<DOC>
[109 Senate Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:30354.wais]
S. Hrg. 109-615
FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2006
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU-
ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978
__________
JULY 19, 2006
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Peggy R. Kuhn, Senior Financial Economist
Mark Oesterle, Counsel
Mark A. Calabria, Senior Professional Staff Member
Lee Price, Democratice Chief Counsel
Stephen R. Kroll, Democratic Special Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
?
C O N T E N T S
----------
WEDNESDAY, JULY 19, 2006
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 2
Senator Bennett.............................................. 4
Senator Reed................................................. 4
Senator Bunning.............................................. 5
Senator Menendez............................................. 6
Senator Dole................................................. 7
Senator Stabenow............................................. 8
Senator Allard............................................... 9
Senator Carper............................................... 10
Senator Sununu............................................... 12
Senator Martinez............................................. 12
Senator Hagel................................................ 12
Senator Dodd................................................. 13
WITNESS
Ben S. Bernanke, Chairman, Board of Governors of the Federal
Reserve System, Washington, DC................................. 13
Prepared statement........................................... 46
Response to written questions of:
Senator Shelby........................................... 49
Senator Reed............................................. 51
Senator Stabenow......................................... 51
Senator Crapo............................................ 54
Additional Material Supplied for the Record
Monetary Policy Report to the Congress, July 19, 2006............ 56
(iii)
FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2006
----------
WEDNESDAY, JULY 19, 2006
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:06 a.m., in room SD-106, Dirksen
Senate Office Building, Senator Richard C. Shelby, Chairman of
the Committee, presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The hearing will come to order. We are
very pleased this morning to welcome Chairman Ben Bernanke
before the Committee on Banking, Housing, and Urban Affairs, to
deliver the Federal Reserve's Semi-Annual Monetary Policy
Report to the Congress.
Chairman Bernanke, your testimony and report this morning
note the economy's strong performance in the first half of
2006. Real gross domestic product, GDP, increased at an annual
rate of 5.6 percent in the first quarter of 2006. Federal
Reserve data released earlier this week showed U.S. industrial
production rising 0.8 percent in June with capacity utilization
now at 82.4 percent, the highest rate since June 2000. We
continue to enjoy a low unemployment rate, both historically
and relative to other industrialized nations.
Some of the most recent economic data make it clear the
balancing act that the Federal Reserve now faces. Energy
prices, including oil, have increased over the past year and
the turmoil in the Middle East adds to concerns in this area.
Housing markets seem to be catching their breath, with the pace
of rapid price appreciation slowing and in some markets showing
small declines. Both factors lead to questions about the
ability of consumers to continue consumption growth in our
economy.
At its most recent meeting on June 29, the Federal Open
Market Committee raised its target for the Federal funds rate
by 25 basis points to 5.25 percent, the seventeenth one-quarter
point increase since June 2004 when the FOMC began raising the
target rate from a then low of 1 percent.
Fed watchers noted that the latest FOMC statement seemed to
leave open the question of whether the FOMC will increase the
Federal funds target at its next meeting, referencing ``the
extent and timing of any additional'' rate increases. Although
the minutes of that meeting will not be released until July 20,
our hearing this morning gives us the opportunity to discuss
which factors were significant in your deliberations and what
factors you may be looking at as the FOMC prepares for its next
monetary policy hearing on August 8. Our hearing this morning
can thus add to the transparency of the FOMC process.
Mr. Chairman, we are pleased to have you with us this
morning. We look forward to discussing in greater detail the
Federal Reserve's performance in carrying out monetary policy
and its views on the future direction of our Nation's economy.
We all look forward to raising a number of questions with you
then.
Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you very much, Chairman Shelby. I
welcome Chairman Bernanke before the Committee.
I think it is fair to say this hearing comes at a
particularly pivotal time for monetary policy. The economy is
slowing down and the run-up in oil prices is contributing to
that slowdown. An oil price spike has preceded a number of
recessions since 1973, but some spikes have occurred without a
subsequent recession. We look to the Federal Reserve to help
avoid a recession this time around.
There are a number of signs of economic weakness. Job
growth has been anemic for the last 3 months, averaging just
over 100,000 jobs per month. The pace is less than 1 percent a
year. Over the last half century we have tended to have such
slow job growth when we are going into or coming out of a
recession. It is less than half the pace of job growth for the
10 years of expansion from March 1991 to March 2001.
Not only are jobs growing slowly, but also all the measures
of wages and compensation show gains below inflation over the
last year. Total compensation, including wages and benefit
costs, have risen 2.8 percent in the last year. Such pay gains
are not putting upward pressure on inflation because they are
almost entirely offset by productivity gains, which are up 2.5
percent. Unit labor costs, which adjust hourly labor costs for
productivity gains, are up by a negligible 0.3 percent in the
last year.
That is shown rather dramatically in this chart, which
shows compensation, productivity, and unit labor costs.
Unfortunately, the only people with pay gains that are
keeping ahead of inflation are those at the top of the ladder.
By this stage in previous business cycle expansions, people at
the middle and bottom of the wage ladder have typically been
enjoying healthy pay gains. This was certainly the case from
1995 to 2000. We need to keep the expansion going so that those
at the middle and the bottom of the pay scale can finally share
in the exceptional productivity gains that they have helped to
create.
With the higher cost of fuel and little room to cut back on
fuel use, consumers have been forced to cut back on other types
of spending and they go into debt. Consumer spending has risen
at less than a 2 percent rate over the last 4 months. To manage
even that modest increase, households have had to reduce
savings and increase borrowing. The household savings rate has
plunged to an unprecedented minus 1.7 percent.
Where is the rise in inflation coming from? Although higher
prices for oil and other commodities have contributed, much
more important is the surge in profit margins. At this hearing
2 years ago, Chairman Greenspan drew attention to this, stating
``from an accounting perspective, between the first quarter of
2003 and the first quarter of 2004 all of the 1.1 percent
increase in the prices of final goods and services produced in
the nonfinancial corporate sector can be attributed to a rise
in profit margins rather than cost pressures.''
He predicted at the time that competition to create new
capacity and hire more workers would bring down the profit
share to more normal levels, but that has not happened. In
fact, the profit share of GDP hit 12.7 percent in the first
quarter, the highest profit margin since 1950. With inflation
racing ahead of wages and rising interest rates, we see a
serious downturn in the housing industry. The housing
affordability index has plunged to the lowest level since 1989
when declining housing led to a recession in 1990.
New home sales so far this year are running 11 percent
below the rate for the same period last year. With sales down,
builders have cut back on new home construction. They are
obtaining permits at a rate of more than 1.7 million a year for
5 months last year, but that rate fell below 1.5 million in the
latest months. We are now down below 1.4 million. This is new
single family home permits, and it shows a rather marked
decline over the last year.
Last week's report on the consensus of blue chip economic
forecasters should also give Federal Reserve policymakers
pause. The consensus expects growth below the trend line
starting with the just-completed second quarter through the end
of 2007. In addition, the blue chip economic forecasters expect
inflation to slow down to about 2.5 percent next year.
I am hopeful that this morning Chairman Bernanke can put to
rest some troubling concerns about monetary policy. The Fed's
statements that future changes in interest rates will depend on
new data, not an all together unreasonable statement I might
say, but it has been interpreted by some commentators to mean
that the Federal Reserve will raise interest rates at every
meeting until inflation comes down.
The headlines of the last two weekly reports from Goldman
Sachs are ``The Stance of Monetary Policy, Enough is Enough.''
And the other one ``Bernanke Preview, Monetary Policy Begins to
Bite.'' Two recent headlines from Merrill Lynch state that its
``getting tougher for the Fed to justify what it is doing'' and
``nearly every indicator showing signs of a slowdown.''
Merrill Lynch Economist David Rosenberg, in a report last
Friday entitled, ``To Pause Or Not To Pause: That Is The
Conundrum,'' expressed this concern: ``The Fed has managed to
elevate a pause to something that is a pretty major event. What
was normal in prior cycles, up or down, is now something that
grabs headlines. The Fed paused twice in the 1999-2000 cycle
and three times in the 1994 cycle, and it elicited a yawn from
the markets. This time around a `pause' is being treated as an
`ease,' which has basically put the Fed in a pickle.''
The 17 Fed rate hikes over the last 2 years are having an
effect. You can see that in the housing sector, job growth, the
blue chip forecast. Both for subdued growth and for falling
inflation over the next year.
I look forward to the opportunity to pursue these concerns
with the Chairman in the question period. I also, just to send
a warning, hope to be able to ask you about the Basel II
situation which I think is a matter that calls for very close
attention, which I do not think it has been receiving.
Thank you very much, Mr. Chairman.
Chairman Shelby. We have established a quorum and at this
time, if you will bear with us, Mr. Chairman, I would like to
move the Committee to executive session to consider a number of
nominations that we have had hearings on.
[Recess.]
Chairman Shelby. We will now resume the hearing.
Senator Bennett.
STATEMENT OF SENATOR ROBERT F. BENNETT
Senator Bennett. Thank you, Mr. Chairman.
Chairman Bernanke, welcome to the Committee. I look forward
to hearing what you have to say today. I will not recite a
bunch of statistics as my colleagues have because I think we
will get into those.
I will look for to your comments with respect to how the
economy is changing. We are in the midst of the Information
Revolution, and just as the Industrial Revolution changed
things rapidly, so I believe the Information Revolution is
changing things, and we need to recognize that sometimes past
benchmarks in the new, changed environment in which we find
ourselves may not be the best benchmarks to look at. We should
look around for new ones and the signs of the changes.
I am particularly focused on the impact of productivity
gains. Productivity has gone up much more rapidly in the
information age than it did in the industrial age and it is
affecting a number other economic indicators.
So, I welcome you here and look forward to a dialogue with
you on these and other related issues.
Chairman Shelby. Senator Reed.
STATEMENT OF SENATOR JACK REED
Senator Reed. Thank you very much, Mr. Chairman. I would
make three points.
Gross domestic product has spiked up in the first quarter
but there is evidence that the economy is slowing even before
most Americans have benefited from the growth we have seen thus
far in the recovery. As my colleagues have pointed out, strong
productivity growth has shown up in the bottom lines of
shareholders but not in the paychecks of workers. We are also
facing soaring energy prices, record budget and trade deficits,
and a negative household saving rate. All of these pose
tremendous challenges to setting monetary policy which the
Chairman and his colleagues are charged to do.
We also have a situation where we no longer maintain the
fiscal discipline that we had in the 1990's which allowed for
monetary policy that encouraged investment and long-term
growth. We have, I think, squandered that fiscal discipline and
that complicates your job also, Mr. Chairman.
I would also associate myself with the comments that
Senator Sarbanes made with respect to the growing inequality of
income, earnings, and wealth in this economy. It is
particularly troublesome because as we pursue some of these tax
policies which further increase the deficit and further erode
the ability to provide basic support to middle-income
Americans, like Pell grants and other programs, the difficulty
of workers in this country to support their families is
infinitely complicated and I think that is something that the
Fed has to be concerned about, even if it does not have direct
policy leverage to use.
So, Mr. Chairman, I look forward to Chairman Bernanke's
testimony. I thank him for his service.
Chairman Shelby. Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman.
This is a very important hearing that we do twice a year
and I cannot remember when it came at a more critical time for
our markets and our economy. It has been a long time since I
have seen a stock market that is as sensitive and unstable as
this one.
Chairman Bernanke, you have only been on the job for 5\1/2\
months but it has been a wild ride. I am disappointed in your
leadership of the Fed so far but I am not surprised. During
your confirmation process, I warned my colleagues that you were
going to be much the same as former Chairman Greenspan, and so
far you have been. The string of interest rate increases
started by Chairman Greenspan has continued, and just as he did
in 2000, I think you are going to overshoot.
Also, you have not ended the group think at the Fed. In
fact, it seems you have gone so far as to hand-pick new Fed
Members that think just as you do.
Some commentators point to the situation in the Middle East
and North Korea as driving the market down, but those tensions
have been around a lot longer than the current market downturn.
Others say high energy prices are hanging over the economy.
Yes, oil is expensive, but it is still below all-time highs
when adjusted for inflation, and our energy expenses are a
smaller percentage of our total expenses than in the past.
Those are not the market's problems.
What is dragging the market down is interest rates and
uncertainty about Fed action. The Fed can do three things with
its interest rate actions. It can overshoot, it can undershoot,
or it can get it just right. It is much easier to mess up than
to get it just right.
The Fed has raised rates at 17 straight meetings. The Fed
funds rate stands at 5.25 percent today and could go higher.
There has been no pause to see how the economy reacts to those
rate hikes. It has been one increase after another. At the
current pace the Fed is going to overshoot and not even know
it. By the time the full impact of interest rate increases is
evident it will be too late. The U.S. economy will be damaged,
and for that matter, the world economy could follow.
The decisions of our central banks are often followed by
foreign central banks and many have raised rates to keep pace
with the United States. So many foreign economies rely on a
strong U.S. economy for their growth and stability. The Fed is
marching into dangerous territory and not looking back. There
is a lot of speculation that the Fed may pause at the next
meeting, but that is another way of saying that the Fed is
still considering another increase. The markets do not know
what the Fed is going to do and they will be on edge until
there is certainty.
Public statements by Fed Members over the last few months
have not helped either. Many Governors have raised concerns
that inflation is growing and said that interest rate hikes
should continue. Others have said that it may be time to pause
but have not dissented in Fed actions.
The most recent official Fed statement has even caused more
uncertainty. It was softer than the tough talk of the Chairman
and others leading up to the meeting yet it does not rule out
further rate increases. I still do not understand what all this
talk and uncertainty is for. Inflation is not out of control.
And I say it definitely, one more time. Inflation is not out of
control. And if you think it is, we will further pursue it in
the question and answer period.
All indicators of inflation show that while it may be
higher than in the past few years, it is still far below what
we saw in the past few decades. Key indicators like gold are
off their highs from earlier in the year and productivity has
kept unit labor costs in check. The Fed is chasing an inflation
monster that is just not there. I hope the Fed realizes that
before it is too late.
Thank you, Mr. Chairman. I look forward to asking some
questions.
Chairman Shelby. Thank you.
Senator Menendez.
STATEMENT OF SENATOR ROBERT MENENDEZ
Senator Menendez. Thank you, Mr. Chairman.
Welcome, Chairman Bernanke. Let me say, recently we learned
that the anticipated deficit for the fiscal year 2006 is down
from what had been projected and for that we should all be
happy. However, we are still talking about a deficit of $296
billion. And though that is better than the original estimated
deficit of $423 billion, which some considered was an inflated
estimate in the first instance, it is a far cry from the $600
billion budget surplus for 2006 that was predicted by the White
House back in 2001.
Now that discussion certainly belies the $10 trillion to
$12 trillion debt that the Congressional Budget Office tells us
we are headed to by 2011. So while some in this country believe
that are our economy is chugging along quite well because our
gross domestic product continues to grow, there seems to be an
increasing gap between the average citizen and those at the top
of our economic ladder. The disparity between the haves and
have-nots seems to be widening at an alarming rate.
When I am back in New Jersey, I hear more and more from New
Jerseyians that they are working harder and longer just to try
to keep their heads above water, whether it is because of
higher costs for college, soaring health care costs, increasing
energy prices, gas prices, stagnant and flat wages, or pensions
being underfunded and in some cases totally abandoned, there is
a huge disconnect between growth in our GDP and the situation
that the average American finds themselves and their families
in.
So the question is, who is this economy working for? I look
forward to your testimony today and to hearing your thoughts on
some of those items I have just mentioned and other challenges
we face as a Nation, such as the cooling off of the housing
market and what that may mean, rising energy prices,
consequences of deficit and debt, record trade deficits, real
wages remaining flat, negative household and national savings,
a variety of global influences and how these factors affect the
dynamic of the modern global economy that we have. Those are
the challenges I hear from average New Jerseyians and Americans
that they are currently facing and that you have before you.
So as we wish you well in the stewardship of the economy,
we look forward to hearing your testimony and hopefully
reflecting upon some of those items. If not, I will pursue it
in my questions.
Thank you, Mr. Chairman.
Chairman Shelby. Thank you.
Senator Dole.
STATEMENT OF SENATOR ELIZABETH DOLE
Senator Dole. Thank you, Chairman Shelby.
Mr. Chairman, I join my colleagues in extending a very warm
welcome to you this morning. We have seen very strong growth in
our economy over the last few years even as our Nation as has
faced some extremely challenging times. I expect the positive
economic trends will continue in the coming months and years.
Still, we have hard work ahead indeed to ensure that all levels
and sectors of the economy benefit from this prosperity.
