Mr. Chairman and members of the committee. Thank you for this opportunity to discuss with you issues surrounding prospective economic developments and the Federal Reserve's recent conduct of monetary policy. Today, I would like to review four interrelated topics: First, the Federal Reserve's long-standing effort to reduce inflation and inflation expectations; second, the immediate economic setting and its implications for policy action in the period ahead; third, the ongoing debate over possible tradeoffs between inflation and unemployment; and fourth, the value of central bank independence and accountability.

The Federal Reserve's Track Record

After seven years of sustained economic expansion, the U.S. economy continues to enjoy relatively low inflation, a vibrant labor market and moderate interest rates. Indeed, with the exception of the brief period of declining output in the aftermath of Iraq's invasion of Kuwait, the U.S. economy has experienced an impressive stretch of almost 15 years of virtually uninterrupted growth and declining inflation expectations. Yet today, despite the understandable concern that such good fortune cannot last indefinitely, we see very few signs that continued economic expansion is threatened.

This enviable performance owes immeasurably to the persistent efforts of Federal Reserve policymakers to reduce inflation and thereby promote the most ideal conditions for maximum sustainable economic growth. In this sense, low inflation has not been an end in itself. A little historical perspective will help us appreciate the extent of policy's success. At present, the percentage of our population employed is the highest ever recorded, yet inflation by almost any measure is the lowest in 30 years. During these past 15 years of committed policy, the volatility of economic growth has declined dramatically as compared to the record of the previous 15 years of very high inflation. In fact, while growth has been slightly stronger in the more recent period, the standard deviation of quarterly changes in real output has fallen by nearly half (from 4.8% to 2.5%) (see Figure 1).

While the Fed's recent track record stands out historically, it also compares favorably to the experience of other countries. The so-called Misery index, which adds the inflation rate to the rate of unemployment as a kind of Everyman's gauge of economic policy, is now at roughly 7 ½%, the lowest since the late-1960s. In that earlier period, the index for the U.S. was worse than the average across all of the OECD countries. Today, the U.S. figure stands five points below the OECD standard (see Figure 2).

I believe that much of this improvement in economic stability reflects the dramatic decline in long-term inflation expectations over this period. At the nadir of our inflation problem, in the fall of 1980 when long-term interest rates were near 15%, a survey of investors and other key professions revealed that these decision makers expected inflation to average almost 9% over the next ten years. Now, when people are polled about their inflation outlook, the answer coming back in recent months has begun to vary between 2.8% and 3.1%, only slightly higher than the current rate of consumer price inflation.

This progress has a number of favorable implications. First, despite a strong economy, interest rates on mortgages and long-term business borrowing are less than half their previous extremes. We can expect that if the Fed overcomes a possible near-term threat of higher inflation, we will see these rates probe even lower levels over the next several years. Second, these low expectations have begun to yield their own dividends because consumers and businesses do not have to waste time and resources planning ways to protect themselves from inflation. They behave in ways that tend to preserve the gains. Credit usage is running at half the rate of the two previous expansions that lasted as long as the current one (see Figure 3); manufacturers are not hoarding materials; and, businesses faced with rising costs are fearful of raising prices. In short, the customer is king again.

Finally, the enhanced credibility of monetary policy implicit in these low expectations means that the Fed has greater latitude in a difficult environment to be patient, awaiting clearer signs of the appropriate policy direction without inviting the potential second-guessing among investors that can create instability in financial markets. Indeed, the Fed's most recent decisions to forego tightening were viewed by many market participants as a reaffirmation of a favorable inflation outlook.

To be sure, the Fed has gained an important assist from a number of developments including the trend toward freer international trade, the stepped up pace of technological change and most recently, the successful efforts of our political leaders to rein in fiscal expansion. However, the ultimate responsibility for monetary stability rests with the central bank. And, for much of this period, the Fed has had to overcome numerous obstacles, not the least of which were sizable fiscal imbalances and the lack of credibility resulting from earlier monetary policy mistakes.

Keeping Score With Policy Rules

One of the most useful tools for assessing Federal Reserve behavior entails the application of so-called policy rules. Policy rules are operational guides for policy. They use formulas to prescribe policy in a systematic fashion designed to keep short-run decisions consistent with the Fed's long-run mandate to achieve "maximum employment" and "stable prices". For the past several years, we at Salomon Brothers have promoted one such rule, which we dubbed the Taylor rule based on a formulation by Professor John Taylor of Stanford University.

