Congressional Testimony

S. HRG. 110-182 FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 2007 HEARING BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED TENTH CONGRESS FIRST SESSION ON OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978 FEBRUARY 14, 2007 Printed for the use of the Committee on Banking, Housing, and Urban Affairs Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html U.S. GOVERNMENT PRINTING OFFICE 38-109 PDF WASHINGTON : 2007 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS CHRISTOPHER J. DODD, Connecticut, Chairman TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama JACK REED, Rhode Island ROBERT F. BENNETT, Utah CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming THOMAS R. CARPER, Delaware CHUCK HAGEL, Nebraska ROBERT MENENDEZ, New Jersey JIM BUNNING, Kentucky DANIEL K. AKAKA, Hawaii MIKE CRAPO, Idaho SHERROD BROWN, Ohio JOHN E. SUNUNU, New Hampshire ROBERT P. CASEY, Pennsylvania ELIZABETH DOLE, North Carolina JON TESTER, Montana MEL MARTINEZ, Florida SHAWN MAHER, Staff Director WILLIAM D. DUHNKE, Republican Staff Director and Counsel AARON KLEIN, Chief Economist PEGGY R. KUHN, Republican Senior Financial Economist JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator JIM CROWELL, Editor (II) C O N T E N TS WEDNESDAY, FEBRUARY 14, 2007 Page Opening statement of Chairman Dodd 1 Opening statements, comments, or prepared statements of: Senator Shelby 4 Senator Casey 5 Senator Bunning 5 Senator Bayh 6 Senator Martinez 6 Senator Menendez 6 Senator Hagel 7 Senator Tester 8 Senator Bennett 8 Senator Brown 9 Senator Allard 10 Senator Reed 10 Senator Sununu 11 WITNESS Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, Washington, DC 12 Prepared statement 60 Response to written questions of: Senator Shelby 64 Senator Sununu 66 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Monetary Policy Report to the Congress dated February 14, 2007 68 Letter to Senator Christopher J. Dodd from Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System dated February 26, 2007 98 Letter to Senator John E. Sununu from Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System dated February 26, 2007 101 (III) FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT TO CONGRESS FOR 2007 WEDNESDAY, FEBRUARY 14, 2007 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Committee met at 10:07 a.m., in room SD-106, Dirksen Sen- ate Office Building, Senator Christopher J. Dodd (Chairman of the Committee) presiding. OPENING STATEMENT OF CHAIRMAN CHRISTOPER J. DODD Chairman DODD. The hearing will come to order. Let me thank all of our colleagues and others who have made it in this morning to participate in this hearing on our first true win- ter morning this year. Mr. Chairman, we thank you for being with us as well, and we appreciate your testimony before the Com- mittee. What I will do is open up with a brief opening statement. I will turn to my colleague, Senator Shelby, and then any of our other colleagues who would like to make some brief opening remarks. Your full statements, I will guarantee you, will be included in the record, as will yours and any supporting documentation, Mr. Chair- man, you would like to be a part of this record this morning. We will try and move along so we can get to the question and answer period with you as quickly as possible. This morning, the Committee is pleased to welcome Federal Re- serve Chairman Bernanke to deliver the Fed's Semi-Annual Mone- tary Policy Report. I want to congratulate you, Mr. Chairman, for completing your first year as Chairman. Following in the footsteps of a very successful Chairman can be difficult, and it is something that I can certainly relate to, sitting in this chair and sitting next to my friend from Alabama. But I believe that you have done a very good job in gaining the respect and confidence of the markets and your colleagues on the Federal Reserve Board. The Fed's monetary policy—most notably, its decision to stop ris- ing interest rates in June—has played a very important role in some recent positive economic developments. During 2006, the economy grew at a sustainable rate and unemployment was kept to under 5 percent. While this is not quite as strong as it was in the late 1990's—when growth was higher and unemployment fell below 4 percent, with much higher labor force participation—this economic news is welcome. Long-term interest rates have remained at modest levels, despite a large Federal budget deficit, a historic (l) current account deficit, and the cumulative effect of the Fed's 2- year cycle raising the interest rates that ended in June. While these developments are, as I said, positive, there are other facts that, in my view, raise some very important questions about our Nation's long-term ability to provide economic security, oppor- tunity, and prosperity to the people of this country. As I travel around these days and talk to many people from all walks of life, I am confronted by people who are concerned about the future, whether or not we will have the kind of stability and long-term growth necessary for our success. What I am hearing from people is that they are concerned about many of the same things. Health care costs are rising at a rate that is unsustainable for businesses and employees. Over the past 6 years, health care costs have increased by 30 percent. More than 46 million Americans have no health insurance at all today, as we all know. That is an increase of 6 million people over the past 6 years. The price of gas- oline, home heating oil, and other forms of energy has skyrocketed over the past years. This past summer, gasoline cost over $3 per gallon in many parts of the country. And while it is much lower today, it is still twice as high as it was 5 years ago. Families are concerned as well that they cannot afford to send their kids to col- lege. My colleague from New York, Senator Schumer, has spent a lot of time on this issue. College tuition has risen by more than twice the rate of inflation over the past 20 years. Room, board, and tuition at many private universities now cost well over $50,000 a year. As these costs rise, working Americans are experiencing more and more uncertainty about their future. People are wondering whether their home is losing value as they see houses in their neighborhood sell for less today than they did a year ago. And mil- lions of Americans are in exotic and subprime mortgages while the potential for sharp increases in monthly payments is right around the corner. Several credible reports say that we are facing a tidal wave of defaults and foreclosures, which could strip these families of their major, if not their only, source of wealth and long-term eco- nomic security. Despite some recent gains in household incomes, the real median family income, what a family right in the middle of the middle class earns in a year, is lower today than it was 6 years ago. People are working longer and harder, and many are not bringing home enough money to keep pace with what they need. And for those who lose their jobs, the prospect of falling out of the middle class is far greater today. Americans are more than twice as likely to ex- perience a precipitous drop in income as Americans of a generation ago, according to a recent research study by Jacob Hacker at Yale University. As we worry about some Americans falling out of the middle class, we must also be concerned about those working hard to climb into the middle class. Over 10 million Americans today do not have access to mainstream financial institutions, such as a bank, a cred- it union, or a thrift. For these entrepreneurs and workers, afford- able credit and capital services are scarce, if not impossible to find. And as a result, millions of our fellow citizens lack the financial tools that they need to build more secure and prosperous futures for themselves and their families. Finally, Mr. Chairman, our Nation finds itself with trade policies that are unsustainable, as well, in my view. We have learned this week that last year, we ran a record trade deficit of $763 billion. Our Nation's current account deficit will approach 7 percent of our GDP. We are relying on over $2.4 billion a day from foreign inves- tors, who are increasingly foreign governments, to finance our eco- nomic growth because of the lack of savings here at home. The Administration has an official trade policy that is, in key re- spects, out of touch with reality. For instance, it is widely believed that China manipulates its currency. We had a very good hearing, as you may know, with Hank Paulson before this Committee a week or so ago on the exchange rate issue. Yet, the Administration refuses to officially recognize that fact. When Chairman Bernanke was in China, as part of the Strategic Economic Dialogue, he gave a speech that pointed out, "effective subsidy that an undervalued currency provides for Chinese firms that focused on exporting." While this subsidy is not the sole cause of either our record inter- national trade deficit or our loss of over 3 million manufacturing jobs, including about 1 million of those jobs in critical national de- fense-related industries, the distortion of Chinese currency manipu- lation is having a very significant negative impact on American manufacturing jobs. As policymakers, I think we need to ask ourselves a very funda- mental question: Are we satisfied with America's place in the world at the beginning of this new century? I do not think that any one of us can look at all the facts and reach any conclusion other than that we can do a lot better than I think we are. And for the sake of the people we serve and generations coming after them, I think all of us would agree we have to do better. There are steps we can and should take, in my view, to build a stronger foundation for a more secure and prosperous future. To- day's hearing provides the Committee with an opportunity to dis- cuss some of these steps. We can start by keeping interest rates at modest levels, and, again, I congratulate the Fed on doing that since last June. Certainly, monetary policy is obviously an impor- tant component of our economic future. The Fed's dual mandate is to promote full employment and price stability. This is a vital and difficult mission, and we look forward to hearing from the Chair- man about the steps the Fed has taken since its last report to ful- fill that statutory mandate. In addition, we need our Federal financial regulatory agencies to be vigilant in assuring not only the safety and soundness of our fi- nancial institutions, but also that those institutions are serving, not thwarting, the aspirations of Americans to build a more secure and prosperous life for themselves and those families. I look forward to discussing the aspects of the Fed's mission as well as with you today, Mr. Chairman, and I will turn to my col- league from Alabama for any opening comments he may have and then to my colleagues here as well for any brief statements they want to make as we start this hearing. Senator Shelby. STATEMENT OF SENATOR RICHARD C. SHELBY Senator SHELBY. Thank you, Chairman Dodd. Chairman Bernanke, we are pleased to have you before the Com- mittee again to deliver the Federal Reserve's Semi-Annual Mone- tary Policy Report. This hearing provides an important mechanism for assuring accountability over the Fed's policies and operations. Chairman Bernanke, you have recently completed one year at the helm of the Federal Reserve System. When President Bush nominated you for this position, I noted at the hearing that you would have big shoes to fill, following in the footsteps of the distin- guished Chairman Greenspan. I also noted my belief that the President made a superb choice in asking you to take on this re- sponsibility. The Federal Reserve's conduct of monetary policy thus far under your leadership has given me further reason to applaud your service. Chairman Bernanke, as 2006 began, there was much debate as to whether the Federal Reserve would prove successful in engineer- ing a "soft landing," after many successive increases in the Fed funds target rate. Certainly the economic data in recent weeks tells us that the debate maybe all but over. Analysts and other Fed watchers are now giving you high praise for the manner in which you have handled your responsibilities, and I join them. Real gross domestic product, GDP, increased at an annual rate of 3.5 in the fourth quarter of 2006. For all of 2006, GDP grew 3.4 percent compared with the 3.2-percent increase in 2005. Both num- bers topped the 20-year average of 3.1 percent. Along with this strong growth, we have seen positive news on the job front. The Labor Department reported that the economy cre- ated, Mr. Chairman, more than 2.2 million jobs last year, 400,000 more than previously estimated. We continue to enjoy a low unem- ployment rate, both historically and relative to other industrialized nations. At its most recent meeting on January 31, Federal Open Market Committee kept the Federal funds target rate at 5.25 percent, the fifth consecutive meeting with no change. Fed watchers noted that the latest FOMC statement seemed more upbeat on growth pros- pects and keeping inflation in check. My colleagues and I, Mr. Chairman, will no doubt spend time this morning trying to figure out how long the FOMC intends to leave short-term rates un- changed. I am certain that today's hearing will also include some discus- sions of the potential risks in the economy, such as the housing market slowdown, among others. Mr. Chairman, while it is our responsibility to continue to exam- ine the horizon for such risks, we must also note the strong per- formance of this economy. I hope that we will also take time today to discuss the very strengths and how to maintain and build upon them. Chairman Bernanke, again, we welcome you back to the Com- mittee, and we like the job you are doing. Chairman DODD. He is not here, but Senator Schumer was next on our list, but, Senator Casey, this early bird rule applies here. Senator Casey. STATEMENT OF SENATOR ROBERT P. CASEY Senator CASEY. Mr. Chairman, thank you very much for gath- ering us here. Chairman Bernanke, thank you for your time here today and for your service. I do not have a long statement, but I just wanted to highlight a couple of things I know that you have touched on before and that I am sure we will speak to today, some of the long-term fiscal chal- lenges that you outlined here in your previous testimony, I guess a week or so ago, with regard to Medicare, Social Security, and other demands that are being placed on the Federal budget into the future. I appreciate the fact that you are thinking about and focusing on that and building that into the planning that you do. I think also the people that I represent in Pennsylvania are con- cerned about those costs. They are concerned about the deficit, which I guess last year was $248 billion. This year, the projection is for something less than that. But they are also concerned about the impact, as Chairman Dodd outlined, of the costs in their own lives, in their real lives, and you know the cost of health care and college tuition and housing and so many other areas. I hope that one of the things we have a chance to discuss today is the impact that those costs have, the impact not just on that family, the hor- rific impact it can sometimes have on their budgets, but also the impact that that has on overall long-term economic growth and sta- bility. So, I look forward to discussing that today with you, and we ap- preciate the time you are spending with us, and we appreciate the report. Chairman DODD. Senator Bunning. STATEMENT OF SENATOR JIM BUNNING Senator BUNNING. Thank you, Mr. Chairman. Chairman Bernanke, thank you for being here today. To repeat what I told you at the Budget Committee hearing a few weeks ago, the Federal Open Market Committee did the right thing by stop- ping the increases in the Fed fund rates after the June 2006 Fed meeting. By holding rates constant, you have done the right thing ever since. After the latest increase, the stock markets took off and the cost of credit leveled off. If the Fed had chosen to continue hik- ing rates, mortgages and other forms of credit would have become less and less affordable to the average American. Over the last 2 years, the costs of credit, such as mortgages, stu- dent loans, and credit cards, have all increased. I am not sure how much more tightening consumers could have handled before serious harm was done to the economy. Higher interest rates accelerated the housing decline. We will not know the full extent of the damage for months, if not longer. If the Fed had not stopped when it did, we would have been in even more danger. You have been at the helm of the Fed for a year now. My initial fears were that you would be a carbon copy of your predecessor, yet you have done some things I have never seen your predecessor do: Embrace open and full debate. There is an old saying that there is a reason we have two ears and one mouth: It is often more im- portant to listen than to talk. During your brief tenure at the Fed, you have made a serious ef- fort to improve on how the Fed listens, but you know I am not going to let you off that easy, even though today is Valentine's Day. The people of my State and I have real concerns about the dangers that lie ahead for our economy. As this Committee discussed with Secretary Paulson last month, our constituents are nervous when they see more and more manufacturing jobs going to the Chinese. They are concerned about the future of the housing market. They are particularly concerned about the effects that the potential re- peal of the Bush tax cuts will have on our economic recovery. You inherited an economy that was approaching a tipping point, and so far you have managed not to push it over. I urge you to act with caution and deliberation in the coming year. Finally, soon there will be two vacancies on the Board of Gov- ernors. I hope the President moves quickly to fill these positions with people who have real experience in financial services and com- mercial banking, not just ivory tower academics. I look forward to your remarks. Thank you, Mr. Chairman. Chairman DODD. Thank you, Senator Bunning. Senator Bayh. COMMENTS OF SENATOR EVAN BAYH Senator BAYH. Thank you, Mr. Chairman. Chairman Bernanke, I suspect that most of the people here today have gathered to listen to you, not me, and I will, therefore, reserve my comments for the question period. Chairman DODD. Very good. Senator Martinez. STATEMENT OF SENATOR MEL MARTINEZ Senator MARTINEZ. I will almost resist the temptation. Chairman DODD. That was a standard Senator Bayh set there. Senator MARTINEZ. But I will be very brief, Mr. Chairman. Thank you very much. Chairman Bernanke, welcome, and I again join in the high praise that you have been receiving for your first year on the job. I will simply look forward to hearing your comments as it relates to the housing market, a great concern to me, housing affordability; also, the issue that we dealt with last week in this Committee, which is subprime lending and the rate of defaults in that area; and just in general the effect of the hurricanes in the Gulf Coast, which continue to be an impact on the economies of the Gulf States. So, I look forward to your comments, and thank you for being with us today. Chairman DODD. Thank you very much. Senator Menendez. STATEMENT OF SENATOR ROBERT MENENDEZ Senator MENENDEZ. Thank you, Mr. Chairman. Chairman Bernanke, welcome. It is great to welcome a fellow New Jerseyan back again to the Committee. Today, some people say the economy is solid due to some of the leading economic indicators appearing generally healthy, with un- employment below 5 percent, with moderate economic growth, with inflation stabilized, and I certainly want to commend you for the stewardship you have shown at the Fed in working on this econ- omy. But at the same I also worry about who is benefitting from this economy and who is being left behind. Indeed, there are serious limitations, I think, in judging a situa- tion solely through looking at the big-picture numbers, as this view often hides the details of a situation, and specifically I am talking about the burden being placed on our middle class. So while some in this country might believe that 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. And the disparity that continues to grow, in my mind, is widening at an alarming rate. When I am back in New Jersey, I hear more and more from New Jerseyans that our current economic policies are not working for them. The middle class continues to shrink, poverty is increasing, the gap between the rich and the poor is growing wider. We have a record-breaking national debt and a record-breaking trade deficit. The personal savings rate is now below zero, which has not hap- pened since the Great Depression. Millions of Americans are seeing their wages stagnant and their pension and health care benefits slashed, while the wealthiest people in the country are doing better than ever. So ultimately my concern is that our economy is not working for the broadest scope of Americans that we would hope. The middle class is shrinking instead of growing, and we seem far more con- cerned about boosting the incomes of the wealthiest Americans while denying our responsibility to those struggling to make ends meet. I do not think we can sustain that position over the long- term. We are borrowing to pay for tax cuts and the war effort. It is an unfair burden we are placing on our children and grand- children. So, I look forward to your testimony today and hearing your thoughts on some of these things I have mentioned, some of the other things I hope you will address, like the cooling off of the housing market, what that may mean; energy prices; the con- sequences of deficit and debt, from large budget deficits to record personal debt. And I understand that in your capacity as Chairman of the Federal Reserve, you are responsible for keeping inflation low and stable while maintaining economic growth, not economic equality. But I do hope either in your opening statement or subse- quently in the questions that we will have an opportunity to ask to hear your views about how we get this economy working in a direction that it really helps middle-class families in this country. Thank you, Mr. Chairman. Chairman DODD. Thank you very much. Senator Hagel. STATEMENT OF SENATOR CHUCK HAGEL Senator HAGEL. Mr. Chairman, thank you. Mr. Chairman, welcome. We are glad you are here. I want to per- sonally thank you for you taking time to address the Greater Omaha Chamber of Commerce at their annual meeting 2 weeks ago. It was a rather significant event, as it always is, and your speech matched the expectations that many had, and I appreciate you very much taking a day of your time to come to my State and deliver that speech and spend some time with our leaders in Ne- braska. And I look forward to your testimony. Thank you. Chairman DODD. Thank you very much. Senator Tester. COMMENTS OF SENATOR JON TESTER Senator TESTER. Thank you, Chairman Dodd. Chairman Bernanke, I want to also welcome you here. This is one of those odd occasions where I do not have another committee. Thank God for snow. So, I look forward to your comments, and I will have questions when you are done. Thank you. Chairman DODD. Thank you very much. Senator Bennett. STATEMENT OF SENATOR ROBERT F. BENNETT Senator BENNETT. Thank you, Mr. Chairman. I had planned to follow Senator Bayh's standard, but I have heard so many things being said here that I think at least one voice should rise in de- fense, if you will, of where certain things have been going. Mr. Chairman, you know my personal affection for you, but it will not be a surprise that I disagree with your opening statement. Chairman DODD. I am shocked to hear that. [Laughter.] Senator BENNETT. And, by coincidence, I suppose the best rebut- tal is in a piece that appeared in this morning's paper by Brian Wesbury, who is the Chief Economist at First Trust Advisors, LP, in Illinois, "A Portrait of the Economy." I would ask unanimous consent that the entire piece appear in the record.* Chairman DODD. Without objection. He starts out, "It is the best of times. It is the scariest of times. Last year, U.S. exports, industrial production, real hourly com- pensation, corporate profits, Federal tax revenues, retail sales, GDP, productivity, the number of people with jobs, the number of students in college, airline passenger traffic, and the Dow Jones In- dustrial Average all hit record levels. For the third consecutive year, global growth was strong, continuing to lift and hold millions of people out of poverty. From 30,000 feet—heck, from 1,000 feet, it sure looks like the best of times. In relative terms, the first 5 years of the current recovery have been much better than the first 5 years of the 1990's recovery. But this has not softened the pes- simism of many pundits and politicians who are either unimpressed or expect the whole thing to come crashing down any minute, unless the Government firmly grabs the rein of the global economy and steers it clear of disaster." *Held in Committee files. 9 And then he goes on to outline the history of how badly things have gone every time the Government has tried to step in and steer it clear, starting with the 1930's and then the 1970's. He makes this comment about the 1970's, which I responded to, and it says, "Forgotten in the rush to pass judgment on capitalism is the fact that the last two times the Government seriously tried to control the economies in the 1930's and 1970's and made a terrible mess of it"—well, I will leave the rest of it for people to read, but the one thing I would say to you, Mr. Chairman, if he is right— and I think he is—in the year of your stewardship, the last year, exports, industrial production, real hourly compensation, profits, tax revenues, retail sales, all are at record levels, you must have been doing a pretty good job. And if you were running for office, you would take full credit for absolutely all of it. Thank you, Mr. Chairman. Chairman DODD. Thank you, Senator Bennett. Senator Brown. STATEMENT OF SENATOR SHERROD BROWN Senator BROWN. Thank you, Mr. Chairman. Chairman Bernanke, I appreciate your joining us today to share your thoughts on the direction of monetary policy in the months ahead. I also appreciate the comments you have made in Nebraska and other places before other groups and the steps you have taken toward greater transparency. I am sure that you can appreciate for most of the families in my State of Ohio and elsewhere, many of the issues we discuss today are far removed from their day-to-day lives. As Senator Menendez said, the uncertainties that middle-class families face are not the uncertainties that the columnist that Senator Bennett mentioned and others and economists worry about as often perhaps as they should. I know and appreciate your acknowledging the widening gap of income in our society. I commend you for adding your voice to that discussion. I agree with you that we should look at ways to im- prove education and training of our citizens, but I do not think that is nearly enough. Globalization has had a tremendous impact on workers in this country, on communities, on teachers, on fire- fighters, on cities' ability to deliver services to their constituents. There is no question that good-paying manufacturing jobs have gone offshore. Fourteen years ago, the trade deficit in this country was $38 billion. Today, announced just this week, it exceeds $760 billion. George Bush the First said that a $1 billion trade deficit translates into 13,000 lost jobs. You do the math. Of course, we must trade with the world. The question is not if we will trade with other countries; rather, it is how we will trade with them and who will benefit. If the beneficiaries are limited to those with investment capital and the losers too often are workers and their communities across the country, we simply will not have a very sustainable trade policy. We devote substantial time and ef- fort to protecting intellectual property in our trade negotiations and enforcement. We need to do this, but we exert almost no effort in protecting the rights of our workers and their counterparts over- seas. That simply has to change. 10 Many in the media and some in Government label those of us who advocate for labor and environmental standards as "protec- tionist." Yet when our trade agreements protect the drug industry or Hollywood films, we call that simply "free trade." If we can pro- tect an Ohio inventor, if we can protect Pharmaceuticals, if we can protect copyrights, as we should, we can do a much better job pro- tecting workers and the environment. I thank you for your time. Chairman DODD. Thank you very much, Senator. Senator Allard. STATEMENT OF SENATOR WAYNE ALLARD Senator ALLARD. Thank you, Mr. Chairman. I would like to thank you and Senator Shelby for holding this important hearing. I always look forward to hearing from Chairman Bernanke. I think that you have started off very well in your tenure as Chairman of the Federal Reserve, and I want to congratulate you on that initial effort. I think you have gained the confidence of the markets, and I think you have gained the confidence of many Members of the Congress, although there are a few skeptics still among us. I would like to emphasize that the economy is doing well. If we look at economic growth, this last year it is 3.4 percent; the pre- vious year it was 3.2 percent. The average over 20 years is 3.1 per- cent. So we are above the average in economic growth. I think a lot of that is attributable to the economic growth package that we put in place in 2003 and the tax cuts that we had in 2001. We have heard a lot of comments here in this Committee about how it is going to impact the family. In my view, the hardest-working Amer- ican is the small businessman, and those economic growth pack- ages were targeted to the small businessman. That is where eco- nomic growth occurs. There are Members in Congress that are pushing hard to do away with those temporary tax reductions that we put in place to stimulate the economy. My question to you is: I hope you will address this. If we let those temporary tax cuts go away, what kind of impact is it going to have on the average family? I think it is going to have a dra- matic impact, particularly on the hard-working men and women of this country who are in business for themselves. And I hope that you can address that in your comments. Thank you very much. Chairman DODD. Thank you, Senator Allard. Senator Reed. STATEMENT OF SENATOR JACK REED Senator REED. Thank you, Mr. Chairman, and thank you, Chair- man Bernanke, for joining us today. Your task in setting the right course of monetary policy is complicated by fiscal policy and inter- national imbalances. We no longer have the fiscal discipline that we had in the 1990's which allowed for a monetary policy that was more encouraging of robust investment and long-term growth. The present large and persistent budget deficits have led to an ever-widening trade deficit that forces us to borrow vast amounts from abroad and puts us at risk of a major financial collapse if for- eign lenders suddenly stop accepting our IOU's. Continued budget 11 and trade deficits will be a drag on the growth of our standard of living and leave us ill prepared to deal with the effects of the re- tirement of the baby-boom generation. Strong investment, financed by our own national saving, not foreign borrowing, is the founda- tion of a strong and sustained economic growth and rising stand- ards of living. One final issue that I would like to raise is the growing inequal- ity of income earnings and wealth in the U.S. economy. Between 2003 and 2005, GDP grew at a rate of 3.5 percent per year. How- ever, after adjusting for inflation, the typical weekly earnings of full-time wage and salary workers at the median of the earnings distribution went up only 0.6 percent between the end of 2000 and the end of 2006. Obviously, these median workers are not sharing in that robust GDP. Data from the Federal Reserve Board Survey of Consumer Fi- nances show that household wealth is very unevenly distributed. The wealthiest 1 percent of families held more of the country's wealth than the bottom 90 percent of families combined. Even more disturbing is the large number of families, particularly African- American and Hispanic communities, that have little or no net wealth. Chairman Bernanke, I was heartened to read you comments in Omaha last week emphasizing the importance of education and training in reducing this economic inequality. And I know you share the concern that widening inequality is not good for our de- mocracy and the fabric of the country. So, I hope you will agree there is an inconsistency at best in the Administration's pursuit of tax breaks for those who are already well off, including the perma- nent elimination of the estate tax, while continuing to propose cuts to elementary and secondary education, student aid and loan as- sistance for higher education, and job training for displaced work- ers. The challenges facing our economy are compounded by the dis- array that characterizes our fiscal policy. We have been running unsustainable fiscal deficits, and in order to make the necessary in- vestments in training and education, we must reverse this course. And I would be remiss if I did not note that the lead story today in most of the wire services is that Chrysler is cutting 13,000 jobs. I suspect that will probably raise the stock of Chrysler, make the investors happy, and investment bankers who are structuring the transformation of the company; it is necessary perhaps to do. But for 13,000 Americans who used to have good jobs with good health benefits, they are in a quandary, and our obligation is to them as well as it is to the shareholders of that company. So, I think we have to do a lot more, and I think you do sense that, and I think together, hopefully, we can make some progress. Chairman DODD. Thank you, Senator Reed. Senator Sununu. STATEMENT OF SENATOR JOHN E. SUNUNU Senator SUNUNU. Thank you very much, Mr. Chairman. Senator Bennett, I thought, was somewhat eloquent in talking about the very positive trends we have seen in the economy: Record job creation and above average recovery period, record homeowner- ship, rising income levels. It is fair to say, though, for any Member 12 who has spent a little time back home, there is a sense of insecu- rity that can be felt even in what are relatively strong economic times. And I think that is an issue or a set of issues dealing with their insecurity or uncertainty that we should deal with as policy- makers and perhaps that at some level can even be addressed by the Fed. But I think it is important to understand that the role of the Fed is not to redistribute wealth, not to raise taxes, not to es- tablish protectionist trade measures. And I think that is a good thing. I suspect maybe Chairman Bernanke thinks that is a good thing, because he has a tall enough order as it is. The areas where the Fed can have a very positive impact within their mission are to deal with the uncertainties of inflation, the un- certainties of establishing a sustainable and steady record of eco- nomic growth, the security that comes from the establishment of safe and sound financial markets. And those are all responsibilities of the Fed, I think responsibilities that Chairman Bernanke takes very seriously. You have spoken very well to those issues in the past, and I look forward to hearing your comments on those and other issues this morning. Thank you Mr. Chairman. Chairman DODD. Thank you very much, Senator Sununu. Mr. Chairman, we welcome you again to the Committee. We are anxious to hear your comments, and your full statement and sup- porting documents will, of course, be a part of the record. STATEMENT OF BEN S. BERNANKE, CHAIRMAN, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM Chairman BERNANKE. Thank you. Chairman Dodd, Senator Shel- by, and other Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. Real activity in the United States expanded at a solid pace in 2006, al- though the pattern of growth was uneven. After a first-quarter re- bound from weakness associated with the effects of the hurricanes that ravaged the Gulf Coast the previous summer, output growth moderated somewhat on average over the remainder of 2006. Real gross domestic product is currently estimated to have increased at an annual rate of about 2.75 percent in the second half of the year. As we anticipated in our July report, the U.S. economy appears to be making a transition from the rapid rate of expansion experi- enced over the preceding several years to a more sustainable aver- age pace of growth. The principal source of the ongoing moderation has been a substantial cooling of the housing market, which has led to a marked slowdown in the pace of residential construction. However, the weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy. Consumer spending has continued to expand at a solid rate, and the demand for labor has remained strong. On average, about 165,000 jobs per month have been added to nonfarm payrolls over the past 6 months, and the unemployment rate, at 4.6 percent in January, remains low. Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen in large part as a result of declines in the price of crude oil. Readings 13 on core inflation—that is, inflation excluding the prices of food and energy—have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated. In the five policy meetings since the July report, the Federal Open Market Committee, or FOMC, has maintained the Federal funds rate at 5.25 percent. So far the incoming data have sup- ported the view that the current stance of policy is likely to foster sustainable economic growth and the gradual ebbing of core infla- tion. However, in the statement accompanying last month's policy decision, the FOMC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected and that it is prepared to take action to address inflation risks if devel- opments warrant. Let me now discuss the economic outlook in a little more detail, beginning with developments in the real economy and then turning to inflation. I will conclude with some brief comments on monetary policy. Consumer spending continues to be the mainstay of the current economic expansion. Personal consumption expenditures, which ac- count of more than two-thirds of aggregate demand, increased at an annual rate of about 3.5 percent in real terms during the second half of last year, broadly matching the brisk pace of the previous 3 years. Consumer outlays were supported by strong gains in per- sonal income, reflecting both the ongoing increases in payrolled em- ployment and a pick-up in the growth of real wages. Real hourly compensation, as measured by compensation per hour in the non- farm business sector deflated by the personal consumption expendi- tures price index, rose at an annual rate of around 3 percent in the latter half of 2006. The resilience of consumer spending is all the more striking given the backdrop of the substantial correction in the housing market that became increasingly evident during the spring and summer of last year. By the middle of 2006, monthly sales of new and existing homes were about 15 percent lower than a year ear- lier, and the previously rapid rate of house price appreciation had slowed markedly. The fall in housing demand in turn prompted a sharp slowing in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about 4V2 months' supply in 2005 to nearly 7 months' supply by the third quarter of last year. Single-family housing starts have dropped more than 30 percent since the begin- ning of last year, and employment growth in the construction sec- tor has slowed substantially. Some tentative signs of stabilization have recently appeared in the housing market. New and existing home sales have flattened out in recent months. Mortgage applications have picked up, and some surveys find that homebuyers' sentiment has improved. How- ever, even if housing demand falls no further, weakness in residen- tial investment is likely to continue to weigh on economic growth over the next few quarters as homebuilders seek to reduce their in- ventories of unsold homes to more comfortable levels. Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid, and delinquency rates on most types of con- 14 sumer loans and residential mortgages remain low. The exception is subprime mortgages with variable interest rates, for which delin- quency rates have increased appreciably. The labor market is expected to stay healthy, and real incomes should continue to rise, although the pace of employment gains may be slower than that to which we have become accustomed in recent years. In part, slower average job growth may simply reflect the moderation of economic activity. Also, the impending retire- ment of the leading edge of the baby-boom generation and an ap- parent leveling out from women's participation in the workforce, which had risen for several decades, will likely restrain the growth of the labor force in coming years. With fewer job seekers entering the labor force, the rate of job creation associated with the mainte- nance of stable conditions in the labor market will decline. All told, consumer expenditures appear likely to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal incomes, if, as we expect, households respond to the slow pace of home equity appreciation by saving more out of current in- come. The business sector remains in excellent financial condition with strong growth and profits, liquid balance sheets, and corporate le- verage near historical lows. Last year, those factors helped to sup- port continued advances in business capital expenditures. Notably, investment in high-tech equipment rose 9 percent in 2006, and spending on nonresidential structures, such as office buildings, fac- tories, and retail space, increased rapidly through much of the year, after several years of weakness. Growth in business spending slowed toward the end of last year, reflecting mainly a deceleration of spending on business structures, a drop in outlays in the transportation sector where spending is no- tably volatile, and some weakness in purchases of equipment re- lated to construction and motor vehicle manufacturing. Over the coming year, capital spending is poised to expand at a moderate pace, supported by steady gains in business output and favorable financial conditions. Inventory levels in some sectors, most notably at motor vehicle dealers and in some construction-re- lated manufacturing industries, rose over the course of last year, leaving some firms to cut production to better align inventories with sales. Remaining imbalances may continue to impose modest restraint on industrial production during the early part of this year. Outside the United States, economic activity in our major trading partners has continued to grow briskly. The strength of demand abroad helped stir a robust expansion in U.S. real exports, which grew about 9 percent last year. The pattern of real U.S. imports was somewhat uneven, partly because of fluctuations in oil imports over the course of the year. On balance, import growth slowed in 2006 to 3 percent. Economic growth abroad should further support steady growth in U.S. exports this year. Despite the improvements in trade perform- ance, the U.S. current account deficit remains large, averaging about 6.5 percent of nominal GDP during the first three quarters of 2006. 15 Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the members of the Board of Governors and presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts, which are based on the information available at that time and on the assumption of appropriate monetary policy, is for real GDP to increase about 2.5 to 3 percent in 2007 and about 2.75 to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. The difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4.5 to 4.75 percent. The risks to this outlook are significant. To the downside, the ul- timate extent of the housing market correction is difficult to fore- cast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to in- crease at the brisk pace seen in the second half of 2006. I turn now to the inflation situation. As I noted earlier, there are some indications that inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated. Recent declines in overall inflation have primarily reflected lower prices for crude oil, which have fed through to the prices of gaso- line, heating oil, and other energy products used by consumers. After moving higher in the first half of 2006, core consumer price inflation has also edged lower recently, reflecting a relatively broad-based deceleration in the prices of core goods. That decelera- tion is probably also due to some extent to lower energy prices, which have reduced costs of production and thereby lessened one source of pressure on the prices of final goods and services. The ebbing of core inflation has likely been promoted as well by the sta- bility of inflation expectations. A waning of the temporary factors that boosted inflation in re- cent years will probably help to foster a continued edging down of core inflation. In particular, futures quotes imply that oil prices are expected to remain well below last year's peak. If actual prices fol- low the path currently indicated by futures prices, inflation pres- sures would be reduced further as the benefits of the decline in oil prices from last year's high levels are passed through to a broader range of core goods and services. Non-fuel import prices may also put less pressure on core infla- tion, particularly if price increases for some other commodities, such as metals, slow from last year's rapid rates. But as we have been reminded only too well in recent years, the prices of oil and other commodities are notoriously difficult to predict, and they re- main a key source of uncertainty to the inflation outlook. 16 The contribution from rents and shelter costs should also fall back following a step-up last year. The faster pace of rent increases last year may have been attributable in part to reduced afford- ability of owner-occupied housing, which led to a greater demand for rental housing. Rents should rise somewhat less quickly this year and next, reflecting recovering demand for owner-occupied housing as well as increases in the supply of rental units, but the extent and pace of that adjustment are not yet clear. Upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period. The rate of resource utilization is high, as can be seen in rates of capacity utilization above their long-term average, and most evidently in the tightness of the labor market. Indeed, anecdotal reports suggest that businesses are having dif- ficulty recruiting well-qualified workers in certain occupations. Measures of labor compensation, though still growing at a mod- erate pace, have shown some signs of acceleration over the past year, likely in part the result of tight labor market conditions. The implications for inflation of faster growth in nominal labor compensation depend on several factors. Increases in compensation might be offset by higher labor productivity or absorbed by a nar- rowing of firms' profit margins rather than passed on to consumers in the form of higher prices. In these circumstances, gains in nomi- nal compensation would translate into gains in real compensation as well. Underlying productivity trends appear favorable, and the mark- up of prices over unit labor cost is high by historical standards, so such an outcome is certainly possible. Moreover, as activity ex- pands over the next year or so at the moderate pace anticipated by the FOMC, pressures in both labor and product markets should ease modestly. That said, the possibility remains that tightness in product markets could allow firms to pass higher labor costs through their prices, adding to inflation and effectively nullifying the purchasing power of at least some portion of the increase in labor compensation. Thus, the high level of resource utilization re- mains an important upside risk to continued progress on inflation. Another significant factor influencing medium-term trends in in- flation is the public's expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as those created by changes in energy costs, become embedded in wage and price decisions and so leave a lasting im- print on the rate of inflation. It is encouraging that inflation expec- tations appear to have remain contained. The projections of the members of the Board of Governors and the presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next. In particular, the central tendency of those forecasts is for core inflation, as measured by the price index for personal consumption expenditures, excluding food and energy, to be 2 to 2.25 percent this year and to edge lower to 1.75 to 2 percent next year. But as I noted earlier, the FOMC has continued to view the risk that inflation will not moderate as ex- pected as the predominant policy concern. Monetary policy affects spending and inflation with long and variable lags. Consequently, policy decisions must be based on an 17 assessment of medium-term economic prospects. At the same time, because economic forecasting is an uncertain enterprise, policy- makers must be prepared to respond flexibly to developments in the economy when those developments lead to a reassessment of the outlook. The dependence of monetary policy actions on a broad range of incoming information complicates the public's attempts to understand and anticipate policy decisions. Clear communication by the central bank about the economic outlook, the risks to that outlook, and its monetary policy strategy can help the public to understand the rationale that is behind pol- icy decisions and to anticipate better the central bank's reaction to new information. This understanding should in turn enhance the effectiveness of policy and lead to improved economic outcomes. By reducing uncertainty, central bank transparency may also help an- chor the public's longer-term expectations of inflation. Much experience has shown that while anchored inflation expec- tations tend to help stabilize inflation and promote maximum sus- tainable economic growth, good communication by the central bank is also vital for ensuring appropriate accountability for its policy actions, the full effects of which can be observed only after a lengthy period. A transparent policy process improves account- ability by clarifying how a central bank expects to attain its policy objectives and by ensuring that policy is conducted in a manner that can be seen to be consistent with achieving those objectives. Over the past decade or so, the Federal Reserve has significantly improved its methods of communication, but further progress is possible. As you know, the FOMC last year, established a sub- committee to help the full committee evaluate the next steps in this continuing process. Our discussions are directed at examining all aspects of our communications and have been deliberate and thorough. These discussions are continuing, and no decisions have been reached. My colleagues and I remain firmly committed to an open and transparent monetary policy process that enhances our ability to achieve our dual objectives of stable prices and maximum sustain- able employment. I will keep Committee Members apprised of the developments as our deliberations move forward. I look forward to continuing to work closely with the Members of the Committee and your colleagues in the Senate and the House on the important issues pertaining to monetary policy and the other responsibilities with which the Congress has charged the Federal Reserve. Thank you. I would be happy to take questions. Chairman DODD. Thank you very much, Mr. Chairman, for a very comprehensive statement. What I am going to do is we will have 7 minutes per Member. I will not hold to that so tightly. I would just ask Members to be conscious of the time, and you have the clocks in front of you here so we can make sure everybody has adequate time to ask questions and give you an adequate time to respond to them as well. Let me pick up, if I can, a number of my colleagues referred to your speech in Omaha. Senator Hagel talked about your reception there and the comments you made about income inequality, and I want to pick up on those comments, if I can as well. 18 I think all of us recognize here, I would say to my friend from Utah, we are all very conscious the tremendous wealth that has been created in certain sectors of our economy, that there are good things that are happening. None of us is suggesting all is bad. There is a sense, as Senator Sununu has said, and others, of un- certainty that people are feeling across the country about the long- term economic growth and stability of the Nation. And I think those of us who are expressing those views to you here, Mr. Chair- man, probably reflect your comments as well as I read them. Your quote in Omaha, "By many measures, inequality in economic out- comes has increased over time." Your predecessor, Chairman Greenspan, was very concerned about the growth in income inequality as well. He testified, "I think the income distribution issue is very critical because we can- not have a significant inequality of income and expect to have sup- port for the type of institutions that have been made this country great." Do you share Chairman Greenspan's concern, Mr. Chairman, that continued economic growth of inequality is a significant threat to our Nation's fundamental promise of economic opportunity? Do you suggest by your comments here that we should have a bal- anced view? I just left a markup a few minutes ago before coming here, marking up a new Head Start bill that will hopefully deal with greater accountability, but serving about 900,000 to 1 million young people in this country in the past 41 or 42 years that has tried to give those children an opportunity to become active and successful members of our economy in the future. I am concerned as we look at this that the decisions we make here will lack that kind of balance, and your comments seem to suggest a similar train of thought. And I wonder if you might just take a few more minutes this morning to expound on those com- ments in Omaha, and just a general observation. I am not asking if you endorse a specific spending program here and there, but just your general observation about this inequality issue and your con- cern that you obviously expressed in Omaha. Chairman BERNANKE. Thank you, Mr. Chairman. The very im- portant drivers of economic growth and prosperity in this country include free and open trade and technological progress. It is very important to allow those forces to continue to operate in our econ- omy. However, we do have to recognize, as I discussed in Omaha, that the effects of these forces can be differential across the popu- lation. They may create greater income possibilities for some than others. They may create painful dislocations, for example, if the composition of industries changes or job skill requirements change. I agree with Chairman Greenspan's general point that in order to support and retain support for policies of free trade, open bor- ders, technological change, flexible labor markets, we need to make sure that the gains and benefits from these powerful, growth-pro- ducing forces are broadly shared and that people understand that these things are good for the American economy and good for peo- ple generally in the economy. How to do that is very difficult. It is easy enough to say let us promote economic opportunity. I certainly support that idea. Doing it is not necessarily easy. I discussed in my speech some general 19 issues and approaches, including education, not only K-12 edu- cation but also training throughout the life span, from early child- hood through adult retraining. We need to help people who are dis- located by these powerful dynamic forces to find new jobs, to find new opportunities. I think that is very important. I would just say, though, that I am glad you did not ask me to endorse specific policies, because making that work in practice is difficult. We have to find ways to achieve these objectives. For ex- ample, retraining workers in ways that are effective, and are effec- tive in terms of the spending that we put into it. So it is a great challenge for us going forward to look among all the possible approaches and decide which types of programs, which types of initiatives will be most effective at achieving this objective. That being said, again, I do agree that we need to spread the benefits widely and make people understand that open trade and technological change are beneficial for not only the economy in the aggregate, but also for the great majority of people in the economy. Chairman DODD. Well, I do not know if you had the chance to read a report called "The Gathering Storm." It was prepared by a number of senior retired corporate executives along with some of our leading academicians in the country about a year and a half ago who took a month off and examined where we were in K-12 in science and math—again, without getting into the specifics of in- dividual programs, but they were very cautious. In fact, they warned us, all of us, those of us who sit on this side of the dais, as well as others across the country, that if we did not make some investments in the quality of education, particularly in math and science, we could find abrupt changes occurring in our country very quickly in this century. I do not know if you have had an opportunity to look at that re- port or not, whether or not you agree with their conclusions about your concerns over whether or not this inequality could be exacer- bated by the failure of us to have a level of education, investments in education from that earliest early childhood area through the higher educational opportunity. Chairman BERNANKE. Mr. Chairman, I did read that report. It had a lot of interesting things to say. I think if you look at it care- fully, it suggests that the issues are different in different parts of the educational system. For example, our universities remain very strong. Our research universities lead the world. So in terms of re- search, development, innovation, and so on, the United States re- tains substantial leadership in the world. But in other parts of the educational system, perhaps in elementary school, for example, we are probably not doing what we should in terms of ensuring that all children have opportunities to learn math and science and the applications of those areas. Again, my wife is a teacher, and I have been in education for a long time. I was on the school board for many years, so I am very sensitive to these issues. But I also appreciate from those par- ticular positions that we have been worrying about educational quality for a long time, and it is a difficult thing to achieve. I en- courage continued thought and continued efforts to improve these vital components of our economy without having any delusions about how difficult that really is to accomplish effectively. 20 Chairman DODD. I thank you for that. I am going to turn to my colleague from Alabama, but I will probably send this as a written question, unless one of my col- leagues raises it with you here. Back in December, Senator Sarbanes, Senator Allard, Senator Reed, Senator Bunning, Senator Schumer, and myself sent you and other regulators a letter regarding these exotic mortgages. We had a hearing here the other day, and I have talked about this. I am a strong advocate of subprime lending. It has made a huge dif- ference in accessibility to homeownership. I am also simultaneously very concerned about the predatory lending practices that go on. That concern about providing those subprime borrowers with the same kind of protections we do to the prime borrowers is a matter of concern to many of us here on this Committee. The letter we got back, frankly, Mr. Chairman, was a little inad- equate. The notion, "We are thinking about it," was nice to know, but I think many of us would like to know they are taking some additional steps. And, again, I will make this a written question to you, but I am very concerned about this issue, and some of the data we are receiving were as many as 2 million of our fellow citizens may be foreclosed out of their homes because of predatory prac- tices. Again, I will not ask you here. I want to turn to Senator Shelby, but I want to raise that issue with you and ask you to be thinking about it because it is an important concern for many of us. Senator Shelby. Senator SHELBY. Thank you, Chairman Dodd. Chairman Bernanke, the Federal Open Market Committee has held the Federal funds rate target at 5.25 percent since June 2006. In the FOMC statement following your most recent meeting in Jan- uary, the FOMC noted, "the high level of resource utilization has the potential to sustain inflation pressures. The Committee judges that some inflation risks remain." Mr. Chairman, what data related to resource utilization will you be paying the closest attention to between now and the next FOMC meeting in March? Chairman BERNANKE. Senator, a flip answer is, "Everything." I should be clear: Our concern is not about the labor market per se. Our concern is about the overall balance of spending and produc- tive capacity. Senator SHELBY. The whole picture. Chairman BERNANKE. The whole picture. The Federal Reserve contributes to setting overall financial conditions, which in turn stimulates spending by consumers and businesses on the product of our companies. If spending is growing more quickly than the underlying produc- tive capacity for a sustained period, we risk creating inflation which will then make it more difficult to sustain a healthy expan- sion over a longer period of time. So we are looking for evidence that consumption spending and other components of spending growth are exceeding the underlying capacity. In doing so, we look at a wide variety of indicators, in- cluding the strength of various spending components, measures of resource utilization, which include not only capacity utilization and 21 unemployment, but also many indicators in labor markets and cap- ital markets. We also look very much at prices because they are the canary in the coal mine. If prices begin to rise, that is indicative that there is too much demand given the amount of supply. We do not have any fixed speed limit in mind when we think about the economy going forward. We do not have any fixed num- ber for the unemployment rate. But rather, we are looking at the overall balance of supply and demand, looking at the evolution of inflation, and trying to ensure that there is a reasonable balance between demand and supply so that our economy can continue to grow at a sustainable, moderate pace going forward. Senator SHELBY. IS your economic goal here basically price sta- bility? Chairman BERNANKE. Price stability consistent with strong em- ployment as well. Senator SHELBY. Productivity. The President's economic report noted that between 2000 and 2005, productivity growth in the United States accelerated to about 3 percent, Mr. Chairman, the fastest growth of any G-7 country, which includes Canada, France, Germany, Italy, Japan, and the United Kingdom. Most other major industrialized countries suffered a slowdown in productivity growth. What factors do you believe explain the difference in productivity growth given that the other G-7 countries also have access to the same technological improvements and broad capital markets the United States has? And could you expand on these differences in productivity, what productivity implies for our standard of living and our long-term growth? Chairman BERNANKE. Senator, you are quite correct that produc- tivity began to grow more quickly in the United States about a dec- ade ago, and that has been a very important factor in the strength of our economy. In 1995, we saw a step-up in productivity growth from 1.5 to 2.5 percent, which seems to have been driven primarily by improved and more efficient methods of producing high-tech equipment— faster computers, stronger, better communications equipment, and the like. Over the succeeding few years—and, in fact, we saw productivity growth step up further around 2000—those technological innova- tions had been diffused through the economy and helping indus- tries across the economy manage their production and distribute their output more efficiently, and reduce costs and increase produc- tivity. So in some sense, the underlying factor is the technological change, the investment in information and communications tech- nologies, and the diffusion of those technologies throughout the economy. Now, you ask, quite properly, why we have seen better results here in the United States than in some other countries, and I have given some speeches on that subject. I do believe that it is the interaction of the new technologies and our flexible dynamic eco- nomic system. That includes flexible labor markets that can adjust to changes in the market associated with technological change. That includes deep and liquid capital markets that can allocate 22 capital toward new ventures, toward new technologies. And I be- lieve that flexibility has been essential in helping us take techno- logical advances and create from them economic benefits. This re- lates to my answer to Chairman Dodd that we need to maintain that flexibility in our economy and that providing broad oppor- tunity and education is one way to support that going forward. Senator SHELBY. Mr. Chairman, I want to get to another part of your responsibilities, and that is, bank regulation. Regulation Z, Senator Dodd has already referred to this. The Banking Committee held a hearing on the credit card industry that was widely fol- lowed. Witnesses at the hearing highlighted a number of troubling industry practices, many of which are subject to Federal Reserve oversight. I understand that the Federal Reserve Board is cur- rently reviewing its Regulation Z, which implements the Truth in Lending Act. What is the status of the Board's Regulation Z review? And does the Board intend to use this review to address any of the question- able industry practices raised in the Committee's hearing? Chairman BERNANKE. Senator, we have been putting a great deal of effort into our review of Regulation Z, with a particular focus on short-term revolving credit, like credit cards. One of the real challenges in improving disclosures for credit cards and other types of lending is to make the disclosures both compliant with legal requirements, but also sufficiently clear and understandable that people can understand what it is that they are getting into. In order to improve the understandability and the clarity of dis- closures, the Federal Reserve has conducted extensive consumer testing. We have not just done it in the ivory tower, as somebody mentioned. We have gone out into the public and conducted focus groups. We have done psychological testing to try to figure out how to structure disclosures in a way that people will notice them, pay attention to them, and understand them. So that has been a big part of our effort. We are very close to the end of that effort. We expect to have a proposed rule out within a few months, by the middle of this year, and I believe and hope that it will address many of the appropriate concerns that people have had about disclosures and practices in the credit card industry and other short-term debt. Senator SHELBY. Chairman Dodd, I know my time is up, but could I just ask the Chairman a question for the record? I think it would take some time. We have been concerned for some time about the implementation of the Basel II Capital Accord and the impact that Basel II may have on safety and soundness of the U.S. banking system. I am worried that Basel II may lead to a sharp reduction in the amount of capital banks are required to hold, which would put U.S. tax- payers ultimately at risk of having to pay for expensive bank fail- ures, if there are some. I believe that it is critical that Basel II be implemented with the utmost care and diligence. Mr. Chairman, would you for the record update the Committee on the status of Basel II Capital Accords, the current time frame for implementing Basel II, and also comment on whether there is another time for banking regulators, including yourself, to finalize the rules in implementing Basel II so that banks adopting Basel 23 II can start the test run for Basel II presently scheduled to begin next year? If you care to, you can do it for the record. Chairman BERNANKE. Should I answer, Mr. Chairman? Chairman DODD. We will make that for the record, and let me add to that quickly before turning to Senator Schumer. Some of my bankers have raised the issue, too, about foreign acquisition of do- mestic banks and whether or not they are really meeting the cap- ital requirements today. We have some real concerns raised by my bankers in Connecticut about this issue. They follow it very closely. And I would add that to the question that Senator Shelby has raised with you, whether or not that is something we should be looking more closely at. Are they actually meeting those criteria be- fore those acquisitions occur? Senator Schumer. Senator SCHUMER. Thank you, Mr. Chairman, and it is your first year. You have completed a year. You are getting good grades ev- erywhere, and I would concur. I think you are doing a fine job and have vindicated the support that you received almost unanimously from this Committee. My first question deals with the issues of income inequality in the speech you gave yesterday where you pointed out that this has just been an ideas, almost instantaneous, economy and wealth ag- glomerates to the top. You talked about Manny Ramirez. I would like to talk about Henry Ford, his great idea. He deserved to be- come rich from it, but he needed a million people to carry it out, and each of them made $10,000 a year to make the cars, distribute the cars. Bill Gates, maybe the Henry Ford of our generation, had an- other. He mass produced in a certain sense computer platforms, but he needed 10,000 people to carry it out, and they each made a couple million dollars. Given that this is happening—and it is not the Government's doing. This is just the nature of our economy, as you pointed out in the speech. Doesn't it make sense, if this goes too far, to have a more progressive tax code, even though Government did not cause it, to keep a middle-class base, to keep too much wealth from agglomerating at the top? I am not asking you any specific policy, but just a general view that wouldn't progressivity, further progres- sivity in the tax code help be an antidote to the natural flow of money to the very top, to the few who create those new ideas and deserve to make money from that and not get in the way of doing that? Chairman BERNANKE. Senator, your comparison of Henry Ford and Bill Gates was very telling, actually. Henry Ford developed the assembly line, and it allowed relatively low-skilled workers to be very productive in that context and generated high wages for those workers. Bill Gates created a new model of operating systems in the high- tech industry. The kinds of workers he needed were much more skilled workers. Senator SCHUMER. Exactly, and many fewer of them as well. Chairman BERNANKE. And fewer of them, certainly. So, I think that one very important lesson from that comparison is that those who are going to benefit the most from globalization and tech- 24 nology are those who have the skills, who have the capabilities to benefit and to be productive in that context. So, I would say whatever we do with tax policy and transfer pol- icy, I hope that we will try to address the issues of skills and indi- vidual productivity. Senator SCHUMER. I agree with you completely. But that is going to take a while. Chairman BERNANKE. Senator, on the issue of progressivity, you will be unsatisfied. As the head of the nonpartisan central bank, I think it is very important for me not to take sides on issues where values are very important. Senator SCHUMER. Talking about more money or more help for education is as much a policy decision as talking about the progres- sivity of the code. I am not asking you about a specific policy, and I think you should address it. Chairman BERNANKE. Senator, I am sorry, I decline, because there really is a value judgment involved in trading off—I talked about this in my inequality speech. I said, on the one hand, you have the importance of promoting incentives. Senator Bennett mentioned entrepreneurs, people who take risks. We have to give them incentives to take risks. On the other hand, as you point out, correctly the tax code has an important role to play in generating more equality. But I am not an elected official, so I cannot com- ment. Senator SCHUMER. Okay. I think you are ducking it, in all due respect, because you do talk about other policy issues, but let me move on. Trade deficit. Are you happy with the size of the trade deficit, at the rate of its growth? And do you think stronger policies, particu- larly against those who we have huge balance of trade deficits with to open their markets, not particularly to close ours, would be help- ful in reducing the trade deficit? Obviously, my focus is on China, but I would ask a more general question. So, the first question, are you happy with the size of the deficit and its rate of growth? Chairman BERNANKE. NO, I am not happy with it. Senator SCHUMER. DO you think policies that would not require, but importune other countries whose markets are not as open as ours to open theirs would be a salutary change and that we should emphasize that as a, if you will, pro-free trade way to deal with the trade deficit? Chairman BERNANKE. Senator, I am entirely in favor of trying to open markets. We have the World Trade Organization, and China is a signatory. We should aggressively pursue attempts to open markets to foreign investment and Senator SCHUMER. DO you think the Chinese have done enough on their currency? Chairman BERNANKE. They have moved in the right direction, but, no, I do not think they have done enough. With respect to trade, though, I would like to add that trade poli- cies alone are not going to resolve the trade deficit. There is also the issue of saving and investment, which we do need to address as well. Senator SCHUMER. I think I agree with you on that. 25 Senators Graham, Baucus, Grassley, and myself are going to try to do a WTO-friendly way or compliant way of getting the Chinese to do more on currency, and I hope you will look at that carefully and be supportive. A final question is on competitiveness of our financial institu- tions and industries. Coming from New York, I am obviously con- cerned, but so should my colleagues from many other States be. The Carolinas, South Dakota, New Jersey, so many other States have a stake here. And the problem we seem to be facing is this: That other regulatory and legal schemes—you know, regimens in other countries are looser than ours. And now that capital can flow quite freely, companies who are international and their loyalty to their stockholders means they are not going to be loyal to the United States or it will precede their loyalty to the United States may seek the lowest common denominator or a lower common de- nominator. And the pretty exquisite balance between regulation and entrepreneurialness that we have had over the last quarter of the last century seems to be in some trouble, that people are flee- ing to go to less regulated places for their short-term gain, even if it creates problems in the system as a whole. Could you comment on that problem? Do you think it is a real one? Do you think it is only caused by simply knowledge spreading and the Internet or is caused by some of these regulatory dif- ferences? And do you think we should look at that in a policy way to do something about it? Chairman BERNANKE. Senator, to some extent, it is caused by the diffusion of knowledge and the growth of other markets, and to the extent that we are having a more competitive, deeper, broad- er capital market around the world, that is probably good for world growth. It is probably good for even our companies because they have more options for raising funds. There is, though, I think, an issue of regulation, as has been pointed out in the two reports that you are quite familiar with. There is a subtle distinction to make. If you take Sarbanes-Oxley as an example, to the extent that Sarbanes-Oxley appropriately balances disclosures and governance against the cost of achieving those disclosures and governance, I think it is worthwhile to keep. Even if there is some short-run tendency for firms to run away from that, because the investor wants that protection, ultimately the investor will reward firms that list on exchanges that have ap- propriate, adequate protections such as a well-designed Sarbanes- Oxley. That being said, there are always concerns about Sarbanes- Oxley, about Basel II, about the regulatory structure, about securi- ties litigation, about CIFIUS, where legitimate questions can be raised whether the costs of those regulatory schemes exceed the ac- tual benefits to investors and to others of implementing them. As a general matter, not just in the context of competitiveness of our exchanges, we should always be looking to restore that balance and make sure that the costs we are imposing from a regulatory side are justified in terms of the social benefits. So, for example, it is a good step that the Public Company Ac- counting Oversight Board and the SEC have taken some steps in revising the audit standard to reduce the burden of SOX 404 while 26 maintaining, I believe, many of the benefits in terms of disclosure and controls that that law was intended to achieve. Senator SCHUMER. Thank you, Mr. Chairman. Chairman DODD. Thank you very much, Senator Schumer. Senator Bunning. Senator BUNNING. Thank you, Mr. Chairman. Two of your predecessors, Paul Volcker and Alan Greenspan, al- ways expressed great concern. I happen to have served on the House Banking Committee when Mr. Volcker was the head of the Federal Reserve and then Chairman Greenspan, both House Bank- ing and now Senate Banking. And yesterday in the Washington Post, there was an article about the inversion of the yield curve for 8 straight months and how local banks and banking in general— and since that is the Fed's charge, to make sure that our banks are sound and secure—were having difficulty with the inverted yield curve. I have questioned you about this before, and you have always said it is not very important in this day and time. I am going to ask you again: How long can we stand to have—we have had it 8 straight months now—an inverted yield curve, where short-term rates are higher than our 30-year bond rate? Chairman BERNANKE. Senator, the usual context of this question is: Does an inverted yield curve presage a recession or a slowdown in the economy? Senator BUNNING. Well, it also hurts our banks very badly. Chairman BERNANKE. I will address that, sir. Just very quickly, though, on the forecasting power of the yield curve: There has been a good bit of evidence that declines in the term premium and per- haps a great deal of saving chasing a relatively limited number of investment opportunities around the world have led to a somewhat permanent flattening—or even inversion—of the yield curve, and that pattern does not necessarily predict slowing in the economy or a recession. Indeed, if you look at other measures of financial mar- kets such as corporate bond spreads, you do not see anything that suggests anticipations of future stress. The question you raise is a different one, of course, which is the effect on the banking system. Specifically, banks that do their tra- ditional business of taking deposits and making loans are going to be put under pressure because the short-term deposit rates tend to be higher than the loan rates they can get. I recognize that is a problem for some banks. Other banks have been able to deal with it by hedging interest rate risk, by getting fees, and finding other ways of doing their business. So, overall, I do not see the banking sector as being under tre- mendous pressure in terms of its profits and asset quality at the moment. But I recognize—particularly for smaller banks, which have fewer options in terms of raising funds and earning fees and income—that the inverted yield curve does produce some pressure. From the Federal Reserve's point of view, we are entirely cog- nizant of that and hear about it from bankers. We have to set mon- etary policy, of course, to achieve overall price stability and max- imum sustainable employment growth. So we sometimes find that in the context of various industries policy creates some pressure in individual industries. But we only have this one tool, and we try 27 to use it to achieve overall macroeconomic stability, while fully rec- ognizing that it does create some problems for some sectors. Senator BUNNING. You are telling us today that an inverted yield curve down the road will not affect the economy. Did I misunder- stand that, or is that accurate? Chairman BERNANKE. I think the yield curve could be inverted for a considerable period without significant implications for the economy as a whole, yes—possibly for some banks, but not for the economy as a whole. Senator BUNNING. How does this economic cycle that we are in, and recovery and expansion, compare to previous recoveries and ex- pansions? In other words, when we hit the wall in 1992 and then also in 2002, how does this recovery that we are involved in now compare to those recoveries? Chairman BERNANKE. I would say that qualitatively it is fairly similar to the recovery that followed the 1991 recession, with many of the same features. There was weakness for some time after the recession ended, including a period of so-called "jobless growth." Senator BUNNING. But we did not have a housing market that Chairman BERNANKE. Well, the housing market was actually quite weak during the recession itself. The decline in residential starts during 1991 was not quite as large, but in the same neigh- borhood, as what we have seen recently. During the recovery pe- riod, we did not have that particular pattern, but in many ways, it was a fairly similar expansion. Senator BUNNING. Could you estimate how close we are to a full employment in the United States? Chairman BERNANKE. It is very hard to say specifically, and I do not pretend to know an exact number or an exact estimate. But the economy has certainly been growing faster than potential for a number of years, and that can be seen in the tightening of labor markets and capacity utilization. So, clearly, we are much closer today, I think it is safe to say, to full employment, to the sustain- able level of growth than we were a few years ago. Senator BUNNING. And in your opening statement, you made the remarks to the effect that you have not seen any new evidence of inflation since your last Fed meeting in January or February? Chairman BERNANKE. We have not had much information on in- flation since just 2 weeks ago, but the recent readings on inflation have been encouraging. Senator BUNNING. Encouraging? Chairman BERNANKE. Yes. Senator BUNNING. Okay. Chairman BERNANKE. But as I indicated in my remarks, they are somewhat noisy, the data, and we do not want to draw a complete conclusion Senator BUNNING. Well, that is why we have Fed meetings, you know, every month or two. Chairman BERNANKE. That is correct, Senator. Senator BUNNING. Thank you very much, Mr. Chairman. Chairman DODD. Thank you very much, Senator Bunning. Senator Casey. 