Congressional Testimony

S. HRG. 110-854 FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 2008 HEARING BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED TENTH CONGRESS SECOND SESSION ON OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978 FEBRUARY 28, 2008 Printed for the use of the Committee on Banking, Housing, and Urban Affairs Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html U.S. GOVERNMENT PRINTING OFFICE 50-369 PDF WASHINGTON : 2009 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS CHRISTOPHER J. DODD, Connecticut, Chairman TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama JACK REED, Rhode Island ROBERT F. BENNETT, Utah CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming THOMAS R. CARPER, Delaware CHUCK HAGEL, Nebraska ROBERT MENENDEZ, New Jersey JIM BUNNING, Kentucky DANIEL K. AKAKA, Hawaii MIKE CRAPO, Idaho SHERROD BROWN, Ohio ELIZABETH DOLE, North Carolina ROBERT P. CASEY, Pennsylvania MEL MARTINEZ, Florida JON TESTER, Montana BOB CORKER, Tennessee SHAWN MAHER, Staff Director WILLIAM D. DUHNKE, Republican Staff Director and Counsel ROGER HOLLINGSWORTH, Deputy Staff Director AARON KLEIN, Chief Economist DEAN V. SHAHINIAN, Senior Counsel JULIE CHON, International Economic Adviser MARK OESTERLE, Republican Chief Counsel PEGGY KUHN, Republican Senior Financial Economist MlKE NIELSEN, Republican Professional Staff Member DAWN RATLIFF, Chief Clerk DEVIN HARTLEY, Hearing Clerk SHELVIN SIMMONS, IT Director JIM CROWELL, Editor (ID C O N T E N TS THURSDAY, FEBRUARY 28, 2008 Page Opening statement of Chairman Dodd 1 Opening statements, comments, or prepared statements of: Senator Shelby 4 Senator Bunning Prepared statement 45 Senator Dole Prepared statement 45 WITNESS Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System 6 Prepared statement 46 Response to written questions of: Senator Shelby 50 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Monetary Policy Report to the Congress dated February 27, 2008 62 (III) FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 2008 THURSDAY, FEBRUARY 28, 2008 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Committee met at 10:11 a.m., in room SD—538, Dirksen Sen- ate Office Building, Senator Christopher J. Dodd (Chairman of the Committee) presiding. OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD Chairman DODD. The Committee will come to order. I am pleased to call the Committee to order this morning. Today, the Committee will hear the testimony of Federal Reserve Chair- man Ben Bernanke on the outlook of the Nation's economy, the Fed's conduct of monetary policy, and the status of important con- sumer protection regulations that are under the Fed's jurisdiction. This is Chairman Bernanke's second appearance before the Com- mittee this year. Mr. Chairman, it is good to have you with us, and, again, it is 2 weeks ago and now again today here. You are becoming a regular here, and so we appreciate your appearance be- fore the Committee. When Chairman Bernanke was first before the Committee 2 weeks ago, I laid out the facts of what I consider to be our Nation's very serious, if not perilous, economic condition. Growth is slowing, inflation is rising, consumer confidence is plummeting, while in- debtedness is deepening. And just as ominously, the credit markets have experienced significant disruptions. Consumers are unable or unwilling to borrow. Lenders are unable or unwilling to lend. There is a palpable sense of uncertainty and even fear in the markets with a crisis of confidence that has spread beyond the mortgage markets to markets in student loans. And I noted this morning— by the way, 2 weeks ago I pointed out that Michigan was indicating some serious problems with student lending, and this morning I am reading where Pennsylvania today—you may have seen the ar- ticle—may decide to also curtail student loans as a result of this growing economic situation. We have also seen the problem with credit cards, government bonds, and corporate finance. Unfortunately, the crisis of confidence does not just exist by American consumers and lenders. It increasingly appears that there is a crisis of confidence among the rest of the world in the United States economy. Yesterday, the dollar reached its lowest level since 1973, when the dollar was first allowed to float freely. And the Fed's own monetary report details an alarming fact. For- (l) eign entities have not only stopped purchasing U.S. securities; they have actually been selling them because they have lost, it appears, confidence in their value. Now, I am going to be raising some ques- tions, Mr. Chairman, about that, and I will be interested in your observations about these reports in the Monetary Policy Report. As I have said previously, the catalyst of the current economic crisis I believe very strongly is the housing crisis. Overall, 2007 was the first year since data has been kept that the United States had an annual decline in nationwide housing prices. A recent Moody's report forecast that home values will drop in 2008 by 10 percent to 15 percent, and others are predicting similar declines in 2009 as well. This would be the first time since the Great Depres- sion that national home prices have dropped in consecutive years. We have all witnessed in the past where regionally there have been declines in home prices, but to have national numbers like this is almost unprecedented, certainly in recent history. If the catalyst of the current economic crisis is the housing crisis, then the catalyst of the housing crisis is the foreclosure crisis. This week, it was reported that foreclosures in January were up 57 per- cent compared to a year ago and continue to hit record levels. When all is said and done, over 2 million Americans could lose their homes as a result of what Secretary Paulson has properly and accurately described as "bad lending practices." These are lending practices that no sensible banker, I think, would ever engage in. Reckless, careless, and sometimes unscrupulous actors in the mort- gage lending industry essentially allowed banks—rather, essen- tially allowed loans to be made that they knew hard-working, law- abiding borrowers would never be able to repay. Let me add here very quickly, because I think it is important to make the point here, that we are not talking about everyone here at all. We are talking about some who engaged in practices that I think were unscrupulous or bad lending practices. But many in- stitutions acted very responsibly, and I would not want the world to suggest here that this Committee believed that this was an in- dictment on all lending institutions. And engaged—those who did act improperly engaged in practices that the Federal Reserve under its prior leadership, in my view, and this administration did abso- lutely nothing to effectively stop. The crisis affects more than families who lose their homes. Prop- erty values for each home within a one-eighth square mile of a foreclosed home could drop on an average as much as $5,000. This will affect somewhere between 44 to 50 million homes in our coun- try. So the ripple effect beyond the foreclosed property goes far be- yond that and has a contagion effect, in my view, in our commu- nities all across this country beyond the very stark reality of those who actually lose their homes, the effect of others watching the value of their properties decline, not to mention what that means to local tax bases, supporting local police and fire, and a variety of other concerns raised by this issue. I certainly want to commend the Fed Chairman—I said so yes- terday publicly, Mr. Chairman; I do so again this morning—for candidly acknowledging the weakness in the economy and for ac- tively addressing those weaknesses by injecting liquidity and cut- ting interest rates. I also am pleased that the administration and the Congress were able to reach agreement on a stimulus package, and our hope is—while some have argued this is not big enough or strong enough, our collective hope is this will work, will have some very positive impact on the economy. Certainly this will have some support, we hope, for working families who are bearing the brunt of these very difficult times. However, I think more needs to be done to address the root cause of our economic problems. Any serious effort to address our eco- nomic woes should include, I think, an effort to take on the fore- closure crisis. And, again, there are various ideas out there on how we might do this more effectively, and certainly the Chairman and others have offered some ideas and suggestions. Senator Shelby and I have been working and talking—and Mel Martinez and oth- ers who are involved in these issues—about ways in which we can in the coming days do constructive things in a positive way to indi- cate and show not only our concern about the issue but some very strong ideas on how we can right this and restore that confidence I talked about earlier. We on this Committee have already taken some steps to address these problems. We have passed the FHA modernization legislation through the Committee and the Senate and continue to work to make it law. We had a very good meeting yesterday, I would point out, Senator Shelby and I and the leadership of the House Finan- cial Services Committee, I say to you, Mr. Chairman, in hopes that we can come to some very quick conclusion on that piece of legisla- tion and move it along here. We appropriated close to $200 million to facilitate foreclosure prevention efforts by borrowers and lenders, and I want to com- mend Senator Schumer and others who have been involved in this idea of counseling and ideas to minimize the impact of this problem as well. In addition, the recently enacted stimulus package that I men- tioned already includes a temporary increase in the conforming loan limits for GSEs to try to address the problems that have spread throughout the credit market and the jumbo mortgage mar- ket. And while this temporary increase is helpful, we still need to implement broad GSE reform. And as I have said previously, I am committed to doing that, and we will get that done. I have spoken about my belief in the need for additional steps to mitigate the foreclosure crisis in a reasonable and thoughtful manner. These steps include targeting some community develop- ment block grant assistance to communities in a targeted way to help them to counter the impact of foreclosed and abandoned prop- erties in their communities. And they include establishing a tem- porary homeownership loan initiative, which I have raised and oth- ers have commented on, either using existing platforms or a new entity that can facilitate mortgage refinancing. But it is not just the Congress that needs to do more, and, again, the Fed needs, in my view, to be as vigilant a financial regulator as it has been a monetary policymaker. That includes breaking with its past and becoming more vigilant about policing indefen- sible lending practices. And, again, I commend the Chairman of the Federal Reserve—we have talked about this here—on the proposed regulations that you have articulated that would follow on the HOEPA legislation. And while I have expressed some disappoint- ment about how far they go in certain areas here, the Chairman and I have talked about this a bit. We will be involved in the com- ment period here and are looking forward to finalizing those regu- lations, and hopefully at least shutting the door on this kind of a problem re-emerging in the coming months and years. So I want to thank you, Mr. Chairman, and your colleagues and urge them to consider some of the stronger measures, and we will offer some additional comments on them. Despite these unprecedented challenges, I think all of us here on this Committee, Republicans and Democrats, remain confident in the future of the American economy, and our concerns that will be raised here this morning should not reflect anything but that con- fidence in the future. We may need to change some of our policies, regulations, and priorities, but we strongly believe that the inge- nuity, productivity, and capability of the American worker and the entrepreneur ought never to be underestimated in this country. And we remain firm and committed to doing everything we can to strengthen those very points. So I look forward to working with my good friend, Senator Shelby, and other Members of the Committee to do what we can here to play our role in all of this in a constructive way, to work with you, Mr. Chairman, and the Federal Reserve, the Secretary of the Treasury, and others of the financial institution regulators to see what we can do in the short term to get this moving in a better direction. So, with that, let me turn to Senator Shelby for his opening com- ments, and then we will try to get to some questions. And I will leave opening comments for the go-around and question period so we can get to a question-and-answer period here to make this as productive a session as possible. But we thank you again for being with us. STATEMENT OF SENATOR RICHARD C. SHELBY Senator SHELBY. Thank you, Chairman Dodd. Chairman Bernanke, we are pleased to have you again before the Committee to deliver the Federal Reserve's Semiannual Monetary Policy Report. I will keep my remarks brief this morning as we are all here to hear your views on the U.S. economy and other related issues. We also have the benefit of having read about your remarks before the House yesterday. Chairman Bernanke, the Federal Reserve has taken a number of steps over the past 6 months to address the tightening of credit markets and the slowdown in economic growth. In a bid to improve interbank liquidity, the Federal Reserve established the term auc- tion facility in December of last year and has conducted, as I un- derstand it, six auctions to date. Since last August, the Federal Open Market Committee has re- duced the Federal funds target a total of 225 basis