar, our external sector does not yet seem poised to contribute steadily to U.S. growth.

…Thus, our baseline outlook for the U.S. 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 scrutiny.

And now for the things that could go wrong:

With regard to the outlook for inflation, future price performance will be influenced importantly by the trend in unit labor costs, or its equivalent, the ratio of hourly labor compensation to output per hour. Over most of the past several years, the behavior of unit labor costs has been quite subdued. But those costs have turned up of late, and whether the favorable trends of the past few years will be maintained is unclear.

…Energy prices represent a second major uncertainty in the economic outlook. A further rise could cut materially into private spending and thus damp the rate of economic expansion. In recent weeks, spot prices for crude oil and natural gas have been both high and volatile. Prices for far-future delivery of oil and gas have risen even more markedly than spot prices over the past year. Apparently, market participants now see little prospect of appreciable relief from elevated energy prices for years to come.

And finally, Greenspan’s final worry, and the one that he spent the most time discussing: unusually low long-term interest rates:

…The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates… This decline in long-term rates has occurred against the backdrop of generally firm U.S. 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.

…Considerable debate remains among analysts as to the nature of those market forces [keeping long-term rates low]. Whatever those forces are, they are surely global, because the decline in long-term interest rates in the past year is even more pronounced in major foreign financial markets than in the United States.

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

…In addition to these factors, 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. What is unclear is whether the excess is due to a glut of saving or a shortfall of investment… [A]s best we can judge, both high levels of intended saving and low levels of intended investment have combined to lower real long-term interest rates over the past decade.

…The economic forces driving the global saving-investment balance have been unfolding over the course of the past decade, so the steepness of the recent decline in long-term dollar yields and the associated distant forward rates suggests that something more may have been at work over the past year.

The reason Greenspan cites unexplainedly low long-term interest rates as a potential risk to the US economy is largely because of what might happen to the housing market if they start rising:

[T]he 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.

…Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor. The apparent froth in housing markets appears to have interacted with evolving practices in mortgage markets.

…[W]e certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial.

This was a fairly upbeat assessment of the state of the US economy, I think, though Greenspan may have spent more time discussing potential macroeconomic concerns than he typically does.

However, I think that there’s one big item that he missed when discussing the possible future trajectory of long-term interest rates: the large and endless budget deficits that seem to be in store for the US government, despite the White House’s whitewashing attempts. I’m guessing that Greenspan would probably be a lot less worried about the potential for a sudden rise in long-term interest rates if the US didn’t face such serious fiscal problems. I know that I would (in addition to just about every macroeconomist I know). Yet he relegated mention of this problem to a footnote, which was probably not read aloud to the Congress. I think that represents a missed chance to remind Congress of the importance of fiscal prudence, and their failure to exercise it.