Congressional Testimony

MONETARY POLICY AND THE STATE OF THE ECONOMY, PART II H E A R I NG BEFORE THE COMMITTEE ON FINANCIAL SERVICES U.S. HOUSE OF REPRESENTATIVES ONE HUNDRED TENTH CONGRESS SECOND SESSION FEBRUARY 27, 2008 Printed for the use of the Committee on Financial Services Serial No. 110-93 U.S. GOVERNMENT PRINTING OFFICE 41-184 PDF WASHINGTON : 2008 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001 HOUSE COMMITTEE ON FINANCIAL SERVICES BARNEY FRANK, Massachusetts, Chairman PAUL E. KANJORSKI, Pennsylvania SPENCER BACHUS, Alabama MAXINE WATERS, California DEBORAH PRYCE, Ohio CAROLYN B. MALONEY, New York MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois PETER T. KING, New York NYDIA M. VELAZQUEZ, New York EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York RON PAUL, Texas BRAD SHERMAN, California STEVEN C. LATOURETTE, Ohio GREGORY W. MEEKS, New York DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas WALTER B. JONES, JR., North Carolina MICHAEL E. CAPUANO, Massachusetts JUDY BIGGERT, Illinois RUBEN HINOJOSA, Texas CHRISTOPHER SHAYS, Connecticut WM. LACY CLAY, Missouri GARY G. MILLER, California CAROLYN MCCARTHY, New York SHELLEY MOORE CAPITO, West Virginia JOE BACA, California TOM FEENEY, Florida STEPHEN F. LYNCH, Massachusetts JEB HENSARLING, Texas BRAD MILLER, North Carolina SCOTT GARRETT, New Jersey DAVID SCOTT, Georgia GINNY BROWN-WAITE, Florida AL GREEN, Texas J. GRESHAM BARRETT, South Carolina EMANUEL CLEAVER, Missouri JIM GERLACH, Pennsylvania MELISSA L. BEAN, Illinois STEVAN PEARCE, New Mexico GWEN MOORE, Wisconsin, RANDY NEUGEBAUER, Texas LINCOLN DAVIS, Tennessee TOM PRICE, Georgia PAUL W. HODES, New Hampshire GEOFF DAVIS, Kentucky KEITH ELLISON, Minnesota PATRICK T. McHENRY, North Carolina RON KLEIN, Florida JOHN CAMPBELL, California TIM MAHONEY, Florida ADAM PUTNAM, Florida CHARLES WILSON, Ohio MICHELE BACHMANN, Minnesota ED PERLMUTTER, Colorado PETER J. ROSKAM, Illinois CHRISTOPHER S. MURPHY, Connecticut KENNY MARCHANT, Texas JOE DONNELLY, Indiana THADDEUS G. McCOTTER, Michigan ROBERT WEXLER, Florida KEVIN MCCARTHY, California JIM MARSHALL, Georgia DEAN HELLER, Nevada DAN BOREN, Oklahoma JEANNE M. ROSLANOWICK, Staff Director and Chief Counsel (II) CONTENTS Page Hearing held on: February 27, 2008 1 Appendix: February 27, 2008 51 WITNESSES WEDNESDAY, FEBRUARY 27, 2008 Bernanke, Hon. Ben S., Chairman, Board of Governors of the Federal Reserve System 6 APPENDIX Prepared statements: Paul, Hon. Ron 52 Bernanke, Hon. Ben S 53 ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD Bernanke, Hon. Ben S.: Monetary Policy Report to the Congress, dated February 27, 2008 63 Castle, Hon. Michael: Letter from former Federal Reserve Chairman Alan Greenspan, dated July 22, 2003 113 (HI) MONETARY POLICY AND THE STATE OF THE ECONOMY, PART II Wednesday, February 27, 2008 U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON FINANCIAL SERVICES, Washington, D.C. The committee met, pursuant to notice, at 10:05 a.m., in room 2128, Rayburn House Office Building, Hon. Barney Frank [chair- man of the committee] presiding. Members present: Representatives Frank, Kanjorski, Waters, Maloney, Gutierrez, Watt, Sherman, Meeks, Moore of Kansas, Capuano, Hinojosa, Clay, McCarthy of New York, Baca, Lynch, Miller of North Carolina, Scott, Green, Cleaver, Bean, Davis of Tennessee, Sires, Ellison, Klein, Mahoney, Wilson, Donnelly; Bach- us, Pryce, Castle, Royce, Paul, Jones, Biggert, Shays, Miller of Cali- fornia, Capito, Feeney, Hensarling, Garrett, Pearce, Neugebauer, Price, McHenry, Campbell, Putnam, Bachmann, Marchant, and McCarthy of California. The CHAIRMAN. The hearing will come to order. First, I would like to note that last summer we saw the passing of the co-author of the Humphrey-Hawkins bill, Congressman Gus Hawkins. He was a Member of the House who had a very distinguished career. He was the predecessor of our colleague from California, Ms. Wa- ters. But the significance of his achievement in structuring that bill, and in particular, giving equal weight to two very important mandates, the need to combat inflation and the need to maintain adequate employment—I think recent events have shown that to be quite wise. I contrast what I think has been the good performance of our Federal Reserve in meeting our needs with a performance that I think has caused more difficultly in Europe in the European Cen- tral Bank where they have only the single mandate. So I want to pay again tribute to the wisdom of Gus Hawkins and to the fidelity with which the Federal Reserve under this Chairman has carried out what can be a complicated and sometimes—it's a relationship with some tension. We meet today under the usual circumstances. For many years past, I have focused on the problems of income inequality in our society and the question about how we promoted growth without it adding to inequality. Both the current Chairman and his prede- cessor acknowledged that those were issues and expressed views about how to deal with them. We have from time to time convened when we were in the midst of a downturn, whether or not it is a recession is a somewhat academic discussion. That we are in a sig- (l) nificant downturn with a very chancey near-term future is indis- putable. What is interesting is the extent to which this is a very different kind of downturn. We don't have the classic cycle where there were excesses, too much inventory, etc. We are in a downturn, maybe a recession, maybe about to become one, in which the single biggest cause was excessive deregulation. The failure to understand that a vibrant, free enterprise system needs as a partner a public sector that understands how the market works, supports it, helps create the conditions in which the free market can flourish, but also pro- vides a set of rules that diminish abuses. That this current downturn was caused by abuses in the loan market for residences is fairly clear. In the report, the Monetary Report that the Chairman presents, on page 3, part 2, "The eco- nomic landscape after the first half of 2007 was subsequently re- shaped by the emergence of substantial strains in financial mar- kets in the United States and abroad, the intensifying downturn in the housing market and higher prices for crude oil. Rising delin- quencies on subprime mortgages led to large losses on related structured credit products." Skipping over, "Consequently, in the fourth quarter, economic activity decelerated significantly, and the economy seemed to have entered 2008 with little forward momen- tum." This is relevant for a number of factors. Yesterday in the hearing we had preparatory to this one, the very distinguished economist, Alice Rivlin, a former Vice Chair of the Board of Governors, said this year in your hearing, monetary policy will not be as important. It will be somewhat down on the list. And I think that is accurate. In the classical recession we have had, the role of monetary policy is fairly clear. Here we have this problem that the normal tools we use, including a stimulus package, which in its detail pleased no one, and was therefore able to pass, and I think will on balance be constructive in helping deal with the shortfall, and we have seen a reduction in interest rates. That is, monetary and fiscal policy have been as stimulative as you can expect in this time. And I sup- port both of those directions, but they are not enough. We are faced with the need to deal with a very serious structural problem, the continuing flood of foreclosures. And this committee will be considering measures to deal with that. Let me note that in the absence of the subcommittee chairman, and given the signifi- cance here, I'm going to take the 8 minutes that we have. And I apologize to my colleagues, but not so much. We have a structural set of issues to deal with. And in this case, relying on fiscal and monetary policy alone won't be enough. Be- cause unless we can deal with the specific structural problem caused by the deregulation more than anything else, and caused by excesses in the private sector, we will not be able to effectively deal with this situation. And in fact, if we were not to deal with this in a structural manner by trying to deal with foreclosures and with property on which there have been foreclosures, we would put too much of a strain on fiscal and monetary policy. It would not be appropriate to rely only on fiscal and monetary policy. So we will be trying in a variety of ways, and we have been talking to regulators, and I appreciate the cooperation we have got- ten from staff at the Federal Reserve and the other Federal regu- latory agencies. We may in the end have some differences, but there has been a cooperative effort to try and figure out how to deal with that. What is clear is that the ideology of deregulation is a large part of the cause of the problems we are in today. Indeed, in the mort- gage market, it is clear. If you look at mortgages originated by the regulated entities, the deposit-taking institutions, subject to bank regulation, they have performed much better than those that came with very little regulation. And it wasn't simply that. What basically happened was that securitization, which has been a great blessing and a great multi- plier of our ability to do things, replaced the lender-borrower dis- cipline. We were told by the private sector that they had ways of replacing that, so that we would have a good deal of responsibility. We had risk management and quantitative models, and a whole range of other things. It turns out, when enough bad loans are put into the system because of the absence of the lender-borrower dis- cipline, i.e., I'm not lending you the money unless I know you're going to pay me back, that some of these techniques did not con- tain the damage; they spread it. And the consequence has been a very serious, worldwide problem wherein the most significant economic troubles since at least 1998, and in America it is probably going to have more of a negative im- pact than then, and the single biggest cause was a failure for regu- lation to keep up with innovation. And of course it has had inter- national consequences as well. We have a new export in America that had a big impact on the rest of the world—bad mortgages, which we exported and which caused economic problems elsewhere. So as we deal with this situation, it is important for us to con- tinue to monitor monetary policy. We have already acted in the fis- cal area. I believe that the Chairman and the Federal Reserve has acted appropriately with regard to monetary policy, but they could not be enough, given the cause of this. And what we need first of all is to deal with the problems that we have seen because of the failure to regulate, and we have to do something about the cascade of foreclosures that we still face, or we do not easily pull out of this problem. And we have to, once we have dealt with that, this com- mittee will begin to work on that, think in cooperation with the regulators and the financial community and others what we do going forward so that we do not lose the virtues of securitization but we are able to diminish some of its abuses. The gentleman from Alabama. Mr. BACHUS. I thank the chairman. Chairman Frank, I appre- ciate you holding this hearing on monetary policy and the state of the economy. And I thank you, Chairman Bernanke, for being here today and for your service to the country. You testified last July concerning the state of the economy and monetary policy. At that time we had a problem in one segment of our economy, and that was subprime lending. And as we all know, since that time, because of what we sometimes refer as inter- connectedness of the markets, it has mushroomed into a full-blown credit crisis. We have unemployment inching up, although it is still at historic lows. It is still very good. We have factory orders and durable goods showing weaknesses, some weaknesses in retail sales, and obviously we are concerned about our credit card and auto lending markets because of the credit crunch. While economic activity and growth have clearly slowed, and while any threats to our economy should not be minimized, I don't believe anything has transpired over the past 7 months that dis- tracts from the competitive strength of U.S. businesses and their innovativeness, and the productivity of American workers still re- mains very high. I think our workers are unrivaled in the world as far as their abilities and their productivity. Moreover, productive steps by the Federal Reserve and other reg- ulators, combined with responses from the private sector and the natural operations of the business cycle, I believe will help ensure that the current economic downturn is limited in both duration and severity. I believe your aggressive cuts in the Fed funds rates and the recently enacted stimulus package will help. Although I believe it may not have the effect that many claim, I do believe that it does serve as a tax cut for millions of hardworking Americans, and it, too, will help. And all of those should begin to have a positive effect on our economy, I believe, by this summer—and I would be interested in your views—laying the groundwork for a much stronger second half of 2008 and sustainable growth in 2009. At that point, I believe the Fed's primary challenge, and we saw it, I think last week and this week, with the CPI and the PPI numbers, your challenge will shift from avoiding a significant economic downturn to containing infla- tionary pressures in our economy. Particularly when I go home, people talk to me about the hard- ship of high gas prices. That's something that I'm not sure any of us have much control over, short term. Long term, there are obvi- ously things, including nuclear power that I have said many times we need to take full advantage of. One lesson we have learned from the subprime contagion is just how highly interconnected our financial markets are. The chairman in his opening statement mentioned a lack of regulation. We have a system of functional regulation where different regulators func- tion in different parts of the market. I'm not sure that part of our problem is not that this sometimes almost causes overregulation, but there may be gaps in the regulation. And I wonder if that is in fact the case, there may be areas where the regulation needs to be strengthened or regulation needs to be coordinated better be- tween different regulators, both State and Federal. As painful as the process and the challenges we have, I think it is pretty evident that we have faced our problems and that we are solving them. I think what we have done is far preferable to the kind of decay and denial that mark the Japanese response to their financial turmoil in the 1990's. And it's the reason I continue to have great confidence in the resilience of the American economy. Chairman Bernanke, in closing, let me say there is perhaps no other public figure in America who has been subjected to as much Monday morning quarterbacking as you have over the last 7 months. But I believe on balance, any objective evaluation of your record would conclude that you have dealt with an exceedingly dif- ficult set of economic circumstances with a steady hand and sound judgment. With that, Mr. Chairman, I yield back the balance of my time. The CHAIRMAN. And next, the ranking member of the sub- committee, the gentleman from Texas, Mr. Paul, for 3 minutes. Dr. PAUL. Thank you, Mr. Chairman. I ask unanimous consent to submit a written statement. The CHAIRMAN. Without objection, the gentleman and any other members of the committee who wish to submit written statements will be allowed to do so. There will be no need for further requests. We will have general leave for everybody. Dr. PAUL. Thank you. The CHAIRMAN. And Chairman Bernanke's full remarks will be submitted as well. Dr. PAUL. Welcome to the hearing this morning, Chairman Bernanke. Obviously, the world, and especially we in this country, have come to realize that we are facing a financial crisis, and I think very clearly it is worldwide. That of course is the first step in looking toward solutions, but I would like to remind the com- mittee and others that there were many who anticipated this not a year or two ago when the crisis became apparent, but actually 10-plus years ago when this was building. The problem obviously is in—the major problem is obviously in the subprime market, but, you know, in the last—in one particular decade, there was actually an increase, in $8 trillion worth of value in our homes, and people interpreted this as real value, and $3 tril- lion was taken out and spent. So we do live in an age which is pushed by excessive credit, and I think that is where our real cul- prit is. But traditionally, when an economy gets into trouble, and they have inflation or an inflationary recession, the interpretation is al- ways that there is not enough money. We can't afford this, we can't afford that. And the politics and the emotions are designed to con- tinue to do the same thing that was wrong, that caused our prob- lem in the first place; that is, it looks like we don't have enough money. So, what does the Congress do? They appropriate $170 bil- lion and they push it out in the economy and think that's going to solve the problem. We don't have the $170 billion, but that doesn't matter. We can borrow it or we can print it, if need be. But then again, the financial sector puts pressure on the Fed to say, well, there's not enough credit. What we need to do is expand credit. But what have we been doing for the past 2 years? You know, it used to be that we had a measurement of the total money supply, which I found rather fascinating, and still a lot of people believe it's a worthwhile figure to look at, and that is M3. Two years ago, the M3 number was $10.3 trillion. Today it is $14.6 tril- lion. In just 2 years, there has been an increase in the total money supply of $4.3 trillion. Well, obviously, if you pump that much money into the economy and we're not producing, but the money we spend comes out of bor- rowed money against houses, where the housing prices are going down, and that is interpreted as increasing our GDP, I mean, it just doesn't make any sense to come back and put more pressure on the Congress and on the Fed to say what we need is more infla- tion. Inflation is the problem. That has caused the distortion. That has caused the malinvestment, and that is why the market is de- manding the correction in the malinvestment and the excess of debt which is not market-driven. The CHAIRMAN. The Chair will announce the procedure for ques- tions. There is obviously a great deal of interest in questioning the Chairman, or making speeches to him. And what we will do since we have a larger committee than any of us wanted, except perhaps for the most junior members, we will begin— Mr. BACHUS. —with an opening statement, his opening state- ment? The CHAIRMAN. Yes, but I'm going to just announce the proce- dures before we get to that. We are going to have the members' questions after the statement in order of seniority on our side. We will pick up at the next hearing later in the year where we left off. The minority is apparently also going to be doing that, so we're going to begin with some members who weren't able on their side to talk later, and then we will go in their order. The Chairman has given us 3 hours, and we appreciate it. I am going to have to hold members pretty closely to the 5-minute rule. Any last thought when the 5-minute bell hits can be completed, but fairly quickly, because we do have all this interest. And with that, Mr. Chairman, please. Mr. BERNANKE. Thank you, Chairman Frank, Ranking Member Bachus, and other members of the committee. I am pleased to present the Federal Reserve's monetary policy to Congress. Mr. WATT. Mr. Chairman, we are having a little trouble hearing down— The CHAIRMAN. Could you pull the microphone closer? Mr. BERNANKE. HOW'S that? In my testimony this morning, I will briefly review the economic situation. Is that okay, Mr. Chairman? Mr. BACHUS. I would just pull it a lot closer. STATEMENT OF THE HONORABLE BEN S. BERNANKE, CHAIR- MAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Mr. BERNANKE. Okay. In my testimony this morning, I will brief- ly review the economic situation and outlook, beginning with devel- opments in real activity and inflation, and then turn to monetary policy. I will conclude with a quick update on the Federal Reserve's recent actions to help protect consumers in their financial dealings. The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted, and pres- sures on bank capital and the continuing poor functioning of mar- kets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domestic product held up well through the third quarter despite the financial turmoil, but it has since slowed sharply. Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate, at 4.9 per- cent in January, has moved up somewhat. Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market. In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course. Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in most areas. Changes in the availability of mortgage credit amplified the swings in the housing market. During the housing sector's expansion phase, increasing lax lend- ing standards, particularly in the subprime market, raised the ef- fective demand for housing, pushing up prices and stimulating con- struction activity. As the housing market began to turn down, how- ever, the slump in subprime mortgage originations, together with the more general tightening of credit conditions, has served to in- crease the severity of the downturn. Weaker house prices in turn have contributed to the deterioration in the performance of mort- gage-related securities and reduced the availability of mortgage credit. The housing market is expected to continue to weigh on economic activity in coming quarters. Home builders, still faced with abnor- mally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and in closely related industries. Consumer spending continued to increase at a solid pace through much of the second half of 2007, despite the problems in the hous- ing market, but it appears to have slowed significantly toward the end of the year. The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in spending, as did the declines in household wealth associated with the weakness in house prices and equity prices. Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the 3 months ending in January, com- pared with an average increase of almost 100,000 per month over the previous 3 months. However, the recently enacted fiscal stim- ulus package should provide some support for household spending during the second half of this year and into next year. The business sector has also displayed signs of being affected by the difficulties in the housing and credit markets. Reflecting a downshift in the growth of final demand and tighter credit condi- tions for some firms, available indicators suggest that investment in equipment and software will be subdued during the first half of 2008. Likewise, after growing robustly through much of 2007, non- residential construction is likely to decelerate sharply in coming quarters as business activity flows and funding becomes harder to obtain, especially for more speculative projects. On a more encouraging note, we see few signs of any serious im- balances in business inventories, aside from the overhang of unsold homes. And, as a whole, the nonfinancial business sector remains in good financial condition with strong profits, liquid balance sheets, and corporate leverage near historic lows. In addition, the vigor of the global economy has offset some of the weakening of domestic demand. U.S. real exports of goods and services increased at an annual rate of about 11 percent in the sec- ond half of last year, boosted by continuing economic growth abroad and the lower foreign exchange value of the dollar. Strengthening exports, together with moderating imports, have in turn led to some improvement in the U.S. current account deficit, which likely narrowed in 2007 on an annual basis for the first time since 2001. Although recent indicators point to some slowing of foreign growth, U.S. exports should continue to expand at a healthy pace in coming quarters, providing some impetus to domestic economic activity and employment. As I have mentioned, financial markets continue to be under con- siderable stress. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjust- able interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of in- vestors to bear risk, difficulties in valuing complex or illiquid finan- cial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the financial markets in re- cent months. To help relieve the pressures in the market for interbank lend- ing, the Federal Reserve, among other actions, recently introduced a term auction facility through which pre-specified amounts of dis- count window credit are auctioned to eligible borrowers. And we have been working with other central banks to address market strains that could hamper the achievement of our broader economic objectives. These efforts appear to have contributed to some im- provement in short-term funding markets. We will continue to monitor financial developments closely. As part of its ongoing commitment to improving the account- ability and public understanding of monetary policymaking, the Federal Open Market Committee, or FOMC, recently increased the frequency and expanded the content of the economic projections made by Federal Reserve Board members and Reserve Bank presi- dents and released to the public. The latest economic projections, which were submitted in conjunction with the FOMC meeting at the end of January, and which are based on each participant's as- sessment of appropriate monetary policy, show that real GDP was expected to grow only sluggishly in the next few quarters, and that the unemployment rate was seen as likely to increase somewhat. In particular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2.5 percent to 2.75 percent as projected in our report last July. FOMC participants' projections for the unemployment rate in the fourth quarter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4.75 percent projected last July for the same period. The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial tur- moil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend, and the unemployment rate edging lower. The improvement reflects the ef- 9 fects of policy stimulus and an anticipated moderation of the con- traction in housing and the strains in financial and credit markets. The incoming information since our January meeting continues to suggest sluggish economic activity in the near term. The risks to this outlook remain to the downside. Those risks include the pos- sibilities that the housing market or the labor market may deterio- rate more than is currently anticipated, and that credit conditions may tighten substantially further. Consumer price inflation has increased since our previous report, in substantial part because of the steep run-up in the price of oil. Last year food prices also increased significantly, and the dollar de- preciated. Reflecting these influences, the price index for Personal Consumption Expenditures increased by 3.4 percent over the four quarters of 2007, up from 1.9 percent in 2006. Core price inflation, that is, inflation excluding food and energy prices, also firmed to- ward the end of the year. The higher recent readings likely re- flected some pass-through of energy costs to the prices of consumer goods and services, as well as the effect of the depreciation of the dollar and import prices. Moreover, core inflation in the first half of 2007 was damped by a number of transitory factors; notably, unusually soft prices for apparel and for financial services, which subsequently reversed. For the year as a whole, however, core PCE prices increased by 2.1 percent, down slightly from 2006. The projections recently submitted by FOMC participants indi- cate that overall PCE inflation was expected to moderate signifi- cantly in 2008, to between 2.1 percent and 2.4 percent, the central tendency of the projections. A key assumption underlying those projections was that energy and food prices would begin to flatten out, as was implied by quotes on futures markets. In addition, di- minishing pressure on resources is also consistent with the pro- jected slowing in inflation. The central tendency of the projections for core PCE inflation in 2008 at 2.0 percent to 2.2 percent was a bit higher than in our July report, largely because of some higher-than-expected recent read- ings on prices. Beyond 2008, both overall and core inflation were projected to edge lower as participants expected inflation expecta- tions to remain reasonably well anchored and pressures on re- source utilization to be muted. The inflation projection submitted by FOMC participants for 2010, which range from 1.5 percent to 2.0 percent for overall PCE inflation, were importantly influenced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate, and about the timeframe over which policy should aim to attain those rates. The rate of inflation that is actually realized will of course de- pend on a variety of factors. Inflation could be lower than we an- ticipate if slower-than-expected global growth moderates the pres- sure on the prices of energy and other commodities, or if rates of domestic resource utilization fall more than we currently expect. Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out, or that the pass-through to core prices from higher commodity 10 prices and from the weaker dollar may be greater than we antici- pate. Indeed, the further increases in prices of energy and other com- modities in recent weeks, together with the latest data on con- sumer prices, suggests slightly greater upside risks to the projec- tions of both overall and core inflation than we saw last month. Should high rates of overall inflation persist, the possibility also ex- ists that inflation expectations could become less well anchored. Any tendency of inflation expectations to become unmoored, or for the Fed's inflation-fighting credibility to be eroded, could great- ly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC to counter shortfalls in growth in the future. Accordingly, in the months ahead, the Federal Reserve will continue to monitor closely inflation and inflation expectations. Let me turn now to the implications of these developments for monetary policy. The FOMC has responded aggressively to the weaker outlook for economic activity, having reduced its target for the Federal funds rate by 225 basis points since last summer. As the committee noted in its most recent post-meeting statement, the intent of those actions has been to help promote moderate growth over time and to mitigate the risk to economic activity. A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of policy is properly cali- brated to foster our mandated objectives of maximum employment and price stability in an environment of downside risk to growth, stressed financial conditions, and inflation pressures. In particular, the FOMC will need to judge whether the policy actions taken thus far are having their intended effects. Monetary policy works with a lag. Therefore, our policy stance must be deter- mined in light of the medium-term forecast of real activity and in- flation as well as the risks to that forecast. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. The FOMC will be carefully evaluating incoming informa- tion bearing on the economic outlook and will act in a timely man- ner as needed to support growth and to provide adequate insurance against downside risks. Finally, I would like to say a few words about the Federal Re- serve's recent actions to protect consumers in their financial trans- actions. In December, following up on a commitment I made at the time of our last report in July, the Board issued for public comment a comprehensive set of new regulations to prohibit unfair or decep- tive practices in the mortgage market under the authority granted us by the Home Ownership and Equity Protection Act of 1994. The proposed rules would apply to all mortgage lenders and would establish lending standards to help ensure that consumers who seek mortgage credit receive loans whose terms are clearly dis- closed and that can reasonably be expected to be repaid. Accordingly, the rules would prohibit lenders from engaging in a pattern or practice of making higher priced mortgage loans without due regard to consumers' ability to make the scheduled payments. In each case, a lender making a higher priced loan would have to use third-party documents to verify the income relied on to make the credit decision. For higher priced loans, the proposed rules 11 would require the lender to establish an escrow account for the payment of property taxes and homeowners insurance, and would prevent the use of prepayment penalties in circumstances where they might trap borrowers in unaffordable loans. In addition, for all mortgage loans, our proposal addresses mis- leading and deceptive advertising practices, requires borrowers and brokers to agree in advance on the maximum fee that the broker may receive, and certain practices by servicers that harm bor- rowers and prohibits coercion of appraisers by lenders. We expect substantial public comment on our proposal, and we will carefully consider all information and viewpoints while moving expeditiously to adopt final rules. The effectiveness of the new regulations, however, will depend critically on strong enforcement. To that end, in conjunction with other Federal and State agencies, we are conducting compliance re- views of a range of mortgage lenders, including nondepository lend- ers. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effec- tive and consistent examinations of, and improved enforcement for, all categories of mortgage lenders. The Federal Reserve continues to work with financial institu- tions, public officials and community groups around the country to help homeowners avoid foreclosures. We have called on mortgage lenders and servicers to pursue prudent loan workouts, and have supported the development of streamlined, systematic approaches to expedite the loan modification process. We have also been providing community groups, counseling agen- cies, regulators and others with detailed analyses to help identify neighborhoods at high risk for foreclosures so that local outreach efforts to help troubled borrowers can be as focused and as effective as possible. We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and com- munity connections to address this critical issue. In addition to our consumer protection efforts in the mortgage area, we are working towards finalizing rules under the Truth in Lending Act that will require new, more informative, and con- sumer-tested disclosures by credit card issuers. Separately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards. Using the Board's authority under the Fed- eral Trade Commission Act, we expect to issue proposed rules re- garding these practices this spring. Thank you. I would be very pleased to take your questions. [The prepared statement of Chairman Bernanke can be found on page 53 of the appendix.] The CHAIRMAN. Thank you, Mr. Chairman. Let me just announce to members, we have one vote apparently on a procedural matter. We will break for that vote, and members who want to start going back—leaving now and coming back, we want to minimize the dis- ruption. We are going to ask the Chairman to give us a few more minutes, but we are going to move promptly. I will ask my ques- tions and then we may get in one more set. Members who want to can go and come back, and we may preserve continuity. Mr. Chairman, I have been here—it's my 28th year, and it's taken me that long to hear the following words, I think, from a 12 Federal Reserve Chairman, "Finally, I would like to say a few words about the Federal Reserve's recent actions to protect con- sumers in their financial transactions." That is a very significant change for the better, and it's particularly relevant, because it is the absence of this kind of approach that brought us to where we are today. You outlined things that you were doing under the Home Owner- ship and Equity Protection Act, and you correctly noted it was passed in 1994. It has taken until your chairmanship for this to be done, and I think we are seeing—and I don't ask you to comment on this—a reversal. I found Mr. Greenspan's response in the 1990's on monetary policy to be a very thoughtful one, when he resisted those who said as unemployment dropped below 5 percent and down into 3.9 percent, that somehow that automatically meant in- flation. He resisted that. He was quite correct. But in another area, I think he erred, and that is his view that regulation was almost never required. And when you have no regu- lation whatsoever, what the Chairman, your predecessor, often told us was that I have two options, whether it was the stock market effervescence or exuberance, whether it was the subprime, I can ei- ther deflate the entire economy or I can let the problems continue. I appreciate that in two areas you have mentioned today, and we aren't going to obviously to agree on all the specifics, you have gone beyond that. And I think, as I said, that is essential. I note you say to reinforce the point about this being a very dif- ferent kind of a recession—or going to be a recession. I don't want to impute to you the view that we're in a recession because I'm not going to be responsible for the nervous people at the stock market who overreact when you twitch your nose. So—but the problems we now have are different. And as you note, there is no inventory over- hang. What is interesting is, as you note, the extent to which the rest of the economy is in pretty good shape, but the regulatory fail- ures and the consequent abuses have caused this very broad-scale problem. As you say at the bottom of page 2, we see very few signs of any serious imbalances in business inventories aside from houses. As a whole, the nonfinancial business sector remains in good financial condition. That makes this an unusual economic problem. It puts con- straints on your ability to deal with it, and it makes it clear, we cannot either deal with the current problem or deal with a poten- tial repetition without getting into sensible regulation. So we look forward to working with you in that regard. I also appreciate your reiterating the importance of worrying about the downside in unemployment. As you note, the central tendency is 5.2 to 5.3 percent, and you are then talking sensibly about downside risks being more likely to that. In other words, we're talking about edging back up close to 6 percent unemploy- ment. If 5.3 percent is the central tendency, and the downside risks in employment are the greater ones, then we have to very careful. So let me now just finally say, and I don't ask you to comment on what I said, but going forward, what is your view—you have talked about the problems with what you have called the originate to distribute model. Is that an area in which working together you think that regulators, the Congress need to adopt—is it possible for 13 us to come up with rules that can preserve the great benefits of securitization and give us a better chance of diminishing the abuses? Mr. BERNANKE. Yes, Mr. Chairman. I think the originate to dis- tribute model and securitization have a lot of value. It allows bor- rowers to have essentially direct access to capital markets, but the recent experience shows we need to do some work on it, both the private sector and in collaboration with supervisors and regulators. We need to have more responsibility and accountability at the point of origination. We need to have better information and clarity about what securitized products contain. If we do those things, I think we can restore this market. But for the moment, as you know, it's very dysfunctional. The CHAIRMAN. Well, I appreciate that. Because one of the points you mention, one of the problems we have now is the lack of con- fidence on the part of investors. And I think this is the case, as I think was the case with much of Sarbanes-Oxley, everybody agrees on, I think, almost all of it, appropriate rules can be pro-market, because they can instill in investors a confidence that they other- wise didn't have. We have a kind of an investors' strike now. We have, as we're going to talk about next week, municipalities offer- ing 100 percent guarantees, in my judgment, full faith and credit general obligation bonds, paying an unfair risk premium. So, it does seem to me that if we work together, we can give the investors more confidence, and that's part of getting us back into the oper- ation. Would you comment on that? Mr. BERNANKE. Well, I certainly agree that we need to work to- gether, that regulators are trying to evaluate what we've learned from this experience and trying to see what we can do better in the future. Industry is doing the same thing. We want to make sure that any rules and regulations we adopt are wise and achieve their objectives and don't impose excessive costs. But clearly, we want to look back at this experience and try to learn what the lessons are. The CHAIRMAN. Thank you, Mr. Chairman. The gentlewoman from Illinois. Mrs. BlGGERT. Thank you, Chairman Bernanke, for your contin- ued efforts to keep our economy growing. And I'd like to thank you for the Federal Reserve's thorough analysis of the debt level of the American families and for promulgating rules relating to high cost mortgages and credit cards. As you know, this committee continues to address issues related to the mortgages and to the credit cards, and I have concerns about some of the legislation before this committee that may cause a fur- ther tightening in the credit market. So I would like to just ask you a couple of questions based on credit cards. And based on the Fed's recent surveys and studies, what do consumers need to know to make informed decisions about their credit cards? And could you just describe briefly the Regulation Z and what you believe it will do to help consumers better understand the terms of their credit card agreements? And when do you anticipate, I think you said this spring, that the regulation will be finalized? And, finally, can you discuss actions that the Fed plans to take and when to crack down on unfair and deceptive practices of bad actors in the credit card industry? In 2 minutes, probably. 