Congressional Testimony

MONETARY POLICY AND THE STATE OF THE ECONOMY, PART I HEARING BEFORE THE COMMITTEE ON FINANCIAL SERVICES U.S. HOUSE OF REPRESENTATIVES ONE HUNDRED TENTH CONGRESS FIRST SESSION FEBRUARY 15, 2007 Printed for the use of the Committee on Financial Services Serial No. 110-3 U.S. GOVERNMENT PRINTING OFFICE 34-673 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) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001 HOUSE COMMITTEE ON FINANCIAL SERVICES BARNEY FRANK, Massachusetts, Chairman PAUL E. KANJORSKI, Pennsylvania SPENCER BACHUS, Alabama MAXINE WATERS, California RICHARD H. BAKER, Louisiana CAROLYN B. MALONEY, New York DEBORAH PRYCE, Ohio LUIS V. GUTIERREZ, Illinois MICHAEL N. CASTLE, Delaware NYDIA M. VELAZQUEZ, New York PETER T. KING, New York MELVIN L. WATT, North Carolina EDWARD R. ROYCE, California GARY L. ACKERMAN, New York FRANK D. LUCAS, Oklahoma JULIA CARSON, Indiana RON PAUL, Texas BRAD SHERMAN, California PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York STEVEN C. LATOURETTE, Ohio DENNIS MOORE, Kansas DONALD A. MANZULLO, Illinois MICHAEL E. CAPUANO, Massachusetts WALTER B. JONES, JR., North Carolina RUBEN HINOJOSA, Texas JUDY BIGGERT, Illinois WM. LACY CLAY, Missouri CHRISTOPHER SHAYS, Connecticut CAROLYN MCCARTHY, New York GARY G. MILLER, California JOE BACA, California SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts TOM FEENEY, Florida BRAD MILLER, North Carolina JEB HENSARLING, Texas DAVID SCOTT, Georgia SCOTT GARRETT, New Jersey AL GREEN, Texas GINNY BROWN-WAITE, Florida EMANUEL CLEAVER, Missouri J. GRESHAM BARRETT, South Carolina MELISSA L. BEAN, Illinois RICK RENZI, Arizona GWEN MOORE, Wisconsin, JIM GERLACH, Pennsylvania LINCOLN DAVIS, Tennessee STEVAN PEARCE, New Mexico ALBIO SIRES, New Jersey RANDY NEUGEBAUER, Texas PAUL W. HODES, New Hampshire TOM PRICE, Georgia KEITH ELLISON, Minnesota GEOFF DAVIS, Kentucky RON KLEIN, Florida PATRICK T. McHENRY, North Carolina TIM MAHONEY, Florida JOHN CAMPBELL, California CHARLES WILSON, Ohio ADAM PUTNAM, Florida ED PERLMUTTER, Colorado MARSHA BLACKBURN, Tennessee CHRISTOPHER S. MURPHY, Connecticut MICHELE BACHMANN, Minnesota JOE DONNELLY, Indiana PETER J. ROSKAM, Illinois ROBERT WEXLER, Florida JIM MARSHALL, Georgia DAN BOREN, Oklahoma JEANNE M. ROSLANOWICK, Staff Director and Chief Counsel (II) CONTENTS Page Hearing held on: February 15, 2007 1 Appendix: February 15, 2007 61 WITNESSES THURSDAY, FEBRUARY 15, 2007 Bernanke, Hon. Ben S., Chairman, Board of Governors of the Federal Reserve System 7 APPENDIX Prepared statements: Neugebauer, Hon. Randy 62 Waters, Hon. Maxine 64 Bernanke, Hon. Ben S 71 ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD Hon. Ben S. Bernanke: Board of Governors of the Federal Reserve System, Monetary Policy Report to the Congress, dated February 14, 2007 81 Responses to questions submitted by Hon. Ruben Hinojosa 112 Responses to questions submitted by Hon. Albio Sires 115 (HI) MONETARY POLICY AND THE STATE OF THE ECONOMY, PART I Thursday, February 15, 2007 U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON FINANCIAL SERVICES, Washington, D.C. The committee met, pursuant to notice, at 10 a.m., in room 2128, Rayburn House Office Building, Hon. Barney Frank [chairman of the committee] presiding. Present: Representatives Frank, Kanjorski, Waters, Maloney, Gutierrez, Watt, Ackerman, Sherman, Moore of Kansas, Capuano, Hinojosa, Clay, McCarthy, Miller of North Carolina, Green, Cleav- er, Bean, Moore of Wisconsin, Davis of Tennessee, Sires, Hodes, Ellison, Klein, Mahoney, Wilson, Perlmutter, Murphy, Donnelly, Wexler, Marshall; Bachus, Baker, Pryce, Castle, Royce, Lucas, Paul, Gillmor, Jones, Biggert, Shays, Capito, Feeney, Hensarling, Garrett, Pearce, McHenry, Campbell, Bachmann, and Roskam. The CHAIRMAN. Today's hearing of the Committee on Financial Services will come to order. This is the semi-annual hearing that we have on the Humphrey-Hawkins Act, with testimony by the Chairman of the Board of Governors of the Federal Reserve Sys- tem, Hon. Ben S. Bernanke. Chairman Bernanke will be testifying on the state of the economy and discussing the Federal Reserve's 2007 Monetary Policy Report to the Congress. Under the proce- dures, Chairman Bernanke alternates between the House and the Senate. This is done twice a year—once a year, the chairman goes to the Senate first, and once a year, he goes to the House first. Since, in this rotation, he went to the Senate first, one assumes that there will be no opportunities to game the stock market today. Those all happened yesterday, so people can stay through the whole hearing. Reporters won't have to leave to run to report to the wire services so people can hysterically overreact to the Chairman's perfectly sensible statements, which, of course, is the pattern. Al- though I know people who are in the market explain that they are not overreacting themselves—they are, in fact, reacting to other people's overreaction—the consequences are the same. I say that because, in the interest of being able to have rational policy discussions unconstrained by irrelevant factors, I just would plead with people not to read excessively into what the Chairman says, and not to read excessively into what we say. We ought to be able to have rational conversations about the important topic of today's hearing without the overreactions. And I would say, since that may not be possible, as far as I am concerned, people over- react at their own peril. And I don't think the Chairman or any- (l) body else should be held accountable because people engage in this form of anticipatory hysteria. As to the subject at hand, and under the rules, there will be four opening statements—by myself, the ranking member of the full committee, the chairman of the Subcommittee on Domestic and International Monetary Policy, and the ranking member of the sub- committee—and the Chairman has very graciously agreed to stay until 2 p.m. I am deeply appreciative of this. This is a very large committee. We will take one 15- to 20-minute break, and members can gauge appropriately. And we will be able to accommodate more of the members if we can. Mr. Chairman, again, I appreciate your willingness to do this. I will be asking the Chairman about some of the specifics of his testimony, and of the areas particularly relevant to monetary pol- icy, but I want to begin with an expression of disappointment, not in Chairman Bernanke, but in the business community and many of my conservative colleagues. I believe that we are at a very sen- sitive point in the making of economic policy in this country. There is, on the part of the business community and many of its supporters, the view that a full embrace of globalization—of techno- logical change, essentially of public policies that allow capital to be fully mobilized and fully mobile, and able to be employed to its best use—is in the best interests of society as a whole. For some time now, until fairly recently, that was the governing policy in the United States, and in much of the rest of the world. That has now come to an end, I believe temporarily, perhaps for a long temporary period, because increasingly, average citizens, in America and in other countries, have come to doubt that the growth that results from this policy of entirely free capital to move to wherever it finds its best return, people have come to doubt that this is in their interest. Indeed, there are a large number of people throughout the world who believe that they are being hurt by this. And in consequence, we are at a policy deadlock. I think people should understand that the chances of an extension of trade pro- motion authority going through are quite slender at this point, un- less there is some change in the attitude of many who are its advo- cates. My own view is that if they were, in fact, to come to an agree- ment in the Doha Round, that the resulting agreement—if they reach it as they currently talk about it—wouldn't pass the House of Representatives. There is resistance, in my view unfortunately, to the general approach that the President took on immigration. In almost all of the important areas in which—and let me just say, this committee reported out earlier this week on a voice vote a bill for foreign investment, and there was a paradox. Because if you talk to the people in the business community, as the ranking member and I, and the former chairman of that subcommittee, and others involved in that, if you talked to them, they were, on the whole, pleased with the result because it was better than they had expected. If you read some of the business press, they were concerned that it was too restrictive. Well, that is an example of where we are. It is a bill that was more restrictive than some might have liked on foreign investment, but better than some people expected reflecting this mood. So I want to reiterate what I said earlier. Many of us are pre- pared to work towards policies that are pro growth, that do take advantage of what you have when capital is allowed to reach its best level and find its greatest return, when technology can be fully taken advantage of, but only if we put in place public policies that make sure that is more fairly shared, and in particular, that re- verse the tendency which the Chairman has acknowledged, and I appreciate that, and which the President has acknowledged, that inequality has been growing. As I said before, inequality is an essential part of a capitalist economy—no one is trying to get rid of it, at least no one sensible. But it can also become excessive to the point where it is socially harmful and economically beyond what is needed for the capitalist system. We are at that point. We are at a point where there is an exces- sive amount of inequality in this economy. And it is growing, and not just in this economy. I recently read an article which said that in the last set of state elections in India, every chief minister who was seen as pro foreign was defeated in terms of the economy. So there is a worldwide concern. We see in Latin America where an anti-democratic left is threatening the democratic left in part be- cause of this economic unhappiness. I don't see any recognition of that. I regret that. But people who will continue to resist trying to do something about healthcare or trying to do something about the right of employees to join unions, even something as minimalist as the minimum wage should not be surprised when they run into absolute resistance to other things which they will argue are good for the economy. With that, I call on the ranking member. Mr. BACHUS. Thank you, Mr. Chairman, and I appreciate you holding this hearing. And Chairman Bernanke, thank you for your report. As you can see, on this committee, we share the same con- cerns, but we have different views on how to address those con- cerns and different philosophies. And as you come before us today, we are interested in your insights regarding not only monetary pol- icy but also the state of the economy, and as the chairman specifi- cally mentioned, global competitiveness and trade and issues of that nature. Of course, when we talk about differences of philosophy—as the chairman and I have—on how to approach these issues, how one perceives the state of the economy greatly depends on one's point of view. From my perspective, the economy appears strong and vibrant, and absent some unforeseen shock, likely to remain so. When I look at your report and the supporting economic data, I see vigorous 3.4 percent growth. I see low unemployment of 4.6 percent and infla- tion of 2.5 percent. And in a society where opportunity awaits anyone who uses their talents and efforts to improve the standard of living for their fam- ily—opportunities are there, educational opportunities, and work opportunities, that is what I see from your report. I see IVz million new jobs created since 2003. I see a structurally sound economy performing as well as it did in the 1990's in what we now know is an artificial economic bubble. Currently, I see strong 2.2 productivity increases and record stock market levels not fueled by unrealistic dot.com speculation, but by globally competitive businesses. I also see most Americans benefiting from the stock market growth through individual stock ownership and retirement funds. In this environment, claiming that record corporate profits do not benefit most Americans—as some on this committee do—is not a valid argument. Others have a different perspective. You have heard the chair- man's perspective. And they see another reality. Some on this com- mittee believe that the best way to create jobs and promote eco- nomic growth is through aggressive trade restrictions and barriers. While I recognize the need to help those economically displaced or as the chairman says, hurt, by global forces beyond their control, economic experience does not lead me to the conclusion that protec- tionism or isolationism is an appropriate response. Some think we need to somehow mandate the elimination of in- come disparities. While I share the exasperation of the chairman over some of the outrageous CEO compensation recently reported, I believe our corporate governance system works and that share- holders will correct these abuses without Government interference. I believe education, not government attempts to redistribute in- come, is the proven route to improve wages for all workers. Chairman Bernanke, the members of this committee, Repub- licans and Democrats alike, respect your experience, your judgment and your obvious commitment to keeping America's economy strong and competitive. We all share a goal of doing that and doing what is best for American workers. We appreciate you being here and look forward to hearing your comments. The CHAIRMAN. The gentleman from Illinois, the chairman of the Subcommittee on Domestic and International Monetary Policy is recognized. Mr. GUTIERREZ. Thank you, Mr. Chairman. And thank you, Chairman Frank. Chairman Bernanke, I think it is safe to say that you and I have different backgrounds and that we bring disparate perspectives to the table when dealing with economic and monetary issues. But after taking over the chairmanship of the Monetary Policy Subcommittee, I am getting a sense of the significant and daunting task that you face. You should rest assured, however, that I will be here over the next 2 years, along with 443 Members of the House and 100 Mem- bers of the other body, to second-guess your every move. When it comes to economic and monetary policy, we are entering a very crucial and complex period, especially for the Federal Re- serve and its mandate of maximum employment, stable prices, and moderate long-term interest rates. For example, the housing boom has taken a substantial down- turn. Energy prices have climbed and we are facing some serious issues about our long term energy security. Some economists warn the threat of inflation is on the horizon. Yet others appear less wor- ried about inflation than the rising mortgage delinquencies and foreclosures effecting a wider economy. The two major Asian currencies are undervalued, and the U.S. trade deficit is at record highs, while accusations of currency ma- nipulations are frequently leveled against both China and Japan. And perhaps most important of all, we face a huge Federal deficit at a time when baby boomers are reaching retirement age and healthcare costs are at an all time high. While I am anxious to hear from you, Mr. Bernanke, what con- cerns me most is retirement insecurity. When it comes to kitchen table issues, retirement insecurity is the obstacle for many Amer- ican families. The U.S. economy is now producing over $13 trillion a year. But many American families are struggling just to maintain their living standards and they are up against stagnating wages, diminishing healthcare, and retirement benefits that are just dis- appearing. More and more families are living paycheck-to-paycheck with very little in their bank accounts or none at all, and paying higher interest rates and more fees than they should. And hanging over their heads is retirement. I know, Chairman Bernanke, that you have publicly addressed the related issues of retirement insecurity, the budget deficit, and the looming retirement of 78 million baby boomers on several occa- sions. But from what I have heard and read, you have approached the problem only in terms of entitlement reform. Entitlement re- form is needed. No question. But this is not just an issue of entitle- ment reform. The skyrocketing cost of healthcare are not just going to disappear if we reduce entitlement spending. The costs will just be shifted to already strapped family budgets. Many baby boomers are simply not financially ready for retirement. If we substantially cut healthcare, and Social Security spending for the baby boomer generation, many will face healthcare crises that will drive them into bankruptcy. The correlation between rising healthcare expenses and personal bankruptcy filings is well-documented. And merely moving these expenses from the public sector to the American families, in my opinion, is not good for long-term economic growth. We need more than entitlement reform to give Americans retirement security. I would like to hear your views on this today. Clearly, no single political party and no single body, the Fed, the Congress, or the Administration, has the answers to the problems we face. We must work together. And I look forward to an open frank dialogue with the Federal Reserve, my subcommittee coun- terpart, Dr. Paul, and the Treasury Department on all these issues. And I yield back the balance of my time. The CHAIRMAN. The gentleman from Texas, the ranking member of the subcommittee. Dr. PAUL. Thank you, Mr. Chairman, and welcome, Chairman Bernanke. I am very pleased to be here today as the ranking mem- ber. In the midst of a great optimism of monetary policy and how the economy is doing, I still have some concerns. And of course, one of my long-term goals has always been to emphasize maintaining the integrity of the monetary unit, rather than looking superficially at some of our statistics. But I also share the concern of the chair- man of the committee of our responsibilities for oversight and your interest as well, Chairman Bernanke, on having the transparency that I think we all desire. Transparency in monetary policy is a goal we should all support. I have often wondered why Congress has so willingly given up this prerogative over monetary policy. Congress, in essence, has ceded total control of the value of our money to a secretive central bank. Congress created the Federal Reserve, yet it had no constitutional authority to do so. We forget that those powers not explicitly granted to the Congress by the Constitution are inherently denied to the Congress, and thus, the authority to establish a central bank was never given. Of course, Jefferson and Hamilton had that debate early on and the debate seemingly was settled in 1913. But transparency and oversight are something else, and they are worth considering. Con- gress—although not by law—essentially has given up all its over- sight responsibilities over the Fed. There are no true audits. Congress knows nothing of the con- versations, the plans, and the action taken in concert with other central banks. We get less and less information regarding the money supply each year, especially now that we don't even have ac- cess to M3 statistics. The role the Fed plays in the President's secretive working group on financial markets goes essentially unnoticed by Congress. The Federal Reserve shows no willingness to inform Congress volun- tarily about how often the working group meets, what action it takes that affects the financial markets, or why it takes these ac- tions. But all these actions directed by the Federal Reserve alter the purchasing power of our money, and that purchasing power is al- ways reduced. The dollar today is worth only 4 cents compared to the dollar that the Federal Reserve started with in 1913. This has significant consequences on our economy and our political stability. All paper currencies are vulnerable to collapse and history is re- plete with examples of great suffering caused by these collapses, especially to the Nation's poor and middle class. This can lead to political turmoil as well. Even before a currency collapses, the damage done by a fiat system is significant. Our monetary system insidiously transfers wealth from the poor and the middle class to the privileged rich. Wages never keep up with profits on Wall Street and the banks, thus sowing the seeds of class and discontent. When economic trouble hits, free markets and free trade are often blamed, while the harmful effects of a fiat monetary system are ignored. We deceive ourselves that all is well with the economy and ig- nore the fundamental flaws that are a source of growing discontent among the various groups. Few understand that our consumption and apparent wealth is dependent on a current account deficit run- ning at approximately $800 billion a year. This deficit shows that much of our prosperity is based on bor- rowing rather than a true increase in production. Statistics show year after year that our productive manufacturing jobs continue to go overseas. This phenomenon is not seen as a consequence of the international fiat money system where the U.S. Government bene- fits as the issuer of the world reserve currency. Government officials consistently claim that inflation is in check at barely 2 percent, but middle class Americans know that their purchasing power—especially when it comes to housing, energy, medical care, and school tuition—is shrinking much faster than 2 percent per year. Even if prices are held in check in spite of our monetary infla- tion, concentrating on the CPI statistics distracts from the real issue. We must address the important consequences of the Fed manipu- lation of interest rates. When interest rates are artificially low, below market rates, insidious malinvestment, and excessive indebt- edness inevitably brings about the economic downturns that every- one dreads. We look at GDP figures and reassure ourselves that all is well. Yet a growing number of Americans still do not enjoy the high standard of living that monetary inflation brings to the privileged few. Those who benefit the most are the ones who get to use the newly created credit first— The CHAIRMAN. The gentleman's time has expired. If the gen- tleman will come to a conclusion. Dr. PAUL. I will yield back. The CHAIRMAN. I will now turn to the Chairman. And he is rec- ognized for his opening statement. Thank you. STATEMENT OF HON. BEN S. BERNANKE, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Mr. BERNANKE. Chairman Frank, Representative Bachus, and other members of the committee, I am pleased to present the Fed- eral Reserve 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 associated with the effects of the hurricanes that ravaged the Gulf Coast in the pre- vious summer, output growth moderated somewhat on average over the remainder of 2006. Real Gross Domestic Product is cur- rently 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 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 sub- stantial 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 slow- er 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 remains 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 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 5Vi percent. So far, the incoming data have supported the view that the current stance of policy is likely to foster sustain- able economic growth and a gradual ebbing of core inflation. However, in the statement accompanying last month's policy de- cision, the FMOC again indicated that its predominant policy con- cern is the risk that inflation will fail to ease as expected, and that it is prepared to take action to address inflation risks, if develop- ments 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 for more than two-thirds of aggregate demand, increased at an annual rate of around 3V2 percent in real terms during the sec- ond half of last year, broadly matching the brisk pace of the pre- vious 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 con- sumption expenditures price index, rose at an annual rate of about 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, when the pre- viously 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 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 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. However even if housing demand falls no further, weakness in residential investment is likely to continue to weigh on economic growth over the next few quarters as homebuilders seek to reduce their inventory 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- 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 those to which we have become accustomed in recent years. In part, slower average job growth may simply reflect a modera- tion in economic activity. Also, the impending retirement of the leading edge of the baby boom generation, and an apparent leveling out of 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 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 in- come. The business sector remains in excellent financial condition with strong growth in profits, liquid balance sheets, and corporate lever- age near historical lows. Last year, those factors helped support 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, 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 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 in motor vehicle dealers and in some construction-re- lated 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 restraints 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 expansion in U.S. real exports, which grew about 9 percent last year. The pattern of real U.S. imports 10 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 6V2 percent of nominal GDP during the first three quarters of 2006. 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 Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts—which are based on informa- tion 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 two- or three-quarters 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 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 4V2 to 4% 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 the developments in the housing market onto consumer spending and employment and housing re- lated industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase 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 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 re- cent years will probably 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. 11 If actual prices follow the path currently indicated by futures prices, inflation pressures 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 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 remain a key source of uncertainty in 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 rental units. But the ex- tent and pace that 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 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 last year, likely, in part, as 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 firm's 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 markup of prices over unit labor costs is high by historical stand- ards, so such an outcome is certainly possible. Moreover, if activity expands over the next year or so at the mod- erate 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 re- source utilization remains 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 expectations appear to have re- mained contained. The projections of the members of the Board of 12 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 2Vi percent this year and to edge lower to 1% to 2 percent next year. But as I noted earlier, the FMOC 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. Consequently, policy decisions must be based on an 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 under- stand and anticipate policy decisions. Clear communication by the central bank about the economic outlook, the risk 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 reaction to new information. This understanding should, in turn, enhance the effectiveness of policy and lead to im- proved economic outcomes. By reducing uncertainty, central bank transparency may also help anchor the public's longer term expectations of inflation. Much experience has shown that well-anchored inflation expectations help to stabilize inflation and promote maximum sustainable eco- nomic growth. Good communication by the central bank is also vital for ensur- ing appropriate 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 clari- fying how a central bank expects to attain its policy objectives and by ensuring that policies are conducted in a manner that can 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 sustainable employment. I will keep members of this committee apprised of developments as our deliberations move forward. I look forward to continuing to work closely with the members of this committee and your col- leagues in the Senate and the House on the important issues per- taining 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. 