In just the past year, the economy has created nearly 2
million new jobs and the national unemployment rate remains
lower, as we have said so often, than the average of the
1970's, the 1980's and 1990's. While we are seeing a cooling of
the housing sector, the other pistons of our economic engine
are firing.
There have been recent reports that wages are going up,
which I hope signals that wages are beginning to catch up with
the very dramatic increases in productivity. Also, consumer
confidence has continued to rise. The first-quarter GDP results
of this year were revised upward to an impressive 5.6 percent,
as we have heard already this morning. This has resulted in
higher than expected tax revenues and a decline in the deficit.
In fact in the first 9 months of fiscal year 2006, we have seen
one of the highest growth in tax revenues in 25 years, second
only to last year. These are indeed indicators of a robust and
expanding economy.
Still, I share the concerns of the American people that
energy prices continue to increase. There is no question these
costs are putting a real strain on families and businesses.
Folks also are concerned about the availability and
affordability of health care.
In order to address this broader problem, I believe we must
empower families to make health care decisions based on their
specific needs and allow them greater choice over how their
health care dollars are spent. We must also work to improve
transparency, portability, and efficiency to better meet
consumers' needs.
In addition, as our overall economy is thriving, we must be
mindful that there are areas in some of our States like North
Carolina where the economic picture is not quite as bright,
where factories and businesses have closed and people are out
of jobs. In North Carolina, we have experienced a transition
from our tradition tobacco and manufacturing industries of
textiles and furniture to new high-growth industries like
biotechnology and pharmaceuticals. These new jobs, as we all
know, require a well-educated and highly trained workforce. To
this end, we must make education and job training a priority
and focus our efforts on closing the gap between skilled and
unskilled workers.
Unfortunately, this gap has only widened since my days as
Secretary of Labor. As our economy moves forward, the
opportunities for lower-skilled workers are simply diminishing.
It is imperative that we educate our less-skilled workers so
that they can take advantage of the new jobs that are being
created.
I continue to have confidence that the very forces that
stimulate economic growth, tax relief to spur investment, free
but fair trade, ever-improving global communications, higher
education and training for workforce, and of course, hard work,
these will ensure that we stay on course toward greater
opportunity for North Carolina and for the Nation.
Mr. Chairman, thank you for being here today. I look
forward to hearing from you and working closely with you on
these and other important issues. Thank you.
Chairman Shelby. Senator Stabenow.
STATEMENT OF SENATOR DEBBIE STABENOW
Senator Stabenow. Thank you, Mr. Chairman, and welcome,
Chairman Bernanke. It is good to have you with us again. I look
forward to your testimony. I have read your statements recently
and have become increasingly concerned about the slowdown you
are referring to, as my other colleagues have as well. I
recognize that while this may be good for inflationary purposes
to hold down interest rates certainly, and slows down growth to
make sure the economy is not moving too fast, in my home State
of Michigan this just means more bad news because we are
already experiencing a slowdown.
As Senator Menendez spoke, he was really speaking about the
squeeze that middle-class families are feeling on all sides
right now, being hit by slowdown in terms of their wages, maybe
losing a job, health care costs going up, if they get health
care at all, maybe faced with losing a pension, and the cost of
college, and the cost of gas, and so on.
So we are feeling that, certainly, in Michigan as we look
at not just one or two plants or one or two jobs but entire
communities that are struggling as we, as a country, try to
figure how we are going to compete in a global economy in a way
that does not lose our way of life.
There are certainly two different views. One says, compete
down to the lowest wage, lowest health care, lose a pension.
And the other says, which I espouse, which is race up, which
means you level the playing field on trade and you address the
costs you can, health care, energy, protect pensions, and then
you race like crazy on education and innovation. That is the
American way.
My concern right now is that in a State like mine, because
we make things, grow things, and have been the leaders in doing
that, we now find ourselves struggling in a global economy
because we do not have those elements in place. We have lost
another 19,000 manufacturing jobs just in the first half of
this year. What I cannot seem to grasp in the graphs and
numbers that you have is really the impact of this as it
relates to middle-class jobs, good-paying jobs in manufacturing
in America. I do not believe we can have a strong economy
unless we make things in this country. That is what we do, make
things and invent things, in Michigan. So, I am interested in
knowing about how you view us in terms of the industries that
have created the middle class of America.
What I do see in your analysis is a growing trade deficit
which is on track to make history again. And we are in a path
in another year of a record trade deficit for the entire
country which means more lost American jobs.
More concerning is the fact that one-third of that deficit
is with one country, China. On Monday, I had an opportunity to
go to a hearing that I was pleased to testify at in Michigan,
in Dearborn, the United States-China Commission came into
Michigan to hear about the concerns from business and labor in
the community about what is happening with China, and our
relationship and how it affects the auto industry and other
industries. And I want you to know there is tremendous concern.
I was very impressed with the Commission. Tremendous concern
across the board, both on the Commission and those who
testified, about what is happening and why we are not enforcing
our trade laws.
We can compete with anybody if it is a level playing field.
China cheats. Other countries cheat. They steal our ideas. They
steal our patents. They manipulate their currency. They dump
counterfeit products. I recognize, Mr. Chairman, this is not in
your jurisdiction but I do want to know what role you believe
our increasing trade deficit has on our ability to enforce our
trade laws.
Furthermore, in your recent testimony at the International
Monetary Conference on June 5 you stated, sustaining global
expansion will require a greater reliance by our trading
partners on their own domestic spending as a source of growth.
This tells me we are going to be increasingly beholden to other
countries in order to reverse the trade deficit. So, I am
hoping to hear more about that in your testimony.
But as I interpret your statement, we are allowing
countries to ignore our trade laws and hurt good-paying,
middle-class jobs while we simultaneously become more reliant,
to use your description, on their spending habits. This is of
great concern to me and I certainly welcome your thoughts and
would appreciate your leadership.
Thank you.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Allard.
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, thank you for holding this
hearing. This is one of the hearings I always look forward to
hearing participation and hearing from the Chairman of the
Federal Reserve. You have been on the job about 5\1/2\ months
now, Chairman Bernanke, and you are settling into the job and I
look forward to hearing what your comments will be.
I am not as down on the economy as some of my colleagues
would express here today. I do think that our pro-growth tax
policies we put in place that were implemented in 2003 have had
a positive impact. And I am interested in hearing from you and
your comments on how we are comparing worldwide. If you look at
our growth in the last 2\1/2\ to 3 years, 20 percent growth,
somewhere around $2.2 trillion in growth, that is almost the
size of the entire Chinese economy. And if you look at the
share of product that we have throughout the world, gross
domestic product might be a way of expressing that, we have
grown 2 percent during that time period.
So it looks to me like we remain competitive in a world
environment and our economy is doing better than other
countries. And I would like to hear some comments that you have
in that regard.
It does not mean that we do not have some problems with our
economy, and things that we need to watch. Areas that I feel
particularly distressing is our runaway spending that we are
having here with the Federal budget, particularly in the area
of mandatory spending. Interest rates are part of that. We must
also, I think, find ways to deal with the rising energy costs.
But historically, it does not seem like energy has had as
adverse an impact on the economy as perhaps other times in our
Nation's history when we have had high energy costs. And also I
am concerned about low personal savings rates.
Now while the Federal Reserve is an independent agency,
Congress must maintain a careful oversight role, particularly
given the importance of the Fed's responsibility. And Chairman
Bernanke, we are eager to hear your assessment of our economy
and we look forward to your economic insights which will be
helpful as we consider various policy issues.
Thank you for taking the time to appear before the
Committee.
Chairman Shelby. Thank you.
Senator Carper.
STATEMENT OF SENATOR THOMAS R. CARPER
Senator Carper. Thanks, Mr. Chairman.
Welcome, it is good to see you and you are good to join us.
I like to sometimes telegraph my questions and use an opening
statement for that purpose. I say this partly with tongue-in-
cheek but some of my colleagues will recall a recently departed
Cabinet Secretary who used to come and appear before us and as
we would give our opening statements he would sit there with
papers spread all around him and read this and that and would
kid him and say, he came and he would read the newspaper and he
would work his Blackberry. And you sit here; you are very
attentive and listen to everyone, writing notes.
So one of the questions I am going to ask you is, what do
you actually think about when we give our opening statements,
because you give every impression of paying great attention,
which we hope is true.
I am going to ask you about your assessment. You have been
in the job for about 6 months. You had big shoes to fill. And I
think most fair-minded, objective people say that you seem to
have settled in pretty well, but just your own assessment. How
is the job similar to what you expected, maybe different than
what you anticipated?
Some of my colleagues have touched on the budget deficit
which is for me still troubling. I think we can all celebrate
strong GDP growth. We should be happy about that. We are. We
should celebrate strong revenue growth and we are. But as we
look ahead I am troubled by the fact that, you know, it is
great that the deficit is down to only $300 billion. That is a
heck of a lot of money in my view.
As we look down the road I do not know that we are really--
assuming any kind of expenditures in Iraq, any kind of
expenditures in Afghanistan, I do not think we assume at all
that we are going to ever fix the AMT problem. I do not think
we are assuming that we are going to do anything about these
tax extenders that are about to expire. And if we do all of
those things, continue to fund Iraq, continue to fund
Afghanistan, fix the AMT, continue these tax extenders, we are
back in the soup again. And that does not even assume that the
boomers ever retire which we are about to, as you know.
I was reading the paper coming down today and it said that
trade numbers are out for June and they reported that the trade
deficit was about $63 billion for the month of June. They said
we are on track for the biggest trade deficit in the history of
our country. And they mentioned one country, I think Senator
Stabenow might have mentioned that country, China. And I
believe the deficit with China for 1 month might have been $17
billion. I think that is what it was.
In any event, I thought to myself, that is a bigger trade
deficit with one country in 1 month than we used to have in a
whole year. When does the rest of the world start to look at
our trade deficit and our inability to balance our budget and
say that if they are going to continue to invest money here
they want a higher interest rate? I just want to talk a little
bit about that when we have a chance.
Maybe the last thing is, in addition to saying grace over
monetary policy and a whole bunch of other duties, you have a
major responsibility as a regulator. We are familiar with those
responsibilities. We have had before this, and hopefully we
will have before the full Senate later this year, legislation
dealing with the regulation of Government Sponsored
Enterprises, Fannie Mae, Freddie Mac, and the Federal Home Loan
Banks.
There are two issues that seem to divide us on that. One is
affordable housing fund, and the second deals with the
portfolio. What should be in the portfolio? Who should be in
the position to say whether portfolios can grow, what kind of
items can be included in those portfolios? In the interest of
telegraphing another pitch I just want you to know that I would
welcome your comments as we get into that.
I think my time has expired. Thank you, Mr. Chairman.
Chairman Shelby. Senator Sununu.
STATEMENT OF SENATOR JOHN E. SUNUNU
Senator Sununu. Chairman Shelby, I have no comment at this
time. I would just like to welcome the Chairman.
Chairman Shelby. Senator Martinez.
STATEMENT OF SENATOR MEL MARTINEZ
Senator Martinez. Thank you, Mr. Chairman. I will not be
nearly that disciplined in my approach.
Mr. Chairman, thank you for being here and thank you for
coming to share with us. I will be very brief actually. I was
noting with particular interest the area of labor in your
report. I noted, in spite of what some would profess to be
gloom and doom that there are a lot of good news in the
economic report and the forecast terms of the labor statistics.
For instance, it seems like this past quarter we were able
to reach a low unemployment level that had not been seen in 5
years, and 4.7 in the second quarter of the year, below 5
percent. That is consistent, and even not quite as good as what
we are experiencing in Florida where I think our unemployment
rate is probably around 2.7 percent. Which gives rise to an
issue that I do not know if you will address but hopefully in
the questioning I will have an opportunity to discuss with you,
which is whether in fact we may not have, in some aspects of
our economy, a labor shortage.
Recently, in the agricultural sector in Florida it was
reported that there will be probably 3 million to 6 million
boxes of citrus that will not be harvested this year because
there simply was not the labor there to pick the fruit. I have
heard of similar reports coming from California. I know in the
housing industry, which seems to have slowed down a bit in
Florida, but still housing construction is strong, that there
is great competition for labor to be able to get the work done.
So as some of us have been struggling to try to put some
sense into our immigration laws one of the issues that we have
repeatedly discussed is some type of a guest worker program and
whether there is the need for such. In fact some Americans, I
think mistakenly believe that if only wages rose a bit that
there would be plenty of people to do many of the tasks that
today we rely on foreign workers to do. The fact is that I
think a healthy combination of a guest worker program as well
as encouraging job training and so forth are part of what needs
to be for our future economic needs.
But I do hope that I get an opportunity to discuss with you
some of these labor issues that I think are also an important
component part of our economic picture.
Thank you very much for being here.
Chairman Shelby. Senator Hagel.
STATEMENT OF SENATOR CHUCK HAGEL
Senator Hagel. Mr. Chairman, thank you.
Chairman Bernanke, welcome. Just a comment regarding your
testimony and the questions that will follow.
As you have heard and as you know because you live with
this every day and have for many years, the strength of our
economy has essentially revolved around, over the last few
years, high productivity, strong housing market, strong
consumer spending, and in my opinion over the last few years
since 2001, tax cuts.
Now the reality is, as has been noted here this morning, we
are facing significantly rising and unstable energy costs.
There is some question about continuation of a strong housing
market. As has been noted this morning, record high personal
debt, record low savings, continued deficit spending by
Government, and I would add to all of this, a rather dangerous
and unstable world environment today. And I do not think it is
isolated just in the Middle East. I happen to believe the
Middle East represents the most combustible time since 1948,
where we are today.
Now I would hope in your testimony that you would give this
Committee some sense of proportion and balance in how all of
this is mixing, and some of these realities are going to
affect, in your opinion, our economy and our growth over the
next year or two, realizing that you cannot predict. That is
not your job. We do want you to do that.
But I do think we need to integrate all these dynamics that
are in play, as well as you can, into a comprehensive economic
fabric as to how you are approaching this at the Fed, as how
you are intending to deal with these things on a comprehensive
monetary policy basis.
I know you understand these things and I would hope that
you could integrate these issues and will in your testimony. I
know we will get to some of these things during the question-
and-answer period.
Thank you very much, Mr. Chairman. Thank you.
Chairman Shelby. Senator Dodd.
STATEMENT OF SENATOR CHRISTOPHER J. DODD
Senator Dodd. Thank you, Mr. Chairman. I have no statement.
Chairman Shelby. I believe that is everybody.
Mr. Chairman, you may proceed as you wish. Your written
statement will be made part of record.
STATEMENT OF BEN S. BERNANKE, CHAIRMAN,
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Chairman Bernanke. Thank you. Mr. Chairman and Members of
the Committee I am pleased to be here again to present the
Federal Reserve's Monetary Policy Report to the Congress.
Over the period since our February report, the U.S. economy
has continued to expand. Real gross domestic product is
estimated to have risen at an annual rate of 5.6 percent in the
first quarter of 2006. The available indicators suggest that
economic growth has more recently moderated from that quite
strong pace, reflecting a gradual cooling of the housing market
and other factors that I will discuss. With respect to the
labor market, more than 850,000 jobs were added, on net, to
nonfarm payrolls over the first 6 months of the year, though
these gains came at a slower pace in the second quarter than in
the first. Last month, the unemployment rate stood at 4.6
percent.
Inflation has been higher than we has anticipated in
February, partly as a result of further sharp increases in the
prices of energy and other commodities. During the first 5
months of the year, overall inflation, as measured by the price
index for personal consumption expenditures, averaged 4.3
percent at an annual rate. Over the same period, core
inflation--that is, inflation excluding food and energy
prices--averaged 2.6 percent at an annual rate. To address the
risk that inflation pressures might remain elevated, the
Federal Open Market Committee continued to firm the stance of
monetary policy, raising the Federal funds rate another three-
quarters of a percentage point to 5.25 percent in the period
since our last report.
Let me now review the current economic situation and the
outlook in a bit more detail, beginning with developments in
the real economy and then turning to the inflation situation. I
will conclude with some comments on monetary policy.
The U.S. economy appears to be in a period of transition.
For the past 3 years or so, economic growth in the United
States has been robust. This growth has reflected both the
ongoing reemployment of underutilized resources as the economy
recovers from the weakness of earlier in the decade, and the
expansion of the economy's underlying productive potential, as
determined by such factors as productivity trends and the
growth of the labor force. Although the rates of resource
utilization that the economy can sustain cannot be known with
any precision, it is clear that, after several years of above-
trend growth, slack in resource utilization has been
substantially reduced. As a consequence, a sustainable,
noninflationary expansion is likely to involve a modest
reduction in the growth of economic activity from the rapid
pace of the past 3 years to a pace more consistent with the
rate of increase in the Nation's underlying productive
capacity. It bears emphasizing that, because productivity
growth seems likely to remain strong, the productive capacity
of our economy should expand over the next few years at a rate
sufficient to support solid growth in real output.