14 Mr. BERNANKE. Yes, I will. The Reg Z regulations are still out for comment. We are receiving comments, which we are going to re- view very carefully. But the intent of Reg Z was to provide clearer disclosure so people could understand what their credit card ac- count involved. In particular, we have created a new Schumer Box, as it is called. It has new information about fees and penalties and provides more information to the consumer about the terms and conditions of their account. In addition, we propose to lengthen the period of time over which a consumer must receive notice before there is a change in terms of their credit card. These disclosures have been consumer tested. We have used companies to go out and use actual consumers to see what works, how much they recall, how much they understand. And we think there will be a substantial improvement in terms of allowing people to understand what is involved in their credit card accounts. We are beginning, as I mentioned, to look at some practices under the Unfair and Deceptive Acts and Practices rules. We an- ticipate setting out a proposal for comments within a couple of months, this spring, to address some issues that the disclosure rules themselves cannot address. The final release of both sets of rules will probably take place later this year. If possible, to mini- mize burden on the industry, would be to release the Reg Z disclo- sures and the new rules on unfair and deceptive acts and practices at about the same time, if possible. So I don't have a specific date yet for that release. Mrs. BlGGERT. My concern is always that sometimes what we do would restore credit, or make it impossible for consumers to have the credit if it is limited. So it would make all consumers, not just the ones who are having the credit problems, have to take responsi- bility for the payments in that effect would restore credit. Do you think the things that you are doing will have any effect on that? Mr. BERNANKE. We are very sensitive—both in the credit card rules and also in the mortgage rules—that these markets are im- portant. We don't want to create a chilling effect. We don't want to shut down these markets. We just want them to work better and, in particular, we think it's important for consumers to have a better understanding of what it is they're buying when they pur- chase products in these markets. Mrs. BlGGERT. If you had to say two things, what would con- sumers need to know to make informed decisions, would be the most important? Mr. BERNANKE. Well, they certainly need to know the interest rate and how it varies over time and what that means to them in terms of payments. And they also need to understand other kinds of penalties or other fees that might occur if they violate certain conditions or other things occur. So they need to have a good un- derstanding, not only of how they use a credit card for example, but also what the cost might be so they can make an informed judgment. Mrs. BlGGERT. Thank you. I yield back. The CHAIRMAN. Mr. Kanjorski has gone to vote and is on his way back. I am going to go vote now, so we may have a break of less than 3 or 4 minutes. 15 As soon as he comes back, he will resume the questions. And I am assured this is the only vote until 4 p.m., so you will be out of here before this happens again. [Recess] Mr. KANJORSKI. [presiding] The committee will come to order. Mr. Chairman, we now have the opportunity to seize control of this committee and do as we will. So, we should get started on all the serious problems that face us. Now, I am going to take my questions now so that we can save your time and the committee's time to get to the precious facts. Mr. Chairman, I listened to your statement in regard to your plans to correct some of the foibles within the subprime mortgage market, how we deal with reserving money for taxes, etc. As you know, this committee has sent and passed through the House a subprime bill that contains as a portion of it my bill or all of my bill, which deals with appraisals, deals with escrow reserve ac- counts, etc., and greater servicing powers on lenders. Yesterday—I think it was yesterday—I had the opportunity to talk with Attorney General Cuomo in New York. He has appar- ently entered into an agreement with Fannie Mae and Freddie Mac, not quite to the level of our legislation, but in the area of tightening up the rules and regulations on appraisals. He tells me that they were sort of inhibited from moving through with the agreement because some of the Federal regulators have not given their approval. He particularly cited, of course, the regulator for Fannie Mae and Freddie Mac. I then proceeded to call and ask him. I do not under- stand the concern. He said that he is going to look into it within the next week, and get back to me with a response. I think he in- tended to talk to you, as a principal regulator of the banks, and to others. I would appreciate it if you would really look at that mat- ter. I think your proposed regulations are very good, and our bill is very good. But, if in the meantime we can get an agreement with the people who write 83 percent of the mortgages in this country, Fannie Mae and Freddie Mac, it would seem to me that we would go a long way in stemming some of the problems that we are having in the mar- ketplace. Even though that agreement would fast be surpassed by your regulations or our legislation, I do not think that we should be particularly egotistic about whose idea is implemented or put forth. I think we ought to just try and work surgically to stop these problems. Do you agree? Mr. BERNANKE. Well, you know, I hope that our regulations are going to take a good, positive step. I am not familiar with all the details of the Cuomo/Fannie agreement. I am in close communica- tion with Mr. Lockhart, the regulator. And I continue to discuss issues with him, but I can't really comment on that specific pro- posal. Mr. KANJORSKI. Well, of course, I am interested. Your regulations will take months to clear all the barriers, get all the comments, will it not? Mr. BERNANKE. NO, sir. I think we will have those out before I appear before you again in July. 16 Mr. KANJORSKI. Before July? I think July is months away. Is that right? Mr. BERNANKE. Yes, sir. Mr. KANJORSKI. NOW, there is this other thing, you know, that I am a little disturbed about, and, to be honest, I have not totally lost faith in the regulators, but I am starting to. As Mr. Frank indi- cated, it seems to me, all of us should look at some introspection here and maybe take some responsibility—I do not want to say blame or fault—for the problem we are in right now. But, certainly we did not quite fulfill our functions. In August, when there was a breakdown in the securitized mar- ket on subprime loans, I was led to believe by regulators in the Ex- ecutive Branch that they thought everything was pretty much tightened up and most of all that we would not have a cross-con- tamination into other securities markets and other problems, and that it was going to be put back together and we would not see that. Then in December, of course, other thunderish shocks hit us, more came in January, and now it seems weekly that some finan- cial entity that we have all relied on that would not be subjected to these crash problems now is. For example, just 2 weeks ago, it was the student loan bonds that were not selling. Last week, it was the auction rate securities that failed and jumped from 4 percent to 20 percent, in some cases. This week it is the variable rate de- mand notes that are failing to have a market because the banks will not come in and play their role of specialist and provide that market. Would you say that this would represent in the credit market a metastization of the problem, that it has spread and it is spreading rather wildly and quickly, and that we should come up with some game plans to do something other than the stimulus demand that we had out there 2 or 3 weeks ago? Mr. BERNANKE. Well, Congressman, as I mentioned in my testi- mony, the subprime problem was a trigger for all this, but there were other things that then began to kick in, including a pull-back from risk taking, concerns about valuation of these complex prod- ucts, issues about liquidity and so on which, as you say, caused the problem to spread throughout the system. Right now, we are looking at solutions. The Federal Reserve, for example, is engaging in this lending process trying to reduce the pressure in the short-term money markets. I think, very impor- tantly, the private sector has a role to play. I would encourage, for example, banks to continue to raise capital so they would be well able to continue to lend. They also need to increase transparency, to provide more information to the markets so the market could begin to understand what these assets are and what the balance sheets look like. Mr. KANJORSKI. On that point, Mr. Chairman, wasn't it quite clear to the Federal Reserve that maybe we didn't have the trans- parency in all these securities that were broken into various tranches? It seems to me, 6 months later, that most banks still don't know what their exposures are. Wasn't that apparent to the regulators? Maybe we should have come forth with some regulatory authority to require these things be broken out in inventories? 17 I have to tell you I am astounded that major banks in this coun- try and around the world are still saying we do not know what our exposure is. That is sort of scary to me. They backed it up periodi- cally on a month-to-month basis coming out and announcing more failures on their part and more losses than they had anticipated. When will we get to the endpoint? What do we have to do? Doesn't the Federal Reserve, the present regulator, have enough authority to demand that nothing be done that's so clouded that you can't understand what your obligation would be or quickly come up with what your exposure would be? Don't we have the ca- pacity to do that? Mr. BERNANKE. Well, there were two sets of issues in this case. The first was that many investors took the credit rating agencies ratings as all the information they needed. They didn't do initial analysis, so they just looked at the rating. They didn't look at what was in these structured credit products. We are now looking at that situation much more carefully. The credit rating agencies are re- viewing their own procedures. And, clearly, investors now under- stand they need to look at more details than just the credit rating. Another issue is that with the markets being relatively illiquid— in many cases quite illiquid—it can be very hard to evaluate what even a straightforward mortgage is worth. With the economy changing, with mortgages and other assets not trading on a liquid market, it makes it more difficult for the banks to evaluate what their holdings are and that's a problem going forward. Going forward, the approaches, I think, involve working with the SEC and the accounting authorities and so on to try to find better ways of disclosure, more transparent approaches to disclosure, and also to take measures to ensure this drying up of liquidity doesn't happen again. There's enough liquidity in markets so that price discovery can take place and we can value what these assets are worth. Mr. KANJORSKI. Thank you very much, Mr. Chairman. I note that I ran away with my time. The chairman is about to come and remove me physically from the chair. Let me recognize Mr. Miller. Mr. MILLER OF CALIFORNIA. Thank you very much. It's good to have you here again. If you'd like to say something really good about the economy, those stockholders would really love it. But, short of that, I remember the first time you testified. My questions were associated with the housing market, and there didn't tend to be that big a concern back then, but I think things have changed. And we've tried to do a lot from our side raising, conforming in high cost areas and GSEs and FHA. And you've low- ered the basis points about 225 basis points to try to stimulate the economy. It has done a good job of lowering cost of funds to lenders, but from mid-January, we are looking at the opposite when it comes to mortgage rates to people who wanted to buy a house. They shouldn't be going up. Could you address that? Mr. BERNANKE. Well, mortgage rates are down some from before this whole thing began. But we have a problem, which is that the spreads between, say, Treasury rates and lending rates are wid- 18 ening, and our policy is essentially, in some cases, just offsetting the widening of the spreads, which are associated with various kinds of illiquidity or credit issues. So in that particular area, you are right. It has been more dif- ficult to lower long-term mortgage rates through Fed action. We are able, of course, to lower short-term rates and they do have im- plications. For example, resets of existing mortgages affect the abil- ity of banks and others to finance their holdings of assets. So I think we still have power to influence the housing market in the broader economy, but your points are well taken. A lot of what we have done has been mostly just to offset the tightening of credit that has arisen because of the financial situation. Mr. MILLER OF CALIFORNIA. I am looking at lending since about January 24th has raised about 56 basis points to the consumer. Yet, your cost to the lenders are down considerably based on what CDs are being, you know, sold out today, and such. Mr. BERNANKE. That's true for even the conforming mortgages like Fannie and Freddie mortgages. Mr. MILLER OF CALIFORNIA. DO you see a benefit and a help to the industry? I do in what we have done in raising and confirming in high cost areas there, but people couldn't get lower-rated GSEs when they sell their home or they're buying a home than they could before. What impact do you see that having in the long term? Mr. BERNANKE. In the jumbo? Mr. MILLER OF CALIFORNIA. Yes, us being able to get a Freddie and Fannie at the $700,000 range. Mr. BERNANKE. Well, I think we are going to have to see. It is going to take a bit of time for them to get geared up to accept those kinds of mortgages, and there has been a ruling by the bond asso- ciation that they can only securitize those jumbo mortgages in sep- arate instruments and not mix them in with the conforming mort- gages. And that will perhaps reduce the liquidity. So it remains unclear how much benefit will come from this; however, my understanding is that Fannie and Freddie are com- mitted to doing a significant amount of securitization of these jumbo mortgages. And we would certainly encourage them to raise capital to allow them to do more and to securitize more of both con- forming and jumbo securities. Of course, at the same time, I hope that Congress will continue to push forward on getting a com- prehensive reform that will make these entities safe and sound for the future. Mr. MILLER OF CALIFORNIA. Yes. On January 17th, you pre- sented your near-term economic outlook to the House Budget Com- mittee. In that outlook you indicated the future market suggests the new prices will decelerate over the coming year. However, since then, all prices have reached record highs in nominal terms. If oil continue to remain at its current levels, thereby adding fur- ther pressure on the overall inflation, it may be more difficult for the Feds to cut interest rates; and, if that were the case, what op- tion do you have beyond cutting interest rates? Mr. BERNANKE. Well, the oil prices rose in 2007 by almost two- thirds. It was an enormous increase and put a lot of pressure, obvi- 19 ously, directly on energy products and is also feeding through into air fares and other energy intensive goods and services. Oil prices are very volatile. They've moved around a lot in the last month or so, but the end-of-year futures markets have oil prices about $95. Oil prices don't have to come down to reduce in- flation pressure; they just have to flatten out. Mr. MILLER OF CALIFORNIA. But if they don't flatten out? Mr. BERNANKE. Well, if they continue to rise at this pace it is going to create a very difficult problem for our economy, because on the one hand it is going to generate more inflation, as you de- scribe, but it is also going to create more weakness because it is going to be like a tax. It is extracting income from American con- sumers. So if that happens, it will be a very tough situation. We are going to have to make judgments looking at the risk to both sides of our mandate and make those judgments at that time. But I think it is relatively unlikely that we will see the same kinds of enormous increases in energy prices this year that we have seen in 2007. Mr. MILLER OF CALIFORNIA. SO you feel confident your projection of a decrease in the long-term throughout the year will come true; that you project this point that you see oil decreasing as the year progresses? Mr. BERNANKE. Well, we don't know what oil prices are going to do. It depends a lot on global conditions, on demand around the world. It also depends on suppliers, many of which are politically unstable or in politically unstable regions or have other factors that affect their willingness and ability to supply oil. So there's a lot of uncertainty about it, but our analysis combined with what we can learn from the futures market suggests that we should certainly have much more moderate behavior this year than we have. But, again, there's a lot of uncertainty around that esti- mate. The CHAIRMAN. The gentlewoman from New York, the chair of the Financial Institutions Subcommittee. The gentlewoman from New York? Mrs. MALONEY. It's my turn? The CHAIRMAN. The gentleman from Illinois. We will get back to you. Sorry. Mr. GUTIERREZ. Let me just follow up. So over the last 6 months, you have taken actions to reduce the cost of money, and in Janu- ary, I called my daughter and told her to go and get a mortgage around the 15th. I think I gave her good advice, Mr. Chairman. I said go and lock it in for as long as you can. She is going to buy her first home. Because it was like 5V2 percent, and I said, "Now is the time, honey." And then I checked the Wall Street Journal and it's like 6.38 per- cent. What happened? I'm sorry, I didn't quite—if money costs less—if the money is cheaper—why are mortgages increasing over the last, I don't know, 45 days? Mr. BERNANKE. Well, again, I don't necessarily want to try to ex- plain fluctuations over short periods of time; financial markets move back and forth. But a couple of things have happened. There has been some back-up in longer-term Treasury rates—the safe long-term rates. But, again, I think a big part of the story is that 20 even as the Fed has lowered interest rates, and as the general pat- tern of interest rates has declined, the pressures in the credit mar- kets have caused greater and greater spreads, particularly for risky borrowers. And that to some extent—I would say not entirely by any means—offset the effects of our easing. Our easing is intended in some sense to respond to this tightening of credit conditions, and, I believe we have succeeded in doing that. But there certainly is some offset that comes from widening spreads, and this is what's happening in the mortgage market. Mr. GUTIERREZ. I just find it—I'm not the economist that you and others are—but I just found it so surprising to watch. Because it hasn't had the same kind of relationship in the past as I have seen what the Fed does. And then I see what the market does. Be- cause it is very substantial. A 30-year mortgage, I mean, between 5V2 and 6V2 percent—it's huge, a lot bigger than between 4V2 and 5V2 percent. The amount of money you pay on a 30-year mortgage really is substantial. So we will talk some more about how we continue to deal with that. I want to take a step back from the macroeconomic discussion for a moment and discuss a regulatory issue. As you know, under our current regulatory scheme, there is no lead Federal regulator to oversee money remitters or the money service business industry. What we have is kind of a patchwork of State and Federal regu- lations. At the Federal level, we have FinCen monitoring money laundering reporting requirements in the Federal Trade Commis- sion with jurisdiction over consumer issues. Last year, I held a cou- ple of hearings in my subcommittee with consumer groups and oth- ers to weigh in on the issue. The consumer groups were unanimous in support for a stronger Federal regulatory scheme with a lead regulator. Because of the ac- count discontinuance problem, the industry sees the benefit of hav- ing a single-lead regulator, where the stakeholders differ as to which regulator should take the lead. Most agree the Federal Reserve will play a substantial role, if not a lead role, because the Federal Reserve's ACH system and its experience with Director Mexico program. But some have advo- cated creating a new Federal agency for this purpose. Do you be- lieve the Federal Reserve would be the appropriate lead regulator for the remittance industry? If not, why not? And is there an agen- cy that is in a better position to monitor the industry; and, should we be looking at creating an entire—or should we be looking at cre- ating entirely? Do you think you should lead? Do you think there is a better agency? Or do you think we should create something new? Because in the hearings it becomes quite clear that financial institutions are going to keep backing away, and as they do, it's going to get harder to get money to people who earn less here back to the very needy ones who really need it, and every nickel counts. What do you think, Mr. Chairman? Mr. BERNANKE. Well, as you point out, the money remittances are currently regulated by States, by the FTC and so on. And I think, as in some other areas, the State regulation varies in terms of its aggressiveness and quality. I am not sure the Federal Re- 21 serve is the right agency. Our expertise is in banking. This is quite a different industry, with many small operators. We have taken a somewhat different approach, which is to en- courage banks and other federally-regulated institutions to offer re- mittance services and to try to attract people interested in that to come into the banking system. The advantage of doing that is, first, banks can often offer better, cheaper services. But, in addition, people who are "unbanked"—that is, they are not part of the regular banking system—through this particular service may become more comfortable with banks, may begin to have a checking account, a savings account, credit and so on. So that has been our approach. It is to encourage banks in their own interest, and also through CRA motivation and other ways, to try to reach out and bring remittances into their operations. Mr. GUTIERREZ. Well, let me just suggest that because the MoneyGrams, the Western Unions, and the large ones, which have many facilities, I agree they should be banked. But in the interim period, they have all of these facilities throughout the neighbor- hoods and they have facilities in the nations which receive the money; that is, they have a disbursement level in the nations where we should have more conversation about how we take that private sector so they are not so fearful anymore as large financial institutions won't back them up but are backing away. Mr. BERNANKE. Congressman, it is worth discussion and Con- gress really needs to think about this. The CHAIRMAN. The gentleman from Texas, Mr. Neugebauer. Mr. NEUGEBAUER. Thank you, Mr. Chairman. I want to turn my attention a little bit. You mentioned in your testimony a little bit about the dollar and the fact it has increased our exports, because American goods are more competitive. But, at the same time, it swings the other way in the fact that it raises prices. It has an inflationary impact on the American consumer. I believe one of the reasons that oil is $100 a barrel today is be- cause of our declining dollar. People settled oil in dollars and I think a lot of them have obviously just increased the price of the commodity. And so I really have two questions. One is, what do you believe the continuing decline of the dollar is? What kind of inflationary impact do you think that is going to have? And then secondly, as this dollar declines, one of the things that I begin to get concerned with is all of these people who have all of these dollars have taken a pretty big hickey over the last year or so and continue to do that. At what point in time do people say, you know, we want to trade in dollars and other currencies, and what implication do you think then that has on the capital markets in the United States? Mr. BERNANKE. Well, Congressman, I always need to start this off by saying that the Treasury is the spokesman for the dollar, so let me just make that disclaimer. We obviously watch the dollar very carefully. It is a very important economic variable. As you point out, it does increase U.S. export competitiveness and, in that respect, it is expansionary. But it also has inflationary consequences, and I agree with you that it does affect the price of oil. It has probably less effect on the price of consumer goods or fin- 22 ished goods that come in from out of the country, but it does have an inflationary effect. Our mandate, of course, is to try to achieve full employment and price stability here in the United States, so we look at what the dollar is doing. We think about that in the context of all the forces that are affecting the economy, and we try to set monetary policy appropriately. So, we do not have a target for the dollar. What we are trying to do is, given what the dollar is doing, figure out where we need to be to keep the economy on a stable path. With respect to your other question, there is not much evidence that investors or holders of foreign reserves have shifted in any se- rious way out of the dollar at this point, and, indeed, we have seen a lot of flows into U.S. Treasuries, which is one of the reasons why the rates on short-term U.S. Treasuries are so low, reflecting their safety, liquidity, and general attractiveness to international inves- tors. So we have not yet seen the issue that you are raising. Mr. NEUGEBAUER. One of the other questions that I have, and just as your thought is, you know, the U.S. economy is based on encouraging the consumer to consume as much as he possibly can. In fact, the stimulus package that we just passed the other day, $160 billion, was really by and large the same to the American peo- ple go out and spend. And this consumption mentality, away from any kind of a sav- ings mentality, concerns me. That means the economy is always going to be a lot more volatile, because there is not much margin. And a year ago, people were testifying for this. Don't worry about the low savings rates, because people had these huge equities in their homes, so that was compensating for the lack of savings in the United States. But now, we see some reports, the valuation of real estate, 10, 12, 15 percent, and the savings rates add to zero and negative. Does that concern you long-term, that we are trying to build an economy on people to use up every resource that they have? Mr. BERNANKE. Yes, Congressman. I think in the long term we need to have higher saving, and we need to devote more toward in- vestment and foreign exports than to domestic consumption. That is a transition we are going to have to make in order to get our current account deficit down, in order to have enough capital and foreign income to support an aging population as we go forward the next few decades. The stimulus package is going to support consumption in the very near term. But there is a difference between the very short run and the long run. In the very short run, if we could substitute more investment, more exports, that would be great. But since we can't in the short run, a decline in total demand will just mean that less of our capacity is being utilized. We will just have a weak- er economy. So that is the rationale for the short-term measure, but I agree with you that over the medium and long-term, we should be taking measures to try to move our economy away from consumption de- pendence, more towards investment, more towards net exports. The CHAIRMAN. The gentlewoman from New York, Ms. Maloney. Mrs. MALONEY. Thank you very much, and welcome, Mr. Bernanke. 23 New problems in the economy are popping up like a not-very- funny version of Whack-a-mole, as Alan Blinder, a former Vice Chair of the Fed, recently observed, and yesterday's news was no exception with their wholesale inflation soaring consumer con- fidence falling and home foreclosures are spiking and falling sharp- ly. Added to this, many people believe that the next shoe to fall will be credit card debt, which is securitized in a very similar way as the subprime debt. And, as you know, the Fed has a statutory mandate to protect consumers from unfair lending practices. But there is a widespread perception that the Federal Reserve and Con- gress did not do enough or act quickly enough to correct dangerous and abusive practices in the subprime mortgage market. Many commentators are now saying that credit cards will be the next area of consumer credit where over-burdened borrowers will no longer be able to pay their bills. We see a situation with our constituents where many responsible cardholders, folks who pay their bills on time and do not go over their limit, are sinking fur- ther and further into a quicksand of debt, because card companies are raising interest rates any time, any reason, retroactively, and in some cases quite dramatically—30 percent on existing bal- ances—and there are very, I'd say scary, parallels between the subprime mortgage situation and what is now happening with credit cards. In your response to Chairwoman Biggert's question on what the most important thing a consumer needs to know about their credit card you responded, and I quote: "Consumers need to know their interest rate and how it varies over time." You also mentioned that it is important for consumers to know how their interest rate works. I have introduced legislation with Chairman Frank and 62 of our colleagues that would track your proposed changes to Regulation Z to always give consumers 45 days notice before any rate increase. But it would also give con- sumers the ability to opt out of the new terms by closing their ac- count and paying off their balance at existing terms. Would you agree that this notice and consumer choice would allow consumers to know their interest rate and how it varies over time and how it works? Mr. BERNANKE. Congresswoman, first of all, I agree. It is very important to protect consumers in their dealings with credit cards. As you mentioned, we have put out Reg Z revisions for comment, and includes this 45-day period. Within the Reg Z authority, we could not take that second step that you mentioned, but as I mentioned in my testimony, we are currently looking under a different authority, which is the FTC, Unfair Deceptive Acts and Practices Authority, at a range of prac- tices including billing practices. And we will hope to come up with some rules for comment within the next few months. So we are looking at all those issues and we will be providing some proposed rules. Mrs. MALONEY. Well, I congratulate you on your efforts in this area. It is very important. Would you agree that regulation of cred- it cards and credit card practices beyond disclosure, beyond Reg Z is necessary? 24 Mr. BERNANKE. If there are circumstances in which the actions of the credit card issuer are essentially impenetrable by the con- sumer, or the consumer doesn't understand and can't be expected to understand the action. Or if the actions of the credit card issuer are in fact literally different from what was promised, that is es- sentially taking different actions specified in the contract. Cer- tainly in both of those cases one would surely say that further ac- tion other than just pure disclosure would be needed. Mrs. MALONEY. And as you said to Ms. Biggert, you believe sub- stantive corrections of credit card practices can be done without re- stricting access to credit or restricting consumer spending? Mr. BERNANKE. Again, I think it is important for people who have credit card accounts or any other form of credit to understand what it is that they are buying, like buying any other product. If you are buying a credit card account, you should know what it is, how it works, and then you can make a reasoned choice. Mrs. MALONEY. Thank you. The CHAIRMAN. The gentleman from Georgia. Mr. PRICE OF GEORGIA. Thank you, Mr. Chairman. Mr. Chairman, we appreciate you being here again today and we know that monetary policy certainly is a balancing act and you have a difficult challenge balancing things. I find it interesting today that some members who are now upset with the current situ- ation were the same ones who were clamoring the most in years past for an expansion of credit. And so I think it may be that those individuals as we clamp down on credit are those who will then be clamoring for us to open it up again in the relatively near future. So it is indeed a balancing act. The Federal Government has come under significant indict- ment by some for its lack of regulation and I am interested in what degree you believe there is responsibility for our current situation that is due to the lack of regulation. Mr. BERNANKE. Well, as I mentioned to the chairman earlier, I think appropriate regulation combined with market forces can pro- vide the best results. I think regulation can often be helpful in situ- ations where there is an asymmetry of information or knowledge, where the one side of the transaction is far more informed than the other side. So, for example, if you have two investment banks doing an over-the-counter derivatives transaction, presumably they both are well-informed and they can inform that transaction without necessarily any government intervention. In the case of consumer credit, though, I think there can be cir- cumstances when the products are very complicated, and it is im- portant to help make sure that there are disclosures and practices so that the consumer can understand properly what it is that they are buying. As I said to Congresswoman Maloney, the market works better if people understand what the product is. And so I think there are circumstances when regulation can be helpful. We also, of course, supervise banks because the government in- sures deposits, and, therefore, we want to make sure that they are acting in a safe and sound way as well. Mr. PRICE. IS overregulation possible or harmful? Mr. BERNANKE. Of course it is possible. As I said in a recent speech, whenever we do regulation, we need to think about the cost 25 and benefit of that regulation, and make sure there is an appro- priate balance between them. And as we have done regulations on mortgage lending, I believe, for example, that subprime mortgage lending, if done responsibly, is a very positive thing and can allow some to get homeownership who might otherwise not be able to do so. There is plenty of evidence that people can do subprime lending in a responsible way. So in doing our regulations, we wanted to be sure that we didn't put a heavy hand on the market that would just shut it down and make it uneconomic. We want to help consumers understand the product, but we don't want to censure the market. Mr. PRICE OF GEORGIA. Sure. Would you agree with the state- ment that excessive deregulation is the single greatest cause of the challenge that we currently find ourselves in? Mr. BERNANKE. Well, I think there were mistakes in terms of regulation and oversight. But I think there also were private sector mistakes as well. Mr. PRICE OF GEORGIA. A lot of other situations going on. Mr. BERNANKE. There are a lot of factors involved. Mr. PRICE OF GEORGIA. The stimulus package that Congress re- cently passed, many of us were concerned about it being temporary and having questionable effect, truly to stimulate the market, the economy, in the long-run. And if we think about the housing situa- tion currently, I think there are two basic options available. One is to try to stimulate housing purchase through some tax policy. And the other is to increase the liability of the taxpayer for becom- ing the natures mortgage banker. Do you have a sense about which road we ought to head down? Mr. BERNANKE. Well, I don't generally comment on specific tax or spending programs. I think what the Fed is trying to do right now is encourage the private sector, the servicers and the lenders, to scale up their efforts to address this tidal wave of foreclosures that otherwise would occur. And I also have discussed the mod- ernization of FHA to provide a vehicle for refinancing of some of these mortgages and supported reform of GSE oversight as another mechanism. So those are the things that currently Fed Reserve has been talk- ing about. Mr. PRICE OF GEORGIA. Having the taxpayer be the sole holder of the nation of mortgages, though, is probably not a wise idea. I want to get to my last question, the final question about oil prices and crude. It has been suggested that increasing domestic produc- tion is not necessarily helpful in decreasing the cost of oil to our Nation, but wouldn't you say that in fact increasing domestic pro- duction or increasing refining capacity, all of that helps decrease, puts downward pressure on the cost of gas sat the pump and would be helpful? Mr. BERNANKE. Increasing supply generally lowers the price, so I think that's correct. But in these circumstances, Congress has to weigh the benefits of more oil supply against other considerations, including environmental issues and the like. Mr. PRICE OF GEORGIA. Thank you. The CHAIRMAN. The gentlewoman from California. 26 Ms. WATERS. Thank you very much, Mr. Chairman, for holding this hearing, and I thank Chairman Bernanke for once again being here and helping us to understand his vision for how we deal with our economy, and, of course, we are all pretty much focused on the subprime crisis, because I think we all understand the role that it is playing in our economy—the negative role that it is playing in our economy at this time. Yesterday, Mr. Bernanke, we had some economists here testi- fying before this committee, and there was some discussion about the role of regulatory agencies, and some discussion about public policymakers and whether or not we were going to overdo it and come up with new laws that may prove to be harmful to the overall industry and thus the economy. And let me just say that I think that you have been very forth- coming in talking about some missed opportunities maybe early on, you know, with maybe what could have been done based on infor- mation that regulatory agencies should have known about, should have had access to, should have acted on. So that is behind us, but I am concerned about voluntary efforts by the financial institutions who have some role in responsibility in the subprime crisis. For example, I held a hearing where Countrywide said that it had made 18 million contacts, had done 60,000 workouts, and out of that, there were 40,000 loan modifications. This other coalition called HOPE NOW said they had done 545,000 workouts, 150 loan modifications, and 72 percent of these were what we found, that 72 percent of these were kind of repayment plans and they were not real modifications. Now we are trying to act on the best informa- tion. And here we have these voluntary efforts that are rep- resenting to us that they are making these contacts. They are doing these workouts, and we look at this. We don't see it in our communities. We don't have people who are saying that they got a workout that made good sense and that they had been contacted. How can you help us if we are to have any faith in voluntary ef- forts at all and not get so focused on trying to produce laws that will do some corrections? How can you help us with determining whether or not this information we are getting is true; whether or not they are doing these workouts; whether or not they are doing this outreach. What do you do to track this voluntary effort? Mr. BERNANKE. Well, Congresswoman, you are quite right that the information has been very mixed. They did a whole bunch of different surveys. They haven't been comparable. We don't nec- essarily know exactly what is going on. I think one of the benefits of the HOPE NOW alliance is that they are trying to get a more comprehensive and more systematic data collection so we will know better how many people are being helped, how many are not, what the form of the help is, and so on. So I do think that the first requirement for a good policy here is to know exactly what's happening, and I agree with you abso- lutely on that. I also have some sympathy for your point that many of the actions being taken are very temporary, like a temporary payment plan or perhaps a forgiveness of a couple of payments, and that kind of thing. 27 In many cases the only solution that is going to be enduring is a more sustainable mortgage or some kind of restructuring or modification. And I do think that we need to encourage the private sector to do a greater share of modifications and restructurings in order to solve the problem rather than just to put it off for a few months. I think that is very important. In addition, I believe the Federal Housing Administration, the FHA, could be helpful in that respect, if it had more flexible prod- ucts and more flexibility to refinance mortgages coming from the private sector to create again a sustainable solution for people in difficulty. Ms. WATERS. We are willing and prepared to do the legislative work. Again, we have relied on a lot of voluntary efforts. And I guess my question to you is, are we going rely on these voluntary efforts to continue to strengthen their product, their work, or is there some way that you can have in your office someone or some- ones who can trace, follow, and dissect and determine whether or not these voluntary efforts are real? Mr. BERNANKE. Well, again, Congresswoman, I think the lead on the data collection is coming from HOPE NOW, but we also get our own data from some of the private suppliers of loan information, for example. So we are doing a good bit of analysis at the Fed, and we are looking for alternative solutions. But, quite frankly, finding solutions that will be focused and help the right people, at a rea- sonable cost, is very difficult. The CHAIRMAN. The gentleman from Delaware. Mr. CASTLE. In recent testimony over in the Senate, and respond- ing to the Senator from my State, Senator Carper, you indicated that Regulation Z might be out by opening day of baseball season. It was unclear to me as to whether everybody understood when opening day of baseball season is. I believe it is March 30th, which is about a month away. But this is not important. What is in it is obviously very impor- tant, but it is not important to have it out in terms of what we are doing here. Congresswoman Maloney indicated that she has al- ready introduced legislation which is very extensive, which may go substantially beyond where Regulation Z may be, with respect to credit cards and the issuance thereof and what can be done under those contracts, and some of her points may be well taken, and some may not be well taken. And I think until we see and compare it to Regulation Z, we're not going to really be able to make that decision. My question to you is, can you be more specific or can you reaf- firm or do you know for sure when the date of opening season of baseball is? Or whatever. I'd just like to get some sense of where this is coming from. Mr. BERNANKE. I thought it meant opening day of football sea- son. I'm sorry. I did misspeak in that answer, and we corrected the answer with Senator Carper. The reason for the delay is that as mentioned, we are going to be doing another set of rules related to the Unfair Deceptive Acts and Practices under the FTC Act. Those should be out, I hope, in the spring. I don't have an exact date, but not too far in the future, and that would give the public a chance to look at and comment 28 on these rules that relate to some of the issues that Congress- woman Maloney was talking about. We would then do a comment period and review those comments. It is our belief that because there would be some interaction between the Reg Z rules and the UDAP rules, in order to minimize the cost for the industry, we would probably be better off releasing both of them somewhat later this year. So the opening day is probably closer to where we would be re- leasing the proposed UDAP rules rather than when we will be hav- ing the final Reg Z rules. I apologize for that. Mr. CASTLE. SO Reg Z may be closer to the World Series, or something of that nature? Would that be a correct statement? Well, I think it's a matter of some concern to us. I hope you un- derstand as your people go about their work, and they have to do their work correctly, how important that it that we have that in order to formulate legislation or determine where we are on legisla- tion. Along those lines, let me ask you another question. In July of 2003, your predecessor, Chairman Greenspan, sent me a letter, which I will submit for the record, expressing deep skepticism about legislators' attempts to limit creditors' use of information re- garding borrowers' payment performance with other creditors when pricing risk. Risk-based pricing, as this practice is commonly called, lowers the price of credit for some and provides access to otherwise unavailable credit to many. Mr. Chairman, do you share Mr. Greenspan's view of that? I quote from the letter, "Restrictions on the use of information about certain inquiries or restrictions not considering the experience of consumers in using their credit accounts will likely increase overall risk in the credit system, potentially leading to higher levels of de- fault and higher prices for consumers?" Mr. BERNANKE. Well, as a general rule, in the same way that riskier credit leads to higher interest rates in the mortgage market, you would expect the same thing would happen in the credit card market, and so reasonable attempts to measure the risk of the bor- rower, I think, are appropriate and could be reflected in interest rates. We will be looking at the specific measures taken and the specific approaches taken when we look at these practices under the UDAP authority, but as a general matter, one would expect a higher rate to be charged to a risky borrower. Mr. CASTLE. Thank you, Mr. Chairman. Let me ask a question on a different subject. We don't have time to go into a lot of details, but what we have seen both in the House of Representatives and in the United States Senate is a series of proposals concerning the mortgage problems. One of these is a proposal in the Senate that gives bankruptcy courts the ability to revise mortgage terms. Over here we have had a suggestion to suspend litigation for a period of time after we pass legislation to allow the banks to reform mort- gages. There are other suggestions of having lump sums of money go the various States, who could then use it to help alleviate the problems of the mortgage companies. 