13 [The prepared statement of Chairman Bernanke can be found on page 71 of the appendix.] The CHAIRMAN. Thank you, Mr. Chairman. I have to say that when you say you would be happy to take questions, you were somewhat more persuasive than when your predecessor used to say that. And I will apologize in advance to the media, because you have, I think, over the past months in particular, said some very reason- able things from my standpoint, so I have less to complain about than they might have hoped, I am sure, in Karl Rove's eyes, so they should not lose heart. I particularly want to begin by thanking you for the very appro- priately nuanced discussion of wages. It has troubled me for some time, and particularly when I read some of the financial pages, that there is a good news, bad news story. The good news is that profits are up; the bad news is that wages are up. And wages are too often written about as if they were simply a constraint on pros- perity. I particularly appreciate on page 7 of your testimony where you note that an increase in wages, certainly to the level of produc- tivity, should not be a problem, and that in general, there is noth- ing automatic about a rise in wages leading to inflation. It depends on the impact on prices. And in that context, I espe- cially welcome your noting that not only the underlying produc- tivity trends appear favorable—and this is in your discussion of wages and inflation. Underlying productivity trends appear favor- able and the markup of prices over unit labor costs is high by his- torical standards. I hope this is widely noted, your statement that, in fact, it would not appear to be wage driven pressure to raise prices, because as you note, the markup of prices over cost in this regard is high by historical standards. I would add you did not cover that, it was not in your topic, that there has also been a reduction in the tax burden. So we ought to be clear that this simplistic notion that if wages go up, that is going to cause inflation, is not the case, and that, in fact, there is, as you say, and I appreciate this, some reason, some room for le- gitimate wage increases to be absorbed without that being infla- tionary. Now, there is, however, some bias still in the way we talk about things. And I did note that there was great relief that you appar- ently indicated yesterday that it is unlikely that you will be pre- siding over increases in interest rates in the future. But as I read your report, it seems to me that frankly, the question ought to be whether or not there are decreases. In the Monetary Policy Report, on the first page of your—let me read two statements: "On balance growth of real Gross Domestic Product appears likely to run slight- ly below that of the economy's potential over the next few quarters, and then to rise to a pace around that of the long run trend." Next paragraph. "Regarding inflation increases in core consumer prices are expected to moderate on balance over the next 2 years." In other words, the prediction is, economic growth below the econo- my's potential for a while, and then reaching potential but not going above it. 14 Similarly, "inflation is going to moderate an economy performing somewhat", not enormously, but "somewhat below potential tend- ing towards potential and inflation that is expected to moderate." I suppose that would be an argument for balance if nothing changes. But I don't see how we get a concern of inflation as the major concern here. And as you say, well, but you're still worried more about infla- tion and the sense is, stop him before he raises again, but no likeli- hood of a drop. I don't understand why this shouldn't make it at least as likely as a drop. Again, we have an economy that is running below poten- tial and we have moderating inflation. Why is that not at least an equal chance for there to be a reduction in the time ahead? Mr. BERNANKE. Mr. Chairman, first of all, policy is going to re- spond to new information. We are going to be continually reas- sessing our outlook and responding appropriately as we see the economy evolving. Policy also has to respond to risks. There are risks in both directions. On the real side, I talked about housing as a downside risk, but there is also some upside risk. We have seen very strong consumer spending numbers. We have seen some strong income growth which suggests that the economy may be stronger than we think. It is possible. And in a sense, ag- gregate spending may exceed our capacity and put pressure on product markets, and that would be a concern. The other issue is on inflation. We have had a period where in- flation has been above where we would like to see it as far as con- sistency with price stability is concerned. In order for this expansion to continue in a sustainable way, in- flation needs to be well-controlled. If inflation becomes higher for some reason, then the Federal Reserve would have to respond to that by raising interest rates. That would not contribute to the con- tinued— The CHAIRMAN. I understand that, Mr. Chairman, but you know, I am a little puzzled—you tell me that your report says production below potential rising to potential. But then you say, well, you think it might be more than you think. I mean, if you think it might be more than you think, why didn't you think it? It does seem to be a little odd for you to say that here is what I think, but I also think it might be worse than I think. That is literally double-think. And what particularly concerns me, I read those two sentences, production now below potential, and prediction only to get to poten- tial not above it, and inflation moderating, and I don't see how that computes with, as I noted earlier, the FOMC has continued to view the risk that inflation will not be moderated as the predominant policy concern. I can understand it being a concern. I don't understand how, given this, it outweighs the other. And let me say in that regard, and I more or less stick to time limits, I appreciate your discussion about transparency on—and your discussing this. And I do want to—let me point—there he is. When I came to Congress, in 1981, the open market committee was, from the standpoint of publicity, the closed market committee because it did not even announce on the day of the vote what the 15 vote was. And that gentleman up there, Mr. Gonzalez of Texas, crusaded, I think, effectively and appropriately, for some trans- parency. We have much more. Here is my concern. When you talk about changing the way you communicate uncertainty, here is the problem. It is easier for you to be certain about what you want the interest rate to be than about what you want employment to be, because you have more control of one than the other. I admire the desire for more trans- parency. I express my concern that procedure and substance may intermix here and that the argument for greater certainty can be- come—and you say we have the two objectives, stable employ- ment—stable prices and employment. But one of those might—I appreciate the fact that you have two children and you love them both. But I am afraid that one of them might get a little bit more for Hanukkah than the other if we are not careful. So I do want to ask that we be kept involved in this process. But I also want to reiterate from the standpoint of what I talked about before from the social health of this country—and I will close. I know there are people saying that the economy is very good. Let me be partisan for a minute. I say to my Republican friends, keep telling the American people how good the economy is, because the disparity between what you tell them is happening and what they feel themselves makes them even angrier. But if inflation is the predominant concern, given your own state- ments, it seems to me that you have made an argument that it ought to be at least balanced; that is troubling to me. Mr. BACHUS. Thank you. Chairman Bernanke, the chairman mentioned the economy and our different perspectives and our viewpoints. The chairman and others have said that all these 7.5 million new jobs that have been created are all low-income work- ers. They are not higher paying jobs. I notice that the Bureau of Labor statistics job data that was released just yesterday indicates that job creation was roughly distributed across the income spec- trum. Can you tell me why there is a perspective and whether it is true that this viewpoint that all these new jobs are low income, when I say that the recovery is benefiting the middle class and the cre- ating higher paying jobs? Mr. BERNANKE. Well, in terms of the distribution of jobs, as I mentioned in my testimony, there is an enormous demand for high- ly skilled workers and of high-paying jobs. And the constraints on the highest paying jobs, for example in manufacturing, is not the demand but the supply. Firms can't find workers of sufficient quali- fications in many different areas. So there certainly has been job creation at the high level as well as throughout the distribution of wages. Mr. BACHUS. SO the economy is, in fact, creating so many highly paid, skilled jobs that there simply is not the workforce to fill those jobs? Mr. BERNANKE. AS I have indicated recently, I think one of the major constraints in our economy and one of the sources of concern about equality and inequality has to do with educational differen- tials. And the more that we can help people acquire sufficient skills 16 so that they can be eligible for those high-paying jobs, the better off we are going to be. Mr. BACHUS. Thank you. The chairman said he was more pleased with you than he has been in the past. And I am sure that he read the same article I read in The American Banker, where it was titled that you had en- dorsed the GSE housing fund—that the affordable housing fund that the chairman put forward. When I saw your testimony I didn't see that in it at all. But let me ask you this question. There is a philosophical debate going on in this committee about the creation of these funds, government control, government mandate, government-directed funds. There really are two of them. One that has gotten all the publicity is the affordable housing fund, to which the GSE's will be required to pay a portion of their revenue. And members of this committee, at least Republican members, we see this as an added cost to low- and middle-income home- owners. Now, I think across the—I will call this the divide, across the divide, there is an agreement that the GSE's could do a better job on their affordable housing mission. But we are very skeptical that if you take money that is designated to provide liquidity for people to buy homes, you either increase the cost of that home, of that home mortgage, or the availability of that home mortgage, and we think there is a better way than a government-dictated plan. Clearer maybe than that is the other proposal that has achieved almost no publicity, and we had a spirited debate in this committee 2 days ago, is that my Democratic colleagues are endorsing an in- surance company's funding of a community reinvestment fund. Massachusetts created such a fund in 1998 where insurance com- panies are directed to pay a part of their income into a fund which the, I guess the State of Massachusetts, directs into affordable housing or community investment projects. And we debated that because we Republicans felt that when we pay our premiums to an insurance company, we want that money to be invested at the highest possible return so that claims can be paid. We feel like the proper role of an insurance company is not to take our money, an insured's money, and invest it in some com- munity's project, we feel that the proper role for them is to pay claims. So I just ask you, first of all, would you clarify your remarks over in the Senate, or is there any clarification needed, and do you have any unease over the creation of more government funds of this na- ture, and the cost on American homeowners or any of us who pay premiums to insurance companies? Mr. BERNANKE. Congressman, the story was misreported, and you misunderstand my position. I did not address the affordable housing fund, either pro or con. The concern that the Federal Re- serve has had for a long time about GSE's is the potential for their portfolios to create systemic risk in our financial system. I should say that we very much support the GSE's housing mission, and we believe, in particular, that the securitization function contributes to liquidity in the mortgage market. Again, our concern is about the portfolios and their enormous size and the complex derivative exer- cises that are needed to maintain the balance of those portfolios. 17 My comment was one that built on suggestions that Chairman Greenspan had made in previous testimonies, which was that one way to limit the growth of the portfolios, but also to achieve the stated public purpose of the GSE's was, in some way, to anchor the portfolios in the public purpose, which is affordable housing. According to OFHEO, only about 30 percent of the portfolios are related in any way to affordable housing. So I think what I would like to see would be the portfolios to be more directly connected to a public purpose, perhaps holding affordable housing mortgages or another way, more directly promoting affordable housing rather than acquiring all different kinds of assets that are not related to affordable housing. Mr. BACHUS. Thank you. The CHAIRMAN. The gentleman from Pennsylvania. Mr. KANJORSKI. Mr. Chairman, welcome to the committee. It is fascinating to listen to the discussion, and obviously long-ranging, but I have a few questions in regard to the emphasis in the public press over the last several months on executive salaries and what the appropriate response would be to them. First of all, I would like your opinion as to how they rate on that scale of fair or unfair—whether or not they should be subjected to oversight, and if subjected to oversight, should they be subjected to some curative action by the Congress? In particular, we are looking at the U.K.'s shareholders' rights approach and their ability to give advisory opinions on executive packages. If you can summarize, in some way, your views and what the ef- fect of that would be, positively or negatively on the market and the economy, it would be most appreciated. Mr. BERNANKE. Thank you. I think it is very important for share- holders to be aware of compensation packages that CEO's are re- ceiving. So if they are displeased, they can register that displeasure through the directors or through selling stock. So I strongly sup- port disclosure efforts. The Securities and Exchange Commission recently built on the efforts of the exchanges, the NYSE, for exam- ple, in requiring more extensive disclosure of compensation pack- ages on details. I think that is a very important step in the direc- tion of making sure that shareholders have full information so they can make appropriate decisions about whether these packages are in the interest of the company or not. Mr. KANJORSKI. DO you have any opinion as to the United King- dom's approach of actually enacting advisory opinions expressed by shareholders and whether or not that has had any positive effect on the reduction of some of these packages and/or other share- holders rights, litigation, and other things that may have been modified? When you look at the numbers, the U.K. is significantly lower than the American market. We are wondering whether that is something that has been reviewed by the Federal Reserve? Mr. BERNANKE. In general, the CEO salaries are lower in Europe than the United States, and, to some extent, it is a puzzle why that is the case. I think there are a lot of reasons for it. But certainly, one thing we want to be sure we are doing is ensuring good disclo- sure and good oversight. I don't really have an opinion on the advisory council. I think we should be sure that the compensation decisions are being made in 18 a disinterested independent way, and that the directors who are in- volved in compensation are independent, and not subject to the in- fluence of the management. Mr. KANJORSKI. Very good. If you rate on a scale of what is eco- nomically fearful in our society today, particularly the domestic economy, what would be the greatest fear that you have? Mr. BERNANKE. There is a set of issues that are interconnected, having to do with savings and deficits and current account and so on. We are a low-saving society in general, and we are facing a de- mographic transition which will mean that a much larger share of our population is of retirement age or outside the workforce. That is going to pose enormous challenges to our fiscal budget. It is also going to pose enormous challenges to our economy as a whole, be- cause with fewer workers, we need to have more capital, more sav- ings, and more preparation for the economy to be able to absorb a larger number of retired workers. Related to that, of course, is the increase in medical care costs which also puts pressure on fiscal policy. So the fiscal issues in the low savings rates, which also con- tribute to the current account deficit, I think are at the center of the issues we should be concerned about. We really need to address our savings issues and the implications of the demographic transi- tion that we are seeing not very far in the future. Mr. KANJORSKI. What role should Congress or the government play in that? Mr. BERNANKE. The government needs to address both the fiscal implications of aging—certainly a part of that is the cost of medical care, which is a big part of the economic cost of aging—and also of the fiscal burden. And to the extent that outside of the fiscal arena we can find ways to encourage savings more broadly, and asset-building, I think that would be very constructive. Mr. KANJORSKI. SO you see a very positive role for government to play? Mr. BERNANKE. Good policies would certainly be helpful, yes. The CHAIRMAN. The Chair wants to announce, in recognizing members, that the two parties follow different patterns, and the Chair is accepting the ranking member's suggestions. So you may notice some disparity. We go by seniority; they go by, I guess, when members arrive. I want to explain that part because a recent analysis of what I am thinking made a great deal of the fact that a certain witness will be testifying tomorrow, and the witness is the choice of the gentleman from Texas. So I realize that people may not be fully aware of what we are doing. Next on the list is the gentleman from Louisiana. Mr. BAKER. I thank the chairman. Chairman Bernanke, following up in some measure on the course relative to problems of significance going forward, there are un- doubtedly negative effects of the inversion in the workforce, where we have more people retired, and less people working. At the same time, though, there has been an offsetting growth that has been, frankly, surprising to me at the number of investors in equities over the last 2 decades. I was particularly struck by the fact, according to the mutual fund industry, that in households 19 with aggregate annual incomes of less than $35,000, 31 percent hold mutual fund holdings. What it triggers for me is an under- standing by working families that for their long-term financial se- curity, they need to be invested in the markets. Now, we can debate whether it is index investing, whether or not actively managed is good or not. The bottom line is, if you are going to do something beyond your earnings from salary, investing in overall economic growth is a very sound policy, particularly for the younger and newer entries into the workforce. There are now issues, I believe, in international competitiveness that are overhangs that cause concern, whether it be potential for class action litigation, whether it is the wage—excuse me, the tax rates here as contrasted with those in Europe, and there seems to be certainly an outflow of manufacturing-type employment to other countries, leaving us with a more technology-based economy going forward. Having said all of that, it seems that with the percentage of Fed- eral spending in 1956 at—20 percent of Federal spending was on Social Security and related entitlements; today we see that crossing over 60 percent. Given your comment and concern as to the biggest problem facing us, how do we provide for retirement security for working families? It seems most Americans have figured that out; they need to be in the markets. Isn't it time for this Congress to really seriously consider voluntary, not saying mandated requirement, but vol- untary flexibility and directing your Social Security or retirement savings into market-invested, market-based investments? It would seem to me that the sooner we get out or away from these enor- mous entitlement obligations with the inversion in the workforce and the expectations of most people to retire at age 65, that there isn't a way out of this morass without allowing people to share in the overall economic prosperity of this Nation through some sort of equities investment. If we don't do that, what is the solution to the retirement prob- lem we face? Mr. BERNANKE. I think it is very valuable for people to have the opportunity to own an account, to have some exposure to invest- ment even if it is in index funds which you point out, so that people have the pride of knowing that they are providing for their own re- tirement. So I think it is a very good idea to encourage people to begin to build wealth, and to begin to hold assets. As you know, the Social Security aspect of this is a very complex debate. The diverting of funds the way you describe has some of the benefits of giving people the opportunity to have control over their own accounts, but it also doesn't really directly address the long-term imbalance on the fiscal side of the spending and reve- nues of the Social Security system. Another approach, which is related and might work better with- out addressing the Social Security concern directly would be to have add-on accounts where people would have the option to put in additional moneys that could be invested in— Mr. BAKER. If I may before my time expires, just as a quick fol- low-up, the rate of return, though, on the Social Security invest- ment is currently so low that if you were to divert any portion of 20 that into an active investment account, the yield would be so much greater than what you currently earn—and I know of your concern that current earnings are paying current retirees' benefits. I believe with the proper managed investment account over time, you could pay those current retirees' benefits and still have a yield sufficient left as a net margin that would beat the current rate of return for a Social Security recipient. In essence, we can accomplish both goals with a very carefully managed investment. Mr. BERNANKE. I understand that position has been espoused. I think just one concern is that the historical outperformance of equi- ties relative to bonds may reflect to some extent the higher riski- ness of stocks. To some extent it is a risk premium, and you know— Mr. BAKER. But there has never been a 10-year period when the market didn't beat Social Security. The CHAIRMAN. It is a very deep issue about why equities have performed better than bonds. But if you look at stock markets in czarist Russia, they wouldn't look so good today. The United States has been very successful. We have had a growing economy. We have succeeded in escaping the Depression and World War II and so on. So in that respect our stock market may not be representa- tive of the world's equities in some sense. It is a very difficult question. I would only make the point that you cannot assume that equities will pay the high rate of return in the future that they have in the past. There certainly is some risk to that. The gentlewoman from California. Ms. WATERS. Thank you very much, Mr. Chairman. I would like to thank Chairman Bernanke for being here this morning. It is always good to have you before this committee discussing the important economic issues of the day. I worked to prepare a statement last evening, but I have decided not to read that state- ment because my staff just gave me this morning, remarks by Chairman Ben S. Bernanke on the level and distribution of eco- nomic well-being. I just read it. I am extremely moved by your remarks, and I do think that you have taken a rather complicated issue and helped to remove it from simply a discussion of you either have education or you don't, you either are going to make it, pull yourself up by your bootstraps, kind of the government has no responsibility for that. It is not that simple. And you talk about opportunity and ensur- ing a fairness and opportunity, but not guaranteeing any outcomes, and you talk about the responsibility of the individual, but in this discussion it was quite expansive. I watched the closing of a Goodyear plant in Los Angeles when I first ran for office, and I saw people who had worked at that plant for 20, or 25 years who paid taxes, sent their kids to school, and had mortgages, suddenly out of a job, and I watched men go to the bar across the street from the plant for the next 5 or 6 years and just drink themselves into oblivion—not being retrained, un- able to get jobs because of their age, etc. You kind of allude to that. You also talk about the importance not only of formal education, K through 12, but also the other opportunities in our society for job 21 training, the community colleges. You even allude to and talk a lit- tle bit about preschool, and of course, I am from Head Start. Hav- ing taught and worked in Head Start, I think that is extremely im- portant, building self-esteem and certain kinds of values at an early age. But I would like to hear you talk a little bit more about policy implications. Aside from that which you alluded to, you know, edu- cation through job training, etc., do you think there is room for per- haps tax incentives to corporations and businesses that do on-the- job training to make sure that people are trained for real jobs that are sustainable? I would like to hear a little bit more about what you think we could do with public policy to close this growing income and wage gap. You discussed the superstars and CEO's and globalization and trade and all of that, and the bottom line is, there is this growing wage and income gap. What other policy possibilities can you share with us for helping to close this gap? Mr. BERNANKE. Thank you for taking the time to read my speech. I know it wasn't a short set of remarks. The broad point I am trying to make in those remarks is that I believe that technology and trade, which are tremendously impor- tant forces for American economic growth, unfortunately have the side effect that they sometimes cause dislocations, like the one you were just describing, and I think it is very important that we not respond to those dislocations by saying, "Well, we are going to stop trade, we are going to stop technological improvement." That is really doing more harm than good, I think. So then the logical consequence is, if we want to protect people and help them deal with these dislocations, and we don't want to stop the processes that generate growth in our economy, we have to find other ways to help people adjust and adapt. And I talked about a number of general approaches in my remarks. I do sincerely believe that what you know and what you can do is critical, that training—not just K-12 education, but all kinds of training—community colleges, junior colleges, online courses, train- ing on the job—all those things are critical to getting people the skills they need so they will be in demand and be able to find good work when changes in the global economy mean that their Good- year plant has shut down. I also indicated in my remarks that we could perhaps reduce some of the anxiety about job loss if we didn't tie all benefits so directly to employment. So, for example, I think it is an issue that healthcare is so directly tied to employment. Ms. WATERS. Portability of healthcare? Mr. BERNANKE. Portability of health insurance would be, I think, a positive development. It would reduce the anxiety that people face when they worry about their jobs, and indeed, some of the anxiety which I hear a great deal about may be less what has actu- ally happened than what people fear may happen. It is the insecu- rity rather than the actual outcome so far that people are worried about. So I think there are, you know, a number of general things we should try to do. Now, one thing I also said in my remarks is that solving this problem is very, very difficult. How exactly we can make sure that 22 training programs work effectively instead of just wasting money is very difficult. Finding the best way to make health insurance portable; there are lots of ways to approach it, but it is difficult. So I turn it back to you, unfortunately. I think the Congress is going to have to think hard about the best ways to address these things, but they need to think about them. Ms. WATERS. Mr. Chairman, I would like to ask unanimous con- sent to submit these remarks for the record. The CHAIRMAN. Without objection. The gentleman from Texas, Mr. Paul. Dr. PAUL. Thank you, Mr. Chairman. I would like to pursue the issue of the current account deficit. It seems like almost all economists express concern, some worry about it, but I can't find anybody who tells us that we should to- tally ignore it. And we do now borrow approximately $800 billion every year. We have a foreign debt of several trillions of dollars, and to me it represents an imbalance which is the consequence of the monetary system and presents a potential problem for us. Like- wise, I see that potential problem in the number of derivatives out there. There is one figure that says there are $236 trillion of de- rivatives, and it seems like very few people understand exactly what that means, and it certainly is so huge and diverse. I don't even think the Congress that we have that is always anxious to regulate everything has offered a scheme for regulating derivatives because, quite frankly, I don't think they are capable of doing that. Foreigners now own 43 percent of our debt, approximately twice as much as the Fed has been required to borrow. And one of the questions I have is how much pressure would it put on you if—I guess in even a theoretical sense, what if they didn't buy any of our debt, and all of a sudden you had to deal with that problem? Right now, there is a sign that maybe they are buying less. We have heard rumors and innuendos in the media and hints from China that, yes, they are not going to be buying as much, and yet there hasn't been really a crisis. There has been no panic, and we know there is self-interest on their part to maintain the dollar be- cause they hold so many. But in many ways I think we get a free ride. We get to export our dollars. We don't have to monetize them here. We get to export our inflation, but it potentially has a problem for us if all of a sud- den they buy less, and these dollars come home or these dollars go into goods and services. Also the other concern that I have that I would like you to ad- dress is the subject of the revaluation of the yuan. I understand you and Secretary Paulson went over to China to put pressure— at least the media presented it that way—put pressure on them to increase the value of the yuan and decrease the value of the dollar in relationship, which in reality, it seems to me, would put pres- sure on our interest rates and push our interest rates up and raise our prices. And some people have reported that couldn't possibly be our policy where we would deliberately want to do that. And then again, it would put more pressure on—I know it is an artificial ar- rangement right now. But in some ways what the Chinese have done is they have re- vived the old Bretton Woods standard of fixing their currency to 23 our dollar, and some people look longingly to the Bretton Woods days where we worked with fixed exchange rates. Of course, there were different conditions then. But if you would, if you would address both what our position is with the Chinese yuan as well as what happens if they signifi- cantly—if the foreigners, especially Japan and China, start to buy a lot fewer dollars and how that would affect your policy. Mr. BERNANKE. Thank you. You are correct that we are to some extent dependent on capital inflows to support the trade and cur- rent account deficits we currently have. The current demand for U.S. assets from abroad both from public and private sources re- mains strong, so there doesn't seem to be any immediate concern that will not continue. However, there is a risk sometime in the fu- ture that there would be less demand for dollar assets, and that could cause some movements in currency and bond markets that might be disruptive. And for that reason I have advocated, as many others in Congress have, that we have tried gradually to move our current account deficit down to a more sustainable level. The way to do that essentially, it is a very complex subject, but essentially the current account deficit arises because of asymmetries in the saving investment balance here and abroad. In the United States we have a decent rate of investment, including construction of new homes, but relatively low saving rates, and that difference we have to borrow abroad, whereas in many other countries in East Asia, and among oil producers and the like, they have an excess of saving over investment, and they are lending us that difference, and that is why the capital flows are moving from abroad to the United States. The way to adjust that, over time, is to create a better balance of savings and investment both in the United States, which would be through primarily greater saving, but also abroad by creating more reliance on domestic demand for growth. So, for example, in China there is a long-term plan, which we support, to try to reduce the reliance of the economy on exports and increase its reliance on domestic consumption, thereby reducing their savings rate to a more appropriate level, which also increases the living standard of their people. So I think with that process we can move gradually toward a greater balance. With respect to the yuan, I think there are several reasons to move towards greater flexibility in the yuan, and I described them in a speech I gave in China. First, China is a very large country, and it should at some point have an independent monetary policy of its own rather than being tied to the United States. In order to do that, they have to have a flexible currency. Secondly, the flexibility of the yuan is needed to accomplish this rebalancing from export orientation to domestic demand that I was referring to earlier. And thirdly, yuan appreciation and flexibility makes some con- tribution to helping us to rebalance the current account deficit we currently have, although I think the larger force quantitively would be the rebalancing of demand from exports towards domestic de- mand in China. The CHAIRMAN. The gentlewoman from New York. Mrs. MALONEY. Thank you, Mr. Chairman. 