From a historical perspective, the Taylor rule is a very helpful way of corroborating the view that policy in recent years has been appropriate. Federal funds rates prescribed by the Taylor formula reveal the sharp change in monetary policy that took place in the early 1980s as the Fed regained control over policy with a strong anti-inflation commitment (see Figure 4). Through most of the period since 1980 the actual fed funds rate has been at or above the prescribed Taylor rate. In contrast, in the 15 years leading up to that change, the funds rate was generally below prescribed levels. This inflationary bias was true even when the funds rate moved above 10% late in the 1970s. The illusion that rates were high is not borne out by the rule. Thus, inflation continued to mount with devastating consequences for employment and economic stability.

The mirror of this illusion may have been at work in this decade as well. When the Fed moved rates from 3% to 6% in 1994-95, many market participants judged that the 6% funds rate was still too low to arrest the inflationary momentum beginning to surface in the economy. The rule, however, characterized policy as appropriate, and as we saw, an early inflation threat was quashed.

This perspective on policy rules raises a significant point in the debate over policy decision-making. The Taylor rule tells us that the forces motivating policy in recent years are quite transparent, not mysterious. One often hears the criticism that the Fed is "flying by the seat of its pants" or that officials are waving swords at imaginary dragons and "fighting the last war." Nothing could be further from the truth. The path of the funds rate implied by the Taylor rule tracks the actual funds rate closely over most of the past decade under Chairman Greenspan's leadership (see Figure 5). This result is not surprising because the rule instructs the Fed to keep inflation trending toward stable prices subject to current economic conditions and the degree of economic slack.

I suspect that the rule does a better job of anticipating changes in Fed policy than many financial market participants because officials are forward-looking, while many observers tend to focus on current price statistics. However, policy affects the economy with a lag. Decisions today will begin to affect the economy in a matter of months, but the ultimate effect on inflation will not be felt for more than two years. Therefore, officials must base their decisions in part on uncertain forecasts and assumptions about fundamental relationships in the economy.

To the extent that policy rules can incorporate rough proxies for expected inflation, they can provide a useful check that policy is on track. In this sense, today's inflation statistics tell us about the appropriateness of decisions made two years ago. Stable underlying inflation in 1997 provides the ultimate verdict that the Fed's decisive shift in 1994 was both timely and appropriate. Without those actions, I suspect today we would have an unappetizing combination of higher inflation, much higher interest rates and a more troubled economic backdrop.

The Current Economic Setting

This brings us to the present situation. I believe that the Federal Reserve faces some significant challenges in the months ahead. My colleagues and I are concerned that rapid growth in nominal demand over the past year may be symptomatic of an overly accommodative monetary policy that will need to be repositioned in order to sustain the current expansion. Despite the current benign readings on inflation, the risks of inflationary imbalances developing are rising ever so slightly, barring an unlikely sharp falloff in nominal demand or the pace of monetary expansion. A similar perception justified the very minor policy adjustment earlier this year; and I suspect we will need further modest tightening in the year ahead.

I recognize that this judgment is not entirely in sync with current market thinking or the present term structure of interest rates; and, it is a minority view among economists who follow the Fed. Indeed, the current euphoria in financial markets increasingly reflects a mistaken, and potentially harmful, view that any limits on the economy's capacity to grow without strain have been repealed by the effects of increased global competition and the rapid pace of technological change. Such "new era" thinking is not new. And, as we have seen in similar episodes historically, there is usually an element of truth in these arguments that is overstated.

However, increased global competition affects neither growth in the labor force nor productivity, the two main forces that govern an economy's ability to grow. Technological advance has the potential to improve efficiencies, and no doubt has already done so for many individual companies. But the advantages to output per worker in the larger macro-economy likely have been small. We suspect that both productivity and output are now being understated slightly. Surging Federal tax revenues and a growing disparity between GDP and its conceptual equivalent, gross domestic income, hint at this shortfall in official statistics. In addition, the maintenance of high profit margins in the face of rising compensation costs and relatively tame price increases suggests that constraints on our abilities to grow are less rigid than in the past. We can be excited about the longer term implications of these developments. But we must separate secular optimism from cyclical reality.