29 Some of this may be beyond your typical perspective, but do you have any thoughts or ideas on any of that kind of legislation, either good or bad, that you can share with us? Mr. BERNANKE. Well, I certainly welcome and commend you and Chairman Frank and others for thinking about these issues. They are the very, very difficult ones. As I said, we have been thinking about them a lot at the Federal Reserve and discussing them with Congress, with the Treasury, and others. At the moment I don't see a clear and obvious additional set of steps that can be taken be- yond what's happening now, other than, as I mentioned, FHA mod- ernization, GSE reform. But we are certainly open to the possibility, and we continue to look at alternatives, but I don't have an additional one to rec- ommend at this point. Mr. CASTLE. Thank you, Mr. Chairman. The CHAIRMAN. Thank you very much. I will now recognize Mr. Meeks for 5 minutes. Mr. MEEKS. Thank you, Mr. Chairman. It is good to be with you, Chairman Bernanke. You know, some- times you get some of these conditions, and you do one thing and it helps, you do something else and it hurts. And such is the situa- tion that I think that we are currently in. It seems to me that if you move aggressively to cut interest rates and stimulate the economy, then you risk fueling inflation, on top of the fact that we have a weak dollar and a trade deficit. You know, you have to go into one direction or the other. Which direc- tion are you looking at focusing on first? Mr. BERNANKE. Congressman, I think I'll let my testimony speak for itself in terms of the monetary policy. I just would say that we do face a difficult situation. Inflation has been high, and oil prices and food prices have been rising rapidly. We also have a weakening economy, as I discussed. And we have difficulties in the financial markets and the credit markets. So that is three different areas the Fed has to worry about—three different fronts, so to speak. So the challenge for us, as I mentioned in my testimony, is to balance those risks and decide at a given point in time which is the more serious, which has to be addressed first, and which has to be addressed later. That is the kind of balancing that we just have to do going forward. Mr. MEEKS. SO you just move back and forth as you see, and try to see if you can just have a— Mr. BERNANKE. Well, policy is forward-looking. We have to deal with what our forecast is. So we have to ask the question, where will the economy be 6 months or a year down the road? And that's part of our process for thinking about where monetary policy should be. Mr. MEEKS. But let me also ask you this. The United States has been heavily financed by foreign purchases of our debt, including China, and there has been a concern that they will begin to sell our debt to other nations because of the falling dollar and the con- cerns about our growing budget deficits. Will the decrease in short- term interest rates counterbalance other reasons for the weakening dollar, enough to maintain demand for our debt? And if that hap- pens, what kind of damage does it do to our exports? And I would 30 throw into that because of this whole debate currently going on about sovereign wealth funds—and some say that these sovereign wealth funds are bailing out a lot of our American companies—so is the use of sovereign wealth funds good or bad? Mr. BERNANKE. Well, to address the question on sovereign wealth funds, as you know, a good bit of funding has come in from them recently to invest in some of our major financial institutions. I think, on the whole, that has been quite constructive. The capital- ization, the extra capital in the banks, is helpful because it makes them more able to lend and to extend credit to the U.S. economy. The money that has flowed in has been a relatively small share of the ownership or equity in these individual institutions, and in general has not involved significant ownership or control rights. So I think that has been actually quite constructive, and again I urge banks and financial institutions to look wherever they may find additional capitalization and allow them to continue normal business. More broadly, we have the CFIUS process, as you know, where we can address any potential risks to our national security created by foreign investment, and I think that is a good process. Other- wise, to the extent that we are confident that sovereign wealth funds are making investments on an economic basis and for re- turns—as opposed for some other political or other purpose—I think it is quite constructive, and we should be open to allowing that kind of investment. Part of the reciprocity is that it has allowed American firms to invest abroad as well, and so there is a quid pro quo for that. Mr. MEEKS. What about the first part of my question? Mr. BERNANKE. I don't see any evidence at this point that there have been any major shifts in the portfolios of foreign holders of dollars. We do monitor that to the extent we can, and so far I have not seen any significant shift in those portfolios. Mr. MEEKS. Thank you. The CHAIRMAN. The gentleman from Alabama. Mr. BACHUS. Thank you. Chairman Bernanke, have the markets repriced risk? Where do we stand there? You know, we talked about the complex financial instruments. Mr. BERNANKE. That is an excellent question. Part of what has been happening, Congressman, is that risk perhaps got under- priced over the last few years, and we have seen a reaction where risk is being now priced at a high price. It's hard to say whether the change is fully appropriate or not. Certainly part of the recent change we have seen is a movement towards a more appropriate, more sustainable, pricing of risk. But in addition, we are now also seeing concerns about liquidity, about valuation, about the state of the economy, which are raising credit spreads above the normal longer-term level, and those in- creased spreads and the potential restraint on credit are a concern for economic growth. And we're looking at that very carefully. Mr. BACHUS. Are investors making a flight to simplicity, or are they getting better disclosures, or is there a role that, say, the Fed- eral Reserve plays on seeing that those disclosures are there or are other regulators? 31 Mr. BERNANKE. Well, we do work with the SEC and the account- ing board and FASB and others to make sure that the accounting rules are followed, and I know they're being looked at and revised to try to increase disclosure. The Basel II Capital Accord also has a Pillar 3, which is about disclosure. So more disclosure is on the way and is a good thing. And we continue to encourage banks and other institutions to provide as much information as they can to investors, and I think that's a very constructive step to take. It's not the whole answer, though, at this point. Relatively simple instruments like prime jumbo mortgages, for example, are not selling on secondary mar- kets, less because of complexity and more just because of uncer- tainty about their value in an uncertain economy. Mr. BACHUS. One thing you didn't mention in your testimony is the municipal bond market, and the problem with bond insurers. Would you comment on its effect on the economy and where you see— Mr. BERNANKE. Yes, Congressman. The concerns about the insur- ers led to the breakdown of these auction rate securities, which were a way of using short-term financing to finance longer-term municipal securities. And a lot of those auctions have failed, and some municipal borrowers have been forced, at least for a short pe- riod, to pay the penalty rates. So there may be some restructuring that is going to have to take place to get the financing for those municipal borrowers. But as a general matter, municipal borrowers have very good credit quality, and so my expectation is that with a relatively short period of time, we'll see adjustments in the market to allow munic- ipal borrowers to finance at reasonable interest rates. Mr. BACHUS. Yes. In my opening statement, I mentioned that we have a functional regulator system, where we have different regu- lators regulating different parts of a market, which we now know is very interconnected. Do you think there are gaps in the regu- latory scheme today that need to be addressed? Maybe the bond in- surers may be an example where we did have State regulation, but it didn't appear that they were up to the task. Mr. BERNANKE. The bond insurer's problem was a difficult one to foresee. I mean, first of all they were buying what were thought to be high-quality credits, and secondly they do have some sophistica- tion of their own, doing some evaluation. So that was a difficult one to anticipate. In general, I think even though we have many regulators, there's a very extended attempt of regulators to work together in a colle- gial and cooperative way, and at the Federal Reserve we certainly try to do that. As I mentioned, we work with the SEC and the OCC and FDIC, and the like, and will continue to do that. One area where sometimes there have been, I think, some coordi- nation problems is between the Federal and the State regulators, and we saw some of that in the mortgage lending issues in the last couple of years. We have undertaken a pilot program of joint ex- aminations, working with State regulators. The idea is to try to im- prove even beyond where we are now in terms of our information sharing and coordination with those State regulators, and that is 32 what we are trying to do. But that is sometimes an area where the communication may not be as good as in some other areas. Mr. BACHUS. Let me ask one final question. You are a former professor, and I think the phrase is "financial accelerator." What that means is that there are problems in the economy called senti- ment problems; there is a lack of confidence. Is negative sentiment a part of what we're seeing now? I know I was in New York, and the bankers there said there were a lot of industries who were just waiting because of what they were reading in the paper, as much as anything else, to invest. Mr. BERNANKE. Well, there is an interaction between the econ- omy and the financial system, and it is perhaps even more en- hanced now than usual in that the credit conditions in the financial market are creating some restraint on growth, and slower growth in turn is concerning the financial markets because it may mean that credit quality is declining. And so this financial accelerator or adverse feedback loop is one of the concerns that we have and one of the reasons why we have been trying to address those issues. Mr. BACHUS. Thank you. The CHAIRMAN. Thank you. The gentleman from North Carolina. Mr. WATT. Thank you, Mr. Chairman. Welcome, Chairman Bernanke. In the 108th Congress, Congressman Brad Miller and I introduced the first predatory lending bill as H.R. 3974. In the 109th Congress, we introduced it in 2005 as H.R. 1182. The regu- lators weren't paying much attention to this, say minimizing the significance of it, and it took a crisis to finally get a bill passed. My concern is that looking finally at the last page of your testi- mony, you finally reached the credit card part of the equation, one paragraph, and my concern is that a lot of people who are seeing their credit dry up on the mortgage side are getting more and more credit on the credit card side, and that could portend potentially a similar kind of effect in the credit card market as we have seen in the mortgage market. Now I have not yet signed on to Ms. Maloney's bill, because we are still looking at it, but I have been meeting with industry par- ticipants, and one of the things that they have said is that we should give them more time for the regulator to do more. That is the same argument that we were hearing back in 2004 and 2005 and 2006: Give the regulators more time. And I asked them, does the regulator have enough authority to really do anything if they were inclined to do something? And it ap- pears to me from page 9 of your testimony, the one paragraph we have, the only authority you appear to have is the Federal Trade Commission Act, or the Truth in Lending Act, which is a disclosure act. Actually the Truth in Lending Act is the one that is under your authority, which is a disclosure statute. I'm not even going to get into the issue that Ms. Maloney raised, do you think we need to do something, but tell me what authority the regulators would need, what authority would you need to be more aggressive in this area, as we were trying to get the Fed to be in 2004 and 2005 in the mortgage area? Even if you were inclined to be more aggressive, if you didn't have the authority, you really couldn't do it, and one of the con- cerns I'm seeing is that disclosure won't do everything. Unfair and 33 Deceptive Trade Practices won't do anything if both of those things are required. Some things are unfair that are not necessarily de- ceptive. What kind of additional authority should we be considering giv- ing to the Fed or to somebody, some regulator if it's not the Fed, and to whom in this area? Mr. BERNANKE. Well, Congressman, as you pointed out, we have two different authorities. We have the Reg Z Truth in Lending au- thority, which is disclosure authorities, and we have already put out a rule for comment. It was a very extensive rule that involved consumer testing and several years of efforts to put together. I think that proposal is going to improve disclosures a lot. But we also have this Unfair Deceptive Acts and Practices au- thority, which allows us to ban—not just failure to disclose—but al- lows us to ban specific practices, which are unfair or deceptive for the consumer, and I think— Mr. WATT. SO you a're interpreting that "or" to be an "or" rather than an "and." Mr. BERNANKE. Yes. Mr. WATT. That's a good— Mr. BERNANKE. That's right. Yes. Mr. WATT. Okay. Mr. BERNANKE. SO we are able to address certain practices of billing, rate setting, rate changing and so on, and in terms of the delay issue, as I mentioned earlier, we will have some rules under this authority out for your examination, and for public comment, sometime this spring, just a few months from now. So you will see what we're able to do with that, and you'll have to make your decision whether or not more action by Congress is needed. Mr. WATT. Thank you, Mr. Chairman. My time has expired and I— The CHAIRMAN. Thank you. The gentleman from Texas, a rank- ing member of the subcommittee. Dr. PAUL. Thank you, Mr. Chairman. Chairman Bernanke, ear- lier you were asked a question about the value of the dollar, and you sort of deferred and said, "You know that is the Treasury's re- sponsibility." I always find this so fascinating, because it has been going on for years. Your predecessor would always use that as an excuse not to talk about the value of the dollar. But here I find the Chairman of the Federal Reserve, who is in charge of the dollar, in charge of the money, in charge of what the money supply is going to be, but we don't deal with the value of the dollar. You do admit you have a responsibility for prices, but how can you separate the two? Prices are a mere reflection of the value of the dollar. If you want to control prices, then you have to know the value of the dollar. But if you are going to avoid talking about the dollar, then all you can do then is deal with central economic plan- ning. You know, if we stimulate the economy, maybe there will be pro- duction and prices will go down, and if prices are going up too fast you have to bring on a recession. You have to try to balance these things, which I think is a totally impossible task and really doesn't 34 make any sense, because in a free market if you had good economic growth you never want to turn it off, because good economic growth brings prices down just like we see the prices of computers and cell phones, those prices come down where there is less government in- terference. But you know the hard money economists who have been around for awhile, they have always argued that this would be the case. Those who want to continue to inflate will never talk about the money, because it isn't the money supply that is the problem, it is always the prices. And that is why the conventional wisdom is, everybody refers to inflation as rising prices, instead of saying inflation comes from the unwise increase and supply of money and credit. When you look at it, and I mentioned in my opening statement that M3, now meas- ured by private sources, is growing by leaps and bounds. In the last 2 years, it increased by 42 percent. Currently, it is rising at a rate of 16 percent. That is inflation. That will lead to higher prices. So to argue that we can continue to do this, continue to debase the currency, which is really the policy that we are fol- lowing, is purposely debasing, devaluing a currency, which to me seems so destructive. It destroys the incentives to save. It destroys—and if you don't save, you don't have capital. Then it just puts more pressure on the Federal Reserve to create capital out of thin air in order to stimu- late the economy, and usually that just goes in to mal-investment, misdirected investment into the housing bubbles, and the NASDAQ bubble. And then the effort is once the market demands the correction, what tool do you have left? Let's keep pumping—pump, pump, pump. And it just is an endless task, and history is against you. I mean, history is on the side of hard money. If you look at stable prices, you have to look to the only historic, sound money that has lasted more than a few years, fiat money always ends. Gold is the only thing where you can get stable prices. For in- stance, in the last 3 to 4 years, the price of oil has tripled, a barrel of oil went from $20 to $30 up to $100 a barrel. And yet, if you look at the price of oil in terms of gold it is absolutely flat, it is absolutely stable. So if we want stable prices, we have to have sta- ble money. But I cannot see how we can continue to accept the policy of de- liberately destroying the value of money as an economic value. It destroys, it is so immoral in the sense that what about somebody who saved for their retirement and they have CDs. And we are in- flating the money at a 10 percent rate, their standard of living is going down and that is what is happening today. The middle class is being wiped out and nobody is understanding that it has to do with the value of money, prices are going up. So how are you able to defend this policy of deliberate depreciation of our money? Mr. BERNANKE. Congressman, the Federal Reserve Act tells me that I have to look to price stability, which I believe is defined as the domestic price—the consumer price index, for example—and that is what we aimed to do. We looked for low domestic inflation. 35 Now you are correct that there are relationships obviously, be- tween the dollar and domestic inflation and the relationships be- tween the money supply and domestic inflation. But those are not perfect relationships, they are not exact relationships. And given a choice, we have to look at the inflation rate, the domestic inflation rate. Now I understand that you would like to see a gold standard for example, but that is really something for Congress, that is not my— Dr. PAUL. But your achievement, we have now PPI going up at a 12 percent rate. I would say that doesn't get a very good grade for price stability, wouldn't you agree? Mr. BERNANKE. NO, I agree. The more relevant one, I think, is the consumer price index, which measures the price consumers have to pay. And last year that was between 3V2 and 4 percent. I agree that is not a good record. Dr. PAUL. And PPI is going to move over into the consumer head- ing as well. Mr. BERNANKE. And we are looking forward this year, trying to estimate what is going to happen this year, and a lot of it depends on what happens to the price of oil. If oil flattens out, we will do better, but if it continues to rise at that rate in 2007, it will be hard to maintain low inflation, I agree. Mr. MOORE OF KANSAS. Thank you, Mr. Chairman. We face sig- nificant challenges in the housing market that have led in part to serious problems in the credit markets and our larger economy. Some of these problems begin as a result of predatory lending prac- tices, which reached epidemic proportions in recent years, and took millions of dollars from American households of the equity in their homes and undermining the economic vitality of our neighborhoods. Approximately 1.8 million subprime borrowers will be facing re- setting adjustable rate mortgages over the next couple of years, un- less the government or the lending industry helps them modify the terms of their loan in some other form. I don't support a government bailout for all these homeowners, particularly for wealthy investors and speculators who borrowed against the equity in their homes, betting on profits from a soaring housing market. But I do believe we need to make a strong effort to help lower-income homeowners, who were the victims of preda- tory lenders, refinance in order to stay in their homes. If foreclosures, Mr. Chairman, continue to rise, what impact do you believe this will have or could have on the economy in the next couple of years? Mr. BERNANKE. The high rate of foreclosures would be adverse to the economy. Obviously, it hurts the borrowers, but it also hurts their communities if there are clusters of foreclosures. And it hurts the broader economy, because it makes the housing market weaker and that has effects on the whole economy. So clearly, if we can take actions to mitigate the rate of fore- closure, do workouts and otherwise modify loans or find ways to help people avoid foreclosure, I think that is certainly positive. Mr. MOORE OF KANSAS. Thank you, sir. Some believe that we should enact legislation that would amend the bankruptcy code to allow judges to modify the terms of a loan on a debtor's principle 36 residence in chapter 13 in order to provide relief to these home- owners. This would essentially treat primary residences in a simi- lar way to credit cards under the bankruptcy code. In 1978, Con- gress created this exemption in the bankruptcy code with the in- tent of encouraging homeownership by providing certainty to mort- gage lenders that terms and conditions of the loan were secure. Do you believe that changes in the bankruptcy code to make pri- mary residence lending more akin to credit cards will place up our pressure on mortgage interest rates and what effect could this have on investor confidence and mortgage-backed securities market in the broader economy? Mr. BERNANKE. Well, I think the proposed changes to the bank- ruptcy code have some conflicting effects. On the one hand, they might help some people who could appeal to the bankruptcy code in order to— Mr. MOORE OF KANSAS. Could you get a little closer to the micro- phone sir, please, thank you. Mr. BERNANKE. The proposed change to the bankruptcy code would have conflicting effects. I think it would help some people. On the other hand, it would probably lead to concern about the value of existing mortgages and probably higher interest rates for mortgages in the future. And so it is a very difficult trade-off. The Federal Reserve did not take a position on the previous bankruptcy code changes— Mr. MOORE OF KANSAS. I understand. Mr. BERNANKE. —and I think we are going to leave this one to Congress to figure out the appropriate trade-off. Mr. MOORE OF KANSAS. Thank you, Mr. Chairman. Mr. CHAIRMAN. Next, we have the gentleman from California. Mr. ROYCE. Thank you, Mr. Chairman. I wanted to ask Chair- man Bernanke a question. To date, the U.S. banking system, I think, has handled the stress originated in the housing sector. But I think this is a result of these institutions being adequately cap- italized prior to the turmoil that we found ourselves into. And given the ability of these institutions now to adequately handle that stress with existing leverage ratio requirements, I won- dered if it caused you to rethink your attitude toward implementa- tion of Basel II? Mr. BERNANKE. NO, Congressman, I still think Basel II is the right way to go, because Basel II relates the amount of capital that banks have to hold to the riskiness of their portfolio. So, if done properly, risky assets require more capital, and that allows for bet- ter risk management and greater safety. Now, it is certainly true that some of the lessons we learned from this previous experience require us to go back and look at Basel II and see, for example, if there are changes that might need to be made. But that is one of the beauties of the system; it is a broad set of principles and can be adapted when circumstances change, as we have seen in the last couple of years. But we look at banks across the country and try to decide why some did well and some did poorly. The ones who did well had real- ly strong risk management systems and good company-wide con- trols for managing and measuring risk. And that is the central idea behind Basel II. 37 Mr. ROYCE. But they were also very well capitalized. Mr. CHAIRMAN. Stop the clock on the gentleman from California. There are three votes coming up. The first one is a general vote. Anyone who feels the need to vote on the general can go, but we are going to keep going. There will then be two further votes, which I think members won't want to miss. And at that point, when the general vote is concluded, and the next vote starts, we will just let the Chairman go. Anyone who wants to, though, can stay. We will have another couple of hours of questions. I plan to stay. I will leave once we get the call for that second vote, and we will all run over there. So the gentleman will resume at this time, and members who wish to stay will be called on through the general vote and then we are going to have adjourn the hearing. The gentleman from California. Mr. ROYCE. Thank you again, Mr. Chairman. I wanted to con- tinue with another question, Chairman Bernanke, and that has to do with the success of our country's economy. I think, to a certain measure, it is based on an economic model that has a solid founda- tion in terms of free and flexible markets, and respect for the sanc- tity of a contract for the rule of law. And understanding this Chairman Bernanke, do you believe it is in the best interest of our economy for the government to begin re- writing contracts between two private parties? And let's say for a minute, should Congress end up setting a precedent and grant the authority to change the terms of a contract, do you believe that this could potentially have a negative impact on the flow of capital that then comes into the housing market? Mr. BERNANKE. I agree the sanctity of contract is very important. It shouldn't be rewritten unless there is evidence of fraud or deceit, or other problems in the contract itself. Mr. ROYCE. And there are several studies, I have seen econo- mists arguing that we could see a 2 percent increase in home loans, because banks would face increased uncertainty of future revenue if loans could be rescinded. And basically, the economists are look- ing at the prospect of a judge undermining existing contracts as a result of such a law. And that is one of the reasons I think mortgage debt has always been treated differently than other types of debt, it was to encour- age lower rates on a less risky investment. And so these lower rates are dependent upon the ability really of the lender to recover collateral, and that would be a heavy price to pay. The last line of questioning that I wanted to pursue with you is one on the estimates that have the deficit rising to $400 billion or more in the coming year. I think a lot of us were concerned about that $152 billion stimulus package. I voted against it because of my concern for what it would do, piling up the deficits. And you know now, we understand that in the Senate, they are working on a second bill, maybe in the $170 billion range without any offsetting spending cuts. And I just ask, are you concerned we may be headed toward the scenario that you described to the Sen- ate Budget Committee when you testified earlier this year? You said at that time you know something to the tune of "a vi- cious cycle may develop in which large deficits could lead to rapid 38 growth in debt and interest payments, which in turn adds to subse- quent deficits." And you said, "ultimately a big expansion of the na- tion's debt would spark a fiscal crisis, which could be addressed only by very sharp spending cuts tax increases, or both should such a scenario play out." If we didn't have the policy changes here in Congress to do some- thing about those deficits and thus I ask you about the magnitude of the deficits that we are running up with the stimulus package and now a second one being organized in the Senate. Your response please, Mr. Chairman? Mr. BERNANKE. Congressman, when I discussed whether the stimulus package should be undertaken, I emphasized it should be temporary and not affect the structural long-term deficit. I do think that there are serious issues with the long-term structural deficit, and they relate primarily to the aging of our society and therefore to entitlements and medical costs. And I stand by what I said to the Senate Budget Committee that it is very important to attack all those issues. Mr. ROYCE. Thank you, Mr. Chairman. Mr. CHAIRMAN. The gentleman from Texas, Mr. Hinojosa. Mr. HINOJOSA. Thank you, Chairman Frank. Chairman Bernanke, I want to follow up on what Congressman Kanjorski touched on briefly in his questions. As chairman of the Sub- committee on Higher Education, I am concerned about the impact that the current crisis in the housing market is having on the li- quidity of the overall marketplace, especially on student college loans. I have talked to banks who say that they are lending money to students and then they package the loans but are having difficulty placing them in the marketplace. Do you believe that we should have some contingency plans to ensure access to college student loans and what should those plans include? Mr. BERNANKE. Congressman, I believe about 80 to 85 percent of the student loans are federally backed or insured in some way. And to my knowledge, those securities are, or soon will be marketed normally. And so I don't expect that part of the market, which is a big part of the market, to have any sustained problems. With respect to the so-called private label student loans, there has been some withdrawal from that market, partly because Con- gress reduced the subsidy, I believe, to those lenders. And cer- tainly, the most recent episode has made it more difficult to market or securitize some of those loans. So there may be some disruption in that market, but I do think that this is a category of loans that has generally performed pretty well, and I expect to see that come back in the near future. I am not sure what else to suggest other than to encourage banks to continue to find new ways to market those loans. Again, most of that market is federally insured already, and I think those loans are going to be fine. Mr. HINOJOSA. The last question I would ask is, in today's news- paper, the Washington Post talks about the, I think they're called appraisers who are forced by someone to falsely increase their ap- praisal value of properties, and what that is doing of course is causing the homeowner to pay such high taxes and also to, in my 39 opinion, contribute to the current crisis in housing market. What are your recommendations for us to stop that and to get to what are realistic appraisals instead of what I just described? Mr. BERNANKE. Well, the Federal Reserve has tried to address that issue. For banks which we directly supervise, we have had a longstanding set of rules about working with appraisers to make sure they are not given incentives to overestimate the value of a property, for example. In our HOEPA regulations, which are out for comment, which I discussed briefly in my testimony, we include some new rules that would prohibit any lender, not just a bank, from explicitly or im- plicitly coercing an appraiser to overestimate the value of a prop- erty. So we are trying to address that in our rules. I'm not sure whether additional Federal action would be needed. My hope is that these steps will address the problem. Mr. HlNOJOSA. Thank you. I yield back, Mr. Chairman. The CHAIRMAN. The gentleman from Texas. Mr. HENSARLING. Thank you, Mr. Chairman, and again welcome, Chairman Bernanke. At a recent appearance before the Joint Eco- nomic Committee, you were quoted as saying, "A net increase in taxes that was substantial would probably not be advisable because of its effect on aggregate demand." In the same appearance, which I think was late last year, you also said, "A large increase in net taxes would tend to be a drag on consumer spending and the econ- omy through a number of different channels." My question is, Mr. Chairman, from your perspective, how do you define substantial? And how to you define large in the context of tax increases? Mr. BERNANKE. Well, I don't have a number in mind, but I'm sure there are small changes that can be made to the tax code. But in the current environment—where consumers are under a lot of pressure and the economy is slowing down—a tax increase that was a significant fraction of a percent of GDP, for example, would be a drag on the consumer, and our demand would have adverse short-term demand effects. Mr. HENSARLING. Well, let me try this one on you, Mr. Chair- man. As you know, presently the alternative minimum tax—Con- gress has a tendency to do what we all know is a 1-year patch— but the AMT is still alive and well. If we don't patch it beyond a year, we have 25 million taxpayers who will pay an average of an extra $2,000 in taxes. Would that qualify as a substantial increase, in your opinion? Mr. BERNANKE. My assumption is that Congress will either patch it or find some alternative solution. But— Mr. HENSARLING. Well, the chairman of the Ways and Means Committee has proposed an alternative that represents a $3.5 tril- lion tax increase over the next 10 years. Coupled with the expira- tion of tax relief that was passed in 2001 and 2003, 90 percent of all Americans would have their taxes raised. In your opinion, would that qualify as a substantial tax increase? Mr. BERNANKE. Congressman, there are two issues. What I was referring to earlier was that in the very short term, higher taxes would offset some of the effects of this fiscal stimulus package that we've seen. In the longer term, I agree that low taxes tend to pro- mote economic efficiency and economic growth, but they have to 40 balanced against the need for revenue for government programs that Congress may want to undertake. That is what Congress's principal job is, to figure out how much taxation is needed to sup- port worthwhile programs. So that is a decision for Congress. Mr. HENSARLING. Mr. Chairman, in today's testimony you said, "The vigor of the global economy has offset some of the weakening domestic demand and that U.S. export should continue to expand at a healthy pace, providing some impetus to domestic economic ac- tivity and employment." Would that be a rough translation that in today's economy, trade is good? Mr. BERNANKE. I think trade is always beneficial, but right now net exports are a positive source of demand and jobs and are help- ing to keep our economy stronger. Mr. HENSARLING. Would you be concerned, as there are I believe five, maybe six free trade agreements that are still pending in Con- gress that Fast-Track authority has expired, and that at least two major presidential candidates that I'm aware of have called for re- ducing trade with our major trading partners, Canada and Mexico? Might that be a bad thing for the economy? Mr. BERNANKE. I don't know the details or concerns people might have on individual agreements, but as a general matter, I think that open trade is beneficial to the economy. There may be disloca- tions that occur because of trade, and a better way to address those dislocations is to help those people directly rather than to shut down the trading mechanism. Mr. HENSARLING. There has been some discussion—I see my time is running out—on proposed credit card legislation. Certainly I guess for the first time in almost a quarter of a century the Fed is undertaking a soup-to-nuts review of Regulation Z. You've been quoted before in budget committee, where I also served, that more expensive and less available credit seems likely to be a source of restraint on economic growth. If the credit card legislation that might be considered by Congress—and I'm not speaking of any spe- cific bill—but if it had the net impact of causing credit card compa- nies to increase credit cost for millions of Americans and cut off ac- cess to credit for millions of other Americans, would that be a source of concern to you? Mr. BERNANKE. Well, it is important for people to know what it is they are buying. They need to have enough information to make a good decision, shop properly, and to get the product they think they are getting. So that is important. Onerous regulations, though, that reduce credit availability unconnected with the issues of disclosure, for example, would be negative in the current environment. Mr. HENSARLING. I am out of time. Thank you. The CHAIRMAN. The gentleman from Missouri. Mr. CLAY. Thank you, Mr. Chairman. Chairman Bernanke, I represent Missouri, and in my district over the last few years, we have experienced tremendous job losses, most notable among them being the losses associated with the de- mise of Arthur Anderson, the moving of the Ford automobile as- sembly plant, a transfer of over 2,000 white-collar jobs due to the BRAC realignment, and there are many more examples. And the 41 repercussions of the housing crisis are beginning to be catastrophic. As a result of these factors, we have many families who work more hours than before for less money, and their liabilities did not change. We have an economic stimulus package that is to be put in effect in the near future. What is being done and what can we realisti- cally expect in the matter of job creation during and beyond the dispersement of the stimulus package? And what can we do to gain back the jobs lost over the last decade? Mr. BERNANKE. Well, there are two separate issues here. First, there's the issue of the unemployment rate as it varies over the business cycle, and we project some increase in that unemployment rate as the economy has slowed down. The Federal Reserve is try- ing to balance off its various mandates, including full employment, and that will certainly be one of the things we're trying to achieve. We hope that any unemployment generated by the current episode will be transitory and we project that it will come back down over the next couple of years. The other set of issues has to do with structural changes arising from trade and technology and all kinds of other changes that our economy has. Frankly, I think that we have to be careful about try- ing to prevent change. That's part of a growing, dynamic economy to have change and development. The best solution over the longer term really, I would say, is two- fold. The first is skills, having a skilled work force that is adapt- able and can find opportunities wherever they may be. And sec- ondly, ways to make it easier for people to move between jobs or deal with temporary periods of unemployment. For example, help- ing to make health insurance or pensions portable between jobs, or otherwise helping people make those transitions. So I think what we want to do is, on the one hand, preserve a dynamic economy, but on the other hand, we want to help people adapt and be prepared for that dynamic economy. Mr. CLAY. DO you see much promise in green technology and the creation of jobs in that sector? Mr. BERNANKE. Well, green technology will no doubt create jobs, but I think the right considerations are: Is this a cost-effective way of achieving the environmental objectives that society has? And we don't want to undertake projects that are not very beneficial just to create jobs. We want to look for projects that are effective at achieving their objectives. Mr. CLAY. Yes, but haven't we learned that a robust economy only for the wealthiest 2 to 10 percent isn't good for the country, and that we ought to be looking at ways to turn the economy around by creating jobs? Mr. BERNANKE. I have talked about inequality and the concerns that raises, and there are a number of ways to address that. But I think the most important is through skill development. Mr. CLAY. And so you would go through skill development other than assisting new technology and assisting new industries in get- ting on line? Mr. BERNANKE. Well, there's a case for the government to sup- port very basic research, but in the case of applied research, gen- 42 erally speaking companies have plenty of incentives to undertake that. Mr. CLAY. Okay. Thank you so much. The CHAIRMAN. The gentleman from Connecticut. Mr. SHAYS. Thank you, Mr. Bernanke. I'd like to cover three areas if I could: Rating agencies; denomination of oil; and the spread of interest and you're lowering rates and interest rates for homeowners going up. First off, have the rating agencies made themselves irrelevant? Have they destroyed their brand? And are they going to be an orga- nization we listen to in the future? Mr. BERNANKE. The rating agencies perform a very important function, and clearly there have been problems in the last few years. They are doing internal reviews and reforms, but we are also looking at it—in fact, on an international basis—to figure out ways to make that work better. Mr. SHAYS. IS there a concern that in order to gain credibility, that they're going to overstate the future liabilities and just accel- erate the reduction of wealth by their looking and devaluing hold- ings? Mr. BERNANKE. DO I think they're going to be too aggressive in terms of downgrading? Mr. SHAYS. Yes. Mr. BERNANKE. I hope that they don't do that, because that would be unconstructive. I hope that they make fair evaluations and try to address the actual credit risk associated with each asset. But there is a bit of risk there, I agree. Mr. SHAYS. Okay. Let me just ask you in regards to—I look at OPEC and I see $100 a barrel, but then I realize that from their standpoint, it's like we're at $50 or $60. Is there a concern that you have that they will go to look at the Euro to value their oil per bar- rel, and if so, what would be its impact? Mr. BERNANKE. The price of oil is set in a global market and re- sponds very quickly to changes in supply/demand as well as cur- rency changes. I'm not aware of any imminent plan to change the currency denomination of oil, but I don't think it would make a major difference to the U.S. economy. Mr. SHAYS. What I used to look at, though, is I would say, you know, OPEC, the price is so high that they are causing tremendous dislocation throughout the world. But from their standpoint, they're saying, you know, we're not getting that much more. And I'm wondering, have you had dialogue with OPEC about this issue, or with folks indirectly about this issue from overseas? Mr. BERNANKE. Whether they price it in dollars, euros, or some- thing else, the exchange rate is known, and so they can always cal- culate the value. I don't think they misunderstand the fact that they are getting a very high price for their oil. Mr. SHAYS. Let me just ask you, in regards to, you've already talked about the spread, the Fed rate, and banks which are private institutions setting mortgages higher—we had a hearing yesterday that was rather depressing and made me want to buy gold—and the bottom line was: We increased the supply of housing exceeding demand, which really accelerated our just trying to have people buy homes, who shouldn't have. And the question is: Does this in- 43 credible excess supply of housing negate what you're trying to do in lowering interest rates? Mr. BERNANKE. Well, the housing market is correcting for that reason, and house prices are declining. But at some point the mar- ket will stabilize, and demand will come back into the market. Con- struction, which is already down more than half, will begin to sta- bilize, and then subsequently prices will begin to stabilize. That's what we're looking forward to. Mr. SHAYS. Well, when do think they will stabilize? Mr. BERNANKE. It is very difficult to know and we have been wrong before. But given how much construction has come down al- ready, I imagine that by later this year, housing will stop being such a big drag directly on GDP. Prices may decline into next year, but we don't really know. The useful thing to appreciate, I guess, is that as house prices fall, they are self-correcting in a way be- cause part of the reason that prices peaked and began to come down was that housing had become unaffordable. The median fam- ily couldn't afford a median home. As prices come down and incomes go up, you get more afford- ability and therefore more people come into the market. Mr. SHAYS. Thank you very much. Thanks for your generosity and for spending time here. Mr. BERNANKE. Thank you. Mr. MILLER OF NORTH CAROLINA, [presiding] The gentleman from Massachusetts, Mr. Lynch. Mr. LYNCH. Thank you, Mr. Chairman, and Chairman Bernanke. I want to go back for just a second. I know that Mr. Meeks asked you about these sovereign wealth funds, and I appreciate your re- sponse that currently right now it's not a big number. Although I think there are reports that there are about $3 trillion in assets right now in these sovereign wealth funds, probably more than the hedge funds and private equity funds combined. And notwithstanding some of the help, as you have noted, they have given in terms of stabilizing some of the effects of the subprime fallout, there is a growing concern, not only here in this Congress on both sides of the aisle, and also hearing it from the EU commissioner, President Sarkozy, that number one, there's very little transparency in terms of the operation of these govern- ment-controlled funds. Number two, there is the fear, unrealized thus far, that these government-controlled funds could invest for political purposes in- stead of a straight return on investment. And what I'm hearing from my colleagues and what we're hearing from the EU and some others is that a sort of protectionist response is coming forward, and I don't necessarily think that is a good thing in the long term in terms of a response to this type of investment by sovereign wealth funds. But you've been dealing, from your testimony, you've been dealing with some of these central banks. We're having a hearing on this next week, but we won't have the benefit of your counsel. What do you think in terms of your dealings with these central banks, might be an appropriate response that could head off some of the, I think, short-view, narrow-view protectionist re- sponses to the sovereign wealth funds activities? 