28 Senator CASEY. Thank you, Mr. Chairman, and the other Chair- man in the room, thank you for your time and for your service. I have two general questions, one on debt and one on children. With regard to debt, I was looking at the report that the Federal Reserve Board is submitting in connection with your appearance here today and your testimony. And, in particular, I wanted to di- rect your attention and the attention of others to the report. I note here that in the section which deals with the Federal Gov- ernment and expenditures and outlays by the Federal Government, it says, "Net interest payments increased 23 percent in fiscal year 2006 as interest rates rose and Federal debt continued to grow." Then it goes on from there and talks about the outlays for Medi- care Part D, Medicare itself up 10.5 percent. It talks about disaster relief, Medicaid spending, and then it gets to the next part of the paragraph. "Outlays for defense in fiscal year 2006 slowed to their lowest rate of increase since fiscal year 2001, although the rise was still about 6 percent." That is the first predicate of my question. It goes on to talk about debt, the Federal debt subject to the stat- utory limit has increased, now we are at the $8.6 trillion level. I guess with that as a predicate, let me tell you what I think about this. I think that that is unsustainable, and as much as we have talked, as important as it is to talk about the good sound bite, reducing our dependence on foreign oil, I think we need a lot more effort in this Congress and in this town on reducing our depend- ence on foreign debt. I think it is making us less safe in the fight against terrorism. I think it is making us less safe in terms of our ability to spend money on defense, not to mention our inability to spend money on good investments in the economy, as you talked about, education, training, and the rest. So, I guess my basic question is: In light of that data, and any other data you want to factor into this question, are these numbers sustainable, an $8.6 trillion debt and a 23-percent increase in net interest payments? Is that sustainable over time? Chairman BERNANKE. I recently testified before the Senate Budg- et Committee, and I pointed out—and it is not exactly a secret— that the long-term prospects for the U.S. fiscal situation are quite serious. In particular, we are going to start seeing—as the popu- lation ages—expanded costs of entitlements, Social Security and Medicare; those grow very quickly. And we will generate, if no ac- tion is taken, an increasing spiral of higher interest payments and debt. I quoted in that testimony several interesting, useful simulations by the Congressional Budget Office. The intermediate simulation suggests that by the year 2030 the deficit will be 9 percent of GDP, and the debt-to-GDP ratio, which is currently about 37 percent, will be closer to 100 percent of GDP—a number which we have not seen since World War II. So, obviously, there are a lot of issues that Congress will debate about short-term spending and tax proposals. But if you think about fiscal sustainability in a longer time frame, dealing with the fiscal implications of the aging population and rising health care costs are going to be dominant, and essentially there will not be any way to address fiscal sustainability without addressing that issue in some way. 29 Senator CASEY. I wanted to pick up, in the remaining time I have, on the issue of how we invest in children, pick up on what Chairman Dodd spoke of earlier. There is a great organization out there that has as its moniker, as its message, "Fight crime, invest in kids." It is a great sound bite. Sometimes we need sound bites to make the point. I would also assert—and I would ask for your sense of this and your reflec- tions on this—that you could use the same construct for the impact on how we invest in children and how we grow our economy. In- stead of saying, "Fight crime, invest in kids," you could say, "Grow the gross national product" or "Grow GDP" or "Grow the economy, invest in kids." Now, I ask you that because we are going to be making some critically important decisions in the next couple of months and cer- tainly in this 110th Congress. Chairman Dodd talked about the issue of the Head Start program. There have been votes cast in the U.S. Senate in the last couple of years where the choice was clearly and unambiguously a choice between investing in Head Start or in- vesting in education or investing in any other support for children and their economic future, not to mention our future, and tax cuts. Sometimes the votes have been that stark, and there are people here who voted for the tax cuts over Head Start and over some other priorities. So, I would ask you about your opinion—and this is a policy question, but I think you can answer this—your opinion on the level of investment in children, whether it is with regard to edu- cation or Head Start, early learning, all of these initiatives to give kids a healthy and smart start in life, how you see that in the con- text of economic growth and GDP growth, and whether or not you think the investment currently is adequate. Chairman BERNANKE. I think that investing in children is ex- tremely important and has significant economic and social benefits. I hope that Congress will continue to look very carefully at that. What I do not know is precisely how best to do that, and I think you are going to have to bring real experts here to talk about dif- ferent approaches—what works and what does not. But I urge you to continue to do that. In terms of priorities, to go back to Senator Schumer's question, clearly, there are always priorities. But you can weigh these things against tax cuts, you can weigh them against other kinds of spend- ing. Clearly, you have to have an overall picture of what is impor- tant. Again, I cannot speak to the overall combination of taxes and spending other than to say that they should be in balance. But I will go so far as to say that I think that there is a significant re- turn to investing in young kids. In my remarks in Omaha, I even cited some Federal Reserve re- search from the Federal Reserve Bank of Minneapolis, which showed the very substantial economic returns associated with early childhood education, and I do think that that is certainly worth in- vestigating. Senator CASEY. Thank you. Chairman DODD. Thank you, Senator Casey. Very good ques- tions. I appreciate your focusing attention on that. 30 I want to just mention, before turning to Senator Martinez, your response, Mr. Chairman, to Senator Schumer's questions about Sarbanes-Oxley and competitiveness. I appreciated your answer very much to that question. There are some things clearly that could be done to try and show some balance and making sure we are not overburdening smaller public companies, but your thrust was that this is working pretty well. And, frankly, anecdotally, I suspect most of us here ask the question of every business we talk to: How is this working? And I must tell you, overall the response I get is a good one. I had one company the other day say to me that, "Even if Con- gress decided tomorrow to repeal Sarbanes-Oxley, we would decide to stay with all the things that have been required of us. We have found that it has been very worthwhile for our company." So, I ap- preciate your comments about that. Senator Martinez. Senator MARTINEZ. Mr. Chairman, thank you very much. I hate to differ with the Chairman, but I must say that the expe- rience that I hear on the competitiveness and Sarbanes-Oxley issue is far different from that. I hear a great deal of concern about the incredible cost and the burden of competitiveness that it has cre- ated. And, in fact, I will begin with this area because I intended to get into it, but our colleague from New York, Senator Schumer, and Mayor Bloomberg recently released a report that I found quite interesting detailing an analysis of market conditions in the United States and abroad and about the concern that there is about whether New York will continue to be the financial capital of the world or whether, in fact, there seems to be others competing for that title, which might include London. And there were some rath- er dramatic statistics of declines and increases in New York vis-a- vis London. One of the things that was mentioned in the report was the U.S. regulatory framework being too complicated and the implementa- tion of Sarbanes-Oxley having produced heavier costs than were ex- pected at the beginning or when you initiated that effort. Also it was mentioned immigration policies which create problems for those abroad who might wish to come here to do business, to invest in America, and the difficulties that current immigration problems raise for that, and some of them coming to be educated, others com- ing just as business people and investors. In any event, I wondered if you had an opportunity to see that report and whether its finding cause the same concerns to you that they raised to me. Chairman BERNANKE. Senator, as I indicated, I do think that we should be trying to reduce regulatory burden, and in particular en- suring that the costs of the burden are commensurate with the benefits. With respect to Sarbanes-Oxley, my intent was to say that I do believe that there are benefits from that legislation, including im- proved controls, improved disclosures, improved governance of cor- porations. So there are certainly some benefits. It is important to decide whether we can reduce the costs and re- tain the benefits, and in that respect, I think that the proposed change in one audit standard being put forth by the SEC and the 31 PCAOB is a step in the right direction because it attempts to focus on the most materially important issues, and it also makes allow- ance for the size and complexity of a firm in setting up the audit standard. So to try to summarize, Sarbanes-Oxley accomplishes some im- portant objectives, but I do believe those objectives can be accom- plished at lower cost, and I think the new audit standard moves in that direction. And in all other regulatory areas, including those the Federal Reserve is involved, we should continually be looking to find ways to accomplish the social or economic objectives of the regulation at a lower cost. Senator MARTINEZ. Well, I agree that there are many good fea- tures to Sarbanes-Oxley. What I was speaking of is some of the ex- cesses, particularly in the auditing arena and some of the areas that have caused such an overburden of costs. So, I appreciate your comment on that. Shifting to the issue of home sales, I used to sit in that very chair when I was Housing Secretary before this Committee, and at times, I would be asked a question about a housing bubble and in the overheated housing market whether, in fact, we were headed for a collapse and a bubble that would burst. In fact, we have seen as significant decrease in housing starts. We have seen the market cool down significantly, but we have not seen a bursting bubble. I always said at the time that the fears of a bubble were misplaced and that the housing market is more regional than it is national, and there were many different features between that and a local- ized market. But do you feel that the fear of a bubble has receded given the fact that the market cooled off, that it has done so in a fairly mod- est way without any cataclysmic consequences? Chairman BERNANKE. Senator, as I indicated in my opening tes- timony, we think we see some tentative signs of stabilization in de- mand in the housing market, that nevertheless takes some time yet to work its way out because of the inventories of unsold homes that still exist on the market. I would emphasize that the signs of sta- bilization are tentative, and we do not want to jump to conclusions. It will be helpful to see what happens when the spring selling sea- son begins and strong demand is at that time. But it is interesting that so far the economy has done a good job of withstanding the slowdown in construction, which, although sub- stantial relative to the last couple of years, is still similar to the late 1990's, for example. It is not that we have had a complete col- lapse in construction by any means. So the decline in construction, while it has slowed the economy, has obviously not thrown us into a much slower growth situation. And we have not seen substantial spillovers from the housing slowdown to consumer spending or to other parts of the economy. So it is early to say that this problem is over. I think we are going to have to continue to watch it very carefully, and as I indi- cated, I think it is a downside risk to the economy going forward. But so far, the economy has reasonably adapted to this adjustment in the housing market. Senator MARTINEZ. YOU mentioned in your remarks also that household finance appears solid and that delinquency rates on 32 most consumer loans, including residential mortgages, were low, but you did note the subprime mortgages with variable interest rates where delinquency rates have increases appreciably. And it is an issue that is of great concern to several of us on this Com- mittee, the issue of predatory lending, the abuse of some of our most vulnerable consumers. Any comments on that or any issues that you see there which could impact the overall economy? Chairman BERNANKE. I think, first of all, that this distress in the subprime area is a significant concern. I am obviously following it very carefully, both in terms of the impact it has on the borrowers and lenders as well. I do not think that it has at this point implications for the aggre- gate economy in terms of the ongoing expansion, but as I said, it is an important issue for those sectors. I could certainly list a wide variety of things that we do to try to address predatory lending, which I do think is an important issue, and I think the subprime market, which is distinct from predatory lending, it is a legitimate market. Senator MARTINEZ. Right. That is a good distinction to make. Chairman BERNANKE. It also has some issues. Just to note one action we have taken recently, along with the other Federal banking agencies, we have issued guidance on non- traditional mortgages, mortgages that involve interest-only or op- tion ARM's that may not be amortizing mortgages. We have em- phasized to the lenders that they should be, first, very careful in their underwriting—that is, they should ensure that the borrower is equipped to deal with payment shock if interest rates go up, that they have sufficient income to meet higher payments; and, second, that disclosures are adequate so that the borrowers are fully in- formed about the nature of the contract that they are getting in- volved in. There are some loans that have been made that are not turning out well, and to the detriment of both the lenders and the bor- rowers. We will certainly be watching that carefully and trying to provide guidance and oversight to minimize that risk going for- ward. Senator MARTINEZ. Thank you, Mr. Chairman. Chairman DODD. Thank you very much, Senator Martinez. Senator Bayh. Senator BAYH. Mr. Chairman, I would like to ask you some ques- tions about our national security interests and the role of the Fed in our financial system in protecting those interests. As you probably have read, there are the tentative outlines of an agreement with North Korea to begin to get them to change their behavior with regard to their nuclear program. And one of the rea- sons that we were able to at least achieve a tentative under- standing was because of pressure that we brought to bear on a bank in Macau that the North Koreans used to interact with the global banking system. Iran, as you know, is pursuing nuclear ambitions as well. Several Iranian banks do business in Western Europe. We are currently at- tempting to do something similar with regard to a couple of Iranian banks. 33 My question to you is: What can the Fed do, what can the United States banking system do, to cut off Iranian access to the global banking system to exert some pressure on them to behave in a more responsible way with regard to their nuclear ambitions? Chairman BERNANKE. Senator, the primary responsibility for ini- tiating such measures and enforcing them is with the Treasury, the Financial Crimes Enforcement Network, for example, and OFAC. They have take the leadership in trying to ensure that American banks and, through negotiation, banks from other countries do not deal with the banks you are referring to in Iran and North Korea. So we are not the leaders in that effort. However, we as bank regulators and overseers have an important responsibility to try to ensure that it is carried out as the rules dictate, and as a very ex- tensive part of our oversight responsibility, we evaluate banks' compliance with the Bank Secrecy Act and other such rules. Senator BAYH. I hope you will make this a priority and bring some sense of urgency to it. Iran is a tremendous problem. You know, the military option is obviously something that no one wants to have to resort to, and so we are looking for other levers that we can utilize to try and get them to do the right thing here. And this seems to have been effective in the North Korean context. My investigations in this area tell me that it has, you know, in- creased the cost of doing business to the Iranians. It has made things more inconvenient for them, and perhaps if we continue to pursue this, we might encourage a change in behavior on their part as well. So, I would encourage you to be vigorous in this effort be- cause it does affect our national security interests in a very impor- tant area. Staying on the subject of Iran for a moment—and you are busy with many other things; you may not have noticed. But they have indicated publicly that their response, if we did get to the point of having to take some action against them because of their nuclear program, would be to try and cut off the flow of oil from the Per- sian Gulf by closing the Straits of Hormuz, so that not only they would suffer but also the Saudis and others, trying to maximize the pain on the global economy. I hope that there is some contingency planning being under- taken, so my question to you is: If such an event were to occur, what would the impact be on the global economy, on the U.S. econ- omy, obviously the price of oil? You mentioned the role that the cost of energy plays in our inflation expectations and that thing. So what would the effect of such an act be on the economy? And, sec- ond, are you aware of any steps that we can take to mitigate those consequences? The President in his State of the Union address has suggested doubling the Strategic Petroleum Reserve, for example. Are there other things that we could do to prepare for such an eventuality so that we would mitigate the consequences? Chairman BERNANKE. Senator, you are pointing to an important problem. I am not really equipped to say what the impact of these actions would be on aggregate supply of oil and on the oil price. I assume it would be dramatic, but I do not know exactly how big the effect would be. 34 It would certainly have an impact on the world economy. There is no question about that. And I doubt that there is anything we can do in advance that would completely offset that impact. In the short-run, one of the tools we have you already men- tioned—the Strategic Petroleum Reserve—which does provide some protection for a certain number of months, anyway, against those kinds of disruptions. I think that would be helpful. In the longer-term, as many people have noted, reducing our de- pendence on oil would be beneficial. If we could find ways to diver- sify our energy portfolio and, therefore, rely less on this particular source, that would be helpful from a national security perspective. Senator BAYH. Well, I know your people are probably stretched to their limits, dealing with a variety of things, but I do think that some part of the Government—whether it is your shop or Treasury or working in concert with some of the national security agencies— we need to at least begin to some thinking about this. God willing, we have a number of years before we get to such an event, and God willing, it will never happen. But I am always a big believer in you start with the worst case, protect yourself from that, and you kind of work back from there. When Secretary Paulson was before us a couple weeks ago, he reiterated the comments that had become routine by his prede- cessors, and that is the Treasury's belief that a strong dollar is in the interest of the United States of America. Do you agree with that point of view? Chairman BERNANKE. Senator, I do agree with it, and I would add that I defer to the Secretary of the Treasury in all matters re- lated to currency policy. I would only add that the Federal Reserve, to the extent that we can keep our economy strong and attractive to foreign investment, will help keep a strong dollar. Senator BAYH. Well, I agree with that, and this relates in some regard to what Senator Casey was asking about. You may recall that previously there had been—oh, there was a rumor in Seoul at one point that they were going to diversify in dollar-denominated assets, and that caused a run on their currency. A similar rumor went through Japan not long thereafter. What would be the impact on the value of the dollar in our econ- omy if the Chinese were to, for example, announce that they were going to either diversify out of dollar-denominated assets or were to, in fact, begin a precipitous sale of such assets? Chairman BERNANKE. Well, Senator, first, I think it is important to understand that that is not a very likely scenario, and China own interests would not be well-served by such actions. They would take portfolio losses themselves and Senator BAYH. Forgive me for interrupting. That is something similar to what the Treasury Secretary said, and the reason for my question, Chairman, is this: You are right, it might not be in their pecuniary best interests, but nation states do have interests other than their financial concerns. Let's just say hypothetically, you know, bringing pressure to bear on Taiwan and Taiwan's allies might be worth the loss of some money to the Chinese at some point in time. 35 So my concern is simply this: Global interdependence is one thing, but the dependency is another. And it puts us in the position of being somewhat vulnerable to another country's view of their own best interests. And I have real concerns about whether that is in our best interest. Chairman BERNANKE. I will answer your question, but I just wanted to reiterate that I think the costs to them of doing this would be greater than the costs to us. That being said, I think a substantial move on their part would be disruptive in the market in the short-term. In the longer-term the dollar, the Treasury yield and so on, would largely recover. Part of the reason is that Chinese holdings of United States fixed- income securities—which, of course, include not only Treasury but also GSE's and corporate debt and other instruments as well— amount to something less than 5 percent of the outstanding dollar fixed-income securities in the global market—which is a very sig- nificant amount, but is not by itself enough to be a monopoly of some sort in this market. So if they were to do that—which, again, I do not anticipate— it would have short-term disruptive effects. I think that most of those effects would be short term as the market, which is very deep and liquid, began to adjust to that shock. Senator BAYH. Thank you, Chairman. My time has expired. Again, the reason for my question is simply, as a great power, I am reluctant to see us, even for a short duration, to be in a position of vulnerability to the actions of another government. Thank you. Chairman DODD. Senator Bayh, thank you. Those are excellent questions, and I appreciate your raising them. Senator Allard. Senator ALLARD. Thank you, Mr. Chairman. We are currently working on our budget, and it is a 5-year budg- et, I assume, you have looked at 5-year projections as far as how our economy is going to be doing. If I remember correctly, you pret- ty much feel that we are going to have a pretty good economy for the next 5 years, certainly within the average. Is that correct? Chairman BERNANKE. We have not released any forecasts of the economy beyond a couple of years. The projections I gave today suggest reasonable growth and inflation over the next 2 years. The underlying fundamentals of the economy in terms of productivity and so on look good to me, and so my expectation is that the econ- omy will continue to be strong after that period. But we have not released any specific forecasts. Senator ALLARD. NOW, in 2009, our Social Security surplus be- gins to decline, and that is the projection that we are looking at now, where we have had the surpluses but now they begin to re- duce. How does that get factored in? That is within the next 2 years. We will be working on the 2009 budget in a year from now. How does that factor into your economic growth projections? Or is it too early to begin to have much validity to that? Chairman BERNANKE. It is a bit early to be thinking about that. From a macroeconomic point of view, if we focus on the cashflows of the deficits, current in, current out, it looks like the deficit will not be rising significantly and may even be declining for the next 36 few years for various reasons. So, I do not anticipate that fiscal pol- icy will be a major force shaping the near-term growth pattern of the economy. The concerns that I emphasized in my Senate Budget testimony were really the longer-term issues of solvency and fiscal responsi- bility in the context of the aging of the population and the large increase in entitlement spending. Senator ALLARD. The deficit is going down. In my view, it is more attributable to revenues. It is not that we have done anything par- ticular to hold down on spending. If we do something—and I do not know how you factor in the expiration of these temporary taxes that have been put in place. It looks to me like they have had a positive impact on the economy and the revenues that are coming in. When those expire, what kind of adjustments do you think we will have to make in our budget projections from that point on? Chairman BERNANKE. Well, again, I am not going to take a posi- tion on whether they should be allowed to expire. I think if they do expire, it would probably increase revenues somewhat. It would have other effects on the economy in terms of incentives and growth potential as well. From the Federal Reserve's point of view, we are simply going to look at the fiscal situation as it evolves and make our adjust- ments to try to maintain full employment as the economy goes for- ward. I think the considerations the Congress should have with re- spect to near-term tax policy should be less to do with maintaining short-term full employment—we will be able to address that—but, rather, think about the long-term trade-offs between the benefits of lower taxes and the costs of lower taxes, essentially. Senator ALLARD. I am going to move over to the small business question. When you look at the economy, it seems as though—most of the figures I look at on the small business sector, they contribute about 50 percent, 52, 53 percent of the growth in the economy. Is that about what you look at? Chairman BERNANKE. It is similar—small and large businesses are similar in magnitude, and so in that respect, you are correct, yes. Senator ALLARD. YOU are saying that the small business sector would grow—you think it is 50-50, then, between economic growth from large business and economic growth from small business? Chairman BERNANKE. I do not recall the exact data, but I believe I have heard that number for job creation as opposed to growth. But it would be similar, yes. Senator ALLARD. Okay. Thank you for that. That was just a point of information. I wanted to see how you were looking at that. Chairman BERNANKE. We can provide you with more detailed in- formation. Senator ALLARD. I would appreciate that, if you could. The other question is Sarbanes-Oxley. Apparently, there is a rise in private equity firms, and they are increasingly acquiring some public companies and apparently taking them private. Does that phenomenon concern you? Chairman BERNANKE. Not necessarily. It can be a good method of enforcing discipline on corporations and management. By taking the firms private, they essentially create a situation where the pri- 37 vate equity investors have a short period of time in which to create a more productive, more effective, and more profitable firm. They then usually try to bring the firm back into the public markets, so it is not in some sense an attempt to permanently escape Sarbanes- Oxley, because they do eventually want to come back into the pub- lic markets. So, generally, it is a policy development in that it creates more competition for corporate control and should increase discipline among management. There may be some circumstances where the leverages are excessive or that there are other problems associated with it. Senator ALLARD. When I was taking economics in college, I think full employment was considered 5 percent. Is there a figure like that that most people generally agree is a full employment figure? Or are there other variables you have to bring in, you cannot use a static number like that? Chairman BERNANKE. The Congressional Budget Office uses, I think, 5.2 percent. Senator ALLARD. Yes. Chairman BERNANKE. But the Federal Reserve does not have a fixed number that we use. Again, as I indicated earlier, we try to look at a wide variety of indicators, both of the labor market and of the general economy in terms of prices, for example. In the past, we have found that the amount of employment the economy can sustain on a long-term basis changes over time. It changes within demographics, with the structure of the labor market, and with the structure of industry. It is not, I think, good policy to have a fixed number in mind. It is important to be flexible, look at all the infor- mation that is coming in, and try to make an ongoing judgment about how the capacity of the economy is adjusting. Senator ALLARD. And do you think the unemployment is at a de- sirable place in the economy right now? Chairman BERNANKE. Well, as I indicated earlier to Senator Bunning, we are certainly much closer to the capacity of the econ- omy now than we were a few years ago, as we have seen unemploy- ment come down and capacity utilization go up. Whether we are at that level or not, again, I cannot say. We will be looking at a wide variety of indicators and trying to make a judgment about where the economy should go. Senator ALLARD. In addition to that, wages have gone up, haven't they? Chairman BERNANKE. Nominal wages have gone up, and we have seen some increase in real wages as well, and that is a good devel- opment. Senator ALLARD. Thank you, Mr. Chairman. Chairman DODD. Thank you, Senator. Senator Menendez. Senator MENENDEZ. Thank you, Mr. Chairman. Chairman Bernanke, I want to start where I started off in my opening comments to you. I am very concerned about the economic squeeze that has been put on the middle class, particularly since the turn of the 21st century. Since the beginning of 2001, middle- class families have experienced increased levels of debt, anemic growth in real wages, all the while essential costs for food, housing, 38 and medical services have increased at levels drastically higher than inflation. As a result, the financial security of middle-class households has suffered, and more and more American families are unable to af- ford life emergencies such as an unexpected health problem or un- employment. Employment opportunities are at their lowest level since the Great Depression. Since the recession ended in November 2001, job growth has averaged a mere eight-tenths of a percent per month, less than a third of the 2.7 percent average growth we experienced in previous recovery periods since World War II. For the first time since the 1950's, job opportunities have actually decreased from a 16-percent growth rate in the 1990's to a 14-percent decrease since March 2001. I look at that and I add to that factor that families seems to me to be living on thin ice. I hear these stories of families in New Jer- sey that they are only one unexpected illness or lay-off away from sinking into perpetual debt. I think one measure of this economic insecurity is the percentage of middle-class families who have at least 3 months of their salary in savings. The percentage of middle- class families who had 3 or more months salary in savings rose 72 percent from 16.7 percent in 1992 to 28.8 percent in 2001. So mid- dle-class families are becoming more secure year by year. But, un- fortunately, in the span of less than 4 years, that percentage dropped by over 36 percent, down to 18.3 percent in 2004. Finally, I noted with interest in your written statement, you said, "Consumer spending continues to be the mainstay of the cur- rent economic expansion." That is true, but when you add that re- ality to anemic growth in wages and sharp increases in the cost of necessities, household debt in America has risen to record levels over the past 5 years. By the third quarter of 2006, outstanding household debt was 130 percent relative to disposable income. That means that the average family is in debt of over $130 for every $100 it has to spend. And, additionally, the average household sav- ings rate has actually been negative for the past seven quarters, averaging about a negative 1 percent rate for 2006. So, I look at all of this, and I say to myself, you know, I have my friends and colleagues who are heralding this great economy. I do not get the sense that people back at home and in other parts of the country feel that good about it. You see it in every poll of the barometer of their feelings. They feel really squeezed and really put upon. And so my question to you is: Aren't these indicators a real cause for concern as it relates to the struggle that the middle-class fami- lies in this country are facing? And how do we create an economy that is more inclusive and which the macro benefits end up being achieved by those who are the great center of those who keep this country afloat? Chairman BERNANKE. Senator, in my remarks in Omaha, I did the usual economist's "on the one hand, on the other hand" ap- proach. On the one hand, average living standards in the United States have risen very substantially since World War II—very sub- stantially—and that is true for the majority of the population. Even in the last 10, 15 years, we have seen on average, or even at the 39 median, middle parts of the income distribution, pretty good overall growth, not year-to-year but over a period of time. So there has been a general improvement in living standards, which has affected a very large part of the population. That being said, on the other hand, there are various issues, as I talked about in my remarks, that inequality has increased. We have seen more concerns about job security related to trade and technology. Health care remains a concern. People are concerned if they lose their job they will not be able to afford new health care or move their health care between their existing employer and a potential new employer. You mentioned wealth. Wealth is very unequally distributed in the United States. A big challenge is to help people in the lower part of the wealth distribution begin to save and accumulate assets so they can have some reserve against the kinds of problems you referred to, like a health emergency or unemployment or some other problem that may arise. So my broad answer is that I do think the economy has strength- ened over time and the benefits have been felt by a large part of the population. But there are persistent issues that relate to peo- ple's sense of security or insecurity, and there is no single answer because each of these issues—wealth creation, health care, inequal- ity—are all large issues, and they each require individual atten- tion. Senator MENENDEZ. I appreciate that. It seems to me that the policies both in the taxing side as well as in the incentive side and in the programmatic side that would go to narrow these divisions— you have mentioned education; I certainly agree with you on that. But we have seen educational outcomes rise, and yet we have still seen inequality rise. We have challenges, as it relates to how families achieve health care. We have challenges maybe in policies that incentivize savings and find ways to help that segment of society save. It seems to me that this consumer-driven expansion of the economy at some point at the cost of debt has a consequence to it. And so it is a real con- cern. One last question. In the written version of your remarks to the Chinese Academy of Social Sciences in December, you referred to China's currency policies as "an effective subsidy" for the country's exporting industries. I am just wondering why you omitted that reference in your presentation on December 15? Chairman BERNANKE. I omitted it because I thought at the time that it would be more clear to my audience there in Beijing if I ex- plained it a little bit differently. But I stand by my written com- ment. I think it is accurate. Senator MENENDEZ. Thank you, Mr. Chairman. Chairman DODD. Thank you very much, Senator. Senator Sununu. Senator SUNUNU. Thank you, Mr. Chairman. I want to first begin by going back to a subject that was brought up, and I think inappropriately so, in a discussion about whether you, Chairman Bernanke, should be willing to talk about "policy" before this Committee. As most everyone has noted, you talked about education in your opening statement. And the suggestion 40 was made, by, I think, more than one Senator, that while education is policy and if you talked about education, therefore, you should be willing to talk about policy prescriptions on the tax side, and in particular talk about raising tax rates. And I think a lot of this dis- cussion about income inequality, quite frankly, is a prelude to a policy recommendation from some on the other side of the aisle to raise tax rates on entrepreneurs and individuals in certain income brackets. Well, I think that that sequence of conclusions is just flat wrong because it is entirely appropriate for the Fed Chairman to talk about education as an input, like productivity or technology. Edu- cation and technology affect productivity, productivity affects growth rates, and perhaps inflation. That is entirely appropriate. But it is, of course, not appropriate for Chairman Bernanke to talk about or recommend specific policy prescriptions in the area of education at the State, the Federal, or the local level, spending on a particular program, school vouchers or issues that people on var- ious sides of the aisle might support. So, I think we need to make this distinction. I think it is unfair to the Chairman to suggest that because he talks about the value of education, generally speaking, to the workforce in terms of its flexibility that he should be willing to weigh in on education legis- lation or tax legislation that Members might be writing. I guess that is the opinion piece, and now I will go on to my questions. You noted that growth in the second half of 2006 was 2.75 per- cent. Was that higher or lower than you originally expected, or ex- pected, say, a year prior, a year out? And why was it higher or lower than your expectations? Chairman BERNANKE. It was close to our expectation. Our as- sessment was that the economy was making a transition to a more moderate and sustainable pace, which would be something in that general vicinity. It does look that the fourth quarter GDP growth number is going to be revised down somewhat, and so the actual number will be a bit lower. But probably the implications will be slightly stronger first quarter, so it does not really change the overall picture, which is that we see the economy growing at a healthy pace, but it is one that is sustainable and not overheated. Senator SUNUNU. Thank you, and I want to apologize for not pre- senting the option that you might have been correct in your projec- tion. I suppose that should have been one of the choices. You noted in your testimony that real incomes should continue to rise. At what rate do you project real incomes to rise over the next four to six quarters? Chairman BERNANKE. Well, it depends on what your definition of "income" is. We have seen real wages growing the last half of 2006 by about 3 percent in real terms. I hope to see continued strong growth in real wages. I am not quite sure whether it will be quite that strong, but I think as long as energy prices do not rise quickly again, we should continue to see good growth in real wages. Broader measures of income should grow broadly at the same pace as GDP, and our forecasts are for something between 2.5 and 3 percent. 