points, taking the target from 5.25 percent to 3 percent. Mr. Chairman, since monetary policy works with a lag, the full impact of this boost to the economy is not yet clear to you or to us. I know that we will spend time this morning discussing the length and the depth of the housing correction that Senator Dodd alluded to, and I think we should. I also want to make sure, however, that this Committee focuses on the risks associated with increasing in- flation. The Labor Department, Mr. Chairman, reported this week, as you know, that wholesale price inflation hit a 26-year high in Janu- ary. The January rise in the Consumer Price Index meant a 12- month change in the overall CPI of 4.3 percent, twice the pace of a year ago. In addition, gold and oil are at all-time highs. These numbers certainly raise questions, Mr. Chairman, as to how much more room the Federal Reserve will have to provide further mone- tary accommodation without threatening long-term price stability, which is very important to all of us. While it is difficult to see our Nation's economy experience minimal growth, the consequences of failing to restrain inflation will be far more painful and more dif- ficult to unwind. Chairman Bernanke, we are pleased to have you with us this morning, and we look forward to your thoughts on this and other issues. Chairman DODD. Thank you very much. Let me correct myself. The tradition has been, Mr. Chairman, if Members do want to make some opening comments at a moment like this, and I do not want to break that tradition. So I am going to ask if any Members would like to make any opening comments at this point, I would be happy to entertain them. I realize that has been the tradition of the Committee, and I do not want to violate the traditions of the Committee. Does any Member want to be heard, some opening comments to make at this point? If they would like to, I would be happy to entertain Senator BUNNING. Let me ask a question. If we do not make them now and we make them during our timeframe, does that limit how many questions we can ask? Chairman DODD. Well, that is the idea. I mean, I do not want to limit your time, but [Laughter.] Chairman DODD. So if you would like to Senator SHELBY. Make your opening statement. Senator BAYH. That would make Chairman Bernanke happy. Chairman DODD. I understand that, and that is why you get the gavel after 27 years. But if you would like to make an opening com- ment Senator BUNNING. OK. Chairman DODD. All right. Anyone else who would like to be heard? Senator SHELBY. Why don't you add a minute and do both? Chairman DODD. We will add a minute. Why don't I add a minute to the time here? Instead of having 5 or 6 minutes, we will make it 7 or 8 minutes. And I have never tried to be too rigid about that, and so we will do it that way if that is all right. That will move things along. Is that OK with everyone? Thank you very much. Mr. Chairman, we welcome you to the Committee. STATEMENT OF BEN S. BERNANKE, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Mr. BERNANKE. Thank you. Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Con- gress. In my testimony this morning, I will briefly review the eco- nomic situation and outlook, beginning with developments in real activity and inflation, and then turn to monetary policy. Senator BUNNING. Mr. Chairman, would you please move that microphone a little closer so we can all hear you? Mr. BERNANKE. HOW is this? Senator BUNNING. That is good. Mr. BERNANKE. I will conclude with a quick update on the Fed- eral Reserve's recent actions to help protect consumers in their fi- nancial 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 continued poor functioning of mar- kets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domes- tic product held up well through the third quarter despite the fi- nancial turmoil, but it has since slowed sharply. Labor market con- ditions 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 many 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 served to increase 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 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 slows and funding becomes harder to obtain, especially for more speculative projects. On a more encour- aging note, we see few signs of any serious imbalances 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 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 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 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 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 inter- bank lending, the Federal Reserve—among other actions—recently introduced a term auction facility, through which prespecified amounts of discount window credit are auctioned to eligible bor- rowers, and we have been working with other central banks to ad- dress market strains that could hamper the achievement of our broader economic objectives. These efforts appear to have contrib- uted to some improvement 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 likely to increase somewhat. In par- ticular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2Vz percent to 23A percent projected in our report last July. FOMC par- ticipants' projections for the unemployment rate in the fourth quar- ter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4% percent projected last July for the same period. The downgrade in our projections for economic activ- ity in 2008 since our report last July reflects the effects of the fi- nancial turmoil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most re- cent 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 stim- ulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets. The incoming in- formation since our January meeting continues to suggest sluggish economic activity in the near term. The risks to this outlook remain to the downside. The risks in- clude the possibilities that the housing market or the 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 per- sonal consumption expenditures—or 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 depre- ciation of the dollar on import prices. Moreover, core inflation in the first half of 2007 was damped by a number of transitory fac- tors—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 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 implied by quotes on futures markets. In addition, dimin- 9 ishing 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 high- er than in our July report, largely because of some higher-than-ex- pected 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 projec- tions submitted by FOMC participants for 2010—which ranged from 1.5 percent to 2.0 percent for overall PCE inflation—were im- portantly influenced by participants' judgments about the meas- ured rates of inflation consistent with the Federal Reserve's dual mandate and about the timeframe over which policy should aim to achieve 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 prices and from the weaker dollar may be greater than we antici- pate. 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 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 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. 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 pres- sures. In particular, the FOMC will need to judge whether the pol- icy actions taken thus far are having their intended effects. Mone- tary 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 by the risks to that forecast. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks 10 to growth remain. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a time- ly manner as needed to support growth and to provide adequate in- surance 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 report last 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 es- tablish 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 con- sumers' 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 deci- sion. For higher-priced loans, the proposed rules 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 bor- rowers in unaffordable loans. In addition, for all mortgage loans, our proposal addresses misleading and deceptive advertising prac- tices, 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 ap- praisers by lenders. We expect substantial public comment on our proposal, and we will carefully consider all information and view- points 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 a streamlined, systematic approach to expedite the loan modification process. We also have been pro- viding community groups, counseling agencies, regulators, and oth- ers 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 ac- tively pursuing other ways to leverage the Federal Reserve's ana- lytical resources, regional presence, and community connections to address this critical issue. 11 In addition to our consumer protection efforts in the mortgage area, we are working toward 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 pleased to take your questions. Chairman DODD. Thank you very much, Mr. Chairman. We will make these 7 to 8 minutes, and, again, I will not be rigid about the time constraints. Let me begin, Mr. Chairman, by going back to that old question that was asked more than, I guess, 30 years ago. I will sort of para- phrase on it, and that is, are we better off today to respond to this situation than we were—in this case I want to ask 7 years ago. The question that Ronald Reagan asked, I think, in 1980 in that cam- paign, Are we better off today than we were yesterday? And the reason I raise that is because I have been struck by the similarities between 2001 and that period going into, potentially falling into a recession, and here we are in 2008. The parallel seems striking to me in some ways, and I want you to comment on this, if you could. At both moments in this 7-year period, we are on the brink of a recession—at least it seems so. The Fed was cutting interest rates very aggressively. A major asset bubble—in this case, it was the high-tech community rather than housing—was bursting. Yet despite those similarities, the dif- ferences in the basic economic information seems to be very, very different as well. Americans had just experienced the greatest eco- nomic boom in a generation. Real wages had gone up substantially. Income inequality had narrowed. The Federal Government was in a surplus. In fact, on this very Committee, your predecessor came to a hearing—I do not know who else was on the Committee in those days, but he came and talked about the things we ought to think about by retiring the national debt entirely. There were some downsides to that, and we actually had a very good hearing with Alan Greenspan about that very question in 2001. The dollar was at record highs as well, and, of course, today we are in the opposite position, with the dollar at its lowest level since we began floating currencies in 1973. Inflation is at a 17-year high. Real wages are falling, and we are faced with record Government debt and deficits. A very different fact situation than was the case in 2001. In 2001, as well, one might argue that there were deliberate ac- tions taken by the Federal Reserve to deal with rising inflation. So the steps were in response to inflation here. Obviously, what is pro- voking, I think, the action—and you can certainly comment on this—is a different fact situation. So the question appears in a sense: Are we in a—what would be your analysis? Are we in a—comparing these two periods in time of history, relatively close to each other, faced with similar situa- tions, it would appear to me that we are not in as strong a position to respond to this as we were in 2001. And so the question is, Are we better off? And if so, I would like you to explain why. And if not, what should we be doing and what different steps should we 12 be taking if we cannot rely on these basic underlying strengths that occurred in 2001 that helped us at that time as opposed to where we are today? Mr. BERNANKE. Mr. Chairman, there are certainly some similar- ities with the 2001 experience, most obviously the sharp change in asset price. In the previous case, it was the stock market, the tech stocks; in this case, it is home prices. But there are some important differences as well, as you point out. The decline in home prices is creating a much broader set of issues, both for borrowers and homeowners, but also for the credit markets. And so we have a sus- tained disruption in the credit process which has gone on now since last August and is not yet near completion. That is a continuing drag on the economy and a continuing problem for us as we try to restore stronger growth. The other problem is that we do have greater inflation pressure at this point than we did in 2001, and that is coming from oil. In 2001, the price of oil was somewhere around $20. Today it is $100. Chairman DODD. Right. Mr. BERNANKE. The increase in commodity prices around the world as the global economy expands and increases demand for those commodities is creating an inflationary stress which is com- plicating the Federal Reserve's attempts to respond. In some other ways, things are different. You pointed out the dol- lar was very strong in 2001. That was in part reflective of a large trade deficit at that time. It has since depreciated. But, on the other hand, part of the effect of that depreciation has been that we are at least seeing some improvement in that trade deficit, which is a positive factor. On the fiscal situation, I agree we are in a less advantageous sit- uation than we were. The deficit is certainly higher, and perhaps even more seriously, we are now 7 years further on toward the re- tirement of the baby boomers and the entitlements, and those costs that are certainly bearing down on us as we speak. So it is a difficult situation, and there are multiple factors. I think there are some similarities, but as a