44 Mr. BERNANKE. Well, I hope the sovereign wealth funds under- stand and appreciate that it is in their own interest, if they want to have access to advanced economies like the United States, that they be sufficiently transparent as to inspire confidence that their motives are economic and not political or otherwise. So we have been encouraging that in discussions and inter- national meetings, for example. And their reply is, "Well, if you'll be open to us, we'll be open to you." And I think that's where we need to be heading. The international agencies, like the International Monetary Fund and the OECD, are working on developing codes of conduct that both the sovereign wealth funds and perhaps the recipients of sov- ereign wealth fund monies may wish to adopt, that determine the transparency, the governance, the behavior of these funds, and the behavior of the host countries. And I do think there is a mutual benefit for us to work together to make sure that, on the one hand, they are, in fact, investing on an economic basis, and, on the other hand, that we are receiving that investment in an open way. Mr. LYNCH. And you're suggesting these would be—I know the discussion right now is voluntary codes of conduct, which would work on our side because we have a number of, I think, self-gov- erning aspects, but those aren't necessarily shared in a lot of these other central banks. Is there any proposition out there to have something that might have some teeth beyond the simple voluntary adoption? Mr. BERNANKE. I think at this point we are making good progress with conversations and discussions, international meet- ings, and I'm hopeful that this will work itself out. Mr. LYNCH. All right. Fair enough. Mr. Chairman, I know you have a shortage of time, so I am going to yield back. Mr. MILLER OF NORTH CAROLINA. Thank you. The gentleman from New Jersey, Mr. Garrett. Mr. GARRETT. I thank the gentleman for yielding, and I thank the Chairman for being here. I would like to preface my question to the Chairman today by first of all voicing my strong concerns with the plan that has been put out recently by the leadership of this committee and others, that would allow the Federal Housing Administration to purchase over 1 million homes over a 5-year period. The conservative cost projections in the committee's budget and the review's estimates that this would at the very least have the Federal Government in the house-buying business to the tune of $15 billion, and this is on top of another proposal that is being worked on right now that would provide as much as $20 billion in the forms of loans and grants, maybe a combination of the two, for the purchase of fore- closed or abandoned homes at or below the market values. Now, there is some justification that has been put out on this in the press by them, that says that there's some public mention that a similar proposal to this was enacted back in the 1930's during the Depression to help distressed homeowners and families. And I know we've heard testimony today and recently, experiencing the rough economic times and the slower-than-expected economic growth, maybe even a recession now or in the future. But based on 45 what I've read and heard, including the witnesses that have come before the committee, I haven't heard anyone saying that we're anywhere near a Depression. So this leads me, Chairman, to this question. If we're going to go and consider such Depression Era ideas as these during these economic downturns, what could we possibly consider if the econ- omy grows even worse than it is today? Mr. BERNANKE. Well, you surprised me there. I thought you were going to ask me about this particular program. Mr. GARRETT. Well, I know your response usually when we ask for particular programs, what your response is. Mr. BERNANKE. Well, it depends on the circumstances. It de- pends on why the economy is worsening and where the problem is. My attitude is that we need to be flexible and address the situation as it arises. It is very hard to conjecture in advance how you will respond to a situation that will have many dimensions to it. In respect to the particular program you mentioned, I think it is worthwhile to be thinking about possible approaches one might take if the housing situation were to get much worse. At the mo- ment, I think that the remedies I would support are expanded pri- vate-sector activities, FHA modernization, GSE reform. Mr. GARRETT. But we don't have to go as far as this until that date comes when things get worse? Mr. BERNANKE. I don't think we're at that point, but I do think it's worthwhile to keep thinking about those issues. I think that are a lot of difficulties, practical difficulties. How would you, for ex- ample, determine who to help? How would you ensure that the loans that you bought were not the bad apples in the barrel? There are a lot of difficult, technical problems. The Federal Reserve is working on issues like this just to try to understand how these things might work. Again, my attitude is that we need to be thinking about different alternatives and pre- paring for contingencies, but at the moment I am satisfied with the general approach that we're currently taking. Mr. GARRETT. I appreciate that. You know, it sometimes seems like Congress is like that old axiom about old generals, that they're always just fighting the last war, as we go into the next battle. Is that the case with regard to regulations as well, that no one really predicted, most people didn't really predict where we are right now, a couple of years ago, or 2 or 3 years ago? So could we get maybe the worst of both worlds if we go in this direction that some are talking about, that we get: (a) the regulations that will maybe tighten the credit market too much on the one hand; and (b) we're still not going to predict what the brilliant minds on Wall Street are going to come up some way to do an end-run around it anyway? Mr. BERNANKE. Well, there is a certain tendency to fight the last war in all areas of effort. But, as this episode has found areas of weakness and problems, we need to do our best to address them, and do our best to be alert to new problems that might crop up in other unforeseen areas. Mr. GARRETT. And just to close, the two gentlemen raised the issue about the dollar and the falling value there, the old axiom in there is, you know, inflation comes when too many dollars are chasing too few goods. So far, what we've done on the fiscal side 46 of this is basically throw more dollars into it with a stimulus pack- age, and my two questions to you are: One, does that do anything to actually change the mind set of creditors as far as their lending practice as a short-term lending like that? Does that really change their actual lending practices. And two, with the overall dollar value, there was an article in the Wall Street Journal today by David Ranson, I believe it is, which looks to say as far as the CPI and the way that we're evaluating the value of these things, that they're really backwards-looking and not forwards-looking, and that maybe we need to change the structure as to how we looked and measured the CPI and some of these valuations as well, in ad- dition. Mr. BERNANKE. Well, I think the Bureau of Labor Statistics does a reasonably good job of measuring consumer prices, and that's the index that we're looking at. What was your, sorry, your first question was? Mr. GARRETT. Well, the first question is, you know, maybe we're looking at this again backwards-looking to some extent, by throw- ing more dollars into the system. One is—we do it one way by throwing dollars through fiscal. You do it the other way by loos- ening up credit. Isn't that just chasing more dollars after we're not producing any more goods? Mr. BERNANKE. Again, the concern is that the economy will be producing less than its capacity, that there will be insufficient de- mand to use the existing capacity of the economy—that is the defi- nition of economic slow-down. So, monetary policy and fiscal policy can be used to address that problem. I don't think it would change the practices of lenders, but it might make them somewhat more confident that the economy would be stronger and make them a little bit more willing to lend. Mr. GARRETT. I appreciate it. Mr. MILLER OF NORTH CAROLINA. The gentleman's time has ex- pired. I now recognize myself. Mr. Chairman, I know that before you had this job, you were the CEO of the Princeton Economics Depart- ment. Mr. BERNANKE. That's correct. Mr. MILLER OF NORTH CAROLINA. And I wanted to pursue a question that Mr. Moore of Kansas asked you. He said that there was legislation now pending that would treat home mortgages and bankruptcy the same way credit card debt was treated. I don't know of any legislation like that. There is, however, legislation pending in both the House and the Senate that would make the treatment of home loans and bankruptcy the same as any other form of secure debt, including debt on investment property, mort- gages on investment property, mortgages on vacation property, car loans, boat loans, loans on a washer and a dryer, or debt secured by any other asset. You said that you thought one result might be changing the bankruptcy law, higher interest rates. And in fact the opponents of that legislation have made some pretty dire predictions that no lender would lend with less than 20 percent equity, that they would make more than an 80 percent loan and the interest rates would go up a point and a half or two points, two and a half points. 47 But they have not produced any kind of economic analysis to sup- port that. I know one member who has said that they offered to let him see—they had an analysis, they'd let him see it privately, which sounded more the way you got offered to look at dirty pic- tures in the old days, not how you looked at economic analysis. A couple of weeks ago, there was a Georgetown study by a fellow named Levitan, that compared the terms of availability of mort- gage lending in places in the United States at the same time that had different laws in effect. Between 1978 and 1994, the courts in different parts of the country interpreted the bankruptcy laws dif- ferently, interpreted whether mortgages could be modified dif- ferently, so in some parts of the country they're being modified fair- ly freely, in some not at all. And the result of that study was that there was no real dif- ference in the terms of availability of credit, and estimated that if there was any real difference at all, it might be 0.1 percent of an interest rate. Are you familiar with any economic study—and again, I assume that I'm correct that the way economists do things is they publish, they let others look at their factual assumptions, follow their logic, and how they reach their conclusions; I think at the Ph.D. level that's called "peer review"; in 8th-grade math class we called that "showing your work." It's the same concept. Are you familiar with any economic analysis that shows a substantial dif- ference in the availability or terms of credit, based upon how mort- gages are treated in bankruptcy? Mr. BERNANKE. Well, elementary analysis would suggest that if the security or the collateralization was less, there would be more of a risk premium of some kind, although it is hard to judge how much. I am not familiar with the study you mentioned, but I would be really interested to see it. Mr. MILLER OF NORTH CAROLINA. Okay. Does that sound like a valid basis for a study for a prediction is if one part of the country had in effect the law as legislation would make it, another part of the country had law in effect at the same time as what the law is now to compare the terms of availability of credit in those two areas? Mr. BERNANKE. That is an interesting approach. I think you would have to make sure that you were controlling for other fac- tors, like regional and other differences, that might also be affect- ing the rates. Mr. MILLER OF NORTH CAROLINA. Okay. I also asked the Con- gressional Research Service to look at—before 1978 the law, bank- ruptcy law is treated, secured or mortgages on investment property and mortgages on homes exactly the same. Neither one could be modified in bankruptcy. After that, at least in some parts of the country, they could not— it remained the same for home mortgages, and it became—it could be modified as to investment properties. I asked them to look at terms of availability of credit before and after 1978 for investment property versus home mortgages. And the conclusion was that if anything credit became more available for investment properties after 1978. There was an increase in mortgage lending, above that for home lending and the terms and 48 credit, the terms and availability, the term seemed to be about the same. But it concluded that it was probably not the result of changes in the law, it was that there were so many forces in effect that it was almost impossible to identify any change. Does that sound cor- rect? Mr. BERNANKE. I don't know that study either. I think it would be interesting to see the difference in terms and availability be- tween primary residences and investment properties today. I think there probably would be some difference at this point. But it would be worth evaluating that more carefully. Mr. MILLER OF NORTH CAROLINA. Okay. But there are several times when the law has changed, and the law has been different in one place or another. Another difference is the State law is on anti-deficiency, on deficiency judgements. Several States, including the world's 5th largest—in California have anti-deficiency statues. All the evidence is that the terms and availability of credit is really no different. Does that suggest, is that a valid basis to con- clude that there is not a substantial change in the terms of avail- ability of credit from changes in the bankruptcy laws? Mr. BERNANKE. Well first of all, I think that taking this empir- ical approach is very worthwhile. This is the kind of thing that can be useful in providing information, but I really can't comment on the quality of the studies you mentioned without looking at— Mr. MILLER OF NORTH CAROLINA. Right, well I know that you haven't seen the study. It was a Georgetown University study. It was, it had foundation funding. It looked like an academic study, it had footnotes, it had charts. It had all those things that you ex- pect of academic studies. And I understand that you haven't reviewed it, but does the basis of the analysis sound like a legitimate basis generally? Mr. BERNANKE. It is an interesting approach to the issue. Mr. MILLER OF NORTH CAROLINA. And you don't know of any study that shows that there is a basis for conclusion that there is a substantial point and a half difference in interest rates? Mr. BERNANKE. I have not reviewed any, no. Mr. MILLER OF NORTH CAROLINA. Okay. The gentleman from Texas, Mr. Green. Mr. GREEN. Thank you, Mr. Chairman, and I thank the chair- man and ranking member for holding this hearing. Chairman Bernanke, it is good to see you again. You have had a very difficult job, and because time is of the essence, I will have but one question that may have a follow-up or two to it. There has been much talk about freezing interest rates for some period of time; one notion is freezing them for approximately 5 years. Would you give us please your thoughts on what the results will be, freezing the interest rates for some period of time, approxi- mately 5 years. My suspicion is that you might cover whether this would cause a shift in investment to other areas, if you would please. Mr. BERNANKE. Well, the idea of the freeze is to find a strategy by which lenders can work out larger numbers of loans. They are facing an unusual situation. Usually each loan, each foreclosure, 49 each delinquency, is different; it depends on personal cir- cumstances. Here we have a situation where literally hundreds of thousands of families or individuals may be facing foreclosure based on broad macroeconomic phenomenon—basically the decline in house prices and concerns with subprime lending. And the issue is, are there ways to be more efficient in working out loans and at larger scale? A freeze, which is what has been suggested by the HOPE NOW approach, is one way to do that. That could be a way to get more time to work out those loans. Again, it is a voluntary approach that they have come to through discussion. It doesn't address by any means all people in this situation. For example, there are a lot of loans that default even before the interest rate resets. Mr. GREEN. Let me intercede for just a moment. If we had a mandatory freeze, what would be the impact, please? Mr. BERNANKE. I don't know what the quantitative impact would be, frankly. Again, it would help some people. There are others who are delinquent even prior to the reset or who have other reasons to be delinquent. Mr. GREEN. Without talking about, if we can, the persons who might benefit directly from the freeze, let's talk about investors. Would it create any sort of shift in investments from mortgages to some other form of investments? Mr. BERNANKE. Well, this goes back to the question I was asked earlier about contracts, and I think that it would be a fairly sub- stantive step to re-write the existing contracts. And Congress would have to give that very serious consideration, because it would affect the valuation of the mortgages and behavior of inves- tors. Mr. GREEN. Thank you very much, Mr. Chairman. I yield back so that you may leave in a timely manner. Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Green, and thank you, Mr. Chairman. I think Chairman Frank promised to have you out by 1 p.m. You are getting 40 seconds extra, and if we both stay in our jobs for a really, really long time, I may sit here some time for your future testimony. Mr. BERNANKE. Thank you. Mr. MILLER OF NORTH CAROLINA. We stand adjourned. [Whereupon, at 1:00 p.m., the hearing was adjourned.] APPENDIX February 27, 2008 (51) 52 Congressman Ron Paul Statement for the Record Financial Services Committee Hearing Monetary Policy and the State of the Economy February 27,2008 Mr. Chairman, A topic that is on the lips of many people during the past few months, and one with which I have greatly concerned myself, is that of moral hazard. We hear cries from all comers, from politicians, journalists, economists, businessmen, and citizens, clamoring for the federal government to intervene in the economy in order to forestall a calamitous recession. During the boom, many of these same individuals called for no end to the Fed's easy credit. Now that the consequences of that easy money policy are coming home to roost, no one wants to face those ill effects. We have already seen a plan from the administration to freeze mortgages, a plan which is alleged to be only a temporary program. As with other programs that have come through this committee, I believe we ought to learn from history and realize that "temporary" programs are almost anything but temporary. When this program expires and mortgage rates reset, we will see new calls for a rate-freeze plan, maybe for two years, maybe for five, or maybe for more. Some drastic proposals have called for the federal government to purchase existing mortgages and take upon itself the process of rewriting these and guaranteeing the resulting new mortgages. Aside from exposing the government to tens of billions of dollars of potentially defaulting mortgages, the burden of which will ultimately fall on the taxpayers, this type of plan would embed the federal government even deeper into the housing market and perpetuate instability. The Congress has, over the past decades, relentlessly pushed for increased rates of homeownership among people who have always been viewed by the market as poor credit risks. Various means and incentives have been used by the government, but behind all the actions of lenders has been an implicit belief in a federal bailout in the event of a crisis. What all of these proposed bailouts fail to mention is the moral hazard to which bailouts lead. If the federal government bails out banks, investors, or homeowners, the lessons of sound investment and fiscal discipline will not take hold. We can see this in the financial markets in the boom and bust of the business cycle. The Fed's manipulation of interest rates results in malinvestment which, when it is discovered, leads to economic contraction and liquidation of malinvested resources. But the Fed never allows a complete shakeout, so that before a return to a sound market can occur, the Fed has already bailed out numerous market participants by undertaking another bout of loose money before the effects of the last business cycle have worked their way through the economy. Many market actors therefore continue to undertake risky investments and expect that in the future, if their investments go south, that the Fed would and should intervene by creating more money and credit. The result of these bailouts is that each successive recession runs the risk of becoming larger and more severe, requiring a stronger reaction by the Fed. Eventually, however, the Fed begins to run out of room in which to maneuver, a problem we are facing today. 1 urge my colleagues to resist the temptation to call for easy fixes in the form of bailouts. If we fail to address and stem the problem of moral hazard, we are doomed to experience repeated severe economic 53 For release on delivery 10:00 a.m. EST February 27, 2008 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 27, 2008 54 Chairman Frank, Ranking Member Bachus, and other members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. In my testimony this morning I will briefly review the economic situation and outlook, beginning with developments in real activity and inflation, then turn to monetary policy. I will conclude with a quick update on the Federal Reserve's recent actions to help protect consumers in their financial dealings. The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted; and pressures on bank capital and the continued poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domestic product (GDP) held up well through the third quarter despite the financial turmoil, but it has since slowed sharply. Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate-at 4.9 percent in January-has moved up somewhat. Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market. In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course. Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in most areas. Changes in the availability of mortgage credit amplified the swings in the housing market. During the housing sector's expansion phase, increasingly lax lending standards, particularly in the subprime market, raised the effective demand for housing, pushing up prices and stimulating construction activity. As the housing market began to turn down, however, the slump in subprime mortgage originations, together with a more general tightening of credit conditions, has 55 - 2 - served to increase the severity of the downturn. Weaker house prices in turn have contributed to the deterioration in the performance of mortgage-related securities and reduced the availability of mortgage credit. The housing market is expected to continue to weigh on economic activity in coming quarters. Homebuilders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and closely related industries. Consumer spending continued to increase at a solid pace through much of the second half of 2007, despite the problems in the housing market, but it appears to have slowed significantly toward the end of the year. The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in spending, as did the declines in household wealth associated with the weakness in house prices and equity prices. Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the three months ending in January, compared with an average increase of almost 100,000 per month over the previous three months. However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year. The business sector has also displayed signs of being affected by the difficulties in the housing and credit markets. Reflecting a downshift in the growth of final demand and tighter credit conditions for some firms, available indicators suggest that investment in equipment and software will be subdued during the first half of 2008. Likewise, after growing robustly through much of 2007, nonresidential construction is likely to decelerate sharply in coming quarters as business activity slows and funding becomes harder to obtain, especially for more speculative projects. On a more encouraging note, we see few signs of any serious imbalances in business 56 -3- inventories aside from the overhang of unsold homes. And, as a whole, the nonfinancial business sector remains in good financial condition, with strong profits, liquid balance sheets, and corporate leverage near historical lows. In addition, the vigor of the global economy has offset some of the weakening of domestic demand. U.S. real exports of goods and services increased at an annual rate of about 11 percent in the second half of last year, boosted by continuing economic growth abroad and the lower foreign exchange value of the dollar. Strengthening exports, together with moderating imports, have in turn led to some improvement in the U.S. current account deficit, which likely narrowed in 2007 (on an annual basis) for the first time since 2001. Although recent indicators point to some slowing of foreign economic growth, U.S. exports should continue to expand at a healthy pace in coming quarters, providing some impetus to domestic economic activity and employment. As I have mentioned, financial markets continue to be under considerable stress. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the financial markets in recent months. To help relieve the pressures in the market for interbank lending, the Federal Reserve—among other actions—recently introduced a term auction facility (TAF), through which prespecified amounts of discount window credit are auctioned to eligible borrowers, and we have been working with other central banks to address market strains that could hamper the achievement of our broader economic objectives. These 57 -4- efforts appear to have contributed to some improvement in short-term fiinding markets. We will continue to monitor financial developments closely. As part of its ongoing commitment to improving the accountability and public understanding of monetary policy making, the Federal Open Market Committee (FOMC) recently increased the frequency and expanded the content of the economic projections made by Federal Reserve Board members and Reserve Bank presidents and released to the public. The latest economic projections, which were submitted in conjunction with the FOMC meeting at the end of January and which are based on each participant's assessment of appropriate monetary policy, show that real GDP was expected to grow only sluggishly in the next few quarters and that the unemployment rate was seen as likely to increase somewhat. In particular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2-1/2 percent to 2-3/4 percent projected in our report last July. FOMC participants' projections for the unemployment rate in the fourth quarter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4-3/4 percent projected last July for the same period. The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial turmoil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend and the unemployment rate edging lower; the improvement reflects the effects of policy stimulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets. The incoming information since our January meeting continues to suggest sluggish economic activity in the near term. 58 -5- The risks to this outlook remain to the downside. The risks include the possibilities that the housing market or labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further. Consumer price inflation has increased since our previous report, in substantial part because of the steep run-up in the price of oil. Last year, food prices also increased significantly, and the dollar depreciated. Reflecting these influences, the price index for personal consumption expenditures (PCE) increased 3.4 percent over the four quarters of 2007, up from 1.9 percent in 2006. Core price inflation—that is, inflation excluding food and energy prices—also firmed toward the end of the year. The higher recent readings likely reflected some pass-through of energy costs to the prices of core consumer goods and services as well as the effect of the depreciation of the dollar on import prices. Moreover, core inflation in the first half of 2007 was damped by a number of transitory factors—notably, unusually soft prices for apparel and for financial services—which subsequently reversed. For the year as a whole, however, core PCE prices increased 2.1 percent, down slightly from 2006. The projections recently submitted by FOMC participants indicate that overall PCE inflation was expected to moderate significantly in 2008, to between 2.1 percent and 2.4 percent (the central tendency of the projections). A key assumption underlying those projections was that energy and food prices would begin to flatten out, as was implied by quotes on futures markets. In addition, diminishing pressure on resources is also consistent with the projected slowing in inflation. The central tendency of the projections for core PCE inflation in 2008, at 2.0 percent to 2.2 percent, was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices. Beyond 2008, both overall and core inflation were projected to edge lower, as participants expected inflation expectations to remain reasonably well-anchored and pressures on resource utilization to be muted. The inflation 59 -6- projections submitted by FOMC participants for 2010-which ranged from 1.5 percent to 2.0 percent for overall PCE inflation—were importantly influenced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate and about the time frame over which policy should aim to attain those rates. The rate of inflation that is actually realized will of course depend on a variety of factors. Inflation could be lower than we anticipate if slowcr-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect. Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate. Indeed, the further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month. Should high rates of overall inflation persist, the possibility also exists that inflation expectations could become less well anchored. Any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC to counter shortfalls in growth in the future. Accordingly, in the months ahead, the Federal Reserve will continue to monitor closely inflation and inflation expectations. Let me turn now to the implications of these developments for monetary policy. The FOMC has responded aggressively to the weaker outlook for economic activity, having reduced its target for the federal funds rate by 225 basis points since last summer. As the Committee noted in its most recent post-meeting statement, the intent of those actions has been to help promote moderate growth over time and to mitigate the risks to economic activity. 60 -7- A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risks to growth, stressed financial conditions, and inflation pressures. In particular, the FOMC will need to judge whether the policy actions taken thus far are having their intended effects. Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation as well as the risks to that forecast. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks. * * * Finally, I would like to say a few words about the Federal Reserve's recent actions to protect consumers in their financial transactions. In December, following up on a commitment I made at the time of our report last July, the Board issued for public comment a comprehensive set of new regulations to prohibit unfair or deceptive practices in the mortgage market, under the authority granted us by the Home Ownership and Equity Protection Act of 1994. The proposed rules would apply to all mortgage lenders and would establish lending standards to help ensure that consumers who seek mortgage credit receive loans whose terms are clearly disclosed and that can reasonably be expected to be repaid. Accordingly, the rules would prohibit lenders from engaging in a pattern or practice of making higher-priced mortgage loans without due regard to consumers' ability to make the scheduled payments. In each case, a lender making a higher- priced loan would have to use third-party documents to verify the income relied on to make the credit decision. For higher-priced loans, the proposed rules would require the lender to establish 61 an escrow account for the payment of property taxes and homeowners' insurance and would prevent the use of prepayment penalties in circumstances where they might trap borrowers in unaffordable loans. In addition, for all mortgage loans, our proposal addresses misleading and deceptive advertising practices, requires borrowers and brokers to agree in advance on the maximum fee that the broker may receive, bans certain practices by servicers that harm borrowers, and prohibits coercion of appraisers by lenders. We expect substantial public comment on our proposal, and we will carefully consider all information and viewpoints while moving expeditiously to adopt final rules. The effectiveness of the new regulations, however, will depend critically on strong enforcement. To that end, in conjunction with other federal and state agencies, we are conducting compliance reviews of a range of mortgage lenders, including nondepository lenders. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of, and improved enforcement for, all categories of mortgage lenders. The Federal Reserve continues to work with financial institutions, public officials, and community groups around the country to help homeowners avoid foreclosures. We have called on mortgage lenders and servicers to pursue prudent loan workouts and have supported the development of streamlined, systematic approaches to expedite the loan modification process. We also have been providing community groups, counseling agencies, regulators, and others with detailed analyses to help identify neighborhoods at high risk from foreclosures so that local outreach efforts to help troubled borrowers can be as focused and effective as possible. We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue. 62 -9- In addition to our consumer proteetion efforts in the mortgage area, we are working toward finalizing rules under the Truth in Lending Act that will require new, more informative, and consumer-tested disclosures by credit card issuers. Separately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards. Using the Board's authority under the Federal Trade Commission Act, we expect to issue proposed rules regarding these practices this spring. Thank you. I would be pleased to take your questions. 