Given the patterns we have observed in overall growth and the incidence of rising resource utilization, it would be highly imprudent for the Fed to assume that the limits to growth have been removed. Whether or not productivity growth has improved or capacity has become more flexible, Federal Reserve officials know that resources have been stretched beyond our long-run potential in recent years as evidenced by falling unemployment, a lengthening workweek, near-record overtime in manufacturing and unprecedented participation in the labor force. Since mid-1992, the economy has grown at an average annual rate of about 2.7%, not very high by new era standards, yet sufficient to pull the unemployment rate down by more than two and a half percentage points. Over a longer span, a simple scatter plot of growth versus changes in unemployment shows that growth barely above 2% has been sufficient to absorb labor slack (see Figure 6).

Apart from the transitory benefits of falling energy prices on headline inflation, there are a number of more fundamental factors that have helped contain price pressures thus far that are not likely to provide much further assistance. These factors include strong labor force growth, declining budget deficits, and substantial world economic slack. We were very fortunate in 1996 that unusually strong hiring demands were accommodated by a surge in the labor force. The numbers of people entering the workforce ballooned by 2%, well beyond the rise in the working-age population. Employment rose by 2 ¹/₄% compared with trend growth in the labor force of little more than 1%. This flexibility among potential job seekers is almost unique in America. But to some extent the rise in participation reflected a catch up from earlier sluggish growth and may have reflected the impact of welfare reform and the reentry of older "downsized" workers encouraged by a revived job market. But this pattern in all likelihood is not sustainable: In the latest three months, the labor force has stopped growing, perhaps signaling that the burst is over.

Similarly, the decline in the budget deficit has brought our fiscal position into virtual balance, removing an important drain on the country's savings at a critical time in the expansion when private investment needs are high. With the budget deficit now well below 1% of GDP and falling, the additional margin of resources freed up from further restraint will be small.

International developments (not to be confused with global competition) including a strong dollar and subdued global demand for commodities also have played an important part in containing U.S. inflation. Our own model simulations show that the 14% appreciation of the broad real trade-weighted dollar since the spring of 1995 has trimmed as much as ½ percentage point off measured consumer price inflation. Although some further appreciation is likely in the near-term, the dollar is not likely to be as significant a factor in dampening inflation (see Figure 7).

Similarly, sluggish global demand has held the prices of commodities in check, but world growth should become progressively stronger heading into 1998. Moreover, this acceleration is already underway. A proxy for global industrial output based on data from the major industrial countries shows that factory output for the first time since 1994 is beginning to outstrip the rise in capacity (see Figure 8). Symptoms of this rebound are beginning to surface in the prices of US producer goods in the very early stages of production. The so-called PPI for crude non-energy materials has risen at a 5 ¹/₂% rate in the past six months; not at a pace that makes tightening urgent, but sufficient to justify the Fed's continuing biased stance (see Figure 9).

With little slack and fading help from temporary factors, we must be sure that demand remains on a path consistent with the economy's long-run supply potential. Despite some softening in key components of demand in recent months, the pattern of growth thus far in 1997 seems to have accelerated a bit from an already solid pace in 1996. Moreover, financial conditions are generally supportive of strong demands on resources in the months ahead. Measures of monetary growth are slightly above their desired ranges and accelerating now. Household financial assets relative to income have risen in the range of 10% to 20% over the past two and a half years, presenting a continuing threat that liquidity might surge. Indeed, the rise in household holdings of securities and mutual fund shares that has followed in the wake of declining inflation expectations has increased the stakes for monetary policy. Almost 30% of household net worth is now held in risk-assets, a dramatic increase from about 12% a little over a decade ago (see Figure 10). This increased exposure to risk is a natural outgrowth of the Fed's success but it also increases the underscores the need for monetary stability.

Some analysts reason that monetary policy is well positioned now because real short-term interest rates are above their historic averages. This comparison is misleading. The long-term average of less than 2% includes a period when the financial system was still highly regulated and dominated by banks. Interest rate policy received an important assist from other regulations that limited the supply of credit. In those earlier days, banks could not compete for savings when market interest rates pierced legal ceilings on deposits. Thus, interest rates did not have to rise very high to choke off all credit to sensitive areas such as housing and autos. Such a system bears no resemblance to today's deregulated, securitized world. Indeed, in the era of deregulation, real short-term rates have averaged roughly 3%, about where they are now. From this perspective, higher than average rates may be needed to promote stability.