Russian novelist once said, "Unhappy families are all unhappy in their own way," and every period of financial and economic stress has unique character- istics. Chairman DODD. Well, do you have any recommendations, then, differently here? If we are responding in a very similar way with different underlying economic fact situations, are there other things we ought to be doing here, taking any kind of a different ap- proach? Or are we secure in feeling that the present course of ac- tion being taken by the Fed and by the administration is going to produce the desired results? That period of recession lasted about 8 months. There are fears that this one, if it takes hold, could be far more long-lasting for the very reasons we have outlined in the underlying problems economically that exist. Mr. BERNANKE. Well, to some extent, the private sector is going to have to work through the problems in the financial markets. That is something that they will have to do with the help and guid- ance of the regulators and the supervisors, which we are certainly doing. We are reviewing our practices and our policies and trying to see how we can improve them. 13 With respect to the broader economy, of course, we have both monetary and fiscal policy action now underway, which I hope will, and we project will, lead to stronger growth in the second half of this year. An important issue, as you have already alluded to, is the effects of the home price declines on consumers and, in par- ticular, the delinquencies and foreclosures which we are now see- ing. I have described briefly in my remarks some of the things that we have done in calling on private servicers and lenders to scale up their activities, to use more streamlined processes. I think it is important for us and for the servicers to move beyond temporary palliatives that they are using in many cases with delinquent bor- rowers and try to find more permanent, sustainable solutions in terms of restructuring mortgages or refinancing into the FHA or other mechanisms. Congress has already taken some steps, as you mentioned, and would urge you to continue to work on FHA modernization and GSE reform. Chairman DODD. Right. Mr. BERNANKE. Those are two areas that can help us meet these challenges. Additional steps may be necessary in the future, but at this point, I think we have taken a number of useful steps. We need to keep thinking about possible future options, but I do not have any additional recommendations right now. Chairman DODD. I do not want to put words in your mouth, obvi- ously, at all here, but I am looking at—obviously the housing burst or bubble, the burst of that bubble is, I think, far more dangerous than a high-tech problem, as you make those comparisons. Infla- tion and trade deficits are worse. Am I hearing you correctly that we are actually in a worse position today to respond to this than we were 8 years ago? Is that how I hear what you are saying? Mr. BERNANKE. I think that is fair in that both fiscal and mone- tary policy face some additional constraints. Many people owned stocks, too, of course, and so that affected their wealth and their willingness to spend. But, in fact, the effects of the stock market declines in 2001 were primarily on investment firms than on con- sumers. In this case, the consumers are taking the brunt of the ef- fects. Chairman DODD. That is a good additional point. I did not make that. Senator Shelby. Senator SHELBY. Thank you, Mr. Chairman. Chairman Bernanke, as I noted earlier, wholesale prices rose by 1 percent in January and 7.4 percent over the past year. This is the fastest increase in 26 years. In your opening statement, you noted greater upside risks to both overall and core inflation than we saw previously. Additionally, the most recent minutes of the Federal Open Market Committee gave anecdotal evidence that in some instances these price increases were passed on to consumers. The FOMC also noted a risk that inflation expectations could be- come less anchored. 14 Do you have any concern at all that the 225 basis-point cut to the Federal funds rate has limited the options that can be used to combat the upside risk of inflation? Mr. BERNANKE. Well, Senator, to answer that question, the PPI, the Producer Price Index, that you referred to mostly reflects the effects of large increases in prices of energy and other commodities. We live in a world where energy and metals and other commodities are globally traded, food as well, and demand of emerging market economies and a growing global economy has put pressure on the available supplies of those resources and has driven up those prices. And as I mentioned, the price of oil has quintupled or more. Senator SHELBY. DO you see that abating? Mr. BERNANKE. In 2007, the price of oil rose by about two-thirds, and I suspect—and the futures markets agree—that it is much more likely that oil prices, while remaining high, will not increase by anything like that amount going forward. If oil prices and food prices do stabilize to some extent, even if they do not fall, that will be sufficient to bring inflation down as we have projected. Now, you are correct, though, that we do have to be very cau- tious. While we cannot do much about oil prices or food prices in the short run, we do have to be careful to make sure that those prices do not either feed substantially into other types of prices, other goods and services produced domestically, and that they do not dislodge inflation expectations or make the public less confident that the Federal Reserve will, in fact, control inflation, as we will. So we do have to watch those things very carefully, and will watch them very carefully. Senator SHELBY. IS that what some of us would talk about, the psychology of inflation? Mr. BERNANKE. Well, that is another way to put it. But, yes, in- flation expectations essentially are measured many different ways, and I think the evidence is that they remain pretty stable. If you look at forecasters' long-term inflation expectations, consumer sur- veys, and even the financial markets, they show that inflation ex- pectations remain reasonably well anchored. But it is certainly something we have to watch very carefully. Senator SHELBY. DO you believe that setting a Fed funds rate target lower than the inflation rate—that is, a negative real rate of interest—can be an appropriate response to an economic slow- down? In other words, how long can the Fed run a negative real rate before inflationary pressures grow to dangerous levels? Mr. BERNANKE. Well, Senator, there are different ways to meas- ure the real interest rate. The one that is relevant is the one that is looking forward, and, again, if oil prices do not continue to rise at this pace they have, I think we would still be on the positive side of the real interest rate. Now, in the past, the Fed has for short periods lowered the rate to a negative level, but as you point out, that is not something you want to do for a sustained period. Senator SHELBY. The Fed cannot ignore price stability, can it, when you are making these decisions to have more liquidity in the financial market? Mr. BERNANKE. Senator, we are facing a situation where we have simultaneously a slowdown in the economy, stress in the financial 15 markets, and inflation pressure coining from these commodity prices abroad. And each of those things represents a challenge. We have to make our policy in trying to balance those different risks in a way that will get the best possible outcome for the American economy. Senator SHELBY. Would you be trying to avoid stagflation, as some people call it? Mr. BERNANKE. I do not anticipate stagflation. I do not think we are anywhere near the situation that prevailed in the 1970's. I do expect inflation to come down. If it does not, we will have to react to it, but I do expect that inflation will come down and that we will have both return to growth and price stability as we move forward. Senator SHELBY. DO you still believe that the fundamentals of our economy is still robust, is strong, other than the housing mar- ket and some of the financial challenges that we have coming out of that? Mr. BERNANKE. Senator, I realize my testimony was not the most cheerful thing you will hear today, and I was thinking very much about the short-term challenges that we face in terms of the finan- cial markets and growth and inflation. But I do very much believe that the U.S. economy will return to a strong growth path with price stability. We have enormous resources, resilience, produc- tivity, and I am quite confident in the American economy and the American people that we will have strong economic growth in the next few years. Senator SHELBY. Mr. Chairman, a commonly watched measure of inflation, as you well know, is the core CPI. Housing constitutes, I understand, almost a third of the core CPI. To what extent has the recent decline in housing prices moderated recent increases in the core CPI? As housing prices go down, inflation, you know, should play here in a negative way, should it not? Mr. BERNANKE. Well, Senator, not necessarily. You can get actu- ally a perverse effect, which is that as house prices Senator SHELBY. And how would that work? Mr. BERNANKE. AS house prices fall, people will become more re- luctant to buy a house because they are afraid that the house price will keep falling, so they rent instead. And that puts pressure on rents and actually could drive up the rent. Senator SHELBY. Good for the landlords and bad for the sellers. Mr. BERNANKE. It can be, and the way the Bureau of Labor Sta- tistics calculates the cost of homeowner ship, it uses a lot of infor- mation from measured rents. So you can actually get—as we did last year—a period where the cost of homeownership as measured by the BLS actually went up, even though house prices were com- ing down, because of the fact that people were renting more and rental costs were going up. That effect has moderated somewhat re- cently, and that has helped to keep down Senator SHELBY. What would be the trend from your perspective in the core CPI if house prices were excluded? Mr. BERNANKE. House prices are not included Senator SHELBY. I know they are not, but what if you did exclude them? What would be the trend in the core CPI? Mr. BERNANKE. I am sorry. House prices are not included in the 16 Senator SHELBY. OK, they are not. Mr. BERNANKE. In the CPI. What is included Senator SHELBY. They are excluded. Mr. BERNANKE. The measure of shelter costs is related to rents drawn from various sources. Senator SHELBY. One more question, Mr. Chairman. What do you judge to be the threat of slow growth continuing with inflation remaining above the Federal Reserve's comfort level? What would you say to that? In other words, what do you judge to be the threat of the slow growth continuing with inflation remain- ing above your comfort level? Mr. BERNANKE. Well, we are certainly aiming to achieve our mandate, which is maximum employment and price stability. We project that that will be happening. We are watching very carefully because there are risks to those projections. One of the risks, obvi- ously, is the performance of the financial markets, and that again, as I mentioned before, complicates the situation. As events unfold—and certainly there are many things that we cannot control or cannot anticipate at this point—we are simply going to have to keep weighing the different risks and trying to find an appropriate balance for policy going forward. Senator SHELBY. AS a bank regulator, too—this will be my last question, Mr. Chairman—do you fear some bank failures in this country? I know there are big risks where they are heavily involved in real estate lending. Does that bother you as a bank regulator? Mr. BERNANKE. Well, I believe the FDIC and the OCC have re- cently provided some information. There probably will be some bank failures. There are, for example, some small or in many cases de novo banks that are heavily invested in real estate in locales where prices have fallen, and, therefore, they would be under some pressure. So I expect there will be some failures. Among the largest banks, the capital ratios remain good, and I do not anticipate any serious problems of that sort among the large internationally active banks that make up a very substantial part of our banking system. Senator SHELBY. DO you see some of those larger banks seeking additional capital to bolster themselves? Mr. BERNANKE. They have already sought something on the order of $75 billion in capital in the last quarter. Senator SHELBY. IS that enough? Mr. BERNANKE. I would like to see them get more. They have enough now certainly to remain solvent and to remain above, well above their minimum capital levels. But I am concerned that banks will be pulling back and not making new loans and providing the credit, which is the lifeblood of the economy. In order to be able to do that, they need in many cases—not all cases, but in some cases at least—they need to get more capital. Senator SHELBY. Thank you. Chairman DODD. Thank you very much, Mr. Chairman. Let me just say to the Chairman, I said this to him privately, but I really appreciate your candor in all of this. Your job is not to be a cheerleader but to lay out for us exactly how you see things. And I for one, anyway—I do not know if other Members feel likewise, but I am very appreciative of the fact that you are very clear and 17 very straightforward on your assessment of these matters, and that is important. Senator Reed. Senator REED. Well, thank you very much, Mr. Chairman. And, Chairman Bernanke, welcome. I will say first that you bring to this very challenging job great intellect and great integrity, and I ap- preciate it very much. And it is a daunting moment in our eco- nomic history. You said in rather unemotional terms, characteristically talked about the squeeze that families are feeling. What I have heard in Rhode Island is exactly