63 64 Monetary Policy Report to the Congress Submitted pursuant to section 2B of the Federal Reserve Act February 27,2008 - = --"--=? -=- -v Board of Governors of the Federal Reserve System 65 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 27,2008 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, 3en Bemanke, Chairman 66 Contents Parti 1 Overview: Monetary Policy and the Economic Outlook Part 2 3 Recent Economic and Financial Developments 3 The Household Sector 3 Residential Investment and Finance 7 Consumer Spending and Household Finance 10 The Business Sector 10 Fixed Investment 11 Inventory Investment 12 Corporate Profits and Business Finance 14 The Government Sector 14 Federal Government 16 State and Local Government 16 National Saving 17 The External Sector 17 International Trade 18 The Financial Account 19 The Labor Market 19 Employment and Unemployment 20 Productivity and Labor Compensation 21 Prices 23 Financial Markets 23 Market Functioning and Financial Stability 29 Policy Expectations and Interest Rates 30 Equity Markets 30 Debt and Financial Intermediation 32 The M2 Monetary Aggregate 32 International Developments 3 2 International Financial Markets 33 Advanced Foreign Economies 34 Emerging-Market Economies Part 3 37 Monetary Policy in 2007 and Early 2008 Part 4 41 Summary of Economic Projections 67 Parti Overview: Monetary Policy and the Economic Outlook The U.S. economy has weakened considerably since rities backed by such mortgages. The loss of confidence last July, when the Federal Reserve Board submitted its reduced investors' overall willingness to bear risk and previous Monetary Policy Report to the Congress, Sub- caused them to reassess the soundness of the structures stantial strains have emerged in financial markets here of other financial products. That reassessment was and abroad, and housing-related activity has continued accompanied by high volatility and diminished liquidity to contract. Also, further increases in the prices of crude in a number of financial markets here and abroad. The oil and some other commodities have eroded the real pressures in financial markets were reinforced by banks' incomes of U.S. households and added to business concerns about actual and potential credit losses. In costs. Overall economic activity held up reasonably addition, banks recognized that they might need to take well into the autumn despite these adverse develop- a large volume of assets onto their balance sheets— ments, but it decelerated sharply in the fourth quarter. including leveraged loans, some types of mortgages, Moreover, the outlook for 2008 has become less favor- and assets relating to asset-backed commercial paper able since last summer, and considerable downside risks programs—given their existing commitments to cus- to economic activity have emerged. Headline consumer tomers and the increased resistance of investors to pur- price inflation picked up in 2007 as a result of sizable chasing some securitized products. In response to those increases in energy and food prices, while core infla- unexpected strains, banks became more conservative tion (which excludes the direct effects of movements in in deploying their liquidity and balance sheet capacity, energy and food prices) was, on balance, a little lower leading to tighter credit conditions for some businesses than in 2006. Nonetheless, with inflation expectations and households. The combination of a more negative anticipated to remain reasonably well anchored, energy economic outlook and a reassessment of risk by inves- and other commodity prices expected to flatten out, and tors precipitated a steep fall in Treasury yields, a sub- pressures on resources likely to ease, monetary policy stantial widening of spreads on both investment-grade makers generally have expected inflation to moderate and speculative-grade corporate bonds, and a sizable somewhat in 2008 and 2009. Under these circum- net decline in equity prices. stances, the Federal Reserve has eased the stance of Initially, the spillover from the problems in the monetary policy substantially since July. housing and financial markets to other sectors of the The turmoil in financial markets that emerged last economy was limited. Indeed, in the third quarter, real summer was triggered by a sharp increase in delinquen- gross domestic product (GDP) rose at an annual rate cies and defaults on subprime mortgages. That increase of nearly 5 percent, in part because of solid gains in substantially impaired the functioning of the secondary consumer spending, business investment, and exports. markets for subprime and nontraditional residential In the fourth quarter, however, real GDP increased only mortgages, which in turn contributed to a reduction in slightly, and the economy seems to have entered 2008 the availability of such mortgages to households. Partly with little momentum. In the labor market, growth in as a result of these developments as well as continuing private-sector payrolls slowed markedly in late 2007 concerns about prospects for house prices, the demand and January 2008. The sluggish pace of hiring, along for housing dropped further. In response to weak with higher energy prices, lower equity prices, and soft- demand and high inventories of unsold homes, home- ening home values, has weighed on consumer sentiment builders continued to cut the pace of new construction and spending of late. In addition, indicators of business in the second half of 2007, pushing the level of single- investment have become less favorable recently. How- family starts in the fourth quarter more than 50 percent ever, continued expansion of foreign economic activ- below the high reached in the first quarter of 2006. ity and a lower dollar kept U.S. exports on a marked After midyear, as losses on subprime mortgages and uptrend through the second half of last year, providing related structured investment products continued to some offset to the slowing in domestic demand. mount, investors became increasingly skeptical about Overall consumer priee inflation, as measured by the likely credit performance of even highly rated secu- the price index for personal consumption expenditures 68 2 Monetary Policy Report to the Congress D February 2008 (PCE), stepped up to 3lA percent over the four quarters ruptions in financial markets. The Committee reduced of 2007 because of the sharp increase in energy prices the target 25 basis points at its October meeting and did and the largest rise in food prices in nearly two decades. so again at the December meeting. In the weeks fol- Core PCE price inflation picked up somewhat in the lowing that meeting, the economic outlook deteriorated second half of last year, but the increase came on the further, and downside risks to growth intensified; the heels of some unusually low readings in the first half; FOMC cut an additional 125 basis points from the tar- core PCE price inflation over 2007 as a whole averaged get in January—75 basis points on January 22 and slightly more than 2 percent, a little less than in 2006. 50 basis points at its regularly scheduled meeting on The Federal Reserve has taken a number of steps January 29-30. since midsummer to address strains in short-term fund- Since the previous Monetary Policy Report, the ing markets and to foster its macrocconomic objec- FOMC has announced new communications proce- tives of maximum employment and price stability. dures, which include publishing enhanced economic With regard to short-term funding markets, the Fed- projections on a timelier basis. The most recent projec- eral Reserve's initial actions when market turbulence tions were released with the minutes of the January emerged in August included unusually large open mar- FOMC meeting and are reproduced in part 4 of this ket operations as well as adjustments to the discount report. Economic activity was expected to remain soft rate and to procedures for discount window borrowing in the near term but to pick up later this year—support- and securities lending. As pressures intensified near the ed by monetary and fiscal stimulus—and to be expand- end of the year, the Federal Reserve established a Term ing at a pace around or a bit above its long-run trend by Auction Facility to supply short-term credit to sound 2010. Total inflation was expected to be lower in 2008 banks against a wide variety of collateral; in addition, it than in 2007 and to edge down further in 2009. How- entered into currency swap arrangements with two oth- ever, FOMC participants (Board members and Reserve er central banks to increase the availability of term dol- Bank presidents) indicated that considerable uncertainty lar funds in their jurisdictions. With regard to monetary surrounded the outlook for economic growth and that policy, the Federal Open Market Committee (FOMC) they saw the risks around that outlook as skewed to the cut the target for the federal funds rate 50 basis points downside. In contrast, most participants saw the risks at its September meeting to address the potential down- surrounding the forecasts for inflation as roughly side risks to the broader economy from the ongoing dis- balanced. 69 Part 2 Recent Economic and Financial Developments Although the U.S. economy had generally performed Change in the chain-type price index for personal well in the first half of 2007, the economic landscape consumption expenditures, 2001-07 was subsequently reshaped by the emergence of sub- stantial strains in financial markets in the United States and abroad, the intensifying downturn in the housing • Total market, and higher prices for crude oil and some other • Excluding food and energy commodities. Rising delinquencies on subprime mort- gages led to large losses on related structured credit products, sparking concerns about the structures of other financial products and reducing investors' appetite for risk. The resulting dislocations generated unan- ticipated pressures on bank balance sheets, and those pressures combined with uncertainty about the size and distribution of credit losses to impair short-term funding markets. Consequently, the Federal Reserve and other central banks intervened to support liquidity 2001 20O2 2003 2004 2005 2006 2007 and functioning in those markets. Amid a deteriorating SOURCE: Department of Commerce, Bureau of Economic Analysis. economic outlook, and with downside risks increas- ing, Treasury yields declined markedly, and the Federal investment, and exports more than offset the continuing Open Market Committee cut the federal funds rate sub- drag from residential investment. In the fourth quarter, stantially. Meanwhile, risk spreads in a wide variety of however, economic activity decelerated significantly, credit markets increased considerably, and equity prices and the economy seems to have entered 2008 with little tumbled. forward momentum. In part because of tighter credit The financial turmoil did not appear to leave much conditions for households and businesses, the housing of a mark on overall economic activity in the third correction has deepened, and capital spending has soft- quarter. Real GDP rose at an annual rate of nearly ened. In addition, a number of factors, including steep 5 percent, as solid gains in consumer spending, business increases in energy prices, lower equity prices, and soft- ening home values, have started to weigh on consumer outlays. In the labor market, private hiring slowed Change in real GDP, 2001-07 sharply in late 2007 and January 2008. The increase in the price index for total personal consumption expendi- Perrenu annual rare tures (PCE) picked up to VA percent in 2007 as a result of sizable increases in food and energy prices. Core PCE inflation, though uneven over the course of the year, averaged a bit more than 2 percent during 2007 as a whole, a little less than the increase posted in 2006. The Household Sector Residential Investment and Finance LJ Economic activity in the past two years has been 2001 2002 2003 2004 2005 2006 2007 restrained by the ongoing contraction in the housing NOTE: Here and in subsequent figures, except as noted, change for a givei sector, and that restraint intensified in the second half period is measured to its final quarter from the final quarter of ihe preceding of 2007. Home sales and prices softened significantly period. Sm/fiCE: Department of Commerce, Bureau of Economic Analysis, further, and homebuilders curtailed new construction 70 4 Monetary Policy Report to the Congress D February 2008 Private housing starts, 1994-2007 Mortgage rates, 2001-08 Millions of units, annual n Adjustable rale __L 1995 1997 1999 2001 2003 2005 2007 2001 2002 2003 2004 2005 2006 2007 2008 NOTE: The data are quarterly and extend through 2OO7:Q4. NOTE; The data, which are weekly and extend through February 20, 2008, SOURCE: Department of Commerce, Bureau of the Census. are contract rates on thirty-year mortgages. SOURCE: Federal Home Loan Mortgage Corporation, in response to weak demand and elevated inventories. many homebuyers apparently expected that home prices In all, the decline in residential investment reduced the would continue to rise briskly into the indefinite future, annual growth rate of real GDP in the second half of thereby adding a speculative element to the market. In 2007 by more than 1 percentage point, and the further addition, toward the end of the boom, housing demand drop in housing starts around the turn of the year sug- was supported by an upsurge in nonprime mortgage gests that the drag on the growth of real GDP remains lending—in many cases fed by lax lending standards,1 substantial in early 2008. By the middle of the decade, house prices had reached The downturn in housing activity followed a multi- very high levels in many parts of the United States, and year period of soaring home sales and construction and housing was becoming progressively less affordable. rapidly escalating home prices. The earlier strength in Declining affordabiHty and waning optimism about housing reflected a number of factors. One was a low future house price appreciation apparently started to level of global real interest rates. Another was that weigh on the demand for housing, thereby causing sales to fall and the supply of unsold homes to ratchet up rel- ative to the pace of sales. Against this backdrop, prices Change in prices of existing single-family houses, began to decelerate, further damping expectations of 1988-2007 future price increases and exacerbating the downward pressure on demand. House prices decelerated dramatically in 2006 and softened further in 2007. In many areas of the nation, existing home prices fell noticeably last year. For the nation as a whole, the OFHEO price index declined in the second half of the year after rising modestly in the first half; that measure had risen 4 percent in 2006 and about 9'/z percent tn each of the two years before that.2 In the market for new homes, the constant-quality index of new home prices fell 2!4 percent over the four quarters of 2007. Moreover, many large homebuilders ! 1 1 : 1 1 1 ! 1 1 ! 1 1 1 1 111! 1. Nonprime mortgages comprise subprime and near-prime loans 1989 1992 1995 1998 2001 2004 2007 and accounted for about one-fourth of all home-purchase mortgages NOTE: The data are quarterly and extend through 2007:Q4; changes are in 2006. Near-prime mortgages are generally less risky than subprime from one year earlier. For the years preceding 1991, the repeat-transactions mortgages but riskier than prime mortgages; they may require lim- index includes appraisals associated with mortgage refinancings; beginning in ited or no borrower documentation, have nontraditional amortization 1991, it includes purchase transactions only. The S&P/Case-Shilier index structures or high loan-to-value ratios, or be made on investment r B e o fl s e to c n ts , C at h ! i c a a r g m o ' , s - D Ie e n n g v t e h r , s L a a le s s V e tr g a a n s s , a c L t o io s n A s n i g n e le th s, e M m ia e m tro i, p o N li e t w an Y a o r r e k a , s S a o n f properties. Diego, San Francisco, and Washington, D.C 2. The index is the seasonally adjusted purchase-only version of SOURCE: For repeat transactions, Office of Federal Housing Enterprise the repeat-transactions price index for existing single-family homes Oversight; for S&P/Case-Shiiler, Chicago Mercantile Exchange. published by the Office of Federal Housing Enterprise Oversight. 71 Board of Governors of the Federal Reserve System 5 reportedly have been using not only price discounts Even so, spreads between rates offered on these loans but also nonprice incentives (for example, paying clos- and conforming loans Temain unusually wide. ing costs and including optional upgrades at no cost) The softness in home prices has played an important in an effort to bolster sales of new homes and reduce role in the ongoing deterioration in the credit quality inventories. of subprime mortgages. The deterioration was rooted In all, the pace of sales of existing homes fell in poor underwriting standards—and, in some cases, 30 percent between mid-2005 and the fourth quarter of fraudulent and abusive lending practices—which were 2007, and sales of new homes dropped by half. Builders based in part on the assumption that house prices would cut production in response to the downshift in demand; continue to rise rapidly for some time to come. Many by the fourth quarter of 2007, starts of single-family borrowers with weak credit histories took out adjust- homes had fallen to an annual rate of just 826,000 able-rate mortgages (subprime ARMs) with low initial units—less than half the quarterly high reached in early rates; of those loans originated in 2005 and 2006, a 2006. Nonetheless, the ongoing declines in sales pre- historically large fraction had high loan-to-valuc ratios, vented builders from making much progress in paring which were often boosted by the addition of an associ- their bloated inventories of homes. In fact, although ated junior lien or "piggyback" mortgage. When house the number of unsold new homes has decreased, on prices decelerated, borrowers with high loan-to-value net, since the middle of 2006, inventories have climbed ratios on their loans were unable to build equity in their sharply relative to sales. Measured relative to the homes, making refinancing more difficult, and also average pace of sales over the three months ending in faced the prospect of significantly higher mortgage pay- December, the months' supply of unsold new homes at ments after the initial rates on the loans reset. the end of December stood at nine months, more than twice the upper end of the narrow range that had pre- Mortgage delinquency rates, 2001-07 vailed from 1997 to mid-2005. The contraction in housing demand and construction was exacerbated in the second half of 2007 by the near elimination of nonprime mortgage originations and a tightening of lending standards on all types of mort- gages. Indeed, large fractions of banks that responded to the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices reported that they had tightened lending standards over this period. None- theless, interest rates on prime conforming mortgages have declined on net: Rates on conforming thirty-year fixed-rate loans dropped from about 6% percent last Prime and near prime summer to just above 6 percent at year-end. This year they dipped as low as 514 percent but have recently moved back up to about 6 percent, within the range that Adjustable prevailed for much of the 2003-05 period? Rates on conforming adjustable-rate loans have also fallen sig- nificantly over the past several months and now stand at their lowest level since the end of 2005. Offered rates on fixed-rate jumbo loans, which ran up in the second Alt-A pools half of 2007, have recently declined somewhat, on net.4 3. Conforming mortgages are those eligible for purchase by Fan- nie Mae and Freddie Mac; they must be equivalent in risk to a prime mortgage with an 80 percent loan-to-value ratio, and they cannot exceed the conforming loan limit. The Economic Stimulus Act of 2008, signed into law on February 13, retroactively raised the con- 2001 2002 2003 2004 2005 2006 2007 forming loan limit for a first mortgage on a single-family home in the contiguous United States from $417,000 to 125 percent of the median NOTE: The data are monthly. For subprime, prime, and near-prime house price in an area, with an overall cap of $729,750. The new con- mortgages, the date extend through December 2007; for mortgages in alt-A forming limit will be in effect through the end of 2008. p da o t o a l s e , x w te h n i d c h th a ro re u g a h m N i o x v e o m f b p e ri r m 2 e 0 , 0 7 ne . a F r o -p r r f i u m rt e h , e r a n d d e ta su il b s p o r n im th e e m b o a r n tg s a i g n e c s lu , d t e h d e 4. Jumbo mortgages are those lhat exceed the maximum size of a in alt-A pools, refer to text. Delinquency rate is tbe percent of loans ninety conforming loan; they are typically extended to borrowers with rela- days or more past due or in foreclosure. tively strong credit histories. SOURCE: First American LoariPerformatice. 72 6 Monetary Policy Report to the Congress • February 2008 Cumulative defaults on subprime 2/28 loans, often carry adjustable rates—have crept up slightly by year of origination, 2001-07 from very low levels. The credit quality of loans that were securitized in pools marketed as "alt-A" has declined considerably. Such loans are typically made to higher-quality borrow- ers but have nontraditional amortization structures or other nonstandard features. Some of the loans are cat- egorized as prime or near prime and others as subprime. The rate of serious delinquency on loans with adjustable rates in alt-A pools currently stand*s at almost 6 per- cent, far above the rates of less than 1 percent seen as recently as early 2006. The rate of serious delinquency on fixed-rate alt-A loans has also increased in recent months. The continued erosion in the quality of mortgage credit has led to a rising number of initial foreclosure Loan age (months) filings; indeed, such filings were made at a record pace NOTE: The data are monlhly and extend (hrough November 2007. Each in the third quarter of 2007. Foreclosures averaged series represents the fraction of loans originated in the indicated year that had about 360,000 per quarter over the first three quarters of d io e a f n au s lt o e r d ig i b n y a te th d e s i o n m di e c t a im ted e i l n oa t n h e a g y e e ; a r f s o r 2 0 e 0 x 1 am s p o l e 2 , 0 r 0 o 4 u g h h a l d y d 6 e f p a e u r l c te e d n t b o y f t a h l e l 2007, compared with a rate of about 235,000 in the cor- time they were twenty-four mouths old. The last nine values for the three responding quarters of 2006. As was the case in 2006, s Ih er in ie y s - y c e o a v r e l r o in an g w 2 i 0 ( 0 h 5 a - 0 f 7 ix e a d r e r a b te a s f e o d r t o h n e f i i n rs c t o t m w p o l e y te e ar d s a a ta n . d A an 2 a / d 2 j 8 u s l t o a a b n le i r s a t a e more than half of the foreclosure filings in 2007 were for the remaining twenty-eight years. subprime mortgages despite the relatively smaller Lo S a O n U P R e C rf E o : r m S a ta n f c f e , calculations based on data from First American share of such loans in total mortgages outstanding. In some cases, falling prices may have tempted more- speculative buyers with little or no equity to walk away Subprime ARMs account for about 7 percent of all from their properties. Foreclosures have risen most in first-lien mortgages outstanding. Delinquency rates areas where home prices have been falling after a period on subprime ARMs began to increase in 2006, and by of rapid increase; foreclosures also have mounted in December 2007, more than one-fifth of these loans some regions where economic growth has been below were seriously delinquent (that is, ninety days or more the national average. delinquent or in foreclosure). Moreover, an increasing fraction of subprime ARMs in the past few years have Avoiding foreclosures—even if it involves granting become seriously delinquent soon after they were origi- concessions to the borrower—can be an important loss- nated and often well before the initial rate was due to mitigation strategy for financial institutions. To limit reset.5 For subprime ARMs originated in 2006, about the number of delinquencies and foreclosures, financial 10 percent had defaulted in the first twelve months, institutions can use a variety of approaches, including more than double the fraction for mortgages originated renegotiating the timing and size of rate resets. A com- in earlier years. Furthermore, the path of the default rate plication in implementing such approaches is that the for subprime ARMs originated in 2007 has run even loans have often been packaged and sold in securitized higher. For subprime mortgages with fixed interest rates, pools that are owned by a dispersed group of investors, delinquency rates have moved up significantly in recent which makes the task of coordinating renegotiation months, to the upper end of their historical range. among all affected parties difficult. In part to address For mortgages made to higher-quality borrowers the challenges in modifying securitized loans, eoun- (prime and near-prime mortgages), performance weak- selors, servicers, investors, and other mortgage market ened somewhat in 2007, but it generally remains fairly participants joined in a collaborative effort, called the solid. Although the rate of serious delinquency on ARMs Hope Now Alliance, to facilitate cross-industry solu- has moved up, that on fixed-rate loans has stayed low. tions to the problem.6 Separately, the Federal Reserve Serious delinquencies on jumbo mortgages—which has directly responded in a number of ways to the prob- lems with mortgage credit quality (described in the box 5. The initial low-rate period for most subprime ARMs originated in the period from 2005 to 2007 was twenty-four months. Roughly \Vi million subprime ARMs are scheduled to undergo their first rate 6. The Hope Now Alliance (www.hopenow.com) aims to increase reset in 2008. Even with the recent declines in market interest rates, a outreach efforts to contact at-risk borrowers and to play an impor- notable fraction of those subprime ARMs are scheduled to reset to a tant role in streamlining the process for refinancing and modifying higher interest rate. subprime ARMs. The alliance will work to expand the capacity of an 73 Board of Governors of the Federal Reserve System 7 entitled "The Federal Reserve's Responses to the Sub- Consumer sentiment, 1994-2008 prime Mortgage Crisis"). Most commercial banks responding to the Federal Reserve's January 2008 Senior Loan Officer Opinion Survey indicated that loan-by-loan modifications based on individual borrowers' circumstances were an impor- tant part of their loss-mitigation strategies. Almost two- thirds of respondents indicated that they would consider refinancing the loans of their troubled borrowers into other mortgage products at their banks. About one- third of respondents said that streamlined modifications of the sort proposed by the Hope Now Alliance were important to their strategies for limiting losses. All of the factors discussed above—the drop in home sales, softer house prices, and tighter lending standards 1994 1996 1998 2000 2002 2004 2006 2008 (especially for subprime and alternative mortgage NOTE: The Conference Board data are monthly and extend through products)—combined to reduce the growth of house- February 2008. The Reuters/Michigan dala are monthly and extend through a preliminary estimate for February 2008. hold mortgage debt to an annual rate of about SOURCE: The Conference Board and Reuters/University of Michigan Sur- VA percent over the first three quarters of 2007, veys of Consumers. down from 11 % percent in 2006. Growth likely slowed further in the fourth quarter. have slowed lately, household wealth has been damped by the softening in home prices as well as by recent Consumer Spending declines in equity values, and consumers' purchasing power has been sapped by sharply higher energy prices. and Household Finance Moreover, consumer sentiment has fallen appreciably, and although consumer credit has remained available Consumer spending held up reasonably well in the to most borrowers, credit standards for many types of second half of 2007, though it moderated some in the loans have been tightened. fourth quarter. Spending continued to be buoyed by Real personal consumption expenditures (PCE) solid gains in aggregate wages and salaries as well increased at an annual rate of 2% percent in the third as by the lagged effects of the increases in household quarter, a little above the average pace during the first wealth in 2005 and 2006. However, other influences half of the year; in the fourth quarter, PCE growth on spending have become less favorable. Job gains slowed to 2 percent. With the notable exception of existing national network to counsel borrowers and refer them to par- ticipating servicers, who have agreed to work toward cross-industry Wealth-to-income ratio, 1984-2007 solutions to better serve the homeowner. Change in real income and consumption, 2001—07 • Disposable personal income | Personal consumption expenditures hllllll L.i_J_J_J_I_J_L_l_l_U_L 1987 1991 199 NOTE: The dala are quarterly and extend through 2007:Q3. The wealth- to-income ratio is [he raiio of household net worth to disposable personal 2001 2002 2003 2004 2005 2006 2007 SOURCE: For net worth. Federal Reserve Board, flow of funds dala; for SOURCE: Department of Commerce, Bureau of Economic Analysis income. Department of Commerce, Bureau of Economic Analysis. 74 8 Monetary Policy Report to the Congress D February 2008 The Federal Reserve's Responses to the Subprime Mortgage Crisis The sharp increases in subprime mortgage avoid foreclosure. Staff members throughout the loan delinquencies and foreclosures over the Federal Reserve System are working to identify past year have created personal, economic, localities that are likeiy to experience the high- and social distress for many homeowners and est rates of foreclosure; the resulting informa- communities. The Federal Reserve has taken a tion is helping local groups to better focus their number of actions that directly respond to these borrower outreach efforts. In addition, the Fed- problems. Some of the efforts are intended to eral Reserve actively supports NeighborWorks help distressed subprime borrowers and limit America, a national nonprofit organization that preventable foreclosures, and others are aimed has been helping thousands of mortgage borrow- at reducing the likelihood of such problems in ers facing current or potential distress. Federal the future. Reserve staff members have worked closely Home iosses through foreclosure can be with this organization and its local affiliates on reduced If financial institutions work with bor- an array of foreclosure prevention efforts, and rowers who are having difficulty meeting their a member of the Federal Reserve Board serves mortgage payment obligations. Foreclosure on its board of directors. Other contributions cannot always be avoided, but in many cases include efforts by Reserve Banks to convene prudent loss-mitigation techniques that preserve workshops for stakeholders to develop commu- homeownership are less costly to fenders than nity-based solutions to mortgage delinquencies foreclosure, In 2007, the Federal Reserve and in their areas. other banking agencies encouraged mortgage The Federal Reserve has taken important Senders and mortgage servicers to pursue pru- steps aimed at avoiding future problems in sub- dent loan workouts through such measures as prime mortgage markets while strli preserving modification of loans, deferral of payments, responsible subprime lending and sustainable extension of loan maturities, capitalization of homeownership. In coordination with other delinquent amounts, and conversion of adjust- federal supervisory agencies and the Confer- able-rate mortgages (ARMs) into fixed-rate mort- ence of State Bank Supervisors, the Federal gages or fully indexed, fully amortizing ARMs.1 Reserve issued principles-based guidance on The Federal Reserve has also collaborated subprime mortgages last summer.3 The guidance with community groups to help homeowners is designed to help ensure that borrowers obtain 1. Board of Governors of the Federal Reserve System (continued on next page) (2007), "Working with Mortgage Borrowers." Division of Banking Supervision and Regulation, Supervision and Regula- 2. Board of Governors of the Federal Reserve System tion Letter SR 07-6 {April 17); and "Statement on Loss Mitiga- (2007), "Statement on Subprime Mortgage Lending," Division tion Strategies for Servicers of Residential Mortgages." Supervi- of Banking Supervision and Regulation, Supervision and Regu- sion and Regulation Letter SR 07-16 (September 5}, lation Letter SR 07-12 (July 24). outlays for new light motor vehicles (cars, sport-utility tivity. For example, average hourly earnings, a measure vehicles, and pickup trueks)—which were well main- of wages for production or nonsupervisory workers, tained through year-end—the deceleration in spending increased only %/i percent over the four quarters of 2007 in the fourth quarter was widespread. PCE appears to after accounting for the rise in the overall PCE price have entered 2008 on a weak trajectory, as sales oflight index. Moreover, for some workers, real wages actually vehicles sagged in January and spending on other goods declined: Real average hourly earnings in manufactur- was soft. ing edged down about % percent last year, while for Growth in real disposable personal income—that is, retail trade—an industry that typically pays relatively after-tax income adjusted for inflation—was sluggish in low wages—this measure of real wages fell about the second half of 2007. Although aggregate wages and 2 percent. salaries rose fairly briskly in nominal terms over that On the whole, household balance sheets remained period, the purchasing power of the nominal gain was in good shape in 2007, although they weakened late eroded by the energy-driven upturn in consumer price in the year. The aggregate net worth of households inflation in the fall. Indeed, for many workers, increases rose modestly through the third quarter, as increases in in real wages over 2007 as a whole were modest, once equity values more than offset the effect of softening again falling short of the rise in aggregate labor produc- home prices. However, preliminary data suggest that 75 Board of Governors of the Federal Reserve System 9 (continued from preceding page) adjustable-rate mortgages that they can afford testing of loan disclosure documents. After a to repay and can refinance without prepayment similar comprehensive analysis of disclosures penalty for a reasonable period before the first related to credit card and other revolving credit interest rate reset. The Federal Reserve issued arrangements, the Board issued a proposal in simitar guidance on nontraditionai mortgages in May 2007 to require such disclosures to be 2006,3 clearer and easier to understand. Like the credit The Federal Reserve is working to help safe- card review, the review of mortgage disclosures guard borrowers in their interactions with mort- will be lengthy given the critical need for field gage fenders. In support of this effort, in Decem- testing, but the process should ultimately help ber 2007 the Federal Reserve used its authority more consumers make appropriate choices under the Home Ownership and Equity Pro- when financing their homes. tection Act of 1994 to propose new rules that Finally, strong uniform oversight of all mort- address unfair or deceptive mortgage lending gage lenders is criticat to avoiding future prob- practices. This proposal addresses abuses relat- lems in mortgage markets. Regulatory oversight ed to prepayment penalties, failure to escrow for of the mortgage industry has become more chal- taxes and insurance, problems related to stated- lenging as the breadth and depth of the market income and low-documentation lending, and has grown over the past decade and as the roie failure to give adequate consideration to a bor- of nonbank mortgage lenders, particularly in the rower's ability to repay. The proposal includes subprime market, has increased, tn response, other protections as weli, such as rules designed the Federal Reserve, together with other federal to curtail deceptive mortgage advertising and to and state agencies, launched a pilot program ensure that consumers receive mortgage disclo- last summer focused on selected nondeposi* sures at a time when the information is likely to tory fenders with significant subprime mortgage be the most useful to them. operations.'1 The program will review compli- The Federal Reserve is also currently under- ance with consumer protection regulations and taking a broad and rigorous review of the Truth impose corrective or enforcement actions as in Lending Act, including extensive consumer warranted. 3. Board of Governors of the Federal Reserve System 4, The other agencies collaborating on the effort are the (2006), "interagency Guidance on Nontraditiona! Mortgage Office of Thrift Supervision, the Federal Trade Commission, Product Risks," Division of Banking Supervision and Regula- the Conference of State Bank Supervisors, and the American tion. Supervision and Regulation Letter SR 06-15 (October 10), Association of Residential Mortgage Regulators, Personal saving rate, 1984-2007 the value of household wealth fell in the fourth quarter, and as a result the ratio of household wealth to dispos- able income—a key influence on consumer spending— ended the year well below its level at the end of 2006. Nonetheless, because changes in net worth tend to influ- ence consumption with a lag, the increases in wealth during 2005 and 2006 likely helped sustain spending in 2007. In the fourth quarter, the personal saving rate was just a shade above zero, about in line with its average value since 2005. Overall household debt increased at an annual rate of about IVA percent through the third quarter of 2007, a notable deceleration from the 101/* percent pace in U_L-L-LJU_J 2006; household debt likely slowed further in the fourth 2003 2007 quarter. Because the growth of household debt about NOTE: The dala are quarterly and extend through 2007 :Q4. SOURCE: Department of Commerce, Bureau of Economic Analysis. matched the growth in nominal disposable personal 76 10 Monetary Policy Report to the Congress • February 2008 Household financial obligations ratio, 1992-2007 Delinquency rates on consumer loans, 1996-2007 1993 I 995 1997 1999 2001 2003 2005 2007 1997 1999 2001 2003 2005 2007 NOTE: The data arc quarterly and extend through 2007 :Q3. The financial NOTE: The data are quarterly and extend through 2OO7;Q4, Delinquency obligations ratio equals Ihe sum of required payments on mortgage and con- rate is the percent of loans thirty days or more past due. sumer debt, automobile Jeases, rent on tenant-occupied property, home- SOURCE: Federal Financial Institutions Examination Council, Consolidated owner's insurance, and property taxes, all divided by disposable persona! Reports of Condition and Income (Call Report). income. SOURCE: Federal Reserve Board. ruptcy law implemented in late 2005, the bankruptcy income through the third quarter, and net changes in rate rose modestly over the first nine months of 2007. interest rates on mortgage debt to that point were small, The issuance of asset-backed securities (ABS) tied to the ratio of financial obligations to disposable personal credit card loans and auto loans (consumer loan ABS) income was about flat. has remained robust. Spreads of yields on consumer Consumer (nonmortgage) borrowing picked up a bit loan ABS over comparable-maturity swap rates have in 2007 to 5% percent, perhaps reflecting some substitu- moved up considerably since July; the rise pushed tion of consumer credit for mortgage debt. The pickup spreads on two-year BBB-rated consumer loan ABS in consumer debt was mostly attributable to faster to almost double their previous peaks in late 2002. growth in revolving credit, a pattern consistent with the Spreads on two-year AAA-ratcd consumer loan ABS results of the Federal Reserve's Senior Loan Officer jumped to between 60 basis points and 100 basis points Opinion Survey. Banks, on net, reported easing lend- after having been near zero for most of the decade, ing standards on credit cards over the first half of 2007 perhaps in part as a result of investors' general reassess- and reported Httlc change in those standards on net over ment of the risk in structured credit products. the second half of the year. In contrast, significant frac- tions of respondents in the second half of 2007 reported that they had tightened standards and terms on other The Business Sector consumer loans, a change that may have contributed to a slowing in the growth of nonrevolving loans over the Fixed In vestment final months of 2007. Average interest rates on credit cards generally moved down in the second half of the Real business fixed investment (BFI) rose at an annual year, but by less than the short-term market interest rate of 8!/a percent in the second half of 2007, largely rates on which they are often based. Interest rates on because of a double-digit rise in expenditures on non- new auto loans at banks and at auto finance companies residential construction. Investment in equipment and have also declined some in recent months. software (E&S), which had accounted for virtually all Indicators of the credit quality of consumer loans of the growth in real BFI from 2003 to 2005, has been suggest that it has weakened but generally remains erratic since early 2006 but, on balance, has decelerated sound. Over the second half of the year, delinquency noticeably. On the whole, the economic and financial rates on consumer loans at commercial banks increased, conditions that influence capital spending were fairly but from relatively moderate recent levels. Meanwhile, favorable in mid-2007, but they subsequently worsened delinquency rates at captive auto finance companies as the outlook for sales and profits soured and as credit increased somewhat but are well below previous highs. conditions for some borrowers tightened. A bright spot, Although household bankruptcy filings remained low however, is that many firms still have ample cash on relative to the levels seen before the changes in bank- hand to fund potential projects. 77 Board of Governors of the Federal Reserve System Change in real business fixed investment, 2001-07 Meanwhile, real outlays on nonresidential construc- tion remained on a strong uptrend. Some of the recent Percent annual rale strength likely represents a catch-up from the prolonged • Structures weakness in this sector in the first half of the decade. • Equipment and soffw With the notable exception of the non-office commer- cial sector—where spending has been about flat since mid-2007—all major types of building continued to exhibit considerable vigor in the second half. In gen- eral, the nonfinancial fundamentals affecting nonresi- dential construction remain favorable: Vacancy rates for office and industrial buildings have fallen appreciably over the past few years despite the addition of a good deal of available space; and, although the vacancy rate for retail buildings has moved up somewhat of late, it i i remains well below its cyclical highs in 1991 and 2003. O High-tech equipment and software However, funding has reportedly become more diffi- • Other equipment excluding transportation cult to obtain in recent months, especially for specula- tive projects, and the slowing m aggregate output and employment is likely to limit the demand for nonresi- n fin dential space in coming quarters. Meanwhile, real out- lays for drilling and mining structures have continued ¥ to rise in response to high prices for petroleum and natural gas. L_L_ Inventory Investment 20Q2 2003 2004 2005 2006 2007 NOTE: High-tech equipment consists of computers and peripheral equip- Although inventory imbalances had cropped up in ment 3nd communi cations equipment. a number of industries in late 2006, overhangs were SOURCE: Department of Commerce, Bureau of Economic Analysis. largely eliminated in the first half of 2007, and firms On average, real outlays on E&S rose at an annual generally continued to keep a tight rein on stocks in the rate of 5 percent in the second half of 2007; in the first second half. In the motor vehicle sector, manufacturers half, these outlays had risen just 2VS percent, in part pursued an aggressive strategy of production adjust- because of a sharp downswing in outlays on motor ments to keep dealer stocks reasonably well aligned vehicles.7 Real investment in high-technology per- with sales. In December 2007, days' supply of light formed well in the second half, with further increases vehicles stood at a comfortable sixty-four days—though in all major components (computers, communications it ticked up in January because of the drop in sales equipment, and software). Real outlays on equipment other than high-tech and transportation (a broad cat- Change in real business inventories, 2001—07 egory that accounts for nearly half of investment in E&S when measured in nominal terms) posted a solid Billions of Chained (2000) dollars, annual rate gain in the third quarter. However, those outlays edged down in the fourth quarter, and the relatively slow pace of orders, along with the downbeat tone in recent sur- veys of business conditions, suggests that the softness 111 in spending has extended into early 2008. I 7. The plunge in business outlays on motor vehicles in Ihe first half was related to new Environmental Protection Agency emissions standards for large trucks, which went into effect at the start of 2007. Many firms had accelerated their purchases of such trucks into 2005 and 2006 so that they could take delivery before the new standards went into effect and thus avoid the higher costs associated with those standards. Outlays on motor vehicles rose modestly, on net, in the 200] 2002 2003 2004 2005 2006 2007 second half of the year. SOURCE: Department of Commerce, Bureau of Economic Analysis. 