41 Senator SUNUNU. And when you talk about broader measures of income Chairman BERNANKE. Including capital income and so on. Senator SUNUNU. You talked about the fact that there was a 7- month supply in unsold homes in the third quarter of 2006. Where do you expect that inventory to go in the next 6 to 12 months? Has it peaked or do you expect the inventories to increase further? Chairman BERNANKE. The predicate is that we have seen what we call "tentative signs of stabilization in demand for housing." If, in fact, the demand for housing is stabilizing—and, again, we will not know that for sure, I think, until we see sales figures in the spring—then we should see from here a gradual decline in the months for sale inventory. The normal, at least for the last 8 to 10 years, is 4V2 months of homes for sale, and my anticipation would be that we would get back toward that general level by the end of next year, assuming that demand stabilizes. Senator SUNUNU. By the end of 2008, not the end of 2007. Chairman BERNANKE. Yes, 2008. Senator SUNUNU. The last question. I guess the question is: Please explain this to me. It is one of the charts, and the monetary policy booklet is, I think, very well written and very informative, no surprise there because, as you know, you have very good staff. But there is the graph of the savings rate from 1983 to 2006. From 1983 to 2006, we had two recessions, three bull markets, two market crashes. We had rising and falling deficits. We did have a relatively steady trend in improving employment numbers and a lowering of the rate of unemployment and a fairly strong record of dealing with and containing inflation. And yet the per- sonal savings rate, you know, that chart is a steady downward trend through all of these things. And I am curious to know what the factors are that go into that steady decline in savings rate. We know it means that people are consuming more than they are earn- ing or a greater proportion of what they are earning. But what is contributing to that trend? And is this something that the Fed is worried about? Chairman BERNANKE. Well, you raise a question that a lot of people have weighed in on. It is a complicated question. I think several factors have been pointed to. One is demographics. Dif- ferent cohorts or different generations have different propensities to save. The baby boomers have not been particularly impressive in that respect, and as they have become the biggest recipients of income their savings rates have shown through. Senator SUNUNU. I apologize for interrupting, but has there been an evaluation of the propensities of different cohorts currently? Chairman BERNANKE. Yes. Senator SUNUNU. And how much of this declining savings rate can be attributed to that one cohort? Chairman BERNANKE. Well, there have been a number of papers, and we would be happy to send you a few surveys or summaries of some of the research that has been done. A number of papers have looked at this demographic issue and viewed it as being im- portant, although not necessarily the whole story. The other important part of the story is that personal savings rates are out of current income, and they do not include capital 42 gains of any kind. So the general strength of the stock market and then more recently of the housing market has meant that people could increase their wealth without saving, and that has been, I think, an important factor in leading to a lower savings rate more recently. The other technical point to make is that private saving actually consists of the sum of the household or personal savings together with the savings done by corporations. Savings by corporations has become a larger share of the private saving than overall, and in a sense, the corporations ultimately belong to the households, wheth- er you are a small business owner who is keeping profits in your business or an investor who is enjoying capital gains in stocks. Some of that saving is not appearing in households because it is taking place in corporations. It is a measurement issue. But I think it is an issue because the national savings rate has come down, and it contributes to issues like the current account deficit we have talked about. Our anticipation, as I mentioned in the testimony, is that the household saving rate should rise a bit in the next couple of years partly because housing prices are not rising as fast and people will turn back to saving from their current income. But we do not anticipate anything like the 12 percent in 1985 anytime soon. It is going to be a slow process. Senator SUNUNU. Thank you very much. Thank you, Mr. Chair- man, and I would note, since I am not a member of the baby-boom generation and you are, I look at every possible opportunity to blame something bad on your generation. Thank you. Chairman DODD. Well, you have not proven you are part of the Greatest Generation either yet. [Laughter.] Senator SUNUNU. And I would never make such a claim. Chairman DODD. I was just going to note, I have been on this Committee some 25 years, and I recall with great fondness your predecessor appearing here on numerous occasions, and I cannot recall specifically the Members who may have raised, but the num- ber of times Chairman Greenspan was asked to support specific tax cut policies was rather frequent on the Committee. So this is not a first-time occurrence that a policy question was raised to a Chair- man of the Federal Reserve. Senator SUNUNU. But my point is that he would never answer the question, and that was the right thing to do. Chairman DODD. And I suspect my colleague from New Hamp- shire may have been one of the people to ask those questions. I would just note as well on the savings rate issue here, I am told—and maybe you can correct me on this if I am wrong, Mr. Chairman—that the last time we had a negative savings rate of this magnitude, it was the Great Depression. Is that correct histori- cally? Chairman BERNANKE. I think that is correct. Chairman DODD. Someone mentioned to me the other day as well that, of course, the consumer debt issues are staggering, and at least the revolving debt, a good part of which is probably credit card debt, on the average is around $9,300 per individual. Does that number ring true with you? 43 Chairman BERNANKE. I do not know the number for revolving debt specifically. The incidence of debt issues varies quite a bit across the population. For a good bit of the population, particularly those of higher incomes, there has been asset accumulation which offsets the debt. Chairman DODD. Right. Chairman BERNANKE. SO, in particular, over the economy as a whole, the average loan-to-value ratio for homes is about 50 per- cent. That is, the mortgage companies own half the housing stock and the public owns half the housing stock. But there are certainly segments of the population who are facing very high debt loads, ei- ther through their mortgage borrowing or through credit card re- volving debt, and for them it is obviously a hardship. Chairman DODD. Thanks very much. Senator Tester. Senator TESTER. Yes, Mr. Chairman, I do have questions, and I do hope to ask them, but my comrade Senator Brown has a com- mitment, and I will defer to him for now. Chairman DODD. Thank you. Senator BROWN. I thank my friend from Montana. Thank you, Senator Tester. Chairman Bernanke, in your remarks last week in Omaha, you noted that our policy responses to economic inequality must be in- formed by our ethics and our values and are ultimately political questions. You said a moment ago that inflation was the canary in the mine. I have for 5 or 6 years worn a depiction of a canary in a cage on my lapel to signify the Government's role in everything from mine safety to the environment to minimum wage to Medi- care. You also expressed—and I think that the ethics and values in our domestic economy, I think those ethics and values are reflected in what we do in our domestic economy, like the canary in the cage. It is minimum wage and it is Medicare and it is Social Secu- rity, and it is helping the middle class thrive, as it has done in the last 100 years. And there has been clearly a consensus in this country, differences on the edges perhaps, but a consensus that those ethics and values drive what we do in our domestic economy. It seems to me those values and ethics do not stop at the water's edge, that as a Nation we should continue to propagate and pro- mote those same ethics and values as we have done in our country in our domestic policies and our domestic economic issues. We should look at those internationally. I know you expressed concern that inhibiting trade flows would do more harm than good, but I would argue that if our country is, in fact, going to live its values and going to live the ethics that we discuss and that we sometimes pat ourselves on the back about, we would look internationally in some of those cases. I would just start by asking if—we have as a Nation our values say that we should not buy products manufactured by slave labor in China. Do you agree with that? Chairman BERNANKE. Absolutely. Senator BROWN. Okay. And would you say then that we should not import products made by child labor. Chairman BERNANKE. Yes. I agree that we should not. 44 Senator BROWN. Okay. Then I guess that would be—the next step would be we should not import products produced in sweat- shops, if we, in fact, can agree on a workable definition of "sweat- shops." Chairman BERNANKE. Well, that is a very difficult qualification you just added at the end. Just to get where you are going, I think it is probably not a good idea to try to enforce Western-level stand- ards of worker benefits in emerging market countries. Since those workers have such low productivity, if we were to insist on the same standards we have in the United States in terms of benefits and the like, the workers would either have very low wages or no job at all. I think the way to get to the kinds of living standards we have in America is to allow people to participate in the market and to produce. We in the United States, of course, have come a long way, start- ing from situations where workers did not have very good protec- tions to a situation now where we have much better protections. Senator BROWN. But, Mr. Chairman, if I could, we also did not have a foreign government implanting on us an economic structure with foreign investment and that international economic structure. Let me take this in a little bit different direction. I agree we should not impose—we should not have imposed under NAFTA or CAFTA minimum wage—the minimum wage that we have in the United States, of course, we should not have imposed it in Guate- mala. But these are not Western—when you talk about Inter- national Labor Organization standards, that is an arm of the United Nations, I believe, and that is not Western economic stand- ards. Does that mean then you would support, if you were looking more internationally, would you support International Labor Orga- nization standards in these trade agreements that we negotiate? Chairman BERNANKE. I believe those standards come in many different levels, and there are literally hundreds of them. Senator BROWN. There are five central International Labor Orga- nization provisions and standards, there are questions within those, but the right to organize and bargain collectively, the prohi- bition on forced labor, the prohibition on child labor, those kinds of general standards that we have not—we did in the Jordan Trade Agreement, but we have not in the last 6 or 7 years. Is that a pol- icy question reflecting our ethics and values that we should pur- sue? Chairman BERNANKE. I think it is. I think it would be reasonable to look to basic human rights, such as slave labor and forced labor. I think those are not something we want to countenance. When it becomes a question of whether we should require minimum wage, for example, it is a much difficult issue, and Senator BROWN. That is not one of the ILO standards. Chairman BERNANKE. Okay. Senator BROWN. Okay. Fair enough. Let me shift for a moment to industrial loan companies briefly. As you know, the FDIC has extended for 1 year a moratorium on commercial firms like Wal-Mart owning a bank through and ILC charter. This Committee and this Congress have just a short time—a year—to address the important issues involved before the 45 moratorium expires. Do you have any concerns on the uneven regu- latory structure between banks and what perhaps would be an un- limited number of commercial firms owning ILC's? Chairman BERNANKE. The Federal Reserve is concerned about an unlimited expansion of the industrial loan company exception. We have two particular concerns, which we have talked about on a number of occasions. First is the mixing of banking and commerce. The Congress in Gramm-Leach-Bliley and other contexts has ex- pressed its desire to keep banking and commerce separated. I agree with that, and I think that is an issue for the Wal-Mart acquisi- tion, for example. The other concern is about consolidated supervision. If there is an acquisition of an ILC by either a commercial or noncommercial firm, I think it is important that the oversight of that combined en- tity be done at the higher level to ensure that there is sufficient financial strength in the holding company to ensure the safety of the deposit insurance funds for the ILC itself. So those two principles are important to keep in mind as we de- bate this question. Senator BROWN. Thank you. And, Chairman Dodd, Senator Johnson as you know has been very involved in the ILC issue. Chairman DODD. Right. Senator BROWN. And we clearly in this Committee need to pur- sue that. Thank you, Senator Tester, very much. Chairman DODD. Thank you very much, and I am sorry Senator Bennett was not here to engage. I know he has some strong inter- est in this subject matter. I was going to give you the opportunity— and I thank Senator Brown for raising the question—there has been some issue about whether or not this is—tough issues have been raised, and I want to give you a chance to respond to this. Some have suggested that the reason the Fed has taken the posi- tion it has is because it is an area of jurisdiction that they like to have. I think I know the answer to this question, but what is your re- sponse to that particular concern? Chairman BERNANKE. If the ILC exemption is limited and not al- lowed to expand indefinitely, we are perfectly comfortable with the FDIC doing the consolidated supervision, and we think they do a very good job. Chairman DODD. Thank you, Mr. Chairman, very much. Senator Crapo. Senator CRAPO. Thank you very much, Mr. Chairman. And Chairman Bernanke, we appreciate you being here with us. I want to return to the global competitiveness issue for a minute. I know that others have spoken to you about this already. First and foremost, I want to commend Senator Schumer for working with Mayor Bloomberg for the McKenzie report. There is also, as you know, the new interim report of the Committee on Capital Markets Regulation, and both of those reports I think add signifi- cantly to this debate and to the issue. I am working on a resolu- tion, and talking with Senator Schumer about it as well, and hope to be working with him on a resolution to help highlight this and 46 to express the sense of the Senate about what steps we need to take in terms of better dealing with our global competitiveness. Now what I want to focus my questioning on with you is deriva- tives and hedge funds. I will start by noting that in the McKenzie report this following quote occurs. London already enjoys clear leadership in the fast-growing and innovative over- the-counter derivatives market. This is significant because of the trading flow that surrounds derivative markets and because of the innovation these markets drive, both of which are key competitive factors for financial centers. Dealers and investors increasingly see derivatives and cash markets as interchangeable, and are therefore combining trading operations for both products. Indeed, the derivatives markets can be more liquid than the underlying cash markets. Therefore, as London takes the global lead in derivatives, America's competitiveness in both cash and derivatives flow trading is at risk, as is its position as a center for financial innovation. Would you agree with that portion of the McKenzie report? Chairman BERNANKE. I agree that derivatives are an incredibly important part of our expanding financial market, part of financial innovation, and I would like to see the United States remain com- petitive in those areas. Senator CRAPO. SO you think it would be appropriate for us to focus in this Congress on things that we can do or not do to assure that we remain competitive or that we become more competitive in those arenas? Chairman BERNANKE. Again, I think the best way to be competi- tive is to make sure that the regulatory structure has a minimal costs as needed to justify the benefits that are seen to be obtained from those regulations. Senator CRAPO. One of the common themes that we are seeing in terms of the movement of business away from the United States to London and other capital markets is just that, the regulatory burdens and the regulatory regime that we impose here in the United States. I do not think anybody would say that we should simply take down our regulatory position, because we do have one of the strongest markets in the world. But the question is, are we over-regulating. I want to go specifically to an issue that you and I have talked about many times before, and that is the regulation of energy de- rivatives. As you know, we have faced proposals in Congress and the Senate now for the last 4 or 5 years to increase the regulatory climate around the handling of energy derivatives. There has yet been another bill introduced just yesterday or day I think, to do the same thing, so we are back into the same issue. You have expressed a position on this in the past. I have in front of me the last letter that was put out by the President's Working Group, of which you are a member. The last paragraph of that let- ter says, "several times in recent years the PWG has been asked for its views on various legislative proposals to expand regulation of energy derivatives. Most recently, in testimony before the Senate Banking Committee on September 8, 2005 representatives of the PWG agencies reaffirmed the position of the PWG that additional regulation of energy derivatives is not warranted." Is that still the position of the PWG, and is it still your position that we do not need to further increase the regulatory regime sur- rounding energy derivatives? 47 Chairman BERNANKE. The PWG has not discussed it recently but I have no reason to think the position has changed. I believe it is a reasonable position, that we should be very careful about adding additional regulatory costs in this market. There are two reasons to regulate. Potentially one is investor protection. But in this mar- ket, of course, we have very large institutions, very sophisticated institutions who are, I think, able to take care of themselves. The other would be a concern about price manipulation. There the CFTC does have, of course, ex post powers to investigate poten- tial frauds or manipulation. But it seems unlikely that manipula- tion in most cases would come from the OTC markets since the ex- changes provide a good venue for determining prices. So, I have not changed the position I expressed before. Senator CRAPO. Thank you. I appreciate you sharing that with us. I suspect that we will be asking the entire PWG to reevaluate this issue since we now have legislation yet again introduced on the issue. So, I would just give you that advance warning that we will be coming to you for some guidance as we once more enter into this debate. Just one last question; moving a little bit to hedge funds. Can you explain what is involved in fostering market discipline in the hedge fund context? It is my understanding that you believe that that is a superior approach to direct regulation. Chairman BERNANKE. That is correct, Senator. The proposal of the President's Working Group, once again, in their report following the LTCM crisis focused on the so-called "in- direct" or market-based regulation of hedge funds. That has essen- tially two components. The first is through the counterparties, that is, the investment banks or the banks, who lend money to the hedge funds or serve as their prime brokers. The supervision proc- ess requires that these large counterparties manage their counterparty risk effectively, that is, that they have good informa- tion about the risks being taken by the hedge funds, their financial positions, and so on. And it is both in the interest of those counterparties, obviously, since they do not want to lose money, that they pay close attention to what their counterparties are doing, and the supervisors give additional encouragement, incen- tive, for the counterparties to manage those risks effectively. The other type of counterparty is the investor itself, particularly large institutions like endowments or insurance companies and the like, which also provide a good bit of market discipline on the hedge funds by gathering information as they make their invest- ment decisions. So we believe that is a very important, and so far, successful method of overseeing hedge funds. I would be very reluctant to get involved in heavy-handed direct regulation of hedge funds. They are a very diverse group of institutions. They have a wide variety of strategies, and one of their key characteristics is that they are very nimble. They change very quickly. And that is good for the economy because they help to create more liquidity in markets, they help to spread risks around more broadly. A regulatory regime that inhibited that flexibility and nimbleness would eliminate a lot of the economic benefits of the hedge funds and the other types of 48 private pools of capital that use sophisticated instruments to share risk. That being said, it is always useful for regulators and super- visors to keep abreast of what is happening in the hedge fund mar- ket, to speak to hedge fund managers, to understand recent devel- opments. The G-7 meeting which I attended over the weekend, in the spir- it of information gathering, proposed that the Financial Stability Forum, which is an international group consisting of central bank- ers and supervisors, update a report they did in 2000 about the status of this market. I think that is consistent with us simply try- ing to keep up our information base that we know enough so that we are keeping up with developments in that industry. Senator CRAPO. Thank you very much, Mr. Chairman. I want to just say, personally, I appreciate your candor and the candor that we get from the President's Working Group as we face these kinds of issues. The expertise that you and the other members of the working group can bring to the issue to help us evaluate them is invaluable, so thank you for providing that. Chairman DODD. Those are great questions, Senator. I appreciate you raising them as well. Very well done. Senator Tester. Senator TESTER. Thank you, Mr. Chairman. I also want to thank Chairman Bernanke for being here today and being forthright in your answers. It is very nice. The reason I want to stick around and ask these questions, quite frankly, is because I value your opinion. It is not for political rea- sons. It is not for anything other than I want to know your perspec- tive. Because quite frankly, from my perspective of being a farmer in North Central Montana, there is a lot of things that are just flat backward in this country right now. So the first question I wanted to ask is what is the number one factor that concerns you as a potential impediment for our eco- nomic growth here in this country? Chairman BERNANKE. Well, over the medium-term, it is the de- mographic transition that we are going through. We are getting older, our society is aging. We are going to have a much larger share of the population in retirement age, or even in the oldest of the old, 80 and 90 years old. And we have not really made good preparation for that, either in terms of broader savings in the soci- ety, or in terms of fiscal policy, which I have discussed in previous context. Senator TESTER. Does the $8.6 trillion debt fall into that issue then? Or is that somewhere else? Chairman BERNANKE. Well, it is closely related because if we do not take some measures to address how we are going to deal with the fiscal implications of an aging society, the debt and deficits are going to grow, interest payments on those debt and deficits are going to grow, and we will be in an unsustainable fiscal situation. So the fiscal picture is closely linked to the underlying demo- graphic changes that are going on. Senator TESTER. I have had a tough time struggling with, be- cause quite frankly tax load is something I am very concerned 49 about, too, as I think everybody on this Committee is. But the debt load concerns me, too, very much. Could you rank them as what could be the most severe impedi- ment? Is it the debt load or is it tax policy that is flawed? Chairman BERNANKE. I do not think I can rank those. The main concern would be that Congress has to decide how big the Govern- ment is going to be and what share of national resources are going to flow through the Government, either for Government spending or through entitlement programs. The tax collections need to be commensurate with that, and that is the main decision. I am not qualified or in a position to tell you how big that share should be. Senator TESTER. Foreign investment. I hear occasionally on TV, I hear from some of my constituents in Montana, that those people that are able to save some dough are being encouraged to put a certain percentage—I think 20, 25 percent is what I am hearing— into foreign markets. Is that a concern? Chairman BERNANKE. NO, not necessarily. Foreign markets have strengthened considerably in terms of their quality. Clearly, the world is experiencing a lot of growth and so there are a lot of op- portunities out there. By investing broadly, an investor diversifies his or her portfolio and reduces the overall risk that they face. Senator TESTER. HOW about from an economic growth standpoint here in this country? I think from an investor standpoint, I hear you. But what about an economic growth standpoint here? Is it a negative factor, positive factor, or no impact? Chairman BERNANKE. I think it is probably slightly positive in the sense that it gives American investors greater diversification. And implicit in your question is where do we get the funds for do- mestic investment? Well, they flow in from abroad. And so by swapping essentially between foreign and domestic in- vestors, you get better diversification for everybody. Senator TESTER. Sounds good. Last question, and this deals with employment versus inflation. It has been talked about here a lot today, but when we get near full employment, does that necessarily drive inflation up? Chairman BERNANKE. There is no specific level of employment or unemployment that is a trigger, in some sense, for inflation. The main concern is to make sure that the overall spending in the econ- omy, which is driven in turn by financial conditions, does not ex- ceed the underlying productive capacity for a sustained period. That seems to generate inflation. But as I have mentioned a couple of times, it is not easy to deter- mine exactly where that balance should be struck. And simply look- ing at the unemployment rate, for example, is not going to tell you. You need to look at a wide variety of indicators, including price in- dicators, to get a sense of when the economy is overheating and when it is more or less in balance. Senator TESTER. That is great. And that is actually what I was hoping to hear. So we should be continuing to strive to make employment com- plete, full to the best of our ability? Chairman BERNANKE. Certainly. The Federal Reserve has a mandate for maximum sustainable employment, and we want to 50 achieve that. We do not want to achieve employment which is high for a short moment but then crashes. Senator TESTER. NO. Chairman BERNANKE. We want something that is sustainable. Senator TESTER. Exactly. Once again I just want to go back, thank you, Mr. Chairman. I think this has been a great hearing. And I want to thank you, Chairman, for your honest forthright answers. Thank you very much. Chairman DODD. Thank you, Senator Tester. Very good. Senator Reed. Senator REED. Thank you very much, Mr. Chairman. Again, thank you, Chairman Bernanke, for your testimony. I was very impressed, as so many of my colleagues were, with your speech in Omaha. I thought it was thoughtful, comprehensive, and balanced, which is typical of your leadership at the Fed. At least one phrase or section struck me as interesting and that is you talked not only about technological change and international trade as causing this divergence between equality of incomes. But you also talked about institutional arrangements. The principal one you alluded to was labor unions. You say in your speech whatever the precise mechanism through which lower rates of unionization affected the wage structure, the available research suggests that it can explain between 10 percent and 20 percent of the rise in wage inequality among men during the 1970's and 1980's. I would suspect if it is 10 percent and 20 percent in the 1970's and 1980's, it is at least that now, perhaps more, since unions have declined since that period of time. And it begs the question is one of the responses to wage inequal- ity a more robust representation in the labor unions in the United States. Chairman BERNANKE. It is difficult to know the answer because, as I indicated in my remarks, there have also been structural changes—like changes in the share of manufacturing employment in the economy as a whole—which have affected the rate of union- ization. It is a little hard to tell whether it is the decline of union- ization itself or the structural reasons for that that are the causes of the inequality. I do think that if workers want to be represented by a union, of course, they should be allowed to do that. Senator REED. One of the issues here is that this is not just the hidden hand of the marketplace and technological change. There is Government policies. Policies which, until recently, one might say favored more, encouraged more participation in unions. Policies pursued by this Administration seem to go against it. The National Labor Relations Board, court decisions, Congressional activities. So this is an area, too, I think, that should be on the table, I pre- sume, in terms of at least consideration by the Congress, if we are really concerned about narrowing this gap in terms of the economic equality. Is that a fair statement? Chairman BERNANKE. Well, again, there is the problem of decid- ing how much of the effect comes from the structural changes that underlie the changes in unionization patterns and how much comes 51 from changes in unionization propensity itself. So, I do not really know how much effect that would have. Senator REED. Well, I think you have opened up a very serious line of inquiry, and I applaud you for doing that. Because once again, I think this is an issue that is there. And maybe anecdotally, I grew up in a State where everyone seemed to be in a union and they seemed to make pretty good wages and had health benefits. And now that is declining dramati- cally. And that, I think, contributes to this anxiety we have all re- ferred to. Today, of course, I alluded in my opening statement, 13,000 workers from Chrysler presumably—I would guess with some sense of probability that they are union workers—are losing their jobs and probably will not find union employment again. So, I think this is something we should consider. Again, I think mentioning it in your speech opens up a line of inquiry that is important. There is another issue, too, that you talked about and we all talk about the average income being stagnant for many working Ameri- cans. There is something else that I am hearing, is that the vola- tility of incomes for individual Americans fluctuates so wildly and causes huge problems. You could be a vice president for sales in a jewelry manufacturing company in Rhode Island making a hand- some salary of $100,000. The next year you are making $35,000 be- cause you are working at a lumber yard. That seems to be more common these days. And again, it gets lost in the aggregate, but for individuals we have to do something. Do you have any first thoughts about this phenomenon? Chairman BERNANKE. Well, it is an issue that has been raised by Mr. Hacker and others, and I have a footnote in my speech about some of the impact it might have on measures of inequality. It is a little bit mysterious exactly what the source of this is. It could be more or less benign things, like job changes and so on. It could be less benign things like periods of unemployment or health problems. There does not seem to be an increase in this pattern. The 1990's, if anything, seemed a little bit less volatile in that respect. There is no data that I know of for the most recent years. So it is a little bit of a black box, a little bit not clear what policy implica- tions of that volatility should be. Senator REED. By the way, anyone who has footnotes to his speeches should be commended, so you are commended on that. Is this an area of inquiry, though, that you intend to pursue at the Federal Reserve, in terms of this volatility as well as the aggre- gate income levels? Chairman BERNANKE. We looked at that in preparing the speech and we did discuss it. And we were not, again, able to come to a strong conclusion about what the policy implications might be, and so we did not highlight it in the remarks. Senator REED. I know that you are—and I think you do this very well—wary of making endorsements of particularly policies. But in your speech you did allude to some policies that should be consid- ered. 52 So in the spirit of what we should be considering, you talk about portability of health and pension benefits as one area. There are other areas, for example wage insurance proposals that have been made. Again, rather than taking a position, is that something that we should be considering? Chairman BERNANKE. The general principle I was trying to ad- dress was the insecurity the people feel about job loss and job change. And I think it would be beneficial if we could reduce that insecurity. One way to do that would be to increase portability of benefits across jobs. There are many ways to do that, so I am not taking a specific means. Wage insurance is an interesting idea that has been advocated by a number of economists. Again, I am not sure I can take a specific position on it. One of the things I said, and I should reiterate, is that it is easy enough for me to say we should address these issues. The actual implementation is quite difficult. These are very complex problems. I just urge Congress to look at them and try to get as much good input and advice as they can in thinking about how to best address these issues. Senator REED. A final issue, which is the Earned Income Tax Credit, which seems to me to be a very efficient way to deal with this issue that has been the constant source of our discussions this morning, inequality of wages, inequality of opportunity. Is that something that we should be looking at seriously, to expand it? Chairman BERNANKE. Well, I was asked in the past about the minimum wage and, at that time, I said the Earned Income Tax Credit had some advantages compared to the minimum wage and that it was better targeted to the poor, to lower income people. And I still believe that to be the case. Of course, it does not come without cost. But I think it does have some advantages. Senator REED. Thank you very much, Mr. Chairman. Thank you. Chairman DODD. Thank you. Senator Carper. Senator CARPER. Chairman Bernanke, I would like to say that we saved the best to the last. That is probably not true, but I might be the last. And for you, that is probably blessed relief. Thanks for coming today. Thanks for sharing your thoughts with all of us, and responding to our questions. Senator Reed mentioned an announcement earlier today by DaimlerChrysler, that they are taking steps to cut their work force, it sounds like, by as much as 13,000 across the country. Sometimes we listen to those announcements and they do not strike very close to home. In our case, in Delaware, they do. We have a DaimlerChrysler assembly plant we have had for over 50 years in Newark, Delaware, close to the university. And so this one is one that is troubling to us. Having said that, I want to ask you a question. I telegraphed my pitch. And then I want to say a couple of other things. I am going to come back and talk to and raise an issue that the leaders of the big three—GM, Ford, and Chrysler—raised with President Bush 2 months ago when they came to Washington. 53 Among the concerns that they raised was concerns about whether or not the Japanese are manipulating their currency in order to make their products more competitive in this country. So that is where I am going with this. But with respect to our own State, we build all of the Dodge Du- rangos and Chrysler Aspens in our plant. We have a reputation for doing a good job, and have had for a long time. About 14 years ago, literally the month I was elected Governor of Delaware in Novem- ber 1992, our friends at General Motors announced that they were going to close their assembly plant in Wilmington, Delaware, along with a bunch of other plants, assembly plants and parts plants, across the country. They ended up closing, I think, just about all of them except this one in Wilmington, Delaware. It is one of two auto assembly plants that is still operating on the East Coast. I think the Ford Taurus plant down in Norfolk is going to close fairly soon. Then there will just be two plants, and one is the GM plant in our State. The other is the DaimlerChrysler plant. Our friends at DaimlerChrysler have announced today that they were going to go back to one shift at our plant in Newark. They are going to prepare to idle the plant at the end of 2009 if they do not have a new product for the plant then, then the plant might close, which is worrisome to us all. But we have seen this movie before and we did not just wait for the inevitable to happen. We fought very hard to make sure that it did not happen. The workers at GM, the labor and the manage- ment people, did a great job. I hope the State did, as well. And we averted what could have been a bad situation, not there is a very successful operation there. There are a number of things, I think, that can be done. This question relates to how do we revitalize manufacturing in our coun- try, particularly auto manufacturing, which I hope we can do and think we ought to. But there are a number of things, in my own view, that can be done and should be done. I will just start with Chrysler, and then I am leading up to monetary policy. The people at Chrysler, they have to make vehicles that people want to buy. They have to make vehicles that are energy efficient, environmentally friendly, have good quality. The people at Chrys- ler, they have to go to what Toyota has done very well, flexible manufacturing where the people at Toyota make maybe three or four vehicles at a plant. And if the demand for product A is strong- er than B, they make more A. If product C gets hot, they make more C. They usually have a fourth vehicle that is a pilot vehicle that they are getting ready to develop and to sell when it is time to launch it on the market. So there is a lot of things that DaimlerChrysler can do. Those are some. There are things that we can do at the local level, in Delaware or any other State that is affected by announcements by this. You could take a page from what happened at our GM plant. It is being more committed to quality, more committed to productivity, more committed to good labor management relations, more committed to innovation, and willing to work and think outside the box. We did that 14 years ago and we need to do that again here, at our New- ark plant. 