the same thing: increased costs for prac- tically everything you need, flat wages, and then the housing prob- lem taking away that sense of well reserve if something goes wrong. In fact, I was particularly struck by comments that were related to me about the bakers in Rhode Island, the family bakeries who have seen the price of wheat go up 200, 300, 400 percent. It is un- precedented, frankly. And if that continues, we are going to have real serious, serious problems, as you alluded to. The Fed has two major responsibilities: monetary policy but reg- ulation of large financial institutions. And in that latter category, I alluded to this in our last conversation in the Committee about your take on, frankly, how well you have activated your regulatory responsibilities in these last few years. We have seen major institutions write off billions of dollars, and mostly because of off-balance-sheet transactions. And it is quite clear that the Fed is there on a daily basis in all the institutions. I think the former Chairman of the CEA, Martin Feldstein, wrote, "The Fed's banking examiners have complete access to all the fi- nancial transactions of the banks that they supervise and should have the technical expertise to evaluate the risks that those banks are taking." Well, it seems quite clear now, with the restatement of balance sheets that these banks are taking lots of risks that they did not really see as risks. Are you satisfied that you have in place the regulatory proce- dures? And are you—I do not know what the right word is—dis- appointed that your regulatory apparatus did not alert the banks or monitor the banks more closely over the last several months? Mr. BERNANKE. Well, Senator, you raise some important ques- tions. First of all, we and our fellow regulators, both in the United States and around the world, are engaged, as you might imagine, in a very serious review of what has happened and what we can do better in the future. The Federal Reserve itself is looking at our own practices and staffing and all those issues. The President's Working Group is working on a set of recommendations looking broadly at the financial markets and the problems that arose. And all of those discussions and information will be feeding into an international analysis—the Financial Stability Forum, the Basel Committee, international groups of financial regulators, central banks, Finance Ministers, and so on—which will try to determine, what the problems were, where we can do better, and what we have learned from this episode. So we are certainly doing a lot of stock taking and trying to determine where there were problems. 18 In terms of the banks it should be emphasized that we do work very closely with the other regulators—the OCC, the FDIC, and others, depending on the type of bank. Our focus, I think of neces- sity, is for the most part on things such as the overall structure of risk management, the practices and procedures that the banks follow. It is very difficult for us to second-guess the specific asset price or asset purchase decisions that they make. I think going forward we do need to look in a much tougher way at the risk management and risk measurement procedures that the banks have. But, again, it is very difficult for us to tell a bank that—when they make a cer- tain investment that they think it is a good investment, and they have done all the due diligence—that it is a bad investment. That is not usually our role. Senator REED. Let me follow up with two questions and ask for a brief response. First, when do you anticipate sharing with this Committee the results of this analysis you are doing of your regu- latory position within the next several months in a detailed basis? Mr. BERNANKE. Well, the President's Working Group and then the international bodies—the Financial Stability Forum, the Basel Committee—are anticipating sharing these reports within the next couple of months. The Financial Stability Forum has already issued a preliminary interim report trying to identify the areas of weakness and problems. Senator REED. Another question, and this goes back to sort of the level of detail. Do your examiners look at what is happening on the trading desks of these large institutions in real time and then com- pare it to what is happening on the asset side? I mean, there has been a suggestion in some institutions that while they were being booked, some of these investments, at a reasonably high price, the traders were selling at a deep discount. Is that something that you did or propose to do in the future? Mr. BERNANKE. Well, again, we cannot look over the shoulder of every trader on every trade, but what we can try to do is ensure that the systems exist so that the bank is ensuring that the appro- priate markdowns are taking place so that they are consistent be- tween the trade and the booking. So we do look at the systems and the risk management systems to try to determine if they are prop- erly managed. Senator REED. Well, you know, I think we have a problem here, frankly, maybe because—and, again, you can take a systematic procedure, see that the procedures are all in place, but if the proce- dures are missing a major point or the assumptions underlying the procedures are outdated—and I would hope that your review would be prompt and timely and allow us to see details of what you have been looking at. Let me ask a question. You brought up Basel II. One of the as- pects of Basel II, to my understanding, is a reliance on ratings and rating agencies. In fact, it has been reported that Northern Rock, the British institution that failed that has now been nationalized by the British Government, was able to lower their risk-weighted assets by 44 percent under Basel II. The CEO at the time described it as the "benefits of Basel." I suspect he is not describing it as 19 that—certainly the Prime Minister is not describing it as the "ben- efits of Basel" now. Does that give you pause with respect to rushing forward with Basel II? Mr. BERNANKE. Well, Basel II, I still believe, is the right direc- tion. It is based on properly measuring risk and relating capital to the amount of risk that you are taking. I think in the case of Northern Rock, the real, most serious problems were not in the asset quality but, in fact, were due to a lack of liquidity planning because they did not have sources of liquidity when the run oc- curred, essentially. And we in our implementation of Basel II here in the United States do make liquidity planning an important part of our analysis. You mentioned credit ratings. It is true that credit ratings do play a role in some of the Basel II risk evaluations. They do not play a unique role. It is generally the case that banks are expected to make independent evaluations along with taking information from the credit ratings. However, this is certainly one of the areas where the Basel Committee, in reviewing the lessons of the recent events, is looking carefully on how or whether to use credit ratings in the risk measurement process. Senator REED. Thank you, Mr. Chairman. Thank you, Chairman Dodd. Chairman DODD. Yes, excellent questions. And, Mr. Chairman, just picking up on Jack Reed's questions here, it may be worth— I had not thought about the Basel implications. We have looked at this thing, obviously, in a more parochial way, but I might ask the Chairman of the Fed to give us—we had one hearing on this. Sen- ator Shelby cares deeply about this issue, as I do as well, the rat- ing agencies. It is a complicated issue. But I think all of us would be deeply appreciative of" some ideas from the Fed to us. If there is any need here for legislative action at all in this area, we would be very interested in hearing your thoughts and ideas on that as well. Mr. BERNANKE. Senator, the Basel Accord is implemented by reg- ulation, and we have determined a joint action by the four bank regulators. We are working together through regulation to try to make improvements. We will certainly take a lot of advice from the Basel Committee and the changes and suggestions that they make. We have a very conservative process in place for introducing the Basel II system, which includes several years of transition floors that will not allow capital to decline very much, and a lookback study that will review the experience both here in the United States and elsewhere to try to understand and make sure that we are confident that the system is going to develop appropriately and provide enough capital for banks. So we will be taking the lessons of the recent experience very much to heart and incorporating them in the system. Basel II has the virtue of being flexible enough that it can adjust when you make changes like this. So I do not think at this point that legisla- tion is necessary. Chairman DODD. OK. Well, I am pleased to hear that, and as I said, it is an excellent question that Senator Reed has asked. Senator Bennett. 20 Senator BENNETT. Thank you very much, Mr. Chairman, and welcome, Chairman Bernanke. I trust you saw the piece in this morning's Wall Street Journal, the op-ed piece by Allan Meltzer. Mr. BERNANKE. Yes. Senator BENNETT. "That 1970's Show." I will give you an oppor- tunity to comment on that. Mr. BERNANKE. Well, Mr. Meltzer, who is an excellent economist and indeed who is a historian of the Federal Reserve, is concerned that the current situation will begin to look like the 1970s, with very high inflation and high unemployment. I would dispute his analysis on the grounds that I do believe that monetary policy has to be forward looking, has to be based on where we think the econ- omy and the inflation rate are heading. And as I said, the current inflation is due primarily to commodity prices—oil and energy and other prices—that are being set in global markets. I believe that those prices are likely to stabilize, or at least not to continue to rise at the pace that we have seen recently. If that is the case, then in- flation should come down, and we should have, therefore, the abil- ity to respond to what is both a slowdown in growth and a signifi- cant problem in the financial markets. He is correct, however, that there is some risk, and if the infla- tion expectations look to be coming unmoored, or if the prices of en- ergy and commodities begin to feed into other costs of goods and services, we would have to take that very seriously. I mentioned that core inflation last year was 2.1 percent, so it is food prices and energy prices, which are internationally traded commodities, which are the bulk of the inflation problem. Again, we do have to watch it very carefully, but I do not think we are anywhere near the 1970s type situation. Senator BENNETT. Thank you. I wanted to get that on the record. As I look at the housing market and talk to some of my friends who are in the housing market, they tell me that the inventory is not monolithic, the inventory overhang—that is that the bulk of the overhang is in the higher-priced homes, because home builders wanted to build places where they would get the highest margin return, and if they built houses in the moderate housing area or affordable housing, their margins were not nearly as great and there were plenty of speculators willing to buy the bigger homes. And, indeed, they tell me that for affordable housing, there is, frankly, not a sufficient supply right now. They are urging me to do something on fiscal policy to stimulate people to build cheaper houses, that the housing construction would begin to catch up—not catch up. Construction levels would begin to pick up, whereas now they are dormant, waiting for the overhang to be worked off. Do you have any data that supports that anecdotal report? Mr. BERNANKE. Well, we do have some data on investor-owned properties, and that has been increasing quite a bit. And my recol- lection is that among the mortgages that are having problems, something on the order of 20 percent of them are investor-owned; therefore, it is not a family that is being in risk of losing their home. So that is a significant consideration, and I think that in those cases investors who make a bad investment should bear the consequences. 