As I have noted, the anticipated moderation in economic
growth now seems to be underway, although the recent erratic
growth pattern complicates this assessment. That moderation
appears most evident in the household sector. In particular,
consumer spending, which makes up more than two-thirds of
aggregate spending, grew rapidly during the first quarter but
decelerated during the spring. One likely source of this
deceleration was higher energy prices, which have adversely
affected the purchasing power of households and weighed on
consumer attitudes.
Outlays for residential construction, which have been at
very high levels in recent years, rose further in the first
quarter. More recently, however, the market for residential
real estate has been cooling, as can be seen in the slowing of
new and existing home sales and housing starts. Some of the
recent softening in housing starts may have resulted from the
unusually favorable weather during the first quarter of the
year, which pulled forward construction activity, but the
slowing of the housing market appears to be more broad-based
than can be explained by that factor alone. Home prices, which
have climbed at double-digit rates in recent years, still
appear to be rising for the Nation as a whole, though
significantly less rapidly than before. These developments in
the housing market are not particularly surprising, as the
sustained run-up in housing prices, together with some increase
in mortgage rates, has reduced affordability and thus the
demand for new homes.
The slowing of the housing market may restrain other forms
of household spending as well. With homeowners no longer
experiencing increases in the equity value of their homes at
the rapid pace seen in the past few years, and with the recent
declines in stock prices, increases in household net worth are
likely to provide less of a boost to consumer expenditures than
they have in the recent past. That said, favorable
fundamentals, including relatively low unemployment and rising
disposable incomes, should provide support for consumer
spending. Overall, household expenditures appear likely to
expand at a moderate pace, providing continued impetus to the
overall economic expansion.
Although growth in household spending has slowed, other
sectors of the economy retain considerable momentum. Business
investment in new capital goods appears to have risen briskly,
on net, so far this year. In particular, investment in
nonresidential structures, which had been weak since 2001,
seems to have picked up appreciably, providing some offset to
the slower growth in residential construction. Spending on
equipment and software has also been strong. With a few
exceptions, business inventories appear to be well aligned with
sales, which reduces the risk that a buildup of unwanted
inventories might act to reduce production in the future.
Business investment seems likely to continue to grow at a solid
pace, supported by growth in final sales, rising backlogs of
orders for capital goods, and high rates of profitability. To
be sure, businesses in certain sectors have experienced
financial difficulties. In the aggregate, however, firms remain
in excellent financial condition and credit conditions for
businesses are favorable.
Globally, output growth appears strong. Growth of the
global economy will help support U.S. economic activity by
continuing to stimulate demand for our exports of goods and
services. One downside of the strength of the global economy,
however, is that it has led to significant increases in the
demand for crude oil and other primary commodities over the
past few years. Together with heightened geopolitical
uncertainties and the limited ability of suppliers to expand
capacity in the short-run, these rising demands have resulted
in sharp rises in the prices at which these goods are traded
internationally, which in turn has put upward pressure on costs
and prices in the United States.
Overall, the U.S. economy seems poised to grow in coming
quarters at a pace roughly in line with the expansion of its
underlying productive capacity. Such an outlook is embodied in
the projections of Members of the Board of Governors and the
Presidents of Federal Reserve Banks that were made at around
the time of the FOMC meeting late last month, based on the
assumption of appropriate monetary policy. In particular, the
central tendency of those forecasts is for real GDP to increase
about 3.75 percent to 3.5 percent in 2006 and 3 percent to 3.25
percent in 2007. With output expanding at a pace near that of
the economy's potential, the civilian unemployment rate is
expected to finish both 2006 and 2007 between 4.75 percent and
5 percent, close to its recent level.
I turn out to the inflation situation. As I noted,
inflation has been higher than we expected at the time of our
last report. Much of the upward pressure on overall inflation
this year has been due to increases in the prices of energy and
other commodities and, in particular, to the higher prices of
products derived from crude oil. Gasoline prices have increased
notably as a result of the rise in petroleum prices as well as
factors specific to the market for ethanol. The pickup in
inflation so far this year has also been reflected in the
prices of a range of nonenergy goods and services, as
strengthening demand may have given firms more ability to pass
energy and other costs through to consumers. In addition,
increases in residential rents, as well as the imputed rent on
owner-occupied homes, have recently contributed to higher core
inflation.
The recent rise in inflation is of concern to the FOMC. The
achievement of price stability is one of the objectives that
makes up the Congress's mandate to the Federal Reserve.
Moreover, in the long-run, price stability is critical to
achieving maximum employment and moderate long-term interest
rates, the other parts of the Congressional mandate.
The outlook for inflation is shaped by a number of factors,
not the least of which is the course of energy prices. The spot
price of oil has moved up significantly further in recent
weeks. Futures quotes imply that market participants expect
petroleum prices to roughly stabilize in coming quarters; such
an outcome would, over time, reduce one source of upward
pressure on inflation. However, expectations of a leveling out
of oil prices have been consistently disappointed in recent
years, and as the experience of the past week suggests,
possible increases in these and other commodity prices remain a
risk to the inflation outlook.
Although the cost of energy and other raw materials are
important, labor costs are by far the largest component of
business costs. Anecdotal reports suggest that the labor market
is tight in some industries and occupations and that employers
are having difficulty attracting certain types of skilled
workers. To date, however, moderate growth in most broad
measures of nominal labor compensation and the ongoing
increases in labor productivity have held down the rise in unit
labor costs, reducing pressure on inflation from the cost side.
Employee compensation per hour is likely to rise more quickly
over the next couple of years in response to the strength of
the labor market. Whether faster increases in nominal
compensation create additional cost pressures for firms depends
in part on the extent to which they are offset by continuing
productivity gains. Profit margins are currently relatively
wide, and the effect of a possible acceleration in compensation
on price inflation would thus also depend on the extent to
which competitive pressures force firms to reduce margins
rather than pass on higher costs.
The public's inflation expectations are another important
determinant of inflation. The Federal Reserve must guard
against the emergence of an inflationary psychology that could
impart greater persistence to what otherwise would be a
transitory increase in inflation. After rising earlier this
year, measures of longer-term inflation expectations, based on
surveys and on a comparison of yields on nominal and inflation-
index Government debt, have edged down and remained contained.
These developments bear watching, however.
Finally, the extent to which aggregate demand is aligned
with the economy's underlying productive potential also
influences inflation. As I noted earlier, FOMC participants
project that the growth in economic activity should moderate to
a pace close to that of the growth of potential both this year
and next. Should that moderation occur as anticipated, it
should also help to limit inflation pressures over time.
The projections of the Members of the Board of Governors
and the Presidents of the Federal Reserve Banks, which are
based on information available at the time of the last FOMC
meeting, are for a gradual decline in inflation in coming
quarters. As measured by the price index for personal
consumption expenditures excluding food and energy, inflation
is projected to be 2.25 percent to 2.5 percent this year, and
then to edge lower, to 2 percent to 2.25 percent, next year.
The FOMC projections, which now anticipate slightly lower
growth in real output and higher core inflation than expected
in our February report, mirror the somewhat more adverse
circumstances facing our economy, which have resulted from the
recent steep run-up in energy costs and higher-than-expected
inflation more generally. But they also reflect our assessment
that with appropriate monetary policy and in the absence of
significant unforeseen developments, the economy should
continue to expand at a solid and sustainable pace and core
inflation should decline from its recent level over the medium-
term.
Although our baseline forecast is for moderating inflation,
the Committee judges that some inflation risks remain. In
particular, the high prices of energy and other commodities, in
conjunction with high levels of resource utilization that may
increase the pricing power of suppliers of goods and services,
have the potential to sustain inflation pressures. More
generally, if the pattern of elevated readings on inflation is
more protracted or more intense than is currently expected,
this higher level of inflation could become embedded in the
public's inflation expectations and in price-setting behavior.
Persistently higher inflation would erode the performance of
the real economy and would be costly to reverse. The Federal
Reserve must take account of these risks in making its policy
decisions.
In our pursuit of maximum employment and price stability,
monetary policymakers operate in an environment of uncertainty.
In particular, we have imperfect knowledge about the effects of
our own policy actions as well as of the many other factors
that will shape economic developments during the forecast
period. These uncertainties bear importantly on our policy
decisions because the full influence of policy actions on the
economy is felt only after a considerable period of time. The
lags between policy actions and their effects imply that we
must be forward-looking, basing our policy choice on the
longer-term outlook for both inflation and economic growth. In
formulating that outlook, we must take account of the possible
future effects of previous policy actions--that is, of policy
effects still ``in the pipeline.'' Finally, as I have already
noted, we must consider not only what appears to be the most
likely outcome but also the risks to that outlook and the costs
that would be incurred should any of those risks be realized.
At the same time, because economic forecasting is far from
a precise science, we have no choice but to regard all our
forecasts as provisional and subject to revision as the facts
demand. Thus, policy must be flexible and ready to adjust to
changes in economic projections. In particular, as the
Committee noted in the statement issued after its June meeting,
the extent and timing of any additional firming that may be
needed to address inflation risks will depend on the evolution
of the outlook for both inflation and economic growth, as
implied by our analysis of the incoming information.
Thank you. I would be happy to take questions.
Chairman Shelby. Thank you Mr. Chairman.
Mr. Chairman, your testimony notes the possibility of some
risk which could add to inflationary pressures, in particular
the possibility of higher energy prices feeding into the prices
of nonenergy goods and services. Your testimony, Mr. Chairman,
also notes the risk to our economy due to a slowing housing
market.
The question is this: What would be the impact, Chairman
Bernanke, on the economy if both of these effects materialized
to a greater degree than is currently anticipated? How would
the Federal Reserve be likely to respond to such a scenario?
These are not out of the question, either.
Chairman Bernanke. No, Senator. As I mentioned, we are
following the data very closely and we revise our forecasts as
needed. Right now we see, of course, the housing market
slowing. We see some offsetting strength in some other sectors
of the economy and our expectation is that the economy is going
to be growing at or about the pace of its underlying potential.
We also think that inflation is going to moderate. We see
some risks to the upside, and that is an issue that we have to
think about. But of course, if we see changes in the data, we
will certainly adjust our balance of risk and thinks about it
accordingly.
Chairman Shelby. Among that same lines, both your
testimony, Mr. Chairman, and your written report this morning
discuss the lag between Fed policy actions and their effects.
Some analysts have remarked on the trade-offs which may exist
between spurring economic growth by way of low interest rate
regime and combating inflation. That is always a challenge.
How do Members of the Federal Reserve know when your
changes to monetary policy have been fully incorporated
throughout the economy?
For example, how does the FOMC go about assessing whether
the 17 quarter point rises in the Federal funds rate are fully
incorporated in the market 3 months from now, 6 months from
now, or some other time? Is that a judgement on your part?
Chairman Bernanke. Senator, it is judgment based on a great
deal of quantitative analysis. We look at extensive models. We
look at statistical models. We look at financial market data.
We use our own judgment. We listen to anecdotes. We try to make
our best judgment about where the economy is heading, including
the effects of the policy actions that we have already taken.
Our goal is to achieve a sustainable, noninflationary
expansion and we are adjusting our policy in a way to try to
meet that goal.
Chairman Shelby. In other words, you do not want the
medicine to destroy the patient; right, in a sense?
Chairman Bernanke. Senator, that is absolutely right.
Again, our goal is to achieve a sustainable expansion.
There are risks in both directions, if I may say so.
Clearly, we do not want to tighten too much to cause the
economy to grow more slowly than its potential, and we are very
aware of that concern, and we think about it and we look at it
and try to evaluate it.
The risk in the other direction is that, if we were to stop
tightening too soon and inflation were to get higher and more
persistent, then we would be faced with the situation of having
to
address that later on with perhaps even more interest rate
increases.
So our goal is to achieve a sustainable expansion. We have
to balance those risks and those two directions. And we do that
by looking forward to our forecasting process and thinking
about how actions we have already taken are likely to affect
the economy in the long-run.
Chairman Shelby. So whatever you do, you have to keep in
mind price line stability at every move, do you not?
Chairman Bernanke. Senator, price stability is part of the
mandate, of course. And I do believe it is important for
achieving stability, and also moderate interest rates. For
example, we talk about mortgage rates and we understand that
our actions affect mortgage rates. But if you look back
historically, the periods where mortgage rates were by far the
highest, were high inflation periods like the 1970's and early
1980's, when mortgage rates reached 18 percent. So if we want
to keep mortgage rates low, we need to keep inflation low.
Chairman Shelby. Mr. Chairman, as the cost of energy, as
you have noted, is often volatile, in part because of its
seasonal use and in part because of factors beyond our control.
Historically, energy prices have been excluded from the measure
of what you call core prices in the consumer price index. If
there is a sustained increase in energy prices, would it be
more appropriate for policymakers to rely upon an inflation
measure which includes the energy cost?
In other words, does the exclusion of energy prices from
the definition of core prices pose any problems for economists
trying to understand the health of our economy at the present
time?
Chairman Bernanke. Mr. Chairman, that is a difficult
question. As you point out, we have excluded it from one of our
basic measures, the core measure, because in the past it has
been a very volatile price. Of course, more recently, instead
of going up and down, it has just gone up.
So the question is what is the purpose of our measure? If
we are trying to forecast inflation over the next couple of
years, we can still look at the futures markets for energy. And
although they have not been very reliable, I have to admit,
they do say that energy prices are likely to be relatively flat
over that period. If that is true, then the core inflation
measure is a better forecast of what total inflation will be a
year or two from now.
On the other hand, the inflation rate that people see is
the overall inflation rate. They see the gasoline price at the
pump. That affects their behavior. That affects their
expectations. If those high inflation rates, including energy,
cause people to develop an inflationary psychology, that would
be a concern that would effect, perhaps, the future course of
inflation.
So depending on the purpose, we do have to look at
different combinations of measures.
Chairman Shelby. We all like 99 cent gasoline, as you well
know, all of us.
Chairman Bernanke. Yes, sir.
Chairman Shelby. Mr. Chairman, last question here for now,
dealing with the housing market GSE's.
In your testimony this morning, you note the cooling down
in the housing market and its associated effect perhaps on
consumer spending.
What effect, Mr. Chairman, if any, would a more significant
slow down in the housing market and asset-based securities
industry have on the financial condition of Freddie Mac and
Fannie Mae? And do you have any concerns regarding effects on
the banking system in this regard?
Chairman Bernanke. Senator, so far the credit quality looks
to be good. We see that mortgages are, for the most part,
fixed-rate despite the fact that we have seen more
nontraditional mortgages and ARM's issued recently. We only see
about 10 percent of all mortgages being repriced during 2006.
Because of these rapid increases in house prices, a lot of
homeowners do have a lot of equity. And, therefore, they are
able to make the payments on their homes. So we do not see any
near-term significant increase in mortgage delinquencies or
credit risk.
The one area that we are watching very carefully is low and
moderate-income subprime mortgage lending. That area, more than
the broader market, has seen adjustable-rate mortgage lending.
And therefore, there is more susceptibility, I think, there to
increases in interest rates affecting the monthly cost of
mortgages.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Thank you very much Mr. Chairman.
Chairman Bernanke, do you agree that the rate hikes over
the last 2 years, 17 successive rate hikes, are beginning to
bite and they have reduce long-term inflation risks?
Chairman Bernanke. Senator, as you know, we started from an
extraordinarily low level of about 1 percent, and we had to
move many times to remove that extraordinary degree of monetary
accommodation from the system. I would agree we have
essentially removed that extraordinary degree of monetary
policy accommodation and we are much more in a more normal
range of interest rates at this point.
I do think it is beginning to have some effect. We are
trying to judge the effect on both real output and inflation,
and trying to make our best judgment.
Senator Sarbanes. If there were no further rate hikes, how
long do you think the negative effects of past rate hikes on
growth and output in jobs would continue?
Chairman Bernanke. Senator, the forecasts that I gave you
earlier are based on our analysis of the future of the economy,
taking into account the policy actions that we have already
taken. So based on those actions, or actually based on
appropriate monetary policy more specifically, the Members of
the FOMC see the economy cooling slightly relative to the last
3 years to a sustainable pace consistent with underlying
productive capacity. And they also see inflation moderating to
a level more consistent with price stability over the next 2
years.
Senator Bennett. Is there a further lag between the slowing
of the economy and changes in core inflation? If so, how long
is that lag?
Chairman Bernanke. Again, our forecasts have tried to
incorporate those legs. If you were asking about even beyond
the 2007 forecast horizon, my guess would be that we would see
some further decline in inflation in 2008.