78 12 Monetary Policy Report to the Congress D February 2008 noted earlier. Apart from motor vehicles, real nonfarm ed to have been negative, primarily because of inventory investment was a modest $10 billion (annual asset write-downs; in contrast, earnings per share of rate) in the first half of 2007; it stayed around that rate the nonfinancial firms appear to have increased about in the third quarter and appears to have remained mod- 13 percent. est in the fourth quarter as manufacturing firms adjusted Nonfinancial business debt is estimated to have production promptly in response to signs of softening grown about 11 percent in 2007, buoyed by robust demand. With only a few exceptions—mostly related to merger and acquisition activity. Net corporate bond the ongoing weakness in construction and motor vehi- issuance was strong throughout the year, although high- cle production—book-value inventory-sales ratios in yield issuance declined aftcT midyear, as yields on such December seemed in line with historical trends. More- bonds increased and spreads over yields on Treasury over, businesses surveyed in January by the Institute for securities of comparable maturity widened to levels not Supply Management reported that their customers were seen since late 2002. The amount of outstanding non- generally satisfied with their current level of stocks. financial commercial paper was about flat, on net, over 2007, held down mostly by runoffs of lower-tier paper in the second half of the year as the market for such Corporate Profits and Business Finance paper came under pressure. After an unprecedented amount of issuance of leveraged syndicated loans over Four-quarter growth in economic profits for all U.S. the first half of 2007, issuance declined considerably corporations came in at about 2 percent in the third in the second half of the year, when demand by non- quarter of 2007, with the entire gain attributable to a bank investors for those loans feil off. Commercial large increase in receipts from foreign subsidiaries. The and industrial (C&f) loans at banks expanded briskly share of profits in the GDP of the nonfinancial sector in 2007 as underlying demand for bank-intermediated peaked in the third quarter of 2006, near its previous business credit seemed to remain solid and banks took high reached in 1997, and has since receded. For S&P onto their balanee sheets loans that had been intended 500 firms, operating earnings per share in the third for syndication. In the Senior Loan Officer Opinion quarter came in about 6 percent below year-earlier Surveys taken in October 2007 and January 2008, con- levels.8 Data from about 80 percent of those firms and siderable net fractions of banks reported charging wider analysts' estimates for the rest indicate that operating spreads on C&I loans—the loan rate less the bank's earnings per share in the fourth quarter fell more than cost of funds—the first such tightening in several years. 20 percent from the fourth quarter of 2006. Earnings Large fractions of banks also indicated that they had per share among the group's financial firms are estimat- 8. The difference between economic profits and S&P operating asset write-downs and capitai losses, which are generally excluded in earnings in the third quarter is attributable primarily to numerous the calculation of economic profits but are included as an expense in operating earnings per share of financial firms. Before-tax profits of nonfinancial corporations as a percent of sector GDP, 1979-2007 Selected components of net financing for nonfinancial corporate businesses, 2003-07 Perwm Billions of dollars, annu _ 14 12 — 10 'I I I I I I I I Ill Ill 1979 I9S3 1987 1991 1995 1999 2003 2007 NOTE: The data are quarterly and extend through 2OO7;Q3. Profits are from domestic operations of nonfinancial corporations, with inventory valuation NOTE: The data for the components except bonds are seasonally adjusted. and capita! consumption adjustments. The data for 2007:Q4 are estimated. SOURCE: Department of Commerce, Bureau of Economic Analysis. SOURCE: Federal Reserve Board, flow of funds data. 79 Board of Governors of the Federal Reserve System 13 Net percentage of domestic banks lightening standards Default rate on outstanding corporate bonds, 1992-2008 and increasing spreads on commercial and industrial loans to large and medium-sized borrowers, 1992-2008 1993 1996 1999 2002 2005 I, ,| i I, i NOTE: The data are monthly and extend through January 2008, The rate for 1993 1996 1999 2002 2005 2008 a given month is the face value of bonds that defaulted in the six months p 2 e 0 N r 0 O 7 y : T e Q a E r 4 : ; . T t N h h e e e t l a d p s a e t t r a c o e b a n s r t e e a r g v d e a r a t i i w s o n n th i e f s r o p f m e ro r c m e a n t s t h u a e g r v e J e a y o n f u g a b e r a n y n e k 2 ra s 0 l 0 l r y e 8 p c s o u o rt n r i v n d e g u y c , a t e w t d ig h i h f c o t h e u n r c in o ti g v m e o e rs f s e d q n i u v d a i i r d n t e e g d r i i b m n y m t t h h e a d e t i a f m a te c o l e y n v t p h a r , l e u c m e e u d o l i f t n i p g a l i i t t e h b d e o s n b i d x y s - m 2 o o u n t t o s t t h a a n p n d e n i r u n i a o g l d i a z . t e th th e e e n d d e fa o u f l t t h s e a c n a d l en th d e a n r standards or an increase in spreads less the percentage reporting an easing or SOURCE: Moody's Investors Service. a decrease. Spreads are measured as the loan rate less the bank's cost of funds, ITie definition for firm size suggested for, and generally used by, survey respondents is ttiat large and medium-sized firms have annual sales of A lesser fraction—about one-fourth—cited concerns SOURCE: Federal Reserve Board, Senior Loan Officer Opinion Survey on about the liquidity or capital position of their own banks Bank Lending Practices. as reasons for tightening. Gross equity issuance picked up in 2007 on an increase in the pace of seasoned offerings. Nonetheless, record volumes of share repurchases and cash-financed tightened lending standards. Most of the banks that mergers and acquisitions pushed net equity retirements tightened terms and standards indicated that they had even higher in 2007 than in 2006. done so in response to a less favorable or more uncer- The credit quality of nonfinancial corporations tain economic outlook and a reduced tolerance for risk. remained strong. The six-month trailing bond default rate stayed near zero through January 2008. The delin- Financing gap and net equity retirement quency rate on C&I loans at commercial banks at the at nonfmancial corporations, 1992-2007 end of 2007 remained near the bottom of its historical range, but it trended higher over the year. Charge-ofTs on C&I loans at banks also increased in 2007, particu- larly in the fourth quarter. Rating downgrades of corpo- rate bonds were modest through the fourth quarter, and over the year the fraction of debt that was downgraded roughly equaled the fraction that was upgraded. For public firms, balance sheet liquidity remained at a high level through the third quarter of 2007, and leverage stayed very low despite robust borrowing and surging retirements of equity. Commercial real estate debt continued to expand briskly in 2007, reflecting in part strong investment in i l i j | j I 1 nonresidential structures, but the overall pace tapered 1992 1995 19! 2001 2004 2007 off some in the second half of the year. As noted above, NOTE: The data are annual: die observations for 2007 are based on partially readings on some market fundamentals for existing estimated data. The financing gap is the difference between capital ex- penditures and internally generated funds, adjusted for inventory valuation. structures—for example, vacancy rates and rents- Net equity retirement is the difference between equity retired through share remained solid. Similarly, the latest data for commer- repurchases, domestic cash-financed mergers, or foreign takeovers of U.S. firms and equity issued by domestic companies in public or private markets. cial mortgages held by life insurance companies or s E t q o u c i k t y o p is ti s o u n a n p c ro e c i e n e c d lu s. des funds invested by private equity partnerships and by issuers of commercial mortgage-backed securities SOURCE: Federal Reserve Board, flow of funds data. (CMBS)—mortgages that mostly finance existing struc- 80 14 Monetary Policy Report to the Congress • February 2008 Net interest payments of nonfinancial corporations Spreads of ten-year investment-grade commercial mortgage- as a percent of cash flow, 1979-2007 backed securities over swaps, by securities rating, 1997-2008 LLU 1979 1983 1987 1991 1995 1999 2003 2007 NOTE: The data are quarterly and extend through 2007:Q3. NOTE: The data are weekly and extend through February 20.2008. SOURCE: Department of Commerce, Bureau of Economic Analysi SOURCE: Bloomberg, tures—show little change in delinquency rates in recent loans. Among the most common reasons cited by those quarters. that tightened credit conditions were a less favorable or In contrast, the delinquency rate on commercial more uncertain economic outlook, a worsening of com- mortgages held by banks about doubled over the course mercial real estate market conditions in the areas where of 2007, reaching almost 23/4 percent. The loan perfor- the banks operate, and a reduced tolerance for risk. mance problems were the most striking for construction Moreover, despite the generally solid performance of and land development loans—especially for those that commercial mortgages in securitized pools, spreads of finance residential development—but some increase in yields on BBB-rated CMBS over comparable-maturity delinquency rates was also apparent for loans backed swap rates soared, and spreads on AAA-rated tranches by nonfarm, nonresidential properties and multifamily of those securities rose to unprecedented levels. The properties. In the most recent Senior Loan Officer Opin- widening of spreads reportedly reflected heightened ion Survey, large fractions of banks reported having concerns regarding the underwriting standards for com- tightened standards and terms on commercial real estate mercial mortgages over the past few years and likely also investors' general wariness of structured finance products. Delinquency rates on commercial real estate Issuance of CMBS in 2007 topped the pace of 2006. loans at banks, 1991-2007 It was fueled by leveraged buyouts of real estate invest- Pertea ment trusts in the first half of the year, but issuance slowed to a trickle over the final four months of the _ — 21 year on tighter underwriting standards and the higher 18 required yields. Nonetheless, the still-steady growth of commercial real estate debt indicates that, thus far, — 15 borrowers have found alternative funding sources for 12 projects. \ Multifamily and ^—^ nonfarmnonresideintial - 9 6 — Construction and^-^____^ 3 The Government Sector land development ^ *===^= Federal Government 1 1 ! 1 i I t 1 1 i i i 1 1 I 1 1 I I i 1991 1993 1995 1997 1999 2001 2003 2005 2007 The deficit in the federal unified budget stood at NOTE: The data are quarterly and extend through 2007:Q4. Delinquency rate is the percent of loans thirty days or more past due or not accruing $162 billion in fiscal year 2007, roughly $250 billion interest. below the recent high reached in fiscal 2004 and equal SOURCE: Federal Financial Institutions Examination Council, Consolidated Reports of Condition and Income (Call Report). to just YA percent of nominal GDP. However, growth 81 Board of Governors of the Federal Reserve System 15 Federal receipts and expenditures, 1987-2007 Change in real government expenditures on consumption and investment, 2001—07 Percent Of nominal GDI" Expenditures • Federal • State and locai _ Expenditures excluding net interest 1987 1991 1995 1999 2003 2007 I j NOTE; The receipts and expenditures data are on a unified-budget basis and 2001 2002 2003 2004 2005 2006 2007 are for fiscal years (October through September); GDP is for the four quarters SOURCE: Department of Commerce, Bureau of Economic Analysis. ending In Q3. SOURCE: Officeof Management and Budget. As measured in the national income and product in revenues has slowed since last summer, and growth accounts (N1PA), real federal expenditures on consump- in outlays has quickened. Given those developments, tion and gross investment—the part of federal spending the deficit during the first four months of fiscal 2008 that is a direct component of GDP—rose at an annual (October 2007 to January 2008) was larger than it had rate of 3/4 percent, on average, in the second half of been during the comparable period of fiscal 2007. Over calendar 2007 after having been unchanged in the first the remainder of fiscal 2008, a slow pace of economic half. The step-up was concentrated in real defense activity and the revenue loss associated with the Eco- spending, which tends to be erratic from quarter to nomic Stimulus Act of 2008 are expected to boost the quarter and rose at an annual rate of AV2 percent in the deficit. second half, somewhat above its average pace over the Nominal federal receipts have decelerated sharply past three years. since posting double-digit advances in fiscal years 2005 Federal debt rose at an annual rate of almost 5 per- and 2006: They rose less than 7 percent in fiscal 2007 cent over the four quarters of calendar year 2007, a bit and have slowed substantially further thus far in fiscal faster than the roughly 4 percent increase in 2006. The 2008. The deceleration has been most pronounced in ratio of federal debt held by the public to nominal GDP corporate receipts, which barely increased in fiscal 2007 remained in the narrow range around 36/4 percent seen after three years of exceptional growth and have fallen well below year-earlier levels so far in fiscal 2008; the downturn has reflected the recent softness in corporate Federal government debt held by the public, 1960-2007 profits. In addition, growth in individual income tax receipts has moderated from the rapid rates seen around Percem of nominal GDP the middle of the decade. Nonetheless, total receipts grew faster than nominal GDP for the third year in a row in fiscal 2007 and reached 18% percent of GDP, slightly above the average of the past forty years. Nominal federal outlays rose less than 3 percent in fiscal 2007 after having risen about 7/4 percent in each of the two preceding years. In large part, the slowing in 2007 reflected a number of transitory factors—most notably, the tapering off of expenditures for flood insur- ance and disaster relief related to the 2005 Gulf Coast hurricanes, which had produced a notieeablc bulge in spending in fiscal 2006. So far in fiscal 2008, sharp 1967 1977 1987 1997 2007 increases in outlays for defense and net interest have NOTE: The data for debt are as of year-end; the observation for 2007 is an helped push spending 8 percent above its year-earlier estimate. The corresponding values for GDP are for Q4 at an annual rate. Excludes securities held as investments of federal government accounts. level. SOURCE: Federal Reserve Board, flow of funds data. 82 16 Monetary Policy Report to the Congress • February 2008 in recent years. The Treasury's decision in May to dis- level, property tax receipts apparently were bolstered continue auctions of three-year nominal notes elicited in 2007 by the earlier run-up in real estate values, but little reaction in financial markets. The Treasury also the deceleration in house prices will likely slow the rise trimmed some auction sizes for a few other coupon in local revenues down the road. Moreover, many state securities over the first three quarters of the year as the and local governments expect to face significant struc- narrower deficit reduced borrowing needs. Data suggest tural imbalances in their budgets in coming years as a that the proportion of nominal coupon securities pur- result of the ongoing pressures from Medicaid and the chased at Treasury auctions by foreign official institu- need to provide pensions and health care to their retired tions edged down over the second half of 2007, but the employees. proportion has changed little, on net, since mid-2005. According to the NIPA, real expenditures on con- sumption and gross investment by state and local gov- ernments continued to expand briskly in the second State and Local Government half of 2007. Much of the strength was in construction spending, which picked up speed early last year after The fiscal condition of state and local governments having been essentially flat between 2002 and 2006. appears to have lost some luster in 2007 after improv- Meanwhile, real outlays for current operations remained ing significantly between the early part of the decade on the moderate uptrend that has been evident since and 2006. Indeed, for the state and local sector as a 2006. whole, net saving as measured in the NIPA, which Boosted by spending on education and industrial aid, is broadly similar to the surplus in an operating bud- borrowing for new capital expenditures by state and get, fell from a recent high of S25 billion in 2006 to local governments was very strong in 2007. Refundings roughly zero, on average, during the first three quarters in advance of retirements were brisk in the early part of 2007. The downshift occurred as revenue increases of the year as issuers locked in low interest rates,b ut tailed off after a period of hefty gains and as nominal refundings subsided in the second half as a result expenditures—especially on energy and health care— of higher volatility and reduced liquidity in the munici- rose sharply. Recent information from individual states pal bond market. By contrast, short-term borrowing points to a good deal of unevenness in current budget picked up a bit during the second half of the year, pos- conditions. Some states—especially those in agricul- sibly because of some deterioration in state and local tural and energy-producing regions—continue to enjoy budgets. strong fiscal positions. Others, however, arc reporting Municipal issuers are benefiting from lower interest sizable shortfalls in revenues, in part because sales tax rates, as bond yields have declined some since midyear. collections are being hit hard by the weakness in pur- However, investors reportedly have become increas- chases of housing-related items. In these circumstances, ingly concerned about the weaker fiscal outlooks for some states may have to cut spending or raise taxes to many state and local governments and the condition satisfy their balanced-budget requirements. At the local of municipal bond insurers. Partly as a result of those developments, the ratio of an index of municipal bond yields to the yield on comparable-maturity Treasuries State and local government net saving, 1987-2007 has climbed to the top end of its historical range. Some indicators of credit quality in the municipal Percent of nominal GDP bond sector have begun pointing to greater weakness in recent months. Rating upgrades have slowed while downgrades have risen. A substantial number of rev- enue bonds for projects insured by a subsidiary of a major investment bank were downgraded in October. In January another group of bonds was downgraded because of the downgrade of their insurer. National Saving Total net national saving—that is, the saving of house- 1989 1992 1995 1998 2001 2004 2007 holds, businesses, and governments excluding depre- NOTE: The data, which are quarterly, are on a national income and product ciation charges—was equal to about 1V2 percent of account basis and extend through 2007:Q3. SOURCE: Department of Commerce, Bureau of Economic Analysis. nominal GDP, on average, during the first three quarters 83 Board of Governors of the Federal Reserve System \ 7 Net saving, 1987-2007 sizable increases for automobiles, agricultural goods, and capital goods, especially aircraft. Exports of ser- vices rose in 2007 but at a slower pace than in the pre- vious year. The value of exports to China, India, Russia, South America, and the members of OPEC rose quite substantially, and gains for exports to Canada and west- em Europe were also sizable. Exports to Mexico and Japan increased at a somewhat slower pace. A slowdown in real imports was also a factor in the positive contribution of net exports to the growth of real GDP last year. The growth of real imports of goods and services decreased to about 1 Vi percent in 2007, down from a 33A percent rise in 2006, in part because of a slowdown in U.S. domestie demand and the depre- I i I I I 1 I I I 1 I I I I 1987 1991 1995 1999 2003 2007 ciation of the dollar. Although real imports of capital NOTE: The data are quarterly and extend through 2OO7:Q3. Nonfederal goods were strong, the growth of most other major cat- saving is the sum of personal and net business saving and She net saving of egories declined. Despite the moderation in the growth state and local governments. SOURCE: Department of Commerce, Bureau of Economic Analysis, of imports overall, the value of goods (excluding oil) imported from western Europe, China, and Mexico still of 2007, The drain on national saving from the federal rose at solid rates. budget deficit was smaller than it had been a few years Given those movements in exports and imports, earlier. However, net business saving receded somewhat along with somewhat higher net investment income, from the relatively high levels of the preceding few the U.S. current account deficit appears likely to have years, and personal saving was very low for the third shrunk in 2007 on an annual basis for the first time consecutive year. since 2001. The current aceount deficit narrowed from Net national saving fell appreciably as a percentage $811 billion in 2006 to an average of $753 billion at of GDP between the late 1990s and the early part of this an annual rate, or around 5¥i percent of nominal GDP, decade; that ratio has changed little since 2002 (apart in the first three quarters of 2007 (the latest available from the third quarter of 2005, which was marked by data). However, its largest component, the trade defi- sizable hurricane-related property losses). If not boost- cit, widened in the fourth quarter because of a steep ed over the longer run, persistent low levels of national increase in the price of imported oil. saving will be associated with either slower capital The price of crude oil soared on world markets formation or continued heavy borrowing from abroad, in 2007. The spot price of West Texas intermediate either of which would retard the rise in the standard of increased from around $60 per barrel at the end of 2006 living of U.S. residents over time and hamper the abili- to about $100 at present. The strong demand for oil ty of the nation to meet the retirement needs of an aging population. Change in real imports and exports of goods and scrviees, The External Sector 1999-2007 International Trade n Imports • Exports The external sector provided significant support to economic activity in the second half of last year. Net exports added almost 1 percentage point to U.S. GDP ii . n i Ji growth during that period, according to the latest GDP release from the Bureau of Economic Analysis, but data received since then suggest a somewhat larger positive contribution. The contribution of net exports was sup- ported by a robust expansion—about 11 percent at an annual rate—of real exports of goods and services that was helped by still-solid growth of foreign economies and the effects of the past depreciation of the dollar. 1999 2001 2003 The broad-based rise in real exports of goods included SOURCE: Department of Commerce. 84 18 Monetary Policy Report to the Congress D February 2008 U.S. trade and current account balances, 1999-2007 to nearly $95 per barrel and likely reflects a belief by oil market participants that the balance of supply and demand will remain tight for some time to come. Broad indexes of non-oil commodities prices remain elevated. Although they fell back slightly over the second half of last year, prices have again risen since the start of 2008. Prices of a number of metals, which surged in the spring on strong global demand, retreated somewhat during the latter half of 2007 as production increased and as users substituted into other materials. However, more recently the prices of copper and alumi- num have moved back up. Prices for food commodities continue to rise steeply. Poor harvests in Australia as well as in parts of Europe and Asia led to higher wheat prices. The price of soybeans also has risen sharply NOTE: The data are quarterly. For the irade account, the data extend because acreage has been shifted to corn production, in through 2007:Q4; for the current account, they extend through 2007:Q3. part to produce biofuel; in addition, the soybean harvest SOURCK: Department of Commerce. in China was down sharply from last year. Import price inflation increased in 2007, with the was powered by the continued expansion of the world depreciation of the dollar providing an important impe- economy through 2007, especially in the developing tus; higher oil and food prices also contributed. Prices countries. In addition, a number of actual and potential of imported goods rose about 8/2 percent in 2007, but disruptions to supply have contributed to the surge in excluding food, oil, and natural gas, such prices rose oil prices. OPEC members announced cuts to oil pro- 2lA percent; both rates were somewhat higher than in duction in late 2006. Despite recent agreements that the previous year. have reversed some of these cuts, OPEC production remains restrained. The growth of production has also been hampered by some governments' moves to take The Financial Account control of oil resources or raise their share of revenues. Geopolitical tensions in the Middle East and instability Although the current account deficit appears to have in Nigeria have contributed to concerns about oil supply narrowed during 2007, it remains sizable and continues as well. The price of the far-dated NYMEX oil futures to require a significant inflow of financing from abroad. contract (currently for delivery in 2016) now has risen As in the past, the deficit was largely financed by for- eign net acquisitions of U.S. securities. Prices of oil and of nonfuel commodities, 2003-08 The global financial turmoil that began in the sum- mer left an imprint on the components of the U.S. January 2003 = 100 U.S. net financial inflows, 2003-07 Billions of dollais 2003 2004 2005 2006 2007 2008 NOTE: The data are monthly. The last observation for the oil price is the average for February 1 through February 21, 2008. The price of nonfuel commodities extends through January 2008. The oil price is the spot price of West Texas intermediate crude oil. The price of nonfuel commodities is an index of forty-five primary~commodity prices. SOURCE: For oil, the Commodity Research Bureau; for nonfuel com- NOTE: The data are quarterly and extend through 2007 :Q3. modities, International Monetary Fund. SOURCE: DepanmenlofCommerce. 85 Board of Governors of the Federal Reserve System 19 Net private foreign purchases of long-term U.S. securities, securities, and a notable pickup in acquisitions of both 2003-07 corporate equities and corporate debt securities. Net purchases of foreign securities by U.S. residents, which represent a financial outflow, were maintained at a brisk pace for 2007 as a whole. Outflows associated with U.S. direct investment abroad remained strong. The Labor Market Employment and Unemployment The demand for labor decelerated early last year and has slowed further of late. The average monthly gain in private nonfarm payroll employment, which slid from about 160,000 in 2006 to 80,000 over the first ten months of 2007, was only 50,000 in November and NOTE: The data are quarterly and extend through 2007:Q3, SOITRCE: Department of Commerce. December, and private employment was nearly flat in January 2008. The civilian unemployment rate, which financial account. After acquiring record amounts of had hovered around AVz percent in the early part of U.S. securities in the first half of 2007, foreign private 2007, drifted up about % percentage point from May to investors sold a sizable net amount of non-Treasury November; it rose another SA percentage point, on net, U.S. securities in the third quarter—the first quarterly over the following two months and stood at 4.9 percent net sale of such securities in more than fifteen years. in January. In contrast, foreign private demand for U.S. Treasury Employment in residential construction has been securities picked up sharply in the third quarter as falling for about two years and now stands 375,000 global investors shifted into less-risky positions. On below the high reached in early 2006. Jobs in related balance, flows out of non-Treasuries and into U.S. Trea- financial industries have also decreased lately. Payrolls suries nearly offset one another, and total foreign pri- in the manufacturing sector, which have been on a vate acquisitions of U.S. securities recorded an unusu- downtrend for more than a quarter-century, have con- ally small net inflow for the third quarter. Preliminary tinued to shrink. Meanwhile, some service-producing data for the fourth quarter indicate renewed foreign industries have maintained solid gains. In particular, acquisitions of U.S. corporate securities, although at a hiring by health and education institutions and by food notably weaker pace than in the first half of the year. services and drinking establishments has remained Foreign private demand for U.S. Treasury securities has strong, and job gains at businesses providing profes- remained strong. As issuers of asset-backed commercial paper around the globe began to encounter difficulties over the sum- Net change in private payroll employment, 2001-08 mer, nonbank entities that had issued commercial paper in the United States and lent the proceeds to foreign parents sharply curtailed those activities. As a result, those entities reduced their claims on foreign par- ents, and net financial inflows from nonbank entities thus were sizable in the third quarter. Foreign inflows through direct investment into the United States surged in the third quarter, as foreign parents injected addi- tional equity capital into their U.S. affiliates. Foreign offleial inflows slowed in the third quarter, as Asian central banks acquired debt securities issued by government-sponsored enterprises (GSEs) but on net sold U.S. Treasury securities. Official inflows appear to have strengthened again in the fourth quarter, with a 2001 2002 2003 20O4 2005 2006 2007 2008 return to moderate purchases of U.S. Treasury securi- NOTE: Nonfarm business sector. The data arc monthly and extend through January 2008. ties, continued strong purchases of GSE-issued debt SouRcn: Department of Labor, Bureau of Labor Statistics. 86 20 Monetary Policy Report to the Congress • February 2008 Civilian unemployment rate, 1974-2008 uary; it has changed little, on net, over the past couple of years after falling appreciably over the first half of the decade. Most other recent indicators also point to some softening of labor market conditions. Initial claims for unemployment insurance, which had remained rela- tively low through the fall, moved up somewhat in the closing months of 2007; though erratic from week to week, they appear to have risen further in early 2008. Meanwhile, private surveys suggest that firms have cut back on plans for hiring in the near term. Households have also become less upbeat about the prospects for the labor market in the year ahead. i i i H m ill 2008 NOTE: The data are monthly and extend through January 2008. Productivity and Labor Compensation SOURCE: Department of Labor, Bureau of Labor Statistics. Output per hour in the nonfarm business sector rose sional and technical services have been sizable as well. 2Vi percent in 2007 after averaging just 1 lA percent per The increase in joblessness since the spring of 2007 year over the preceding three years. Although estimates has been widespread across major demographic groups. of the underlying pace of productivity growth are quite In January 2008, unemployment rates for men and uncertain, the pickup in measured productivity growth women aged 25 years and older were both about % per- in 2007 suggests that the fundamental forces support- centage point above the levels of last spring, and—as ing a solid underlying trend remain in place. Those typically occurs—rates for teenagers and young adults forees include the rapid pace of technological change as showed larger increases. Among the major racial and well as the ongoing efforts by firms to use information ethnic groups, unemployment rates for blaeks and His- technology to improve the efficiency of their opera- tions. Increases in the amount of capital per worker panics rose somewhat more than did unemployment also appear to be providing an impetus to productivity rates for whites, a differential also typieal of periods growth. when labor market conditions soften. An increase in the number of unemployed who had lost their last jobs Hourly compensation rose at a relatively moder- (as opposed to those who had voluntarily left their jobs ate rate in 2007 despite a pickup in overall consumer or were new entrants to the labor foree) accounted for price inflation, a continued advance in labor produc- about half of the rise in the overall jobless rate between tivity, and generally tight labor markets. The employ- the spring of 2007 and January 2008. The labor force Change in output per hour, 1948-2007 participation rate stood slightly above 66 percent in Jan- Labor force participation rate, 1974-2008 111 III!Ill i { j 1 1 I I i 1 j 1 1 1 NOTE: Nonfarm business sector. Change for each multiyear period is measured to the fourth quarter of the final year of the period from the fourth NOTE: The daia are monthly and extend through January 2008, quarter of the year immediately preceding the period. SOURCE: Department of Labor, Bureau of Labor Statistics. SOURCE: Department of Labor, Bureau of Labor Statistics, 87 Board of Governors of the Federal Reserve System Measures of change in hourly compensation, 1997-2007 Change in unit labor costs, 1996-2007 1997 1999 2005 2007 5996-2000 2001 2002 2003 2004 2005 2006 2007 NOTE: The data are quarterly and cxiend through 20O7:Q4. For nonfarm Nora: Nonfarm business sector. The change for 1996 to 2000 is measured business compensation, change is over four quarters; for the employment cost to 2000:Q4 from 1995:Q4. index (ECI), change is over the twelve months ending in the Sast month of SOURCE: Department of Labor, Bureau of Labor Statistics. each quarter. The nonfarm business sector excludes farms, government, nonprofit institutions, and households. The sector covered by the ECI used h n e e r w e i E s C th I e s s e a r m ies e a w s a t s h e in n tr o o n d f u ar c m ed b f u o s r i n d e a s t s a s a ec s to o r f p 2 lu 0 s 0 1 n , o b n u p t r o t f h it e in ne st w it u s ti e o ri n e s s . A is I percent. Unit labor costs rose about 2% percent per continuous with the old year, on average, from 2004 to 2006 after having been SOURCE: Department of Labor, Bureau of Labor Statistics. nearly flat over the preceding three years. ment cost index (ECI) for private industry workers, which measures both wages and the cost of benefits, Prices increased 3 percent in nominal terms over the twelve months of 2007, about in line with its pace in 2005 and 2006. Within the ECI, wages and salaries increased Headline consumer price inflation slowed dramatically 3 lA percent in 2007, the same as in 2006 but % per- in the third quarter of 2007, when energy prices hit a centage point above the increases in 2004 and 2005. lull after their first-half surge, but it moved back up in Meanwhile, increases in the cost of providing benefits the fourth quarter as energy prices climbed again. Over have slowed markedly in recent years, in part because the year as a whole, the overall PCE chain-type price employer contributions for health insurance have decel- index rose V/i percent, 11/2 percentage points more than in 2006. Core price inflation excludes the direct effects erated. The increase in benefits costs in 2007, which of increases in food and energy prices; these increases amounted to just 2Vi percent, was also held down by were sharp last year. Like headline inflation, core PCE a drop in employer contributions to defined-benefit inflation was uneven from quarter to quarter in 2007; retirement plans in the first quarter. The lower contribu- over the four quarters of the year, it averaged a bit more tions appear to have been facilitated by several factors, than 2 percent. In 2006, the core index rose VA percent. including a high level of employer contributions over Although data for PCE prices in January 2008 are not the preceding few years and the strong performance of yet available, information from the consumer price the stock market in 2006. index (CPI) and other sources suggests that both total According to preliminary data, nominal compensa- and core inflation remained on the high side early this tion per hour in the nonfarm business sector—an alter- year after having firmed in the fourth quarter of 2007. native measure of hourly compensation derived from The PCE price index for energy rose nearly 20 per- the compensation data in the NIPA—rose 3% percent cent over the four quarters of 2007 after having fallen in 2007, somewhat faster than the ECI. In 2006, the modestly in 2006. The retail price of gasoline was up nonfarm business measure had risen 5 percent, with about 30 percent over the year as a whole, driven higher an apparent boost from a high level of bonuses and by the upsurge in the cost of crude oil. In 2008, gasoline stock option exercises, which do not seem to have been prices through mid-February were around the high lev- repeated in 2O07.9 The moderation in this measure last els seen late last year. Prices of natural gas rose sharply year, along with the step-up in measured productivity growth, held the increase in unit labor costs in 2007 to 9. Income received from the exercise of stock options is included but not in the ECI. Income received from most types of bonuses is in the measure of hourly compensation in the nonfarm business sector included in both measures of compensation. 22 Monetary Policy Report to the Congress • February 2008 in early 2007, but they receded over the second half of Change in core consumer prices, 2001-07 the year as inventories reached their highest levels since the early 1990s. So far in 2008, natural gas prices have risen notably as inventories have fallen back into line Core consumer price index with seasonal norms. Consumer prices for electricity Chain-type price index for core PCE rose sharply last fall, likely because of last year's higher prices of fossil fuel inputs to electricity generation. Last year's increase in the PCE price index for food kill and beverages, at AlA percent, was the largest in nearly two decades. Food prices accelerated in response to strong world demand and high demand for corn for the production of ethanoi. Taken together, prices for meats, poultry, fish, and eggs rose 5a/i percent, and prices of dairy products were up at double-digit rates. Prices for purchased meals and beverages, which typically 2001 20O2 2003 2«M 2005 2006 2007 are influenced more by labor and other business costs SOURCE: For core consumer price index, Department of Labor, Bureau of than by farm prices, also recorded a sizable increase Labor Statistics; for core PCE price index, Department of Commerce, Bureau last year. In commodity markets, grain prices soared to of Economic Analysis. near-record levels in late 2007 as strong global demand outstripped available supply, and they have moved somewhat higher since the turn of the year. Mean- last spring; apart from a downward blip in the autumn, while, spot prices of livestock have declined of late; it remained there through January 2008 and spurted to the decrease should provide some offset to the upward 3% percent in the preliminary estimate for February. In pressure from grain prices and thus help limit increases contrast, most indicators suggest that expectations for in consumer food prices in coming months. longer-run inflation have remained reasonably well con- The pattern of core PCE inflation was uneven dur- tained. The preliminary February result for median five- ing 2007. In the first half of the year, core inflation was to ten-year inflation expectations in the Reuters/Univer- damped significantly by unusually soft prices for appar- sity of Michigan survey, at 3.0 percent, was around the el, prescription drugs, and nonmarket items (especially middle of the narrow range that has prevailed for the financial services provided by banks without explicit past few years. And according to the Survey of Profes- charge); all of these developments proved transitory and sional Forecasters, conducted by the Federal Reserve were reversed later in the year with little net effect on Bank of Philadelphia, expectations of CPI inflation over the next ten years have remained around 2Vi per- core inflation over the year as a whole. Meanwhile, cent, a level that has been essentially unchanged since the rate of increase in the core CPf dropped from 23/i percent in 2006 to 2'A percent in 2007; the main 1998. Meanwhile, ten-year inflation compensation, as measured by the spreads of yields on nominal Treasury reason for the sharper deceleration in the core CPI than securities over those on their inflation-protected coun- in the core PCE price index is that housing costs, which terparts, has changed little, on balance, since mid- rose less rapidly in 2007 than they had in 2006, carry 2007. much greater weight in the core CPI. More fundamentally, the behavior of core inflation in Last year's sharp rise in energy prices also left an 2007 was shaped by many of the same forces that were imprint on the price index for GDP, whieh rose a at work in 2006. The December jump in unemployment little more than 2% percent for the second year in a notwithstanding, resource utilization in labor and prod- row.J0 Excluding food and energy prices, the increase uct markets remained fairly high last year, and increases in GDP prices slowed from 3 percent in 2006 to in prices for energy and other industrial commodities 2% percent in 2007; significantly smaller increases continued to add to the cost of producing a wide vari- in construction prices accounted for much of the ety of goods and services. Higher prices for non-oil deceleration. imports also likely put some upward pressure on core inflation. Meanwhile, the news on inflation expectations has been mixed. Probably reflecting the higher rate of actual headline inflation, the median expectation for year-ahead inflation in the Reuters/University of Michi- 10. The effect of energy prices on GDP prices was much smaller gan Surveys of Consumers moved up from 3 percent than that on PCE prices. The reason is that much of the energy-price increase was attributable to the higher price of imported oil, which is in early 2007 to between VA percent and 3Vi percent excluded from GDP because it is not part of domestic production. 