21 Senator BENNETT. That is my own attitude as well. But we are having conversations about stimulus packages around here, and it had not occurred to me, until I had this information from people in the housing market, that if we could stimulate people to buy the lower-priced houses, and those are the people who need the shelter, anyway, and there is not a surplus of inventory there, that that would have a very salutary effect both in terms of taking care of people's needs and on the economy, because home builders would start to build again, they just would not be building in that portion of the housing market where there is an oversupply. But you do not have any specific data as to where the price points are in the inventory overhang? Mr. BERNANKE. I could probably obtain such data. I am not sure that directly trying to stimulate specific types of house construction is necessarily the most efficient way to go about it. Probably the better thing is to try to ensure strong employment so people have the income and they can purchase the home they want to have, or they can rent if they prefer. But I do not have the data with me. Senator BENNETT. Well, I would appreciate it if we could get some because I find this an intriguing idea. I know in Utah, which has not been hurt as badly by the housing problem as some other States—because we generate something like 30,000 new families every year that need houses. But in Utah, above a certain level, around $400,000, there is a glut of houses on the market and, therefore, nobody in that market or above can sell their house. But for houses in the $200,000 area, which we would now begin to think of as an affordable housing range, there does seem to be something of a shortage. So if you have any data on that that you could share with us, I would appreciate it. Because as we formulate the stimulus pack- age, Mr. Chairman, this is something I think we ought to look at. It is a little more sophisticated and has drilled down through the data to a more granular level. But anything we can do to get the construction business started—you say, well, it is maybe too long term out, but there are a lot of jobs that people can get in the con- struction business if they are building the lower-priced houses that right now the construction workers do not have anything to do. Mr. BERNANKE. Senator, one thing that is certainly true is that a lot of the big house price declines are taking place in high-priced areas like California and Florida, Nevada, Arizona, where prices went up a lot before, and now they are coming back down. Senator BENNETT. That is the price range that it is hitting in Utah as well. Thank you, Mr. Chairman. Chairman DODD. Not at all. And I might have missed this in your point here, but seemingly one of the issues we are grappling with here is the oversupply. And you are raising a different ques- tion. Where is that oversupply occurring? But one of the concerns I have is that allowing the market to take over here, if your supply increases and demand is not keeping pace, then obviously your ability for the market to really help stabilize this problem here is going to be de minimis, it seems to me. 22 Senator BENNETT. My point is that the market is not monolithic. There is an oversupply at the high range, but I am being told that in the lower range Chairman DODD. Well, that is a good question and one we ought to—if you have the ability to give us some information on that, I would be very interested in that as well, Mr. Chairman. Let me turn to Senator Menendez. Senator MENENDEZ. Thank you. Thank you, Mr. Chairman, for your testimony and your service. It seems to me—and I am sure all of us—that the central bank is faced increasingly with the contradictory pressures of the slowing economy and rising consumer prices—gas prices, food prices, en- ergy prices as a whole, to name a few. Isn't revving up a slow econ- omy far easier than slowing inflation once it has become en- trenched? Mr. BERNANKE. AS you say, if it becomes entrenched, if inflation expectations were to rise and that were to lead to a wage-price spi- ral, for example, or, non-energy, non-food prices rising more quick- ly, that would be more of a concern. As I said, we are concerned. I do not wish to convey in any way that we are not concerned about it. We are trying to balance a number of different risks against each other. With respect to inflation, as I said, our anticipation is that infla- tion will come down this year and be close to price stability this year and next year. If it does not, then what we will be watching particularly carefully is whether or not inflation expectations or non-energy, non-food prices are beginning to show evidence of en- trenchment, of higher inflation, as you point out. That would cer- tainly be of significant concern to us and one that we are watching very carefully. Senator MENENDEZ. Let me ask you, with consumers reluctant to spend and businesses reluctant to invest and lenders reluctant to lend and home prices going downwards, is the lower interest rates, do you believe, going to be enough to do the trick? Mr. BERNANKE. Well, I think it is certainly helpful, and we also have a fiscal package, as you know. A lot is going to depend on the underlying resilience of the economy itself and of the financial sys- tem to work through these problems and to bring us back to a situ- ation where we can grow in a normal way. Senator MENENDEZ. HOW about something that you do not have control over, which is the foreign confidence in the American dol- lar? Isn't your ability to continue to cut rates to some degree re- strained by the willingness of foreign countries to continue to fi- nance the current account deficit? Mr. BERNANKE. Well, it is a complex question. We Senator MENENDEZ. Can you give me a simple answer? Mr. BERNANKE. I will try. It is important for the U.S. economy to be strong and an attractive place for investment. And I think we are better off in the medium term trying to ensure good, strong growth in the economy to attract foreign investment than we are falling behind and allowing the economy to drop into a severe de- cline. So there is a balance there. We have to think about the short- term return, which is partly related to our interest rate decisions, 23 but we also need to think about the medium term, where we want to make sure the economy is growing in a stable and healthy way which will attract foreign investment. Foreign investment, I should emphasize, continues to be strong. We are not seeing any significant shifts of out of dollars among offi- cial holders, for example. And I anticipate that we will continue to have the capital inflows we need, in part, going back to my earlier comments, because I do think that the world recognizes that the U.S. economy has underlying strengths and resilience that will bring us back to a strong growth path within the next couple of years. Senator MENENDEZ. If then the Fed's decision at this point in time—of course, it always depends upon the point in time—is that dealing with the slowing economy is the present priority, and as the Chairman has said on more than one occasion, that if there is a great challenge in the economy, it stems from the mortgage melt- down, the housing market meltdown, are we—I have a real con- cern. You know, in March of last year, I and a few others said we are going to have a foreclosure tsunami, and everybody pooh- poohed that and said that is an overexaggeration. And, unfortu- nately, we are well on our way, and we have not even seen the to- tality of it. The question is, when I see the Center for Responsible Lending say that basically the present administration's plans will only deal with 3 percent of the properties, removing them from foreclosure, and I see Moody's saying that the experience of 2007 is largely around 3.5 percent of workout, at the end of the day is a 97-percent market correction something that we are willing to accept and something that we need to accept? Or is that a percentage that is far too high? Mr. BERNANKE. Senator, there have been about four or five stud- ies reviewing the experience of servicers and lenders and trying to work out mortgages, and, unfortunately, we are still getting a very mixed and fuzzy picture about exactly what is happening. One of the benefits, I think, of some of the recent actions associated with the Hope Now Alliance, for example, is that I hope we will be get- ting better, more up-to-date, and more consistent data on what is actually happening in the field. I do agree that while the servicers seem to have made some progress in scaling up their activities, they are not yet to the point where they can deal with what you called the "tsunami of fore- closures," which is already well underway. And for that reason, we continue to urge them to expand their efforts further, to work to- ward more permanent solutions. Senator MENENDEZ. But if that were to be the figure, is that an acceptable market correction figure, 97 percent of the couple of mil- lion families in this country ready to lose their home? Is that what we are willing to accept, both in the context of public policy as well as in the context of our economy? Mr. BERNANKE. Well, even under regular circumstances, unlike what we have today, the number of foreclosure starts that actually ends in an eviction or a sale is well less than 97 percent. So I am not quite sure what to compare it to. Obviously, the more people who are able and desire to stay in their home, the more we can 24 help, the better that is going to be. And I strongly support in- creased efforts by the servicers and lenders to address this issue. Senator MENENDEZ. Well, my concern is we were behind the curve in trying to deal with the issue, and my concern is now we seem to be continuing behind the curve in stemming the hem- orrhaging that is going on. One last question. The central bank has always seen its core mis- sion as safety and soundness. Consumer protection I hope is going to increasingly be something that you will consider a core mission as well. And I heard your remarks at the very end of your testi- mony. Is it your intention—when you talk about issuing something on unfair and deceptive practices, is that in relation to credit cards, mortgages, to REITs? Is it cross-cutting? Mr. BERNANKE. We have already issued the HOEPA rules, which address unfair, deceptive acts and practices relating to mortgages, for comment. We are currently receiving comments on those. The new rules, which I alluded to, for the spring are under the FTC unfair, deceptive acts and practices code, and they would apply to credit cards, and possibly other things, but primarily cred- it cards. Senator MENENDEZ. Thank you, Mr. Chairman. Chairman DODD. Thank you very much. Senator Allard. Senator ALLARD. Thank you, Mr. Chairman, and thank you, Chairman Bernanke. Mr. Chairman, we have to, I think, remind ourselves exactly what is involved in a recession. I hear the reporters, I think erro- neously, reporting a recession when actually we are having an eco- nomic slowdown. I would like to have you define for the Committee what would constitute a recession. Mr. BERNANKE. Well, recessions are generally called, so to speak, by a committee called the Business Cycle Dating Committee, which is part of the National Bureau of Economic Research—a committee of which I was once a member, by the way—which looks at a wide variety of indicators to see essentially if the economy contracted over a period of time. It is a somewhat subjective decision, and it is often made well after the fact because of the revisions of data and so on. A more informal but widely used definition of recession is two consecutive quarters of negative growth. That would be an alter- native that people use. Senator ALLARD. There was a newspaper article or report that came out, I think in the last day or two, suggesting that somehow or other the Federal—or you and the Fed may be running out of tools to control inflation. Do you have a comment on that comment? Mr. BERNANKE. Well, as I said, we are trying to use our principal tool, which is the Federal funds rate, to balance the various risks that we see in inflation and growth and financial stability. We do not really have additional tools on inflation. We do have additional tools to deal with financial problems, such as, the term auction fa- cility, which we are currently using, and other steps that we have taken or could take. 25 With respect to inflation, I think our principal tool would be the interest rate. Senator ALLARD. NOW, the Congress, through public policy, I think on a macro scale, may have some impact on the economy. And in general terms, if the Congress was to increase spending, what do you feel would—what kind of an impact would that have on the economy? And then look at the other side. Suppose Congress would increase taxes. What kind of an impact would that have per- haps on today's economy where we are standing? Mr. BERNANKE. Well, from a short-term aggregate demand view- point, spending tends to add to demand, and if the economy is at a point where its resources are not being fully utilized, it could lead to more increased utilization of resources; whereas, higher taxes in a short period of time, if it reduces consumer spending, for exam- ple, could lead to less use of resources. The Congress has passed a fiscal stimulus package which tries to address the issues of aggregate demand and sufficient demand for utilization of resources. I would urge the Congress, in looking at additional spending and tax plans, to think about the underlying effects on the efficiency and effectiveness of the economy, that is, not to make decisions based on short-term demand considerations but to think about how these spending programs or tax programs affect how well the economy will grow over the long term. Senator ALLARD. SO you are thinking about Social Security, Medicare, and Medicaid primarily on those costs, I would assume? Mr. BERNANKE. Well, and from a fiscal perspective in the longer term—and by longer term, I means only a few years from now be- cause we are coming very close to the point where the baby-boom generation is going to begin to retire in large number. By far, the biggest issue is entitlements, particularly the Medicare part, but Social Security as well. Senator ALLARD. Yes, I appreciate those comments. The other thing, you talk about, you know, inflation being pushed by energy and food costs. What is offsetting that? There must be some—to come out with an average of 2 percent, a little over 2 percent, there must be somewhere over here where we are getting a lesser amount that is offsetting those increases. Where do you see that happening? Mr. BERNANKE. Well, what we saw in 2007 was about 2-percent inflation excluding energy and food. When you add on the energy and food, you get something more like 3.5 percent by our preferred indicator, which is obviously a high rate of inflation and we are not comfortable with. Senator ALLARD. SO you do not see a sector of the economy that is being driven down in a way that it has an offsetting effect. You are just seeing this just averaging out as a part of the average. OK. We have on ethanol, for example, on energy, we have a really high tariff. It is 51, 52 percent. And energy builds into the whole economy. It is a fundamental driver. What do you think about us looking at reducing some of those high tariffs like that? What kind of an impact would that have on our economy? 