Senator Sarbanes. I am concerned about this perception I
quoted in my outset, ``To Pause or Not to Pause, That is the
Conundrum,'' and that ``The Fed has managed to elevate a pause
to something that is a pretty major event. What was normal in
prior cycles, up or down, is now something that grabs
headlines.''
And then the commentator noted ``The Fed paused twice in
the 1999-2000 cycle, three times in the 1994 cycle. It elicited
a yawn from the markets. This time it is attracting enormous
attention.''
There is an article in this morning's Wall Street Journal
in which they quote Alan Greenspan, who made this observation
after a series of rate increases: ``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.''
He made that statement to the Senate days after the Labor
Department had reported the biggest monthly increase in the
core CPI since 1992. What is your reaction to that?
Chairman Bernanke. I absolutely agree with your point,
Senator. In fact, in my testimony before the Joint Economic
Committee, I argued that at some point, a point which I did not
specify, the Fed would have to get off this 25 basis point per
meeting escalator and adopt a more flexible approach, possibly
varying its pace of tightening, possibly taking a pause.
That has been the practice in the past. That is the
practice of the European Central Bank and the Bank of Japan
today. They do not move at every meeting. They move based on
the state of the economy and based on the pace at which they
wish to tighten.
So I did make that point. I think it is still relevant. But
of course, we always look at this meeting by meeting, and we
will be evaluating all options when we come to meet in August.
Senator Sarbanes. This development in the housing market
that I showed earlier, and the drop in the new housing starts,
that is a 22 percent drop in a matter of months.
Now the National Association of Home Builders, which
obviously would be quite concerned about something of this
sort, has written to Members of the Committee about this. And I
understand that some forecasters say that this could result in
a 1.5 percent drop in GDP.
Now we have relied on the strong housing market to keep the
economy up in recent times, and now this seems to indicate a
deterioration in that position.
Furthermore, in your statement when you talk about higher
core inflation, you reference increase in residential rents, as
well as the imputed rent on owner-occupied homes. Now the
Association of Home Builders makes, it seems to me, a rather
valid point in communicating with us about this measure, saying
that the weakness in new housing increases the demand for
rental housing. Therefore, the price of rental housing goes up
and the imputed value of the owner's equivalent rent--which
they are not actually paying, it is a statistical measure--that
goes up. And therefore, the core inflation goes up. Then the
reaction to the core inflation going up is to raise the
interest rates in order to check what is perceived as an
inflation problem.
The raise in the interest rates intensifies this trend in
the decline in new housing, available housing, greater demand
for rental housing, a greater imputed value into the core
inflation measure. And you have this vicious circle contributed
to by the raised interest rates.
That seems to me to have some validity, that observation.
What is your reaction to that?
Chairman Bernanke. Senator, on your first point about
housing, we are watching housing market very carefully. I would
point out that there have been some offsets in nonresidential
construction, in exports, and in investment. So other parts of
the economy are picking up to offset some of the weakness we
see in the housing market. But we are watching that very
carefully.
Your point on owner-occupied equivalent rent is a good
point and we are quite aware of it.
Senator Sarbanes. Seventy percent of the housing in this
country is owner occupied; correct?
Chairman Bernanke. Senator, what I was going to say is, and
I think that is a good reason, that for example we focus more
on the personal consumption expenditure deflator, which puts a
much lower weight on that than does the CPI, for example.
In addition, as I mentioned in my testimony, the increase
in inflation we have seen is a much broader phenomenon than
that single component. If that single component was the only
issue, I would think twice. But I do see movements in inflation
in a broad range of goods and services.
Senator Sarbanes. Is it worth thinking one-and-a-half 5
times when you see that component doing that thing?
Chairman Bernanke. No, I will think twice, Senator.
Senator Sarbanes. Mr. Chairman, I want to make one final
point, if I could, with the Chairman. I want to use two charts
to show it.
One is a chart showing that rising profits more than
account for inflation in the nonfinancial corporations. What
this shows is the red line represents the increase accounted
for by higher profits. The blue line is the increase in prices.
And it goes back to the chart I showed about the labor costs.
It seems to me it is fair to say, at least up to this
point, that a rise in labor costs, which had 0.3 percent I
guess, most of it is we have increased productivity, is not a
factor in looking at a current inflationary situation. Would
you agree with that?
In fact, the whole thing is skewed so that the benefits of
whatever economic activity is taking place are going very much
to profits, which then translate out to this growing inequality
in incomes and wealth in the country.
Chairman Bernanke. Senator, I agree that there is more of a
problem in the product markets than in the labor markets. In
the product markets they are sufficiently tight that firms are
developing pricing power and they are passing on their energy
and materials costs.
It still is an inflation problem because if inflation
rises, it is still going to have the same adverse affects. It
is going to get into expectations. I am not saying that is
going to happen. Our forecast is for inflation to decline over
time. But it is a risk. And nevertheless, if it is coming from
product markets more than labor markets, it is still a risk to
inflation.
Senator Sarbanes. Thank you, Mr. Chairman.
Chairman Shelby. Senator Bennett.
Senator Bennett. Thank you.
Chairman Bernanke, we have had a lot of conversations about
wage growth compared to inflation. I find it hard to get a
single statistic on this. If you look at the narrow measure of
labor compensation that is labeled average hourly earnings,
which does not include any benefits, then you get one answer.
If you look at the more comprehensive measures of labor
compensation, such as those that come from the Bureau of Labor
Statistics, productivity statistics, and the employment cost
index from the International Compensation Survey, you get
another answer.
If you take those BLS measures that include benefits as
well as that which shows up in the W-2, suggesting that
benefits sometimes very often comprise 30 percent of
compensation. So leaving them out of the figure would be kind
of misleading. If you take the information from the BLS
statistics, you find that workers have made gains, in some
cases very healthy gains, after adjusting for inflation.
Now, what statistics do you use when you look at this? And
can you give me some help as to where I should go?
Chairman Bernanke. Senator, we look at them all. I am sorry
that I cannot point to one in particular.
But you do make a valid point, which is that if you look at
nonfarm business compensation per hour, you have real increases
about 2.5 percent over the past few years. If you look at real
average hourly earnings, it is much closer to zero.
The difference, as you point out, is really two things. One
is the fact that the former, the nonfarm business compensation,
includes benefits. But it also includes the full universe of
workers, not just production workers. So depending on what
sector you are looking at, you might use one or the other.
For purposes of looking at household income, that is how
much income consumers have to spend, you would probably look at
the nonfarm business compensation. If you are looking at costs
affecting manufacturing, for example, you would look at some of
the average hourly earnings numbers.
Senator Bennett. When I was an employer, I learned very
quickly you cannot look at your labor costs in terms of what
shows up on the W-2. Your labor costs are based on the entire
compensation package, which includes all of the benefits. And
you learned very quickly that if you did not recover enough
value added from the employee's work to cover everything, what
is in the W-2 plus the Social Security plus the health care,
plus the unemployment compensation, plus, plus, plus all of the
other things that got added on. If you did not get sufficient
value added from the work of the employee to cover all of that,
you could not afford the employee. And all of that was always
significantly higher than the earnings that was reported in the
W-2.
So, I have to continue to look at that when we have these
arguments about compensation and where it really goes.
Let me shift completely from that argument to another one
that we have had maybe in some of the opening statements. You
have suggested that persistently low, long-term interest rates,
even as short-term rates have risen significantly, comes as a
result of a global savings glut with respect to global
investment opportunities. And it is that global savings glut
that has allowed large amounts of savings to flow into the U.S.
investments.
I was at the Aspen Ideas Festival and one economists there
said people send their money here because, number one, it is
the safest place to do it. And number two, they get a higher
rate of return in the United States than they get elsewhere.
Do you still believe there is a global savings glut and
that we can expect people to continue to want to put their
money here?
Chairman Bernanke. I think there still is a global savings
glut. It may have moderated somewhat because of increased
growth in some of our trading partners. But on the other hand,
there has also been, of course, these large revenues that the
oil producers are accumulating because of the high price of
oil. They are not able to absorb, or use those revenues at
home, very quickly. So they are taking that money and putting
it back into the global financial system. So that is
contributing to this overall global savings glut.
I would say that real interest rates at the long end have
recent risen a bit recently. And I think that some moderation
in the global savings glut, together with some return toward
normalcy in term premiums, may account for that. So, I think
there has been some change. But the broad idea that the global
savings glut is out there, I think, is still valid.
Senator Bennett. So you are suggesting that foreign
investment in the United States is not about to dry up at any
point soon?
Chairman Bernanke. I do not think it is going to dry up. I
do think that over a period of time we should become more
reliant on our own saving and reduce the current account
deficit.
Senator Bennett. Surely.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Reed.
Senator Reed. Thank you very much, Mr. Chairman.
Thank you, Mr. Chairman, for your testimony today. You have
indicated that you expect inflation to moderate going forward.
Is that a consequence of the slowing economy or moderating
economy?
Chairman Bernanke. That is one part. But in addition, we
are seeing, we are hoping at least that these energy price
increases will not continue at the same pace as they have been
going on in the past. And that would remove a source of
inflation pressure, as well.
Senator Reed. If the economy moderates, what will that do
to already, from my perspective, inadequate job growth? Would
you anticipate job growth to also moderate?
Chairman Bernanke. I think that job growth will continue to
be close to what the labor force growth demands, in some sense.
There has been a change in the last few decades in terms of the
rate of growth of the labor force, in part because, for
demographic and other reasons, the share of the population that
participates in the labor force has flatted out and now looks
to be declining.
It therefore appears that the number of jobs we need to
create each month to keep the unemployment rate roughly
constant is lower today than it would have been, say, in the
early 1990's. And so I think job growth will be lower than it
has been over the last 15 years. But I think it will be close
to where it needs to be to keep the unemployment rate at a
healthy, low level.
Senator Reed. But that is a function of the participation
rates. And for some reasons, demographic rates, an older
population you would have a lower participation rate. But you
still have a significant number of Americans that are looking
for both work or looking to move up. And with a job rate that
simply replaces the new entrants in the job market, that is not
going to provide the type of robust job growth that most people
associate with a vibrant economy.
Chairman Bernanke. What we see in the labor market, and it
is a very difficult problem, is a bifurcated market. What we
see is people who are skilled, who are machinists, registered
nurses, truck drivers with a commercial driver's license, and
so on, are finding a lot of opportunities. People with less
skills are finding it more difficult.
That is, of course, a serious problem for our economy. But
it is one probably that needs to be addressed more by education
and skill training and other approaches rather than monetary
policy.
Senator Reed. I think that is a conclusion we have all
reached. But in the short to intermediate run, it is hard to
reeducate a workforce. And people have to be able to live and
work. And that is a dilemma that we both face.
Is it accurate to say that some of the productivity gains
have been increased not by upgrading the skills of Americans or
the equipment they have, but by simply shipping jobs overseas?
That as you lower the unit cost of labor, for example, and your
output is constant that would seem to me to increase
productivity. Are some of these productivity gains a direct
result of outsourcing American jobs?
Chairman Bernanke. I do not think we have clear knowledge
of which direction that effect is working. It depends on the
composition of jobs that have been outsourced. It depends on
how it affects the productivity of firms that remain in the
United States. For example, if they are able to improve their
global supply chains and the like.
I think the primary source of the productivity gains are
two. First is the improvements in information communication
technology we have seen over the last 20 years or so.
But second, the United States has done a lot better at
using those technologies than a lot of other industrialized
countries. I think that relates to the fact that we do have
very flexible product and labor markets. We have deep capital
markets that provide funding for new ventures. And we have an
economy that has an entrepreneurial spirit.
So we have made better use of those technological changes
than some other countries. I think that is the primary source
of our productivity gains.
Senator Reed. But is it worth, in terms of just an
analytical approach, to look at the effect on productivity of
outsourcing jobs? We take great pride in increased
productivity. But I think if part of the story is it represents
the loss of American jobs, it is not as compelling or as
desirable a notion.
Chairman Bernanke. We could look at that. As I said, I do
not think we have clear evidence on that point. I think a
broader issue is competition.
There is some very interesting research done by the
McKinsey Corporation that has looked at firms around the world
and looks at their productivity gains. What it finds is that
firms that are exposed to competition, as unpleasant as that
might feel, increase their productivity gains much more
rapidly.
And so one of the benefits, I think, of a more open trading
system, a more open economy where we compete with, and trade
with, countries around the world, despite the fact that it does
create stress and sometimes changes and dislocations, is that
competition forces productivity gains and has been, I think, a
source of growth for us as well as for our trading partners.
Senator Reed. Thank you, Mr. Chairman.
Chairman Shelby. Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman.
Chairman Bernanke, as I said in my opening statement, the
stock market has been on a wild ride since you took over in
February. I have a chart here that I would like to share with
you.
Since you were sworn in, the Dow is down 65 points, 0.61
percent. Standard & Poor's is down 43.22 points, 3.49 percent.
The Nasdaq has suffered what we call a severe drop. It is down
262 points or 12.85 percent.
Since your lapse in judgment, in your words, took place,
the Dow is down 567 points, a total of 5.26 percent. Standard &
Poor's is down 73.75, almost 6 percent. The Nasdaq is down 279
points, 13.67 percent.
But even more importantly, since the May 10 Fed rate
increase, the Dow is down 840 points, 7.78 percent. Standard &
Poor's is down 88.28, 7.14 percent. And the Nasdaq is off
295.02, or 14.4 percent.
My question, to follow that up, why do you think the
markets have reacted so drastically to the Fed's actions?
Chairman Bernanke. Senator, I do not think it follows
necessarily that they are reacting to the Fed's actions. There
are a lot of factors in the world that could explain why the
markets are down. We have geopolitical uncertainty and oil
prices going on. We have, around the world, many other central
banks raising interest rates. And that has led to a clear
reduction in the amount of risk that people willing to take on.
We have seen that in lots of markets, in other stock markets in
other countries, as well. There is greater uncertainty now
about inflation and growth in the U.S. economy. I think all of
those things can help explain why the markets are down.
I would add that the literature suggests that stock markets
do not do well in periods of inflation. I think the best thing
the FOMC can do, to strengthen, to get the stock market up,
although that is not one of our mandated goals but I think it
would be a good thing, but to help get the market up, would be
to go toward our mandated goals and create stable growth and to
keep inflation low. And that is what we intend to do.
Senator Bunning. Do you know how this translates for the
average American? Into the higher interest rates, which the
FOMC has done, into lower values on their pension plans? This
is average America. Lower 401(k) values by billions of dollars.
It seems like a straw horse to use higher energy costs when
higher energy costs have been occurring off and on since 1974,
we have had an unstable energy market, sometimes to the extreme
of $12 or $8 per barrel to $78 plus per barrel, which it hit
this past week. So that is not a real factor. That is one that
is coming and going. That is why it is not in the core
inflation rate.
These are real problems that everyday Americans are facing.
And your action on the FOMC, and your 11 other people that are
with you, deciding interest rates on a given day, trying to
project 9 months down the road how it will affect the U.S.
economy is just breathtaking.
Last week, a writer for one of our wonderful business
publications, Business Week, said if you, as a Chairman of the
Federal Reserve, expect growth to moderate and inflation to
ease, why do you even consider another rate hike?
Chairman Bernanke. Senator, again, I do not think you have
made the case that this is not a fundamental set of factors
affecting the stock market. If we had stopped raising rates at
4.25 or 4.50, I think there would be a lot of concern in the
market and in the economy about inflation at this point. We
have tried to balance those inflation concerns against growth
concerns. We are looking at both very carefully.
As far as the future policy, as I said, we have not made
any future decisions. We are going to be looking at the
situation at each meeting. We do have to take into account,
though, the possible risks, as well as the expected path that
we are looking forward to, because if there is a chance that a
very bad outcome might occur, there is a risk management
approach, which Chairman Greenspan and other central bankers
apply, which suggests that you need to lean a bit against that
possible outcome.
But again, we will be looking at all the data and thinking
hard about it when the time comes for us to meet again.
Senator Bunning. Thank you, Mr. Chairman. My time has
expired. I will wait for the next round.
Chairman Shelby. Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman.
Mr. Chairman, I want to return to some of the issues I
raised in my opening statement. It appears to me that we have
an economy in which increasing productivity and large tax
revenues are driving up our gross domestic product. But that,
in turn, has benefited a very small number of people who own
capital.
As I said to you in my opening statement, in New Jersey
when I talk to people, they tell me that they are constantly
feeling squeezed by higher tuition rates as they try to send
their kids to college, facing the challenges of the costs of
taking care of a loved one, facing higher energy prices to heat
or cool their homes, facing higher gas prices, facing higher
insurance premiums and copays, and yet finding their median
incomes are flat over the last 5 years.