89 Board of Governors of the Federal Reserve System 23 Alternative measures of price change, 2005—07 around midyear, as credit quality in that sector contin- ued to worsen and losses mounted, investors began to retreat from structured credit products and from risky Price measure 2005 2006 2007 assets more generally. Strains began to emerge in the G C r h o a s i s n - d t o y m pe estic product<GDP) 3.4 2.7 2.6 leveraged syndicated loan market in late June and then Excluding food and energy 3.3 2.9 2.3 surfaced in the asset-backed commercial paper and Personal consumption expenditures (PCE) 3.2 i.9 3.4 term bank funding markets in August. After a respite in Excluding food and energy 2.2 2.3 2.1 Market-based PCE excluding food late September and October, revelations of larger-than- and energy 1.7 2.0 1.9 expected losses at several financial firms and a weaker Fixed-weight economic outlook contributed to year-end pressures in Consumer price index 3.8 1.9 4.0 Excluding food and energy 2.1 2.7 2.3 short-term funding markets that exacerbated financial NOTE: Changes are based on quarterly averages of seasonally adjusted data. strains and heightened market volatility. Financial mar- SOUHCE: For chain-type measures. Department of Commerce, Bureau of kets remained volatile through mid-February, in part Economic Analysis; for fixed-weight measures. Department of Labor, Bureau of Labor Statistics. owing to a further downgrading of the economic out- look and problems at some financial guarantors. Signs of investor nervousness about the mortgage Financial Markets situation first appeared in December 2006 and then intensified in late February 2007, at a time when softer- Domestic and international financial markets experi- than-expected U.S. economic data were adding to mar- enced substantial strains and volatility in 2007 that were ket uncertainty. Over this period, mortgage companies sparked by the ongoing deterioration of the subprime specializing in subprime products began to experi- mortgage sector and emerging worries about the near- ence considerable funding pressures, and many failed, term outlook for U.S. economic growth. Substantial because rising delinquencies on recently originated losses on structured products related to subprime subprime mortgages required those firms to repurchase mortgages caused market participants to reassess the the bad loans from securitized pools. Financial markets risks associated with a wide range of other structured calmed in April, however, and liquidity in major mar- financial instruments. The result was a drying up of kets remained ample. In June, rating agencies down- markets for subprime and nontraditional mortgage graded or put under review for possible downgrade the products as well as a significant impairment of the mar- credit ratings of a large number of securities backed by kets for asset-backed commercial paper and leveraged subprime mortgages. Shortly thereafter, a few hedge syndicated loans. Those dislocations generated unex- funds experienced serious difficulties as a result of pected balance sheet pressures at some major financial subprime-related investments. institutions, and the pressures in turn contributed to Prices of indexes of credit default swaps on residen- severe strains in short-term bank funding markets. The tial mortgage-backed securities backed by subprime Federal Reserve responded to the financial turmoil and the risks to the broader economy along two tracks: It mortgages—which had already weakened over the first took a series of actions to support market liquidity and half of 2007 for the lower-rated tranches—dropped functioning (partly in coordination with foreign central steeply in July for both lower-rated and higher-rated banks), and it eased monetary policy in pursuit of its tranches. Subsequently, investor demand for securities macroeconomic objectives. As a result of the downward backed by subprime and alt-A mortgage pools dwin- revision to the economic outlook and strained finan- dled, and the securitization market for those products cial conditions, yields on Treasury securities fell, risk virtually shut down. Those developments amplified spreads widened significantly, equity prices dropped, credit and funding pressures on mortgage companies and volatility in many financial markets increased. specializing in subprime mortgages; with no buyers for the mortgages they originated, more of those firms were forced to close or drastically reduce their operations, and subprime originations slowed to a crawl. Origina- Market Functioning and Financial Stability tions of alt-A mortgages—which had held up over the first half of the year—also dropped sharply beginning in The ongoing erosion in the credit quality of subprime July. Interest rates on jumbo loans increased, but insti- residential mortgages, particularly adjustable-rate tutions that had the capacity to hold such loans on their mortgages, has exposed weaknesses in other financial balance sheets continued to make them available to markets and posed challenges to financial institutions. prime borrowers. In contrast, the market for conforming Over the first half of 2007, problems were mostly iso- mortgages for prime borrowers was affected relatively lated within the subprime mortgage markets. However, little. Indeed, the issuance of securities carrying guaran- 90 24 Monetary Policy Report to the Congress G February 2008 Prices of Indexes of credit default swaps on loans, trading volumes were reportedly large, but bid- subprime mortgages, 2007-08 asked spreads widened sharply and prices, which had been high in the first half of 2007, declined markedly. Implied spreads on an index of loan-only credit default swaps (LCDX) spiked in July and remained elevated in August. Unable to distribute many leveraged syndicated loans that they had reportedly underwritten—a problem apparently affecting about $250 billion of such loans in the United States alone—banks faced the prospect of bringing those loans onto their balance sheets as the underlying deals closed. At the end of July, European asset-backed com- mercial paper (ABCP) and short-term funding markets were roiled by warnings of heavy losses associated with commercial paper programs backed by U.S. sub- July prime mortgages. On August 9, a major European bank 2007 announced that it had frozen redemptions for three of sho N w OT n E r : e f T e h r e to d p at o a o a ls r c o : f dd aa m iill o yy r t aa g nn a dd eg ee ee s x s x tt tt ee hh nn aa dd tt ww tthh ee rr rr oo ee ui o g r h i g F in eb at r e u d a r i y n 2 2 1 0 . 0 2 6 0 : 0 H 8 2 . . The series its investment funds, citing its inability to value some of SOURCE: Markit. the mortgage-related securities held by the funds. After that announcement, liquidity problems and short-term funding pressures intensified in Europe and emerged in tees from Fannie Mae or Freddie Mac rose somewhat in U.S. money markets. Partly in response to those devel- the second half of the year. opments, the Federal Reserve and other centra! banks The unprecedented decline in the value of highly took steps to foster smoother functioning of short-term rated tranches of mortgage-related securities led inves- credit markets (refer to the box entitled "The Federal tors to doubt their own ability, and that of the rating Reserve's Responses to Financial Strains"). agencies, to evaluate many other types of structured Spreads on U.S. ABCP widened considerably in instruments. The loss of confidence was reflected in mid-August, and the volume of ABCP outstanding significantly higher spreads on the debt of collateralized began a precipitous decline as investors balked at roll- loan obligations (CLOs), and the issuance of such debt ing over paper for more than a few days. Outstanding weakened noticeably over the summer. Because CLOs European ABCP also declined substantially, and the had been the largest purchasers of leveraged syndicated market for Canadian ABCP not sponsored by banks loans, the drop in issuance contributed to the decline in leveraged lending. In the secondary market for such LCDX indexes, 2007-08 Gross issuance of securities backed by alt-A and subprime mortgage pools, 2002—08 D Ait-A • Subprime — 60 1 — 45 — 30 — 15 2007 2008 2002 2003 2004 2005 2006 2007 2008 NOTE: The data are daily and exiend through February 21, 2008- Each LCDX index consists of 100 single-name credit default swaps referencing NOTE: Mortgages in ah-A pools are a mix of prime, near-prime, and entities with first-lien syndicated loans that trade in the secondary market for subprime mortgages; for further details on alt-A pools, refer to text. leveraged loans. Series 8 began trading on May 22, 2007, and series 9 on SOURCE: Inside MBS & A BS. October 3,2007. SOURCE: Markit. 91 Board of Governors of the Federal Reserve System 25 Commercial paper, 2005-08 One-month Libor minus OIS rate, 2007-08 if dollars 280 — <• —1,200 240 — —1,100 —1,000 2 1 0 60 0 — _ — — 8 9 0 0 0 0 20 J 0 u 7 ly 2008 120 — — 700 NOTE: The data are daily and extend through February 21, 2008. An overnight index swap (OIS) is an interest rate swap with the floating rate lied — 600 to an index of daily overnight rales, such as the effective federal funds rate. At maturity, two parties exchange, on the basis of the agreed notional 2005 2006 2007 2008 amount, the difference between interest accrued at the fixed rate and interest accrued through geometric averaging of the floating, or index, rate. Ou N t O si T a E n : d i T ng h s e a d r a e t a s ea a s r o e n a w ll e y e k a l d y j us a t n ed d . F ex o t r e n A d A - t r h a r t o e u d g a h s s F et e - b b r a u c a k r e y d , 2 s 0 p , r e 2 a 0 d 0 o 8 n . SOURCE;: For Libor, British Bankers' Association; for the OIS rate. Prebon. thirty-day exposures is over AA financial rate; for A2/P2-rated nonfinancial, spread is over AA nonftnancial rate. SOURCE: DTCC. virtually collapsed.1' Structured investment vehicles on their funding capacity. Moreover, creditors found (SIVs) and single-seller ABCP conduits that were heav- they could not reliably determine the size of their coun- ily exposed to securities backed by subprime mortgages terparties' potential exposures to those markets, and experienced the greatest difficulties. Unlike traditional concerns about valuation practices added to the overall ABCP programs, SIVs had very little explicit liquid- uncertainty. As a result, banks became much less will- ity support from their sponsors. As a result, investors ing to provide funding to others, including other banks, became particularly concerned about the ability of especially for terms of more than a few days. Spreads StVs—-even those with little or no exposure to residen- of term federal funds rates and term Libor over rates tial mortgages—to make timely payments, and demand on comparable-maturity overnight index swaps wid- for ABCP issued by SIVs fell sharply. Over the next ened appreciably, and the liquidity in these markets few weeks, some U.S. issuers invoked their right to diminished (for the definition of overnight index swaps, extend the maturity of their paper. Others temporarily refer to the accompanying figure). European banks drew on their bank-provided baekup credit lines, and a also sought to secure term funding in their domestic few issuers defaulted. The general uncertainty and lack currencies, and similar spreads were seen in term euro of liquidity also led to some decrease in demand for and sterling Libor markets. Liquidity in the foreign lower-tier unsecured nonfinancial commercial paper- exchange swap market was poor over this period, and especially at longer maturities—and spreads in that European firms found it more difficult and costly to use segment of the market widened markedly in August as the foreign exchange swap market to swap term funds well. Issuers of high-grade unsecured commercial paper denominated in euros or other currencies for funds were largely unaffected by the turmoil and experienced denominated in dollars. Term funding markets in the little disruption. Japanese yen and Australian dollar also came under At the same time, term interbank funding markets pressure as foreign institutions attempted to borrow in the United States and Europe eame under pressure. in those currencies and swap the funds into dollars or Banks recognized that the difficulties in the markets euros. for mortgages, syndicated loans, and commercial paper Against that backdrop, investors fled to the relative could lead to substantially larger-than-anticipated ealls safety of Treasury securities, particularly Treasury bills, during mid-August. For example, inflows into money market mutual funds investing only in Treasury and 11. In December, a group of investor representatives agreed in principle to restructure Canadian nonbank ABCP into longer-term agency securities jumped in August. Surges of safe- notes. haven demand eaused Treasury bill rates to plunge at 92 26 Monetary Policy Report to the Congress LI February 2008 The Federal Reserve's Responses to Financial Strains In response to the serious financial strains that level. (Indeed, despite heightened demand for emerged last August, the Federal Reserve has liquidity, the effective federal funds rate was undertaken a number of measures to foster the somewhat below the target for a time in August normal functioning of financial markets and and eariy September, as efforts to keep the rate thereby promote its dual objectives of maximum near the target were hampered by technical fac- employment and price stability. tors and financial market volatility,} After the In mid-August, the Federal Reserve, as well September meeting of the Federal Open Market as several foreign central banks, took actions Committee, conditions in overnight funding designed to provide liquidity and help stabilize markets improved further. The volume of loans markets. On August 9, the European Centra! to depository institutions made through the Bank (ECB) conducted an unscheduled ten- discount window increased at times because der operation in response to sharply elevated of term loans to a relatively small number of demands for liquidity by European banks, an institutions, but it remained generally moder- action it repeated several more times in sub- ate, institutions may have been reluctant to use sequent weeks. On August 10, similar stresses the discount window, perhaps fearing that their emerged in U.S. money markets, and the Fed- borrowing would become known and would be eral Reserve added substantial reserves to meet seen by creditors and counterparties as a sign of heightened demand for funds from banks. financial weakness—the so-called stigma prob- Short-term markets remained under consider- lem. Nonetheless, collateral placed by banks able pressure over subsequent days despite the at the discount window in anticipation of pos- provision of ample liquidity in overnight funding sible borrowing rose sharply during August and markets by the Federal Reserve, the ECB, and the September, which suggested that some banks central banks of other major industrialized coun- viewed the discount window as a potentially tries. On August 17, the Federal Reserve Board valuable option. announced a narrowing of the spread between Pressures in financial markets ebbed for a the federal funds rate and the discount rate from time in the fall but rose again later in the year. 100 basis points to 50 basis points and changed On November 26, the Federal Reserve Bank of discount window lending practices to allow the New York announced some additional modest provision of term financing for as long as thirty temporary changes to the SOMA securities lend- days, renewable by the borrower, To ease pres- ing program that were designed to further relax sures in the Treasury market, the Federal Reserve the limitations on borrowing particular Treasury Bank of New York announced on August 21 securities and to improve the functioning of some temporary changes to the terms and con- the Treasury market. In addition, the New York ditions of the System Open Market Account Reserve Bank stated that the Open Market Trad- (SOMA) securities lending program. ing Desk planned to conduct a series of term The Federal Reserve's efforts achieved some repurchase agreements that would extend over of the desired results. The provision of increased year-end and that it would provide sufficient liquidity generally succeeded in keeping the reserves to resist upward pressures on the federal federal funds rate from rising above its intended funds rate around year-end. Then on December (continued on next pago) 93 Board of Governors of the Federal Reserve System 27 (continued from preceding page) 12, the Federal Reserve and several foreign lower in the January and February auctions. central banks announced a coordinated effort The lower spread apparently reflected some to facilitate a return to more-normal pricing and improvement in banks' access to term funding functioning in term funding markets. As part of after the turn of the year. Although isolating that effort, the Federal Reserve announced the the impact of the TAF on financial markets is creation of a temporary Term Auction Facility not easy, a decline in spreads in term funding {TAF} to provide secured term funding to eligible markets since early December provides some depository institutions through an auction evidence that the TAF may have had beneficial mechanism beginning in mid-December. The effects on financial markets. The initial experi- Federal Reserve also established swap lines ence with the TAF suggests that it may welt be with the ECB and the Swiss National Bank a useful complement to the discount window in {SNB}, which provided dollar funds that those some circumstances, and the Federal Reserve central banks could lend in their jurisdictions. Board will consider making it a permanent addi- At the same time, the Bank of England and the tion to the Federal Reserve's available instru- Bank of Canada announced plans to conduct ments for providing liquidity to the banking similar term funding operations in their own system. currencies. The swap arrangements with foreign central The Federal Reserve has conducted six TAF banks aiiowed for up to $20 billion in currency auctions thus far, two of $20 billion in Decem- swaps with the ECB and up to $4 billion with ber, two of $30 billion in January, and two of the SNB. Drawing upon these lines, the ECB S30 billion in February. The auctions attracted a auctioned $10 billion in dollar funds on Decem- large number of bidders. The ratio of the dollar ber 17 and another $10 billion on December value of bids to the amount offered (the bid-to- 20 in coordination with the Federal Reserve's cover ratio) at the two auctions in December TAF auctions. The SNB auctioned $4 billion in was about 3. The auctions in January and Febru- funds on December 17. The bid-to-cover ratios ary were somewhat less oversubscribed, with at the ECB and SNB auctions in December bid-to-cover ratios of roughly 2 on January 14, ranged between 1 !4 and 414; the actions were February 11, and February 25 and of VA on Jan- considered successful in helping to give foreign uary 28, The lower bid-to-cover ratios in those financial institutions access to additional doHar auctions may have reflected improved liquidity funding. The December loans were renewed by in term funding markets, the larger auction size, the ECB and SNB at auctions in January, with and, for the January 28 auction, some uncertain- bid-to-cover ratios ranging from VU to 2%. The ty about the monetary policy action that would ECB and SNB have not conducted auctions in be taken at the January 29-30 FOMC meeting. February; ECB officials have indicated that con- The spread of the interest rate for the auc- sideration would be given to reactivating dollar tioned funds over the minimum bid rate (the auctions if conditions appear to warrant such overnight-index-swap rate corresponding to actions. the maturity of the credit being auctioned) was about 50 basis points in December but was 94 28 Monetary Policy Report to the Congress • February 2008 times, and the considerable volatility in that market was alt-A mortgage markets remain essentially shuttered. likely exacerbated in September by a seasonal reduction Conditions in the market for leveraged syndicated loans in bill supply. Bid-asked spreads in the Treasury bill have worsened, and the forward calendar of committed market widened substantially in this period. deals remains substantial. Risk spreads on corporate Financial conditions appeared to improve somewhat bonds widened significantly in January, and equity in late September and October after the larger-than- prices dropped. Most recently, demand has evaporated expected reduction of 50 basis points in the federal for auction-rate securities—long-term debt (much of funds rate at the September FOMC meeting and a few which is municipal bonds) with floating interest rates encouraging reports on economic activity. Spreads in that are reset at frequent, regular auctions—and thereby many short-term funding markets partially reversed imposed higher rates on issuers and reduced liquidity their August run-ups. Bid-asked spreads in the inter- for current holders. dealer market for Treasury bills were a bit less elevated In January and February, problems at several finan- than they had been in August. But the Treasury bill cial guarantors intensified as rating agencies and inves- market remained thin, and yields were volatile at times. tors became more concerned that guarantors' exposures In the syndicated loan market, implied LCDX spreads to collateralized debt obligations that hold asset-backed partly reversed their summer surge, and some multibil- securities (especially those backed by subprime resi- lion-dollar deals were successfully placed in the market. dential mortgages) had imperiled the guarantors'AAA However, underwriting banks were forced to take siz- ratings, indeed, the rating agencies downgraded a few able discounts from par value to induce investors to financial guarantors and put some firms on watch for purchase the loans, and they retained significantly possible downgrades; financial guarantors' equity prices larger-than-intended portions of deals on their own bal- declined, and credit default swap spreads increased. A ance sheets. The improvements in market functioning number of guarantors are undertaking efforts to bolster proved to be short lived, in part because of a further their financial strength. worsening in the outlook for the housing sector and Financial guarantors have played an important role associated concerns about possible effects on financial in the markets for municipal bonds and for some struc- institutions and the economy. tured finance products by providing insurance against The strains in financial markets intensified during default. Those markets have already felt some effects November and December. The syndicated loan mar- from the stress at the financial guarantors and could be ket again ground to a halt, and spreads on the LCDX more substantially affected by any future downgrades. indexes moved up. The heightened uncertainties and The direct exposures of U.S. banks to losses from ongoing financial turmoil, along with the desire of downgrades of guarantors' ratings—through banks' financial institutions to show safe and liquid assets on holdings of municipal bonds and credit protection on their year-end statements, generated significant year- structured products—appear to be moderate relative to end pressures in short-term funding markets for the the banks' capital. But some large banks and broker- first time in several years. Spreads on one-month Libor dealers could experience significant funding pressures and term federal funds shot up in late November when from structured products tied to municipal bonds that their maturities crossed year-end. Similarly, spreads might return to their balance sheets if guarantors are on ABCP and lower-tier unsecured commercial paper downgraded below specified thresholds or if inves- widened further over the period. Strong demand for tors choose to unwind their investments in advance of safe assets over year-end drove yields on short-dated potential downgrades. Treasury bills maturing in early 2008 to low levels, and Although U.S. financial markets and institutions liquidity in that market was impaired at times. have encountered considerable difficulties over the past In mid-December, the Federal Reserve announced several months, the financial system entered that period coordinated action with a number of other central banks with some distinct strengths. In particular, most large to help facilitate a return to more-normal pricing and financial institutions had strong capital positions, and functioning in term funding markets. The efforts of the the financial infrastructure was robust. Although some central banks, combined with the passage of year-end, large financial institutions have experienced sizable appeared to help steady short-term financial markets losses, the sector generally remains healthy. A number in early 2008. So far this year, commercial paper of the firms that have reported sizable write-downs of spreads—both for ABCP and for lower-tier unsecured assets have been able to raise additional capital. Market paper—and term bank funding spreads have dropped, infrastructure for clearing and settlement performed although they remain above the levels that prevailed well over the year, even when volatility spiked and trad- before last August. In contrast, liquidity in the Treasury ing volumes were very large. bill market has been inconsistent. The subprime and Moreover, not all markets experienced significant 95 Board of Governors of the Federal Reserve System 29 impairment. For instance, the investment-grade corpo- TIPS-based inflation compensation, 2003-08 rate bond market reportedly functioned well over most of the period, and the unsecured high-grade commercial paper market appeared little affected by the difficul- ties encountered in other short-term funding markets. — Ten-year The securitization of consumer loans and conforming residential mortgages was robust. Despite a few notable failures, hedge funds overall seemed to hold up fairly well, and counterparties of failing hedge funds did not sustain material losses. Policy Expectations and Interest Rates The current target for the federal funds rate, 3 percent, 2003 2004 2005 2006 2007 2008 is substantially below the level that investors expected NOTE: The data are daily and extend through February 21,2008. Based on at the end of June 2007. Judging from futures quotes a comparison of the yield curve for Treasury inflation-protected securities (TIPS) with the nominal off-the-run Treasury yield curve. at that time, market participants expected the FOMC SOURCE: Federal Reserve Board calculations based on daia provided by the to shave at most 25 basis points from the federal funds Federal Reserve Bank of New York and Barclays. rate by February 2008 rather than the 225 basis points that has been realized. Investors currently expect about 100 basis points of additional easing by the of the year, and ten-year yields shed about 100 basis end of 2008. Uncertainty about the path of policy had points. Treasury yields fell significantly more in early been very low during the first half of the year, but it 2008, especially for shorter-term securities, as policy increased appreciably over the summer and generally expectations shifted down in response to signs of fur- has remained around its long-run historical average ther weakness in the economic outlook. As of February since then. 21, the two-year yield was about 2 percent, and the ten- Although nominal Treasury yields rose somewhat year yield was about 3% percent. over the first half of last year, rates subsequently fell Yields on inflation-indexed Treasury securities also sharply as the outlook for the economy dimmed and as declined considerably in the second half of 2007 and market participants revised their expectations for mon- into 2008. The difference between the five-year nomi- etary policy accordingly. Treasury bill yields deelined nal Treasury yield and the five-year inflation-indexed to particularly low levels at times because of increased Treasury yield—five-year inflation compensation— demand for safe and liquid assets. On net, two-year yields fell roughly 180 basis points in the second half Spreads of corporate bond yields over comparable off-the-run Treasury yields, by securities rating, 1998-2008 Interest rates on selected Treasury securities, 2003-08 Ten-yes 19* 2000 2002 2004 2006 2008 U L J | NOTE: The data are daily and extend through February 21, 2008. The 2003 2004 2005 2006 2007 2008 spreads shown are the yields on ten-year bonds less the ten-year Treasury yield. NOTE: The data are daily and extend through February 21,2008. SOURCE: Derived from smoothed corporate yield curves using Merrill SOURCE: Department of (he Treasury. Lynch bond data. 96 30 Monetary Policy Report to the Congress • February 2008 edged down over that period. Meanwhile, the ten-year Implied S&P 500 volatility, 2000-08 inflation compensation measure changed little. As noted earlier, survey-based measures of short-term inflation expectations rose somewhat in 2007 and early 2008, presumably because of the increase in headline infla- tion. Survey measures of longer-term inflation expecta- tions changed only slightly. Yields on corporate bonds firmed a bit over the first half of 2007, and spreads of those yields over yields on comparable-maturity Treasury securities changed little, on net. Since June, yields on AA-rated corporate bonds have decreased somewhat, on net, while those on BBB- rated bonds increased slightly; spreads on AA-rated and BBB-rated bonds have risen about 90 and 130 basis J U points respectively- Moreover, yields on speculative- 2000 2002 20O4 2006 200S grade securities have increased substantially over the NOTE: The data arc weekly and extend through February 21, 2008. The same period, and their spreads have shot up almost series shown—the VIX—is the implied thirty-day volatility of the S&P 500 stock price index as calculated from a weighted average of options prices. 300 basis points. SOURCE: Chicago Board Options Exchange. pushed broad indexes down about 8 percent. Equity Markets The continued uncertainty surrounding the ultimate size and distribution of losses from subprime-related Broad equity indexes logged increases of around and other investment products, as well as the potential 10 percent over the first half of 2007 but then lost effects of the financial turmoil on the broader economy, ground over the second half; they ended the year with contributed to higher volatility in equity markets and gains of 3 percent to 6 percent. The increase reflected a wider equity premium. The implied volatility of the continued strong profitability in many nonfinaneial sec- S&P 500, as calculated from options prices, rose signifi- tors, particularly energy, basic materials, and technol- cantly in the second half of 2007 and remains elevated. ogy. By contrast, stock indexes for the financial sector The ratio of twelve-month-forward expected earnings fell about 20 percent in 2007 as investors reacted to the to equity prices for S&P 500 firms increased over the fallout from the problems in the subprime mortgage second half of 2007 and into 2008, while the long-term sector. So far in 2008, growing concerns about the eco- real Treasury yield decreased. The difference between nomic outlook, along with announeements of additional these two values—a measure of the premium that substantial losses at some large financial firms, have investors require for holding equity shares—has precipitated a widespread drop in equity prices that has reached the high end of its range over the past twenty years. Flows into equity mutual funds were heavy early in 2007 but slowed substantially after the first quarter. Stock price indexes, 2005-08 Indeed, equity funds that focused on domestic holdings January .1,2005 = 100 experienced consistent net outflows beginning in the spring. By contrast, inflows into foreign equity funds held up through the end of 2007 despite the weakness in many foreign stock markets in the fourth quarter. Both domestic and foreign equity funds experienced large outflows in January as equity prices tumbled worldwide, but flows appear to have stabilized in February. Debt and Financial Intermediation The total debt of the domestic nonfinaneial sectors appears to have expanded about 8 percent in 2007, a NOTE: The data are daily and extend through February 21. 2008. SOURCE; DOW Jones Indexes, slightly slower rate of growth than in 2006. The slow- 97 Board of Governors of the Federal Reserve System 31 Change in total domestic nonfmanciai debt, 1991-2007 somewhat faster in 2007 than in 2006, which is con- sistent with some substitution of nonmortgage credit for mortgage credit. To fund the rapid expansion of their balance sheets, commercial banks mainly turned to a variety of managed liabilities, including large time deposits and advances from Federal Home Loan Banks. Branches and agencies of foreign banks also tapped their parent institutions for funds. The growth of bank credit slowed in January 2008, as declines in holdings of securities and residential mortgages partly offset con- tinued growth in most other loan categories. Bank profits declined significantly in 2007 as fallout from the subprime mortgage crisis and related finan- cial disruptions caused trading income to plunge and 1991 1993 1995 1997 1999 2001 2003 2005 2007 loss provisions to more than double from the previ- NOTE: The data are annual and are computed by dividing the annual flow ous year. Over the second half of 2007, the return on for a given year by ihe level at the end of ihe preceding year. Value for 2007 assets and the return on equity both dropped to levels is partialiy based on estimated data. SOURCE: Federal Reserve Board, flow of funds data. not seen since the early 1990s. Weak profits or outright losses, along with significant balance sheet growth, ing reflected a deceleration of household debt that was also put pressure on capital ratios at some of the largest only partially offset by a considerable step-up in bor- commercial banks. In response, a number of banking rowing by businesses and governments. organizations raised significant amounts of new capital Commercial bank credit rose WA percent last year, in the second half of 2007 and early 2008. Loan delin- a pickup from the 93A percent gain in 2006.n The quency rates rose noticeably for many loan categories, acceleration of bank credit, as well as the differences but especially for residential mortgages, construc- in growth rates across bank asset classes, reflect in part tion and land development loans financing residential the effects of the financial market distress. As already projects, and other construction and land development noted, commercial and industrial loans surged in 2007 loans. because of extremely rapid growth in the second half Other types of financial institutions also faced sub- of the year that in part resulted from the inability of stantial challenges in 2007. As a result of exposures to banks to syndicate leveraged loans. At various times subprime loans, some thrift institutions had significant over the second half of the year, banks' balance sheets losses. Several of the major investment banks and their were boosted by extensions of credit to nonbank finan- affiliates booked losses on mortgage-related products cial institutions, a category that includes loans to ABCP and other exposures that were large enough to lead programs that were no longer able to issue commercial some of them to raise additional equity capital. paper. Through the third quarter of 2007, the growth In the third quarter, Fannie Mae and Freddie Mae of residential mortgages (excluding revolving home equity loans) was fairly robust, but the value of such Commercial bank profitability, 1988-2007 loans on banks' books contracted in the fourth quarter. The reversal likely stemmed from a stepped-up pace of securitization of conforming mortgages and a slowing of new originations in response to the weaker demand and the tightening of lending standards reported in the Senior Loan Officer Opinion Surveys covering the second half of 2007. The growth of revolving home equity loans picked up in 2007, particularly late in the year; because rates on such loans are generally tied to short-term market rates, which declined over the second half of 2007, that form of financing may have become relatively more attractive. Bank consumer loans grew \2, The data for commercial bank balance sheets are adjusted 1992 1995 1998 2001 2004 2007 for some shifts of assets and liabilities between commercial banks Nora: The data are annual and extend through 2007. and nonbanks, including those resulting from mergers, acquisitions, SOURCE: Federal Financial Institutions Examination Council, Cor changes in charter, and asset purchases and sales. Reports of Condition and Income (Call Report). 32 Monetary Policy Report to the Congress D February 2008 M2 growth rate, 1991-2007 Equity indexes in selected advanced foreign economies, 2006-08 Week ending January 6, 20O6 = 100 100 90 Japan \ 1991 1993 1995 1997 1999 2001 2003 2005 2007 NOTE: The data are annual on a fourth-quarter over fourth-quarter basts, M2 consists of currency, traveler's checks, demand deposits, other checkable NOTE: The data are weekly. The last observation for each series is the deposits, savings deposits (including money market deposit accounts), small- average for February 18 through February 21,2008. denomination time deposits, and balances in retail money market funds. SofiRCE: Bloomberg. SOURCE: Federal Reserve Board, Statistical Release H.6, "Money Slock Measures." slowing growth weighed on investor sentiment, mar- each experienced sizable losses on their mortgage ket volatility rose substantially, and on net most major portfolios and on credit guarantees. In response, both foreign stock markets fell. Despite the rocky end to the firms raised additional equity. The firms also tightened year, most major equity indexes in the advanced foreign underwriting standards slightly and increased the fees economies, with the exception of Japan, finished higher that they charge to purchase some types ofloans. All on net in local-currency terms compared with the begin- else equal, these changes would be expected to increase ning of 2007. However, indexes of the stock prices of borrower costs for conforming loans. financial firms in those countries declined 10 percent to 30 percent. The financial turbulence had less effect on equity prices in emerging markets, and most major The M2 Monetary Aggregate Equity indexes in selected emerging-market economies, 2006-08 M2 gTew at a solid rate, on balance, in 2007 and the early part of 2008. Growth was supported by declines in Week ending January 6,20O6 = 100 the opportunity cost of holding money relative to other financial assets. The considerable growth of money market mutual funds also boosted M2 as investors — 450 sought the relative safety of these liquid assets amid — 400 the volatility in various financial markets. The currency component of M2 decelerated further in 2007 from its already tepid pace in 2006; it actually contracted from November through January 2008, probably because of — 250 reduced demand from foreign sources. — 200 International Developments 2006 2007 2008 International Financial Markets NOTE: The data are weekly. The last observation for each series is ihe average for February 18 through February 2!, 2008. For the Latin American and emerging Asian groups, each economy's index weight is ils market Global financial markets weTe calm over the first half capitalization as a share of the group's total. The Latin American economies of 2007 except for a brief period in late February when are Argentina, Brazil, Chile, Colombia, Mexico, and Peru. The emerging Asian economies are China, India, Indonesia, Malaysia, Pakistan, the equity markets were roiled in part by worries about U.S. Philippines, South Korea, Taiwan, and Thailand. subprime mortgage lenders. After midyear, as the global SOURCE: For Latin America and emerging Asia, Morgan Stanley Capita! International (MSCI) index; for China, Shanghai composite index, as financial turmoil began in earnest and the possibility of reported by Bloomberg. 99 Board of Governors of the Federal Reserve System 33 Yields on benchmark government bonds in selected U.S. dollar exchange rate against advanced foreign economies, 2004-08 selected major currencies, 2004-08 Week ending January 9.2004 * 100 — e — 2004 2005 2004 2005 2006 2007 2008 NOTE: The data, which re for ten-year bonds, are weekly. The last NOTE: The data, which are in foreign currency units per dollar, are weekly. observation for each series i Ihe average for February 18 through February The last observation for each series is the average for February 18 through 21,2008. February 21 f2OO8. SOURCE: Bloomberg. SOIIRCE: Bloomberg. emerging-market stock indexes outperformed their Kingdom, and Japan ended the year 20 to 30 basis counterparts in the advanced economics. So far in 2008, points lower, on net, while they were about 10 basis stock markets in both advanced and emerging-market points higher in the euro area than at the start of the economies are down further as concerns about global year. Yields on inflation-protected long-term securities growth have increased. followed a similar pattern; inflation compensation (the Long-term bond yields in the advanced foreign econ- difference between yields on nominal securities and omies rose over the first half of 2007 but then reversed those on inflation-protected securities) fell modestly course as investors reacted to signs in many countries in Canada and rose slightly in the euro area. Since the of deteriorating financial conditions, a softening eco- beginning of 2008, yields on nominal securities in most nomic outlook, and expectations for a lower future economies have declined; yields on indexed securities path of monetary policy rates. All told, the net changes have fallen in the euro area but have risen in Canada, were not large; long-term rates in Canada, the United the United Kingdom, and Japan. The Federal Reserve's broadest measure of the nom- U.S. dollar nominal exchange rate, broad index, 2004-08 inal trade-weighted foreign exchange value of the dollar has declined about 8 percent on net since the beginning Week ending January 9,2004 = 100 of 2007. Over the same period, the major currencies index of the dollar has moved down a bit more than 10 percent. The dollar has depreciated about 9lA percent against the yen and slightly more than 10 pereent versus the euro. The dollar has depreciated roughly 13 VS percent against the Canadian dollar and in Novem- ber briefly touched its lowest level in decades against that currency. The dollar has deelined 8!