54 The State can work even harder to provide a nurturing environ- ment for manufacturing jobs. There is a lot that we have done and there is more than can still be done. And at the Federal level, and I am finally coming to my question to you, but at the Federal level we do a fair amount with R&D. The President has proposed, in his budget, significant investments in research and development with respect to new battery technology, these lithium ion batteries that can be used to plug in hybrid vehi- cles, flex fuel/plug-in hybrid vehicles, which I think is a very prom- ising technology. We have an opportunity to use the Government's purchasing power on the civilian side and on the defense side, to help commer- cialize technologies that have a great deal of promise, whether they are variable fuel, flex fuel, plug-in hybrids, or next generation hy- brids or low emission diesel. We have tax credits in our law. We have a tax credit for people who buy highly energy efficient hybrids and it caps out at 60,000. After 60,000 units have been sold by a manufacturer, I think that tax credit begins to go away. But until it does, there is a tax credit that can incentivize people to buy high energy efficient hybrids. We have a mirror tax credit that not many people know about but they are going to be learning about, that works on the diesel side, highly energy efficient low-emission diesel, which DaimlerChrysler is beginning to bring onto the roads here, also qualifies for a similar tax credit. We can do better work on the health care costs, harnessing infor- mation technology, and all kinds of things to work on the health care side. Those are things for the people at DaimlerChrysler to do, State and local, at the plants themselves that are put here in harm's way. And there are opportunities for us at the Federal level. Now to you. The people who run these three companies—GM, Ford, and Chrysler—suggested to the President that the Japanese were manipulating the currency. Secretary Paulson was there, he pushed back and said no, in fact, we talked about this here in the last month. And he said no, I do not think they are. Maybe they were at one time, but we do not think they are today. There was a time not long ago when the Japanese economy was in such a fund, they were going through deflation. And we wanted them to take strong actions to change that. But fast-forwarding to the present, what is going on? Are these concerns or allegations, are they baseless? Is there some basis to them? Is this something that we should be mindful of, concerned about, do something about? Chairman BERNANKE. The Treasury and the Federal Reserve have expressed the view that exchange rates should be determined in free and open markets. As best as we can tell, the yen's value is being determined in a free, open, and competitive market. There is no evidence of any intervention going on. The last time the Japa- nese purchased dollars was in March 2004. The behavior of the yen appears to be consistent with the mone- tary policies they are conducting which, in turn, are closely related to the state of their domestic economy. So we do not see any ma- nipulation or intervention in the value of the yen. Senator CARPER. HOW would we know if they were doing it? 55 Chairman BERNANKE. We can see it, for example, in the case of China where there is a very closely managed exchange rate. It moves very slowly and there are large capital inflows. In order to maintain the yuan within the range that they are trying to achieve, they have to acquire huge amounts of reserves and they have to sterilize the effects of those reserves on the domestic money supply. And so there is a very clear type of behavior that we can see. Now it is true that there are many factors that affect the value of a currency. But to my knowledge there are no overt interven- tions or any such factors affecting the yen at this time. Senator CARPER. My last, if I could, just in closing. If you are giv- ing advice to domestic auto manufacturers on what to do to regain market share to return to profitability, what are some of the steps that you would suggest that they and we take? Chairman BERNANKE. YOU made a number of good points. One of them, I think, is R&D. It is not really true that U.S. manufac- turing is disappearing. That is not the case. The output of U.S. manufacturing has grown more quickly than almost any other in- dustrial country in the last 10 years and it has been supported by enormous increases in productivity, which is one of the reasons why we need fewer and fewer workers. But the output continues to rise. The other feature of U.S. manufacturing is that it has shifted very much from lower tech type production to the most high tech type production. We see that in airplane exports and sophisticated capital equipment, medical equipment, silicon chips and so on, things that we currently export. And indeed, one more point, one effect of that has been that the demand for labor and manufacturing has shifted very dramatically from low-skilled workers to the highest skilled workers. One of the things that has really supported those successful areas of manufacturing has been our leadership in R&D and tech- nology. The Government can support that in various ways. Among them, helping to support basic research, which may not be in the interest of" any specific company to undertake on its own, but with Government assistance or Government coordination the industry as a whole can undertake and find, in the case of automobiles, new fuel efficient technologies, for example, or other changes that make the cars more attractive. Senator CARPER. Mr. Chairman, you have been good with your time. Thank you, Chairman Bernanke. Thank you, Mr. Chairman. Chairman DODD. Thank you. Senator CARPER. That is probably good advice, not just for auto manufacturers, but for people running for President. Chairman DODD. Or any office, for that matter. Senator CARPER. There you go. Thank you. Chairman DODD. The basic research point is an excellent one. I do not have the numbers on the top of my head here, but the de- cline of the U.S. Government's commitment to basic research has dropped precipitously. I think over the last number of years, it is not something that has occurred in the last couple of years. I am pleased to hear you say that. That is something we do not pay enough attention to, and how much we have benefitted over the 56 years for applied research to live off the basic research commit- ments we have made in the past, so it is worthwhile. If I can, Mr. Chairman, just a couple of points I wanted to raise with you, and I thank my colleague from Delaware for his com- ments. Just a couple of cleanup things. I mentioned earlier, the issue we had in the hearings on the predatory lending issue. We did not bring up GSE's today. My col- league from Delaware has a strong interest, as I do. And we are going to move fairly quickly here on a Senate bill. It is an impor- tant issue. Although I think things are in pretty good control. It is not as if there is some immediate threat out there. There are a number of things we need to be doing and we intend to move in that direc- tion. One of the things I wanted to raise with you, because with Fannie Mae and Freddie Mac, is the purchasing of some of these ARM's that are pretty abusive. Understand in these things, the broker and the bank is out of it pretty quickly, 10 to 12 weeks. These things are bundled and then go off and are securitized. And the fact that Fannie and Freddie are purchasing these at a pretty high standard, AA or AAA, whatever the standard is they are applying to them, concerns me in a sense. One good way to begin to try and reverse some of these practices, in addition to what regulators may be able to do, is to have some different re- quirements here in terms of the securitization of these products. I wonder if you have any comment on that at all you care to share. Chairman BERNANKE. I am not quite sure about how one distin- guishes so-called "legitimate ARM products" from those which may be less legitimate. If you could do so, then that would be a direction to go. I think more broadly that it would be a good thing for the GSE portfolios to be more consistent with their housing mission. Accord- ing to OFHEO, the GSE portfolios are only 30 percent related to affordable housing. The rest is all different other kinds of things. So to match their mission with their portfolios would be, I think, very desirable. The specific suggestion you make might be feasible, but it would require some way of determining which types of loans are to be ac- ceptable or not. Chairman DODD. I just wanted to raise that point with you. Let me come back, if I can, to the points that Senator Carper was raising about trade and foreign governments. It was reported yes- terday, you have heard this again from some other colleagues this morning, that our trade deficit has now reached a record $763 bil- lion last year. That is the fifth straight year that we have had a record trade deficit. The Wall Street Journal reported, "Following yesterday's report, economists on Wall Street said the Government, later this month, would likely lower its final growth estimate sharply for the fourth quarter." In order to finance our trade budget and current account deficits, we are required to have an influx of something in the neighborhood of a little less than $2.5 billion of foreign capital on a daily basis, 57 as I am told. Now some have argued that this is all right and it is no great threat because it is coming from the private investors offshore. But in your report the Fed states, "On net private foreigners pur- chased few U.S. treasuries." The obvious question is then it is governments who appear to be buying them. I put that in the form of a question. I should not make the statement. Is it your conclusion that the decline in pri- vate investors here, it is governments then that are purchasing this? Chairman BERNANKE. Are you referring to private foreign inves- tors or private domestic? Chairman DODD. Yes, private foreign investors. Chairman BERNANKE. Private foreign investors are still holding significant U.S. assets, but it is true that acquisition of treasuries and other fixed income instruments for the purposes of foreign re- serves are an important component of the in-flow. Chairman DODD. The end of the line was, in fact, that foreign di- rect investment flows in the United States remains robust. So again, it is that public commitment that we are relying on at this particular junction. So it is not so much the private foreign inves- tor, it is the governmental investor that we are Chairman BERNANKE. We can send you some numbers. It de- pends on the instrument. Foreign private investors are more likely to buy equities, for example, than central banks. Chairman DODD. Going back to the issues raised earlier about China, and again the question is a good question Senator Carper was raising. He talks about the yen and I think you had—and I agree with your answer on the yen, based on what I have known. It is troubling, to some degree. We have the cost like a health care cost, I think at a GM automobile, is $1,500. I think someone has made that conclusion. At Toyota, it is $150. So in addition to what other factors may exist out there, we have some built-in costs that I think have contributed to the lack of com- petitiveness, in some cases, in our American-produced automobiles. But there is an issue of China's manipulation of their currency. What would recommend, if anything at all? I accept the fact that they are getting better. And I heard you say that is the case. But we get this all the time. When Senator Carper and I go back to our constituencies, one of the first questions that come up, if we get into any discussion of economics at all, is this issue. I am just won- dering if we are not doing enough or there is something else we could be doing to take what you have said here and call it what it is. I agree with you, it is manipulation of their currency. There is no question about it. Then what do we do about that? How do we respond to this? Chairman BERNANKE. Senator, I did not use the word manipula- tion. Chairman DODD. I thought I heard you say that? Chairman BERNANKE. NO, sir. If I did, it was a mistake. Chairman DODD. I tried. Chairman BERNANKE. I think a point to make, and this is, to some extent, recognized in Secretary Paulson's Strategic Economic dialogue, is that while the exchange rate is a very important issue 58 and one that we are continuing to press China on, we have many, many other issues of mutual concern in economics. Just to talk specifically about the trade balance, another dimen- sion besides the exchange rate is whether China can become more reliant on its own domestic demand, its own consumption spending as a source of growth, rather than relying on exports to the United States. I think it is somewhat encouraging that the Chinese have offi- cially recognized the problem of a growing trade surplus and both the economic and political risks that that poses. They have pro- posed a plan for trying to increase domestic consumption which, over time, should reduce the reliance of China on exports. It should reduce their trade surplus. So there are some other measures that they are taking, albeit ones that will take some time to work. But again, rather than putting everything on that particular issue of the exchange rate, we should also note that we have com- mon interests with the Chinese on matters of the environment, for example, on matters of energy, trade and investment, and immigra- tion and visas. So, I would hope that while we continue to press China to make progress on this very important issue of the exchange rate, it is not exclusive of all the other very important issues that we have in common and that we could collectively benefit from if we were to work with the Chinese to come to better arrangements than we have. Chairman DODD. I appreciate that. Again, I know you appreciate the concerns we hear about and using your language in China, the subsidy notion here. And clearly, when you have lost your job be- cause the company you work for can no longer compete because your competitor is able to adjust that currency to such an extent that it causes your job to disappear, that level of frustration is be- yond just an intellectual exercise. If you are walking home that night to face your family because there is no longer the job there, and what it means. I want to return last, if I can, to one point. Again, your candor has been terrific and your comments. The quote that Jack Reed raised in your Omaha speech, where too often this discussion about unionization falls on an ideological fault line. And I appreciate im- mensely here that you talked about it based on just data here, rather than drawing conclusions about whether you like or dislike unions. But the important role they played, in terms historically of clos- ing income gaps. This is not the first time we are talking about in- come gaps. In fact, income gaps were far more pronounced during the early part of the 20th century. And what I read from your quote here is that, and I will ask the question here in a sense. You talk about these numbers back in the 1970's and 1980's, and I presume even earlier, some of those in- come gaps that closed up, you attribute to the fact that there was the ability of people to organize and to negotiate for better wages and working conditions for themselves. I wonder if you might just expound on that a little bit, without getting involved in the ideological discussion. I am not asking you to do that. But it is a very important point, I think, as those of us 59 try to assist in this effort of closing that gap, to realize how impor- tant that particular element can play in making it possible for peo- ple to move up that economic ladder. Chairman BERNANKE. I was reporting some research, which I think is good research. Chairman DODD. I know you were. Chairman BERNANKE. Again, I think that workers who wish to be represented by unions have every right to do, and we should not block that in any way. We should give them the opportunities to do that. The implications of unionization for income equality or inequal- ity, as I indicated before, are a bit difficult to tease out because there have been changes in union rates. But there have also been changes in the structure in the economy, the most notable one being the decline of manufacturing jobs and manufacturing employ- ment, and the increase in international competition. There cer- tainly was a time when GM, for example, had a certain amount of monopoly power and was able to charge probably a higher price than it otherwise could. And now, of course, GM is in very intense competition with other companies around the world. So it is an open question, a very interesting question, to what ex- tent that association between wage changes and unionization is causal—that the changes in unionization have changed the wage pattern—or to what extent they are both the product of a third force such as the change in manufacturing employment or the change in the extent of international competition. The kinds of studies we have seen so far really cannot distin- guish between those two hypotheses. Chairman DODD. I appreciate your comments. This will be part of an ongoing conversation. But the comments here, based on just hard data I thought were very valuable to contribute to the debate and discussion as to what we need to be doing to move forward in closing that gap that you have spoken about so eloquently. Thank you immensely. I thank my colleagues, they have had to leave here. But there were great questions that came up this morn- ing and your answers were very candid and very straightforward and forthright, and we appreciate it immensely. So we look forward to having an ongoing conversation with you and we thank you for your appearance here this morning. This hearing will stand adjourned. [Whereupon, at 1:18 p.m., the hearing was adjourned.] [Prepared statements, response to written questions, and addi- tional material supplied for the record follow:] 60 PREPARED STATEMENT OF BEN S. BERNANKE CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM FEBRUARY 14, 2007 Chairman Dodd, Senator Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. Real activity in the United States expanded at a solid pace in 2006, although the pattern of growth was uneven. After a first-quarter rebound from weakness associ- ated with the effects of the hurricanes that ravaged the Gulf Coast the previous summer, output growth moderated somewhat on average over the remainder of 2006. Real gross domestic product (GDP) is currently estimated to have increased at an annual rate of about 2% percent in the second half of the year. As we anticipated in our July report, the U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable average pace of growth. The principal source of the on- going moderation has been a substantial cooling in the housing market, which has led to a marked slowdown in the pace of residential construction. However, the weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the econ- omy. Consumer spending has continued to expand at a solid rate, and the demand for labor has remained strong. On average, about 165,000 jobs per month have been added to nonfarm payrolls over the past 6 months, and the unemployment rate, at 4.6 percent in January, remains low. Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen, in large part as a result of de- clines in the price of crude oil. Readings on core inflation—that is, inflation exclud- ing the prices of food and energy—have improved modestly in recent months. Never- theless, the core inflation rate remains somewhat elevated. In the five policy meetings since the July report, the Federal Open Market Com- mittee (FOMC) has maintained the Federal funds rate at 5Yi percent. So far, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing of core inflation. How- ever, in the statement accompanying last month's policy decision, the FOMC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected and that it is prepared to take action to address inflation risks if developments warrant. Let me now discuss the economic outlook in a little more detail, beginning with developments in the real economy and then turning to inflation. I will conclude with some brief comments on monetary policy. Consumer spending continues to be the mainstay of the current economic expan- sion. Personal consumption expenditures, which account for more than two-thirds of aggregate demand, increased at an annual rate of around 3V2 percent in real terms during the second half of last year, broadly matching the brisk pace of the previous 3 years. Consumer outlays were supported by strong gains in personal in- come, reflecting both the ongoing increases in payroll employment and a pickup in the growth of real wages. Real hourly compensation—as measured by compensation per hour in the nonfarm business sector deflated by the personal consumption ex- penditures price index—rose at an annual rate of around 3 percent in the latter half of 2006. The resilience of consumer spending is all the more striking given the backdrop of the substantial correction in the housing market that became increasingly evident during the spring and summer of last year. By the middle of 2006, monthly sales of new and existing homes were about 15 percent lower than a year earlier, and the previously rapid rate of house-price appreciation had slowed markedly. The fall in housing demand in turn prompted a sharp slowing in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about AVi months' supply in 2005 to nearly 7 months' supply by the third quarter of last year. Single- family housing starts have dropped more than 30 percent since the beginning of last year, and employment growth in the construction sector has slowed substantially. Some tentative signs of stabilization have recently appeared in the housing mar- ket: New and existing home sales have flattened out in recent months, mortgage applications have picked up, and some surveys find that homebuyers' sentiment has improved. However, even if housing demand falls no further, weakness in residen- tial investment is likely to continue to weigh on economic growth over the next few quarters as homebuilders seek to reduce their inventories of unsold homes to morecomfortable levels. 61 Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid, and delin- quency rates on most types of consumer loans and residential mortgages remain low. The exception is subprime mortgages with variable interest rates, for which de- linquency rates have increased appreciably. The labor market is expected to stay healthy, and real incomes should continue to rise, although the pace of employment gains may be slower than that to which we have become accustomed in recent years. In part, slower average job growth may simply reflect the moderation of economic activity. Also, the impending retirement of the leading edge of the baby-boom gen- eration, and an apparent leveling out of women's participation rate in the workforce, which had risen for several decades, will likely restrain the growth of the labor force in coming years. With fewer jobseekers entering the labor force, the rate of job cre- ation associated with the maintenance of stable conditions in the labor market will decline. All told, consumer expenditures appear likely to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal incomes if, as we expect, households respond to the slow pace of home-equity appreciation by saving more out of current income. The business sector remains in excellent financial condition, with strong growth in profits, liquid balance sheets, and corporate leverage near historical lows. Last year, those factors helped to support continued advances in business capital expend- itures. Notably, investment in high-tech equipment rose 9 percent in 2006, and spending on nonresidential structures (such as office buildings, factories, and retail space) increased rapidly through much of the year after several years of weakness. Growth in business spending slowed toward the end of last year, reflecting mainly a deceleration of spending on business structures; a drop in outlays in the transpor- tation sector, where spending is notably volatile; and some weakness in purchases of equipment related to construction and motor vehicle manufacturing. Over the coming year, capital spending is poised to expand at a moderate pace, supported by steady gains in business output and favorable financial conditions. Inventory levels in some sectors—most notably at motor vehicle dealers and in some construction- related manufacturing industries—rose over the course of last year, leading some firms to cut production to better align inventories with sales. Remaining imbalances may continue to impose modest restraint on industrial production during the early part of this year. Outside the United States, economic activity in our major trading partners has continued to grow briskly. The strength of demand abroad helped spur a robust ex- pansion in U.S. real exports, which grew about 9 percent last year. The pattern of real U.S imports was somewhat uneven, partly because of fluctuations in oil imports over the course of the year. On balance, import growth slowed in 2006, to 3 percent. Economic growth abroad should support further steady growth in U.S. exports this year. Despite the improvements in trade performance, the U.S. current account def- icit remains large, averaging about 6V2 percent of nominal GDP during the first three quarters of 2006 (the latest available data). Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing dimin- ishes. Such an outlook is reflected in the projections that the Members of the Board of Governors and Presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts— which are based on the information available at that time and on the assumption of appropriate monetary policy—is for real GDP to increase about 2V2 to 3 percent in 2007 and about 2% to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. This difference partly reflects an ex- pectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4V2 to 4% percent. The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than ex- pected if consumer spending continues to increase at the brisk pace seen in the sec- ond half of 2006. I turn now to the inflation situation. As I noted earlier, there are some indications that inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will consequently be some time before we can be confident that un- derlying inflation is moderating as anticipated. Recent declines in overall inflation have primarily reflected lower prices for crude oil, which have fed through to the prices of gasoline, heating oil, and other energy products used by consumers. After 62 moving higher in the first half of 2006, core consumer price inflation has also edged lower recently, reflecting a relatively broad-based deceleration in the prices of core goods. That deceleration is probably also due to some extent to lower energy prices, which have reduced costs of production and thereby lessened one source of pressure on the prices of final goods and services. The ebbing of core inflation has likely been promoted as well by the stability of inflation expectations. A waning of the temporary factors that boosted inflation in recent years will prob- ably help foster a continued edging down of core inflation. In particular, futures quotes imply that oil prices are expected to remain well below last year's peak. If actual prices follow the path currently indicated by futures prices, inflation pres- sures would be reduced further as the benefits of the decline in oil prices from last year's high levels are passed through to a broader range of core goods and services. Nonfuel import prices may also put less pressure on core inflation, particularly if price increases for some other commodities, such as metals, slow from last year's rapid rates. But as we have been reminded only too well in recent years, the prices of oil and other commodities are notoriously difficult to predict, and they remain a key source of uncertainty to the inflation outlook. The contribution from rents and shelter costs should also fall back, following a step-up last year. The faster pace of rent increases last year may have been attributable in part to the reduced afford- ability of owner-occupied housing, which led to a greater demand for rental housing. Rents should rise somewhat less quickly this year and next, reflecting recovering demand for owner-occupied housing as well as increases in the supply of rental units, but the extent and pace of that adjustment is not yet clear. Upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period. The rate of resource utilization is high, as can be seen in rates of capacity utilization above their long-term average and, most evidently, in the tightness of the labor market. Indeed, anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in certain occupations. Measures of labor compensation, though still growing at a moderate pace, have shown some signs of acceleration over the past year, likely in part the result of tight labor market conditions. The implications for inflation of faster growth in nominal labor compensation de- pend on several factors. Increases in compensation might be offset by higher labor productivity or absorbed by a narrowing of firms' profit margins rather than passed on to consumers in the form of higher prices; in these circumstances, gains in nomi- nal compensation would translate into gains in real compensation as well. Under- lying productivity trends appear favorable, and the markup of prices over unit labor costs is high by historical standards, so such an outcome is certainly possible. More- over, if activity expands over the next year or so at the moderate pace anticipated by the FOMC, pressures in both labor and product markets should ease modestly. That said, the possibility remains that tightness in product markets could allow firms to pass higher labor costs through to prices, adding to inflation and effectively nullifying the purchasing power of at least some portion of the increase in labor compensation. Thus, the high level of resource utilization remains an important up- side risk to continued progress on inflation. Another significant factor influencing medium-term trends in inflation is the public's expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as those created by changes in energy costs, become embedded in wage and price decisions and so leave a lasting imprint on the rate of inflation. It is encouraging that inflation expectations appear to have remained contained. The projections of the Members of the Board of Governors and the Presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next. In particular, the central tendency of those forecasts is for core inflation—as measured by the price index for personal consumption expenditures excluding food and energy—to be 2 to 2Vt percent this year and to edge lower, to 1% to 2 percent, next year. But as I noted earlier, the FOMC has continued to view the risk that inflation will not moderate as expected as the predominant policy concern. Monetary policy affects spending and inflation with long and variable lags. Con- sequently, policy decisions must be based on an assessment of medium-term eco- nomic prospects. At the same time, because economic forecasting is an uncertain en- terprise, policymakers must be prepared to respond flexibly to developments in the economy when those developments lead to a reassessment of the outlook. The de- pendence of monetary policy actions on a broad range of incoming information com- plicates the public's attempts to understand and anticipate policy decisions. Clear communication by the central bank about the economic outlook, the risks to that outlook, and its monetary policy strategy can help the public to understand the rationale behind policy decisions and to anticipate better the central bank's reac- 63 tion to new information. This understanding should, in turn, enhance the effective- ness of policy and lead to improved economic outcomes. By reducing uncertainty, central bank transparency may also help anchor the public's longer-term expecta- tions of inflation. Much experience has shown that well-anchored inflation expecta- tions tend to help stabilize inflation and promote maximum sustainable economic growth. Good communication by the central bank is also vital for ensuring appro- priate accountability for its policy actions, the full effects of which can be observed only after a lengthy period. A transparent policy process improves accountability by clarifying how a central bank expects to attain its policy objectives and by ensuring that policy is conducted in a manner that can be seen to be consistent with achiev- ing those objectives. Over the past decade or so, the Federal Reserve has significantly improved its methods of communication, but further progress is possible. As you know, the FOMC last year established a subcommittee to help the full Committee evaluate the next steps in this continuing process. Our discussions are directed at examining all aspects of our communications and have been deliberate and thorough. These dis- cussions are continuing, and no decisions have been reached. My colleagues and I remain firmly committed to an open and transparent monetary policy process that enhances our ability to achieve our dual objectives of stable prices and maximum sustainable employment. I will keep Members of this Committee apprised of devel- opments as our deliberations move forward. I look forward to continuing to work closely with the Members of this Committee and your colleagues in the Senate and House on the important issues pertaining to monetary policy and the other respon- sibilities with which the Congress has charged the Federal Reserve. Thank you. I would be happy to take questions. 