24 And welcome back, Chairman Bernanke. Many of my colleagues have been quoting "American Banker." I would like to show you "The Hill." There you are on the cover. It says your testimony sparked a stock price rally, and the Dow is up 87 percent, and there is great optimism for our economy, and I hope you are right. I hope the stock market is right. But regrettably, some of my constituents are not feeling opti- mistic. They feel that the economic expansion has not ended up in their take-home pay, and some are very concerned about losing their homes, and I share that concern. They are concerned about the rising rate of mortgage defaults and home foreclosures. In my district employment is high and stable, yet I am being told that foreclosures are at rates that are up by an order of magnitude— they have jumped up dramatically from what they were last year. Some of my colleagues tell me that they are experiencing the same thing in their districts around the country, and they are being told that homeowners are losing their homes in very stable neighbor- hoods, and some say that this is due to various causes such as un- employment. Yet in my district and others where employment is high, and in some other areas, it is due to the decline in the hous- ing market. But many also ask whether certain mortgage products, particu- larly in the subprime market, have contributed to this foreclosure crisis or challenge. In particular, many point to the so-called 2/28 ARM's, and some have described them—and I quote—as an inher- ent predatory product. And as you have told me and others, these 2/28 ARM's are 80 percent of the subprime market. Recently the Fed wrote back to Senator Dodd, taking the position that in its recent guidance on nontraditional mortgages, they did not extend to 2/28 for similar projects. And since these are what many people think is the problem, my question is why is the Fed not addressing the 2/28's and issuing guidance for what many peo- ple feel is the main problem in the foreclosure rates and the loss of homes of many people? You eloquently have said many times that homeownership leads to participation in our economy and increased wealth for Ameri- cans, yet if you are losing your home, it is leading you to a personal crisis, and if it continues, we will be facing a tremendous crisis in our economy and in our districts. And now for your comments on whether or not the Fed plans to extend guidance to the 2/28 subprime project, products. Mr. BERNANKE. YOU are correct, Congresswoman. There has been a surge in delinquencies and foreclosures, particularly—as I men- tioned in my testimony—in subprime lending with variable rates, rates that adjust with short-term interest rates, and that is a con- cern to us. We certainly have been following it carefully. It is obvi- ously very bad for those who borrow under those circumstances, and it is not good for the lenders either, who are taking losses. We have tried, together with the other banking agencies, to ad- dress some of these concerns. We recently issued a guidance on nontraditional mortgages, which had three major themes. The first was that lenders should underwrite properly, that is, they should make sure that borrowers had the financial capacity to pay even when rates go up, and not simply underwrite based on the initial 25 rate but also deal with the possible payment shock. Secondly, that lenders should give full disclosure and make sure that people un- derstand the terms of the mortgages they are getting into. And I would add that the Federal Reserve provides a number of docu- ments, booklets, and descriptions that are required to be included along with mortgage applications for adjustable rate mortgages. And thirdly, and this is more on the issue of the lenders rather than the borrowers, that lenders should make sure they appro- priately risk manage these exotic mortgages, which we don't have much experience with, so some caution is needed in managing them, as we are now seeing. So those, I think, are very good prin- ciples, and I think we would stand by those principles. Now the question has arisen whether the 2/28's, 3/27's are cov- ered by this guidance, and I think the answer is yes and no. The guidance as written refers to specific types of mortgages, including those that have negative amortization, that is, the amount owed can actually go up for a period, which is not usually the case with 2/28's and 3/27's. So in that respect, those types of mortgages were not, you know, literally included in that initial guidance. We, the Federal Reserve, along with the other banking agencies, are currently preparing a clarification to the initial guidance which will say that these same principles apply also to mortgages of this type that have variable rates, and particularly those that are of a subprime nature. But I would just say now that I hope that in our guidance, in our supervision, that we have conveyed to lenders that those three principles, good underwriting, good disclosure, and good risk management, are broad, good business principles, and they should be applying those to all mortgages they make. Mrs. MALONEY. My time is up, but, Mr. Chairman, can I just ask when will this guidance be up? Because it is very important. What is the time frame for my constituents? Mr. BERNANKE. Very soon, very soon. The CHAIRMAN. The gentlewoman from Ohio. Ms. PRYCE. Well, thank you, Mr. Chairman. Welcome, Mr. Bernanke. It is great to have you here. I would like to actually discuss for a moment the cost of healthcare in this country, it is definitely one of the major concerns when I talk to business and industry in my district. It certainly drives up the cost of doing business in our country. Certainly not the only thing, regu- lation, litigation and other factors, but it is more important because it affects families everywhere. The greatest problem is that people just can't find health insur- ance that they can afford; therefore, they don't get the medical treatment that they need. And it occured to me, and many others that one of the reasons for this is because there is really no con- sumer factor in healthcare in this country. We don't shop for our benefits. We take what our insurance companies provide for us. Market forces seem to work very well in all other aspects of our society. Is this what is wrong with our healthcare delivery system, this lack of market force, so to speak? And as I am sure you are aware, the President has proposed a very ambitious healthcare plan designed to provide enhanced tax benefits to individual pur- chasers, and I assume that is so that more people will purchase in- surance, more people will shop for insurance, and therefore they 26 will pay more attention to their healthcare needs, and it would bring healthcare more in line with how we make other purchases in this country. I just would like to know if you think that would be a good way to go, how it might affect international competitiveness, and then, of course, your thoughts on portability. I assume you made mention in response to Mrs. Maloney, or I guess it was Ms. Waters, that pensions and healthcare should be portable, and if you have time on my time, would you further your response? Thank you. Mr. BERNANKE. Congresswoman, you are correct in pointing out a very serious, serious problem, and I think you are also correct that one of the main reasons why healthcare is so expensive in the United States has to do with the fact that we are always buying it with somebody else's money and not with our own money. We have a system where technology is advancing rapidly, where our ability to do new and sophisticated tests, and provide new and so- phisticated drugs, and new procedures is advancing rapidly. In most industries, new technologies save costs, but not in medicine because of third-party payment, and the doctor and the patient are not making a cost-based decision. The cost efficiency is not perhaps what it should be. Now, one approach to this is to increase market forces in the de- termination of what test to order and what costs and how much to shop and so on. There are ways to do that. The health saving ac- counts, for example, create a catastrophic coverage, ask for a cata- strophic coverage, and ask people to save money within this ac- count to buy coverage for medical care below the catastrophic level. Some people may be uncomfortable with having to make those kinds of decisions, so an alternative is to have competition between, say, HSA catastrophic plans and other types of medical manage- ment, HMO's, PPO's, traditional insurance and the like. By cre- ating more competition, I think there would be some benefits. But, again, it is a complex subject. There are a lot of other things we could do. I think we could increase transparency in terms of hospitals and doctors letting us know what they charge, what their quality is, and improving information technology in healthcare, which I think would reduce errors and create more consistency across the country. We currently have very big differences in the cost of managing a certain kind of condition in different parts of the country. More uniformity and more best practice would help re- duce costs as well. So I think markets could have a useful role to help reduce, or at least control, the cost. Portability is a difficult question. One approach to portability is to have insurance companies insure workers rather than insure employers, so to speak. That would require somehow creating dif- ferent kinds of pools rather than employer-based pools. You need pools in order to share risk, and there are some issues associated with that. The main alternative would be to give people the ability to take their policy from their current employer and then move over to an- other employer with the same policy. These are all things we should be looking at, but none of them is a really simple problem because in each case we want to make sure that people are buying as part of the pool, a risk pool, rather than buying on an individual 27 basis where, if they are ill or have a preexisting condition, they won't be able to afford insurance. Ms. PRYCE. Thank you very much. The CHAIRMAN. The gentleman from North Carolina. Mr. WATT. Thank you, Mr. Chairman. Welcome, Chairman Bernanke. I am over here. I happen to like your predecessor. The problem is I didn't understand a thing he ever said. So you are a breath of fresh air in the sense that, wheth- er I agree with you or not, at least you are speaking in English, and I can understand what you are saying. And I especially want to thank you for your response to Ms. Waters' question. Let me follow up quickly on Mrs. Maloney's question, because I am not clear, and I hope you can answer this question just with a yes or a no answer. Does the guidance that the underwriting— the guidance that you are issuing regarding 2/28 and 3/27 mort- gages require that those mortgages be underwritten to the fully in- dexed rate just like you do with traditional mortgages, or does it not? Mr. BERNANKE. This is a joint guidance. We are still working on it with the other banking agencies. We have not yet determined that. Mr. WATT. But the one that you put out previously, did it re- quire— Mr. BERNANKE. Yes. Mr. WATT. SO if it were the same, it would require— Mr. BERNANKE. Same principle, yes. Mr. WATT. Okay. The increase in foreclosures is a serious prob- lem, and one of the concerns we have is that the Fed has never adopted a final rule under its authority under the truth and lend- ing act to prohibit practices or acts that it found to be unfair or deceptive or designed to evade the purposes of HOPA over the en- tire class of mortgage loans. There has never been a real rule on these things, and I think that is one of the things that is putting pressure on us to be more aggressive in having a Federal predatory lending standard, or at least a Federal predatory lending floor. I am wondering whether you view that as a problem, and maybe I could just get you to discuss with me why the Fed has never used that more aggressive, unfair, deceptive trade practices language to be more aggressive in this area in light—and especially in light of the increasing number of foreclosure that we are experiencing. Mr. BERNANKE. Congressman, we have found that it is very dif- ficult to write rules in advance that strike out entire practices under all circumstances. We find it is more effective to be flexible and work on a case-by-case basis. It is one of these things like, "You know it when you see it." And so what we have done rather than write specific rules, is to work with the FDIC to develop a set of principles, and there has been much talk lately about principles-based regulation. One of the principles on which we are making these decisions provides guid- ance to the banking agencies for implementing to take action against unfair and deceptive acts and practices, and we believe that set of principles provides full authority for not only us, but also the OCC and other agencies to take actions to prevent unfair and deceptive acts or practices. So, for example, the OCC has re- 28 cently taken substantial action, I think it was a credit card case, based on this, and they were not inhibited from taking those ac- tions because of any lack of rulemaking. Again, whether an act is unfair and deceptive depends often frequently on the context and circumstances. Mr. WATT. Can I just interrupt you long enough to ask you to comment on whether you think we need a Federal predatory lend- ing statute? Mr. BERNANKE. I think good progress has been made in trying to understand how to distinguish predatory lending from legitimate subprime lending. That is always the challenge. How do you define the rules in a way to address predatory lending without driving out legitimate subprime lending? And what we have seen lately is that a number of States, and your own State, North Carolina, has been one of the pioneers there, have introduced legislation which have moved the ball forward in terms of achieving that objective. And I was very pleased to see that because I think the States are good laboratories. They can really try out different things, and we can see what works and what doesn't work. At some point when we understand well enough how to distin- guish between predatory and legitimate lending, probably a Fed- eral standard would be a good idea because it would eliminate the many differences across States and make it more costly for lenders to lend on a national basis. I don't really have a good judgment as to whether the States have reached a point where we feel, you know, we are ready to do that, but at some point we should really consider— Mr. WATT. In the meantime should we be talking about a Fed- eral floor as opposed to a preemptive stand? Mr. BERNANKE. I have no objection at all to your discussing those issues. I think the question is making sure that you are making a clear distinction between predatory— The CHAIRMAN. I would ask the gentleman to yield. I just want to say, first of all, the question he raises is a very important one that is widely—is of great concern to the civil rights community. I will say a couple of things, if I could, because this is really essen- tial. First, the State versus Federal has been complicated by the very strong preemptions of State law issued by both the Office of the Comptroller of the Currency and the Office of Thrift Supervision. So part of the problem we face is that some of those State laws that we agree are good ideas don't reach, for instance, operating subsidiaries of national banks. So the argument for me being at the State level would have been stronger if it hadn't been for those pre- emptions. Secondly, with regard to the rule—and the gentleman's question is one many feel strongly about. I understand your argument that you can still reach these after the fact, but some people feel, and I am inclined to agree with them, that there might be a greater de- terrent effect if there was to be some rulemaking. It is one thing to go to people's rescue after the fact, but it does seem to be a pro- liferation here, and that is why we think we may need more. But we will be continuing this discussion. Mr. WATT. I yield back, Mr. Chairman. 29 The CHAIRMAN. The gentleman from California. Mr. ROYCE. Thank you, Mr. Chairman, and thank you, Chairman Bernanke. This committee has been debating GSE reform now for some time, I think for about 4 years now. Surprisingly, while debating reform with Fannie Mae and Freddie Mac, we have not heard testi- mony from the Federal Reserve on this topic, and we are going to re-engage in this debate next month, and I was wondering if you would be willing to come up and to testify as to the Federal Re- serve's view on GSE reform. I think it would be very helpful for all of us. Mr. BERNANKE. The Federal Reserve has testified in the past, I believe. I believe Chairman Greenspan has testified, but if that is not the case— Mr. ROYCE. He has testified as to the subject, but I am thinking about the hearings we are going to hold specifically on GSE reform. And that was my question as to whether you might testify on that. Mr. BERNANKE. We would be very interested in having our per- spective heard on this issue. Mr. ROYCE. I hope the committee leadership can accommodate you on that. I also wanted to say that it is not just New York that has grown quite concerned about the disadvantage competitively that our cap- ital markets face and the flight of capital. I think all over the United States, people are getting worried. We saw the Bloomberg- Schumer report, and then the Committee on Capital Markets Regu- lation report that came out, and they have really stressed this issue. And I also noticed last November, the late Dr. Milton Friedman said this, and I would just like to read it quickly. He said, "Sar- banes-Oxley is very unfortunate. It tells every entrepreneur in America, don't take risks, that is not what we want. The function of the entrepreneur is to take risks, and if he is forced not to take risks and spend on accountants rather than products, the economy is not going to expand or grow." And then also the same month, Alan Greenspan said that most of Sarbanes-Oxley is, "a cost creator with no benefit I am aware." And he went on to say that regulatory and statutory, statutory changes need to be made as well if we are going to move forward. And he concluded with something that I thought was rather force- ful. He said, "I hope it happens before the whole financial system walks off to London." It seems to me that Dr. Greenspan and others were concerned that the regulatory climate will not only deter investment in the country, but that it is also going to suppress future entrepreneur- ship and suppress innovation. And I was going to ask you because, you know, if they are correct, that could have a very harmful effect not only on future U.S. productivity, but as a result of that will re- duce the potential standard of living gains in this country. And so, Chairman Bernanke, do you share the concerns of Dr. Greenspan and Dr. Friedman on this issue? Mr. BERNANKE. Let me say this: I think it is very important that as we try to achieve the objectives of greater clarity and trans- parency in corporate governance and internal controls and so on 30 that we do it at the lowest cost we can, and I think that it is a good development that the Public Company Accounting Oversight Board along with the SEC has recently promulgated for a comment a new audit standard which would be less "checking of the box" and more focused on the major concerns of the company, and also that would take into account the size and complexity of the com- pany, so we wouldn't be putting these costs on the smaller compa- nies. I think that is an important step in the right direction. I would be curious to see how that goes. More generally, you know, as a regulator, I think it is very im- portant that we have to achieve the objectives that Congress gives us, and there are some very important ones, but we also need to do the best we can to minimize the cost and unnecessary burden created by those regulations. Mr. ROYCE. But going back to my question, and quoting former Chairman Greenspan again, he spoke to the regulatory changes that you spoke to, but he also spoke to statutory changes that he thought were necessary. And that very much concerns us going for- ward in terms of whether or not we addressed these recommenda- tions made by the Bloomberg-Schumer report or made by the Com- mittee on Capital Markets Regulation report. Mr. BERNANKE. We are continuing to monitor the application and effectiveness of Sarbanes-Oxley. I am not prepared at this point to call for any specific legislation changes. I would like to see how the audit standard works. Mr. ROYCE. Well, in the meantime, to paraphrase Dr. Greenspan, hopefully it will happen before the financial system walks off to London, because as I read the papers every week, that egress, that exit, is becoming more and more pronounced, and we have an ar- ithmetical increase not just of capital flight, but also a resistance of companies coming into the public market in the United States. Capital is basically avoiding our capital markets with very dire consequences, I think, in the long term, to the standard of living here in the United States and our competitive position. Mr. Chairman, thank you. The CHAIRMAN. Thank you. The gentleman from California. Mr. SHERMAN. I would like to comment first on the gentleman— the other gentleman from California, and that is that we have in our capital markets kind of a one-size-fits-all approach. You are ei- ther a private company, or you are so public that your statements are so good that if widows and orphans want to put 100 percent of their net worth into your stock, it is entirely legal to do so. We might want to explore some intermediary category where the amount of disclosure does not meet full-blown Sarbanes-Oxley on the one hand, and investment, while publicly traded, is only among highly accredited investors who are investing less than 1 percent of their net worth. I think as long as—to be a public company, you have to be a company that I want my mother to, legally at least, be able to put 100 percent of her net worth in means that you are going to have to meet a very high standard. I have a number of questions for you. One is to respond to that, and I will lay out a few others, and you will probably have to re- 31 spond for the record, Mr. Bernanke. But if I talk fast, maybe you will be able to comment orally. The first is, you have talked about the problem of income inquality. Do you know of any systematic economywide approach with a near-term effect to deal with such income inequality other than making our tax system more progressive? Second, we have a lot of smart, educated young people. They go and get college educations, but they only have the slightest infor- mation about which careers will be in demand by our economy. Should we publish an official guide that is forward-looking, that uses our best economic resources to project for the guidance of young people what careers will be in demand in the decades to come? Third, over in the Senate you talked about your concern that the ILC loophole could be used to mix banking and commerce. I wonder if you have an equal concern—I hope you have an equal concern— about the exploitation of other loopholes that combine real estate brokerage with banking, or auto sales with banking, or any kind of sales with banking on just on the pretext that the sale—that the consumer needs financing. And I hope that you are as strong at preventing bankers from getting into commerce as you are in pre- venting commercial firms like Wal-Mart from getting into banking. Last year we talked about the need for certain—my perceived need for an emergency plan to be available to deal with a precipi- tous decline of the dollar. You responded to me in the letter of April 25, 2006, noting that from 1985 to 1988, we had a roughly 40 percent decline in the value of the dollar, and the sky did not fall. But do you think that the risk of a 40 percent decline in the U.S. dollar in 4 weeks, rather than 4 years, is so remote that we shouldn't think about it, or are you just confident that our society and the world trading system could adjust to it? Or should we be doing some planning, given that we have had another year since we have talked last of record trade deficits? Finally, the New York Fed processes dollar transactions. We re- cently stopped two Iranian banks from having access to that through U-turn transactions. What would be the effect if we pre- vented all Iranian banks from having such access? I ask for you to comment from a technical monetary policy, you know, banking reg- ulatory policy. Obviously we have other venues to talk about, whether that would be a good approach in negotiating with Iran. Or could we cause significant concern in Tehran if we didn't stop at the two banks, but went with all Iranian banks in banning their access to transactions through the Fed? Do you have any other comments? Mr. BERNANKE. I can respond quickly to a few. Multiple stand- ards for Sarbanes Oxley is an interesting idea, but I would note that the audit standard that allows size and complexity to be a con- sideration does to some extent do that. On income inequality, this is a very long-term trend. At least since the 1970's, and according to some measures from the 1950's, we have been seeing this trend, and I don't think there is any real- ly good way to reverse it overnight. I think it is going to be a slow progress. 32 Mr. SHERMAN. Although a more progressive income tax system would do a lot to change the ultimate flows of income, or do you disagree? Mr. BERNANKE. It would not do so without some cost to incen- tives and the like. On official guides to future skills, I think the best thing we can do for young people is to make sure they have good general analyt- ical skills, and that they are not—it has turned out well for us that we don't necessarily put kids in the eighth grade— Mr. SHERMAN. SO if we had lots of people with good analytic skills— The CHAIRMAN. I'm sorry. We don't have time for further ques- tioning. I will give the gentleman 30 seconds. Mr. SHERMAN. Please continue. Mr. BERNANKE. I would focus on general problem-solving skills that are most flexible. On real estate brokerage, the Federal Reserve and the Treasury have never had an opportunity to make a determination about whether this fits under the Gramm-Leach-Bliley law. Congress has not permitted us to go ahead with that, and so we have had an op- portunity to look at it. With respect to financial crises, I would just say that the Federal Reserve takes financial crisis management extremely seriously, and we have made a number of efforts to improve our monitoring of the financial markets to study and assess vulnerabilities, and to strengthen our own crisis management procedures and our busi- ness continuity plans. And, I hope we never have another financial crisis, but should one ever occur, we want to be well prepared for that. I would have to get back to you on the Iranian question. The CHAIRMAN. Thank you. The gentleman from Connecticut. And the Chair will announce that the Chairman has been very gracious to agree to give us until 2 p.m.