And so, with all of those challenges and negative personal
savings, who is this the economy working for?
Chairman Bernanke. Senator, I think what you are addressing
is the issue of inequality. I agree that inequality is
potentially a concern for the U.S. economy. We want everybody
in the society to have a chance to participate in the American
Dream. We want everybody to have a chance to get ahead. And to
the extent that incomes and wealth are spreading apart, I think
that is not a good trend.
That however is a development, a trend, that has been going
on for about 25 years now, according to most of the studies. It
is therefore, a big challenge to think about what to do about
it. I could go into some of the literature, if you would like,
about some of the research on why this is happening. But I do
think that fundamentally the increased importance of skilled
jobs and of technology in our society puts a higher premium on
people with more education, more experience, and more skills.
I think really the only long-term solution to this problem
is to try to upgrade the skill levels of our workers. And I
think that is not necessarily a 10, 15, or 20 year process
because people can learn, as Senator Dole often says, in
community colleges or technical schools. They can learn on the
job. There are all kinds of adult training and various things
that can be done. I think we need to take that seriously
because I think that is really the only way we can address this
issue on a long-term basis.
Senator Menendez. Often when we talk about inequality, we
think about the people at the lowest level. I am talking about
middle-class families who are facing those squeezes of all of
these higher costs. Many of them are pretty well-educated. And
yet their incomes remain relatively stagnant.
Our global challenge is it used to be that the casualties
of global trade were those at the lowest skill levels. But I
have software engineers telling me that they are losing their
jobs, and they make some pretty significant incomes. And that
the certainty of their job employment has moved. One guy told
me he is in his third different company in the last 18 months,
not because he is not a good employee, but because the global
challenges are either consolidation or offshoring of the
services that he provides.
So it seems to me that we have to look at the underpinnings
of this in terms of middle-class families increasingly being
squeezed.
And we talk about inflation. If all of these prices are
going up and yet your incomes remaining relatively flat is not
inflationary to the average family, it seems to me they are
pretty inflationary.
The other question I would like to ask you is what do you
see currently as the most significant threat to economic
expansion, in your view?
Chairman Bernanke. Economic expansion in the short term?
Senator Menendez. Yes.
Chairman Bernanke. I think it is the risk that we are
considering, and again it is just a risk, that inflation might
move up and might force us to be more aggressive, which we do
not want to do, because we hope that inflation will stay under
control or come down as we expect it to. I think that is a
risk.
We also have the geopolitical issues. We have seen the
latest in the Middle East, for example. Oil prices are a risk
and a concern, and we are paying very close attention to that
situation as well.
Senator Menendez. And last, I had asked you in a written
question which you answered about paying down publicly held
debt and the importance of that. Now we see where CBO tells us
we are headed to $12 trillion worth of debt by 2011. How much
importance do you place on paying down that publicly held debt
in the context of long-term economic health?
Chairman Bernanke. Senator, I think it is really important
to think about the long-run. And what we are facing going
forward is an aging population, increasing costs of medical
care, and the costs for our entitlement programs that are going
to be rising very seriously.
So, I think the strongest case for trying to pay down some
debt sooner is to try and provide some buffer or some savings
that will help us meet those challenges as we go forward. I
think that the most serious long-term issue for our budget, is
these growing transfer programs.
Senator Menendez. Thank you, Mr. Chairman.
Chairman Shelby. Senator Dole.
Senator Dole. Mr. Chairman, are there signs that wages are
beginning to catch up to past productivity growth? And if not,
when do we expect this to happen? And would it be a concern to
the Fed? Can you have a period in which wages catch up to
productivity without an increase in inflation?
Chairman Bernanke. Senator, we see some evidence of this,
but it is not very overwhelming. For example, the average
hourly earnings number is up about a percentage point this last
year versus the previous year. We are seeing anecdotally that
firms are finding it harder to hire skilled workers and are
either giving or contemplating wage increases. So our forecast
is for increase in wage growth going forward.
But again, it has been slow coming. I want to be clear
about that.
As far as inflation is concerned, I want to also be very
clear that increases in the real buying power of workers are
not inflationary.
For example, if it happens because the inflation rate is
going down and a given wage buys more, there you have an
increase in real wages without any inflation.
Similarly, if wages go up but they are offset by
productivity gains, which has been the case for the last few
years, you have higher real wages but no inflation.
And third, another possibility is that markups go down, the
margins go down.
So, I do think the wages will rise. I am a little surprised
they have not risen more already. I believe that real wage
increases, though, are not at all inconsistent with our
prediction that inflation is going to moderate over the next
couple of years.
Senator Dole. Congress has been engaged in a debate over
increasing the minimum wage. As a former Labor Secretary who
has testified on this issue, I know that increasing the minimum
wage is not an effective mechanism for lifting people out of
poverty. I have long advocated for increasing the earned income
tax credit and jobs and skills training, which I think are far
more effective at relieving poverty.
Would you share with this Committee your thoughts on the
most effective ways that Congress can act to reduce poverty?
Chairman Bernanke. Senator, the minimum wage is
controversial because economics suggests that, when you raise
the minimum wage, you would pay a higher wage to some workers,
but then some workers would not get work because of the higher
wage. The research on this is controversial. Some people have
argued that the effect is very small. Others think it is
larger.
My inclination is to say that you would like to find ways
of increasing the return to work, which do not have the effect
of potentially shutting some people out of the workforce. So, I
think I would agree, and I have said this in previous
testimony, that the earned income tax credit, which provides
extra income to people who are working, and increased training
for increased skills and productivity, are in my opinion
probably more effective ways to approach this question.
Senator Dole. Thank you.
Another question. Do you believe that Fannie Mae and
Freddie Mac's regulator should have the authority to allow the
GSE's to increase their portfolios when there is a downturn in
the housing market?
Chairman Bernanke. This is another controversial issue. The
point is sometimes made that the GSE's can enter into a
situation where there is a downturn and provide extra liquidity
in the market through their portfolios to support the mortgage-
backed security market, for example.
In our research at the Federal Reserve, we have not found
that to be a very important effect. We have really found very
little effect in that direction. We would also point out that
if you are going to do that, what you want to have in your
portfolio is liquid assets like treasuries, not MBS, because
you cannot increase liquidity if you buy MBS with other MBS. So
we have been some concerns about that.
Now having said that, I think it is worth, for the purposes
of trying to come to some kind of agreement on GSE's
legislation, we could perhaps discuss or consider the
possibility that the director might provide some emergency
ability to GSE's to make extra purchases during times in which
the director judged the housing market to be in distress for
some reason, but then to get rid of that extra portfolio, get
rid of the extra MBS, over a period of time when the emergency
was eliminated.
Again, we do not really see much evidence that this is
necessary. But if that were part of an overall agreement that
brought a strong and effective regulator to the GSE's, it might
be worth considering.
Senator Dole. Thank you. I believe my time has expired, Mr.
Chairman.
Chairman Shelby. Thank you. Senator Carper.
Senator Carper. Thank you very much.
I had indicated several questions I was going to ask you.
One is what do you think about when we give our opening
statements. I will ask you that in private on another day.
I want to go back to this issue of GSE regulations, of
Fannie Mae and Freddie Mac and the Federal Home Loan banks. I
know our Chairman has raised this issue and Senator Dole has
just raised it and I suspect others have as well.
As Chairman of the Federal Reserve, you regulate some of
our biggest entities and holding companies in the country. I
want to just come back and ask you for some advice as we try to
find--we have really differences in two principal areas. One of
those is with respect to an affordable housing fund and how to
structure that. The House has passed legislation, by a pretty
wide margin, where they establish one.
I think they ask for setting aside I want to say 5 percent
of net income from Fannie Mae and Freddie Mac to go into an
affordable housing fund, that monies would be apportioned from
there into affordable housing in our different States.
The other issue, of course, is the portfolio, what could be
in it? How much can it grow? What powers do we give the
regulator with respect to regulating what is in the portfolio?
If you are giving us advice, and you have given us a little
bit but I am going to ask you just, sitting back, looking at it
as a regulator yourself, what would you want to have as a
strong regulator and legislation that would enable you to do a
good job? If you were regulating the GSE's.
Chairman Bernanke. Senator, I do not have much to offer on
the affordable housing. I know that is an item for negotiation.
I would just point out that an alternative would be to put it
directly on budget rather than to do it indirectly through the
GSE's.
With respect to the portfolios, as you know, the Federal
Reserve has argued for a substantial time that the portfolios
are larger than is needed to serve the fundamental housing
mission of the GSE's. My advice would be not to set a hard cap
or a number and restrict the portfolio in that way, but to give
strong guidance to the regulator about how to relate the
portfolio to the mission of the GSE's.
For example, it would make perfectly good sense for the
GSE's to hold affordable housing mortgages that are difficult
to securitize in their portfolio, for example, or maybe to hold
liquidity for some of the issues that Senator Dole is raising.
But I think by grounding the size of the portfolio in the
mission of the GSE's, you would bring down, over time, the
portfolio to a safer level and not hurt the underlying mission
of the GSE.
Senator Carper. How important do you think it is that we
find common ground and actually regulate in this area this year
before we call it a day?
Chairman Bernanke. I do think it is very important. The
Federal Reserve was drawn to this issue initially because we
felt that while the securitization function of the GSE's is
extremely valuable and constructive, we felt that the large
portfolios exceeded what was needed for the housing purpose,
and indeed posed a threat to the stability of the financial
system.
The reports we have seen recently on GSE accounting by
OFHEO and so on, which cast into doubt the underlying
accounting and internal controls of these agencies, I think
just heightens my concern that those large portfolios at some
point might create serious problems for financial markets.
Senator Carper. Thank you.
I suspect others have already talked to you about, as you
have raised short-term interest rates, and we have actually
seen the emergence of an inverted yield curve. Why is that
happening? Do you think it is going to persist? Is it something
we should be concerned about?
Chairman Bernanke. Senator, there appears to be a
structural tendency for the yield curve to be flatter than it
was in the past. Part of it, as I answered to Senator Bennett,
is the global savings glut which is keeping long-term real
interest rates lower than they otherwise would be.
The second is, for a variety of reasons that I went into in
a speech earlier this year and talked about in some detail, for
a variety of reasons the term premium, the risk premium on
long-term debt, seems to have been lower recently than
historically.
And for those reasons, the term structure seems to be
flatter structurally than has been the case historically,
although there has been a bit of an increase, I think, in the
long rates in both the term premium and the portion
attributable to the savings glut, I think, since the beginning
of the year.
Senator Carper. A question on energy independence, if I
could. I mentioned in my earlier comments that over a third of
the trade deficit this year now is imported oil. When we look
at inflation, a significant part of what is pushing up prices
is the cost of energy.
Our neighbors down to the south in Brazil, about 15 years
or so ago they had said they wanted to become energy
independent. And they have done a fair amount of work. We hear
a lot about what they have done with flexible fuel vehicles and
greater reliance on ethanol.
We, meanwhile, have gone in the other direction over the
last 15 years. We have become more and more dependent on
foreign oil and it takes an ever larger bite out, in terms of
with respect to the trade deficit.
Your advice for our country with respect to moving toward
energy independence and whether or not it is something we
should be taking seriously? And if so, what counsel would you
have for us there?
Chairman Bernanke. I think as a practical matter being
literally energy independent is not something that is feasible
in the near-term.
Senator Carper. It will not happen in my term and probably
not yours either.
Chairman Bernanke. I think what we should do broadly is to
diversify our portfolio, to have a wider range of energy
sources including ethanol, coal, nuclear, and other
possibilities.
And I think there are a number of ways Government can help,
but in two ways in particular. The Government has, in the past,
been effective in helping in basic research. That is research
that individual companies do not find it profitable to
undertake because they cannot appropriate the returns.
I think we also need to try to increase the amount of
regulatory certainty. It is certainly appropriate to have
regulations that offset environmental and other concerns. That
is totally appropriate. But there is so much uncertainty about
what the regulations will be when the time comes to apply them
that many projects simply do not get undertaken.
So if we can provide clearer mechanisms by which those who
wish to build new energy sources can understand what is
expected of them, I think we will see, given the very high
prices we are seeing for oil, we will see, over the next few
years, a lot of alternative energy sources coming forward.
Senator Carper. Thank you.
I would just share with you and our friends, I think it was
106 years ago this year that the very first diesel engine was
introduced. I believe it was at an exhibition in Paris, France.
It was powered by peanut oil.
We now just opened up last month, in the central part of my
State, not too far from where Senator Sarbanes is from, Dover,
a biodiesel refinery which is run entirely on soybean oil,
which we have a lot of on the Delmarva Peninsula, as Senator
Sarbanes knows.
The other thing, we just got a new air conditioner at our
house, and we also got a new air-conditioning standard, a new
SEAR standard for air-conditioning efficiencies this year. The
new standard is SEAR-13, as opposed to SEAR-8. And we had a
battle over whether we were going to go to SEAR-10 or SEAR-13.
We ended up at SEAR-13.
What that means, just the difference between a SEAR-10 and
a SEAR-13 with respect to energy consumption, it means roughly
50 or so power plants we will not have to build over the next
15 or 20 years, simply by having SEAR-13 standards for new air
conditioners, as opposed to SEAR-10.
Thank you.
Chairman Shelby. Senator Sununu.
Senator Sununu. Thank you, Mr. Chairman.
Chairman Bernanke, in your testimony you used what seems to
me to be an interesting phrase in a couple of places. That is
the phrase ``appropriate monetary policy,'' ``reflect our
assessment that, with appropriate monetary policy--the economy
should continue to expand at a sustainable pace and core
inflation--from its recent level over the medium term.'' You
use it in another place.
Could you elaborate a little bit on what appropriate
monetary policy is? Is that not too hot, not too cold?
Chairman Bernanke. I wish I could, Senator. The forecasts
are made under that assumption, and each person who is
submitting their forecast makes their own assumption about what
that would be.
So what I take this to be is really a summary view of what
we can achieve, where we should be heading with policy.
Senator Sununu. If everything goes perfectly?
Chairman Bernanke. No, not perfectly, but if things go as
generally expected.
I think there is a lot we could do to make those forecasts
more informative and that might be one direction to go in the
future. But I understand that is an ambiguous phrase.
Senator Sununu. You also say in your testimony that ``It
bears emphasizing that, because productivity growth seems
likely to remain strong.'' So you were assuming that
productivity growth will remain strong.
On what are you basing that assumption?
Chairman Bernanke. I am basing it on looking at the pattern
of recent years. First, we saw the productivity gains mostly in
the industries producing high-tech equipment, as companies
learned how to build ships faster, for example.
Then we saw it moving into the users. That is firms that
were not high-tech producers but were using and consuming those
goods to increase their own productivity. And what we see as we
talk to people in the industries and the like is we see first
that there is continuing innovation and improvement at the
level of high-tech producers.
And moreover, what we hear from CEO's and the like is that
they feel there is a lot more diffusion to take place before
they have fully exhausted the benefits of new technologies in
terms of increased productivity.
As a historical matter, when productivity changes from a
high level to a low level, it does tend to last for a while.
And that is another piece of encouraging evidence.
Senator Sununu. So you have what you feel to be some pretty
good anecdotal evidence.
Chairman Bernanke. It is mostly anecdotal, a little
statistical. The fact is that as our society relies more and
more on productivity gains as a source of growth, the
forecasting is going to get tougher because it is more
difficult to forecast in say the size of the workforce.
Senator Sununu. Which are you more worried about with
regard to the medium term prospects for inflation: Inflationary
expectations or the absolute level of inflation based on
changes in energy prices or labor prices?
Chairman Bernanke. Senator, the two interact because if
there was just a one-time pass-through and the public were
completely convinced that the Fed would keep inflation low and
expectations were low and the Fed were perfectly credible, then
that inflation would be just a temporary thing and would come
back down.
So the risk is the interaction of the two. The risk is that
inflation will go up because of energy prices, because of
greater pass-through, and that will feed into inflation
expectations, which then will feed into a round of additional
price increases and the like.
You really cannot get a permanent increase in inflation
unless people increase their inflation expectations. That is
why the Fed's credibility is, I think, such a major asset of
the United States.
Senator Sununu. It seems to me to the extent that you are
in the midst of a little bit of a dilemma it is as follows.
Right now, inflation is above what has been stated in different
ways your target range. We have still got high energy prices.
So that would suggest that the absolute level of inflation
remains a concern.
On the other hand, you have a forecast for moderating
growth. You have a slowdown in the housing industry. So while
the inflation numbers may push you toward a rate increase, the
moderating growth that has been forecast might encourage you to
pause or to forgo further rate increases. That is a dilemma. I
think we all understand that.