64 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKE Q.I. I have been concerned for some time about the implementa- tion of the Basel II Capital Accord and the impact Basel II may have on the safety and soundness of the U.S. banking system. In particular, I am worried that Basel II may lead to a sharp reduc- tion in the amount of capital banks are required to hold, which would put U.S. taxpayers at risk of having to pay for expensive bank failures. Accordingly, I believe that it is critical that Basel II be implemented with the utmost care and diligence. Would you please update the Committee on the status of the Basel II Capital Accords and the current timeframe for implementing Basel II? I would like you to comment on whether there is enough time for banking regulators to finalize the rules implementing Basel II, so that banks adopting Basel II can start the test run for Basel II presently scheduled to begin next year. What, if any, is the likeli- hood that the timeframe currently envisioned may need to be ad- justed? A.1. First, let me reiterate that the primary goal of the agencies in implementing Basel II in the United States is to enhance the safety and soundness of the U.S. banking system. Accordingly, we will not permit capital levels to decline under the Basel II frame- work so as to potentially jeopardize safety and soundness. We re- main committed to ensuring that regulatory capital levels at all U.S. banking organizations remain robust. It is important to keep in mind that under Pillar II, banking supervisors will be reviewing total capital plans relative to risk at each Basel II bank, not just the minimum capital requirements calculated under Pillar I. We also continue to believe, subject to the receipt of comments on the outstanding Basel II notice of proposed rulemaking (NPR), that it is critical to move forward with Basel II implementation so that our largest and internationally active banking organizations have the most risk reflective regulatory capital framework and can re- main competitive with other banking organizations that apply simi- lar risk sensitive frameworks. The Basel II NPR issued in September 2006 remains open for comment through March 26, 2007. As outlined in the NPR, the first opportunity for a bank to be able to begin a parallel run (that is, apply the Basel II framework and report results to the appropriate supervisor, but continue to use Basel I ratios for regulatory pur- poses) would be January 2008. The first opportunity for a bank to begin applying the Basel II framework subject to the proposed transition floors would be January 2009. We remain committed to this schedule; however, it will be challenging to meet the pre- viously announced June 2007 date for a final rule. We are very in- terested in public comments submitted on the proposal. We will need to take sufficient time to fully consider comments and to make corresponding modifications to the proposed framework as the agencies deem to be appropriate. Because the comment period is still open, it is difficult to estimate how comprehensive the com- ments will be. While we already are aware of a number of issues raised by the industry, in complex rulemakings such as this one there are always unanticipated issues as well. The extent and com- plexity of the comments overall will have an impact on the ulti- 65 mate timing for issuing a final rule. We continue to believe that it is important to meet the previously stated first live start date of January 2009 and at this time do not anticipate that that start date will need to be adjusted. Q.2. Your testimony noted that the U.S. current account deficit re- mains large, averaging about 6V2 percent of nominal GDP. You also note that economic growth abroad should support further steady growth in U.S. exports this year. Do you anticipate much improve- ment in the current account deficit over the next year as a result of export improvement? Do you see any other economic factors changing over the next year that might lead to an improved trade deficit? A.2. In the past year, U.S. exports have grown strongly, reflecting a number of factors, including solid foreign economic growth, in- creases in investment spending abroad that have boosted sales of capital goods produced in the United States, and the booming mar- ket for agricultural goods and other commodities. These develop- ments have played out against the backdrop of continued innova- tion and productivity growth in the U.S. economy that, along with the decline in the foreign exchange value of the dollar since earlier in this decade, have buoyed the attractiveness of American-made products. As a result of strong export growth, in combination with sharp declines in the price of imported oil, the trade deficit has narrowed from 6 percent of U.S. GDP in the third quarter of last year to about 5Vi percent of GDP in the fourth, and the current account deficit has improved by a broadly similar extent. These movements, coming as they did toward the end of 2006, may well cause the trade and current account deficits for 2007 as a whole, measured as a share of GDP, to be smaller than those for 2006. Focusing on their evolution from the current quarter onwards, however, it is uncertain whether our Nation's external deficits will narrow further over the next few years. On the export side, the ex- traordinary growth in overseas sales of some U.S. products during 2006 may be difficult to sustain; for example, exports of aircraft grew more than 20 percent last year. On the import side, the price of imported oil has bounced back from recent lows, and futures markets suggest that further increases may be in the offing. An- other important determinant of U.S. trade flows, the foreign ex- change value of the dollar, is volatile and extremely difficult to pre- dict. Finally, even if the trade balance were to continue to improve, it is not clear that the current account balance—which is equal to the trade balance plus the balance on international income flows and transfers—would follow suit. The need to finance continued trade deficits, even if these deficits are smaller than in the past, puts upward pressure on the Nation's external debt and thus in- vestment income payments to foreigners, thereby tending to ex- pand the current account deficit. Q.3. This Committee continues to have a great degree of interest in the Chinese economy, particularly currency practices. China's foreign exchange reserves now stand at over $1 trillion, creating excess liquidity in their banking system. Some financial experts have stated that the United States should not view China's large stock of foreign currency reserves as a problem. What is your view 66 of this level of reserves? Do you believe China's ratio of reserves to money supply is reasonable? To what extent do you believe that China's reserves are the result of speculation? Could this, in fact, result in an even lower value for the RMB should that currency be- come more flexible in the future? A.3. For some time now, the monetary authorities in China have been resisting upward pressure on the value of the renminbi in for- eign exchange markets by purchasing dollars and perhaps other foreign currencies. Even though these accumulated purchases have reached a value of more than $1 trillion, it is not certain that the accumulation has created excess liquidity in China's banking sys- tem. Reserves and liquidity do not move in lockstep in China, be- cause Chinese authorities have policy tools available to drain li- quidity, including issuance of official securities (so-called "steriliza- tion bonds") and increasing banks' reserve requirements. At present, it does not appear that China has had any substantial dif- ficulty using either of these tools to drain liquidity, although that may change in the future. Because the linkage between reserves and money need not be tight, it would be hard to determine a rea- sonable range for the ratio of reserves to the money stock appro- priate for China's economy. I do not believe China's substantial accumulation of reserves in itself represents a problem for the United States or for United States monetary policy. Official demand in China and other coun- tries for United States assets reflects the dollar's role as pre- eminent reserve currency, which results in great part from the strength of our economy and the safety and liquidity of the United States financial system. Because foreign holdings of U.S. Treasury securities represent only a small part of total U.S. credit market debt outstanding, U.S. credit markets should be able to absorb without great difficulty any shift in foreign allocations. And even if such a shift were to put undesired upward pressure on U.S. in- terest rates, the Federal Reserve has the capacity to operate in do- mestic money markets to maintain interest rates at a level con- sistent with our domestic economic goals. It is not easy to identify the portion of the upward pressure on the renminbi, and hence on the accumulation of reserves, that might be the result of speculation. It is also difficult to predict where the renminbi would settle were the currency to float freely. However, speculation in the renminbi would not occur if investors did not expect the Chinese currency to appreciate at some point. It seems reasonable to conclude that, at the present exchange rate with the dollar, the renminbi is undervalued. RESPONSE TO A WRITTEN QUESTION OF SENATOR SUNUNU FROM BEN S. BERNANKE Q.I. Does the arbitrary deposit cap, which bars any U.S. bank from an acquisition that would give it more than 10 percent of the Na- tion's total bank deposits, make American banks vulnerable to for- eign acquisition? A.1. Federal law currently prohibits a bank holding company or bank from acquiring an additional bank if, after the acquisition, the resulting banking organization would control more than 10 per- cent of all deposits held by insured banks and savings associations 67 in the United States. At the present time, it appears unlikely that this restriction makes U.S. banks materially more vulnerable to ac- quisition by a foreign entity than they would be if this deposit cap were not in place. Of course, as the banking and financial systems evolve, the impact of the current deposit cap also may change, and thus the Congress may wish to review the benefits and costs of the current restriction at regular intervals. The deposit cap could potentially increase the likelihood of for- eign acquisitions of U.S. banks if it prevented U.S. banks from reaching the size needed to achieve important economies of scale or scope. However, research overwhelmingly indicates that econo- mies of scale in banking are achieved at sizes far below those of our largest banks. In addition, the landmark Gramm-Leach-Bliley Act significantly expanded the ability of U.S. banking organizations to achieve any important economies of scope that may exist within the broad financial services industry. Indeed, U.S. banks are among the most profitable, most efficient, and best capitalized in the world. 68 For use at 10:00 a.m., EST Wednesday February 14,2007 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress February 14, 2007 69 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 14, 2007 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES The Board of Governors is pleased to submit its Monetary Policy Report to the Congress pursuant to section 2B of the Federal Reserve Act. Sincerely, Ben Bernanke, Chairman 70 Contents Page Monetary Policy and the Economic Outlook 1 Economic and Financial Developments in 2006 and Early 2007 4 71 Monetary Policy Report to the Congress Report submitted to the Congress on February 14, 2007, The monetary policy decisions of the Federal Open pursuant to section 2B of the Federal Reserve Act Market Committee (FOMC) in 2006 were intended to foster sustainable economic expansion and to promote a return to low and stable inflation. In that regard, the MONETARY POLICY AND THE ECONOMIC OUTLOOK economic outlook for this year and next appears favor- able. Although the contraction in homebuilding has been The U.S. economy turned in another solid performance a drag on growth, that restraint seems likely to diminish in 2006, although the pattern of growth was uneven. over 2007. Further gains inreal wages as well as ongoing After rebounding in the early part of the year from increases in employment should support a solid rise in hurricane-related disruptions in the autumn of 2005, the consum er spending. In addition, at the beginning of 2007, pace of expansion during the remaining three quarters households'balance sheets appeared to be in good shape. averaged somewhat below that of the preceding twoy ears, Whereas gains in home prices slowed last year, household responding in part to the removal of monetary policy net worth increased moderately as stock market wealth accommodation since 2004. The housing market cooled grew and households lessened their accumulation of debt. substantially, and, in the latter part of 2006, the production Delinquency rates on consumer loans and on most types of light motor vehicles also stepped down. Elsewhere in of mortgages remained low, although they increased the economy, activity remained strong. Consumer spend- markedly for subprime mortgages with variable interest ing increased vigorously in 2006 as households' real rates. As for businesses, balance sheets are quite liquid, income made strong gains. Business investment rose at credit quality is good, andmostfirms enjoy ready access a solid rate for the year as a whole, although it deceler- to funds. These favorable financial conditions, along with ated late in the year inpart because of some softening in further expansion in business output, user costs of capital purchases of equipment related to construction and motor equipment that rem ain attractive, and the potential for fur- vehicle manufacturing. Demand for U.S. exports rose at a ther gains in efficiency, should continue to spur business robust pace in 2006, supported by strong economic activ- investment. In addition, sustained expansion in foreign ity abroad. Against this backdrop, businesses continued economies ought to maintain demand for U.S. exports. to add jobs at a steady rate, and the unemployment rate On balance, growth of real gross domestic product in the decreased further. United States appears likely to run slightly below that of the economy's potential over the next few quarters and Total consumer price inflation declined in 2006 from its then to rise to a pace around that of the economy's long- elevated pace in 2005, as energy prices fell, on net, after run trend. rising rapidly over the preceding couple of years. Crude oil prices rose during the first half of 2006 but turned down Regarding inflation, increases in core consumer prices sharply later in the year. As a result, consumer price infla- are expected to moderate, on balance, over the nest two tion climbed in the first half of the year before slowing in years. Along with inflation expectations that are well the second half. The sharp movements in prices of crude anchored, some of the factors that boosted inflation in oil appear to have affected not only prices of gasoline and recent years seem likely to lessen. In particular, the paths other petroleum -based types of energy but also prices of a for prices of energy and other commodities embedded in broader range of goods and services that use petroleum- futures markets suggest that the impetus to core inflation based inputs. Partly as a result, consumer price inflation from these influences will diminish further. In addition, excluding food and energy—so-called core consumer the outsized increases in shelter costs that boosted core price inflation—moved up during the first half of the year inflation last year are not expected to persist. Although but eased subsequently. On balance, core inflation was a unit labor costs in the nonfarm business sector have been bit higher over the four quarters of 2006 than in 2005. rising, the average markup of prices over such costs is Measures of long-term inflation expectations, however, high by historical standards. The relatively high markup remained well anchored. suggests that further increases in costs could be absorbed, 72 2 Monetary Policy Report to the Congress • February 2007 at least to some extent, by a narrowing of firms'1p rofit the risk that inflation will fail to moderate as expected is margins rather than by passing on the costs in the form its predominant policy concern. of higher consumer prices, especially if pressures on resources ease modestly as anticipated. The outlook for real economic activity is uncertain. Monetary Policy, Financial Markets, An upside risk is that consum er spending, which has been and the Economy in 2006 and Early 2007 especially buoyant in recent months, may continue to expand at a pace that would ultimately lead to an escala- The FOMC firmed the stance of monetary policy tion of pressures on resources and prices. Alternatively, 25 basis points at each of its four meetings over the first prospects for residential construction, which are difficult half of 2006. The Committee raised its target for the to assess, may pose some downside risks. Although federal funds rate at its January and March meetings as residential real estate markets have shown some recent available information pointed to accumulating pressures signs of stabilizing, homebuilders' inventories of unsold on inflation and solid economic growth. Although read- homes remain elevated. Further cutbacks in construction ings on core inflation had remained favorable, increases to reduce inventories toward more-comfortable levels in energy prices and the relatively high level of resource could become steeper andmore persistent than currently utilization threatened to add to existing inflation pressures. anticipated. Moreover, if home values were to depreciate Meanwhile, underlying aggregate demand, supported sharply, the resulting erosion of household wealth could by robust consumer spending and accelerating business impose appreciable restraint on consumer spending. investment, appeared to be growing at a solid rate. By Whether inflation will moderate gradually as expected the time of the May and June meetings, data pointed is also uncertain. On the one hand, the nation's potential to a moderation in the growth of consumer spending to produce could increase more rapidly than anticipated, and a further cooling m the housing market However, or product and input markets could work efficiently at core consumer prices had risen more rapidly. Although higher rates of utilization, either of which could lead to a the Committee judged inflation expectations still to lower trajectory for inflation than currently forecast. On be contained, it was mindful that the rising prices of the other hand, expanding global demand and threats to energy and other commodities could impart greater supply from actual and potential disruptions pose upside inflationary momentum. Against this backdrop, the risks for energy prices. In addition, brisk world demand FOMC voted to increase the policy rate a further for non-energy materials and commodities could lead to 25 basis points at both the May and June meetings, further upward pressures on business costs. Also, if infla- bringing the federal funds rate to 5lA percent. In the state- tion were to persist around the elevated average level of the ment accompanying its June decision, the FOMC indicated past three years, longer-run inflation expectations could that it believed that the moderation in economic activity deteriorate, particularly if pressures on resources were to would help to limit inflationary pressures over time but intensify. At recent meetings, the FOMC indicated that also noted that some upside inflation risks remained. As Selected interest rates, 2004-07 Percent Ten-year Treasury — 5 — 4 — 3 Target federal funds rate — 2 — 1 1/2S 3/16 5/4 NOTE; The dara are daily and extend through February 7. 2007. The ten-year Treasury rate is the constant-ma&arity yield based on the securities. The dates on the hoiizuuttil axis are thoise of FOMC meetings. SOURCE: Department of the Treasury and the Federal Res erve. 73 Board of Governors of the Federal Reserve System 3 it had in its May statement, the FOMC made clear in demand for housing might be stabilizing. Business invest- June that the extent and timing of additional firming ment had softened in the fourth quarter, and industrial would depend on the evolution of the outlook for both production decelerated sharply in the fall, but consumer inflation and economic growth as implied by incoming spending posted robust gains in the final months of 2006. information. At its January 2007 meeting, the Committee again decided In the second half of the year, a further slowdown to leave its target for the federal funds rate unchanged, in residential construction activity and a contraction in reiterated concern about inflation risks, and again cited motor vehicle production created a significant drag on the role of incoming data m determining the extent and economic activity. However, consumer spending held up, timing of any additional finning. and employment rose at a solid pace. Meanwhile, energy In recent years, the FOMC has worked to improve prices reversed much of their increases of the first half of the transparency of its decisionmaking process, and the the year, sending headline inflation lower. Core inflation Committee continues to examine whether further changes also eased som ewhat, albeit to a rate above its year-earlier would improve its communications with the public. In level. Against this backdrop, the FOMC left the stance spring 2006, the Chairman appointed a subcommittee to of policy unchanged at its final four meetings of help the FOMC organize the discussion of abroad range of 2006. Committee discussions in those meetings focused communicationissues. The FOMC began its consideration in part on developments in the housing market and of these issues at its August meeting and has discussed their implications for the broader economy. Although them at several meetings since then. the housing market was weakening throughout this period, the Committee judged that the downturn had not spilled over significantly to consumer spending. Economic Projections for 2007 and 2008 The economy was expected to expand over coming quarters at a rate close to or a little below its long-run In conjunction with the FOMC meeting in January, the sustainable pace. At the same time, FOMC members members of the Board of Governors and the Federal noted that, even though core inflation had slowed from the Reserve Bank presidents, all of whom participate in the very rapid rates of the spring and summer, current rates deliberations of the FOMC, provided economic projec- remained undesirably high. Most members expected core tions for 2007 and 2008. The projections indicate that the inflation to moderate gradually, but they were uncertain participants expect sustainable expansion of real economic about the likely pace and extent of that moderation. Thus, activity during the next two years, assuming an appropri- in statements accompanying each rate announcement ate course for monetary policy. The central tendency of over this period, the FOMC reiterated that inflation risks the FOMC participants' forecasts for the increase in real rem ained and that the extent and tim ing of any additional GDP is 2% percent to 3 percent over the four quarters of policy firming would depend on the outlook for both 2007 and 23A percent to 3 percent over the four quarters inflation and economic growth implied by incoming of 2008. The central tendency of their forecasts for the information. civilian unemployment rate is 4Yz percent to 4% percent Over the period between the December 2006 and Janu- in the fourth quarter both of this year and of 2008. For ary 2007 FOMC meetings, incoming data on inflation and inflation, the central tendency of the forecasts anticipates economic activity were generally more favorable. Core an increase in the price index for personal consumption inflation receded further from the elevated levels reached expenditures excluding food and energy—the so-called in early 2006, and some indicators suggested that the core PCE price index—of 2 percent to 2W percent over Economic projections of Federal Reserve Governors and Reserve Bank presidents for 2007 and 2008 Percent 2007 2003 Indicator 2006 actual Range te C n e d n e t n ra c l y Range te C n e d n e t n ra c l y Change, fourth quarter to fourth quarter1 Nominal GDP. 5.9 A'A-5H 5-5'A 4M-3i4 AV*-5V4 Real GDP 3.4 2W-3W 2W-3 2W-3W 2V4-3 PCE price index excluding food and energy... 2.3 2-2 W 2-2>A 1K-2W P/4-2 Average level, fourth quarter civilian un employ ment rate 4.5 AlA-AV*. A'A-i'A 4W-5 A<A-VA [eforfourlh quarter of year indicated. 74 4 Monetary Policy Report to the Congress • February 2007 the four quarters of 2007 and 1% percent to 2 percent over Change in PCE chain-type price index, 2000-06 the four quarters of 2008. The economy is projected to expand at a moderate rate. Although the cooling of the housing market con- • Total tinues to damp economic activity, the drag on economic H Excluding food and energy growth from declining construction activity is expected to diminish later this year. Household spending for goods and services should rise at a solid pace, in part as a result of ongoing gains in real wages and employment and of generally strong household balance sheets. Business outlays for new equipment and software are expected to increase at a rate consistent with a m oderate expansion in business output and to be supported by continuing declines in the user cost of high-technology capital equipment and by favorable financial conditions. In addition, the solid 2000 2001 2002 2003 2004 2005 2006 J_J expansion of economic activity abroad should maintain the IN nt The data are lor jrfi^ on umptinn e\penr!rtiu „ (PCE). rising demand for U.S. exports of goods and services. SOURCE.: Department of Coi et, Bureau of Economic Analysis. Decreased pressures from the costs of energy and other commodities, in an environment of moderate eco- nomic expansion and well-anchored longer-run inflation is reported to have increased at an average annual rate of expectations, are expected to contribute to further easing 2% percent over the final three quarters of 2006, down in inflation. In addition, increases in productivity should from the average VA percent pace in 2004 and 2005. The help to limit cost pressures. slowdown principally was the result of the contraction in residential construction, which intensified later in the year, and the marked decline in production of light motor ECONOMIC AND FINANCIAL DEVELOPMENTS vehicles in the second half of the year as manufacturers took steps to trim dealers5 inventories. In other sectors IN2006AND EARLY 2007 of the economy, consumer spending remained strong as The especially brisk pace of economic activity in early employment and income made further solid gains, and 2006 primarily reflected arebound after hurricane-related business outlays for new structures and equipment rose disruptions in the autumn of 2005. During the rest of the considerably over much of the year. Financial market con- year, however, economic activity slowedto a pace some- ditions were generally supportive of economic expansion what below the average rate of recent years. Real GDP in2006. Equity markets recorded sizable gains, andlong- term interest rates rose only modestly from historically low levels. Risk spreads on corporate bonds remained narrow or declined further. Overall economic condi- Change in real GDP, 2000-06 tions were such that businesses maintained a steady pace of hiring, and the unemployment rate moved down further. Consumer price inflation, as measured by the rise in the PCE price index, moved down m the second half of 2006 after having stepped up in the first half. Energy prices, which rose during the first half and turned sharply downward later in the year, played an important role in shaping the contour of total consumer price inflation. In addition, core PCE price inflation easedmodestly over the second half of 2006. Apparently influenced by incoming data on inflation and economic activity, measures of long- term inflation expectations rose early in the year but ended the year slightly lower than at the beginning. Nonethe- 2(100 2001 2002 2003 20M 2005 1006 less, core PCE price inflation for the year as a whole—at 2VA percent—was a bit higher than in the preceding year, •NOTE: Here and in subsequent figures, except as noted, change for a given period is measured to its final quarter from the final quarter of the preceding which perhaps reflected in part the high level of resource period. utilization. SOURCE: Department at'Commerce, Bureau of Economic Analysis. 75 Board of Governors ofihe Federal Reserve System 5 The Household Sector ate pace of growth; expenditures in this category rose 2% percent in 2006, about the same average pace as in Consumer Spending 2004 and 2005. The rapid increase in consumer spending in 2006 was In 2006, real household income was boosted by gains supported by rising employment, gains in real income, in wage and salary income and the increased purchasing increases in household wealth, and favorable financial power resulting from the deceleration in overall consumer conditions. Over the four quarters of 2006, real PCE prices. Labor income received by households rose both rose 3% percent—faster than in 2005 and at roughly the because of gains in real hourly wages and because of same rate as in 2004. The rise in consumer outlays was sustained increases in employment. However, the pickup particularly robust in the first quarter of 2006 but then in real after-tax income was damped because tax pay- moderated in the middle of the year, when households' ments made by households increased at a rate greater than gains in real income slowed and consumer sentiment that for income. The acceleration in tax payments likely softened. Consumer spending rose briskly again in the reflected, at least in part, several factors: tax payments fourth quarter of the year as gains in real income picked on larger capital gains realizations, which are excluded up andconsumer confidence improved. from income in the national income and product accounts (NIPA); gains in real income that moved some households Household spending for new motor vehicles slowed into higher tax brackets; and possibly a further shift in the in 2006; sales of 16.5 million new light vehicles (cars, distribution of income toward high-income households sport-utility vehicles, and pickup trucks) were below the that typically face higher tax rates. All told, real after-tax average of nearly 17 million sold in the preceding two income rose 3 percent over the four quarters of 2006, up years. Moreover, households' apparent concerns about from the negligible gain posted in 2005 but a little below elevated gasoline prices, particularly early in the year, the average rate of increase in 2003 and 2004. shifted the composition of light vehicle sales toward more fuel-efficient autos and away from light trucks and SUVs. The rise in after-tax income in 2006 was outpaced by The shift helpedboost the share of total sales capturedby increases in household spending. As a result, the personal foreign producers because they tend to offer more fuel- saving rate declined further in 2006 and averaged negative efficient vehicles. 1 percent for the year as a whole. Households apparently Real PCE for goods other than motor vehicles rose were inclined to increase their spending further above 43A percent over the four quarters of 2006, about in line their disposable income, at least in part, because their with the brisk average pace in the preceding two years. wealthcontinuedtorise. The ratio of household net worth Households increased their spending for a broad range of to income, which has been trending higher since 2003, consumer goods, though the rise was particularly strong inched up further in 2006. Although increases in the value for electronic equipment and other durables. Real spend- of homes slowed significantly, the value of corporate equi- ing on gasoline remained about constant in the first half ties held by households both indirectly—such as in mutual of the year but increased in the second half as prices fell. funds and retirement accounts—and directly appreciated Consumer spending for services maintained a moder- considerably. Personal saving rate, 1983-2006 Change in real income and consumption, 2000-06 Perosnt, annual rate Ij Disposable personal income _!_ ]_L_L_U 1986 1990 1994 1998 2002 2006 2000 2001 2002 2003 2004 200J 2006 rx: The dala are quarterly and extend (trough 2006:Q4. S iifii E Department at Commerce, Bureau ol Economic Analysis ;ECE: Department of Commerce, Bureau of Economic Analysis. 76 6 Monetary Policy Report to the Congress • February 2007 Wealth-to-income ratio, 1983-2006 Residential Investment The deterioration of conditions in the housing market played a significant role in restraining the pace of eco- nomic expansion in 2006. The demand for new and exist- ing homes began to weaken in the middle of 2005, and the subsequent decline steepened through the first half of 2006. As a result, the inventory of unsold new homes relative to sales rose sharply. Apparently prompted by lower demand and excessive inventories, homebuilders began to cutback on the pace of new construction near the beginning of 2006, and the decline in activity continued throughout the year. Later in the year, however, some indicators were hinting that the demand for housing was starting to stabilize. NOTE: The data are quarterly and extend through 200S:Q3. The By the middle of 2006, sales of both new and existing tc-tficiome ratio ia the ratio of household net worth to disposable f homes had fallen dramatically to a pace that was about RCE; For nei worth, Federal Re:-ve Board, flow of funds c 15 percent below that of a year earlier. Concurrently, , Department of Commerce, Bur u of Economic Analysis. inventories of unsoldhomes relative to sales rose consider- ably above the level that had prevailed during the period of robust housing demand from the late 1990s into 2005. Consumer sentiment deteriorated in the first half of By the third quarter of 2006, the backlog of unsold new 2006, according to the Reuters/University of Michigan homes had reached 63A months' supply, and the stock Surveys of Consumers (Reuters/Michigan). In the spring, of existing homes for sale had risen to about 7 months' consumer confidence had moved to its lowest level for the supply—both well above the average of about AVi months' year, probably in part because energy prices had surged. supply of new and existing homes in 2005. By the end of The subsequent decline in energy prices, along with the 2006, however, there were tentative signs that the demand rise in the stock market and reductions in the unemploy- for homes was stabilizing. The decline in sales of new and ment rate, boosted consumer confidence in the second existing homes appeared to bottom out in the summer, half of the year. On net the Reuters/Michigan index of and sales were roughly constant over the later part of the consumer sentiment was a shade higher at the end of year. In the fourth quarter, builders' inventories of unsold 2006 than at the beginning of the year; sentiment moved new homes were reported to have edged down a bit from up further in early 2007 to near the upper end of its range their third-quarter level, while the stock of existing homes since 2003. for sale remained about the same as in the third quarter. Despite these developments, the extent of any improve- ment in the inventories of unsold homes is obscured by the failure of these figures to account for recorded sales Consumer sentiment, 1993-2007 of new homes that are subsequently canceled. The drag on new residential construction in 2006 imposedby the contraction in home sales and the buildup of inventories was significant. Both the number of permits 140 — Conference Bi issued for new single-family homes and the number of home starts dropped sharply. As of Ihe fourth quarter of 20063 new single-family homes were started at an annual rate of 1.23 million units, almost 30 percent below the average pace in 2005; permits were down by a similar amount. In contrast to the marked slackening in construc- tion of new single-family homes, the rate of starts of new multifamily homes in 2006, at 337,000 units, was about the same as in the preceding several years. Housing activity, as measured by real expenditures on 1993 1995 1997 1999 2001 2003 2005 2007 residential structures in the NIPA, trimmed '/* percent- Nora: The data are monthly and exteud ihrongh January 2007. age point from the rate of real GDP growth in the first SOUR.CS: The Conference Board and Reuters/University of Michigan Sur- veys of Consumers. half of 2006, but the drag intensified to subtract about 77 Board of Governors of the Federal Reserve System 7 Private housing starts, 1993-2006 Mortgage rates, 2002-07 — K - V A r 1 Multu&mily Adjustable rate 1998 2000 2002 2004 2006 NCTTE: The data are quarterly and extend through 2006:Q4. NOTE: The data, which are weekly and extend through February- 7, 2007, SOURCE: Department of Commerce, Bureau of the Census. art contract rates on thirty-yearmortEages. EkJiJRCE: Federal Home Loan Mortgage Coiporation. 1 Vi percentage points from the annual rate of increase in real GDP in the second half. For 2006 as a whole, the transactions. The increase in the OFHEO house-price contraction in real residential investment lowered the index over the four quarters ending in the third quarter annual rate of growth in real GDP 3A percentage point of 2006 (a calculation that smoothes through some of the after having added Vi percentage point, on average, to the quarterly volatility in the data) was 6 percent, the small- rate from 2003 through 2005. est four-quarter increase since the late 1990s. The aver- age price of existing single-family homes sold, which is The rate of house-price appreciation slowed substan- published by the National Association of Realtors (NAR) tially in 2006 after several years of very rapid gains. The and does not control for the types of homes sold, declined repeat-transactions index of home prices published by the about 2 percent over the four quarters of 2006, compared Office of Federal Housing Enterprise Oversight (OFHEO) increased at an annual rate of only 1 lA percent in the third with average gains of roughly 9 percent in 2004 and 2005. The outright decline in the NAR index of home prices quarter of 2006, down substantially from average gains relative to the deceleration in the constant-quality OFHEO of about 10 percent in 2004 and 2005. The OFHEO index home-price index suggests that the composition of existing attempts to control for the quality of existing single-family homes sold shifted toward lower-priced homes. homes sold by using prices of homes involved in repeat The cost of mortgage financing increased in the first half of 2006, but rates decreased in the second half. Change in prices of single-family houses, ] 9S3-2006 The average rate for a thirty-year fixed-rate mortgage was 6l/a percent at the end of 2006? about the same as at the beginning of the year. The average for a one-year adjustable-rate mortgage declined also in the second half and stood at 5% percent at the end of 2006, about VA percentage point above the level at the start of the year. According to respondents to the Reuters/Michigan survey, relatively low mortgage rates and the perception that purchase prices were more favorable improved their assessment of homebuying conditions in the second half of 2006. Household Finance : The data e quarterly, and change is from o r earlier. Tbe Household sector debt is estimated to have slowed from rreeppeeaatt-ttrraannssaaccttiioonnss iinnddeexx eexxtteennddss tthhrroouugghh 22000066::QQ33.. FFoor foe years preceding the robust 11 VA percent increase posted in 2005 to a still- 11999911,, tthhaatt iinnddeexx iinncclluuddeess aapppprraaiissaallss associiadt ed wihith mortgage refinancings; b p b r ee i gg c ii e nn nn in iinn d gg e x ii nn e x 11 t 99 e 9 n 9 d 11 s ; jj t tt h ii r nn o cc u ll g uu h dd ee 2 ss 0 p 0 pu 6 ur : r Q cchh 4 aa . se transactions only. The existing home v a i g d o ro ro p u i s n S t V h i e p p e a r c c e e n o t f i n m 2 o 0 rt 0 g 6 a . g T e h d e e b d t e c g e r l o e w ra t t h io f n ro r m ef le a c b t o e u d t Ov S e O r U si R g C h E t; : f F o o r r e x r i e s p ti e n a g l h tr o fi m flS e B p e r ti i o c ii e .f s i , , N O at f i f o ic n e a l o A f s s F o e c d ia e t r i a o l n H o o f u R s e in a g lt o E rs n . terprise 14 percent in 2005 to less than 9 percent in 2006. Despite 78 Monetary Policy Report to the Congress • February 2007 Household financial obligations ratio, 1992-2006 meet their debt service obligations, although there are indications of growing strains among some borrowers. Delinquency rates on subprime residential mortgages with, variable interest rates have increased markedly; still, delinquency rates on other mortgages and consumer loans have remained low. Household bankruptcy filings during 2006 ran at a pace well below the average of the preceding several years. Bankruptcies likely were damped in 2006 by the decisions of some households to file before the implementation of more-stringent bankruptcy require- ments in October 2005. However, even allowing for such an effect, the recent pace is low relative to pre-reform norms. 1992 1934 199S 1998 2(300 2002 20t 2006 NCH-E: The daia are quarterly- and extend through 2006;Q3. The fmencial The Business Sector obligations ratio equals the sum of required payments on mortgage and con- sumer debt, automobile leases, rent on tenant -occupied property,, home- Fixed Investment owner's insurance, and property taxes, all divided, by disposable persona! SOURCE: Federal Reserve Board. Total real business fixed investment rose 63A percent over the four quarters of 2006, up from a 5% percent the reduction in mortgage borrowing, home equity lend- increase in 2005 and about the same pace as in 2004. In ing remained active, and the gross volume of cash-out general, the fundamentals supporting business capital refinancing exceeded 2005 levels. Meanwhile, consumer debt expanded only moderately in 2006. Change in real business fixed investment, 2000--06 Although household indebtedness increased less rap- idly in 2006 than in 2005, it still outpaced the growth of disposable personal income. In addition, the rise in interest • Structures rates contributed to higher debt service payments, and the ^ Equipment and software household financial obligations ratio continued its upward trend of the past decade to reach a record high. Evidence to date suggests that most households have been able to jJLl Delinquency rates on selected types of household loans, 1998-2006 High-tech equipment ai Other equipment exclii' — 30 — 2C NCTE: The data are quarterly. The data for credit card pools and mortgages 2000 2001 2002 2003 2004 2005 2096 extend through 2QD6:Q3; the rats for auto loans extends through 2U06:Q4. SOURCE,: For credit cards, Moody's Investors Service; for auto loans, the J^ors: High-tech equipment consists of computers and peripheral equip- financing subsidiaries of the three major U.S. automobile manufacturers; for ment and communications equipment. mortgages, Mortgage Bankers Association. SOURCE: Department of Commerce, Bureau of Ecoaomie Analysis. 79 Board of Governors of the Federal Reserve System 9 spending remained favorable in 2006: The strong rise in ever, spending for these capital goods softened in the profits continued to help firms maintain substantial liquid final quarter of the year. Although the declines in the assets, user costs for equipment declined further, and fourth quarter were generally broad based, they were interest rates and credit spreads remained relatively low. led by decreases in spending for equipment related Although the pace of real business outlays for equipment to construction and motor vehicle manufacturing. and software slowed somewhat in 2006, investment in However, the backlog of orders for capital goods such nonresidential structures rose 113A percent. Capital spend- as industrial machinery and other types of heavy ing was quite robust during m ost of the year, adding about equipment remained substantial at the end of 2006, and 1 percentage point to the annual rate of increase in real it should sustain production and shipments of these items GDP over the first three quarters, but it decelerated sharply in early 2007. in the fourth quarter, The deceleration reflected, in part, Real outlays for nonresidential construction increased a slowing in spending for business structures from its 11 % percent in 2006 after having been little changed since brisk pace earlier in the year, a drop in outlays for trans- 2003. However, die rise in business construction spending portation equipment, and some weakness in purchases slowed near the end of 2006 from its rapid pace earlier in of equipment related to construction and motor vehicle the year; outlays increased at an annual rate of only about manufacturing. 