To be sure, current financial conditions are not as stimulative as those at the end of 1993 when the Fed was deliberately accommodative. Pent-up demand in some key areas such as motor vehicles has been satisfied. Nonetheless, recent declines in market interest rates have revived housing and spurred new gains in share prices that have reduced the cost of capital to business substantially and buoyed household wealth. Consumer spending on highly discretionary goods and services continues to soar. In this setting, the risks lie decidedly in the direction of excess demand and potential inflationary imbalances.

The Inflation-Unemployment Debate

There is another very common way in which the monetary policy debate is phrased that I believe is unhelpful. It is the Phillips curve framework, which posits a short-run tradeoff between inflation and unemployment when inflation expectations are low. The evidence for this short-run tradeoff is compelling and if we know the so-called natural rate of unemployment, this relationship can be a very useful forecasting tool. But we cannot be certain of the natural rate ahead of time. And in the current circumstance, there is considerable doubt about what level of unemployment is the lowest consistent with full employment. Moreover, under conditions where inflation expectations are high or rising, any such tradeoff ceases to exist because inflationary policies fail to produce even temporary job gains.

Put differently, there is no long-run tradeoff between inflation and unemployment. Thus, a monetary policy that pursues price stability is also one that produces the maximum gains in employment. As we have seen, bringing inflation expectations down over 15 years has fostered the strongest job market in a generation.

Unfortunately, the short-term tradeoffs have led to false characterizations of policy on both sides of the political aisle. Hence, we hear criticism of the Fed that officials worry that unemployment is too low or that too much growth may cause inflation. Of course, inflation is not caused by too many people working. Nor is unemployment a cure for inflation. Yet output and employment fostered by overly accommodative monetary policy is not growth in a meaningful sense because it is transitory. In this context, an old cliché that "There is no free lunch" may apply; put in policy terms, this might be expressed as "Central banks can print money, but they cannot print savings."

The challenge for the Federal Reserve is not to discern whether unemployment is too low but whether or not strong demand is being supported by saving and productivity or by excess credit and artificially low interest rates. Is growth the sort that will breed inflationary imbalances or is it sustainable? In the words of Chairman Greenspan, this is "what making monetary policy is all about."

To its credit, the Fed has not been drawn into the debate on these false terms. There is ample evidence that recent policy decisions have not been driven by Phillips curve logic. For example, in January 1996, the Fed reduced rates with unemployment at 5.6%, below the 6% to 6 ¼% range that many economists reasoned was the threshold for rising inflation. And, of course, the recent decisions to maintain a steady course were taken in the context of the lowest unemployment rate in 24 years and trailing four-quarter growth in GDP of 3 ¹/₂%, higher than the long-run trend.

In fact, the Fed does not set limits for economic growth. Nor is it necessary that it have precise estimates of full employment. If economic growth is rising sharply above its underlying potential, the disparity will cast a shadow in the form of lengthening delivery times, rising costs for materials, and increased overtime. Rising bond yields and other market signals could provide evidence that inflation expectations are edging up. Similarly, if hiring is surpassing the numbers of new job seekers such that labor cost pressures begin to outstrip gains in productivity, this could be a sign of excess demand that threatens the durability of the economic expansion. In each case, policymakers would have compelling reason to counter these tendencies before they burst forth in higher inflation.

In recent months, despite impressions that the economy is stretching to meet demand, the urgency for action to head off inflation has been lessened in part because we simply have not seen these symptoms of strain develop with the intensity that historical experience would have suggested. Nonetheless, officials inevitably will want to form some judgments about what full employment and potential growth might be in the period ahead, particularly if demand remains as strong as we have seen in the past year and a half. Had it not been for the unusual surge in the labor force last year, the rapid pace of hiring would have pushed the unemployment rate down to 4 ½% by now, a rate few, if any, economists would deem sustainable. With respect to growth itself, the Taylor rule's inclusion of the gap between actual and estimated potential output could make this tool a useful first approximation of policy's appropriate stance. At present, the rule is prescribing a funds rate very close to the Fed's current 5 ½% target. An alternative version proposed by Federal Reserve Governor Meyer recommends a somewhat higher rate. Our own economic forecast implies that the prescribed funds rate will rise above 6%.