To what extent is the fact that you now find yourself in
this dilemma the result of a slowness or a delay to action in
beginning this cycle of rate increases?
Chairman Bernanke. To comment on your first part of your
question, we cannot do anything about this month's inflation
number because our policy works with a lag. And so we have to
be looking at a forecast or a future to make those judgments
and to assess the risks.
I do not know the answer to your second question.
Senator Sununu. First of all, the second question was the
good one. I did not have a first question.
I think we are working under the assumption that the
forecast for inflation is in the, I think you said 2.25
percent, 2.5 percent, that is still above the 1 to 2 percent
target.
Chairman Bernanke. We do not have a target, Senator.
Senator Sununu. I stand corrected.
But the answer to the second question, is this the result
of slowness to act or delay to act initially in the tightening
cycle?
Chairman Bernanke. I think certainly an important part of
what has happened has been the increases in energy and
commodity prices. That has directly added to total inflation,
and now we are seeing it passing through, to some extent, to
core inflation. I think if energy prices were $40, I think
things would be much better. I would say that.
Whether policy has been optimal or not, I really cannot
judge.
Certainly, along with fiscal stimulus and other measures we
did succeed in getting the economy back on a strong growth
track in the middle of 2003. And we have seen 3 years of strong
growth. It took a while for jobs to come back but eventually
the labor market also began to improve.
Senator Sununu. When you say I cannot judge, is that
because you are not technically suited to do that evaluation?
Or because you do not think it would be productive in your
current occupation?
Chairman Bernanke. We could try to do an evaluation with
our models and the like. I am not sure how accurate it would
be. In addition, the interesting thing about the energy price
increases is that if you go back for 3 or 4 years and you look
at each month at what the futures market was expecting, it was
always expecting these things. We have had these increases, the
energy prices are going to finally stabilize. And every single
month it has been wrong.
And so this increase in energy prices and commodity prices
certainly has been a significant contributor. And I think that
we would not really be talking about this now if energy prices
were still $30 or $40 a barrel.
Senator Sununu. Thank you, Mr. Chairman.
Chairman Shelby. Senator Dodd.
Senator Dodd. Thank you, Mr. Chairman. And thank you, Mr.
Chairman, for your presence here today.
I want to raise three quick issues if I can with you. I
think all three of them could normally consume significant more
time than will be allotted to me here to talk about him. And I
realize we are here today to talk about monetary policy, but
obviously fiscal policy has a direct bearing on monetary
policy.
I am concerned, along with I presume many of my colleagues,
about the rising level of our debt. I recall only a few years
ago having a hearing in this Committee with your predecessor on
which we actually had a hearing about what the effects would be
about eliminating the national debt.
Here we find yourselves today, 5 years later, with $8.4
trillion in debt, $2.6 trillion of it occurred in the last 4 or
5 years. In fact, more debt accumulated, I gather, in this
period of time than all of our previous administrations
combined, and the implications of that.
It has been reported that our Vice President allegedly
commented that deficits just do not matter. I am quoting him
here, that is what I am told he said. I disagree with that. I
would like to know how you feel about this.
I want to raise with you, in the conjunction of this rising
level of debt, and the accumulation of it, the implications
about how much of it is being held offshore. I noted when you
consider some of the problems we are wrestling with today,
whether it is the presence of a--the possibility of a presence
of a growing weapons of mass distraction on the Korean
Peninsula and obviously the problems we are facing as we speak
here in the Middle East, the issue of immigration and the
policy on our southern border.
I note that of the 10 top holders of our national debt are
China at some $326 billion, oil exporters of $103 billion,
Korea at $69 billion, Hong Kong at $51 billion. And coming in
at number 10 is Mexico at $43 billion.
My experience has been that when you are trying to lecture
your banker, it can be dangerous in a sense. And I wonder if
you are as worried, as many of us are, about this trend and
whether or not we should be more concerned about this growing
problem, a trillion dollars of it now or more of our debt being
held offshore, and what the implications could be here, and
what these implications mean in terms of the monetary policy
for the country.
Chairman Bernanke. That was a lot of questions, Senator.
Senator Dodd. I realize that, and I apologize.
Chairman Bernanke. First, I think I will comment that, in
retrospect, the idea that the national debt would disappear was
never all that realistic. The share of GDP that was collected
in taxes in the late 1990's was over 21 percent, compared to a
historical average of about 18 percent. A lot of that came
basically from the stock market, which we know now was not
sustainable at the pace it was rising.
Nevertheless, I do think that deficits matter. I think the
size of Government also matters. But deficits matter because
they represent additions to debt that our children and
grandchildren will either have to pay through higher taxes or
reduced services. And so I think they do matter.
I would add, though, that one must also think about the
size of the Government and what share of the GDP we want to
devote to Government services.
With respect to the offshore holdings, you can look at it
two different ways. From one perspective, it is a good thing
that countries that are holding reserves want to hold them in
the form of U.S. Treasuries because we have a deep and liquid
capital market which is very attractive and very safe and very
low cost to people as a way of holding wealth. And we do not
want to do anything that would disturb that. We want people to
want to hold our assets. It is good for our country.
On the other hand, from a different perspective, I think
that part of what you are getting at is the fact that with a
large current account deficit, the external debt that the
United States owes, whether it be held in the form of treasury
debts or MBS or whatever, is growing over time.
And as I agreed, I think it would be very desirable for us
over a period of time to reduce that current account deficit
and reduce, therefore, the growth in the holdings of U.S.
assets abroad.
Senator Dodd. Just a related quick question here. You
mentioned earlier our trading partners and the economic
circumstances in those countries where, in fact, some of the
very nations that are purchasing a lot of this debt may find
more attractive markets elsewhere than the United States. Does
that pose a problem, in your mind, for the United States in the
shorter term?
Chairman Bernanke. That is what I was saying, that it is in
our interest to keep our debt attractive both because the
capital markets are deep and liquid and because our economy is
strong. I do not really see a good alternative right now. I
think that the great majority of the international reserves are
held in U.S. dollars and I think that will continue to be the
case.
However, from a current account perspective, if we look
forward 5 or 10 years at the rate we are going, there will be
increasing reluctance of foreigners to hold U.S. assets. And
that will have effects on our economy and we need to address
that.
Senator Dodd. Mr. Chairman, I will come back to the savings
rate and the consumer debt issue, which is a concern of mine as
well. And I want to just quickly raise this issue about the job
creation issue, because it seems to me based on indications--
this did not happen, by the way, in the last 4 or 5 years.
There has been a trend, as you pointed out, over the last 20 or
30 years where we are seeing job growth occurring at the very
low level of the lower-income levels and at the upper-income
levels. It is in that middle range, that middle-income earner
that Senator Menendez talked about, and Senator Reed addressed,
where we see not just a skill gap. But it seems to be hollowing
out of job opportunities in that area. And that troubles me
very deeply, with that sense of being a low-income earner and
the sense of upper mobility, moving into those middle-income
jobs. And they just seem to be disappearing at an incredible
rate.
I heard you say you had not really examined the outsourcing
issue of jobs. I wish you would. It would be interesting to
come back and give us some report on how you look at that issue
of that. If I am correct, is there a hollowing out occurring
here? And if so, how troubling is that to the Federal Reserve?
Chairman Bernanke. Let me give you an example, which would
be manufacturing, that certainly Senator Stabenow, for example,
would be interested in.
Whether you think U.S. manufacturing is strong or not
depends on how you look at it. In terms of output and
production, U.S. manufacturing output is up 50 percent in the
last 10 years. It is growing faster than in any other major
industrialized country.
And moreover, we have moved toward higher tech, higher
value-added, types of manufacturing. So from that perspective,
manufacturing in the United States is alive and well.
On the other side, you look at the labor inputs, you look
at the number of workers. Because manufacturing has also been
extraordinarily productive, we have about a 6 percent a year
increase in manufacturing productivity over the last 10 years,
we can produce that extra output with many fewer workers. And
so the number of manufacturing jobs, and I think these are the
kind of jobs that you are possibly referring to, has been
declining.
One thing to say about that, which is actually I think very
interesting, is that even though the overall number of
manufacturing jobs has declined quite significantly, the number
of high skilled manufacturing jobs has actually been rising.
And so again, and I know this sounds repetitive, but again
there is a solution, which is to help workers get the skills
that will give them those opportunities.
But I agree that manufacturing is an example where the
overall number of jobs has declined as the productivity of that
sector has increased.
Senator Dodd. Could you just add, by the way, you said to
Senator Reed that the number of jobs that needed to be created
on a monthly basis is dropping. I know the number today is
roughly about 150,000 jobs per month. At least that is the
number I have always used. What is the number you have in mind
that we will be looking at?
Chairman Bernanke. I think it is dropping. I would say now
it is more like 130,000. And within the next few years we might
be down to 100,000. This is all based on research at the
Federal Reserve on labor force participation rates, which
suggests that we will be seeing, over the next 10 years, some
significant decline from the current rate. About 66 percent of
the adult population is in the labor force. We expect to see
that coming down, and therefore the number of jobs a month we
need to keep the unemployment rate constant is likely to fall,
as well.
Senator Dodd. Thank you, Mr. Chairman.
Chairman Shelby. Senator Allard.
Senator Allard. Thank you, Mr. Chairman.
Obviously, we are going through a period of time where
there has been a huge relative change in the price of energy.
And the most recent period of time when we experienced this
great a change would be in the late 1970's.
At that particular point in time in our Nation's history,
we had double-digit inflation, we had double-digit
unemployment, we had double-digit interest rates. In fact, all
of this was put together and frequently referred to as the
misery index.
We have a similar situation today. But when you look at
these same figures that we looked at today, our unemployment is
4.6 percent. Our inflation rate is 4.3 percent. Our interest
rate is 5 to 6 percent.
What is the difference between the late 1970's, when we had
this huge increase in energy costs, yet the economy did not
respond, and today when we have a huge increase--the economy is
still staying very strong.
I wondered if you could shed some light on your view on
that?
Chairman Bernanke. Thank you, Senator.
There are a lot of reasons including, for example, the fact
that we are less energy intensive as an economy now than we
were 30 years ago.
But the one I would like to somewhat self-servingly
emphasize, and it relates to my answer to Senator Sununu, is
the fact that the Fed has a lot more credibility for keeping
inflation low and stable.
In the 1970's, when the energy crisis arose, it generated
expectations of further increases in wages and prices, and you
got into a wage price spiral. The Fed was caught between a rock
and a hard place, having to raise rates very significantly in
order to try to arrest that inflation, at the same time leading
to deep recessions.
Over the last 20 years or so, the U.S. economy has become
much more stable. And one of the very important reasons for
that is the fact that the Fed has gained strong credibility for
keeping inflation low.
The Michigan Survey just came out, and the front page was
describing inflation expectations of the American public. And
they have a lot of confidence that the Fed will keep inflation
low, despite the fact that gas prices are up at the pump.
To the extent that the Fed's credibility is strong and
people think that inflation will be low in the long-term, when
energy price increases hit, it causes a temporary burst of
inflation. But if nobody expects it to continue, then it will
just moderate away. And we do not get into this pattern of
having to raise rates a lot and getting into a stagnant,
inflationary situation.
So, I think monetary policy is not the only factor. There
are other factors. But I think it does have a lot to do with
the better performance we have seen the last 4 or 5 years.
Senator Allard. Has the tax stimulus package had an impact
on this?
Chairman Bernanke. I think the tax stimulus package did
help the economy recover from the 2003 period. And monetary
policy helped, as well.
Senator Allard. Now the United States has been enjoying a
period of economic expansion. What do you see as a single
biggest threat to the continuation of that expansion?
Chairman Bernanke. I think I had a similar question earlier
and I mentioned two things. One would be that we would have an
inflationary problem which is greater than we now expect. And
the other would be energy prices coming from geopolitical
concerns or other sources. I think those are two.
Obviously you can think of others. Senator Sarbanes has
pointed to the housing market and other things. But I think
those would be the ones I would point to.
Senator Allard. My colleague from Connecticut talked about
the debt. We have the public debt and then we have the total
debt, which includes transfer funds for Social Security into
the debt.
If we did not have a deficit today and even, in fact, had a
surplus, wouldn't our total debt figures increase because of
the transfer from Social Security surpluses into the general
fund? Would that not reflect on the total debt figure?
And if we are ever really going to accomplish total debt
reduction, how are we going to do that without mandatory
spending reform?
Chairman Bernanke. You are correct that because we have a
consolidated budget the money we are essentially borrowing from
Social Security, which shows up as paper in the trust fund,
does not count in the deficit. So in that sense, a broader
sense, if you want to think about the U.S. deficit as being the
current flow deficit plus the accrued liabilities to future
Medicare and Social Security recipients, it is actually a lot
larger than the official deficit.
And all that is just another way of saying that as we look
forward to the next 10 or 15 years, we are going to be seeing a
lot more pressure coming from these transfer programs and we do
need to be thinking about how we are going to address those
problems.
Senator Allard. I see, Mr. Chairman, my time has expired.
Chairman Shelby. We have concluded our first round.
I have two questions I am going to submit to you, Mr.
Chairman, for the record. One has to do with the Basel II
capital standards. Senator Sarbanes raised Basel II earlier. We
have some concern there. We have talked with you about this
privately before.
The other one has to do with the Chinese economy. And I
know you will respond to these.
Chairman Bernanke. Yes, sir.
Chairman Shelby. Senator Sarbanes, do you have any other
comments or questions?
Senator Sarbanes. A few questions, Mr. Chairman.
Chairman Bernanke, first of all, just to be clear, you make
constant reference to the cost of energy going up and you
relate that to a potential inflation problem. But it is my
understanding it also has a relationship to a slowing down the
economy problem, as well.
So once again you are caught betwixt and between. It works
in one direction to create more of an inflationary concern, but
it also works in a direction to create more of a concern about
the possibility of an economic downturn. Would you agree with
that statement?
Chairman Bernanke. Yes, I would.
Senator Sarbanes. Now let me ask you this question. In view
of the energy situation, the fact that household savings rate
is now down at minus 1.7 percent, which is I think
unprecedented certainly over a very long period of time. This
chart I showed about new single-family housing home permits,
which is way down, almost 25 percent since a year ago. And what
we are hearing from the people in the housing field is that
there is a real slow down.
The inequality in income which we referred to earlier,
which I think erodes purchasing power on behalf of the people
not at just the lower end but the median portion of the income
scale. The people that are getting these benefits, their
consumption is not going to go up significantly because they
are getting these benefits. But the people who are falling
behind, it is going to impact consumer purchasing.
This raise in interest rates, of course, carries with it
making much more expensive servicing the national debt. We have
run up the debt, the interest rates are going up. Now we have
to have a bigger item in the budget to handle the interest
charges.
When you put all of this together, how worried are you
about the possibility that we could have a substantial economic
downturn?
Chairman Bernanke. Senator, you raised a lot of issues.
I would just say that I take very seriously the dual
mandate, which is to keep the inflation low and to keep the
economy growing at its potential. And we are setting our
policies in a way that we think will do that. Our forecast is
for the economy to grow near potential, and for inflation to
moderate, and so that is consistent with what Congress has
charged us to do.
I do not see a recession as being very likely. We can never
rule out anything. My expectation is that the economy will
continue to grow going forward.
Consumption, in particular, can still be strong enough to
support growth even as the savings rate moves northward. I
believe the savings rate will be improving somewhat over the
next couple of years.
Senator Sarbanes. I think the Members of the FOMC have some
very tough decisions to make here in this particular--I think
you yourself said we were in a transition period. I think you
said that at the outset of your statement.
And of course, only some of the Federal Reserve regional
presidents are on the Open Market Committee. A lot of them seem
to be running around making statements nowadays about the
situation. I am not sure where that exactly takes us. I just
make that observation.
I want to just ask one final question, and the Chairman
referenced the Basel II. I actually want to get that out here
on the table.
The Fed has taken the lead on this issue amongst our
regulatory agencies. I am concerned that the Fed--and this is
really before your watch--that the Fed has gotten us down a
path that is now very difficult for us.
In fact, I note that four of the largest U.S. banks have
recently written the Federal bank regulatory agencies, saying
that they want the option of adopting alternative
methodologies, including the standardized approach, which are
permissible under the Basel II framework.
Other countries are allowing this. We are the only country,
apparently, proposing to limit its banks to the advance
approach option only.
I do not know how we got so far down the path that when we
ran the quantitative impact analysis, we had these tremendous
drops in the capital the banks would be required, which have
set off alarm bells all over the place. I mean virtually
everyone has looked at that and said well, this is not a good
model.