—we will take a break for about 15 minutes at noon. So the gentleman from Connecticuit will—after his questioning and an- swers, we will take a 15-minute break. Mr. SHAYS. Thank you for being here. I want to kind of agree with Congressman Watt. I thought the responsibility of the Fed Chair was to speak in tongues, so I have been a little shocked that I can actually understand you. The only other person I have trouble understanding is sometimes the chair- man when he gets excited. I want to ask you, I think of ourselves as a consuming Nation that drives our economy, and yet I wrestle with the fact that we talk about how we should save. Now, I am a consumer. The only savings I have is my house and my Thrift Savings Plan. Should I feel guilty? Mr. BERNANKE. It is not a question of feeling guilty. The question you want to ask yourself is, are you well prepared for retirement? Mr. SHAYS. Well, really what I am trying to say is if I want my country to be stable, are we asking Americans to stop consuming and to save? What are we asking them to do? Mr. BERNANKE. Well, I think the issue is at the national level. Your question is at the individual household level. At the national 33 level, low rates of savings create the need to borrow from abroad, and it does have some risks involved. The most direct way to ad- dress savings is to try to improve the saving of the government sec- tor. Mr. SHAYS. What confuses me is that we are trying to get con- sumers to consume so that our economy moves forward. So I just wonder how you would wrestle with that, and how do you wrestle with it? Mr. BERNANKE. There is no inconsistency. In short-term business cycle dynamics, consumer spending can drive growth. But over a longer period, if people save more, then that can be replaced by higher, stronger investment spending, for example, and that would be a desirable way to go. Mr. SHAYS. Okay. With regard to tax cuts, I believe that divi- dends and capital gains in particular have had a huge impact in getting us to have constant growth since we have lowered these rates. I am concerned that my Democratic colleagues are going to allow these tax rates to go up. I am interested to know your opin- ion. Mr. BERNANKE. I think most economists would say that lower dividend and capital gains tax rates have efficiency gains. They are providing centers for saving. They reduce distortions in capital structure. They allow retained earnings to be circulated back into the capital markets, and there are many other areas where I think they contribute to efficiency in the economy. As always, with any tax measure, there are competing consider- ations of revenue and progressivity and so on. And as you know, given my position as the head of a nonpartisan central bank, I can't really take positions on specific measures. Mr. SHAYS. Well, okay. It just seems to me that you can give us advice as to whether or not you believe that continuing these low rates will contribute to a stronger economy. And if you don't think that, then you should tell us. If you think that letting them go up will not impact our economy, you should tell us that. I think that is a fair question. Mr. BERNANKE. Well, let me say this, which is that there needs to be a balance between spending and taxes. So I think that well- designed lower taxes can contribute to a stronger economy. But there is also a responsibility to make sure that the spending is commensurate with that. Mr. SHAYS. Right. Let me get to the next one. When I am encouraged to refinance my house and pay 2 percent to 3 percent, you know, and then you look at the fine print, and you are paying 7 percent or more. So I see this, and think that—well, I am not following them. I think a lot of people are. What is the role of the Fed to try to address that issue, if" any? Mr. BERNANKE. The size of the cost to refinancing? Mr. SHAYS. The incredible amount of effort to get consumers to basically use their homes, thinking that they are only going to pay a 2 percent or 3 percent rate, when in actual effect they are going to pay 7 percent or 8 percent. They have to pay it. They just don't have to pay it each year. Mr. BERNANKE. Adjustable-rate mortgages and the like. 34 Mr. SHAYS. Adjustable rates, but where they actually pay less each year, less than the rate they are being charged. Mr. BERNANKE. Those are option ARM's and so on. Those have negative amortization. Mr. SHAYS. I shouldn't have said it that way. But the bottom line is that I am scared many people are just going to fall into that trap. Mr. BERNANKE. I share your concern. As I was discussing earlier, our nontraditional mortgage guidance is very clear that lenders should, first of all, make sure people understand what it is they are signing, what they are getting involved in, and secondly should un- derwrite in such a way that if the borrower stays in that mortgage and rates go up, then the borrower will be able to make the pay- ments and not be foreclosed. Mr. SHAYS. Thank you. I yield back. The CHAIRMAN. We will now take a 15-minute recess. [Brief recess] The CHAIRMAN. We are going to convene a minute early, but the next person on our list here is from Kansas, Mr. Moore. Would someone please close the doors—thank you—and Mr. Chairman, we appreciate, again, your giving us all this time. The gentleman from Kansas is recognized for 5 minutes. Mr. MOORE OF KANSAS. Thank you. Mr. Chairman, thank you and welcome to the committee, and I appreciate your coming here and taking our questions. I want to follow up on kind of an area at least that the gen- tleman from Texas asked you about, and that was our debt as a Nation and what that is going to do to future generations in our country. I have seven grandchildren, and I am very concerned that we are accumulating a debt in this country that presently stands at $8.7 trillion. I understand it has gone up approximately $3 trillion in the past 6 years, and I was at the White House about 6 weeks ago, and I had a chance to talk with the President. I said, Mr. Presi- dent, I am not pointing a finger at your Administration, and saying it is your fault, because this goes back 25 years, 30 years, but through a process of borrowing and accumulating debt, interest on our national debt now stands at $8.7 trillion, and as I think Mr. Paul pointed out, over 40 percent of our debt is held by foreign na- tions. Should we, as a Nation, be concerned about that much debt? Should we, as a Nation, be concerned about the fact that more than 40 percent of our debt is held by foreign nations? If for any reason, whatever reason, foreign nations decide to sell off our debt, what impact, if any, would that have on interest rates in our country? Mr. BERNANKE. The Federal debt that I am most concerned about is sort of the implicit debt, the debt associated with our promises to future retirees for Social Security and Medicare. If we were to stop here in some sense, it would not be quite so bad. The amount of government debt held by the public currently is about 37 percent of the GDP, which is fairly normal across industrial countries, lower than some in fact, but the situation is going to get a lot worse as we have retirements of the baby boomers and so on and medical care costs go up. 35 According to the Congressional Budget Office, in the immediate scenario, by 2030, the debt, instead of being 37 percent of GDP, will be 100 percent of GDP, and the deficit will be 9 percent of GDP instead of being a little under 2 percent as it is this year. So, if we allow things to continue, the debt interest cycle will continue to build up, and we will hurt our fiscal position to the detriment of our children and grandchildren. On the issue of holding the treasury debt, the reason that foreign countries hold our debt is, for the most part, because they find it beneficial to themselves to have ownership of this very safe, liquid, and convenient form of assets, and I find it unlikely that anywhere in the foreseeable future there will be a major sell-off of any kind. If there were to be some sell-off, there would probably be some short-term effects, but— Mr. MOORE OF KANSAS. What kind of short-term effects, Mr. Chairman? Mr. BERNANKE. We would have movements in the asset financial markets, responding to the sale of the treasuries and other securi- ties. Mr. MOORE OF KANSAS. Would interest rates respond to the sale of securities? Mr. BERNANKE. The impact effect of large sales of treasuries would be to raise interest rates, yes, but over a longer period of time, I believe interest rates are determined by fundamentals, by Federal Reserve policy, and I would also point out that the owner- ship, say, by the Chinese, of dollar-denominated assets is less than 5 percent of all of the fixed-income dollar assets in the world, even though it is a larger share, as you point out, of the treasury mar- ket. So I do not consider that to be a major concern. As I mentioned earlier in response to a question, there could come a point where foreign investors become less willing to accu- mulate more of our debt and would begin to drive up interest rates, and in order to avoid that contingency down the road, we should probably be trying to bring our current account down gradually over time. Mr. MOORE OF KANSAS. Well, I understand, and I appreciate the fact that you, I am sure, feel a responsibility not to alarm people by any statements you might make, but my concern again is if for- eign nations decide for whatever reason to sell off our debt, that is going to—there is the old law of supply and demand in effect, and if foreign nations are not going to hold our debt, that means that we are going to have to finance that, and I would think that would cause interest rates to go like this. I remember 30 years ago there was a guy named Jimmy Carter, who was President of the United States. We had interest rates going up to 12-, 14-, 16 percent. That would be absolutely dev- astating for our Nation right now, and I am not trying to be an alarmist here. I just do not want to see us get in a position where anything like that happens again to our country, because that would be devastating, I think, for small businesses, for consumers, for people in this country, and that is my concern, I guess. One more question. Oh, we are out of time. Sorry. Mr. Chairman, thank you very much. The CHAIRMAN. Would the Chairman like to respond? 36 Mr. BERNANKE. NO. The CHAIRMAN. Well, then we will take one more question. Mr. MOORE OF KANSAS. Okay. I understand that you all have a rule that says that the presidents of your banks have to retire at a certain age. Is that consistent with what some people are saying, that be- cause of life expectancy going up that we should require people to retire at a certain age? Mr. BERNANKE. We have thought it valuable to have some turn- over there. We do not have quite the same pressures that the pri- vate market would have, you know, with leadership in a company, so we think that getting new leadership is beneficial, but if there are concerns I would be certainly willing to ask our committees to look at that. I have found, basically, that there has been a reason- able amount of turnover in the sense that people do not stay so long as to stagnate, but they stay long enough that their knowledge and experience can accumulate. The CHAIRMAN. Of course, they could always retire, rest for a few years, and then run for the Senate. The gentleman from Texas. Mr. HENSARLING. Thank you, Mr. Chairman, and Chairman Bernanke, thank you for your patience. To some extent, I would like to follow up a bit on a line of ques- tioning from my colleague from Kansas, and I know that his com- mitment to the long-term fiscal health of our Nation is a very sin- cere one. We sometimes come about it in different ways, but I know his commitment is sincere. I was reviewing testimony you gave before the Senate Budget Committee recently on entitlement spending, and you have alluded to it today. I have had the occasion now to hear from the heads of OMB, GAO, CBO, and the Secretary of the Treasury, and there seems to be consensus among all of them that the number one fis- cal challenge we face as a Nation is the pace of growth in entitle- ment spending. Would you concur in that assessment that it is, indeed, our num- ber one fiscal challenge? Mr. BERNANKE. Yes, or, more broadly, how to deal with the aging of the population. Mr. HENSARLING. YOU spoke earlier about the percentage of debt to GDP by 2030, and you mentioned, I guess, the challenges of try- ing to, without entitlements, reform the level of spending decreases or tax increases, some combination of the two. I think I heard you say before we are not going to grow our way out of this challenge, is that correct? Mr. BERNANKE. That is correct. Mr. HENSARLING. If Congress ignored any entitlement spending reforms and chose no other offsets within the Federal budget, using 2030 as our guideline—it is kind of a good placeholder for the next generation—have you looked at models on what type of tax burden would be necessary to be placed on our people to balance the budg- et, say, in 2030? Mr. BERNANKE. Well, the projection would be that in 2030 the entitlement programs would be about 15 percent of GDP, which means that the entitlement programs and interest on the debt to- 37 gether would be something about our total budget today. So in- creases would have to be related to how much additional spending you would have. If you want to keep nonentitlement spending con- stant, you would have to raise tax rates approximately 6 or 7 per- centage points of GDP, from about 18 percent now to about 25 per- cent of GDP, with no other changes in order to retain about the same deficit. Mr. HENSARLING. The Comptroller General has previously testi- fied that if that happens, in his opinion, we are on the verge of being the first generation in our Nation's history to leave the sub- sequent generation with a lower standard of living, less oppor- tunity. Would you agree with that assessment? Mr. BERNANKE. Those are very high tax rates, and they would have adverse effects on growth. Mr. HENSARLING. Changing subjects, Mr. Chairman, the debate about trade versus protectionism is as old as our Republic is. It is a debate that has certainly reared its head again in our Congress, many believing that somehow present trade policies have negative impacts on low income. I recently saw some Bureau of Labor statis- tics figures that indicate, within the last 5 years, the price of dura- ble goods have dropped 8.7 percent, appliances 6.5 percent, toys 25.8 percent, and televisions 55.4 percent. Low-income people in the Fifth Congressional District of Texas, whom I represent, buy televisions, toys, durable goods, and appliances, and last I looked, each of these had a very heavy trade component. If trade barriers were erected, might the cost of these actually go up instead of decrease, and might that have a detrimental impact on low-income Americans? Mr. BERNANKE. Certainly. Yes, I agree. Mr. HENSARLING. That was such a quick answer that I was not ready for the next question. Mr. BERNANKE. Well, I can elaborate. Mr. HENSARLING. NO. I think I will quit while I am ahead, Mr. Chairman. I think I will quit while I am ahead. To the extent that I have any time left, subprime lending—you mentioned that there is a great challenge in figuring out the dif- ference between predatory and subprime. I believe the world works off of incentives. Are subprime lenders incented to actually take back the collat- eral, to take back the house, to repossess it, particularly since, I think you testified, we are now in a softening real estate market, and if that is not the incentive structure might the competitive marketplace help ameliorate what we are seeing as far as some of the high foreclosure rates? Mr. BERNANKE. TO some extent, that is correct. It is certainly the case that subprime lenders, certainly the legitimate subprime lend- ers, are not looking to have foreclosures. It is bad for their busi- ness—they lose money—and we have seen some failures of small lenders, and we have seen credit default swaps that measure the risk of subprime mortgages, those spreads widen considerably, and so, clearly, it is not in the interest of lenders to make bad loans. Mr. HENSARLING. I am out of time. Thank you for your testi- mony. 38 The CHAIRMAN. The gentleman from North Carolina. Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman, and Mr. Chairman. Mr. Chairman, I also read your remarks in the Greater Omaha Chamber of Commerce that Ms. Waters spoke of. She said she was very moved in reading it. I am not sure I have ever really been moved by a speech by an economist, but I have found a fair amount to agree with in what you have said, and there were things that we had discussed earlier when you testified here before and, actu- ally before that, things that—topics about which I had questioned Chairman Greenspan earlier. You talked about the widening inequality, that between 1979 and 2006 the wages of the people who are right in the middle had gone up by a total of 10.5 percent, the people in the bottom quintile, the bottom 20 percent, 4 percent, and those in the top quintile had gone up 34 percent, that the share of after-tax income for the top 1 percent had almost doubled as a percentage of all wages, all com- pensation from 8 percent to 14 percent over a slightly lesser period of time, and that even within that 1 percent there was a widening inequality. I asked you then about what programs we could get at, and you mentioned education again and specifically community colleges, life-long learning, job training, how to make sure that our workers have the skills to be personally responsible for increasing produc- tivity so they might be compensated better. In the President's most recent budget, all line items for career and technical education in 2007 were $1,312 billion, and in the proposed budget it is $617 mil- lion. So it is being cut by more than half. Does that show a commitment—is that what we need to be doing if we do recognize income inequality as a significant problem for so- ciety? Mr. BERNANKE. One point I tried to make in my remarks was that solving these problems of retraining and job search in life are difficult, and people may differ on how best to accomplish it. I do not know from your numbers whether there were offsets in other programs or different approaches—I simply do not know—but I think there is a legitimate debate among all of us about what are the most cost-effective, effective ways, to help people overcome the skills gap so that they can get better work. Mr. MILLER OF NORTH CAROLINA. Actually, Mr. Sherman men- tioned a systematic economic approach to approaching income in- equality. I think before, I just asked if you could name any pro- gram that addressed anything Congress was doing and the Presi- dent was doing that seemed to be addressing economic inequality, growing differences in income, and you mentioned specifically edu- cation. That was what you talked about. If we are serious about closing economic inequality, isn't that ex- actly what we should be looking to, making a real commitment to job training, to adult education, to education from pre-kindergarten all the way through life-long learning? Mr. BERNANKE. I think we should, but I do not want to support or attack any specific program because there are many approaches to doing it. The President will, no doubt, reply that he has the No 39 Child Left Behind Program, which is an attempt to increase the quality of schools. Mr. MILLER OF NORTH CAROLINA. Which has also been funded at much less the level than what was promised, dramatically less, and actually the very programs within No Child Left Behind that are most clearly directed at closing achievement gaps are the very pro- grams that have been cut the most. Chairman Bernanke, you also, in your speech in Omaha, talked about the kind of superstars in the world economy and how much— given what the economy is like now, relatively small differences in ability or in appeal from the very, very best and people who are just very, very good but not the very, very best—resulted in dra- matic differences in income, and then you also mentioned CEO pay and said that in many cases CEO's who had failed spectacularly, who had appeared to have crashed and burned, had still done very well or were still compensated at breathtaking levels, and in ear- lier testimony you said that European CEO's appeared to be paid significantly less than American CEO's. Are European companies doing significantly less well because they do not have the superstars? Is there anything that suggests, really, that there is a difference based upon skill level between American CEO's and European CEO's? Mr. BERNANKE. I have not really studied that. I think that there are some CEO's in Europe who are paid lower levels, and probably there are fewer in sort of the same league as the American CEO's. I think it is very important that boards of directors take share- holder interests very seriously when they make these compensation decisions, and that they try to attract the very best talent, and that they pay in a way that will motivate good performance. The CHAIRMAN. The gentleman from New Jersey. Mr. GARRETT. Thank you, Mr. Chairman, and thank you, Mr. Chairman, for your testimony today. I appreciate your spending the time with us. I would like to go back and begin my questioning with a topic that is of great importance to me, and we have already touched on it, at least with one series of questioning, and that is dealing with GSE reform. On the one hand, I am pleased to see that the Administration is taking what I would say is a slightly tougher tone, if you will, on pushing for a brighter line test between what is appropriate and what is inappropriate between the primary and the secondary mar- kets and what the GSE's are involved in. That is on the positive side. On the negative side, from my position, I have seen something of a softening with the Treasury stance with regard to portfolio limitations, which I believe should be a true concern to us. I know that there are ongoing negotiations, if you will, between the Treas- ury and our esteemed and gracious chairman behind us to try to reach a compromise on this issue, and as part of the negotiations there is consideration of what has been dubbed the MTI, the mort- gage tax increase, better known as the "Housing Fund," and I would be curious to have your take on an aspect of that. I raised a similar question to you when you were here before the committee a year ago and new on board, but I know since that time 40 you have had an opportunity to get into the weeds a little bit more on this topic. You have already testified here and before other com- mittees with regard to the importance of the housing market in general to our boom in the economy that we have had and the slight slowness of the housing market and what impact that could have on the overall economy. My first question to you is: What additional impact could we see if we did have a tax, if you will, on that marketplace by having a fee or an assessment on the GSE's for this new Housing Fund, or the MTI? Mr. BERNANKE. SO you are arguing that the Housing Fund would raise the cost of mortgages because we are putting a tax on the GSE's? Mr. GARRETT. Yes. Well, we know the corporations in general do not pay their taxes in one way or another. The cost of doing busi- ness is not borne by the business but is passed on to the consumers in one sense or another. Here, the business that it is being passed on is to the low- and moderate-income homeowner who is trying to get into the market, which is the whole idea behind GSE's. Mr. BERNANKE. Well, I have not done any analysis of that par- ticular issue. I would reiterate what I said before, which is I think, that it is important for the GSE's to support affordable housing. The way I would recommend it would be to tie their portfolios to affordable housing products, for example, by holding MBS that are based on affordable housing mortgages, for example. That would seem to be a direct way to both create some limits, some limitation on the ra- pidity of the expansion of their portfolio, while still having a direct impact on the affordable housing. I have not taken a position on the Housing Fund, and I am afraid, if I do so, it will be portrayed as a change in position, be- cause the Fed is focused very much on the safety and soundness and the systemic risk implications of the portfolios, and I think that is where the Federal Reserve needs to keep its focus. Mr. GARRETT. DO you agree with my basic economic assessment that when you have a corporation such as GSCR or any corporation in general that the taxes that we assess on them are not borne, in essence, by them, but it has to be passed on to someone? Mr. BERNANKE. Well, it could be passed on to the shareholders in terms of a lower share price. That is another possibility. So I would have to think about the incidence of that. Mr. GARRETT. And, of course, the economic philosophy to that is, when you put a cost onto the share price of a company where they have to get their investments from, that impacts upon the econ- omy. We can go into that. Can you elaborate a little bit more on the portfolio idea that you were talking about? I am limited in my time here. Are you sug- gesting that you allow them to increase the—or have an increase in the portfolio size of those holdings for the low- and moderate- income portfolios, and if that is the case, doesn't that go beyond what the GSE's were intended for—or what the portfolios were in- tended for in the first place? They were just for securitizing the 41 loans, and they were just there to be in and out, if you will. Why would we need that to occur? Mr. BERNANKE. I think the ideal situation would be one in which the portfolios did exactly what you said. They were to be the weigh station for securitized mortgages, and they would contain mostly liquid assets for the purpose of purchasing mortgages and then selling them back to the market. Mr. GARRETT. Right. Mr. BERNANKE. I would like to see a bill. I think we need to have a strong regulator in this arena, and we need to find some way that we can limit the growth of the portfolios. As a practical mat- ter, I think that restricting portfolios to mortgages related to af- fordable housing might be an appropriate compromise and an ap- propriate approach that would provide some limitation, but the Federal Reserve has always been concerned about the size of port- folios. It never has found a substantial benefit to homeowners from large portfolios. Mr. GARRETT. Does the Treasury have the authority— The CHAIRMAN. Gentlemen, we are into the timing. The gentleman from Missouri. Mr. CLAY. Thank you, Mr. Chairman, and thank you for holding this hearing. Mr. Bernanke, welcome. I represent the First Congressional Dis- trict of Missouri, which is comprised of north St. Louis City and north St. Louis County. Continuing with the same line of questioning as the gentleman from New Jersey about housing, in my district, and in many other districts across the country, we have a tremendous housing crisis. This must be addressed, and it must be done with urgency, espe- cially when it comes to affordable housing. What changes in housing policy can be made that the United States can better foster an urban housing policy that puts people in homes in the inner cities so that they can build wealth through ownership and pass it on to future generations? What are your ideas on this, and what is your approach to this housing crisis? Mr. BERNANKE. Well, I recently had the opportunity to visit Ana- costia in the District of Columbia and to see some of the projects going on there, and we saw the actions of community development financial institutions, CDFI's, who have worked together with banks, private investors, and with government sources to finance some very impressive projects, some new apartments, and some so- cial centers for the community, with very good results, and I think that collaboration that we saw with the CDFI's, managing together with some nonprofit institutions, other nonprofit institutions, and private sector input, is a very promising approach to this. Mr. CLAY. It sounds like we have to be creative in order to re- build our inner cities and to come up with creative concepts so that people can take ownership of their neighborhoods, of their commu- nities. It sounds like that is what you are saying, and you promote those policies. Mr. BERNANKE. Ownership is very important because people then feel they have a responsibility for their community and for their home, and it is also valuable to try to develop a community, not house by house but in a broader sense, because unless you have a 42 retail area and a school and a social area and other amenities, the house property values are not going to justify the cost. So you need to build a neighborhood rather than just an individual house. Mr. CLAY. Thank you for that response. Let me shift over to a worker issue. Yesterday, DaimlerChrysler, throughout the United States and particularly in St. Louis, announced plans that will affect approxi- mately 1,300 jobs at our Fenton plant in St. Louis County. They are losing an entire shift which makes the minivans. There have been other massive layoffs by the other automakers. Additionally, these corporations are trying to do away or drastically reduce leg- acy cost, healthcare, retirees' benefits, and pensions. Many of these employees have lost benefits that were promised them in exchange for working their careers at their workplace. They earned them, and now, as they approach retirement, they are not there. Do you have new approaches or plans for long-term employee healthcare, retirement benefits and pensions, and how do we ad- dress the problem facing our industrial workers in the automobile industry and manufacturing sector? We can include the airline em- ployees and many other workers throughout this economy in that. What new systems will we put in place to replace these traditional safety nets that they have worked for and depended on all of their lives? What solution do you think we should be putting in place, and what are your thoughts on this? Could you elaborate? Mr. BERNANKE. Well, first, if firms make promises to workers with respect to retirement benefits or healthcare benefits, we should make sure that those promises are kept. The recent legisla- tion on pensions that Congress passed tried to toughen up the re- quirements for funding pensions, tried to make them more