3 percent in the fourth quarter. For 2006 as a whole, sizable Real investment in high-technology equipment rose gains were posted for office, retail, and industrial build- 9 percent in 2006, about the same average annual pace as ings. In addition, outlays for drilling and mining structures in the preceding two years. Further decreases in the prices associated with energy exploration were strong. At the end of high-technology equipment continued to reduce the of 20063 forward-looking indicators for nonresidential user cost of this type of equipment. Real business spend- construction activity appeared to be favorable: Vacancy ing for computing equipment increased 14!4 percent, and rates for buildings in both the office and industrial sectors, software spending posted an S percent gain, both roughly which peaked a few years ago, continued to drift down, comparable to their average rates of increase in the pre- and the vacancy rate for retail buildings remained at the vious two years. Business outlays for communications low level that has prevailed since 2000. equipment rose almost 7 percent in 2006. Spending for communications equipment was particularly robust in the early part of the year and was likely boosted in part by Inventory Investment spending to replace equipment damagedby the hurricanes in die autumn of 2005. Investment in communications hi the first half of 2006, dealer stocks of motor vehicles equipment last year continued to be supported by demand rose noticeably as sales slowed, particularly for light from telecommunications service providers that were trucks. The increase in the prices of gasoline earlier in expanding their broadband networks. the year appeared to have reduced consumers' demand Real business investment in transportation equip- for light trucks and SUVs, which tend to be less fuel ment—typically a volatile category of investment—was efficient. Dealers' inventories of these vehicles reached an about unchanged onnet in 2006. For motor vehicles, busi- elevated 90 days' supply at the end of the second quarter. ness spending increased less than 1 percent over the year. As a result, motor vehicle manufacturers scaled back the Purchases of light vehicles weakened, partly because of production of light trucks over the second half of 2006, cutbacks in sales to rental companies. In contrast, business which helped to reduce dealers' inventories during that outlays forinediura and heavy trucks accelerated in 2006, period. Nonetheless, at Hie end of 2006, inventories of reportedly in anticipation of new emissions regulations light vehicles still appeared to be above desired levels. by the Environmental Protection Agency that went into Manufacturers cut production further in January of this effect at the beginning of 2007. New orders for medium year, helping them make additional progress in reducing and heavy trucks reached new highs early in 2006, and the stock overhang. production and sales remained strong through the end Excluding motor vehicles, inventories held by busi- of the year. Outlays for new aircraft were brisk in early nesses in the manufacturing and trade sectors appeared 2006, but they were depressed over the remainder of the generally to be well aligned with, sales in the first half of year; all told, aircraft investment declined more than 2006. However, later in the year, a variety of indicators 15 percent for the year as a whole. suggested that som e businesses accumulated an undesired Real investment in equipment other than high-tech and level of stocks. The book value of manufacturing and trade transportation goods—a broad category that represents inventories (excluding motor vehicles) rose relative to about half of total nominal business spending for equip- sales from September through November. The increases ment and software—rose at an average annual rate of were particularly noticeable for firms that supply the 5/4 percent during the first three quarters of 2006. How- conslruction and motor vehicle sectors, although increases 80 10 Monetary Policy Report to the Congress • February 2007 Change in real business inventories, 2000-06 Financing gap and net equity retirement at nonfinancial corporations, 1991-2006 Billion! oF shamed (7.00!) dollErs, annual rate 2000 2001 2002 2003 2004 200J 2006 SOURCE: Department of Cor u of Economic Analysis. 1991 1994 199-7 2000 20 03 2006 NOTE: The datu are annual; the observations for 20Q6 are based on partially estimated data. Tlie financing gap is die difference between capital eapaadi- tures and internally generated funds, adjusted for inventory valuation. Net were apparent in a few other sectors as well. Survey equity retirement is the difference between equity retired through share repur- data also suggested that inventories for some businesses c an h d as e e q s, u i d ty o m is e a s i t e ic d b ca y s h d - o f m in e a s n t c ic e d c o m m e p r a g n e i r e s s , i o n r p fo u r b e l i i g c n o r t a p k r e iv o a v t e e r s m o ar f k U et . s S . . E f q ir u m ity s were viewed as too high. However, manufacturers outside iiisuasce includes funds inveateri by private equiiy partnerafaips and Sock option proceeds. of the motor vehicles sector appear to be making SOURCE: Federal Reserve Board, flow of funds data. relatively prompt adjustments to their production, which to date seem to be limiting the extent of undesired stockbuilding. of a year earlier. About two-thirds of firms in the S&P 500 have reported earnings for the fourth quarter. Current market estimates of earnings per share for S&P 500 firms Corporate Profits and Business Finance call for roughly 10 percent growth in the fourth quarter over year-earlier levels. Earnings growth was widespread Profits of nonfinancial corporations extended their upward across sectors in 2006 but was particularly strong for move, pushing the ratio of before-tax profits to income in financial films. this sector to nearly 14 percent, the highest level reached Firms' capital expenditures exceeded internal funds since 1969. In the third quarter, operating earnings per raised in 2006, an indication that businesses funded share for S&P 500 firms came in 20 percent above levels investm ents not only with current cash flow but also with external funds and liquid assets. Borrowing by nonfinan- Before-tax profits of nonfinancial corporations cial firms picked up in 2006 in association with increased as a percent of sector GDP3 1Q79-2006 real investment as well as with extensive retirements of equity, which resulted from record share repurchases and heavy merger and acquisition activity. Net bond issuance proceeded at a faster clip than in the past several years. Similarly, commercial paper issuance was the strongest it had been since 2000, and commercial and industrial lending by banks was rapid as well. The Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lend- ing Practices revealed that a significant net fraction of respondents to that survey eased credit standards and terms on commercial and industrial loans during 2006. Bankers indicated that they were responding to more- aggressive competition and greater liquidity in the second- ary market for such loans. Loan officers also reported that a contributing factor was an increased tolerance for risk. 1982 1986 1990 1994 1998 2002 2D0S NOTE: The data are quarterly a tend through 2006:Q3. Profits are from The expansion of commercial mortgage debt in 2006 domestic operations of nonfuia corporations, with inventory valuation. remained rapid by historical standards but fell off from and cspit&l consumption EidjustiDcnts. SOURCE: Department of Commerce, B u of Economic Analysis. the swift pace of 2005. The deceleration likely reflected 81 Board of Governors of the Federal Reserve System 11 Selected components of net financing Net interest payments of nonrmancial corporations fornonfinancial corporate businesses, 2003-06 as a percent of cashflow, 1979-2006 Bfflicns of dollars, annual rate 2003 20 04 1982 1986 1990 1994 1998 2002 2006 NOTE: Hie daiafortbe (nponenta except bands are seasonally adjusted, NOTE: The data are quarterly and extend through 2006;Q3. The dsta for the sum of letted components are quarterly. 'Hie dala for SOURCE: Department of Commerce, Bureau of Economic .Analysis. 2006:Q4 are estimated SOURCE; Federal Reserve B :urilies Data Company; and Federal Financial Institutions Exam ma icil, Consolidated Reports of Condi- mergers and acquisitions and share repurchases increased tiom aid Income (Call Report). considerably. Onbalance, despite increased borrowing andnet equity the rise in mortgage rates and a net tightening of credit retirements, the strength of corporate earnings growth has standards for these loans—an explanation consistent with left the credit quality of nonfinancial firms solid. Balance responses to the loan officer survey. sheet liquidity remains high, and corporate leverage is near Gross public issuance of equity by nonfinancial historical lows. Li addition, net interest paym ents relative corporations in 2006 roughly maintained the moderate to cash flow remained near the low end of the range seen pace of the past couple of years, and private equity issu- over the past two decades. The six-month trailing bond ance appears to have risen a bit to finance buyouts and default rate fell during the first half of the year as defaults other restructurings. Still, net equity issuance turned by some large firm s in the troubled airline and autom obile more negative as equity retirements from cash-financed sectors in late 2005 dropped out of the series, and it was near zero throughout the secondhalf of 2006. Delinquency Net percentage of domestic banks, tightening rates on business loans remained quite low. standards on commercial and industrial loans to large and medium-sized borrowers, 1992-2007 Default rate on outstanding corporate bonds, 1992-2006 I I I I l_ 1992 1995 1998 3001 200=1 2007 pe M r y O e T a E r : . t T h h e e l a d s a t t a o , b a s r e e r v d a r t a i w on n i f s r o fr m om a l s i u e r v J e a y nu g a e ry n e 2 ra 0 l 0 ly 7 s c u o r n v d e u y c , t w ed h i f c o h u r t im tim er e s s 1994 1997 2000 2003 200 6 20Q6:Q4. Net percentage is ihe percentage of banks reporting a tightening of NOTE: The daia are monthly and Extend through December 20G6. The rate standards less the percentage reporting an easing. The definition forfinn =i?e for a given month is the face value of bonds that defaulted in the six months suggested for, and generally used by, survey respondents is that large and ending ic that month, multiplied by two to anmialize the defaults and then medium-sized firms nave sales of £50 million or more. divided by the face value of all bonds outstanding at the end of the calendar SOURCE: Federal Reserve, Senior Loan Officer Opinion Survey on Bank quarter immediately preceding ihe Kis-month period. Lending Prauiiues. SOURCE: Moody's Investors Service. 82 12 Monetary Policy Report to the Congress • February 2007 The Government Sector realizations (which are excluded from MPA incom e), the effect of som e taxpayers moving into higher tax brackets Federal Government as their real incomes increased, and possibly a further shift in the distribution of income toward high-income The deficit in the federal unified budget narrowed further households that typically face higher tax rates. In the during the past year. The unifiedbudget recorded a deficit first quarter of fiscal 2007, revenues were more than of $248 billion in fiscal year 2006—$70 billion smaller 8 percent greater than in the same period a year earlier, than in the previous fiscal year. The federal deficit in fiscal as both individual and corporate tax payments continued 2006 was a bit less than 2 percent of nominal GDP, signifi- to rise briskly, cantly lower than its recent fiscal year peak of more than Nominal federal outlays increased about IVi percent V-A percent of GDP in 2004. In fiscal 2006, outlays rose in fiscal 2006 and were about 20VA percent of nominal about in line with nominal GDP, but receipts increased GDP, well above their most recent fiscal year low of less at a faster pace. From October through December—the first quarter of fiscal 2007—the federal deficit was almost than 1 S'/3 percent of GDP in 2000. Net interest payments increased 23 percent in fiscal 2006, as interest rates rose $40 billion less than in the same period a year earlier, as and federal debt continued to grow. Outlays for Medicare the rise in receipts continued to outpace the growth in increased IOV2 percent, reflecting in part new benefits outlays. The latest projections from the Congressional payments associated with the Part D prescription drug Budget Office and the Administration anticipate that the program, which started in January 2006. At the same unified deficit in fiscal 2007 will be smaller as a percent- time, outlays for Medicaid declined a bit, to some extent age of nominal GDP than it was in fiscal 2006. Although because ofashiftofsomeMedicaidpayments to Medicare the unified deficit has improved recently, the federal Part D. Spending for disaster relief and national flood budget will face the mounting pressures of providing insurance was almost $28 billion greater in fiscal 2006 Social Security and health benefits to a rapidly growing than in the previous fiscal year, prim arily owing to the fed- number of beneficiaries as the baby-boom generation ages eral governm ent's response to the hurricanes in the autumn in coming years. of 2005. Outlays for defense in fiscal 2006 slowed to their In fiscal 2006, nominal federal receipts rose 11% per- lowest rate of increase sincefiscal 20013 although the rise cent and were equivalent to almost 18Vi percent of nominal was still about 6 percent. In the first quarter of fiscal 2007, GDP, substantially higher than their recent fiscal year low totalfederal outlays were only 1 percent greaterthan those of 1 6VA percent of GDP in 2004. Income tax receipts from in the same period a year earlier; in this period, defense individuals outpaced the rise in taxable personal income spending was 12 percent above its year-earlier level, but (as measured in the NIPA), while surging corporate tax outlays related to disaster relief and flood insurance were payments about matched the robust growth m profits. markedly lower than they were a year earlier. As noted above, the increase in individual income tax As measured in the NIPA, real federal expenditures liabilities relative to taxable income in the MPA appears to on consumption and gross investment—the part of fed- have reflected, atleast in part, taxes on larger capital gains eral spending that is a direct component of real GDP— Federal receipts and expenditures, 1986-2006 Change in real government expenditures Percent of nominal GDP on consumption and investment 2000—06 H State and local — 12 — 9 n. rl 1986 1990 1994 2002 2006 NOTE; The receipts and expenditures data.are on a.unifjed-budgetbasis and are for fiscaJ years (October through September); GDP is for the four quartets 2000 2001 2002 2003 2004 2005 2006 ceding in Q3. SOURCE: Office of Management and Budget. SOURCE: Department of Commerce. Bureau lOfEcanomic Analysi 83 Board of Governors of the Federal Reserve System 13 Net saving, 1986-2006 Federal government debt held by the public, 1960-2006 Fere ait of nominal GDP i_J_l L_J_ i__i_J_"i_L_± I I I I I I I i I I I I I L JJiilLLLLLLLLLLl JilLJ.U ILLLLLLLllLl LLLLLLIJILLLJ JJJ 1985 1990 1994 1998 2002 2006 1966 1976 1986 1926 2006 NOTE: The data are quarterly and extend through 2!iO6:Q3. Nomiederal "NOT?:: The final observation is for 2QO6:Q3. For previous years, the data s s a ta v t i e n g an i d s l t o h c e a l s u g m ov e o r f n p m e e rs n o ts n . al raid, net business saving and the net saving of f a o t r a d n e a b n t n a u re a l a r s a o te f . y E e x a c r- l e u n d d ehs a s n e d cu t r h i e ti e c s o r h r e e l s d p o a n s d i i n n v g e s v t a m lu e e n s t s f o o r f G fe D de P r a a l r e g f o o v r e Q rn 4 - SOURCE: Department of Commerce, Bureau of Economic Analysis. ment accounts. SOURCE: Federal Reserve Board, flow of funds data. increased 2l/j percent over the four quarters of calendar Early in the first quarter of 2006, federal debt subject year 2006 and contributed about VA percentage point tot he to the statutory limit reached the then-current ceiling of growth rate of real GDP in that year. The increase was the $8.2 trillion. The Treasury employed various methods to result of a pickup in real defense purchases, which rose avoid breaching the limit until the Congress increased it more than 4 percent during calendar 2006 after two years to nearly $9 trillion in March. As of the end of December, of smaller increases. At the same time, real nondefense the total amount of federal debt subject to the limit was purchases declined more than 1 percentafter having risen, $8.6 trillion, on average, about 2 percent per year over the preceding In February, the Treasury auctioned thirty-year bonds two years. for the first time since 2001. The offering was appar- The reduction in the unified deficit in the past two years ently well received, as was the reopening of ihe issue in implies that the federal govemm ent required less national August. The Treasury announced in August that it would saving to finance its operations. However, nonfederal sav- issue thirty-year bonds on a quarterly basis beginning in ing, which excludes borrowing by the federal government 2007. from total net national saving, remained relatively low. The acquisition of Treasury debt by foreigners slowed Although the saving rate for private business and state further in 2006 from its peak in 2004. However, out- and local governments has increased in recent years, the improvement has been offset by declines in the personal saving rate. Total national saving, net of depreciation, was Treasury secisiities held by foreign investors 2 percent of nominal GDP in the third quarter of 2006. as a share of total outstanding, 1998-2006 The recent national saving rate is an improvement from the lows of a few years ago, but it has been insufficient to avoid an increasing reliance on borrowing from abroad to finance the nation's capital spending. Federal Borrowing The Treasury responded to the reduction in the federal deficit in 2006 by paying down Treasury bills over the course of the year and by trimming the gross issuance of marketable Treasury coupon securities. As of the third quarter of 2006, the quantity of federal debt held by the 1998 15*99 2000 2001 2002 2003 2U04 2005 2006 public as a percentage of nominal GDPhad declined about NOTE: The data are quarterly and erctend through 2006:Q3. % percentage point, to about 36 percent SUJRCE: Federal Reserve Board, flow of funds data. 84 14 Monetary Policy Report to the Congress • February 2007 standing Treasury debt also grew more slowly, leaving quarters of 2006. States and localities generally have seen the share of outstanding debt held by foreign investors improvement in their fiscal positions recently, but in com- little changed, on balance, from its average level over ing years most governments will have to face the budget the preceding two years. According to Treasury data on pressures of providing pension and health benefits to an international capital flows, foreigners (official and other) expanding number of retired employees, and the states' purchased considerably fewer U.S. Treasury coupon costs for Medicaid are expected to rise substantially as securities in 2006 than in 2005. The average proportion the baby-boom generation ages. of nominal coupon securities purchased by foreign and Real expenditures by state and local governments international investors at auctions in 2006 about matched on consumption and gross investment, the component the average from the previous year at 16 percent, but it of these governments' spending that enters directly into was down noticeably from an average level of 25 percent the calculation of real GDP, rose 3 percent over the four in 2004. quarters of 2006. That increase was the largest since 2001 and contributed about VA percentage point to the change in real GDP during the year. Real expenditures for invest- State and Local Government ment rose 4%percentJ largely because of astrong increase in real construction spending in the first half of the year. The fiscal positions of state and local governments Spending for current consumption in real term s increased improved further in 2006. Apart from federal grants-in- 2lA percent over the four quarters of 2006. Hiring by aid, revenues rose at an annual rate of 7 percent over the state and local governments stepped up last year. Of the first three quarters of 2006 after posting relatively strong cumulative increase in employment of 254,000 in 2006, gains in the preceding two years. Receipts from taxes on about two-thirds of the jobs were in education. retail sales and on individual and corporate incomes con- tinued to rise at a brisk pace, however, decreasing gains in house prices slowed the rise in property tax revenues in the State and Local Government Borrowing third quarter of 2006 from the rapid pace in the previous two years. The sustained strength in total revenues, along Borrowing by state and local governments droppedbelow with the efforts of states and localities to restrain spending its rapid 2005 pace amid improved fiscal positions and for health care, has enabled these jurisdictions to step up fewer advance refunding issues. Nonetheless, bond issu- spending on other programs and still rebuild their reserve ance for new capital expenditures, particularly for edu- funds. As measured in the NIPA, net saving by state and cation and transportation, boosted long-term borrowing. local governments excluding social insurance funds—a Credit quality in the state and local sector rose substan- measure that is broadly similar to the surplus in an operat- tially in 2006, as the number of credit-rating upgrades far ing budget—was almost $4 billion during the first three exceeded the small number of downgrades. The External Sector State and local government net saving, 1986-2006 The U.S. current account deficit averaged $875 billion at Percent of r.Qsmna.1 GE'F an annual rate, or about 6V2 percent of nominal GDP, in the first three quarters of 2006 (the latest available data). The deficit was wider than in 2005, partly because of a larger deficit on trade of goods and services. In addition, net investment income, which turned negative in the fourth quarter of 2005, remained negative in the first three quarters of last year, further expanding the current account deficit. International Trade 1991 1994 1997 3000 2C03 2006 After widening through most of 2005, the nominal trade NOTE: The data, vtiLich are quarterly, are on a national income and j deficit leveled out in the first half of 2006, rose to a record account basis and extend through 2306:Q3. Net saving excludes socia high in August, and then narrowed noticeably through SOURCE: Department of Commerce, Bureau of Economic Analysis. November (the latest available data). On average, the 85 Board of Governors of the Federal Reserve System 15 U.S. trade and current account balances, 1999-2006 Change in real imports and exports of goods and services, 1999-2006 Percsii: oF nominal G-DF • Imports HI Exports U — 3 — 10 1993 2000 2001 2002 2003 2004 2005 2006 NOTE: The dSa are quarterly. For the trade account, Hie observation for 1999 2000 2001 2002 2003 2004 2005 2006 20G6:Q4 is estimated Hie data for the cuircnt account extend through URCE,: Department of Commerce. 2006:Q3. SOURCE-: Department of Commerce. sharply in the second and third quarters; they decelerated nominal trade deficit was wider in 2006 than in the pre- toward the end of the year as prices of exported fuels vious year. Nominal imports of goods grew more slowly retreated from their high levels and as prices of exported than exports did early last year and, after reaching late- metals moved up more slowly. summer peaks, dropped because of declines in both the Real imports of goods and services rose 3 percent last price and volume of imported oil. Meanwhile, imports of year, more slowly than in the previous year. As with the services decelerate d sharply in the second half of last year. growth in real exports, real import growth got off to a In contrast, nominal exports of goods and services pushed quick start last year amid robust domestic growth. But upward steadily throughout the year and grew significantly import growth slowed, on average, in the middle quarters faster than did nominal imports. Given that die level of of the year, along with U.S. real GDP growth, and real exports was smaller than the level of imports, the faster imports fell in the fourth quarter as a result of a sharp export growth during 2006 was not enough to narrow the drop in oil and natural gas imports. Despite some fourth- nominal trade deficit. Although the nominal trade deficit quarter declines, for the year imports increased in every last year (through November, annualized) was wider in major end-use category except petroleum and natural gas. dollar terms, the trade deficit as a share of GDP, at just Imports of services rose more than 5 percent last year, a under 6 percent, was about the same as in 2005. step-up from the previous year's sluggish pace. Real exports of goods and services grew a robust Prices of imported non-oil goods increased less than 9VA percent last year. In the first quarter, growth was 1 percent, on balance, in 2006 despite some wide gyra- boosted by a catch-up of exports affected by hurricane tions. After falling in the first quarter, prices reversed damage in late 2005. Throughout the year, exports were course, surged upward, and then cooled in the fourth supported by strong foreign economic activity. Real quarter. The quarterly p attem was driven by m ov em ents in exports of goods rose 10'/i percent last year, a little faster nonfuel commodity prices, which soared in the second and than in the previous year Export growth was spread fairly third quarters before leveling off in the fourth quarter. evenly across all m aj or end-use categories, though exports Metals figured prominently among the nonfuel com- of computers and semiconductors expanded noticeably modities that boosted trade prices last year. Prices for a more slowly than in 2005. By destination, exports to China variety of metals—including copper, aluminum, nickel, and other emerging Asian economies grew very rapidly, and zinc—skyrocketed in the second quarter. Factors as did those to South America. Exports to Mexico and contributing to the surge in prices included growing western Europe rose at a more modest pace. Real exports demand, particularly from developing countries, low lev- of services were up a solid 6% percent for the year, double els of inventories for som e metals, and perhaps increased the pace of 2005. speculative demand. Prices for nickel and zinc continued Prices of exported goods rose at a 3 lA percent rate last to move up throughout the year. In the second half of the year, a little faster than their pace in 2005. Reflecting the year, aluminum prices trended sideways, and copper prices effects ofvery large jumps in prices of industrial supplies, moved down from their peaks as inventory and supply particularly fuels and metals, export prices moved up conditions improved somewhat Formostof thesemetals3 86 16 Monetary Policy Report to the Congress • February 2007 Prices of oil and of nonfuel commodities, 2003-07 2004. Oil demand over the past year has also increased modestly in developing countries despite high prices. January 2C03 = 100 The Financial Account Foreign official inflows in the first three quarters of 2006 were above then 2005 pace but remained below the record levels of 2004. Most of these official inflows were attributable to Asian central banks and took the form of purchases of U.S. government securities, primarily bonds and mortgage-backed securities issued by government- sponsored enterprises (GSEs). Preliminary data indicate a slight easing of official purchases in the fourth quarter 2003 20W 2003 2006 2007 of 2006. Net private inflows slowed in the first quarter but have changed little since then. NOTE: The data are monthly and extend through January 2007. The oil price is the spot price of West Texas intermediate crude oil. The price of nonfoel commodities is an usdex of forty-five primary-commodity prices. SOURCE: For oil, libe Commodity Research Bureau; for nonfliel com- modities. International Monetary Fund. U.S. net financial inflows, 2003-06 those price trends have continued this year. An exception ] Official is zinc, the price of which has plummeted. 1 Private • 250 The spot price of West Texas intermediate crude oil averaged $66 per barrel in 2006, nearly $10 per barrel 200 higher than in 2005; moreover, crude oil prices were especially volatile last year. The spot price climbed from around $61 per barrel at the end of 2005 to a peak of $77 per barrel in August as violence in the Middle East a shut- down of the Prudhoe Bay oil field in Alaska, and forecasts of an active hurric ane season led to increased dem and. In the event, oil supply was affected far less than anticipated by these factors, and oil prices declined over the next few months as demand dropped and elevated petroleum inventories were drawn down. Oil dem and for heating was NOTE: The data are quarterly and extend through 2006:Q3. SO'.IRCE: Department ol Commerce. depressed by above-average temperatures in the Northern Hemisphere in the fourth quarter and in the early weeks of 20073 and the spot price fell further, to around £50 per Net private foreign purchases of long-Term U.S. securities, barrel in raid-January, before moving back up to $58 per 2QQ3-06 barrel at the end of the month. Far-dated futures prices began last year at about $60 per barrel, moved in a pattern similar to spot prices throughout most of the year, and • Bonds averaged just over $61 per barrel in January 2007. M Equitic — 200 Notwithstanding the decrease of global oil prices since — 150 August, several factors continue to support these prices at historically elevated levels. Ongoing violence has dimin- — 100 ished oil production in Iraq and Nigeria. The continuing dispute with Iran over its nuclear program threatens a possible curtailment of Iranian exports. Energy investment by international oil companies has been hampered in some countries, such as Russia and Venezuela, by increased gov- ernment control of domestic energy industries. Moreover, in response to the recent decline in oil prices, OPEC has 20(33 2004 reduced its crude oil production to the lowest level since NOTE: The dam are quarterly and extend through 2Q06:Q3. SCUR.CE; Department of Cor 87 Board of Governors of the Federal Reserve System 17 Foreign private purchases of U.S. securities in the Civilian unemployment rate, 1974-2007 second and third quarters of 2006 slowed slightly from the extraordinary pace set in the second half of 2005 and early 2006, but preliminary fourth-quarter data show recent demand to have been strong. More than half of private flows last year took the form of purchases of corporate bonds, and most of the remainder went toward A investment in GSE bonds and corporate equities. On net, r\ private foreigners purchased few U.S. Treasuries. Foreign A — 6 direct investment flows into the United States remained robust Net purchases of foreign securities by U.S. residents, a financial outflow, set a record pace in the first three quarters of 2006. Preliminary data show a further surge I_LJ_LU _UJ_l JJ_Li_LLLLLL JJJJJJJ. LLLLLLLLLJjJ in net purchases in the fourth quarter. Demand for foreign 1977 1987 1997 2007 bonds by U.S. residents slightly exceeded that for foreign NOTE: The dstaare monthly and extend through January 20C7. equities. After the expiration of the partial tax holiday SOURCE; Departmiait gf Labor, Bureau of Labor Statistics. implemented in the Homeland Investment Act of 2004, U.S. direct investment abroad dropped back to more second and third quarters of 2006, and this sector shed normal levels. workers in the fourth quarter. Although hiring for nonresi- dential building construction remained brisk for most of the year, the steep decline in housing starts curtailed the The Labor Market overall demand for construction workers. Employment in the manufacturing sector, which rose in the first half of Employment and Unemployment 200&. declined in the second half as factory output slowed. From July to December, many of the factory layoffs were Labor markets remained strong in 2006. Nonfarm payroll at makers of motor vehicles and parts and at producers employment increased 186,000 per month, on average, closely tied to the construction industry. Outside of the during the second half of 2006, a rate essentially the construction and manufacturing sectors, employment same as in the first half of the year. Employment rose generally increased at a solid pace in the second half of 111,000 in January of 2007. The unemployment rate in 2006, and hiring was particularly rapid in a number of the fourth quarter of last year—AlA percent—was at its service industries—especially those providing education lowest quarterly level since 2001, and it was little changed and health services, professional and technical business in January 2007. services, and financial services. hi response to the contraction in homebuilding, hir- As aresult of the continued expansion of labor demand ing in the construction sector slowed considerably in the in 2006, the unemployment rate fell further. After remain- ing around 4% percent in the first three quarters of 2006, Net change in payroll employment, 2001-07 the unemployment rate edged down to 414 percent in the fourth quarter. The tighter labor market was associated with anoticeable increase in employment among individu- als who had not been participating in the labor force. In line with this cyclical tightening of the labor market, the labor force participation rate ticked up during 2006, from 66 percent in the first quarter to 66VA percent in the fourth quarter, after a lA percentage point rise during 2005. The recent rise in the participation rate follows a period of decline beginning in the late 1990s that in part reflected some longer-term secular trends in labor force behavior. Those trends included a leveling off in the participation rate of women and an increase in the proportion of the workforce in older age groups, which have lower average participation rates. 2001 2002 2003 2004 2005 2006 2007 Other indicators also suggest that labor market condi- 1 S S O [O U T R E C I E T ; S S D ci e iff p fi a T r ii t m O e U n S t H I o & f K L S a s b e o c r t , o r B . ureau of Labor Statistics. tions remained generally favorable during the second half 18 Monetary Policy Report to the Congress • February 2007 Labor force participation late, 1974-2007 cent average annual rate of increase during the first half of this decade and the second half of The 1990s. During that earlier period, productivity gains were spurred by the rapid pace of technological change, the growing abil- ity of firms to use information and other technology to improve the efficiency of their operations, and increases in the amount of capital per worker. Despite the recent slowing in productivity growth, these underlying factors do not appear to have waned. Accordingly, the recent slowdown in labor productivity may be at least in part a temporary cyclical response to the m oderation in the pace of economic activity in 2006 rather than a meaningful downshift in the longer-run trend. As the labor market tightened in 2006, the rise in iJJJJJJJJ.J_LLi 1 I I 1 I I I i I I i i I I I i I i II i I I I il 1977 1987 1997 2007 hourly labor compensation, which includes both wages NOTE: The data are monthly and exttnd through January 2007. and employer payments for employee benefits, stepped SOURCE; Department of Labor, Bureau of Labor Statistics. up for workers in the nonfarm business sector. In nominal terms, compensation per hour increased almost 5 percent over the four quarters of 2006, compared with an average of 2006. Layoffs remained low as new claims for unem- 4 percent rise in the preceding two years. After adjusting ployment insurance fluctuateda round arelatively subdued compensation for increases in the PCE price index, real level of 315,000 per week. In addition, data reported by compensation per hour rose 3 percent in 2006, up from the Bureau of Labor Statistics showed a further increase an average gain of about 1 percent in 2004 and 2005. during the later part of the year in the rate of job openings as a percentage of private-sector employment. An alternative measure of employee compensation is the employment cost index (ECI) for private nonfarm businesses, which is based on a survey of firms conducted Productivity and Labor Compensation by the Bureau of Labor Statistics. According to this mea- sure, nominal hourly compensation increased 3VApercent The growth rate of labor productivity in the nonfarm busi- in 20063 VA percentage point faster than in 2005. In real ness sector, which had slowed in 2004 and 2005 from an terms, the ECI for hourly compensation rose 1 VA percent exceptionally rapid pace earlier in the decade, remained last year after averaging a 'A percent increase over the relatively subdued in 2006. Over the four quarters of 2006, output per hour of work in the nonfarm business sector increased 2 percent, compared with about a 3 per- Measures of change in hourly compensation, 1996-2006 Change in output, per hour, 1948-2006 — Nonftrm busim compensation per hour Employment cost index 1956 1*358 S000 2002 2004 NOTT: The data are quarterly and extend through 2006: Q4. For nonfartii business compensation, change is over four quarters; far the employment coa 73 1 9 9 5 7 4- 1 0 9 0 0 6 n i e n a o d c n e h p x r o q ( f u E it a C r i t I n e ) r s , . t c iw h T a t h i n o e g n e n s , o i s n a f n o a d r \ m e h i o t u b h s u e e s h t in w o e l e d s h s s . e s T m e h c o e to u s r th e c s e t x o e c r n l u d c d i o n e v g s e r i f e n a d r t m h b s e y , l t a h g s e o t v E m e C r o n n I m t u h e s n o e t d f , NOTE: INJonfarm business sector. Change for each muftiyear period is here is the same as the n old aim bussici •sector plus nonprofit institution;;. A nttasured fiwn the fourth quarter of the year immediately preceding the new ECI series was introduced for daia as of 2001, hut the new aeries is period to the feiurth quarter of !he final year of the period. continuous with the old. SOURCE: Department of Labor, Bureau of Labor Statistics. SOUU.CE: Department of Labor, Bureau of Labor StSistics. 89 Board of Governors of the Federal Reserve System 19 Change in unit labor costs, 1996-2006 Alternative measures of price change, 2004-06 Percent Chain-type Gross domestic product (GDP) Personal consumption expenditures (PCE)... Excluding food and energy , Market-based PCE excluding food and Fixed-weight Consumer price index Excluding food and energy 2.1 2.1 2.6 NOTE: Changes are based on quarterly averages of seasonally adjusted data. SOURCE: For chain-type measures. Department of Commerce, Bureau of Economic Analysis; for fixed-weight measures, Department of Labor, Bureau of Labor Statistics. 1996-2000 2001 2002 2003 2D04 2003 2006 NOTE: Nonfe™ business sector. The change for 1996 in 2000 is i from 1995:Q4ro2000:Q4. 2006, a step-down from the 3 percent increase recorded SOHP.CE: Department of Labor, Bureau ofLabor Statistics. in 2005. The drop in energy prices in the latter part of 2006 accounted for the deceleration in the headline preceding two years. The nominal wages and salaries number. Core inflation moved higher in the first part component of the ECI rose 3'/4 percent in 2006, while the of 2006 but then eased toward the end of the year. benefits component advanced 3 percent. On balance, core PCE prices rose about 2!4 percent From the perspective of employers, the acceleration over the four quarters of 2006, a little faster than the in hourly compensation in the nonfarm business sector 2 percent increase in2005 The market-based component last year boosted the average labor costs associated with producing a unit of output 2% percent, up from increases of the core PCE price index—which excludes imputed of about 1Y* percent in both 2004 and 2005. Although the prices that are not observed in market transactions and rise in unit labor costs increased, firms' profit margins that often change irregularly—increased 2 percent in appeared to remain elevated in 2006 relative to longer-run 2006, about !4 percentage point more than in the previ- standards. ous year. Energy prices recorded dramatic swings during 2006. PCE energy prices increased at an annual rate of about 15 percent in the first half of the year and declined at Prices an annual rate of almost 17 percent in the second half. The sharp movements in consumer energy prices in Headline inflation slowed in 2006. The PCE chain-type 2006 were associated primarily with fluctuations in price index rose 2 percent over the four quarters of prices for crude oil. The changes in energy prices also were amplified by a widening in the margin of the retail Change in core consumer prices, 2000-06 price of gasoline over the associated cost of crude oil in the first half of the year and by som e narrowing of that ni argin in the second half. Onbalance,thePCE energy price index 8 Chain-type price indexforcore PCE decreased 4 percent over the four quarters of 2006. Food price inflation remained fairly moderate in 2006. The PCE index for food and beverages increased 2% per- cent, roughly the same pace as in the preceding year. Retail prices of meat and poultry rose modestly for 20063 as robust demand was met by ample supplies of meat. Prices of wheat rose over the course of the year, and prices of corn and soybeans spiked at the end of the year in the wake of downward revisions to estimates of crop production. Prices of corn also were boosted during the year by LJ_'_B L^MA J I increased demand for com to produce ethanol. But the 2000 2001 2002 1003 2004 2001 small share of wheat, com, and soybeans in the total value S i mrE Foi LOTB consume! price mde\ Depaitmen! 