How seized of this issue is the Federal Reserve? We
expressed repeated concern here from the Congress. The Chairman
has held a number of hearings on this issue to try to maintain
oversight. But it seems to have almost a life of its own. It
seems to me the Fed really needs to grab hold of this issue and
start thinking it through because everyone who is looking at
this thing thinks this is not going to work.
And yet I get reports that the Fed continues to press ahead
on this path, I guess in part because the Fed is being pushed
by its international partners to do so. But I, for one, think
you need to really take a hard look at this and reconsider
exactly where we are.
You do not have to answer that. I just leave that with you,
unless you have some comment.
Chairman Bernanke. I would like to comment briefly,
Senator. I think you and I or a group need to talk about this
in much more detail. I would just make a few comments.
One is that the notice for proposed rulemaking which is
going out is a joint product of all four Federal banking
agencies. So it is an agreed upon notice. And it is one where,
of course, we are going to invite all kinds of comments from
all parties who are interested.
I discussed the QIS-4 in previous testimony. I will not
take time to do that. But we certainly agree that we would not
tolerate, would not want to see capital levels decline anywhere
like what was seen in the QIS-4.
We do think that safety and soundness of the banking
system, given how complex and sophisticated it is becoming,
does require some significant updates of the Basel II approach.
And the banking agencies have essentially agreed that this is
the right framework. But we are very open both to suggestions
about details and also about methods of making sure the capital
does not fall unduly.
If I may finally say, on the three methods, I believe it is
the case that other countries will be asking their largest and
most sophisticated banks to use the advanced method because
that is really the only one of the three that is appropriate
for the kind of international banks that we are talking about.
Senator Sarbanes. We understand that the Conference of
State Bank Supervisors has recently written, encouraging
consideration of the standardized approach in the
implementation of Basel II. And this also apparently is the
request that these major U.S. banks have now made to the
regulatory agencies. It is an approach apparently being allowed
by other countries.
What is the problem in considering the standardized
approach?
Chairman Bernanke. It is being allowed for other countries
for the appropriate banks, for small banks. The standardized
approach is very similar to what we have now. What we are doing
is proposing a Basel I-A, that is a modification of the
existing system that would be appropriate for the smaller and
medium-sized banks in our system. And that is analogous to what
foreign countries will be doing when they put smaller banks on
the standardized approach.
But I do not think you are going to see any large
international, sophisticated, complex banks with all these
different kinds of derivatives and off-balance sheet activities
and operational risks, you are not going to see any of those on
the standardized approach because they just do not accommodate
the risks that those banks are taking.
Senator Sarbanes. So you would not allow that as an option?
You would not be prepared to even consider it is an option?
Chairman Bernanke. We are prepared to consider anything,
but I think that my judgment is that the standardized approach
is essentially the same as the existing approach and would not
be adequate for complex internationally active banks.
Senator Sarbanes. Thank you, Mr. Chairman.
Chairman Shelby. Senator Bunning.
Senator Bunning. I apologize, but since we only get to see
you twice a year, I am going to ask some more questions.
Does it concern you that so many on the Federal Reserve
Board come from an academic background? Do you think it would
be beneficial to have some of the remaining vacancies filled
with someone with experience in the business or finance world?
Chairman Bernanke. Well Senator, we have an opening right
now. As you know, Mark Olson, who is a banker, former President
of the American Bankers Association, has moved over to the
accounting board. I would very much like to see his replacement
be somebody with a similar set of banking and financial
business skills, yes.
Senator Bunning. That is a yes answer.
Chairman Bernanke. Yes.
Senator Bunning. I do not get many of them from you. That
is okay.
The Fed minutes say that there is a discussion of a range
of options. But it turns out that the vote is almost always
unanimous. I had to go back, I cannot remember when the last
dissenting vote in the FOMC occurred. Leading up to the June
meeting, public statements by some of the Fed Members indicated
there might be a pause. But once again the vote was unanimous
to raise rates.
How much serious debate is there really if the Fed keeps
coming up with unanimous decisions?
Chairman Bernanke. Senator, different committees have
different approaches to decisionmaking. The Monetary Policy
Committee in the United Kingdom, for example, like the Senate,
is where everybody votes directly. And on a recent occasion,
the Governor of the Bank of England was voted down in his
recommendation.
Senator Bunning. Gee, that would be a very pleasant
surprise at times.
Chairman Bernanke. In the Federal Reserve, we are more of a
consensus-based organization. We do try to come to an agreement
among ourselves, the same way other organizations like the
European Central Bank do. But I assure you that we have lengthy
and spirited discussions within the meetings, and outside the
meetings with staff. And each person is contributing a
perspective and a point of view to the policy.
Senator Bunning. Mr. Chairman, they never show up in the
minutes of the FOMC meetings. All this discussion, all this
debate never shows up in the minutes when we get them.
Chairman Bernanke. Perhaps the minutes could be more
detailed.
Senator Bunning. Transparent?
Chairman Bernanke. Possibly. Another possibility, sir, is
to look at some of the transcripts, which are of course only
available with 5-year legs. But they give a full verbatim
description of the meeting. You will see there, if you look,
quite a bit of debate and discussion. That is the tradition we
continue today.
Senator Bunning. It took me years of practice, but before
Chairman Greenspan left, I was actually able to understand what
he was talking about. There is still a problem with
understanding what the Fed is thinking though totally. You have
thought about bringing back the balance of risk statements or
doing something else so people can understand what is going
through all of your heads.
Is that a fact? Is that going to happen?
Chairman Bernanke. In the short-run, Senator, we are trying
to maintain some continuity with previous practice so as not to
confuse people who are paying attention to the Fed too much.
But what we are doing, as was revealed in the minutes, we have
set up a small committee which is going to help the entire FOMC
think through our entire range of communications, all aspects,
including the minutes, including the statements, and try to
develop a better, more explicit, and more useful form of
communication.
And I will certainly keep Congressional leaders apprised of
this. And if anything happens that is a departure from past
practice, I will certainly let you know about it and get your
input.
Senator Bunning. Last but not least, one thing different in
your time as Fed Chairman than when Chairman Greenspan, is the
amount of attention the public is paying to statements from
other Fed Members. There was even a Bloomberg article yesterday
about that.
Do you have any problem with other Fed Members speaking out
with different points of view? Do you think that is good for
the markets and the economy?
Chairman Bernanke. Senator, you were asking about
differences of opinion and getting around group think, and this
is one way in which Members of the FOMC can express different
shades of their views.
We do not restrict, we do not coordinate, the speeches of
FOMC Members. They are going out on their own in their own
districts and talking about whatever issues are important to
them. And sometimes they make comments on monetary policy.
Senator Bunning. Most of those people that are speaking out
are members of the four banks that happen to be also Members of
the FOMC, the different banks that are also members, four
different ones.
Chairman Bernanke. Not necessarily, Senator. All 12 bank
presidents do come to the meeting and offer their views. Of
course only four----
Senator Bunning. Vote.
Chairman Bernanke. Actually five, including the Bank of New
York, vote.
Senator Bunning. Thank you very much, Mr. Chairman.
Chairman Shelby. Thank you.
Chairman Bernanke, we appreciate your appearance here. We
wish you well in your job. We know it is difficult, but we
think you are up for the job.
Chairman Bernanke. Thank you very much, Senator.
Chairman Shelby. The hearing is adjourned.
[Whereupon, at 12:39 p.m., the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF BEN S. BERNANKE
Chairman, Board of Governors of the Federal Reserve System
July 19, 2006
Mr. Chairman and Members of the Committee, I am pleased to be here
again to present the Federal Reserve's Monetary Policy Report to the
Congress.
Over the period since our February report, the U.S. economy has
continued to expand. Real gross domestic product (GDP) is estimated to
have risen at an annual rate of 5.6 percent in the first quarter of
2006. The available indicators suggest that economic growth has more
recently moderated from that quite strong pace, reflecting a gradual
cooling of the housing market and other factors that I will discuss.
With respect to the labor market, more than 850,000 jobs were added, on
net, to nonfarm payrolls over the first 6 months of the year, though
these gains came at a slower pace in the second quarter than in the
first. Last month, the unemployment rate stood at 4.6 percent.
Inflation has been higher than we had anticipated in February,
partly as a result of further sharp increases in the prices of energy
and other commodities. During the first 5 months of the year, overall
inflation as measured by the price index for personal consumption
expenditures averaged 4.3 percent at an annual rate. Over the same
period, core inflation--that is, inflation excluding food and energy
prices--averaged 2.6 percent at an annual rate. To address the risk
that inflation pressures might remain elevated, the Federal Open Market
Committee (FOMC) continued to firm the stance of monetary policy,
raising the Federal funds rate another \3/4\ percentage point, to 5\1/
4\ percent, in the period since our last report.
Let me now review the current economic situation and the outlook in
a bit more detail, beginning with developments in the real economy and
then turning to the inflation situation. I will conclude with some
comments on monetary policy.
The U.S. economy appears to be in a period of transition. For the
past 3 years or so, economic growth in the United States has been
robust. This growth has reflected both the ongoing reemployment of
underutilized resources, as the economy recovered from the weakness of
earlier in the decade, and the expansion of the economy's underlying
productive potential, as determined by such factors as productivity
trends and growth of the labor force. Although the rates of resource
utilization that the economy can sustain cannot be known with any
precision, it is clear that, after several years of above-trend growth,
slack in resource utilization has been substantially reduced. As a
consequence, a sustainable, noninflationary expansion is likely to
involve a modest reduction in the growth of economic activity from the
rapid pace of the past 3 years to a pace more consistent with the rate
of increase in the Nation's underlying productive capacity. It bears
emphasizing that, because productivity growth seems likely to remain
strong, the productive capacity of our economy should expand over the
next few years at a rate sufficient to support solid growth in real
output.
As I have noted, the anticipated moderation in economic growth now
seems to be under way, although the recent erratic growth pattern
complicates this assessment. That moderation appears most evident in
the household sector. In particular, consumer spending, which makes up
more than two-thirds of aggregate spending, grew rapidly during the
first quarter but decelerated during the spring. One likely source of
this deceleration was higher energy prices, which have adversely
affected the purchasing power of households and weighed on consumer
attitudes.
Outlays for residential construction, which have been at very high
levels in recent years, rose further in the first quarter. More
recently, however, the market for residential real estate has been
cooling, as can be seen in the slowing of new and existing home sales
and housing starts. Some of the recent softening in housing starts may
have resulted from the unusually favorable weather during the first
quarter of the year, which pulled forward construction activity, but
the slowing of the housing market appears to be more broad-based than
can be explained by that factor alone. Home prices, which have climbed
at double-digit rates in recent years, still appear to be rising for
the Nation as a whole, though significantly less rapidly than before.
These developments in the housing market are not particularly
surprising, as the sustained run-up in housing prices, together with
some increase in mortgage rates, has reduced affordability and thus the
demand for new homes.
The slowing of the housing market may restrain other forms of
household spending as well. With homeowners no longer experiencing
increases in the equity value of their homes at the rapid pace seen in
the past few years, and with the recent declines in stock prices,
increases in household net worth are likely to provide less of a boost
to consumer expenditures than they have in the recent past. That said,
favorable fundamentals, including relatively low unemployment and
rising disposable incomes, should provide support for consumer
spending. Overall, household expenditures appear likely to expand at a
moderate pace, providing continued impetus to the overall economic
expansion.
Although growth in household spending has slowed, other sectors of
the economy retain considerable momentum. Business investment in new
capital goods appears to have risen briskly, on net, so far this year.
In particular, investment in non-
residential structures, which had been weak since 2001, seems to have
picked up appreciably, providing some offset to the slower growth in
residential construction. Spending on equipment and software has also
been strong. With a few exceptions, business inventories appear to be
well-aligned with sales, which reduces the risk that a buildup of
unwanted inventories might act to reduce production in the future.
Business investment seems likely to continue to grow at a solid pace,
supported by growth in final sales, rising backlogs of orders for
capital goods, and high rates of profitability. To be sure, businesses
in certain sectors have experienced financial difficulties. In the
aggregate, however, firms remain in excellent financial condition, and
credit conditions for businesses are favorable.
Globally, output growth appears strong. Growth of the global
economy will help support U.S. economic activity by continuing to
stimulate demand for our exports of goods and services. One downside of
the strength of the global economy, however, is that it has led to
significant increases in the demand for crude oil and other primary
commodities over the past few years. Together with heightened
geopolitical uncertainties and the limited ability of suppliers to
expand capacity in the short run, these rising demands have resulted in
sharp rises in the prices at which those goods are traded
internationally, which in turn has put upward pressure on costs and
prices in the United States.
Overall, the U.S. economy seems poised to grow in coming quarters
at a pace roughly in line with the expansion of its underlying
productive capacity. Such an outlook is embodied in the projections of
members of the Board of Governors and the Presidents of Federal Reserve
Banks that were made around the time of the FOMC meeting late last
month, based on the assumption of appropriate monetary policy. In
particular, the central tendency of those forecasts is for real GDP to
increase about 3\1/4\ percent to 3\1/2\ percent in 2006 and 3 percent
to 3\1/4\ percent in 2007. With output expanding at a pace near that of
the economy's potential, the civilian unemployment rate is expected to
finish both 2006 and 2007 between 4\3/4\ percent and 5 percent, close
to its recent level.
I turn now to the inflation situation. As I noted, inflation has
been higher than we expected at the time of our last report. Much of
the upward pressure on overall inflation this year has been due to
increases in the prices of energy and other commodities and, in
particular, to the higher prices of products derived from crude oil.
Gasoline prices have increased notably as a result of the rise in
petroleum prices as well as factors specific to the market for ethanol.
The pickup in inflation so far this year has also been reflected in the
prices of a range of nonenergy goods and services, as strengthening
demand may have given firms more ability to pass energy and other costs
through to consumers. In addition, increases in residential rents, as
well as in the imputed rent on owner-occupied homes, have recently
contributed to higher core inflation.
The recent rise in inflation is of concern to the FOMC. The
achievement of price stability is one of the objectives that make up
the Congress's mandate to the Federal Reserve. Moreover, in the long
run, price stability is critical to achieving maximum employment and
moderate long-term interest rates, the other parts of the Congressional
mandate.
The outlook for inflation is shaped by a number of factors, not the
least of which is the course of energy prices. The spot price of oil
has moved up significantly further in recent weeks. Futures quotes
imply that market participants expect petroleum prices to roughly
stabilize in coming quarters; such an outcome would, over time, reduce
one source of upward pressure on inflation. However, expectations of a
leveling out of oil prices have been consistently disappointed in
recent years, and as the experience of the past week suggests, possible
increases in these and other commodity prices remain a risk to the
inflation outlook.
Although the costs of energy and other raw materials are important,
labor costs are by far the largest component of business costs.
Anecdotal reports suggest that the labor market is tight in some
industries and occupations and that employers are having difficulty
attracting certain types of skilled workers. To date, however, moderate
growth in most broad measures of nominal labor compensation and the
ongoing increases in labor productivity have held down the rise in unit
labor costs,
reducing pressure on inflation from the cost side. Employee
compensation per hour is likely to rise more quickly over the next
couple of years in response to the strength of the labor market.
Whether faster increases in nominal compensation create additional cost
pressures for firms depends in part on the extent to which they are
offset by continuing productivity gains. Profit margins are currently
relatively wide, and the effect of a possible acceleration in
compensation on price inflation would thus also depend on the extent to
which competitive pressures force firms to reduce margins rather than
pass on higher costs.
The public's inflation expectations are another important
determinant of inflation. The Federal Reserve must guard against the
emergence of an inflationary psychology that could impart greater
persistence to what would otherwise be a transitory increase in
inflation. After rising earlier this year, measures of longer-term
inflation expectations, based on surveys and on a comparison of yields
on nominal and inflation-indexed government debt, have edged down and
remain contained. These developments bear watching, however.
Finally, the extent to which aggregate demand is aligned with the
economy's underlying productive potential also influences inflation. As
I noted earlier, FOMC participants project that the growth in economic
activity should moderate to a pace close to that of the growth of
potential both this year and next. Should that moderation occur as
anticipated, it should help to limit inflation pressures over time.
The projections of the Members of the Board of Governors and the
Presidents of the Federal Reserve Banks, which are based on information
available at the time of the last FOMC meeting, are for a gradual
decline in inflation in coming quarters. As measured by the price index
for personal consumption expenditures excluding food and energy,
inflation is projected to be 2\1/4\ percent to 2\1/2\ percent this year
and then to edge lower, to 2 percent to 2\1/4\ percent next year.
The FOMC projections, which now anticipate slightly lower growth in
real output and higher core inflation than expected in our February
report, mirror the somewhat more adverse circumstances facing our
economy, which have resulted from the recent steep run-up in energy
costs and higher-than-expected inflation more generally. But they also
reflect our assessment that, with appropriate monetary policy and in
the absence of significant unforeseen developments, the economy should
continue to expand at a solid and sustainable pace and core inflation
should decline from its recent level over the medium term.