trans- parent, and to increase the premium paid to the Pension Benefit Guarantee Corporation. Those kinds of measures can help ensure that companies will not renege on the promises that they have made to their workers, so that is very important. I would say, more generally, that we need to diversify, to have more than one source of retirement security. Some people rely on defined benefit pensions. We need to expand access to defined con- tribution plans like 401(k)s and other kinds of private savings, and then there is, of course, Social Security, which we want to make sure is on a sustainable, long-term path. So if we put all of those things together, you can help people finance a reasonable retire- ment. The CHAIRMAN. The gentlewoman from West Virginia. Mrs. CAPITO. Thank you, Mr. Chairman. I have a question. You mentioned in your opening statement that there has been a large amount of consumer spending. We see a lot of credit card debt by individuals, a lot of higher education loan debt for young people coming out of college, also into the profes- sions, medical school. How are people going to be able to overcome this debt when the wages are only rising a certain percent? Do you see this as a long- term problem that seems to be concentrated—I mean, if you are a college student, you can get a credit card like that and run it up to the maximum quite quickly and pay $20 a month, probably, for 43 the rest of your life. What kind of problem do you think that pre- sents to our economy? Mr. BERNANKE. Well, the incidence of delinquencies and bank- ruptcies for the economy as a whole remains quite low. Because the job market is pretty good and incomes have gone up, wealth has gone up, the stock market is up, and so on. Most families, many of them, have home equity built up and have been able to manage their finances pretty effectively, and as I said, we have not seen any significant increase in financial stress in the broader economy. Now, there are pockets of problems, as I mentioned already sev- eral times, such as the variable rate subprime mortgage area. I think there are a number of approaches. The one that the Federal Reserve is particularly involved in is disclosures. We are respon- sible for Regulation Z, which implements the Truth in Lending Act, and it includes such things as the famous Schumer Box and other things that show to potential credit card applicants what are the terms, you know, what are the fees and so on. We are in the process now of completely reworking Reg Z for credit cards, for revolving debt, and we anticipate going out with a proposed rule in the next couple of months, and we have worked very hard on that. In particular, one thing we have done—people find it very difficult to understand the legalese that they see in the credit card applications, the credit card contracts, and yet of course the legal information has to be there. Otherwise, it is not a legiti- mate contract, and so the challenge is to create disclosures that meet the legal standards but that are also understandable, and so we have gone out and done a lot of consumer focus group testing and those kinds of things to try to find disclosures that will actu- ally work in practice, and we hope that these new disclosures we are going to put out for comment in just a couple of months will be helpful in helping people understand, you know, the terms and conditions of credit cards and make them use them more respon- sibly. Mrs. CAPITO. Well, I will look forward to that, and I think it is an excellent idea, and I think that it is difficult when you turn it over and look at the fine print. I am admitting to not reading my credit card disclosures as closely as I should. I do not often mention it, but I am from the State of West Vir- ginia, and it is very reliant on coal, and the energy production is extremely vital to our State economy, but we also have a popu- lation that is very sensitive to gas prices, to the price of healthcare, to all of the things that hit your pocketbook immediately. When you look at the long term, what do you see in terms of— and I know, in some of your statements, you sort of exclude the en- ergy prices. Is that because of the volatility of that or, in trying to move from nonreliance on foreign sources of oil, do you think we are ever going to make an impact on the pocketbook of the indi- vidual citizen? Mr. BERNANKE. Well, in the short term the demand for oil is in- elastic; that is, it does not respond much to price changes, and so when there are fluctuations in the demand for oil, you get these big spikes and movements in oil prices, and we have seen quite an in- crease in oil prices in the last few years, as you know. Over the longer term, higher oil prices actually have a benefit, which is that 44 they encourage conservation, and they encourage alternative sup- ply sources. Coal, of course, is actually a very promising source. It is, of course, a traditional source of energy, but assuming we can find ways to address the environmental implications—and there are many promising directions there—coal could be a very big part of our energy diversification in the future. So my expectation is that as long as the markets are allowed to work, together with some support for research and development from the Government, together with clear and effective regulation, that we will solve our energy problems and that solution is going to come not just from one single magic bullet; it is going to come from a wide variety of different alternative sources, including, I think, coal. Mrs. CAPITO. Thank you. Do I have time for one more? The CHAIRMAN. YOU do. Go ahead. Mrs. CAPITO. I have one more quick question, and this is sort of an educational question for me. When I read your statistics and I see the large, you know, macro view that you have, living in a small State that has fluctuations always sort of at the bottom end of the economic scale in terms of per capita income, we always feel in small States that sometimes all of the statistics that we read are sort of driven by New York, California, Florida, and Texas. When you are formulating your data that you bring before us, what kind of considerations do you make for smaller States or does just the population number drive all of your statistics? Mr. BERNANKE. Well, we see a lot of State data, for example, un- employment rate data by State, but the other important thing about the Federal Reserve is that it is a Federal—that is, a region- alized—system, and as I am sure you know, we have 12 Reserve Banks around the country— Mrs. CAPITO. Right. Mr. BERNANKE. —and one of the most important elements of our monetary policy meetings is when we go around the table and ask each Bank president from each part of the country what is going on in your State, what is going on in your region, what is going on in various industries, various sectors, and various geographic areas within your Federal Reserve district; that gives us an awful lot of detailed information about what is happening in different parts of the country. This is a very large, diverse economy. The ag- gregate statistics really cover up a huge amount of heterogeneity in terms of economic activity and developments in the economy. So we pay a lot of attention to regional information in trying to under- stand what is happening in the economy. Mrs. CAPITO. All right. Thank you. The CHAIRMAN. The gentleman from Missouri. Mr. CLEAVER. Thank you, Mr. Chairman, Mr. Bernanke. We are very likely going to have as a part of the upcoming elec- tions a great deal of divisive language based on people's concerns about immigration, and in June of 2006, 500 American economists, including 5 Nobel laureates, signed an open letter on immigration and sent it to President Bush and to Members of Congress, and in that letter we are reminded, sir, that we are a nation of immi- 45 grants, and it talks about the economic benefits of immigration and speaks to the power of immigration to strengthen America and to lift the poor out of poverty, and the consensus reached is that most Americans, contrary to what is being said on the nightly news, ben- efit from immigration, but there is one portion of the letter that I think is extremely significant, and if you do not mind, I will just read from the letter: "Immigrants do not take American jobs. The American economy can create as many jobs as there are workers willing to work so long as labor markets remain free, flexible and open to all workers on an equal basis." Now, shortly after this letter was sent to us, Jack Kemp, George Shultz, Jeane Kirkpatrick, and 30 other non-liberals, including the former RNC Chairman, signed a separate open letter on immigra- tion, and it embraced Ronald Reagan's view of allowing open, sen- sible immigration, and they go on to recite Reagan's quote from Winthrop about the city on the hill. Now, the statistics support these letters, and recent studies show that since 1980, immigrants have boosted the U.S. GDP by $10 bil- lion per year, and during the 1990's, when the labor force grew by 16.7 million workers, 38 percent of those workers were foreign- born. In other words, at a time when U.S. unemployment was hit- ting record lows, immigrants filled 4 out of every 10 jobs. Now, in January of 2000, your predecessor, Chairman Greenspan, com- mented that easing restrictions on immigration would go a long way in solving labor shortages. Now, without going on, I am more interested in finding out whether or not you believe that immigration has a positive or a negative impact on our economy. Do you share in the philosophy of the 500 economists, and what do you think should be done with regard to the American workforce and immigration? Mr. BERNANKE. Well, it is certainly true, as they say, that immi- grants built the country. All of my grandparents were immigrants, and they came and they had new lives, and they contributed to our economy. So immigrants have played, historically, a very important role in U.S. economic development. I agree with you that they do not take jobs, and the labor market does adjust to the number of people available to work. We have had a lot of immigration. The unemployment rate is quite low. It is somewhat more controversial. Do they affect wages? One concern that some people have had is that because many of the more recent immigrants have relatively low skills that they compete, to some extent, with low-skilled workers in the United States and may have some effect on their wages. Most estimates are that those are pret- ty small effects, but there may be some effects. So I certainly agree that immigrants have played a big role. They continue to play a big role, and we need to have a national policy on that. I think I would stop short of recommending a specific program. This is a very tough issue and one I think Congress really has to take the lead on about how many people and under what condi- tions we admit, but it is certainly the case today that immigrants are playing a major role in our economy. There is no question about that. 46 The CHAIRMAN. If the gentleman would yield, could I just ask: Would it also have implications—you have talked about the decline in the labor rate participation. Would it also have implications for our ability to deal with the entitlement issue? Mr. BERNANKE. It goes in the right direction, but the CBO has done some simulations that suggest even fairly large increases in immigration, say from 1 million to 2 million, would not solve the problem by any means, but it does go in the right direction. The CHAIRMAN. It alleviates it. Mr. BERNANKE. Yes. The CHAIRMAN. I thank the gentleman. Mr. CLEAVER. Mr. Bernanke, have you seen the movie, "A Day Without Mexicans?" Mr. BERNANKE. I have seen it, yes. Mr. CLEAVER. Would you recommend that for all Members of Congress and for people running for public office? Thank you very kindly. The CHAIRMAN. Did you say, "A Day without Questions?" Mr. CLEAVER. "A Day without Mexicans." It is a new motion pic- ture that— The CHAIRMAN. The gentlewoman from Minnesota. Mrs. BACHMANN. Thank you, Mr. Chairman, and thank you, Mr. Chairman, for being here before this committee. I have appreciated your responses to the questions, and in par- ticular, my colleague, Mr. Hensarling from Texas, had asked you about the entitlement problem that we will be having, and that is where my question is going as well. He had mentioned the Comp- troller General and some of the comments that the Comptroller General had made. One of those that really captured my attention was the statistics that he gave that already our Federal Govern- ment's net liabilities exceed $43 trillion or about $350,000 for every full-time worker in the United States. Without fundamental changes and absent any movement by the Congress on changes in our entitlement, I am just wondering, Mr. Chairman, do you believe that there is any plausible amount of tax increases that could possibly deal with the coming crisis in our en- titlement programs? Mr. BERNANKE. Well, the tax increases would have to be quite large. The Congressional Budget Office has done some simulations, assuming 25 percent tax increases, which do not quite solve the problem. So it would have to be a pretty large increase in taxes to solve it. Mrs. BACHMANN. And that is something that, I think, haunts all of us as we are looking toward the future, especially toward 2030. We are concerned about that. I appreciate your response on that. My next question deals with a happier subject of productivity, and that is something where the United States has been phe- nomenal in the area of productivity. You are quite familiar with the President's economic report that noted that between 2000 and 2005, here in America, we had a productivity increase of about 3 percent, which far outpaced the productivity growth levels in the other G7 nations. Whereas many of them suffered a slowdown in productivity growth, the United States, in fact, accelerated and is at an enviable level. 47 I am just wondering, sir, if you have insight into perhaps what some of the factors are that led to this remarkable productivity growth given that Western European nations as well as the other G7 nations have the same access to technological improvements as, say, the broad capital markets that we have. I am just wondering if you could state for this committee why we have seen better re- sults here in the United States than we have seen in the other G7 countries. Mr. BERNANKE. That is an issue that has received a lot of atten- tion. It is a good puzzle why we have gotten differential results. I think the answer is the interaction of the technologies and the eco- nomic system. To go back to themes we have already addressed today, tech- nology creates change, and the system has to be able to adapt to change in order to make full use of the technology, and in the United States the combination of very deep capital markets which have been able to fund new start-up firms or venture capital sup- port for entrepreneurial activities and a flexible labor market which has allowed for changes in the way people work and the dis- tribution of workers across industries and across occupations has allowed these new innovations, these technological innovations and information communication technologies not only to lead to in- creased productivity within the narrow sphere of high technology industries but to spread out through the whole economy and to in- crease productivity in financial services, in retailing, in whole- saling, and in manufacturing. As firms have been able to apply effectively these technological innovations, in some countries there is a great deal of rigidity in the structure of labor and product markets, and those rigidities have prevented the technological innovations from being applied as effectively or as quickly as in the United States. Mrs. BACHMANN. Thank you. My final line of questioning goes to the legislation that Congress may very soon pass, and that would be the increase in the min- imum wage. We are looking at increasing perhaps at the level of 40 percent minimum wage in the upcoming bill. First, I am wondering if you could estimate how close we are cur- rently to full employment here in the United States. I know, in Minnesota, we have just enjoyed wonderful low levels of unemploy- ment. I think, for 2 months last summer, we were the job creators for about 10 percent of all new jobs across the country. We have a wonderfully strong, diverse economy. I was wondering first if you could comment, sir, on where you be- lieve we are at in terms of full employment in this country, and second, I was wondering if you could share with us what your opin- ion would be on the impact of raising the minimum wage on em- ployment. First, at the level that we are looking at now to go to $7.25, there were comments made by one of our United States Sen- ators that he may be introducing a bill in perhaps 6 months to raise that minimum wage up to over $9 an hour. So, if you could, just comment on the impact of raising the min- imum wage on employment and where you believe we are at in terms of full employment now. 48 Mr. BERNANKE. On the full employment issue, I do not know pre- cisely where full employment is or whether we have reached it or not. I do know that the economy has come a ways in the last few years in increasing the utilization of underutilized resources. The unemployment rate has come down. Capacity utilization has gone up, and so we are certainly closer than we were a year or two ago, and, indeed, as you point out, in some areas labor markets are pretty tight and skilled workers have a lot of opportunities for work. On the minimum wage, economists generally agree that a higher minimum wage will have an adverse effect on employment of low- skilled workers, but they disagree extremely on how big that effect would be. Some are saying it would be very small. Others are say- ing it would be more significant. So I can only say that probably there will be some employment effect, but it is very difficult to know how big it would be. Given that a relatively small number of workers today are at the Federal minimum wage, in part be- cause State minimum wages or many of them are higher than the Federal minimum wage, I do not think that the employment impli- cations of the proposed bill for the Nation as a whole would be very significant one way or the other. Mrs. BACHMANN. And— The CHAIRMAN. We are over time. Mrs. BACHMANN. Thank you. The CHAIRMAN. The gentleman from Tennessee. Mr. DAVIS OF TENNESSEE. Mr. Chairman, thank you very much. I have a comment and then a question. We hear a lot about undocumented workers in our country, and we hear between 12 million and 15 million working today who may or may not have legal documentation to indicate that they are actu- ally here working as authorized by the certain laws that we have in this country, and then I hear that we have 4V2 percent unem- ployment. The 4V2 percent unemployment means we have roughly 6 million people in this country not working—is that about right?— 135 million people working. So, if we were to round up those 15 million undocumented work- ers and send them back wherever they came from, would we have a deficit of 9 million employees to work in America's job market? What would that do to our economy? Mr. BERNANKE. Well, it is certainly true that where we are today is that there are a lot of immigrant workers, many of them undocu- mented, who are working in various industries ranging from manu- facturing to agriculture to leisure and hospitality and construction and other areas, and if they were all to leave immediately then there would be obviously a disruption in those industries and labor shortages in those industries. Mr. DAVIS OF TENNESSEE. I ask that mainly to make a point. We have a lot of folks out here today who have a lot of ideas about America's economy, and we have a lot of ideas about some of the comments that have been made by many about the illegal immigration situation. My real question to you is this: As I go back from about the 1970's, late 1960's, up through about right now, we have gone from having a balance of trade in our favor to where we have gradually 49 gone to a whole other level, over $700 billion for the last 2 or 3 years in deficits in trade. Now that means that we are sending $700-some billion more out of America's economy to other nations of the world that are holding that money. They are our dollars. It is a part of our capital assets of this country that is showing that up, and when I look at that, I get kind of frightened at it, and I look at the district that I represent and I see a Saturn plant in Spring Hill that has temporary layoffs, perhaps, and I fear that they may become more permanent than temporary, those 5,000 or 6,000 jobs that we may be losing. The Carrier Corporation just left my district. So when I look at my Congressional district, which is the fourth most rural in America, this great booming economy that we seem to have throughout America does not exist in my district, and it does not exist I believe, perhaps, in most rural areas of America. As to the trade deficits and the budget deficits that we continue to elevate, are we just looking for a train wreck to happen, and are we sitting here in Congress kind of like Nero did in Rome as it burned, doing nothing about it? How do we stop this bleeding of huge deficit spending? Because we have seen us grow from 18.5 percent in a gross domestic spending percentage of government to about 20 percent in the last 5 or 6 years. We have seen an increase in spending, a dramatic increase, and our revenues have gone down to fund government as the Congress for the last 5 or 6 years has seen fit to spend. So, in essence, there are two or three problems that I have, and I think it is hurting a lot of the more rural areas and maybe not the more urban areas, but we have lost 3 million industrial jobs. We are no longer producing. In export and production, we are con- suming someone else's production. So how do the trade deficits, the budget deficits impact us, and when will we be in a situation where we no longer enjoy the great economy supposedly that we have, and when will it become a threat even to the world economy if that does happen? Mr. BERNANKE. That is a very wide-ranging question. I think I would like to separate that into two issues. One is the trade aspect, and the other is the budget/current account deficit issue. On trade, as I have discussed several times today, trade can cre- ate painful dislocations, painful changes. Competition from abroad, movements of firms out of the country, can cause people to lose jobs, and that is a serious problem. On the other hand, trade also creates a lot of benefits to the country. It creates a lot of jobs both in terms of exports, and in terms of transplants. Like you men- tioned Saturn. Well, there are also transplanted auto firms that hire Americans here in the United States, and as someone men- tioned here, it does allow Americans to purchase goods and services at a lower price than they otherwise would. So there are disrup- tions caused by trade. There are also a lot of benefits from trade, and one of the messages I have been trying to convey is that the right solution is not to stop trade or to block trade but, rather, to try to find ways to help people adjust or to retrain as necessary to deal with these very real—and I take them very seriously—disloca- tions and problems that arise because of this changing, dynamic economy we have. 50 A somewhat different question is about the trade deficit and the current account deficit, and to some extent, it is related to the budget deficit in the sense that, as I have indicated, the current ac- count deficit reflects the fact that our savings rate is low relative to our investment, and therefore we have to borrow the difference abroad. In order to mitigate that situation over time, we need to raise our national saving, and that could be done either in terms of private saving or it could be done in terms of reducing budget deficits or increasing surpluses at both the Federal and the State and local government levels. That is going to take some time. I think, you know, we do not have to solve this problem overnight, but we should be, I think, working to reduce the current account deficit over time and at the same time that we continue to allow trade and technology to help our economy grow more quickly. Mr. DAVIS OF TENNESSEE. We have actually tripled our budget— The CHAIRMAN. I am sorry. The gentleman's time is up. We can- not ask a new question. The gentleman from Delaware. Mr. CASTLE. Thank you, Mr. Chairman. Chairman Bernanke, I thank you for being here. I would also like to thank you for the cooperation of the Federal Reserve in the new dollar gold coin which we passed through this particular com- mittee. I happen to be the sponsor of it. I think this is the issuance date today, as a matter of fact. Although we did something with the Treasury and the Mint people with George Washington and the Statue of Liberty on the other side, but your acquisition of $300 million is a nice start. We hope to make some $5 billion. So this is something that actually produces revenue for the U.S. Govern- ment. Going to a subject I want to ask you a question about, though, this committee, in a bipartisan way, passed the Sarbanes-Oxley Act in 2002, and you have heard, I am sure, a lot of criticism on that law—and I have read about it—and some praise of it one way or another, but they talk about the rising cost of regulation, and this, according to some people, is creating an incentive for firms to be listed on foreign markets or to withdraw from public markets alto- gether. We have more private capital and that kind of thing going on in the United States of America now, and there are other meas- ures besides Sarbanes-Oxley that are attributed with those prob- lems. In your opinion, has rising regulatory costs or other regulatory blocks of some kind or another weakened the international com- petitive position of our stock exchanges, and do they pose a threat to our competitiveness in the future? Mr. BERNANKE. TO some extent, the declining relative position of the American exchanges reflects the natural growth and develop- ment of exchanges abroad, in London, in Asia and so on, and as those economies, those exchanges become larger, more efficient, and deeper; that is actually not a bad thing because it gives, for example, American companies more alternatives for raising money. On the other hand, to the extent that business is being driven offshore by high regulatory costs, which was the conclusion of these two recent studies on capital market competitiveness, then that is a problem and we need to begin to address those costs. 51 The Sarbanes-Oxley issue that you raised earlier has been cited by a number of these studies, and the SEC and the Public Com- pany Accounting Oversight Board have recently issued a new audit standard which will attempt to reduce the costs of implementing Sarbanes-Oxley's Section 404 on internal controls and, in par- ticular, to make it more focused on the most important matters rather than on trivial matters and also more appropriate for small- er and less complex firms. So I think that is going to be an impor- tant step in reducing that particular set of costs. There are many other issues, some of which Congress could ad- dress—issues of tort reform and litigation, the CFIUS bill about foreign investment coming to the United States, and striking the appropriate balance there between keeping a flow of foreign invest- ment into the United States versus appropriate national security considerations. The Federal Reserve is working on the Basel II bank capital accord regulation, and we are working on that, and we want to make sure that does not put American banks at a capital disadvantage in the capital markets. So it is certainly important for us across a whole variety of regu- latory areas to try to keep those costs down and to keep working to reduce the burden of regulation on American public companies. Mr. CASTLE. Well, thank you. I do not mean to speak for our chairman or ranking member here, but I think these issues are of great importance to this particular committee. So, hopefully, we can be kept informed. Changing subjects, I am looking at page 2 of your testimony in which it says that the Federal Open Market Committee has main- tained Federal fund rates, etc., of 5Vi percent, and it says that, more or less, the risk of inflation is not overwhelming at this point. Then it goes on to say—and again, you have indicated this—the "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." I suppose I should have learned this in Economics 101, but in addition, if there is an addi- tion to dealing with interest rates, are there other things that the Federal Open Markets Committee can do with respect to that issue? Mr. BERNANKE. NO. That is the basic tool. The CHAIRMAN. If the gentleman would yield. Mr. CASTLE. I yield. The CHAIRMAN. He said he could not speak for me, but he just asked essentially the same question I asked. So, on those two ques- tions about the congruity of those two statements, I agree with the gentleman. Mr. CASTLE. And I also apologize for being absent and not here when you asked, Mr. Chairman. I had a good reason for it, though. The CHAIRMAN. Submit it in writing. Mr. CASTLE. I have last year introduced legislation about trans- parency in hedge funds. I am concerned about hedge funds. You answered this yesterday in Senate testimony and basically indi- cating that the liquidity of hedge funds could be very important. I don't have a problem with that either, but I do have a problem in terms of what hedge funds could do with respect to commodity markets and a variety of things they get into because of the enor- 52 mity of it and the number of them that have opened in recent years and where they are going. I am not one who looks for overregulation or overtransparency, if there is such an expression, but I think proper transparency is in order. I would like your thoughts, if you could, about where we are with respect to hedge funds, and what do you think the role of the—regulatory role or perhaps our committee role in this area should be. Mr. BERNANKE. Well, the approach that regulators have taken since the report of the President's Working Group after the LTCM crisis has been a market-based approach, an indirect regulation ap- proach, whereby we put a lot of weight on good risk management by the counterparties to the hedge funds such as the prime dealers, the lenders, as well as the good oversight of the investors, the insti- tutions and so on that invest in hedge funds. And we found that is a very useful way to control leverage and to provide market dis- cipline on those funds. The original report of the President's Working Group also sug- gested disclosures, and that never went anywhere in Congress, and I think part of the problem was it was difficult to agree upon what should be disclosed and what would be useful. The hedge funds are naturally reluctant to disclose proprietary information about their trading strategies and approaches, and their positions change very quickly, and so therefore position information can be overwhelming and perhaps not very useful. I think it is important to continue to think about hedge funds. They certainly play an important role in our financial system. Ex- actly, you know, what a disclosure regime would look like, though, is not yet clear to me how that best would be organized. The CHAIRMAN. The Chair is about to recognize the gentleman from Minnesota. I do want to thank the Chairman. It is the first time in my memory that freshman members of this extremely large committee are able to ask questions because—I appreciate the chairman being around because we are going to be able to accom- modate our four remaining members, but the ranking member had one very specific brief question he wanted to ask, and if there is no objection, I will recognize him for that. Mr. BACHUS. Mr. Chairman, this is more of a concern. Governor Susan Bies recently announced her retirement. I am very con- cerned about that in that she was expert on not only risk manage- ment, but on Basel, and I felt like under her leadership we made tremendous strides in Basel. She had real banking experience with a regional bank. And with Mark Olsen gone, too, I am just con- cerned that as that process goes forward—you know, he has a com- munity banking background—that we had people who were bank- ers that we deal with as this process goes forward, because those are two major losses. Mr. BERNANKE. We will miss Governor Bies, as well. She was an extraordinary colleague and very, very knowledgeable about bank- ing matters, as you indicate. I think we will have good continuity. We have the skills at both the Board level and at the staff level to continue to move forward effectively with Basel II. And we will, of course, wait for the Presi- dent to nominate two people to the Board. 