1 I ab' i Bureau of of food production limited their effect onretail foodprices. Labor Statistics; for core PCE price index, Department of Commerce, Bureau of Economic Analysis. Prices for food consumed away from home, which are 90 20 Monetary Policy Report to the Congress • February 2007 influenced importantly by the costs of labor, energy, and TIPS-based inflation compensation, 2003-07 other business inputs, increased 3>VA percent in 2006, a more rapid pace than that for prices of food consumed at home. The core PCE price index accelerated to an annual rate of about 2Vi percent in the first half of 2006 on the strength of pickups in the price indexes for both goods and services. In the spring, increases in housing rents were particularly sharp. The rise may have reflected in part a shift in demand toward rental housing as ris- ing mortgage rates and lofty home prices made home purchases less affordable. The pass-through of higher energy costs to a broad range of goods and services also probably contributed to the acceleration in core consumer price inflation in the first half of 2006. 2003 2004 2005 2006 2007 In the second half of 2006, core PCE price inflation NOTE: The daia are daily and extend through Febiuaiy 7, 2007. Based on a edged down to an annual rate of just below 2Va percent. comparison of the yisld curve for Treasury inflation-protected securities (TIPS) with the nominal off-the-nin Treasury yield curve. The deceleration was the result of a decrease in core goods SOURCE: Federal Reserve Board calculations based ou dataprovidsd. by ihe prices, which likely reflected in some measure the wan- Federal Reserve Bank of New York and Barclays. ing influence of energy prices. In contrast, core services inflation in the second half of the year remained at about likewise suggest that longer-run inflation expectations the sam e pace as in the first half Although housing rents have remained contained According to the Survey of Pro- rose more slowly in the second half of the year, their effect fessional Forecasters, conducted by the Federal Reserve on the PCE for core services was mostly offset by faster Bank of Philadelphia, expectations of inflation over the price increases for medical care and a number of other next ten years remained at 2V& percent in 2006, a level that services. has been essentially unchanged since 1998. In addition, The swings in energy costs in 2006 were apparent in inflation compensation implied by the spread of yields on the prices of inputs used in die production and sale of final nominal Treasury securities over their inflation-protected goods and services, especially of items for which energy counterparts stayed within the relatively narrow range of costs represent a relatively large share of total production 2 percent to 2% percent during Ihe year. costs, including industrial chemicals, plastics, fertilizer, and stone and clay products. In addition, the prices of some commodities, such as a variety of m etals, rose significantly U.S. Financial Markets in 2006 in response to strong worldwide demand. As a result, the core producer price index for intermediate Financial conditions in the United States supported goods, which excludes food and energy, rose 5lA percent economic growth in 2006. Yields on long-term Treasury in 2006, up from the A3A percent increase in 2005. The securities climbed a bit, on balance, but stayed low by index increased at an annual rate of IVA percent in the historical standards, while strong corporate profits helped first half of 2006, but it decelerated to an annual rate fuel substantial gains in equity markets. Liquid corporate of about VA percent in the second half as energy costs balance sheets and low corporate leverage helped keep risk declined. spreads on corporate bonds narrow. Meanwhile, business For the year as a whole, measures of long-term inflation borrowing picked up to a rapid pace, spurred in part by a expectations remained well anchored although short-term rise in merger and acquisition activity. In the residential expectations were heavily influenced by fluctuationsi n real estate sector, mortgage borrowing slowed markedly, energy prices. The Reuters/Michigan survey measure of as house prices decelerated, especially in the second half the median expectation of households for inflation over of the year. Consumer credit expanded at a moderate pace. the next twelve months was about 3 percent in December, Nonetheless, household debt growth outpaced the growth down from its peak of 3% percent in August. Longer-term of disposable personal income, and the financial obliga- inflation expectations recorded in the Reuters/Michi- tions of households inched higher. Although households gan survey showed less variability. The median survey generally appeared able to meet their obligations, signs respondent in December expected the rate of inflation of financial strain were apparent in subprime variable-rate during the next five to ten years to be 3 percent, down mortgages. The M2 monetary aggregate expanded at a from its peak of 3Va percent in August. Other indicators moderate pace in 2006. 91 Board of Governors of the Federal Reserve System 21 Interest rates on selected Treasury securities, 2003-07 Spreads of corporate bond yields over comparable off-the-nm Treasury yields, 1998-2007 High-yield _J I NOTE: The data are dsiSy aid extend through February 7,2007. SOURCE; Departmeat of the Treasury. Tht ddia are dad, ;\tend Ihro igh Telnnrj Interest Rates othed corporate yield using Mei Lynch bond data. Market interestratesrosemodestly, on balance, in 2006— counterparts in 2006. Medium- and long-term inflation yields on two- and ten-year nominal Treasury securities compensation—measured from spreads between yields increased about 40 and 30 basis points respectively. on nominal and inflation-indexed securities—were about Changes in interest rates seemed largely tied to changes unchanged to a little lower, on net, and during the year in the outlook for economic growth and inflation Rates these measures exhibited only modest swings in response across the maturity spectrum increased notably over the to incoming inflation data and oil price movements, first half of the year, as incoming data on activity and In the corporate bond market, yields on investment- inflation came in higher than markets had expected and grade securities moved about in line with those on com- as the FOMC raised the target federal funds rate 25 basis parable-maturity Treasury securities. In contrast, yields points at each of its first four m eetings. At the tim e of the on speculative-grade securities fell slightly, pulling risk June FOMC meeting, interest rate futures market quotes spreads lower in that segment of the market. The narrow- indicated that market participants perceived considerable ness of investment- and speculative-grade spreads seems odds of an additional rate tightening by year-end. Howev- to reflect investors' sanguine perceptions of corporate er, market interest rates declined, on net, over subsequent credit quality over the medium term, which likely reflect months in response to incom ing data suggesting that infla- in large part the strength of business balance sheets and a tion pressures were moderating and that economic growth benign economic outlook. The term structure of forward was slowing. Market expectations for the trajectory of risk spreads for corporate bonds supports this view, as the federal funds rate over the next several years shifted forward spreads one and two years ahead are low, while down considerably during the second half of the year. the spreads further out the curve are more in line with More recently, m arket participants have backed away from historical norms. expectations of a substantial easing of monetary policy as incoming data on economic activity have been stronger than expected. Investors now expect the FOMC to ease Equity Markets policy only slightly over the next two years. Although investors modestly revised their medium-term policy Broad equity indexes soared 10 percent to 20 percent in expectations over the course of the year, the Committee's 2006, boosted by strong growth in corporate earnings. interest rate decisions were largely anticipated in financial Share prices rose across a wide range of sectors, but markets by the time of each meeting. Throughout the year, increases in telecommunications and security broker- forward-looking measures of uncertainty about monetary age stocks were especially noteworthy. The difference policy inferred from interest rate options remained near between the twelve-month forward earnings-price ratio the low end of historical ranges. for the S&P 500 and the long-term real Treasury yield—a Yields on inflation-indexed Treasury securities crude measure of the premium that investors require for increased about as much as those on their nominal holding equity shares—was little changed on balance, The 92 22 Monetary Policy Report to the Congress • February 2007 Stock price indexes, 2Q05-Q7 quarter, but the turbulence was short lived. The liquida- tion of a few sizable hedge funds attracted considerable January 3, 2005 = 100 attention for a time but had little discernible effect on the broad functioning of markets. Even the liquidation of Amaranth—a hedge fund that was wound down in the fall after reporting a loss in excess of $6 billion, mostly in energy trades—left little imprint on financial markets, although it raised some concerns about risk-management practices. Implied volatilities, risk spreads, and various other potential measures of financial stress generally stayed at very low levels throughout the year, suggesting that investors were comfortable taking on risk, likely in part because they were confident about the economic and financial outlook. Throughout the year, bid-ask spreads on the most NCTE: "Die data are daily aid extend ifarough Februaiy 7, 3007. actively traded Treasury securities remained within narrow SOUBCE: Frank Russell Company; Dow Jones Indexes ranges. Some instances of questionable trading activities occurred in the secondary market for Treasury securities over the course of the year. The Interagency Working Implied S&P 5QG volatility, 2000-07 Group for Treasury Market Surveillance monitored these situations closely.1 In November, the Federal Reserve Bank of New York arranged a meeting with all primary dealers to discuss developments in Treasury markets and to encourage the firms to review their internal oversight of trading operations. Subsequently, a private-sector group sponsored by the Federal Reserve Bank of New York released a draft report laying out a set of best practices for firms active in the Treasury market on topics such as appropriate trading strategies and internal controls. In July, the Federal Reserve Board implemented a revision to the treatment of GSEs and certain international organizations under its Policy on Payments System Risk. Under the change, interest and redemption payments on 2000 2001 2002 2003 2004 2005 2006 2007 securities issued by these institutions are now released se N rie C s T E sh : o T w h n e is d a th ta e a i r m e p w lie e d e k t l h y i rt a y n -d d a y ex v le o n la d t il t i h t r y o u o g f h t h F e e b 8 r & ua P r y 5 0 9 0 , s 2 to 0 c 0 k 7 . p T ri h c e e only when the issuer's Federal Reserve account contains ind S e O K U R a C s E c : a l C cu h l i a c t a e g d o f r B o o m a r a d w O e p ig ti h o t n e s d , E a x v c e h r a a n g g e e o . f options prices. t s u u t f i f o ic n i s e n n t o f l u o n n d g s e r to m c o ay v e e r m th p e lo p y a y d m ay e li n g t h s t ; c th re a d t i i t s 3 t o th f e u s n e d i n su st c i h - payments. The Board of Governors determined that the change represents an appropriate risk-m anagem ent policy implied volatility of the S&P 500 calculated from options for the central bank and is consistent with the general prices spiked temporarily in the late spring in connection practices of private issuing andpaying agents In addition, with a period of strain in several m arkets but rem ained near GSEs and international organizations are now subject to a historical lows for the remainder of the year. Net inflows penalty fee for daylight overdrafts resulting from general into domestic equity mutual funds were quite modest in corporate payment activity (activity other than interest and 2006, while inflows into international equity funds were redemption payments). This change aligns the policy for exceptionally strong. GSEs and international organizations with that for other Federal Reserve account holders that do not have regular access to the Federal Reserve's discount window and thus Market Functioning and Financial Stability are not eligible for intraday credit. The transition to the Overall, financial markets functioned smoothly over the year and proved resilient to several shocks. Equity markets in the United States and currency and fixed- 1. The group was established in 1992 and includes representatives income markets in several emerging-market economies from the Board of Governors of the Federal Reserve System, the Trea- sury, the Securities andExchange Commission, the Commodity Futures experienced heightened volatility late in the second Trading Commission, and the Federal Reserve Bank of New York. 93 Board of Governors of the Federal Reserve System 23 new policy occurred smoothly with minimal effects on the past ten years and is about 5 percentage points the functioning of the payments system and no notable above the average observed in the 1980s and early adverse effects on short-term funding markets. 1990s. Commercial bank credit expanded 9Vz percent Following up on a meeting with the Federal Reserve in 2006, supported by brisk growth in loans to busi- Bank of New York in the fall of 2005, the largest par- nesses. Bank credit also was boosted in the autumn by ticipants in the fast-growing market for credit derivatives a consolidation of a substantial volume of thrift assets agreed to a series of steps to strengthen that market's onto a commercial bank's balance sheet that had resulted infrastructure. Over the course of 2006, credit derivatives from an internal reorganization at a large bank holding dealers phased out the practice of transferring positions to company. a different counterparty without first obtaining the consent Bank lending to businesses through commercial and of the original counterparty. They also reduced by 85 per- industrial loans increased at a rapid pace last year. The cent the number of trade confirmations outstanding more growth was fueled by vigorous merger and acquisition than thirty days; they doubled the share of trades that are activity, rising outlays for investment goods, ongoing confirmed via an electronic platform, to SO percent of total inventory accumulation, and an accommodative lending trade volume; and they agreed upon a new protocol for environment. Bank loans secured by commercial real the settlement of such derivatives after a, credit event. estate, though strong, decelerated over the course of the year. The moderation in commercial real estate lending was consistent withresponses by large andmedium-sized Debt and Financial Intermediation by Banks banks to the Senior Loan Officer Opinion Survey on Bank Lending Practices, which pointed to slowing demand and a net tightening of credit standards for such loans in the Total debt of the domestic nonfinancial sectors expanded second half of the year. Consumer loans and residential an estimated 7% percent in 2006, well below the pace in mortgages held by banks grew at a moderate rate for the 2005 but still faster than that of nominal income. Debt year as a whole. However, excluding the effects of the growth slowed markedly in the household and government thrift consolidation, residential real estate lending slowed sectors, but business debt accelerated. considerably in the fourth quarter, no doubt reflecting in About 30 percent of the growth in nonfinancial part the downturn in the housing market. sector debt in 2006 was intermediated by the banking sector. This share is about even with the average over Commercial bank profits as a percentage of average assets were strong in 2006 and rose slightly above 2005 levels. Net interest margins declined a bit further, likely Change in domestic nonfinancial debt, 1991—2006 in response to continued competitive pressures and a modest inversion of the yield curve, but bank profitability was supported by growth in non-interest income and by well-contained costs. Continued strong asset quality also helped to support profitability in 2006 by allowing banks to reduce their loan-loss provisioning. Robust asset qual- ity was reflected in loan delinquency and charge-off rates that remained at low levels through the end of 2006. The M2 Monetary Aggregate and Reserves Components M2 expandedat a 5 percent rate last year, somewhat faster than in 2005. Typically, as short-term interest rates rise, deposit rates lag somewhat, increasing the opportunity Federal, — cost of holding money. In 2006, this effect apparently held by public slowed money growth less thanwouldhave been expected on the basis of historical norms, and the velocity of M2 1992 1994 1996 1998 20DD 2002 2004 20(16 rose only about % percent. Retail money market mutual NOTE: Fur 2006, change is from 2005;Q3 !.u 2006;Q3 at an animal iale. FOT funds and small time deposits, components of M2 whose earlier years, the data are annual nnd are computed by dividing the annual flow for a given year by the level at the end of the preceding year. The total yields move most closely with market rates, grew rapidly. consists of components shown. Noofederal debt consists of the outstanding However, liquid deposits, which constitute the largest credit market debt of slate und local governments, households, nonprofit organizations, and noafinancial businesses. Federal debt held by the public component of M2, and whose yields adjust more gradu- excludes securities held as investments of federal government accounts. ally, were about flat on net. Currency expanded a modest SOURCE: Federal Reserve Board, flow of funds data. 94 24 Monetary Policy Report to the Congress • February 2007 M2 growth rate, 1991-2006 Official or targeted interest rates in selected foreign industrial countries, 2004-07 — 4 — 3 — 2 — 1 Japan 0 1992 1994 1996 1998 2000 2002 2004 2006 _ J L OTE: The data ore annual on a Q4 over Q4 basis. M2 consists of eurrenc 2004 2005 2006 2007 veler's checks, demand deposits, other checkable deposit^ savin] NOT?-: The data are daily. The last observation for sssh. series is Febiuar osits (including money fisatket deposit sccoiini'g)., small-dm omitistfic 7, 2007. The data shown are the overnight rate for Canada, the refinandn e deposits, and balances in retail money market fluids. rate for the euro area, the call money rate for Japan, and the repurchase rat OURCE: Federal Reserve Board, Statistical Release I-L6P "Money Stoi for tbe United King dam. SOURCE: The ceniraJ bank of each area or country shown. 314 percent, an increase similar to that in 2005, reflecting the spring, the Bank of Japan (BO J) raised its policy rate weak, possibly negative, net demand from overseas. 25 basis points in July. Weak consumer spending and low Part of the Financial Services Regulatory Act of 2006 inflation have apparently deterred the BOJ from tighten- gave the Federal Reserve authority, beginning in October ing since then. With growth in the European economies 2011, to pay interest on reserve balances and to further firming, concerns over inflationary pressures promptedthe reduce or eliminate reserve requirements. At the October European Central Bank to raise its policy rate five times FOMC meeting, die Chairman asked the staff to prepare last year, to 3.5 percent. The Bank of Canada tightened for the implementation of this legislation. 75 basis points in several steps over the first half of the year but has left the overnight rate unchanged since then. After keeping its policy rate constant in the first half of the International Developments year, the Bank of England tightened policy 25 basis points in August and November 2006 and in January 2007. The Foreign economic growth was generally strong in 2006, statements accompanying each tightening cited the upside as expansion continued in all major regions of the world, risks to inflation posed by low levels of spare capacity. The Japanese economy decelerated somewhat but main- During the first half of 2006, ten-year sovereign yields tained positive growth, and the pace of activity in the euro in the euro area, Canada, and Japan rose sharply on bal- area picked up. Labor market conditions in both areas ance: Increases ranged from 45 basis points in Japan to improved. Emerging-market economies also recorded 75 basis points in Germany. Yields on inflation-protected solid growth last year and experienced no apparent last- long-term securities in these economies also rose during ing ill effects from the brief period of financial market the first half of 2006 but not as much as nominal yields volatility that hit some of them particularly hard in the and thus implied a noteworthy rise in inflation compensa- late spring. Although there are signs that steps taken to tion. These developments occurred largely in reaction to slow growth of investment in China have been effective, continuing upward pressures on inflation, which stemm ed the Chinese economy continued to grow rapidly. Rising from a further run-up in energy prices and indications that energy prices boosted consumer price inflation in many global economic growth remained robust areas of the world early last year, but m onetary tightening From their midyear highs, nominal government bench- appears to have prevented inflation from moving signifi- mark bond yields fell noticeably until about the begin- cantly higher, and the effects of higher energy prices on ning of December in most major advanced economies, core prices were modest. as investors reacted to moves in U.S. rates and evaluated Industrial countries tightened monetary policy in 2006, the implications for the global economy of the economic Some countries paused around the same time as the Fed- slowdown that seemed to be under way in the United eral Reserve, and others continued to tighten throughout States. Over this period, yields on ten-year nominal bonds the year. After ending its policy of quantitative easing in declined by amounts that ranged from about 25 basis 95 Board of Governors of the Federal Reserve System 25 Yields oil benchmark government bonds in selected U.S. dollar exchange rate against foreign industrial countries, 2004-07 selected major currencies, 2004—07 We* raiding Jamisry 2, 2D04=i0Q U.K. pound NOTE: The data are for ten-year bonds and are weekly. The last observatSor NCTS:The data. are vt,ekly Eaid EII foreign *:iirreney unitsper doll for each series is the average for February S tlsrough February 7. 2007. The lntobservation foreach scriesis ihe averagii for February5 throu SOURCE: Bloomberg L.P. February7, ZQQZ SCURC]J: Bloonnberg L.P. points in the United Kingdom to about 70 basis points in euro area, the United Kingdom, and Canada since their Canada. Yields on inflation-indexed securities declined December lows. As aresult, inflation breakeven rates have less; modest declines in inflation breakeven rates were been little changed. attributed in part to lower energy prices in the second half The Federal Reserve's broadest measure of the nomi- of the year. nal trade-weighted exchange value of the dollar declined Since the beginning of December, however, nominal 3% percent from the beginning of last year through early and indexed government bond yields have risen once February of this year. Over that period, the dollar appreci- again in most advanced economies, partly because new ated 21/4 percent against the yen and 114 percent against the data releases appeared to alleviate investors' concerns that Canadian dollar, but it depreciatedabout 9 percent, on net, global economic growthm ight slow appreciably, Yields on against the euro, almost 13 percent against sterling, and 4 both ten-year nominal and indexed securities have risen percent against the Chinese renminbi. The renminbi's rate 15 basis points in Japan and 25 to 50 basis points in the of appreciation stepped up in late 2006 and early 2007, but daily fluctuations in the dollar-renminbi exchange rate were very small. U.S. dollar nominal exchange rate, broad index, 2004-07 Most of the dollar's overall decline in 2006 occurred between mid-April and early May. During this period, Week ending January 9, Z0M = 10C m arket participants reportedly sensed that the FOMC was approaching the end of its series of policy tightenings, and interest rate differentials moved against the dollar. Traders also refocused on the large and persistent U.S. current account deficit, which was further boosted by crude oil prices that had moved above $70 per barrel. To date in 2007, the dollar's broad nominal exchange value has risen 1 percent on balance. In the wake of strong advances in 2005, major global equity indexes posted solid gains, on balance, in 2006 and in early 2007. After rising 5 percent to 10 percent m Li J j the first quarter of 2006, most global indexes fell sharply 2004 2005 2006 2007 beginning in early May to reach intra-year lows in mid- NOTE: The data are weekly and are in foreign currency units per dollar. June, Market participants attributed the drops in share The last observation is the average for February 5 through February 7, 2007. prices to increased uncertainty about prospective inflation, l T i. h S e . b d r o o l a la d r H ag id a e in s s i t s S a he w c e u ig rr h e t n e c d i e a s v e o r f a g * e l a o rg f e th .g e r f o o u r p e i o g f n th e e x c m ha o n st g e im v p a o lu rt e a s n t o U f t . h S e . caused in part by the run-up in energy prices, and to a trading partners. The index weights, which change over time, are derived retreat from risk-taking. Broad-based gains in stock prices from U.S. export shares and from U.S. and foreign import shares. since midsummer appear to be associated with a scaling SOURCE: Federal Reserve Board. 96 26 Monetary Policy Report to the Congress • February 2007 Equity indexes in selected foreign industrial countries, 7.5 percent in December, continuing a downward move- 2004-07 ment that began in 2004, Wages and salaries in the manu- facturing and services sector grew at an average annual Week aiding January 2, 20M -100 rate of 2lA percent in the first three quarters of the year—a bit lower than their rate of growth in 2005. Higher energy prices boosted euro-area consumer price inflation, which rose to about 2'/i percent in the first half of 2006; late in the year, it dropped below the European Central Bank's target ceiling of 2 percent. Core inflation remained near 1 Vz percent. Canada — 120 Real GDP in the United Kingdom grew 3 percent last year, and real GDP in Canada grew 3 percent, on aver- Uniled Kingdom — 100 age, through the first three quarters. Despite declining consumer confidence in the United Kingdom, the pace of consumption growth over the year was slightly higher than in 2005, and consumer spending in Canada, supported NOTE: The data are weekly. The last observation for each series is the by moderate employment growth, also remained robust. average for February 3 through Tthmsrj 7, 2007. Declines in energy prices brought Canadian consumer SOURCE: Bloomberg L.P. price inflation down after the middle of the year to a twelve-month change of about 1 Vz percent in December, below the Bank of Canada's 2 percent inflation target. back of expectations for future tightening of monetary Inflation in the United Kingdom edged up throughout the policy in several countries and with declines in energy year, partly because of increases in electricity and natural prices. Since raid-June, broad stock market indexes have gas prices that were implemented in the fall. gained 10 percent to 20 percent in Europe, Japan, and Canada. Emerging-Market Economies Industrial Economies Real GDP growth in China remained strong but moderated a bit in the second half. The mild slowdown suggests that After increasing at an annual rate of roughly 2 percent the administrative measures put in place by the Chinese in the first half of 2006, Japanese real GDP grew only authorities to cool investment have had an effect. The % percent in the third quarter, largely because of slower trade surplus recorded a substantial increase in 2006. growth of consumption. Capital spending was an impor- Four-quarter inflation picked up near the end of last year tant contributor to growth of output throughout the year, to over 2 percent, reflecting higher food prices. supported by strong corporate profitability. Labor market Elsewhere in emerging Asia, economic performance conditions continued to improve; the unemployment rate was generally solid in 2006. InKorea, GDP growth slowed was about 4 percent in December, its lowest level since from the strong pace registered in 2005, partly because 1998, and the ratio of job offers to applicants remained of monetary tightening, and consumer price inflation close to a thirteen-year high. However, wage growth was remained modest. The pace of growth in other countries very subdued, as firms controlled cost increases, and unit stayedstrong throughout 2006 as aresult of robust exports labor costs continued to fall. In 2006, consumer prices and, in some cases, strengthening domestic demand. started to rise again, posting small twelve-month increases Four-quarter inflation moderated across the region. That after June, and land prices in Japan's six largest cities rose moderation resulted from the waning effects of earlier for the first time since 1991. However, the GDP deflator reductions or removals of domestic fuel subsidies, but the continued to decline slowly. previous tightening of monetary policy in the region and Real GDP in the euro area accelerated somewhat in an appreciation of exchange rates also made a contribu- 2006, posting average growth of 3VA percent at an annual tion, Capital inflows into several Asian emerging-market rate over the first three quarters. Output growth was sup- economies—particularly Thailand—in late 2006 and ported in part by strong consumer spending, which grew early this year put upward pressure on local currencies. substantially faster than in 2005. The stronger perfor- Measures taken by Thai authorities seemed to succeed in mance of the economy was reflected in improving labor limiting upward movement of the baht, but share prices market conditions: The unemployment rate in the euro in the Thai stock market fell sharply. Financial markets area fell 0.8 percentage point during the year to reach in other countries in the region were less affected 97 Board of Governors of the Federal Reserve System 27 Equity indexes in selected emerging-market economies, and showed no noticeable spillovers from events in 2004-07 Thailand. Output growth in Mexico was exceptionally strong in the first half of last year, especially in the manufacturing, construction, and services sectors. Growth stepped down in the second half; construction activity remained robust but was offset by a slowdown in exports of manufactured goods to the United States. Mexican consumer price infla- tion was elevated during the second half by higher food prices and reached rates above the 4 percent upper limit of the central bank's inflation target range; at year-end, inflation was still at the top end of the range. market economies Brazilian output growth was solid in the first quarter but slowed noticeably later in the year, partly because of weak manufacturing performance. Brazilian four-quarter 2004 2005 2006 inflation fell markedly, from almost 6 percent at the end NOTE: The data are weekly. The last observation for each series is the of 2005 to just over 3 percent in December. InArgentina, average for Febniary 5 through February 7, 2007. The Laiki American econ- steady growth in investment and consumption kept real omies aro Argentine, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. The Asian economies are China, India, Indonesia, Malaysia, Pakistan, the GDP on a solid uptrend throughout 2006. The Argentine Philippines, Souih Korta, Taiwan, and Thailand; each economy's index government continued to attempt to bring down inflation weight is its market eajiilalizalion as a. share of the group's total. SOURCE: Morgan StanSey Capital International (MSC.I) index. through voluntary price agreements with producers in several sectors; although inflation had edged down to the single-digit range by year-end, it was still high. 98 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM WASHINGTON. D. C. 30551 February 26, 2007 The Honorable Christopher J. Dodd Chairman Committee OH Banking, Housing, and Urban Affairs United Siates Senate Washington, B.C. 20510 Dear Mr. Chairman: Enclosed is the information you requested during the Senate Banking Committee's hearing on monetary policy regarding the financial flows to and from the United States on a balance of payments basis between 2004-2006. Please let me know if I can be of further assistance. Sincerely, Enclosure 99 Insert page 138, following line 11: Chairman Bernanke subsequently submitted the following information for the record: The attached table reports the financial flows to and from the United States on a balance of payments basis for the period 2004-2006. (Data for 2006 are not complete; the missing components are indicated by NA in the column for 2006Q4.) Private foreign investors did reduce their acquisition of U.S. Treasury securities in 2006, as can be seen on line 12 of the table. However, such acquisitions rebounded in the fourth quarts of the year. Furthermore, private foreign investors did add to their holdings of total U.S. securities pine 11) by an amount in 2006 ($670 billion) that was nearly equal to the amount they acquired in 2005 ($674 billion). They increased or maintained, their pace of acquisition of U.S. government agency bonds, corporate bonds, and corporate equities. They also increased their acquisition of other liabilities reported by banks (mostly interbank liabilities) (line 16). The sum of foreign direct investment into the United States for the first three quarters of 2006 exceeds that for the full year of 2005 (line 18). Foreign official assets in the United States (line 2) also increased last year. The increase in these holdings of U.S. Treasuries (line 4) was up irom 2005 but below the pace of 2.004. The increase in other categories of securities rose as well. It is noteworthy that acquisition of foreign assets by U.S. residents (line 20) rose sharply in 2006. The size of acquisition rose for all categories other than foreign equity. The sharp rebound in U.S. direct investment abroad reflects the ending of the tax advantage of repatriating income provided by the Homeland Investment Act that resulted in net return of funds in this category to the United States in the third and fourth quarters of2005. Attachment Foreiga-Owned Assets in the U.S. and U.S.-Owned Assets Abroad (Billions of U.S. Dollars) February 21,2007 2005 2005 2005 2005 2006 2006 2006 :2006 2004 200S 2006* Ql Q2 Q3 Q4 Ql Q2 03 Q4* 1. Total foreign assets in the US, net increase 1,450 1,212 1,653 224 346 389 253 527 365 400 361 2. Foreign official assets in the US, net increase 388 199 266 19 75 34 72 76 76 81 34 3. Total securities, net foreign official purchases 319 176 245 36 40 33 67 76 33 87 48 4. US Treasury securities 263 72 104 9 17 8 37 42 -9 47 23 5. US govt agency bonds 42 85 107 24 19 n 24 24 30 33 20 6. Corporate bonds 11 18 2$ 3 4 6 6 S 6 6 9 7, Corporate stacks 2 1 6 -0 -0 1 0 2 6 1 -3 8. Other liabilities to foreign official 69 24 20 -16 34 1 3 -1 42 -7 -14 institutions reported by banks 9. AH ofliet -0 -0 2 -1 0 0 -0 0 1 1 NA 10. Foreign private assets in the US, net increase 1,062 1,013 1,387 205 272 355 181 452 289 319 327 o 11. Total securities, net private purchases 484 674 670 164 126 190 194 181 137 132 220 o 12. US Treaswy securities 103 199 52 86 14 37 62 -5 10 -7 55 13, US govt agency bonds 67 72 120 2 20 34 17 42 28 26 24 14. Corporate bonds 255 316 395 58 78 89 91 90 101 91 113 15. Coiporate stocks 60 86 103 IS 13 30 24 54 -1 22 28 16. Other liabilities reported by batiks 337 180 424 -70 153 95 2 149 80 89 107 17. Liabilities reported by non-banks 93 30 154 80 -20 20 -50 75 25 53 HA 18. Foreign Direct Investment in US 133 no 135 31 8 44 27 45 46 44 NA 19. All other IS 19 4 1 5 5 9 2 I 1 NA 20. Total US-owncd assets abroad (- is a net increase) -868 -427 -1,017 -87 496 -132 -11 -356 -211 -224 -225 21. Total securities, net US purchases (-) -147 -180 -283 -50 -46 -37 -47 -54 -54 -53 -122 22, US acquisitions of foreign bonds -62 -38 -147 -10 -21 -2 -4 -13 -37 -45 -53 23. US acquisitions of foreign stocks -85 -142 -135 -40 -25 -35 -43 -41 -17 -8 -69 24. Claims reported by US banks -362 -213 -46S 53 -174 -103 10 -196 -81 -86 -103 25. Claims reported by US non-banks -120 -44 -101 -67 57 -29 -5 -46 -31 -23 NA 26. US Direct Investment abroad -244 -9 -171 -31 -34 30 26 -61 -47 -63 NA 27. All other 5 20 4 8 0 6 5 2 1 1 NA U.S. Department of Commerce, Bureau of Economic Analysis. * Where reported, data for 2006 O4 are preliminary estimates derived from partial data from tto Treasury International Capitil System, ts.ggregates for 04 and year 2006 are sums of reported data and do not include estimates for entries with "NA". 101 BOARD OF GOVERNORS FEDERAL RESERVE SYSTEM WASHINBTDN. D. Z, SQ55I s. B&RNANKE: February 26, 2007 The Honorable John E. Sununu United States Senate Washington, D.C. 20510 Dear Senator: This letter follows up on your question during my appearance before the Senate Banking Committee on February 14 about tie reasons for the decline in the personal saving rate. One important factor appears to have been what economists call "the wealth effect." Capital gains on households' assets, such as houses and equities, are not counted as part of saving, which is defined as current disposable income less consumption. When wealth increases, people tend to increase their consumption relative to their current income, and thus the saving rate declines. The chart on page 6 of the Monetary Policy Report to the Congress shows that household wealth relative to income has risen, on net, over the past two decades, which has likely contributed to the decline in the personal saving rate. Corroborating this view, a Federal Reserve Board working paper entitled "Disentangling the Wealth Effect: A Cohort Analysis of Household Saving in the 1990s" by Michael Palunibo (on the Board staff) and Dean Maki (formerly on the Board stafi) provides evidence that higher-income households, which tend to hold a greater share of aggregate wealth, markedly reduced their saving rates when wealth rose in the late 1990s. A copy of this paper is enclosed. A few studies of household saving have attempted to estimate rates of saving by different age groups. I should note that this is a difficult exercise because the available data are not detailed enough to exactly apportion aggregate consumption and income to households by age. In general, this line of research has found that saving rates for all age groups have been declining for at least the past decade, with the largest decreases apparently occurring among older households. A number of factors may have contributed to this larger falloff in the saving rate for older households, including the wealth effect since older households tend to hold a larger portion of aggregate wealth than younger 102 households. One example of this research is a recent paper (also enclosed) by Alicia Murmell (Center for Retirement Research at Boston College and formerly the Director of Research at the Federal Reserve Bank of Boston) and two coauthors entitled "How Much is the Working-Age Population Saving?" I hope you find this Information helpful. Sincerely, Enclosures Attachments held in Committee files.

Ben S. Bernanke (2007, February 13). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_20070214_chair_federal_reserves_first_monetary_policy

@misc{wtfs_testimony_20070214_chair_federal_reserves_first_monetary_policy,
  author = {Ben S. Bernanke},
  title = {Congressional Testimony},
  year = {2007},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_20070214_chair_federal_reserves_first_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}