26 Mr. BERNANKE. Well, Senator, as you know, I favor open trade, and I think that allowing Brazilian ethanol, for example, would re- duce cost in the United States. Senator ALLARD. And is that—when you look at the food—the way I look at it is when you have an ethanol—you have your food products being diverted to ethanol production, it has an impact on both food as well as the cost of energy and whatnot. Is it a signifi- cant enough part of the economy that we need to look at that more seriously? Mr. BERNANKE. I do not have an estimate of the overall effect. I think it would be hard to do. But it is the case that a significant portion of the corn crop is now being diverted to ethanol, which raises corn prices. And there are some knock-on effects; for exam- ple, some soybean acreage has been moved to corn production, which probably has some effects on soybean prices, too. So there is some price effect on foodstuffs coming through the conversion to en- ergy use. Senator ALLARD. Well, you know, the wheat farmers in my State are saying that wheat is at a historic high for them, and so I won- der just, you know, how much of that—I suppose, again, that is a dryland crop, but there is some conversion to dryland corn. But, again, that seems to have some impact on the grains in general, and the poultry people and the livestock people—well, all livestock people—swine, poultry, and beef in particular—all have concerns about that. So I was curious to see how you were evaluating that policy in respect to the total economy, and obviously you do not have too much to say on that because you do not think it is too big a part of the economy. Is that right? Mr. BERNANKE. Well, again, I do not know quantitatively how big the effect is, but there is some inflationary pressure coming through foods, including corn and soybeans, and obviously other crops like wheat which have suffered various supply problems in the last year. Senator ALLARD. Yes, OK. Well, Mr. Chairman, I see my time has run out. Chairman DODD. Great questions, too, and we will come back to those maybe in a little bit. Senator Reed was raising with me pri- vately the issue as well, and I think it is worth exploring. The issue of the question of the value of the dollar, the rising price of oil, the dollar denomination oil pricing, whether or not that can shift in these commodities generally is an interesting issue. But let me turn to Senator Bayh. Senator BAYH. Thank you, Mr. Chairman. Mr. Bernanke, thank you for you—Chairman Bernanke, I should say. Thank you for your presence today, and thank you for your service to our country. I think you have your priorities right. You mentioned that the risks in the forecast are to the downside and that our principal concern at this moment—you have to strike a balance, but our principal concern should be avoiding an economic downturn of severity and duration while continuing to focus on in- flation in the longer term. As you and some of my colleagues have pointed out, the genesis of much of this originated in the housing sector, particularly with some of the subprime type mortgages. And it seems to me that you, 27 in setting monetary policy, erred on the side of—not erred, but you have been more aggressive than less and tried to minimize the downside risk to the economy. And that is as it should be. My question to you is: Should not Congress do the same in ad- dressing the housing problem? The President has the voluntary Hope Now initiative you have outlined. I think it would be chari- table to say that the results of that have been modest to date. You indicate there is not a lot of data, but it certainly does not seem as if it has had much of an impact. There are some proposals, fairly narrowly circumscribed ones be- fore us, that would focus on this issue, allowing bankruptcy courts, only with regard to outstanding subprime mortgages, to revisit some of these issues, only when the borrowers have passed a strict means test. The interest rates would be set at prime plus a risk premium, and if the homes were ever resold, the lenders would participate in the upside, any potential upside, if the property would revalue. Now, the President has threatened to veto this initiative, and some have claimed that it would add as much as 2 percent to the cost of a mortgage. I find that to be not a credible analysis when it, by definition, does not apply to future mortgages. This is a one- off event, the greatest housing downturn in the last 50 years, fairly narrowly circumscribed. So my question to you is: Just as you have emphasized being more aggressive at this moment, should not we? And as an econo- mist, is it credible to think that this would add 2 percent to the cost of a mortgage moving forward in this narrowly circumscribed manner? Mr. BERNANKE. I do not know how much it would add. I think it would probably add something because the collateral would be less secure. Senator BAYH. This only applies to past loans, by definition, not future ones. Mr. BERNANKE. Well, then the question is raised: Will this hap- pen again? Senator BAYH. Well, every 50 years when we have a calamity like this, maybe so. Mr. BERNANKE. YOU know, I see concerns on both sides of this, and I understand the rationale for wanting to make those changes. I also see some concerns about the effects on the marketplace and, for example, on holders of current loans, how they would react. Senator BAYH. There are some implicit risks in the more aggres- sive monetary policy you have pursued. Mr. BERNANKE. Monetary policy is my domain, and I Senator BAYH. My point is and the question I am raising, just as you have been more aggressive—and appropriately so—should not we? Mr. BERNANKE. I think there is an argument for being aggressive in general, but I would just decline, if you would permit me, to en- dorse that particular action. I am really at this point focused on FHA and GSE reform as being two useful steps in the direction of helping the housing market. And we should continue to think about alternatives. But at this point I do not have, good additional measures to suggest to you. 28 Senator BAYH. Well, I do not want to put you in the business of getting into the debate between the legislative and executive branches here, but I do think at this moment, as we have all recog- nized, this is a perilous moment for the economy. It seems to me that there are risks on either side, but the balance here, it seems to me, lies on being a little more aggressive than less. And that ought to apply to all aspects of our policy, not just one particular subset. We have had a big discussion here about inflation versus growth. Again, I think you have your priorities right in that regard. You have pointed out that the core rate, while modestly above target, has—the principal thing driving this in the near term has been food and energy costs, and that you do not see any persistent rise in the core over the longer term. My question, Mr. Chairman, is: What indicia of economic sta- bility or greater growth would alleviate your concerns and would allow you to then perhaps pivot and focus on the inflation concern more than we currently are? Mr. BERNANKE. Well, Senator, first, I do not want to leave the impression that we are looking only at one Senator BAYH. NO, no. You were very balanced. Mr. BERNANKE. We are always trying to balance these risks and always trying to continually re-weight our thinking about the dif- ferent risks to the economy. Senator BAYH. Maybe a better way to put my question would be: When will the risks be back in equilibrium as opposed to—what in- dicia will you look at to reassure yourselves that the economy is stabilized and growth is resumed at an acceptable level? Mr. BERNANKE. One of the concerns that I have is that there is some interaction between the credit market situation and the growth situation—that is, if the economy slows considerably, which reduces credit quality, that worsens potentially the condition of credit markets, which then may tighten credit further in a some- what adverse feedback loop, if you will. I think that is an undesir- able situation. I would feel much more comfortable if the credit markets were operating more nearly normally and if we saw fore- casted growth—not necessarily current growth but forecasted growth—that looked like it was moving closer toward a more nor- mal level. So what I would like to see essentially is a reduction in the downside risks which I have talked about, particularly the risk that a worsening economy will make the credit market situation worse. Senator BAYH. Well, let me ask you—but I have got only 1 minute so I am going to need to hurry. I did have two questions. What aspect of the credit markets will you look to? And, in par- ticular, I have been interested—you talked about the flight from risk. There have been some aspects of the credit market that seem to me to be almost without risk, and yet people are fleeing from those as well. These auction rate securities, very short term, the underlying assets, particularly in the municipal sector, virtually no risk of default, and yet that seems to have seized up as well. What do you think will lead people to begin to assume rational levels of risk again? And what indicia will you look to in the credit 29 markets to reassure yourself that this situation is beginning to work itself through? Mr. BERNANKE. Well, there is reluctance to take risk, and there are also concerns about understanding exactly what a particular fi- nancial asset consists of. And there are still some issues of trans- parency and so on that need to be worked out. I think that a stable situation would be one in which good qual- ity credits like, major municipal borrowers would not have dif- ficulty in getting credit, and the issue would be the same for good quality credits of firms and households as well. So when you see a pulling back, and seeing the problem spread through a variety of markets, which is interfering with the normal flow of credit, then obviously that is not a normal, healthy situa- tion. Senator BAYH. Mr. Chairman, I have just one—my final ques- tion. Mr. Chairman, it has been visited by a couple of my col- leagues; particularly Senator Reed I thought was excellent in his questioning. It has to do with the credit agencies. We had a couple of very capable individuals come before our caucus to focus on some of these economic concerns, and the issue of the rating agencies came up. And one of them, in response to my question about—mar- kets can operate efficiently, but that presumes they have access to accurate information. In this case, you know, clearly that was not always so. And this is the problem with the credit markets in part you have pointed out here. So what can we do to avoid this again? You have mentioned that you and your people are looking at that. But when I asked the question, this individual said, "Well, I am not sure any additional action by the Government is necessary. The market will work this out. These rating agencies, their share prices will be punished and, therefore, they will have an incentive to not do this again." But whether it is in regard to certain types of Latin American credit or other areas, it seems that the markets have a way of for- getting the lessons of history, focusing on short-term decision mak- ing, every 7, 8, 10 years or so, and we kind of end up in some of these problems again. And the consequences to the broader econ- omy here have been so profound and so great, it seems to me, that in addition to relying on the market, perhaps there should be some parameters to ensure that we do not end up in this situation again, which leads us to either regulatory or legislative action. So, just broadly speaking, do you think that some additional ac- tions, either regulatory or legislative, may be in order to ensure that this situation does not repeat itself in the future and that we do not just simply rely upon the punishment of the market to pre- vent this in the future? Mr. BERNANKE. Well, regulatory action is already being con- templated. The Securities and Exchange Commission, which has authority over the credit rating agencies, is reviewing the situation, and seeing whether additional steps need to be taken. Of course, the Congress already gave the SEC some powers, which they have begun to implement. The fault lies on both sides of the equation, if you will—with the credit rates, but also with the investors, who over-relied on those ratings and did not do sufficient due diligence. In that respect, as 30 I mentioned before, the Basel Committee is looking at the use of ratings in risk measurement for banks, and I would encourage the regulators of pension funds and other investors, for example, to en- sure that investors do due diligence over and above simply looking at the rating and assuming that is all you need to know. Senator BAYH. Thank you, Mr. Chairman. Chairman DODD. Thank you, Senator, very, very much. Again, some very, very good questions. Senator Bunning. Senator BUNNING. Thank you, Mr. Chairman. My opening state- ment I will submit for the record. Chairman DODD. By the way, I should have made that point. All opening statements and any supporting documents people want to have will all be included in the record, and I appreciate you raising that. Senator BUNNING. Chairman Bernanke, can you explain what in- formation or event caused the Fed to change its view on the condi- tions of the economy and the financial markets and led to the Jan- uary 21 intermeeting rate cuts? Mr. BERNANKE. Yes, Senator. First of all, as you know, we cut rates by about 100 basis points during the fall, reacting to the drag on the economy arising from the housing markets and from the credit market situation. Around the turn of the year and early in January, the data took a significant turn for the worse, and it seemed clear that the economy was slowing, and slowing more than anticipated, and that the credit market condition situation was con- tinuing. On January 9, I called a meeting of the Federal Open Market Committee by video conference to discuss the situation. It was agreed by the committee that some substantial additional