53 The CHAIRMAN. I would like to say to the Chairman that I hope that you can, in fact, bring the Basel process to a conclusion and I never have to think about it again for about 6 years. The gentleman from Minnesota. Mr. ELLISON. Thank you, Mr. Chairman. And thank you, Mr. Chairman. Mr. Chairman, in your remarks on page 2, you noted that real hourly compensation rose at an annual rate of about 3 percent in the latter half of 2006. Could you describe how the longer period of time, for example, over the past 10 or, say, 15 years, what have real wages looked like? Mr. BERNANKE. I don't know the exact number over the last 10 years, but there has been a pattern, we have seen this time and we saw before, in the late 1990's, when productivity picked up quickly during that period in the late 1990's, real wages lagged be- hind productivity for a while, and then they began to catch up to it. I think in the current episode a couple of things have been at work. One is that the labor market remains somewhat weak even after the recession ended in 2001. A second concern has been the oil price increases, given nominal wage increases, modest nominal wage increases, when oil prices go up so much that it takes away from the buying power of real wages. And then thirdly I think it is, again, somewhat normal for real wages to catch up later in the business cycle to—and particularly when there have been periods of increased productivity growth as we have seen in the last 3 years. So I am encouraged to see this increase in real wages. Barring new shocks, new increases in oil prices, I would think we would see further increases in real wages going forward. And I would just add that the 3 percent number is for the whole nonfarm business sec- tor, but you get about the same number for average hourly earn- ings for production workers, which is more representative of the broader middle of the middle distribution. Mr. ELLISON. I am encouraged by the increase in real wages, too, since the middle of 2006, but I have heard people describe the real wages over the longer period, maybe 20 years or so, as flat. And so I don't know if that conflicts with what you are saying or if it is—or if what you are saying is more descriptive of more recent events. Mr. BERNANKE. The behavior of real wages depends on the skill levels. I have some discussion of this in this speech that Represent- ative Waters referred to on inequality. Over the last 25, 30 years, we have seen really modest increases in real wages for those with less than a high school education, much more significant increase in real wages for those who have a college education or better, and intermediate increases for high school graduates. So it depends very much on where you are in the wage scale. Mr. ELLISON. Thank you. I want to ask you a little about loans. What is your best prescrip- tion or recommendation to fix what I would generally describe as predatory loans? And I am not only referring to the mortgage mar- ket, but what could also—some phenomena in the credit card area? 54 It sounds like what you are saying what we need is more disclosure to the consumer. Did I understand your views accurately on that? Mr. BERNANKE. Well, I indicated that it is very difficult. And I am not just trying to hedge here, because we want to eliminate predatory and abusive lending, but we don't want to shut down the legitimate subprime market. And that is sometimes a difficult task, and that is why I was praising some of the State efforts that rep- resent good experiments along those lines. So approaching that I think involves disclosure, it may involve barring certain practices as well. The Federal Reserve, I should say, is very much involved in trying to control predatory lending. We are responsible for the Home Mortgage Disclosure Act. We re- cently added information requirements there on pricing so we can find out whether pricing is varying across, for example, minorities and nonminorities. We are responsible for the Home Ownership Equity Protection Act and other things, Regulation Z. So we are very much involved in that from the Federal level. But again, I think there is still a lot of creativity we can see at the State level to try to understand better how to address this problem. Mr. ELLISON. Thank you, Mr. Chairman. I only have 5 minutes. So is the proposal—the rule proposal regarding regulation Part D, is that basically a rule—do you anticipate that rule focusing on dis- closure, or will it include barring certain practices? Mr. BERNANKE. Did you say Regulation Z? Mr. ELLISON. Yes. Mr. BERNANKE. Yes. That is part of the Truth in Lending Act. By nature of the act, it is focused on disclosures, and it will be fo- cused on short-term credit like credit cards. Mr. ELLISON. DO you have any views on things like universal de- fault? This is a credit card practice I am sure you are familiar with. If you default, if you are late on one credit card, a credit card com- pany you are not late on can jack up your rate. Do you have any views on that practice and how Congress might approach that kind of phenomena? Mr. BERNANKE. That is a difficult one. We don't want to rule out the possibility that when someone's creditworthiness drops for a variety of reasons, that their creditors get that information and use it. However, I think some of the concern about universal default provisions is that people don't get enough warning or notice that this condition is going to kick in. So that might be one direction to go, which is to increase the amount of warning that consumers get when their credit histories deteriorate and when that may af- fect their pricing and their credit cards. Mr. ELLISON. Thank you. The CHAIRMAN. The gentleman from Illinois. Mr. ROSKAM. Thank you, Mr. Chairman. Mr. Chairman, I am a new Member of Congress and a new mem- ber of the committee, and I appreciate the detailed questions that my colleagues have asked. I guess I would ask a broader question, and that is, you know, it seems to me that economic strength and weakness, success and failure is mysterious in a lot of ways, and it is difficult for somebody outside of this arena to gaze in and real- 55 ly discern all the factors that go into a good, successful mix. And I realize there is really nobody who can do that. But for purposes of this committee and future committees that have this responsibility of oversight for you, Mr. Chairman, and the Fed, what are the things that you are responsible for? What are the tools that you have at your disposal? And can you sort of, and maybe in an Econ 101 sort of fashion, in the remaining 4 minutes just break that down and say, look, maybe start—these are the things that we frankly have no influence over, that are just off the table. I think that would help me and maybe some other members of the committee in the future. Mr. BERNANKE. Well, the Federal Reserve has multiple respon- sibilities. The one that is best known is our responsibility for mone- tary policy, which we use to pursue the Congressional mandate of price stability and maximum sustainable employment. It is important that the Federal Reserve be independent and be able to make independent decisions about interest rates in order to preserve the credibility of the central bank. However, it is also im- portant that Congress exert oversight over the Federal Reserve to make sure that we are following our stated mission, and that we are pursuing coherent and rational plans. The other areas include banking supervision, where we are in- volved in developing the new capital accord, providing various guid- ances and regulations together with the other banking agencies, and there we are more like the other agencies in terms of the kinds of responsibilities we have. We have considerable responsibility in the consumer protection area—that has come up a lot today—for various regulations that provide disclosures to consumers on credit cards, on mortgages, and that provide some tools to address predatory lending, or high-cost lending. And there, like other agencies, we are given instruction by the Congress, by the law, in terms of what the Congress wants us to achieve and with what instruments. And then it is our job to im- plement the regulations that will most effectively accomplish Congress's goals. So we have a range of activities, all of which fall into the under- side of Congress obviously. The CHAIRMAN. I thank the gentleman. The Chair will now exer- cise his prerogative. We have four Members left who haven't asked questions. We have about a half hour. That is going to be the end of it. So I will go to the gentleman from Colorado, the gentleman from Ohio, the gentleman from Indiana, and the gentlewoman from Wisconsin. Anyone who is within the sound of my voice or whose staff is here, don't bother to show up because we are going to end it at this. And the gentleman of Ohio is recognized—I am sorry the gentleman from Colorado. Mr. PERLMUTTER. Thank you, Mr. Chairman, and Chairman Bernanke, thank you for your stamina and patience. I have several questions. The CHAIRMAN. What about mine? Mr. PERLMUTTER. Well, yours has been remarkable, Mr. Chair- man. Thank you. On page 2 of your report, you say that consumer spending con- tinues to be the mainstay of the current economic expansion. 56 Where are we on consumer debt? I mean, have you seen a trend in that, and can you tell me where we are? Mr. BERNANKE. Consumer debt has risen quite a bit. It is rising more slowly recently mostly because home mortgages aren't rising as quickly due to the flattening out of prices and the slower amount of home purchase. Generally speaking, though, as we said in the testimony, house- holds are in reasonable financial shape. Offsetting their debt is an increase in wealth; the stock market is up. House prices over the last few years have gone up a lot, and so many people have a con- siderable amount of equity in their home. And moreover, the strength of the labor market means that the job availability, in- comes, wages are also pretty strong. So for the larger part of the population, finances seem reasonably good relative to historical norms. Now, of course, there are always some people who are having problems, and as I noted in testimony, there are some sectors, no- tably the subprime lending sector, where we were seeing some dis- tress, and we are watching that very carefully. Mr. PERLMUTTER. SO no alarm bells in the trend of consumer debt, because I guess my perception has been that we have had sig- nificant increase to consumer debt really as compared to over the last 10 years, and that there have been some concerns about that. Mr. BERNANKE. There have been increases in consumer debt. There have been even larger increases in consumer assets, and so our wealth has grown. Our wealth is now at the highest level ever. So, again, for most people there is a reasonable balance between assets and liabilities. Again, there are some pockets of concern, but I don't think that at this point that they have significant implications for the behav- ior of the overall economy, although we obviously have to watch the individual sectors. Mr. PERLMUTTER. Okay. Any exact pro or con by the recent changes in the Bankruptcy Code now that we have had a year, year-and-a-half under our belts? And, you know, if you don't, if it is too early to tell, then that is fine, too. Mr. BERNANKE. It is a bit early to tell. We saw a big spike in bankruptcy filings in advance of the law because people, if they were thinking of going bankrupt, they wanted to get that done be- fore the law change. Since then we have seen a moderate rate of bankruptcy, I think somewhat lower than in the past, but whether that is due to the change in the law or just to generally good finan- cial conditions in the last few years is hard to say. Again, we have seen, for example, very few delinquencies in consumer credit or in mortgages outside the subprime market, so there has been a gen- erally good credit situation in the last couple of years, and that seems to be reflected in a relatively low rate of bankruptcies. Mr. PERLMUTTER. Speaking of the subprime market, last week the bottom kind of fell out of that market, or there was a tremen- dous drop in that market. Has that leveled off? I haven't read any- thing since Friday, but it seems there was a tremendous loss of value in that market. Mr. BERNANKE. There have been a few small companies that have gone out of business, and others that have lost money. Now- 57 adays, mortgages are not just made and held by individual firms, they are then securitized and sold into the general financial mar- kets. And so we can look at financial market prices and see what the market more broadly thinks is happening in this area. And the value of subprime-mortgage-backed securities has dropped pretty significantly, suggesting that financial market investors are con- cerned about the loss probabilities in this area. Mr. PERLMUTTER. My last question, I had a number of organiza- tions, interest groups, approach me on the issue of banks getting into the real estate business as opposed to remaining in the lending business. Does the Fed have an opinion on that, or do you have an opinion on that? Mr. BERNANKE. The Federal Reserve is charged, along with the Treasury, in determining whether allowing banks to enter the real estate brokerage business is consistent with Gramm-Leach-Bliley. However, the Congress every year has essentially forbidden that consideration, so we have not yet had an opportunity to consider whether, based on the law, that should be allowed, so we have not had the opportunity to try to evaluate that. Mr. PERLMUTTER. DO you have an opinion on it, or if the answer is no, it is premature, that is fine. Mr. BERNANKE. Since I am charged with making a determina- tion, it would certainly be inappropriate for me to speak about it until such time as I have a chance to look at the information and data. The CHAIRMAN. The gentleman from Ohio. Mr. GlLLMOR. Thank you, Mr. Chairman, and also thank you, Mr. Chairman, for spending so much time with us. I want to touch on the question of ILC's. As you know, a lot of retail firms are trying to make an end run around the banking laws. Chairman Frank and I have had legislation in now for three Congresses. In the past you have always—also your predecessor, Mr. Greenspan, made comments in favor of closing that loophole. Would that still be your opinion? Mr. BERNANKE. Yes, it would. Mr. GlLLMOR. Let me ask you another question regarding the economy, which has been generally good by all historical standards and when you have a good economy for a long time, you have low interest rates, thank goodness. We are all happy to see that. You see some of the economic commentators talking about whether it is time for the Fed to take the punch bowl away, and I guess my question is while the party is still going good economically, do you think we are still sober enough to leave the punch bowl there? So my question is what are you going to do with the punch bowl? Mr. BERNANKE. We are going to conduct monetary policy so as to satisfy the chairman and meet our congressionally mandated re- sponsibility for maximum employment and price stability. Mr. GlLLMOR. Thank you. One other question, and I don't know if you are familiar with this recent report, but many of us are worried about America's global competitiveness, and the World Economic Forum recently re- leased its Global Competitiveness Report in which the United States dropped from first to sixth. 58 I guess my question is, do you agree with that assessment and the recommendations made therein? Mr. BERNANKE. First, I think that notion of competitiveness be- tween countries is a little bit deceiving. It is not quite the same as GM and Ford. Any country that is successful in increasing its pro- ductivity will increase its wages and living standards independent of whether other countries are doing the same. I have looked at that report. It seems to me that the change in ranking is based on relatively small changes in the numbers. Some macroeconomic factors like our savings rate have entered into that calculation. So I don't take that in particular as an alarm bell. I don't think it is particularly significant, but, as always, we need to find ways to improve our macropolicies, improve our regulatory policies, and keep the country as productive and efficient as pos- sible. Mr. GlLLMOR. Thank you very much, Mr. Chairman, and thanks again for spending so much time with us. Mr. BERNANKE. Thank you. The CHAIRMAN. And thanks to the gentleman from Ohio for drop- ping in. Mr. GlLLMOR. I was on the Floor, Mr. Chairman. The CHAIRMAN. The gentleman from Indiana. Mr. DONNELLY. Thank you, Mr. Chairman. Thank you, Chairman Bernanke. My district has Chrysler plants, Delphi plants, and small manu- facturers, the heartland of this country, and in your testimony you talked about painful changes that are taking place. What the peo- ple of my district have asked me to tell you is that the changes are even more painful when the competition isn't fair. And we see China manipulating their currency, having no labor standards, no environmental standards, and intellectual piracy. And I guess my question to you, Mr. Chairman is do you see this as unfair competi- tion, and if so, why do we let this continue? Mr. BERNANKE. Well, I have spoken about the yuan, about the Chinese currency, and I think that it is undervalued. And I think that the Chinese ought to allow it to be more market-determined, that they should move in that direction. I also think that we should continue to work with them to en- force their intellectual property rights and to make sure that both sides are living up to trade agreements. So going forward, I agree that trade agreements need to be en- forced, and intellectual property rights are important, and we should continue to apply pressure to China on those issues. Mr. DONNELLY. I appreciate that. There is a feeling back home and on my part that the Chinese don't take us seriously in that re- spect—that we talk and we talk and we talk, and while we talk, more jobs leave my district from manufacturers who have shaved every corner they can, who have put in all the computer integra- tion they can, and they see product coming into this country at costs they can't even touch to manufacture. And so there is a feeling that you are the home team, our Treas- ury Secretary, he is the home team. He was over in China recently, and there is a dispiritedness both on Republicans and Democrats, this is bipartisan, that the home team has walked away. Our own 59 coaches have left us on the field all by ourselves. And so when I go back and say, well, they are talking, my manufacturers laugh and say, well, they will talk us until our doors are closed. So what do I tell them about that, Mr. Chairman? Mr. BERNANKE. The Chinese have recognized that the large trade surplus is, in fact, a problem for them as well, and they understand that there is a risk of reaction, protectionism perhaps, and they have made it part of their official economic plan to try to reduce the trade surplus that they currently have. Greater exchange rate flexibility is part of the way to do that, but in addition, the Chinese are currently trying to increase the re- liance of their economy on domestic consumption, domestic spend- ing, and reduce reliance on exports. If they can make that adjust- ment towards a domestically driven economy, reduce their export reliance, that will help more, I think, even than some other meas- ures to create a better global balance. So that is one step that they are taking. I would also say in terms of our conversations in discussions with the Chinese that I think that while the exchange rate is a very, very important issue, there is a wide range of issues that we as Americans have to discuss with the Chinese including issues of trade; you mentioned intellectual property rights and trade agree- ments, but things like the environment. For example, I think there is a lot of mutual benefit if, for example, we were able to provide equipment and technology to the Chinese to help them clean up their air, that would be beneficial to both parties. Similarly energy security is another interest we have in common. So another way to look at this is that, yes, we have to keep work- ing on the exchange rate, but we also have a lot of other things that we need to be talking about, and I think it is important to keep that conversation going. Mr. DONNELLY. And I guess I would ask you to discuss with the Chinese when you talk to them, and the Secretary of Treasury when he talks to them, that the folks back home who are running these shops, who are supplying families with the money to pur- chase their home, and we have increasingly high foreclosures back home, have said to me, Joe, we sent you there to do something about this, and if the Treasury Secretary and the Fed and the President aren't willing to do it, then we are looking to Congress to step up and take the steps necessary to make this a fair ballgame, again because they feel it is a rigged game, and our team won't step up for the people at home. Thank you very much, Mr. Chairman. The CHAIRMAN. The gentlewoman from Wisconsin. Ms. MOORE OF WISCONSIN. Well, thank you very much, Mr. Chairman, and thank you very much, Mr. Chairman, for your pa- tience here today. Thank you, Mr. Chairman. I did have an opportunity to review your testimony before the committee, and I do want to thank you. I have a reached some conclusions, which I guess I want to sort of vet with you. As others have mentioned, you mention several times in your tes- timony that consumer spending continues to be the mainstay in the current economic expansion, and you also seem to indicate that the 60 resilience of this consumer spending is important towards sus- taining our economic growth. You also indicate that increase in people's compensation accounts for this, and that our higher labor productivity and perhaps a nar- rowing of corporate profits might offset the higher labor produc- tivity and that narrowing—I am sorry—profit margins of compa- nies might prevent higher prices from occurring, and people might experience a real higher compensation. A couple of questions come to mind when I review this testimony. First of all, I guess I want to ask you if you account for this strong- er gain in personal income as many of us do, foresee that it is all aggregated kind of at the top, that this increase in consumer spending is a very narrow number of consumers, and that imposes some kind of risk unless we spread the purchasing and consumer spending power a little bit broader. And secondly, leading into that sort of executive compensation, if we were to—again, if we are depending—if our economy is de- pending on consumer spending, wouldn't it be better if we sort of spread the wealth a little bit and, in keeping with your testimony, resist raising prices by narrowing corporate prices, profits? Mr. BERNANKE. Well, as I discussed, there has been a long-term trend toward increased inequality in the United States that has been going on for a long time, but it is certainly an issue. I think most recently there has been some improvement just in terms of general earnings in the broader economy. I mentioned the statistic of the average hourly earnings which are for production workers, so that does not exclude the top 20 percent of wage earners, and that has grown recently at a pretty reasonable pace. So I think that real wage gains currently are going to help support consump- tion spending. But I agree that we want to see a broad-based con- sumption in order to make this sustainable. Ms. MOORE OF WISCONSIN. I am glad that you mentioned, be- cause there seems to be a lot of resistance toward things like rais- ing the minimum wage. I think we talk a lot about minimum-wage workers, but there are people who don't make the minimum wage that could benefit and would spend if they had more so-called dis- posable income. And I think your testimony really contributes a great deal to the discussion of how important it is to support our economy through elevating people's wages, and that is what I took away from your testimony. Thank you. Mr. BERNANKE. Thank you. Ms. MOORE OF WISCONSIN. I yield back, Mr. Chairman. The CHAIRMAN. I thank the gentlewoman, and I want to thank the Chairman, and I want to say that I thank the members of the committee. This has been a very thoughtful discussion. I appreciate the Chairman. I think these are issues that we will continue to talk about. And the hearing is adjourned. [Whereupon, at 1:50 p.m., the hearing was adjourned.] APPENDIX February 15, 2007 (61) 62 Statement and Questions for Humphrey-Hawkins Hearing Rep. Randy Neugebauer, Deputy Ranking Member House Financial Services Committee February 15, 2007 Chairman Frank, Ranking Member Bachus, thank you for holding this important hearing. Chairman Bernanke, thank you for appearing before the committee today and for your thoughtful testimony. Mr. Chairman, over the past several years, smart fiscal policies, including tax relief and spending restraint, have contributed to tremendous economic growth and deficit reduction. In short, our economy is strong. With 111,000 new jobs created in January, and more than 2.1 million new jobs created over the past 12 months, our workforce continues to grow. Since August 2003, more than 7.4 million jobs have been created - more jobs than all the other major industrialized countries combined. In addition, our economy grew by a solid 3.4 percent last year. This economic growth has generated increased tax revenues and has dramatically improved the budget outlook. If Congress continues to show restraint in spending, and our economy continues to climb as a result of extended tax cuts, we will eliminate the budget deficit in five years, and reap a surplus in the year 2012. Despite the successes we have enjoyed, however, more needs to be done. In order to sustain economic growth, entitlement spending must be restrained. It is imperative that we make meaningful reforms to control the rapid growth of these outlays, and I am pleased President Bush's budget proposal includes several reform options for Congress to consider. 63 It is also important for Congress to promote a stable housing market. As our nation's housing market continues to show tremendous resiliency and strength, we must work to ensure that Government Sponsored Enterprises, such as Fannie Mae and Freddie Mac, are financially and ethically sound. In addition, we must work to reform our health care system, diversify our energy resources, and promote a more balanced trade position. We must also focus on the fiscal education of America's youth, and work with state and local leaders to implement common sense education priorities that promote a basic understanding of finance. With these things in mind, 1 would like to ask you three unrelated questions: 1. The personal savings rate of Americans has recently fallen to a 73-year low. In your estimation, how does this impact our current housing situation? 2. Can you give me an indication of your level of concern about the default rates on home mortgages — especially as it applies to subprime mortgages? 3. In your estimation, has Congress shown adequate concern about the growth of entitlement spending? Again, thank you for your testimony. I look forward to reading your responses to my questions. 