/z percent against the Chinese renminbi since the beginning of 2007, and the pace of depreciation accelerated late last 2004 2005 2006 2007 2008 Advanced Foreign Economies NOTE: The data, which are in foreign currency units per dollar, are weekly. The last observation for each series is the average for February 18 through F ex e c b h ru an ar g y e 2 v 1 al , u 2 e 0 s 0 o 8 f . t T he h e U b .S ro . a d d o lJ in a d r e a x g a i i s n s a t w th e e i g cu h r te re d n a c v ie e s r a o g f e a o l f a r t g h e e g f r o o r u e p ig o n f Economic activity in the major advanced foreign econo- the most important U.S. trading partners. The index weights, whieh change mies posted relatively strong growth over the first three i o m ve p r o r t t i m sh e a , r e a s re . derived from U.S. export shares and from U.S. and foreign quarters of 2007, and labor markets tightened. Howev- SOURCE: Federai Reserve Board. er, evidence of a slowdown has accumulated since the 100 34 Monetary Policy Report to the Congress U February 2008 summer. Financial market strains appear to be weighing Official or targeted interest rates in selected on growth in the major economies. Surveys of banks advanced foreign economies, 2004-08 have revealed a tightening of credit standards for both households and businesses. Both consumer and busi- ness confidence have slid since August, and readings from surveys of economic activity have declined. Retail sales have slowed, and housing markets in a number of countries that until recently had been robust—including Ireland, Spain, and the United Kingdom—have soft- ened. According to initial releases, real GDP growth for the fourth quarter slowed in a number of countries. Although growth in Japan rebounded in the fourth quarter—pushed up by strong exports and capital Japan spending—household spending has been relatively weak, and the construction sector has been depressed by changes to regulations that have resulted in bottle- 2004 2005 2006 2007 2008 necks in reviewing building plans. NOTE: The data are daily and extend through February 21, 2008. The data Headline rates of inflation have continued to rise in shown are, for Canada, the overnight rate; for the euro area, the minimum bid rate on main refinancing operations; for Japan, the call money rate; and. for some economies, mainly because of increasing food ihe United Kingdom, the official bank rale paid on commercial reserves. and energy prices. The twelve-month change in con- SOURCE; The central bank of each area or country shown. sumer prices in the euro area exceeded 3 percent in January, up from less than 2 percent just a few months what higher inflation, major foreign central banks earlier; core inflation (which excludes the changes in either have cut official policy rates or have remained the prices of energy and unprocessed food) has moved on hold since late 2007—a change from earlier market up as well. Canadian inflation climbed from less than expectations of further rate increases. The Bank of Can- 1 percent late in 2006 to about 2V% percent in the sec- ada and the Bank of England iowered their targets for ond half of 2007; however, core inflation has slowed in their respective overnight rates. The European Central recent months, partly because of the continued strength Bank and the Bank of Japan have kept their policy rates of the Canadian dollar. Although inflation in Japan was at 4 percent and 0.5 percent respectively. (Further dis- close to zero for most of 2007, the rate picked up to cussion of actions by foreign central banks is in the box roughly 3A percent at the end of the year, again mainly a entitled "The Federal Reserve's Responses to Financial result of the rise in energy prices. Strains.") Faced with a weaker outlook for growth but some- Change in consumer prices for major foreign economies, Emerging-Market Economies 2004-08 The growth of output in the emerging-market econo- mies also slowed in the second half of 2007 but was stilt strong. In China, government policy measures helped moderate the growth rate of real GDP in the sec- ond half. To damp loan growth, the government in 2007 repeatedly raised the reserve requirement ratio and the benchmark rate at which banks can lend to their cus- tomers. In addition, the government directed banks to freeze their level of lending over the final two months of 2007 at the October level. Chinese authorities also allowed the renminbi's rate of appreciation to step up in late 2007, and the People's Bank of China noted in its monetary policy report in November that it would be 2004 2005 2006 2007 2008 using the exchange rate as a tool to fight inflation. NOTE: The data are monthiy, and change is from one year earlier. The data Elsewhere in emerging Asia, growth appears to have extend through December 2007 for Japan and through January 2008 for stepped down to a more tempered pace in several coun- Canada, the euro area, and the United Kingdom, SOURCE: Haver. tries in the second half of the year, though generally 101 Board of Governors of the Federal Reserve System 35 from very strong levels in the first half. One factor sup- unfavorable weather in several producing regions. Meat pressing growth in these export-dependent economies and dairy prices have also increased as consumption appears to be a softening of the rate of activity in the of these products in developing countries has grown rest of the world. rapidly and as the price of animal feed—mostly grain— In Mexico, output growth was moderate in 2007 has risen. Inflation rose during 2007 in many emerging and followed roughly the same pattern as in the United Asian economies, including China, where the inflation States. The growth of economic activity exceeded rate for the twelve months ending in January reached 5 percent during the third quarter but slowed to 3 per- just over 7 percent. Also, the pace of consumer price cent in the fourth quarter. In Brazil and other Latin inflation rose in the second half of the year in Argen- American countries, growth was robust. tina, Chile, Mexico, and Venezuela. The rise in inflation Increases in the prices of food and fuel contributed in Venezuela was compounded by stimulative monetary to a rise in consumer price inflation in many emerging- and fiscal policies. market economies. Prices of edible oils and grains were boosted by increased demand, higher energy prices, and 102 Part 3 Monetary Policy in 2007 and Early 2008 Throughout the first half of 2007, the available infor- and credit conditions had become somewhat tighter mation pointed to a generally favorable economic for some households and businesses. Participants in outlook despite the ongoing correction in the housing FOMC meetings (Board members and Reserve Bank market. Indicators of consumer and business spend- presidents) noted that adjustments in the housing sector ing were somewhat uneven, but their generally positive had the potential to prove deeper and more prolonged trajectories suggested that the housing market develop- than had seemed likely earlier in the year, and a further ments were, as yet, having little effect on the broader underperformance in the housing area represented a sig- economy. Net exports, spurred in part by a falling dollar, nificant downside risk to the economic outlook. None- were providing support to economic growth. Outside of theless, incoming data indicated that economic growth the subprime mortgage sector, financial conditions in had strengthened in the second quarter, as a quicker general were fairly accommodative. The Federal Open pace of business spending offset a slowdown in con- Market Committee expected core inflation to moderate sumer outlays. Participants believed that the economy from the somewhat elevated level that had prevailed at remained likely to expand at a moderate pace in coming the start of the year, but high resource utilization had quarters, supported in part by continued growth in busi- the potential to sustain upward pressure on inflation. As ness investment and a robust global economy. Although a result, during the first half of the year, the Committee core inflation had moved lower since the start of the consistently noted in its statement that its predominant year, participants were still concerned about several policy concern was that inflation would fail to moderate factors—including a continued high level of resource as expected. However, in part owing to indications of utilization—that could augment inflation pressures. increasing weakness in the housing sector, the Commit- They believed that a sustained moderation in those tee emphasized in the statements issued at the conclu- pressures had yet to be convincingly demonstrated. sion of its March, May, and June meetings that its As a result, the FOMC decided to leave the target for future policy actions would depend on the evolution the federal funds rate unchanged at 5% percent and, of the outlook for both inflation and economic despite somewhat greater downside risks to growth, growth. reiterated that the predominant policy concern When the Committee met on August 7, financial remained the risk that inflation would fail to moderate markets had been unusually volatile for a few weeks, as expected. Selected interest rates, 2005-08 NOTE: The daia are daily and extend through February 21, 2008. The ten-year Treasury rare is ihe constant-maturity yield based on the most actively traded securities. The dates on the horizontal axis are those of regularly scheduled FOMC meetings. SOURCE: Department of the Treasury and the Federal Reserve. 103 38 Monetary Policy Report to the Congress D February 2008 In the days following the August 7 FOMC meeting, At the time of the October FOMC meeting, the data financial conditions deteriorated rapidly as market par- indicated that economic growth had been solid in the ticipants became concerned about counterparty credit third quarter. A pickup in consumer spending and con- risk and their access to liquidity. After an FOMC con- tinued expansion of business investment suggested that ference call on August 10 to review worsening strains spillovers from the turmoil in the housing and financial in money and credit markets, the Committee issued a markets had been limited to that point. Although strains statement indicating that the Federal Reserve would in financial markets had eased somewhat on balance, provide reserves as necessary through open market tighter credit conditions were thought likely to slow operations to promote trading in the federal funds mar- the pace of economic expansion over coming quarters. ket at rates close to the FOMC's target rate of 514 per- Furthermore, the downturn in residential construction cent. As conditions deteriorated further, the Committee had deepened, and available indicators pointed to a met again on August 16 by conference call to discuss further slowing in housing activity in the near term. the potential usefulness of various policy responses. FOMC meeting participants noted that readings on core The following day, the Federal Reserve announced inflation had improved somewhat over the year and changes in discount window policies to facilitate the anticipated that some of the moderation likely would be orderly functioning of short-term credit markets. Fur- sustained. Nonetheless, participants expressed concern thermore, the FOMC released a statement indicating about the upside risks to the outlook for inflation, stem- that the downside risks to growth had increased appre- ming in part from the effects of recent increases in com- ciably and that the Committee was prepared to act as modity prices and the significant decline in the foreign needed to mitigate adverse effects on the economy. exchange value of the dollar. Against that backdrop, the (The box entitled "The Federal Reserve's Responses Committee decided to lower the target for the federal to Financial Strains" provides additional detail on the funds rate 25 basis points, to 4Vi percent, and judged outcomes of these conference calls and other measures that the upside risks to inflation roughly balanced the taken by the Federal Reserve to facilitate the orderly downside risks to growth. functioning of financial markets over the second half of Also at the October meeting, the Committee contin- the year, including coordinated actions with other cen- ued its discussions regarding communication with the tral banks.) public. Participants reached a consensus on increasing At the time of the September FOMC meeting, the frequency and expanding the content of their pcri- financial markets remained volatile. Liquidity in short- odie economic projections. Under the new procedure, term funding markets was significantly impaired amid which was announced on November 14, the FOMC heightened investor unease about exposures to sub- compiles and releases the projections made by the prime mortgages and to structured credit products more Federal Reserve Governors and Reserve Bank presi- broadly. Credit generally remained available for most dents four times each year, at approximately quarterly businesses and households, but the Committee noted intervals, rather than twice each year, as had been the that the tighter credit conditions for other borrowers practice since 1979. In addition, the projection hori- had the potential to restrain economic growth. Incom- zon has been extended from two years to three years. ing economic data were mixed: Consumer spending FOMC meeting participants provide projections for appeared to have strengthened from its subdued second- the increase in the price index for total personal con- quarter pace, but a further intensification of the housing sumption expenditures (PCE) as well as projections contraction and slowing employment growth suggested for real GDP growth, the unemployment rate, and core a weaker economic outlook. Participants noted that PCE price inflation. Summaries of the projections and incoming data on core inflation continued to be favor- an accompanying narrative are published along with able and that the downwardly revised economic outlook the minutes of the FOMC meeting at which they were implied some lessening of pressures on resources, but discussed. Beginning with the present report, the pro- they remained concerned about possible upside risks jections made in January are included in the February to inflation. To forestall some of the adverse macro- Monetary Policy Report to the Congress, and the pro- economic effects that might otherwise arise from the jections made in June are included in the July report. disruptions in financialm arkets and to promote moder- In a conference call on December 6, Board members ate growth over time, the FOMC lowered the target for and Reserve Bank presidents reviewed conditions in the federal funds rate 50 basis points, to AY* percent. domestic and foreign financial markets and discussed The Committee also noted that recent developments two proposals aimed at improving market functioning. had increased the uncertainty surrounding the economic The first proposal was for the establishment of a tempo- outlook and stated that it would act as needed to foster rary Term Auction Facility (TAF), which would provide price stability and sustainable economic growth. term funding through an auction mechanism to eligible 104 Board of Governors of the Federal Reserve System 39 depository institutions against a broader range of col- exchange swap lines with the European Central Bank lateral than that used for open market operations. The and the Swiss National Bank. second proposal was to set up a foreign exchange swap In a conference call on January 9, the Committee arrangement with the European Central Bank to address reviewed recent economic data and financial mar- elevated pressures in short-term dollar funding markets. ket developments. The information, which included At the conclusion of the discussion, the Committee weaker-than-expected data on home sales and employ- voted to direct the Federal Reserve Bank of New York ment for December, as well as a sharp decline in equity to establish and maintain a reciprocal currency (swap) prices since the beginning of the year, suggested that arrangement for the System Open Market Account the downside risks to growth had increased signifi- with the European Central Bank.13 The Board of Gov- cantly since the time of the December FOMC meeting. ernors approved the TAF via notation vote on Decem- Moreover, participants cited concerns that the slowing ber 10. of economic growth could lead to a further tightening At the Committee's meeting on December 11, par- of financial conditions, which in turn could reinforce ticipants noted that incoming information suggested the economic slowdown. However, participants noted economic activity had decelerated significantly in the that core inflation had edged up in recent months and fourth quarter. The housing contraction had steepened believed that considerable uncertainty surrounded the further, and participants agreed that the sector was inflation outlook. Participants were generally of the weaker than had been expected at the time of the Com- view that substantial additional policy easing might mittee's previous meeting. Moreover, spillovers from well be necessary to support economic activity and housing to other parts of the economy had begun to reduce the downside risks to growth, and they discussed emerge: Consumption spending appeared to be soften- the possible timing of such actions. ing more than had been anticipated, and employment On January 21, the Committee held another confer- gains appeared to be slowing. Participants noted that ence call. Participants in the call noted that strains in evidence of further deterioration in the credit quality some financial markets had intensified and that incom- of mortgages and other loans to households appeared ing evidence had reinforced their view that the outlook to be spurring lenders to further tighten the terms on for economic activity was weak. Participants observed new extensions of credit for a widening range of credit that investors apparently were becoming increasingly products. Financial market conditions had worsened concerned about the economic outlook and that these significantly. The financial strains were exacerbated by developments could lead to an excessive pullback in concerns related to year-end pressures in short-term credit availability. Against that background, members funding markets, and similar stresses were evident judged that a substantial easing in policy was appropri- in the financial markets of major foreign economies. ate to foster moderate economic growth and reduce the Although a surge in energy prices pushed up headline downside risks to economic activity. The Committee consumer price inflation during September and October, decided to lower the target for the federal funds rate Committee members agreed that the inflation situation 75 basis points, to V/i percent, and stated that appre- had changed little from the time of the previous meet- ciable downside risks to growth remained. Although ing. In these circumstances, the FOMC lowered the inflation was expected to edge lower over the course of target for the federal funds rate a further 25 basis points, 2008, participants underscored that this assessment was to 4'A percent, and, given the heightened uncertainty, conditioned upon inflation expectations remaining well the Committee decided to refrain from providing an anchored and stressed that the inflation situation should explicit assessment of the balance of risks. The Com- continue to be monitored carefully. mittee also indicated that it would continue to assess The data reviewed at the regularly scheduled FOMC the effects of financial and other developments on eco- meeting on January 29 and 30 confirmed a sharp decel- nomic prospects and act as needed to foster price sta- eration in economic growth during the fourth quarter of bility and sustainable economic growth. In addition to 2007 and continued tightening of financial conditions. that poliey move, the Federal Reserve and several other With the contraction in the housing sector intensifying central banks announced on December 12 the measures and a range of financial markets remaining under pres- they were taking to address elevated pressures in short- sure, participants generally expected economic growth term funding markets. The Federal Reserve announced to remain weak in the first half of 2008 before picking the creation of the TAF and the establishment of foreign up strength in the second half. However, the continu- ing weakness in home sales and house prices, as well as the tightening of credit conditions for households and businesses, were seen as posing downside risks to 13. A swap arrangement with the Swiss National Bank was approved by the Committee on December 11. the near-term outlook for economic growth. Moreover, 105 40 Monetary Policy Report to the Congress n February 2008 many participants cited risks regarding the potential mittee believed that it remained necessary to monitor for adverse feedback between the financial markets inflation developments carefully. Against that backdrop, and the economy. Participants expressed some concern the FOMC decided to lower the target for the federal about the disappointing inflation data received over funds rate 50 basis points, to 3 percent. The Committee the latter part of 2007. Although many expected that a believed that the policy action, combined with those leveling out of prices for energy and other commodi- taken earlier, would help promote moderate growth ties, such as that embedded in futures markets, and a over time and mitigate the risks to economic activ- period of below-trend growth would contribute to some ity. However, members judged that downside risks to moderation in inflation pressures over time, the Com- growth remained. 106 Part 4 Summary of Economic Projections The following material appeared as an addendum to Table I. Economic projections of Federal Reserve Governors the minutes of the January 29-30, 2008, meeting of and Reserve Bank presidents the Federal Open Market Committee, In conjunction with the January 2008 FOMC meet- 2008 2009 2010 ing, the members of the Board of Governors and the Central tendency' 1.3 to 2.0 2.1 to 2.7 2.5 to 3.0 presidents of the Federal Reserve Banks, all of whom participate in the deliberations of the FOMC, provided Jnemployment rate 5.2 to 5.3 5.0 to 5.3 4.9 to 5.1 projections for economic growth, unemployment, and October projections..... 4,8 to 4.9 4,8 to 4.9 4.7 to 4.9 PCE inflation 2.1 to 2.4 1.7 to 2.0 1.7 to 2.0 inflation in 2008, 2009, and 2010. Projections were based on information available through the conclusion .'ore PCE inflation 2.0 to 2.2 1.7 to 2.0 1.7 to 1.9 of the January meeting, on each participant's assump- October projections , 1.7 to 1.9 1.7 to 1.9 1.6 to 1.9 tions regarding a range of factors likely to affect eco- Range2 Growth of real GDP 1.0to2,2 1.8 to 3.2 2.2 to 3.2 nomic outcomes, and on his or her assessment of appro- October projections i.6to2.6 2,0 to 2.8 2.2 to 2.7 priate monetary policy. "Appropriate monetary policy" October projections 4.6 to 5.0 4.6 to 5.0 4.6 to 5.0 is defined as the future policy that, based on current PCE inflation 2.0 to 2.8 1.7 to 2.3 1.5 to 2.0 information, is deemed most likely to foster outcomes October projections , 1.7 to 2.3 1.5 to 2.2 1.5 to 2.0 for economic activity and inflation that best satisfy the 1.9 to 2.3 1.7 to 2.2 1.4 to 2.0 participant's interpretation of the Federal Reserve's dual 1.7 to 2.0 1.5 to 2.0 1.5 to 2.0 objectives of maximum employment and price stability. NOTE: Projections of the growth of real GDP, of PCE inflation, and of core PCE inflation are percent changes from the fourth quarter of the previous year to The projections, which arc summarized in table 1 the fourth quarter of the year indicated. PCE inflation and core PCE inflation are the percentage rates of change in, respectively, the price index for personal and chart I, suggest that FOMC participants expected consumption expenditures and the price index for personal consumption that output would grow at a pace appreciably below its expenditures excluding food and energy. Projections for the unemployment rate are for the average civilian unemployment rate in !he fourth quarter of the year trend rate in 2008, owing primarily to a deepening of indicated. Each participant's projections are based on his or her assessment of the housing contraction and a tightening in the avail- appropriate monetary policy. ability of household and business credit, and that the 1. The centra! tendency excludes the three highest and three lowest projections for each variable in each year. unemployment rate would increase somewhat. Given 2. The range for a variable in a given year includes all participants'projections, the substantial reductions in the target federal funds from lowest to highest, for that variable in that year. rate through the January FOMC meeting as well as the assumption of appropriate policy going forward, output growth further ahead was projected to pick up to a pace erably lower than the central tendency of the projec- around or a bit above its long-run trend by 2010. Infla- tions provided in conjunction with the October FOMC tion was expected to decline in 2008 and 2009 from meeting, which was 1.8 to 2,5 percent. These down- its recent elevated levels as energy prices leveled out ward revisions to the 2008 outlook stemmed from a and economic slack contained cost and price increases. number of factors, including a further intensification of Most participants judged that considerable uncertainty the housing market correction, tighter credit conditions surrounded their projections for output growth and amid increased concerns about credit quality and ongo- viewed the risks to their forecasts as weighted to the ing turmoil in financial markets, and higher oil prices. downside. A majority of participants viewed the risks to However, some participants noted that a fiscal stimu- the inflation outlook as broadly balanced, but a number lus package wouid likely provide a temporary boost of participants saw the risks to inflation as skewed to domestic demand in the second half of this year. to the upside. Beyond 2008, a number of factors were projected to buoy economic growth, including a gradual turnaround in housing markets, lower interest rates associated with The Outlook the substantial easing of monetary policy to date and appropriate adjustments to policy going forward, and an anticipated reduction in financial market strains. Real The central tendency of participants' projections for real GDP was expected to accelerate somewhat in 2009 and GDP growth in 2008, at 1.3 to 2.0 percent, was consid- 107 42 Monetary Policy Report to the Congress • February 2008 Chart 1: Central tendencies and ranges of economic projections Real GDP growth Perc i Central tendency of projections - Range of projections — 5 — 4 — 3 I 2003 2004 2006 2007 2008 2009 Unemployment rate Percent — 7 — 5 — 4 I 2003 2004 2005 2006 2007 2008 2009 PCE inflation Percent — 4 — 2 2005 2006 2007 2008 2009 2010 Core PCE inflation Percent — 4 — 3 — 2 — 1 2003 2004 2005 2006 2007 2008 2009 2010 Note: Sec notes to table 1 for variable definitions. 108 Board of Governors of the Federal Reserve System 43 by 2010 to expand at or a little above participants' esti- risks to their projections of unemployment as tilted mates of the rate of trend growth. to the upside. The possibility that house prices could With output growth running below trend over the decline more steeply than anticipated, further reducing next year or so, most participants expected that the households' wealth and access to credit, was perceived unemployment rate would edge higher. The central ten- as a significant risk to the central outlook for economic dency of participants' projections for the average rate growth and employment. In addition, despite some of unemployment in the fourth quarter of 2008 was 5.2 recovery in money markets after the turn of the year, to 5.3 percent, above the 4.8 to 4.9 percent unemploy- financial market conditions continued to be strained— ment rate forecasted in October and broadly suggestive stock prices had declined sharply since the December of some slack in labor markets. The unemployment meeting, concerns about further potential losses at rate was generally expected to change relatively little in major financial institutions had mounted amid worries 2009 and then to edge lower in 2010 as output growth about the condition of financial guarantors, and credit picks up, although in both years the unemployment rate conditions had tightened in general for both households was projected to be a little higher than had been antici- and firms. The potential for adverse interactions, in pated in October. which weaker economic activity could lead to a wors- The higher-than-expected rates of overall and core ening of financial conditions and a reduced availability inflation since October, which were driven in part of credit, which in rum could further damp economic by the steep run-up in oil prices, had caused partici- growth, was viewed as an especially worrisome pos- pants to revise up somewhat their projections for infla- sibility. tion in the near term. The central tendency of partici- Regarding risks to the inflation outlook, several pants' projections for core PCE inflation in 2008 was participants pointed to the possibility that real activity 2.0 to 2.2 percent, up from the 1.7 to 1.9 percent cen- could rebound less vigorously than projected, leading to tral tendency in October. However, core inflation was more downward pressure on costs and prices than antic- expected to moderate over the next two years, reflecting ipated. However, participants also saw a number of muted pressures on resources and fairly well-anchored upside risks to inflation. In particular, the pass-through inflation expectations. Overall PCE inflation was pro- of recent increases in energy and commodity prices as jected to decline from its current elevated rate over well as of past dollar depreciation to consumer prices the coming year, largely reflecting the assumption that could be greater than expected. In addition, partici- energy and food prices would flatten out. Thereafter, pants recognized a risk that inflation expectations could overall PCE inflation was projected to move largely in become less firmly anchored if the current elevated step with core PCE inflation. rates of inflation persisted for longer than anticipated Participants' projections for 2010 were importantly or if the recent substantial easing in monetary policy influenced by their judgments about the measured rates was misinterpreted as reflecting less resolve among of inflation consistent with the Federal Reserve's dual Committee members to maintain low and stable infla- mandate to promote maximum employment and price tion. On balance, a larger number of participants than stability and about the time frame over which policy in October viewed the risks to their inflation forecasts should aim to attain those rates given current economic as broadly balanced, although several participants con- conditions. Many participants judged that, given the tinued to indicate that their inflation projections were recent adverse shocks to both aggregate demand and skewed to the upside. inflation, policy would be able to foster only a gradual The ongoing financial market turbulence and tight- return of key maeroeconomic variables to their longer- ening of credit conditions had increased participants' run sustainable or optimal levels. Consequently, the uncertainty about the outlook for economic activity. rate of unemployment was projected by some partici- Most participants judged that the uncertainty attending pants to remain slightly above its longer-run sustainable their January projections for real GDP growth and for level even in 2010, and inflation was judged likely still the unemployment rate was above typical levels seen to be a bit above levels that some participants judged in the past. (Table 2 provides an estimate of average would be consistent with the Federal Reserve's dual ranges of forecast uncertainty for GDP growth, unem- mandate. ployment, and inflation over the past twenty years.u) In contrast, the uncertainty attached to participants' Risks to the Outlook 14. The box "Forecast Uncertainty" at the end of this summary discusses the sources and interpretation of uncertainty in economic Most participants viewed the risks to their GDP projec- forecasts and explains the approach used to assess the uncertainty and tions as weighted to the downside and the associated risks attending participants' projections. 109 44 Monetary Policy Report to the Congress D February 2008 Table 2. Average historical projection error ranges projections for real GDP growth was markedly wider Percentage points than in the forecasts submitted in October, which in tum were considerably more diverse than those submitted in 2008 2009 conjunction with the June FOMC meeting and included Real GDP1 ±1.2 ±1.4 in the Board's Monetary Policy Report to the Congress Unemployment rate3 ±0.5 ±0.8 in July. Mirroring the increase in diversity of views Total consumer prices' ±1.0 ±1.0 on real GDP growth, the dispersion of participants' NOTE: Error ranges shown are measured as plus or minus the root mean squared error of projections that were released in the winter from 1986 through projections for the rate of unemployment also widened 2006 for the current and following two years by various private and government notably, particularly for 2009 and 2010. The disper- forecasters. As described in the box "Forecast Uncertainty," under certain as- sumptions, there is about a 70 percent probability that actual outcomes for real sion of projections for output and employment seemed GDP, unemployment, and consumer prices will be in ranges implied by the aver- largely to reflect differing assessments of the effect of age size of projection errors made in the past. Further information is in David Reifschneider and Peter Tulip (2007), "Gauging the Uncertainty of the Economic financial market conditions on real activity, the speed Outlook from Historical Forecasting Errors," Finance and Economics Discussion with which credit conditions might improve, and the Series #2007-60 (November). 1. Projection is percent change, fourth quarter of the previous year to fourth depth and duration of the housing market contraction. quarter of the year indicated. The dispersion of participants' longer-term projections (pe 2 rc . e P n r t o ) j . ection is the fourth quarter average of the civilian unemployment raie was also affected to some degree by differences in their 3. Measure is the overall consumer price index, the price measure that has judgments about the economy's trend growth rate and been most widely used in government and private economic forecasts. Projection the unemployment rate that would be consistent over is percent change, fourth quarter of the previous year to the fourth quarter of the year indicated. The slightly narrower estimated width of the confidence interval time with maximum employment. Views also differed for inflation in the third year compared with those for me second and first years is about the pace at which output and employment would likely the result of using a limited sample period for computing these statistics. recover toward those levels over the forecast horizon and beyond, given appropriate monetary policy. The dispersion of the projections for PCE inflation in the inflation projections was generally viewed as being near term partly reflected different views on the extent broadly in line with past experience, although several to which recent increases in energy and other commod- participants judged that the degree of uncertainty about ity prices would pass through into higher consumer inflation was higher than normal. prices and on the influence that inflation expectations would exert on inflation over the short and medium run, Participants' inflation projections further out were influ- Diversity of Participants'Views enced by their views of the rate of inflation consistent with the Federal Reserve's dual objectives and the time Charts 2(a) and 2(b) provide more detail on the diversi- it would take to achieve these goals given current eco- ty of participants' views. The dispersion of participants' nomic conditions and appropriate policy. 110 Board of Governors of the Federal Reserve System 45 Chart 2(a): Distribution of participants' projections (percent) Real GDP Unemployment rate Number of participants Number of participants 2008 HA January projections — 16 October projections — 14 — 12 — 10 ir 0 2009 - 16 — 14 — 12 - 10 n i I ill Mwm m 1 t IB SIMM i •I i i i 11 1 i 1 ! 1 1 1 0 1.0- 12- 1.4- !.6- 1.8- 2.0- 2.2- 2.A- 2.6- 2.8 - 3.0- 3.2- 4.6- 4.8- 5.0- 5.2- 5.4- 5.6- 1.1 1.3 l.S 1,7 1.9 2.1 2.3 2.5 2.7 23 3.1 3.3 4.7 4.9 5.1 5.3 5.5 5.7 Number of particpmt, Num er of parteipants _ 2010 _ 2010 — 16 — 16 - — 14 - — 14 - — 12 - — 12 - n — 10 : — 10 — 8 • •• _ i ig. — 6 _ H — 6 _ 'HI — 4 —r- — 4 tall! 1_ J J \ 11H2H_ •Hut — 2 11 i i i i i i i i i i i _| 11 i 1 1 4.6- 4.8- 5.0- 5.2- 5.4- 5.6- U 1.3 1.5 1.7 1.9 1\ 2.3 2.5 2.7 2.9 3.1 3.3 4.7 4.9 5.1 5.3 5.5 5.7 Ill 46 Monetary Policy Report to the Congress D February 2008 Chart 2(b): Distribution of participants' projections (percent) PCE inflation Core PCE inflation Number of paitic[pants Numbcr of panicipant. 2008 2008 IBS anuary projections SHHJanuary projections — October projections — 14 — October projections — 14 - — 12 - — 12 - — 10 - — 10 - — 8 - L nH - 8 1 1 SSI •HI — H1Ii1i • — 6 _ | iIll — 4 — 11• — 4 1 u| IB — 2 - IBM— 2 1 1 —1 0 1 ii •m J 1. , i | I i i ll ll i i i 1 1.5- 1.7- 1.9- 2.1- 2.3- 2.5 - 2.7 - 1.3- 1.5- 1.7- 1.9 2.1- 2.3- 1.6 1.8 2.0 2.2 2.4 2.6 2.8 1.4 1.6 1.8 2.0 2.2 2.4 Number _ 2009 — 16 _ 2009 - - 14 - - - 12 - 10 1 8 1 - 6 Jim 4 n i_ m HHHm 11 i i 1.5- 1.7- 1.9- 2.1- 2.3- 2.5- 2.7- 1.6 t.8 2.0 2.2 2.4 2.6 2.8 1 1 1 1 1 Numberofparricipan — - n - 1 iliit Bii 1 1 1 1 1 1 1.3- 1.5- 1.7- 1.9- 2.1- 1.4 1.6 l.S 2.0 2.2 1 1 1 1 1 16 14 12 10 8 6 4 2 0 1 2.3- 2.4 Numberof partcipants _ 2010 — 16 - — 14 - • — 12 - - 10 SI 1. 1 1 1 1 1 1.5- 1.7- 1.9- 2.1- 2.3- 2.5- 2.7- 1.6 1.8 2.0 2.2 2.4 2.6 2.8 1 1 1 I _ 2010 - - - 8 6 4 2 1 1 1 1 1 Numberofpartkip _ - - - -II 1 1 1 1 1 1 1 1.3- 1.5- 1.7- 1.9- 2.1- 1.4 1.6 1.8 2.0 2.2 1 1 1 1 nts 16 14 12 10 8 6 4 2 2.3- 2.4 112 Board of Governors of the Federal Reserve System 47 Forecast Uncertainty The economic projections provided by the mem- past and the risks around the projections are bers of the Board of Governors and the presi- broadly balanced, the numbers reported in table dents of the Federal Reserve Banks help shape 2 might imply a probability of about 70 percent monetary policy and can aid public understand- that actual GDP would expand between 1.8 per- ing of the basis for policy actions. Considerable cent to 4.2 percent in the current year, and uncertainty attends these projections, however. 1.6 percent to 4.4 percent in the second and The economic and statistical models and rela- third years. The corresponding 70 percent confi- tionships used to help produce economic fore- dence intervals for overall inflation would be casts are necessarily imperfect descriptions of 1 percent to 3 percent in the current and second the real world. And the future path of the econo- years, and 1,1 percent to 2,9 percent in the third my can be affected by myriad unforeseen devel- year. opments and events. Thus, in setting the stance Because current conditions may differ from of monetary policy, participants consider not those that prevailed on average over history, only what appears to be the most likely econom- participants providejudgments as to whether the ic outcome as embodied in their projections, uncertainty attached to their projections of each but also the range of alternative possibilities, the variable is greater than, smaller than, or broadly likelihood of their occurring, and the potential similar to typical levels of forecast uncertainty costs to the economy should they occur. in the past as shown in tabte 2. Participants Table 2 summarizes the average historical also providejudgments as to whether the risks accuracy of a range of forecasts, including those to their projections are weighted to the upside, reported in past Monetary Policy Reports and downside, or are broadly balanced. That is, par- those prepared by Federal Reserve Board staff in ticipantsjudge whether each variable is more advance of meetings of the Federal Open Market iikely to be above or below their projections of Committee. The projection error ranges shown the most likely outcome. Thesejudgments about in the table illustrate the considerable uncer- the uncertainty and the risks attending each tainty associated with economic forecasts. For participant's projections are distinct from the example, suppose a participant projects that real diversity of participants' views about the most GDP and total consumer prices will rise steadily likely outcomes. Forecast uncertainty is con- at annual rates of, respectively, 3 percent and cerned with the risks associated with a particular 2 percent. If the uncertainty attending those pro- projection, rather than with divergences across a jections is simitar to that experienced in the number of different projections. 113 HOARD DP GOVERNORS OF THE FEDERAL RESERVE SYSTEM WASHINGTON, B. C anSBI ALAN OBcr««PiM July 22, 2003 The Honorable Michael N. Castle House of Representatives WU D.C. 20515-OS01 This tetter responds to your request of July 18,2003, seeking my views as to whether proposed changes to the Fait Credit Repotting Act might affect the pricing of credit based upon risk at might potentially bear upon die safety and soundness of creditors. The proposed amendments referred to in your tetter would limit use in credit evaluation systems of certain types of informaSon, such as information regarding (he number of inquiries about the consoOTW made to a credit «$o^ and would also restrict consideration of other types of information, such as information about the consumer's personal Credit experiences vdth other creditors in credit decisions thai bivolve the Interest rate on an account. T^Monnatioa gathered by credit reporting companiea on the borrowing and payment experiences of consumers Ss a cornerstone of $e consumer credit system in this country. Experience indicates that access to the information assembled by these companies and credit evaluation systems based on Hut information have improved the overall quality and reduced the cost of credit decisions while expanding the availability of credit. Credit evaluation systems rely on information to measure the credit risk posed by current and prospective borrowers. In the process of credit evaluation, creditors seek to use tafornaatlan that helps than better distinguish between good and bad credit risks. The information items that receive positive and negative weights in credit evaluation systems ate (hose that have demonstrated statistical usefulness In this process. Consumers' performance on credit accounts as well BS »fr* number and recency of certain types of inquiries to credit reporting companies are credit criteria that ore statistically associated with cieditworftuneas in evaluative systems that an used for credit panting and pricing, Records of consumers' usage of, and payment performance on, credit accousts with other creditors are fundamental building blocks for evaluations of creditwonhiness, For example, where a creditor commits to allow a consumer to make 114 The Honorable Michael N. Castle Page Two purchases or obtain cash advances from time to time on a revolving line of ciedit, the consumer's performance on other credit accounts can well presage the credit risk outlook for the auditor's awn account. Similarly, an upBUige Is recent inquiries could indicate that a borrower in Saanrial distress is seeking to gain access to more credit. Thus, restrictions on the use of Information about certain inquiries or restrictions on considering the experience of consumers In naing their credit accounts wDl likely increase overall risk in the credit system, potentially leading to Higher levels of deftult and higher prices for consumers. Even wifli higher prices far credit, elevated levels of default may raise risk levels for credit-granting institutions. In sum, In deoidiag wh^er to restrict the nwctfwrtsin information in aedit evaluations, QieCkmgcc^elicn^ be aware tii^ such restrictions are lik^yiodiniiaish the effectiveness of statistical sysssoa that have played a significant tole hi reducing &e overall cost of credit sod widening its availability. I hops these comments are useM.

Ben S. Bernanke (2008, February 26). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_20080227_chair_monetary_policy_and_the_state_of_the

@misc{wtfs_testimony_20080227_chair_monetary_policy_and_the_state_of_the,
  author = {Ben S. Bernanke},
  title = {Congressional Testimony},
  year = {2008},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_20080227_chair_monetary_policy_and_the_state_of_the},
  note = {Retrieved via When the Fed Speaks corpus}
}