cuts in the Federal funds rate were likely to be necessary. The thought at the time of that meeting was that it might be worth waiting until the regular meeting at the end of the month where we could have a fuller discussion and see the revised forecast and so on, taking into account the possibility that we could also move intermeeting, if necessary. On January 10, I gave a speech where I informed the public that I thought that substantive additional action might well be nec- essary, thereby signaling that the conditions had changed and that further rate cuts were likely to happen. In the days that followed that speech, the tone of the data dete- riorated considerably further, which made me think that the out- look was, in fact, much weaker and the risks were greater. That was showing up both in the data and in the financial markets. We were seeing sharp declines in equity prices. We were seeing wid- ening of spreads. And we were also seeing, again, adverse data. On January 21, I became concerned that the continued deteriora- tion of financial markets was signaling a loss of confidence in the economy, and I felt the Fed, instead of waiting until the meeting, really needed to get ahead of that and take action. So I called an FOMC conference call, and we agreed at that point to cut the Fed- eral funds rate target by 75 basis points. There was an understanding at that meeting that further addi- tional action was very likely to be needed, but we felt that we could 31 wait another 10 days until the regular meeting to determine ex- actly how much additional action. At the meeting at the end of January, we had a full review, discussion, forecast round and so on and determined that an additional 50 points was justified. Looking back, as the data have evolved, I think that the 125 basis points was appropriate for the change in the tone of the econ- omy, and I think it was the right thing to do. Senator BUNNING. Are the days of constant and gradual Fed rate changes over? In other words, are large and intermeeting rate changes going to become a regular part of the Fed toolbox now? Mr. BERNANKE. I cannot make any guarantees, Senator, but in general, we prefer to move at the regularly scheduled meetings. As I said, that is a chance to get together in Washington and to have a full briefing by the staff and to have all the information made available to us. Senator BUNNING. How about which do you see as a greater threat to the economy, a credit crunch now or higher inflation in the future as a result of efforts to stop a credit crunch? Mr. BERNANKE. Senator, we have to keep balancing those things. As I said, our current view is that inflation will moderate this year as oil and food prices do not rise as much this year as they did last year. We are also watching very carefully to make sure that higher oil and food prices do not feed into other costs and into other prices or that inflation expectations do not become unanchored. If those developments began to happen, that would certainly force us to pay very serious attention. At the moment, I think the greater risks are to the downside— that is, to growth and to the financial markets; but, again, we are always vigilant on all of our objectives and are always trying to balance those risks against each other. Senator BUNNING. YOU read the Wall Street Journal. I am very sure of that. Today, in the Wall Street Journal, "Report on profits a bright spot in the gloom. The Dow Jones Industrial Average has gained 6 percentage points since the first day of the year." In the Standard & Poor's index, 462 corporations have reported their earnings for the fourth quarter; 62 percent of those that have re- ported topped their earnings estimates—62 percent. If you drop out financials, carve out financials, which were 12 percent lower, the gloom and doom that I have heard here today is not gloom and doom. Are you going to tell me that these same corporations that reported—and we had a really low growth rate in the fourth quar- ter—are going to be worse in the first quarter? Or are we also going to have the same kind of reporting in the first quarter of 2008 that this profit report on the Standard & Poor's and the Dow is not as accurate in the first quarter as it was in the fourth? Mr. BERNANKE. Well, Senator, you are absolutely correct that profits at the nonfinancial firms have remained pretty good. I do not have with me an estimate of the profits for the first quarter. But firms seem to be indicating concerns about the future. For ex- ample, if you look at the ISM survey of non-manufacturing indus- tries, it dropped very significantly a few weeks ago, suggesting a good bit more pessimism on the part of firms. Senator BUNNING. But isn't one of the real signals that we really have to watch the unemployment rate in the United States of 32 America? And that moved from 4.9 to 5 percent in the fourth quar- ter. And where is it now? Where do you estimate it to go in the first quarter of 2008? Mr. BERNANKE. It jumped in December from 4.7 to 5.0, which is a pretty significant jump, and it was certainly something that we looked at. And Senator BUNNING. Well, that was kind of indicated by the low growth rate and the reasonable expectation that the job rate would be higher, unemployment in the fourth quarter. I am asking about 2008. Mr. BERNANKE. Well, I reported our projections for the fourth quarter, which were 5.2 to 5.3 percent in the fourth quarter. We are seeing unemployment insurance claims rising, which I think is consistent with the somewhat higher unemployment rate going for- ward. Senator BUNNING. What are you telling me? Mr. BERNANKE. That the unemployment rate is likely to go up from here. Senator BUNNING. HOW bad? Are you saying 5.6, 5.7? Mr. BERNANKE. The baseline projection we have made for the fourth quarter is 5.2 to 5.3, but there are downside risks. Things could get worse than that. We do not know. But it is not our main projection. It is just a risk that we see out there. Senator BUNNING. Then does that bode well with the lowering of interest rates and the higher rate of unemployment? That indicates to me that someone in the Journal today that talked about stagfla- tion might be talking more sense than we might anticipate. Mr. BERNANKE. Well, again, Senator, we are just trying to bal- ance the risk of growth, inflation, and financial stability. Monetary policy works with a lag, and, therefore, we have to Senator BUNNING. Well, I understand that very clearly. We should have lowered rates earlier, and all of a sudden we lowered them 2.25 points—225 basis points in less than—what?—6 weeks, 8 weeks. Mr. BERNANKE. It was 125. Senator BUNNING. 125. Mr. BERNANKE. Yes, Senator. Senator BUNNING. Well, if you count the fourth quarter of last year, what was the total? Mr. BERNANKE. We lowered 50 basis points in September, 25 in October, 25 in December, and 125 in January. Senator BUNNING. Then it was 225. Mr. BERNANKE. Not in the fourth quarter. Senator BUNNING. NO, no. Total. Total since the last Mr. BERNANKE. That is right. Senator BUNNING. That is considerable, and the market condi- tions indicated that that was absolutely necessary. Mr. BERNANKE. I think so. The housing market decline and the weakness in the credit markets were suggestive of Senator BUNNING. Well, the weakness in the credit markets, Chairman Bernanke, were signaled last year, early in the year. I mean, it was not—it did not take a rocket scientist to figure that out. And I know with all the great economists that you have on the Federal Reserve and your members of the Federal Open Market 33 Committee are a lot sharper than the people sitting up here at this table. And you had a big heads-up signal that the housing market was in the tank early last year. Mr. BERNANKE. But the housing market was not affecting the broad economy. When we lowered interest rates on the last day of October, that morning we received a GDP report for the third quar- ter of 3.9 percent, which was subsequently revised to 4.9 percent, and inflation was a problem. So, in fact, I think if we look back on this episode, we will see that the Fed lowered interest rates faster and more proactively in this episode probably than any other pre- vious episode. As you point out, the unemployment rate is still below 5 percent, and Senator BUNNING. I lived through the Greenspan years. I know exactly what you are talking about. Thank you. Chairman DODD. Thanks very much. Senator Schumer. Senator SCHUMER. Mr. Chairman, with your and the Commit- tee's permission, Senator Tester has to be somewhere at noon and so do I, so I volunteered to split my time with him and let him ask the first question and leave, and then I will—if that is OK with you and the rest of the Committee. Chairman DODD. Fine. Senator TESTER. Thank you, Senator Schumer, and thank you, Mr. Chairman, and thank you, Chairman Bernanke. I appreciate your forthrightness today and always. I want to talk about commodities for a little bit. I am a farmer. I am happy when commodities go up. But as was earlier pointed out today, oftentimes this can end up potentially like it was in the 1970s when we saw a big commodity raise; we saw the inputs that went into agriculture go through the roof; we saw food prices on the shelf go up because commodity prices were higher; and then commodity prices fell back. Those inputs that went into production agriculture stayed up, and the food on the shelf stayed up, too, be- cause they said there was not enough wheat in a loaf of" bread to make a difference after they raised the prices because commodities went up. My question to you is: Do you see that playing out the same way? I mean, we are going to see food prices go up probably, it would be my guess. We already have. And we have already seen inputs go up on the farm for production agriculture. I anticipate this commodity price will not stay where it is at forever. They usu- ally do adjust, and they usually adjust down. And food prices will stay up, inputs will stay up. Do you see that same thing happening again? And is there anything we can do if it is that way? Mr. BERNANKE. If commodity prices come down, including energy prices and raw food prices, I would expect to see, perhaps with a lag, finished food prices come down as well. As we have been dis- cussing, the commodity prices, both food and energy, have been the primary source of the recent inflation. If they stabilize, even if they remain high, then inflation will moderate. And I expect that would happen, at least over time, at the finished level as well as at the raw level. 34 Senator TESTER. OK. Thank you very much, and I want to thank Senator Schumer again. Thank you very much. Senator SCHUMER. My pleasure. Two questions, Mr. Chairman. The first involves these sort of combination, creating problems now, of marking to market and the credit crunch, freeze, call it what you will. You know, when I first got here on the Banking Committee, banks really did not mark to market, and we regarded it as great progress that they now have to mark to market, like securities firms and others always did. It is a proper valuation of their assets. The problem here is nobody knows how to mark to market be- cause there is no market. In too many areas, no one is buying. And so you do not know what they do when they make a valuation. I have heard from many people that that valuation is—they make it artificially low, and that further exacerbates. It is a vicious cycle because then they do not have the capital, they cannot do any more lending, and everything is frozen up. Is there a way to deal with that problem now? Is there a way to say, yes, you have to mark to market, but in these unusual cir- cumstances you can do it 6 months from now, or something to that effect, quarterly, yearly? I am not an expert here, but I do know it is a real problem. How do you mark to market when there is no market? And because there is no market, rare, almost never occurred in such large parts of the credit market before, is this an unusual circumstance where this does not work? And my second question—and I will ask you to answer both—is this: The worry I think people have—and we have seen some ques- tions on this—is that it is a lot easier to get the economy going than to shut inflation off. And the worry is that we go back to the situation in the late 1970s where the economy was stalling, rates were lowered, and then there was nothing that the Fed could do other than very late and drastic action to curb inflation. It was a difficult struggle. We went through it in the 1980s, and I remember paying 21 percent on my mortgage when I first signed my mort- gage in 1982. Do we have better tools now that can control, you know, if infla- tion should start going beyond what you imagine for all the—we are global economy. You have less experience and less tests in this interconnected world than you did 20 years ago. Do we have better tools? Are you worried that if inflation really starts chugging along, that even a quick raise in interest rates will not be able really to head it off without really severe damage to the economy? So those are my two questions. Mr. BERNANKE. Thank you, Senator. On the first one, you raise a very good point. The Federal Reserve has long had sort of a mixed view about fair-value accounting. We think that market- traded assets should be valued at the market price and that inves- tors are entitled to know what that price is. But we have always recognized—and we had in mind things like bank loans, for exam- ple, that are relatively illiquid—that it might be difficult to value them on a fair-value basis and that there could be problems arising there. 