64 OPENING REMARKS of the HONORABLE MAXINE WATERS D-CA 35th COMMITTEE ON FINANCIAL SERVICES HEARING TO RECEIVE TESTIMONY of the CHAIRMAN, BEN BERNANKE, OF THE FEDERAL RESERVE BOARD OF GOVERNORS THURSDAY, FEBRUARY 15, 2007 Good morning. Mr. Chairman and ladies and gentlemen, it has been exactly one year since we first heard from the then-new Chairman of the Federal Reserve Board of Governors, Ben Bernanke. Mr. Bernanke, I want to congratulate you on this milestone and thank you for your willingness to work closely with the Members of the Committee on Financial Services. Indeed, I have watched you during this first year of your tenure as the Chairman of 65 the Fed and have been most interested in your ideas about income inequality, investment in education, community investment and other economic issues. As you know, when you appeared before the Committee in July 2006 to present your midyear report to Congress, you identified three issues that you felt could influence the economy—energy prices, stagnation of the housing market and resources utilization. In July 2006, the price of a barrel of oil was $ 78.00, representing a 30 percent increase from six months earlier when oil was $55.00. The current price of oil is approximately $59.00 per barrel, but oil price volatility must be factored into any predictions about the future of the U.S. economy. The U.S housing market has slowed considerably. Scarce resources are being stretched even thinner because of worldwide 66 demand for those resources, led by China, India and other growth economies. Chairman Bernanke, you were undoubtedly correct in identifying the three issues that would impact the U.S. economy moving forward. And here we are six months later with what could be the beginning stages of a major slowdown in the U.S. economy because housing is no longer robust, oil prices are likely to increase, and resources are not unlimited. Something has to give, and maybe it is the end of the ride for this economic growth cycle. It has been more than five years since the expansion began in November 2001, and working Americans are still waiting for their share. According to some reports, "the economy is showing remarkable parallels to the situation of a decade ago." The first five years of the expansion in the 67 1990s brought with it record corporate profits, a robust stock market, and increased wealth for the very few. That expansion would ultimately last for ten years. Wage increases have been almost nonexistent for the American worker. In December 2006, five years after the economy started to grow, the wages of the American worker were approximately 1.7 percent higher, adjusted for inflation, than when the economy sank in November of 2001. Most of the gains experienced by workers were realized in the last few months of that expansion. In April 1996, five years after that expansion, wages were actually worth four tenths of a percent less than when the expansion began. In addition, we have to take into account that productivity growth for 2006 was 2.1 percent and has not been that low since 1997. These two indicators might 68 suggest to some that we are in for along ride unless you believe that we will have five uninterrupted years of growth in both productivity and wages. These economic indicators tell us a lot about why there is growing income inequality in the U.S. I am afraid that if the economy continues to turn in the opposite direction from where it has been these last five years, income inequality will increase. As income inequality grows, we will see more people slip into poverty, while unemployment will add to the economic woes of the already strapped American worker. Finally, Chairman Bernanke, I am really interested in the policy debate around the U.S. trade imbalance. We have had a trade imbalance for the last five years. Just two days 69 ago we learned that the trade deficit of $763.3 billion for 2006 - a 6.5 percent increase over 2005 - is the largest in our history. Imported oil and vast amounts of consumer goods from China and other major importers account for the large part of the U.S. trade imbalance. We hear that trade deals are good and that trade deals are bad. Whatever view you accept, it is clear that U. S. exports are not substantial enough to offset the imbalance, although we increased exports over last year by 13 percent. Of course, we know that the Administration is pro-Free Trade and believes that the loss of American jobs is solely a result of technology, rather than to flood of inexpensive goods coming into the country from abroad. Unemployment is extremely high in communities affected by the loss of manufacturing jobs. Some of the 70 unemployment is intractable, and many of the unemployed for years instead on months. As Chairman now for one year, what can you tell us about the role of the Federal Reserve in addressing these problems? Is it just a matter of monetary and fiscal policy, or are is there a real policy fix for the problems that we are facing in the US? What will we experience if the current expansion has come to an end and growth slows? Once again, I am extremely pleased to be able to hear your views and prescriptions for our economy, particularly the neglected segments of the population — the poor, the unemployed and underemployed. Many of these people missed out on the benefits of the recent expansion. Thank you. 71 For release on delivery 10:00 a.m. EST February 15,2007 Statement of Ben S. Bernanke Chairman Board of Governors of the Federal Reserve System before the Committee on Financial Services U.S. House of Representatives February 15, 2007 72 Chairman Frank, Representative Bachus, 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 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 (GDP) is currently estimated to have increased at an annual rate of about 2-3/4 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 ongoing 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 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 six 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 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. 73 -2- In the five policy meetings since the July report, the Federal Open Market Committee (FOMC) has maintained the federal funds rate at 5-1/4 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. 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 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 expansion. Personal consumption expenditures, which account for more than two-thirds of aggregate demand, increased at an annual rate of around 3-1/2 percent in real terms during the second half of last year, broadly matching the brisk pace of the previous three years. Consumer outlays were supported by strong gains in personal income, 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 expenditures 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 74 -3- in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about four-and-a-half months' supply in 2005 to nearly seven 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 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. However, even if housing demand falls no further, weakness in residential 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 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 consumer loans and residential mortgages remain low. The exception is subprime mortgages with variable interest rates, for which delinquency 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 generation, 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 creation 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 75 -4- 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 expenditures. 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 transportation 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 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 support further steady growth in U.S. exports this year. Despite the improvements in trade performance, the 76 - 5 - U.S. current account deficit remains large, averaging about 6-1/2 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 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 2-1/2 to 3 percent in 2007 and about 2-3/4 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 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 4-1/2 to 4-3/4 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 expected if consumer spending continues to increase 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 77 -6- oil, which have fed through to the prices of gasoline, 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 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 probably 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 pressures 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 affordability 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. 78 -7- 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 depend 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 nominal compensation would translate into gains in real compensation as well. Underlying 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. Moreover, 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 upside 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 79 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 2-1/4 percent this year and to edge lower, to 1-3/4 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. Consequently, policy decisions must be based on an assessment of medium-term economic prospects. At the same time, because economic forecasting is an uncertain enterprise, policymakers must be prepared to respond flexibly to developments in the economy when those developments lead to a re-assessment 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 behind policy 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 anchor the public's longer-term expectations of inflation. Much experience has shown that well- anchored inflation expectations tend to help stabilize inflation and promote maximum 80 -9- sustainable 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 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 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 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 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 sustainable employment. I will keep members of this Committee apprised of developments 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 responsibilities with which the Congress has charged the Federal Reserve. Thank you. I would be happy to take questions. 81 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 82 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Submitted pursuant to section 2B of the Federal Reserve Act February 14,2007 83 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 84 Contents Page Monetary Policy and the Economic Outlook 1 Economic and Financial Developments in 2006 and Early 2007 4 85 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 in real 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 consumer 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 two years, Whereas gains in home pnces 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, and most firms 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 m the year in part because of some softening in further expansion in business output, user costs of capital purchases of equipment related to construction and motor equipment that remain 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 pnces fell, on net, after run trend. rising rapidly over the preceding couple of years. Crude oil pnces rose dunng 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 next 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 pnces 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, 86 2 Monetary Policy Report to the Congress D February 2007 at least to some extent, by a narrowing of firms' profit 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 consumer 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 and more 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 in 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 5 lA 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 1/28 3/16 5/4 9/20 10/25 12/12 NOTE The data arc daily and extend through February 7, 2007 The ten-year Trc;ury rate is the constant-maturity yield based on the most actively traded securities The dates on the horizontal axis are those of FOMC meetings SOURCT Department of the Treasury and the Federal Reserve 87 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 in determining the extent and economic activity. However, consumer spending held up, timing of any additional firming. 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 somewhat, albeit to a rate above its year-earher 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 a broad range of 2006. Committee discussions in those meetings focused communication issues. 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 m real remained and that the extent and timing of any additional GDP is 2'/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 4Vi percent to 43A 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 pnee index—of 2 percent to 2'A percent over Economic projections of Federal Reserve Governors and Reserve Bank presidents for 2007 and 2008 Percent 2007 2008 Indicator 200 M 6 F . a M c O tual 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, Jaurth quarter tojourth quarter'- N R PC e o a F m l , i G n p a r D i l c P G e D in P dex excluding food and energy 5 3 2 4 9 3 4 2 Y ' 2 A - 4- 2 - V 5 W A V t 2Y 2 5 2 - - - 2 5 3 % lA 2 V 4 l V A h- 1 - T - 3 5 A 1 ' / / , ; 2 I 4 V 3 3 / 4 A 4 - 2 3 -5 'A Average level, fourih quarter Civilian unemployment rate 4 5 41/J-4V4 A'A 4V. 4>A-5 A'/i-AV* rage for fourth quarter of previous year ,e for fourth quarter of year indicated 4 Monetary Policy Report to the Congress • February 2007 the four quarters of 2007 and I3/* 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 • 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 • 1 11 r i generally strong household balance sheets. Business outlays for new equipment and software are expected to increase at a rate consistent with a moderate 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 expansion of economic activity abroad should maintain the rising demand for U.S. exports of goods and services. N SO O U T R E C E T h D e e d p a a ta rt m ar e c n f t o o r f p C e o rs m on m a e l r c c o e n , s B u u m re p a ti u o n o f e E x c p o e n n o d m itu ic re A s n (P a C ly E si ) s 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 IN 2006 AND EARLY 2007 took steps to trim dealers' inventories. In other sectors of the economy, consumer spending remained strong as employment and income made further solid gains, and The especially brisk pace of economic activity in early business outlays for new structures and equipment rose 2006 primarily reflected a rebound after hurricane-related considerably over much of the year. Financial market con- disruptions in the autumn of 2005. During the rest of the ditions were generally supportive of economic expansion year, however, economic activity slowed to a pace some- in 2006. Equity markets recorded sizable gains, and long- what below the average rate of recent years. Real GDP term interest rates rose only modestly from historically low levels. Risk spreads on corporate bonds remained narrow or declined further. Overall economic condi- tions were such that businesses maintained a steady Change in real GDP, 2000-06 pace of hiring, and the unemployment rate moved down further. Consumer price inflation, as measured by the rise in the PCE pnee index, moved down in the second half of 2006 after having stepped up in the first half. Energy III 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 t: LJ addition, core PCE price inflation eased modestly 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- 2000 2001 2002 2003 2004 2005 2006 less, core PCE price inflation for the year as a whole—at VA 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 of Commerce, Bureau of Economic Analysis 89 Board of Governors of the Federal Reserve System 5 The Household Sector ate pace of growth; expenditures in this category rose 23A 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 ¥A 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 and consumer 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 lax 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 helped boost the share of total sales captured by 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 were inclined to increase their spending further above Real PCE for goods other than motor vehicles rose their disposable income, at least in part, because their 4Vi percent over the four quarters of 2006, about in line wealth continued to rise. The ratio of household net worth with the brisk average pace in the preceding two years. to income, which has been trending higher since 2003, Households increased their spending for a broad range of inched up further in 2006. Although increases in the value consumer goods, though the rise was particularly strong of homes slowed significantly, the value of corporate equi- for electronic equipment and other durables. Real spend- ties held by households both indirectly—such as in mutual ing on gasoline remained about constant in the first half funds and retirement accounts—and directly appreciated of the year but increased in the second half as prices fell. considerably. Consumer spending for services maintained a moder- Personal saving rate, 1983-2006 Change in real income and consumption, 2000-06 • Disposable personal income • Personal consumption expenditures 2000 2001 2002 2003 2004 2005 2006 NOTE The data arc quarterly and extend through 2006 Q4 SOURCE Department of Co ce, Bureau of Economic Analysis SOURCE Department of Commerce, Bureau of Economic Analysis 90 6 Monetary Policy Report to the Congress • February 2007 Wcalth-to-mcomc 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 cut back 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. 1986 1990 1994 1998 2002 2006 NOTF. The data are quarterly and extend through 2006 Q3 The wcalth- By the middle of 2006, sales of both new and existing to-income ratio is the ratio of household net worth to disposable personal homes had fallen dramatically to a pace that was about income 15 percent below that of a year earlier. Concurrently, SOURCE For net worth, Federal Reserve Board, flow of funds data, for income, Department of Commerce, Bureau of Economic Analysis inventories of unsold homes 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. By the third quarter of 2006, the backlog of unsold new Consumer sentiment deteriorated in the first half of homes had reached 6% months' supply, and the stock 2006, according to the Reuters/University of Michigan of existing homes for sale had risen to about 7 months' Surveys of Consumers (Reuters/Michigan). In the spring, supply—both well above the average of about 41/2 months' consumer confidence had moved to its lowest level for the supply of new and existing homes in 2005. By the end of year, probably in part because energy prices had surged. 2006, however, there were tentative signs that the demand The subsequent decline in energy prices, along with the for homes was stabilizing. The decline in sales of new and rise in the stock market and reductions in the unemploy- existing homes appeared to bottom out in the summer, ment rate, boosted consumer confidence in the second and sales were roughly constant over the later part of the half of the year. On net, the Reuters/Michigan index of year. In the fourth quarter, builders' inventories of unsold consumer sentiment was a shade higher at the end of new homes were reported to have edged down a bit from 2006 than at the beginning of the year; sentiment moved their third-quarter level, while the stock of existing homes up further in early 2007 to near the upper end of its range for sale remained about the same as in the third quarter. since 2003. 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 imposed by the contraction in home sales and the buildup of inventories was significant. Both the number of permits issued for new single-family homes and the number of home starts dropped sharply. As of the fourth quarter of 2006, 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 !995 1997 1999 2001 2003 2005 2007 residential structures in the NIPA, trimmed % percent- NOTE The data arc monthly and extend through January 2007 age point from the rate of real GDP growth in the first SOURCE The Conference Board and Reuters/University of Michigan Sin half of 2006, but the drag intensified to subtract about 91 Board of Governors of the Federal Reserve System 7 Private housing starts, 1993 2006 Mortgage rates, 2002 07 Millions ofuniis.ai Multifamily — Adjustable 1998 2000 2002 2004 2006 NOTT The data arc quarterly and extend through 2006 Q4 NOTE The data, which are weekly and extend through February 7, 2007, SOURCT Department of Commerce, Bureau of the Census are contract rates on thirty-year mortgages SOURCE Federal Home Loan Mortgage Corporation 1 VA 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 VA 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) with average gains of roughly 9 percent in 2004 and 2005. increased at an annual rate of only 11*4 percent in the third 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, 1983-2006 The average rate for a thirty-year fixed-rate mortgage was 6V4 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 5V4 percent at the end of 2006, about Repeat-transaction: '/4 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 1986 1990 1994 1998 2002 2006 NOTE The data arc quarterly, and change is from one year earlier The Household sector debt is estimated to have slowed from repeat-transactions index extends through 2006 Q3 For the years preceding the robust H3/4 percent increase posted in 2005 to a still- 1991, that index includes appraisals associated with mortgage refinancings, beginning in 1991, it includes purchase transactions only The existing home vigorous 8% percent in 2006. The deceleration reflected price index extends through 2006 Q4 a drop in the pace of mortgage debt growth from about SoLFRcr For repeat transactions, Office of Federal Housing Enterprise Oversight, for existing home prices, National Association of Realtors 14 percent in 2005 to less than 9 percent in 2006. Despite 92 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 1994 1996 1998 2000 2002 2004 2006 NOTE The data are quarterly and c\u.nd through 2006 Q3 The financial 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 di\ided b\ di posable personal SOURCE Federal Reserve Board Total real business fixed investment rose 63A percent over the four quarters of 2006, up from a 514 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 softwar 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 i i J IF Delinquency rates on selected types of household loans, 1998-2006 Creditcard pools — 6 High-tech equipment and software Other equipment excluding transportatio / —" — 5 — 30 — 4 — 20 Auto loaiis at domestic PL auto finarice companies — 3 — 10 0 Mortgages 2000 2002 2004 2006 NOTE The data are quarterly The data for credit card pools and mortgages 2000 2001 2002 2003 2004 2005 2006 extend through 2006 Q3, the rate for auto loans extends through 2006 Q4 SOURCE For credit cards, Moody's Investors Service, for auto loans, the NOTE 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 Economic Analysis 93 Board of Governors oj 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 1 PA percent. Capital spend- as industrial machinery and other types of heavy ing was quite robust during most 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, the 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 2006, 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 8 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 damaged by the hurricanes in the autumn of 2005. Investment in communications In 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 on net 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 for medium and heavy trucks accelerated in 2006, period. Nonetheless, at the 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 manufactunng 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 3 5 percent for the year as a whole. suggested that some 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 thai 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 5Vi percent during the first three quarters of 2006. How- construction and motor vehicle sectors, although increases 94 10 Monetary Policy Report to the Congress u February 2007 Change in real business inventories, 2000-06 Financing gap and net equity retirement at nonfinancial corporations, 1991-2006 Billions ol chained (2000) dollars. I - I. \ 0 Firlancing gap\ /- - 100 — - 200 2000 2001 2002 2003 2004 2005 2006 1 1 1 1 1 1 II 1 1 SOURCE Department of Commerce, Burc&u of Economic Analysis 1991 1994 1997 2000 2003 2006 NOTE The data are annual, the observations for 2006 are based on partially estimated data Trie financing gap is the difference between capital expendi- 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 chases, domestic cash-financed mergers, or foreign takeovers of U S firms and equity issued by domestic companies in public or private markets Equity were viewed as too high. However, manufacturers outside issuance includes funds invested by private equity partnerships and stock of the motor vehicles sector appear to be making option proceeds 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 firms. 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 investments not only with current cash flow but also with external funds and liquid assets. Borrowing by nonfinan- Before-tax profits of nonfinancial corporations cial firmsp icked up in 2006 in association with increased as a percent of sector GDP, 1979-2006 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. — 14 Similarly, commercial paper issuance was the strongest it had been since 2000, and commercial and industrial — 12 lending by banks was rapid as well. The Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lend- — 10 ing Practices revealed that a significant net fraction of respondents to that survey eased credit standards and — 8 terms on commercial and industrial loans during 2006. Bankers indicated that they were responding to more- — 6 aggressive competition and greater liquidity in the second- ary market for such loans. Loan officers also reported that I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I ll a contributing factor was an increased tolerance for risk. 1982 1986 1990 1994 1998 2002 2006 NOTE The data are quarterly and extend through 2006 Q3 Profits are from The expansion of commercial mortgage debt in 2006 domestic operations of nonfinancial corporations, with inventory valuation remained rapid by historical standards but fell off from and capital consumption adjustments SOURCE Department of Commerce, Bureau of Economic Analysis the swift pace of 2005. The deceleration likely reflected 95 Board of Governors of the Federal Reserve System 11 Selected components of net financing Net interest payments of nonfinancial corporations for nonfinancial corporate businesses, 2003-06 as a percent of cash flow, 1979-2006 Btlhon* of 4o1!a». annual ra Q Commercial paper 9 Bonds B Bank loam Sumot ^^ components 2003 2004 1990 1994 1998 2002 2006 NOTE: The data for the com[jncnts except bonds are seasonally adjusted NOTE The data are quarterly and extend through 2006 Q3 The data for the sum of seleced components arc quarterly The data for SOURCE Department of Commerce, Bureau of Economic Analysis 2006 Q4 are estimated SOURCE Federal Reserve B<ard, Securities Data Company, and Federal Financial Institutions Examinaton Council, Consolidated Reports of Condi- mergers and acquisitions and share repurchases increased tion and Income (Call Report) considerably. On balance, despite increased borrowing and net 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 qualify 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. In addition, net interest payments 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 firms in the troubled airline and automobile more negative as equity retirements from cash-financed sectors in late 2005 dropped out of the series, and it was near zero throughout the second half 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 1992 1995 1998 2001 2004 2007 NOTE The data are drawn from a survey generally conducted four times 1994 1997 2000 2003 2006 per year, the last observation is from the January 2007 survey, which covers 2006 Q4 Net percentage is the percenlage of banks reporting a tightening of NOTE The data arc monthly and extend through December 2006 The rate standards less the percentage reporting an easing The definition for firm size 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 in that month, multiplied by two to annuahze the defaults and then medium-sized firms have 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 the six-month period Lending Practices SOURCE Moody's Investors Service 96 12 Monetary Policy Report to the Congress • February 2007 The Government Sector realizations (which are excluded from NIPA income), the effect of some 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 unified budget 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 3'/2 percent of GDP in 2004. In fiscal 2006, outlays rose Nominal federal outlays increased about T/2 percent in fiscal 2006 and were about 20% 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 than 18/2 percent of GDP in 2000. Net interest payments first quarter of fiscal 2007—the federal deficit was almost increased 23 percent in fiscal 2006, as interest rates rose S40 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 of a shift of some Medicaid payments 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, pnmarily owing to the fed- number of beneficiaries as the baby-boom generation ages eral government'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 1VA per- lowest rate of increase since fiscal 2001, although the rise cent and were equivalent to almost 18/4 percent of nominal was still about 6 percent. In the first quarter of fiscal 2007, GDP, substantially higher than their recent fiscal year low total federal outlays were only 1 percent greater than those of 161/4 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 in 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 NIPA appears to on consumption and gross investment—the part of fed- have reflected, at least 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 on consumption and investment, 2000-06 Expenditui • Federal • State and local 1986 1990 1994 1998 2002 2006 NOTE The receipts and expenditures data are on a unified-budget basis and are for fiscal years (October through September), GDP is for the four quarters 2000 2001 2002 2003 2004 2005 2006 ending in Q3 SOURCE Office of Management and Budget SOURCE Department of Commerce, Bureau of Economic Analysi 97 Board oj Governors of the Federal Reserve System 13 Net saving, 1986-2006 Federal government debt held by the public, 1960-2006 NO-IT The data arc quarterly and extend through 2006 Q3 Nonfcdcral NOTE: The final observation is for 2006 Q3 For previous