Central Bank Independence: The Fed As Good Citizen

As citizens, we all have a keen interest in the success of monetary policy. As overseer of the value of money and the stability of the financial system, the Fed is guardian of the lifeblood of the market economy. Success in that effort depends crucially on the independence of the central bank. However, the issue of independence has stirred much controversy because it is viewed by some observers as undemocratic. Therefore, we need to clarify what we mean by central bank independence in a democratic society and why it is so vital to economic stability.

The most important element of independence is that the central bank is free to decide how to achieve the goals set by Congress. In turn, it should be understood that, except in the most extreme circumstances, those judgments are final and cannot be overruled by Treasury. Independence does not mean that the Fed should be free to set its own goals, pursued in a closed fashion, unaccountable to the public.

However, freedom to set strategy and choose the instruments of policy has clear advantages. First, because policy works with a lag, officials often find that their decisions require a long-term focus, that looks beyond the immediate situation. Such long-horizon planning is difficult to achieve in a political setting. Second, because there may be short-term costs to decisions with larger long-term payoffs, a captive central bank would be biased toward inflationary policy. Third, central bankers should be specialized and technically proficient. Economics is not a laboratory science, and -- subject to rules of accountability--, officials should be thoroughly familiar with the uncertainties and complex interactions of the financial system and the economy.

In practice, there is a large and growing body of evidence that supports the logic of central bank independence. The empirical evidence shows overwhelmingly that economic performance is superior in those countries with a high degree of central bank independence (CBI). Researchers have developed a number of benchmarks (based on various legal provisions ) for gauging the extent of independence and have related these to measures of growth and inflation. Countries with more CBI have experienced lower inflation without a loss in economic growth. The evidence fully supports economists' notion that there is no long-run tradeoff between inflation and unemployment. While some have found that economic volatility has increased, the U.S. experience has been quite the opposite as we have shown.

This track record has played a role in the spread of independence. Over the past decade, several countries in all regions of the world have fortified the degree of central bank independence. One of the first acts of the new government in Britain earlier this year was to free the Bank of England from the reins of the Treasury.

Superficially, such independence may appear undemocratic. But the goals for the Federal Reserve and other central banks have been established by the public's elected representatives. In countries such as New Zealand and the United Kingdom, the executive and legislative branches have set a specific inflation target and the central bank must aim to hit it. If it misses, the bank must explain why in public. In the same vein, the proposed European Central Bank's mandate is simply price stability, implying that the price target has been set once and for all as approved by 15 legislatures that ratified the Maastricht Treaty. The Fed's objectives have been set by Congress, and its senior officials are appointed with 14-year terms by the President. As amended, the Federal Reserve Act mandates the Fed to pursue "maximum employment, stable prices, and moderate long-term interest rates." It does not say "5% unemployment" or "relatively small increases in the consumer price index." Nor should it. The avoidance of highly specific measures is far sighted and its so-called "dual mandate" assures the public that policy will have a long-term focus because only stable prices will promote maximum employment.

Moreover, the language of the Fed's mandate recognizes the imperfections in the inflation data as well as the inexact channels through which inflation works. After all, inflation ultimately is a process, not a statistic. We cannot know ahead of time how the misallocation of resources engendered by inflationary policy will show through in the economy. It may appear in the prices of goods and services, but business expansions in the past have ended because of similar distortions in the prices of housing and real estate and the prices of capital goods and financial assets, all validated by excess money and credit. Put differently, Adam Smith and Henry Thornton never saw a CPI, but they understood inflation as well an any macroeconomist.

These uncertainties and the discretionary powers given to the Fed, increase the importance of open dialogue about the conduct of policy. The Federal Reserve must account for its actions and the underlying rationale in forums such as this. This practice results not only in a better understanding of the importance of the Fed's mission but it offers the Fed the opportunity to enhance the credibility of its stated goals. Recent experience has taught us that when a central bank can "walk the walk" as well as "talk the talk," its power to carry out its task and its flexibility to err without serious consequence are strengthened. Although the Fed still has work to do, the current generation of Fed leaders has set a standard for commitment to price stability. In doing so, they have followed the public's will.