Although our baseline forecast is for moderating inflation, the
Committee judges that some inflation risks remain. In particular, the
high prices of energy and other commodities, in conjunction with high
levels of resource utilization that may increase the pricing power of
suppliers of goods and services, have the potential to sustain
inflation pressures. More generally, if the pattern of elevated
readings on inflation is more protracted or more intense than is
currently expected, this higher level of inflation could become
embedded in the public's inflation expectations and in price-setting
behavior. Persistently higher inflation would erode the performance of
the real economy and would be costly to reverse. The Federal Reserve
must take account of these risks in making its policy decisions.
In our pursuit of maximum employment and price stability, monetary
policy makers operate in an environment of uncertainty. In particular,
we have imperfect knowledge about the effects of our own policy actions
as well as of the many other factors that will shape economic
developments during the forecast period. These uncertainties bear
importantly on our policy decisions because the full influence of
policy actions on the economy is felt only after a considerable period
of time. The lags between policy actions and their effects imply that
we must be forward-looking, basing our policy choices on the longer-
term outlook for both inflation and economic growth. In formulating
that outlook, we must take account of the possible future effects of
previous policy actions--that is, of policy effects still ``in the
pipeline.'' Finally, as I have noted, we must consider not only what
appears to be the most likely outcome but also the risks to that
outlook and the costs that would be incurred should any of those risks
be realized.
At the same time, because economic forecasting is far from a
precise science, we have no choice but to regard all our forecasts as
provisional and subject to revision as the facts demand. Thus, policy
must be flexible and ready to adjust to changes in economic
projections. In particular, as the Committee noted in the statement
issued after its June meeting, the extent and timing of any additional
firming that may be needed to address inflation risks will depend on
the evolution of the outlook for both inflation and economic growth, as
implied by our analysis of the incoming information.
Thank you. I would be happy to take questions.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM BEN S. BERNANKE
Q.1. China's foreign exchange reserves stand at $941.1 billion,
creating excess liquidity in their banking system. In addition,
various estimates of China's first and second quarter growth
rates suggest that the Chinese economy has grown by upward of
10 percent this year.
Do you see any danger that the Chinese economy is
overheating? Are the Chinese now willing to take all necessary
steps, like a revaluation of their currency, which could rein
in problems before they pose systemic risk?
A.1. The ratio of investment to GDP was over 40 percent in
2005, which is likely too high a rate for an economy to absorb
efficiently. This is leading to overcapacity in some industries
and is likely to add to the already large stock of bad loans in
the future. However, there is less evidence of widespread
overheating. Inflation is still quite low, at about 1\1/2\
percent for consumer prices on a 12-month basis, despite the
fact that the money supply has been growing at a rate of almost
19 percent.
Chinese authorities have indicated that they would like
investment to slow and that they would also like growth to be
better balanced between external and domestic demand. They have
taken some steps to try to encourage consumption. However, they
still have not allowed a substantial appreciation of the
reminbi, a step that many analysts argue would be the most
effective way to address the imbalances in the economy.
Q.2. Has the Federal Reserve been asked or offered to provide
guidance to the Chinese Central Bank and are you concerned
about any spillover effects that a Chinese economic crisis
could have in U.S. markets?
A.2. The Federal Reserve has provided technical assistance to
the People's Bank of China for a number of years on various
aspects of central banking. The Federal Reserve has also been
supportive of the U.S. Treasury's initiative to provide
technical assistance to China in the economic and financial
areas.
We believe that the chance of a Chinese economic crisis is
very low for the foreseeable future. Although the banking
sector is burdened with an enormous and probably growing stock
of problematic loans, the government possesses sizable
resources and is unlikely to allow the banking system to fail.
The large stock of foreign exchange reserves also makes a
potential currency crisis a very low probability event.
However, we do not entirely discount the possibility of a
``hard landing,'' in the form of significantly slower growth,
as the authorities attempt to reduce investment growth from its
current rapid pace. We do not think this is the most likely
outcome, but it is a possibility. Such an outcome would have
significant repercussions for other Asian economies, including
Japan, and would also be detrimental for some of the other
emerging market economies, notably in Latin America and the
Middle East, that have been supplying the enormous Chinese
demand for oil and other commodities. The impact on the United
States would be less direct, given that China is not a major
buyer of our exports, but the overall impact on world GDP would
certainly have some negative effect on the United States.
Q.3. In recent weeks, several banks have suggested that the
current Basel II framework should be revised to provide any
bank the option to use either the advanced approach or the
standardized approach set forth in the original Basel II
framework. Apparently, there is concern that Basel II as set
forth in the draft NPR released last March would not be cost
effective for banks to implement. Does the Federal Reserve
support allowing banks such an option? If not, please explain
your rationale. Does the Federal Reserve believe that concerns
about the cost effectiveness of Basel II as presently set forth
in the draft NPR are valid? Would you please update the
Committee on the Federal Reserve's timetable for the
implementing Basel II and Basel IA? Please provide specific
dates, if possible, by which the Federal Reserve expects to
have completed each of steps for implementing Basel II and
Basel IA.
A.3. The Federal Reserve and the other banking agencies have
received several comment letters asking that we provide
optionality in the United States. Basel II framework similar to
that provided in the Basel Mid-Year text. As with other
comments we have received on the draft Basel II NPR, and
consistent with out duties under the Administrative Procedure
Act, we will seriously consider the merits of the suggestion.
As I tried to indicate in my response to a similar question
posed by Senator Sarbanes, I am concerned that the Basel II
standardized approach would not accommodate the risks that the
large, complex, internationally active banks take, both on and
off their balance sheets. In my judgment, elements of the Basel
II standardized approach, particularly those related to the
measurement of credit risk, would be more appropriately applied
to smaller, less complex, and primarily domestic U.S. banking
organizations. That is how it was designed and that is how it
appears it will be implemented in other countries. For example,
there is no evidence that any of the largest 50 non-U.S. G-10
banks plans to adopt the standardized approach, even though
they have the option to do so.
Evaluating the cost effectiveness of Basel II NPR requires
measurement of both costs and benefits, both of which are
difficult. With respect to the costs of compliance, it should
be noted that many of the risk measurement and risk management
policies and practices required by the draft Basel II NPR are
policies and practices that banking organizations adopted or
would have adopted even in the absence of Basel II in order to
(i) improve their own understanding of their risk profile; (ii)
meet supervisory expectations for good risk measurement and
management; or (iii) satisfy Basel II regulatory capital
requirements in other jurisdictions. On the benefits side, we
expect that Basel II will improve the risk sensitivity of our
bank regulatory capital framework, remove opportunities for
regulatory capital arbitrage, improve our supervisory ability
to evaluate a bank's capital adequacy, improve market
discipline of banks, and, ultimately enhance the safety and
soundness of our banking system. Given the inherent
complexities in measuring costs and benefits, it is difficult
to evaluate the question of cost effectiveness in any simple
terms. We have sought, and will continue to seek, comment from
banks and others to gain a better understanding of the costs of
compliance with our Basel II proposals.
The timetable for implementation of Basel II and Basel IA
is set by the four Federal banking agencies acting in concert.
That timetable currently contemplates adoption of final rules
for Basel II and Basel IA by mid-2007 so that the parallel run
for Basel II can begin in January 2008. Transitional capital
floors and other safeguards will be in place at least through
January 2012 and perhaps longer for some banks depending on
when they complete their parallel run.
RESPONSE TO A WRITTEN QUESTION OF SENATOR REED
FROM BEN S. BERNANKE
Q.1. Chairman Bernanke, in your testimony you state that the
standardized approach is ``essentially the same as the existing
approach'' in Basel I. My understanding is that the
standardized approach has some significant differences,
including, for example, greater differentiation of assets by
credit quality; an operational risk charge; more accurate
measures of counterparty exposure; recognition of some credit
risk mitigation measures; and risk-weighting of mortgages.
Could you clarify for the record whether you really believe
that the standardized approach is the same as Basel I?
A.1. I believe that the general broad-brush approach to risk-
weight categories and the expectations for risk management
contained in the credit risk standardized approach in Basel II
are not a large change from our existing Basel I-based capital
rules. To be sure, there are a number of differences between
Basel I and the credit risk standardized approach in Basel II,
and your question highlights many of these differences.
However, my remarks were made in the context of whether the
Basel II credit risk standardized approach would be appropriate
for large, internationally active banking organizations in the
United States. In my opinion, the Basel II credit risk
standardized approach is much less risk-sensitive than the
Basel II advanced approach and does not make use of the most
advanced risk management practices. For example, I note that
the Basel II credit risk standardized approach generally
provides the same risk weight for all first-lien mortgage loans
(35 percent), nonmortgage retail loans (75 percent), and
unrated corporate credits (100 percent), regardless of the
creditworthiness of the borrower.
As you are aware, the agencies intend to update the Basel
I-based capital rules for most banks in the United States. In
updating those rules, we expect to utilize some of the
improvements in the Basel II standardized approach.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR STABENOW
FROM BEN S. BERNANKE
Q.1. On Wednesday, July 12, China's top planning agency
forecasted that China would report a more than 10 percent
growth for the first half of the year.
In response, the National Development and Reform Commission
reiterated their calls for stronger action to curb excessive
investment. And, the Financial Times reported that credit
tightening policies are imminent--a matter of weeks not months.
Given that the United States-China trade deficit continues
to surpass previous records every passing month, we need to be
much more in tune with Chinese economic policies. Therefore, my
question for you is--do you think China will begin to tighten
their lending policies and if they do, how will it impact our
trade deficit and the global economy at large?
A.1. China has taken a number of steps this year to try to
restrain growth in lending, with limited success. Chinese
authorities have imposed some administrative controls, raised
interest rates, and increased banks' reserve requirements. Most
recently, the Chinese central government has issued a circular
requiring a review of all new investment projects undertaken
this year in excess of RMB 100 million, with a cutoff of RMB 30
million in sectors that are thought to have excess capacity
(including steel, aluminum, and autos). If these measures are
still not successful in slowing investment growth, they are
likely to do more. In any case, slower growth is not likely to
translate into any improvement in our trade deficit with China.
In fact, if slower growth in China resulted in reduced growth
in China's imports, the Chinese trade surplus would increase.
Q.2a. The next time we meet will be at the end of 2006. From
now until then, China is gearing up for its first real push
into the U.S. auto market.
In your opinion, how will the entrance of China--who has a
history of under pricing their products through currency
manipulation--affect the manufacturing industry in the United
States?
A.2a. I understand that three Chinese companies are aiming to
introduce autos and light trucks into the U.S. market over the
next several years. Overall, they are not likely to have a
significant impact on the U.S. auto industry because they are
small: The largest, Chery, sold fewer than 200,000 vehicles
globally last year compared with GM's sales of more than 8
million vehicles. More important over the longer-run, our
experience with other foreign firms indicates that offering
vehicles at a low price will by no means guarantee their
success. The quality and reliability of these vehicles will be
an important determinant of their effect on the domestic market
for vehicles. Foreign firms also will need to adapt their
designs to meet strict U.S. safety and emissions standards and
to establish new dealerships.
Q.2b. I have one broader question about manufacturing in the
United States. Every quarter I review the manufacturing numbers
produced by the Bureau of Labor Statistics. As you can see from
this graph--manufacturing continues to decline, ever since
2000. When do you see this slowing down? And in Michigan, the
graph looks like this. Again, how do you analyze these trends
and what do you expect in the future?
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A.2b. Although manufacturing employment fell substantially
during the last economic downturn, declines in the sector
slowed markedly beginning in late 2003 and from April through
July of this year, manufacturing jobs and the average factory
workweek were up from the lows reached last fall. Over the
longer-run, even as manufacturing employment has been
declining, manufacturing production has risen solidly. This is
because the reduction in labor input has been more than offset
by rapid increases in productivity. Indeed, we estimate that
overall manufacturing capacity in the United States in 2005
stood about 50 percent higher than in 1995.
Of course, underlying those positive overall trends are
structural changes that affect the composition and location of
manufacturing jobs. For example, many of the expanding
manufacturing industries in recent years, such as computers and
electronic components, have located outside of the Midwest. The
Federal Reserve Bank of Chicago, which studies trends in the
Midwest, notes that structural developments in the motor
vehicle industry have had an important effect in the region and
in Michigan.\1\ With the introduction of new assembly by
transplants, the geographic distribution of motor vehicle
production has spread to the mid-South. And, the loss of market
share of sales by the Big Three producers to the transplant
firms has exacerbated the loss. Suppliers have followed the
shift in assemblies.
---------------------------------------------------------------------------
\1\ William A. Testa, Thomas H. Klier, and Richard H. Mattoon,
``Challenges and Prospects for Midwest Manufacturing,'' Chicago Fed
Letter (March 2005).
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RESONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM BEN S. BERNANKE
Q.1. I am very concerned about the potential efforts in this
Congress to change the manner in which we regulate derivatives
or to impact the manner in which derivatives operate in the
economy. As you know, the President's Working Group on
Financial Markets has explained why proposals we have faced in
the last couple of years for additional regulation of energy
derivatives were not warranted, and has urged Congress to be
aware of the potential for unintended consequences. Do you
share this view? Do you agree with the view of Alan Greenspan
and others that derivatives have helped create a far more
flexible, efficient, and resilient financial system? Are you
aware of any evidence that additional reporting requirements or
other regulatory actions would reduce energy prices and price
volatility or are energy prices and price volatility determined
by the market?
A.1. I share the view that additional regulation of energy
derivatives is not warranted. More generally, I agree that
derivatives have created a more flexible, efficient, and
resilient financial system. To be sure, as Chairman Greenspan
recognized, derivatives pose a variety of risk management
challenges that users must address. In particular, they must
effectively manage the counterparty risks associated with
derivatives. Thus far, with a few notable exceptions they have
done so and, as a result, derivatives have produced the
benefits that you have mentioned.
I am unaware of any evidence that supports a view that
additional reporting requirements or other new regulations
would reduce energy prices or energy price volatility. Prices
and volatility are indeed determined by the market, and as far
as I am aware, energy prices and volatility recently have moved
in ways that seem sensibly related to fundamentals.
Q.2. Mr. Chairman, in your Sea Island speech in May on the
subject of ``Hedge Funds and Systemic Risk,'' you noted that
``[t]he primary mechanism for regulating excessive leverage and
other
aspects of risk-taking in a market economy is the discipline
provided by creditors, counterparties, and investors.''
You further observed that, in light of 1998's LTCM episode,
the President's Working Group's ``central policy recommendation
was that regulators and supervisors should foster an
environment in which market discipline--in particular,
counterparty risk management--constrains excessive leverage and
risk-taking.''
You also noted that the PWG rejected so-called ``direct
regulation'' of hedge funds, observing that ``[d]irect
regulation may be
justified when market discipline is ineffective at constraining
excessive leverage and risk-taking but, in the case of hedge
funds, the reasonable presumption is that market discipline can
work. Investors, creditors, and counterparties have significant
incentives to rein in hedge funds' risktaking. Moreover, direct
regulation would impose costs in the form of moral hazard, the
likely loss of private market discipline, and possible limits
on funds' ability to provide market liquidity.''
Can you tell us a little more about what is involved in
fostering market discipline in the hedge fund context and why
you believe that is a superior approach to ``direct
regulation?''
A.2. The creditors and counterparties of hedge funds are
regulated banks and securities firms. Banking and securities
supervisors have been fostering market discipline by issuing
supervisory guidance on counterparty risk management, by
encouraging private
sector initiatives to identify and promote best practices for
risk management, and by undertaking supervisory reviews that
assess whether banks and securities firms' practices are
consistent with supervisory guidance and emerging best
practices.
As I indicated in my Sea Island speech, I believe that it
is a reasonable presumption that market discipline can
effectively constrain hedge funds' leverage. The banks and
securities firms that provide hedge funds with leverage have
strong incentives and capabilities to constrain their leverage
so as to avoid counterparty losses. Supervisors of those banks
and securities firms can and should take action if competition
appears to be dulling those incentives in ways that threaten
the counterparties and the financial system. Direct regulation
of hedge funds could weaken market discipline if hedge funds'
creditors and counterparties came to view direct regulation as
an effective substitute for their own due diligence and
monitoring of risks. Furthermore, development of an effective
regulatory regime for hedge funds would be challenging in light
of the diversity of hedge fund investment strategies and the
speed with which their risk profiles tend to change. A
regulatory regime that was insufficiently risk sensitive could
impair hedge funds' ability to bear risks and provide liquidity
to financial markets, which would make our financial system
less efficient and less resilient.
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