years, the data saving is the sum of personal and net business saving and the nci saving of for debt arc as of year-end, and the corresponding values for GDP arc for Q4 at an annual rate Excludes securities held as invesiments of federal govcm- SouRcr Federal Reserve Board, How of funds data increased 2 'A percent over the four quarters of calendar Early in the first quarter of 2006, federal debt subject year 2006 and contributed about XA percentage point to the 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 percent after 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 the issue in implies that the federal government 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 securities 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 1999 2000 2001 2002 2003 2004 2005 2006 public as a percentage of nominal GDP had declined about NOTE The data are quarterly and extend through 2006 Q3 V% percentage point, to about 36 percent. SOURCE Federal Reserve Board, flow of funds data 98 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 Us 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 % percentage point to the change in real GDP during the year. Real expenditures for invest- State and Local Government ment rose 4% percent, largely because of a strong 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 terms increased improved further in 2006. Apart from federal grants-in- 214 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 dropped below 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 an annual rate, or about 6/2 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 1988 1991 1994 1997 2000 2003 2006 After widening through most of 2005, the nominal trade NOTE The data, which are quarterly, are on a national income and product deficit leveled out in the first half of 2006, rose to a record iccouni basis and extend through 2006 Q3 Net saving excludes social insur- high in August, and then narrowed noticeably through ance funds SOURCE Department of Commerce, Bureau of Economic Analysis November (the latest available data). On average, the 99 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 Pcra:.lDrnom,nalGUP Pete 0 n • Imports • Exports — 15 — 10 — 5 0 1999 2000 2001 2002 2003 2004 2005 2006 Nmr The data are quarterly For the trade account, the observation for 1999 2000 2001 2002 2003 2004 2005 2006 2006 Q4 is estimated The data for the current account extend through SOURCE 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 decelerated 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 the 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 pattern was driven by movements in exports of goods rose 10% 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 major 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 some metals, and perhaps increased the pace of 2005. speculative demand. Prices for nickel and zinc continued Prices of exported goods rose at a VA 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 of very 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. For most of these metals, 100 16 Monetary Policy Report to the Congress • February 2007 Prices of oil and of nonfuei commodities, 2003-07 2004. Oil demand over the past year has also increased modestly in developing countries despite high prices. The Financial Account Foreign official inflows in the first three quarters of 2006 were above their 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 of 2006. Net private inflows slowed in the first quarter but 2003 2004 2005 2006 2007 have changed little since then. NOTC 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 nonfucl commodities is an index of forty-five primary-commodity prices SOURCE For oil, the Commodity Research Bureau, for nonfuei 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. • 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 — 150 especially volatile last year. The spot price climbed from around $61 per barrel at the end of 2005 to a peak of $77 — 100 per barrel in August as violence in the Middle East, a shut- down of the Prudhoe Bay oil field in Alaska, and forecasts — 50 of an active hurricane season led to increased demand. In 0 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 demand for heating was N SO O U T R E C E T h D e e d p a a ta rt m ar e e n q t u o a f r i C e o rl m y m an e d rc e e xtend through 2006 Q3 depressed by above-average temperatures in the Northern Hemisphere in the fourth quarter and in the early weeks of 2007, and the spot price fell further, to around $50 per Net private foreign purchases oflong-term U.S. securities, barrel in mid-January, before moving back up to $58 per 2003-06 barrel at the end of the month. Far-dated futures prices ofd< began last year at about $60 per barrel, moved in a pattern similar to spot prices throughout most of the year, and • Bonds • Eqmtic averaged just over $61 per barrel in January 2007. — 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 reduced its crude oil production to the lowest level since NOTE The data are quarterly and extend through 2006 Q3 SOURCE Department of Commerce 101 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 investment in GSE bonds and corporate equities. On net, private foreigners purchased few U.S. Treasuries. Foreign 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 in net purchases in the fourth quarter. Demand for foreign bonds by U.S. residents slightly exceeded that for foreign NOTE The data az monlhly and extend through January 2007 equities. After the expiration of the partial tax holiday SOURCE Departir;nt of 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 2006, 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—4/4 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. In response to the contraction in homebuilding, hir- As a result 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, 200 f-07 the unemployment rate edged down to 4/4 percent in the fourth quarter. The tighter labor market was associated Thousands of jobs, monthly average with a noticeable 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 66% percent in the fourth quarter, after a % 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- NoTr Nonfarm business sector SOURCT. Department of Labor, Bureau of Labor Statistics tions remained generally favorable during the second half 102 Monetary Policy Report to the Congress • February 2007 Labor force participation rate, 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 moderation 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 hourly labor compensation, which includes both wages NOTE The data arc monthly and extend 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 fluctuated around a relatively 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 3Vi percent The growth rate of labor productivity in the nonfarm busi- in 2006, 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 % percent exceptionally rapid pace earlier in the decade, remained last year after averaging a !4 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 1996 1998 2000 2002 2004 2006 NOTE The data are quarterty and extend through 2006 Q4 For nonfarm business compensation, change is over four quarters, for the employment cost index (ECI), change is over the twelve months ending in the last month of each quarter The nonfarm business sector excludes farms, government, nonprofit institutions, and households The sector covered by the ECI used NOTE Nonfarm business sector Change for each multiyear period is here is ihc same as the nonfarm business sector plus nonprofit institutions A measured from the fourth quarter of the year immediately preceding the new ECI series was introduced for data as of 2001, but the new series is period to the fourth quarter of the final year of the period continuous with the old SOURCE Department of Labor, Bureau of Labor Statistics SOURCE Department of Labor, Bureau of Labor Statistics 103 Board of Governors of the Federal Reserve System 19 Change in unit labor costs, 1996-2006 Alternative measures of price change, 2004-06 Percent Pnce measure 2004 2005 2006 Chain-type . 5 Gross domestic product (GDP) 32 3 1 25 jross domestic purchases 3 7 36 Personal consumption expenditures {PCE) 30 3 I I 9 •—• 4 Excluding food and energy 22 2 1 2 3 Market-based PCE excluding food and energy 1 7 ] 8 20 — 3 Fixed-weight Consumer price index 33 3 7 1 9 Excluding food and energy 2 1 2 I 26 Changes are based on quarterly averages of seasonally adjusted data SOURLF For chain-type measures. Department of Commerce, Bureau o Economic Analysis, for fixed-weigh! measures. Department of Labor, Bureau o Labor Statistics 1996-2000 2001 2002 2003 2004 2005 2006 NOTT. Noniarm business sector The change for 1996 to 2000 it from 1995 Q4 to 2000 Q4 2006, a step-down from the 3 percent increase recorded Soi'KCR Department of Labor, Bureau of Labor 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 VA 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% 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 in 2005. The market-based component last year boosted the average labor costs associated with of the core PCE price index—which excludes imputed producing a unit of output 2% percent, up from increases prices that are not observed in market transactions and of about VA percent in both 2004 and 2005. Although the that often change irregularly—increased 2 percent in rise in unit labor costs increased, firms' profit margins 2006, about yA percentage point more than in the previ- appeared to remain elevated in 2006 relative to longer-run ous year. standards. 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 pnce of gasoline over the associated cost of crude oil in the first half of the year and by some narrowing of that margin in the second half. On balance, the PCE energy price index • Core consumer price index decreased 4 percent over the four quarters of 2006. • Chain-type price index for core PCE Food price inflation remained fairly moderate in 2006. The PCE index for food and beverages increased 2 lA per- cent, roughly the same pace as in the preceding year. Retail prices of meat and poultry rose modestly for 2006, as robust demand was met by ample supplies of meat. Prices l l l l l ll 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 increased demand for corn to produce ethanol. But the 2000 2001 2002 2003 2004 2005 2006 small share of wheat, corn, and soybeans in the total value SOURCE For core consumer pnee index, Department of Labor, Bureau of of food production limited their effect on retail food prices. Labor Statistics, for core PCE price index, Department of Commerce, Bureau Prices for food consumed away from home, which are 104 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 lA 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 — Five-year, five-year ahc: rate of about 2V2 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 NOTC The data are daily and extend through February 7, 2007 Based on a edged down to an annual rate of just below 2% percent. comparison of the yield curve for Treasury inflation-protected securities (TIPS) with the nominal off-the-run Treasury yield curve The deceleration was the result of a decrease in core goods SouRcr. Federal Reserve Board calculations based on dala provided by the 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 same 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 214 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 the 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 23A percent during the year. costs, including industrial chemicals, plastics, fertilizer, and stone and clay products. In addition, the prices of some commodities, such as a variety of metals, 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 5 % percent economic growth in 2006. Yields on long-term Treasury in 2006, up from the 43/4 percent increase in 2005. The securities climbed a bit, on balance, but stayed low by index increased at an annual rate of 1'A 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 3'/4 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 fluctuations in 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 3VA 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 VA percent in August. Other indicators moderate pace in 2006. 105 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-run Treasury yields, 1998-2007 NOTE The data arc daily and extend through February 7, 2007 1999 2001 2003 2005 2007 SOURC I. Department of the Treasury Norn The data are daily and extend through February 7, 2007 The ten-year high-yield, tcn-ycar BBB, and ten-year AA indexes arc compared with the ten-year Treasury yield Interest Rates SOURCE Derived from smoothed corporate yield curves using Merrill Lynch bond data Market interest rates rose modestly, 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 meetings. At the time 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 incoming 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 arc more in line with More recently, market 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 106 22 Monetary Policy Report to the Congress • February 2007 Stock price indexes, 2005-07 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 financialm arkets, 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 NOTF The data arc daily and extend through February 7, 2007 actively traded Treasury securities remained within narrow SOURCE 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 500 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 m 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 NOTE The data arc weekly and c\tcnd through February 9, 2007 The series shown is the implied thirty-day volatility of the S&P 500 slock price only when the issuer's Federal Reserve account contains index as calculated from a weighted average of options prices sufficient funds to cover the payments; that is, these insti- SOURCE Chicago Board Options Exchange tutions no longer may employ daylight credit to fund such payments. The Board of Governors determined that the change represents an appropriate risk-management 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 and paying agents. In addition, with a period of strain in several markets but remained near GSEs and international organizations are now subject to a historical lows for the remainder of the year. Net inflows penally 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 Market Functioning and Financial Stability access to the Federal Reserve's discount window and thus 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 and Exchange Commission, the Commodity Futures experienced heightened volatility late in the second Trading Commission, and the Federal Reserve Bank of New York 107 Board oj 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 914 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 arc activity, rising outlays for investment goods, ongoing confirmed via an electronic platform, to 80 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 with responses by large and medium-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 an estimated 73A percent in 2006, well below the pace in second half of the year. Consumer loans and residential 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 expanded at 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, — 5 cost of holding money. In 2006, this effect apparently held by public IQ slowed money growth less than would have been expected I I I I I I on the basis of historical norms, and the velocity of M2 1992 1994 1996 1998 2000 2002 2004 2006 rose only about V* percent. Retail money market mutual funds and small time deposits, components of M2 whose yields move most closely with market rates, grew rapidly. However, liquid deposits, which constitute the largest credit market debt or state and local governments, households, nonprofit organizations, and nonfmancial 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 SOURCF. Federal Reserve Board, flow of funds data 108 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 1992 1994 1996 1998 2000 2002 2004 2006 NOTE The data arc annual on a Q4 ovcrQ4 basis M2 consists of currency, 2004 2005 2006 2007 traveler's checks, demand deposits, other checkable deposits, savings NOTE The data are daily The last observation for each series is February deposits (including money market deposit accounts), small-denomination 7, 2007 The data shown are the overnight rate for Canada, the refinancing time deposits, and balances in retail money market funds rate for the euro area, the call money rate for Japan, and the repurchase rate SOURCF Federal Reserve Board, Statistical Release H 6, "Money Stock for the United Kingdom Measures " SOURCE The central bank of each area or country shown 3/2 percent, an increase similar to that in 2005, reflecting the spring, the Bank of Japan (BOJ) 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 prompted the reduce or eliminate reserve requirements. At the October European Central Bank to raise its policy rate five times FOMC meeting, the 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 stemmed 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 monetary 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 basts 109 Board of Governors of the Federal Reserve System 25 Yields on benchmark government bonds tn selectei U.S. dollar exchange rate against foreign industrial countries, 2004-07 selected major currencies, 2004-07 ending January 2, 2004 = 100 United Kingdom — 3 — 2 — I NOTE The data arc for tcn-ycar bonds and are weekly The last obscn NOTE The data are weekly and are in foreign currency units per dollar for eaeh series is the average for February 5 through February 7, 2007 1 he last observation tor eaeh series is the average for February 5 through SOURCE Bloomberg L P February 7, 2007 SOUKCL Bloomberg 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 dechned December lows. As a result, 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 33/4 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 2 lA percent against the yen and 1 lA percent against the data releases appeared to alleviate investors' concerns that Canadian dollar, but it depreciated about 9 percent, on net, global economic growth might 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, 2004 = 100 market participants reportedly sensed that the FOMC was approaching the end of its series of policy tightenings, — 104 and interest rate differentials moved against the dollar. 102 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 in 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, T U h S e b d r o o l a l d ar i a n g d a e i x n s i t s t a h e w c e u ig rr h e t n ed ci e a s v e o r f a a g e l a o rg f e t h g e r o fo u r p e i o g f n t h e e x c m h o an st g e im v p a o lu rt e a s n t o f U 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 110 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 ending January 2, 2004 = 100 rate of 2% 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 Japan rose to about 2!4 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 Yz percent. Real GDP in the United Kingdom grew 3 percent last year, and real GDP in Canada grew 3 percent, on aver- 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 NOTF The data arc weekly The last obscrvalio by moderate employment growth, also remained robust. average for February 5 through February 7,2007 Declines in energy prices brought Canadian consumer Somcr. Bloomberg I. P price inflation down after the middle of the year to a twelve-month change of about 1 Yi 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 mid-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 VA 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. In Korea, 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 stayed strong throughout 2006 as a result 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 3% 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 Ill 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 Week ending January 2, 2004 = 100 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 e L m a e ti r n g i A ng m -m er a ic r a k n et 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. 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 2007 inflation fell markedly, from almost 6 percent at the end NOTE The data are weekly The last observation for each sencs is the of 2005 to just over 3 percent in December. In Argentina, average for February 5 through February 7, 2007 The Latin American econ- steady growth in investment and consumption kept real omics arc Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela The Asian economics are China, India, Indonesia, Malaysia, Pakistan, the GDP on a solid uptrend throughout 2006. The Argentine Philippines, South Korea, Taiwan, and Thailand, each economy's index government continued to attempt to bring down inflation weight is its market capitalization as a share of the group's total SOURCE Morgan Stanley Capital International (MSCI) 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. 112 BOARD DF DQVERNQR5 OF TH£ FEDERAL RESERVE SYSTEM WASHINGTON. D, C. 30551 March 5, 2007 The Honorable Ruben Hinojosa House of Representatives Washington, D.C. 20515 Dear Congressman: I am pleased to enclose my responses to your additional questions following the February 15 hearing before the Committee on Financial Services. I have also forwarded a copy to the Committee for inclusion in the hearing record. Sincerely, Enclosure 113 Chairman Beraanke subsequently submitted the following in response to questions received from Congressman Ruben Hinojosa in connection with the February 15, 2007, hearing before the House Financial Services Committee: Q.I. On the Education and Labor Committee, on which I serve as Chairman of the Higher Education Subcommittee, we constantly struggle to set the parameters of the student loan programs to provide the lowest costs to student borrowers and to the government while ensuring that there is sufficient capital either through subsidizing private lenders or through direct loans from the Department of Education. It is very difficult for the Congress to receive information from the Department of Treasury and Education Department as to their true costs of subsidizing private lenders versus direct loans. Do you or your staff know why this is the case? And, can you please speak to the issue of subsidized private loans versus direct loans. A. 1. The student loan programs are quite complex and well outside the range of expertise and operational responsibility of the Federal Reserve. The complexity of the programs substantially complicates the analysis of the relative cost of the loan guarantee program versus the direct lending program. One very recent paper that undertakes that analysis is by Deborah Lucas of the Kellogg School of Management at Northwestern University and Damien Moore of the Congressional Budget Office. It is entitled "Guaranteed vs. Direct Lending: The Case of Student Loans," and can be found at http://www.kellogg.northwestern.edu/research/risk/federal/lucas moore.pdf. Q.2. Chairman Bernanke, as Chairman Frank noted during his opening remarks, our economy is becoming increasingly global in nature every day. In light of this situation, some countries will benefit from globalization more than others. At present, the United States has a large trade deficit with China, a country that helps finance our national debt, which I believe is now approaching $8.5 trillion. I realize that China, in turn, has its own trade deficit with its neighbors, but overall, it is my understanding that China still has a trade surplus with a majority of the world. Am I correct in this assertion? A.2. In 2006, China's bilateral trade surplus in goods with the United States was $233 billion, based on U.S. Census Bureau data. Although China ran a trade deficit with many of its neighbors, China's overall multilateral balance (as reported in Chinese customs basis statistics) was a surplus of $177 billion. Chinese data show a significantly smaller bilateral surplus between China and the United States than do U.S. data, reflecting, among other factors, differences in the treatment of shipments through Hong Kong. However, either source of data suggests that trade with the United States accounts for a very large 114 -2- portion of China's overall multilateral balance, and China's trade with the rest of the world excluding the United States is accordingly much closer to balance. Q.3. Recently, I learned that South Africa has fairly large investments in China. In fact, South Africa has more investments in China than China has in South Africa, which seems to be unique. Just how powerful economically is South Africa compared to India and China? A.3. Data on bilateral flows between China and other countries are not generally available for portfolio investment, that is, transactions in financial instruments such as stocks or bonds. However, such data are available for bilateral flows of direct foreign investment. They show that South African foreign direct investment into China amounted to $130 million U.S. dollars in 2005 (the latest available year), well above Chinese direct investment flows into South Africa of $45 million in that year. Even so, inflows from South Africa have represented less than a percent of total Chinese direct investment inflows in recent years. Inflows from India have been even smaller, at roughly $20 million in 2005. In contrast, the United States' direct investment inflows into China have been averaging 10 percent of total Chinese direct investment inflows in recent years ($3 billion in 2005). South Africa is not unique in channeling more direct foreign investment flows into China than it is receiving from China. The same is true of many countries. There is no common standard for measuring a country's economic power, nor even for defining what economic power might mean. One candidate for measuring economic power might be a country's gross domestic product (GDP) as a share of world GDP. Using this measure, South Africa represents only Vz percent of world GDP. (South African GDP was about $240 billion U.S. dollars in 2005, measured at market exchange rates.) This is about one third of India's share, and an even smaller proportion of China's 5 percent share (Chinese nominal GDP was $2,244 billion in 2005). By comparison, U.S. GDP was $12,456 billion U.S. dollars in 2005, 28 percent of world GDP. 115 BOARD DF GOVERNORS FEDERAL RESERVE SYSTEM WASHINGTON, D C. ED55I March 29, 2007 The Honorable Albio Sires House of Representatives Washington, D.C. 20515 Dear Congressman: I am pleased to enclose my response to your additional question following the February 15 hearing before the Committee on Financial Services. I have also forwarded a copy to the Committee for inclusion in the hearing record. Sincerely, Enclosure 116 Chairman Bernanke subsequently submitted the following in response to a written question received from Congressman Albio Sires in connection with the February 15, 2007, hearing before the Committee on Financial Services: Small banks play a large role in this renewed commitment to our communities and I want to ensure that our small community banks are stabilized. Chairman Bernanke, can you please tell me what the FED is doing to ensure that our community banks stay strong? The Federal Reserve firmly believes that community banks play an important role in the U.S. economy, as they have throughout our history. Although significant consolidation in the banking industry has occurred over the past two decades, community banks continue to thrive by providing traditional relationship banking services to members of their communities. Their local presence and personal interactions give community bankers an advantage in providing financial services to customers for whom information remains difficult and costly to obtain by large out-of-market institutions, despite technological advances. The Federal Reserve and the other federal banking agencies maintain a robust supervision program for community banks that is far more proactive than the programs in place during the late 1980s and early 1990s. The agencies today practice "risk-focused" supervision, which focuses on identifying weaknesses in bank practices and processes (e.g., underwriting, credit administration) so that corrective action can be taken before any such weaknesses are manifested in poor financial performance. Every community bank is subject to a full-scope, on-site examination at least once every 18 months, and at least once every 12 months if the bank has assets of $500 million or more. This asset threshold limit was recently raised from $250 million to $500 million. The Federal Reserve is sensitive to the regulatory burden on community banks, and has supported relief from this and other regulatory requirements over the past few years, consistent with safe and sound banking principles. The Federal Reserve also maintains extensive surveillance systems to identify specific institutions whose financial performance may have changed between examinations, as well as to identify any trends in financial performance across various regions and nationally. If surveillance information detects possible issues with a specific institution, supervisory follow-up is initiated, which may include an on-site review or acceleration of the regularly scheduled examination. As a result of these efforts and the aforementioned risk-focused approach, issues are generally identified at an earlier stage when they are more easily corrected. While some banks do encounter more serious financial difficulties, to date, these have been a very small proportion. 117 -2- Overall, the financial condition of community banks in the United States remains strong. The condition of community banks tends to reflect that of the local economies in which they operate. Should economic conditions in those markets encounter adverse change, the Federal Reserve is prepared to expand and accelerate normal supervisory programs to assure that communities remain served by healthy financial institutions.

Ben S. Bernanke (2007, February 14). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_20070215_chair_monetary_policy_and_the_state_of_the

@misc{wtfs_testimony_20070215_chair_monetary_policy_and_the_state_of_the,
  author = {Ben S. Bernanke},
  title = {Congressional Testimony},
  year = {2007},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_20070215_chair_monetary_policy_and_the_state_of_the},
  note = {Retrieved via When the Fed Speaks corpus}
}