35 As you point out, we now have a situation where some assets which are normally tradable are perhaps not generally tradable. The accounting profession has created a system which, attempts to get around that problem. There are these three different levels where you have a market valuation or a model valuation or a judg- ment valuation. I think that is one of the major problems that we have in the current environment. I do not know how to fix it. I do not know what to do about it. I think the accountants need to make the best judgment they can. Senator SCHUMER. Some have suggested, you know, delaying a mark to market, even using this system until there is a market and letting the—because you really do not know the value of the asset. And if you undervalue it, you may be hurting things as much as if you overvalue it. Mr. BERNANKE. I understand your concern, Senator, but the risk on the other side is that if you do too much forbearance or delay mark to market, that the suspicion will arise among investors that you are hiding something. Senator SCHUMER. Right. What about a rolling average that takes into account 6 months back? Mr. BERNANKE. Senator, I have not worked through any pro- posals like that. This is really an Accounting Board responsibility. I agree there is a severe problem. It is difficult to change the rules in the middle of a crisis. Senator SCHUMER. I know. Mr. BERNANKE. It is one of those things that we are going to have to put on the list of issues to evaluate as we try to learn the lessons from this experience. Senator SCHUMER. But you do admit it is a serious—it is one of the nubs of the problem now, even though it has not been talked about that much. Mr. BERNANKE. And the direction of how to fix it is not at all clear. Senator SCHUMER. OK. Second question. Mr. BERNANKE. On your second concern, I think we are better off now than we were in the 1970s in that there is a much broader recognition of the importance of price stability and greater con- fidence that central banks will deliver price stability. The indicia of inflation expectations, where some of them have moved a bit, are basically stable. We have not seen any major shift in views about inflation and where inflation is likely to go. The Federal Reserve has emphasized the importance of maintaining price stability and has indicated that we will watch very carefully and make sure that we do not see any deterioration in either broad measures of infla- tion expectations or increased pass-through of food and energy prices into other prices. We will watch those carefully and we will respond Senator SCHUMER. But do you believe if you miscalculate and in- flation starts coming out of the box more quickly than you think, do you have tools to deal with that or is that still a very difficult area, once inflation rears its head, it is very hard to put the genie back in the bottle? Or are we much better at it now than we were 20 years ago? 36 Mr. BERNANKE. Well, if higher inflation were to become well em- bedded in inflation expectations and wages and other parts of the economy, it would be difficult, and we do not really have new meth- ods. It is a risk, and we take it very seriously, and we are moni- toring it very closely. But as I have said several times, we are deal- ing with a number of different concerns here, and we are try- ing Senator SCHUMER. I know. It is not easy. Mr. BERNANKE. the risks as best we can. Senator SCHUMER. Thank you, Mr. Chairman, and I thank my colleagues. Chairman DODD. Well, thank you very much, Senator, very much. Senator Dole. Senator DOLE. Thank you. Mr. Chairman, I do not have to tell you that my State of North Carolina has lost a lot of manufacturing jobs over recent years, and you and I have had discussions about job retraining programs. I am very pleased that Congress has now begun to debate the best way to reform the Trade Adjustment Assistance, the TAA Program. And I would like to ask your opinion about what you feel the im- pact would be of congressional reauthorization and if there are any particular aspects of reform that you would want to suggest for the workforce of the 21st century. Mr. BERNANKE. Well, Senator, as I have argued in a number of speeches, for example, globalization and trade have a lot of bene- fits, but they also have some costs. They cause dislocation. They cause loss of jobs. And my view is that the best way to deal with that problem is not to shut down trade but, rather, to help those who are affected adjust to their circumstances. Senator DOLE. Right. Mr. BERNANKE. And so as a general matter, we should look for ways to help people through skill acquisition or other kinds of as- sistance that allow them to take advantage of the new opportuni- ties to replace the ones that they lost. I do not want to comment on specific elements. I know there are some competing TAA bills being considered, and I think that is really up to Congress to make those detailed decisions. But I do think that it is much better than shutting down trade to try to help people adjust to the effects of trade. I had the opportunity recently to speak in Charlotte, and one of my themes there was although North Carolina certainly has lost a lot of manufacturing jobs, if you look at the city of Charlotte and how it has reinvented itself to become a financial center, a services center and a center for the arts and many other things, there is a tremendous opportunity in a dynamic economy, as the one we have, to find new opportunities, to find new businesses and indus- tries. And so rather than try to freeze the industrial structure the way it is, we are better off helping people move to the new opportuni- ties, and TAA is one potential way of trying to assist that process. Senator DOLE. Thank you. Mr. Chairman, let me ask you about Sarbanes-Oxley. Some smaller banks appear to be clearly overbur- dened by compliance with Sections 404 and 302. These financial in- 37 stitutions are already highly regulated, and it has become increas- ingly apparent that these regulations, while they were well in- tended, only increased the cost of doing business. I would really ap- preciate your comments on what needs to be done here. Mr. BERNANKE. Well, it has been recognized that Section 404, in particular, imposes a lot of costs. It does have some benefits and helps improve internal controls. The Securities and Exchange Com- mission and the PCAOB have recently issued an audit standard which tries to take a more balanced, risk-focused approach to en- forcement of 404. And I hope as a general matter that that will re- duce the costs while preserving the benefits of Sarbanes-Oxley. In the case of banks in particular, there is a good bit of overlap, obviously, already with some of the rules that they have to follow under existing bank regulations. And I think it would be useful to consider where there are redundancies or overlaps that could be re- duced in the future. Senator DOLE. Thank you, Mr. Chairman. Over recent months, much has been written in the financial press regarding whether or not key worldwide central bankers—the Bank of England, Bank of Japan, European Central Bank, and the United States, et cetera— should become more coordinated in their monetary policy efforts. Proponents of such efforts point to the current spread between var- ious key country lending rates. What is your reaction to this debate? Mr. BERNANKE. Well, Senator, first of all, the major central banks do cooperate on many things. We meet quite often. I see my colleagues at international meetings here and in other countries very frequently. We are on the phone together, and we try to keep each other apprised of what is happening in our own economies and in the global economy, what we are planning, what we are thinking. We have worked together on some measures recently. In Decem- ber, when we introduced the term auction facility, we did that in a coordinated way with the ECB, the Swiss National Bank, the Bank of England, and the Bank of Canada—who also undertook various liquidity options at that time. So there is a lot of coordina- tion and cooperation in that respect. With respect to monetary policy per se, although we keep each other apprised, each economy is in a different place, in a different situation, and there is no necessity that each country has to have the same policy. I think the policy that is chosen depends on the particular circumstances of that country or that region. And so that is one of the benefits of having flexible exchange rates to provide some insulation, some ability for countries to run independent monetary policies. And so it has been our practice, as you know, for each major cen- tral bank to run an independent monetary policy, and while we keep each other apprised, I do not expect to see any extensive co- ordination in the near future. Senator DOLE. Thank you very much. Thank you, Mr. Chairman. Chairman DODD. Thank you very much. Senator Corker. 38 Senator CORKER. Mr. Chairman, thank you, and I thank you for your testimony. I listened carefully to what you had to say because I know you choose your words carefully. You need to because every- body in the world is listening to what you have to say. But I did notice that, you know, you mentioned that in every other sector of our economy, we are doing well except in the financial area. And I noticed that you have mentioned not to make—we shouldn't make decisions for the short term, that as it related to the housing issue itself, that you knew of no good additional measures, that you are focused on GSE reform and FHA reform. And I know the Senator from Indiana talked about on our side being aggressive. I would say that what we do ends up being a law that cannot be changed. What you do can be changed at the very next meeting, and so you have a great deal more flexibility to really look at indicators and make changes than we do. Our changes usually stay there for a long time. I was up at the New York Stock Exchange last week and noticed that they are trying to put in place the ability for people to know quickly what the value of their credit instruments are, that there is not the transparency there that we have in the equity markets. And my sense is because there is no transparency today, that even if we did not have the subprime issue, because people are making money packaging things and selling them off to the next person, that even if the subprime market had not tanked the way that it had, we still would have had writedowns because people were mak- ing so much money off of fees. Is that a fair assessment? Mr. BERNANKE. Well, I think the subprime crisis sort of triggered these events. But it is true that investors have lost confidence in a lot of different assets at this point, including, it was mentioned, some student loans and other things as well. And part of the prob- lem—not all of the problem, but part of the problem—is that in these complex structured credit products, it is very difficult for the investor to know exactly what is in there and what derivative sup- port or credit liquidity support is involved. Senator CORKER. SO, in essence, the subprime issue that has oc- curred has caused us to look at those in a more healthy way, and hopefully the market will create some mechanisms for us to actu- ally value those in real time and create a way for us to have some transparency there. Is that correct? Mr. BERNANKE. I hope so. But, again, as Senator Schumer sug- gested, if the accounting industry or the regulators can be of help there, I think we ought to try to be of assistance. Senator CORKER. YOU mentioned that leverage was at all-time lows in other sectors, and, you know, I still am shocked that when we had a credit problem, it was our wisdom to sprinkle money around America in an America that already had an incredibly low savings rate and ask them to spend it as quickly as possible. And I get concerned about actions that we might take here that, in es- sence—I know you mentioned at the last meeting several times the word "correction." I know Chairman Dodd somewhat chastised me at the end because I was pressing for an answer. But do you still believe that—and he did so in a very amicable way. I appreciate 39 that. But, in fact, do we have a crisis right now in housing, or do we have a correction? The reason I ask, I look at delinquencies over 30 days. Every- thing is over 30 days, all the way through foreclosure. And even though I know we are having some extreme issues in some of the higher-cost housing, it really is not very much different than it has been over the last 30 years, only about a percent and a half dif- ferent as far as delinquencies go. Is this a correction or is this a crisis as it relates to housing itself? Mr. BERNANKE. Senator, I do not know what terms to use. The housing market certainly has come down quite a bit, down to less than half the amount of construction that we had a couple years ago. Prices are falling. Foreclosures are up probably this year about 50 to 75 percent over last year. So, you know, there are certainly some major things going on in the housing market, and they have created some problems in the credit markets and the rest of the economy as well. Senator CORKER. IS this the kind of thing, though, that the mar- ket can take care of itself? You know, you do not seem to have any other ideas legislatively that we might come forward with to deal with this problem. Is this something the market itself can deal with? Mr. BERNANKE. Well, the first line of defense for dealing particu- larly with foreclosures is to have servicers and lenders work with the borrowers to try to restructure their mortgages or otherwise find a solution. And the Treasury, the Fed and other regulators and the Congress certainly have encouraged the private sector to ramp up their efforts as much as possible to try to deal with as many people as possible, because there certainly is a significant in- crease in the number of troubled borrowers. I have suggested other things—and things that this Congress has undertaken, like FHA modernization and GSE reform—that could be helpful in bringing the housing market back. Senator CORKER. And, obviously, we have two instruments—ei- ther monetary policy or fiscal policy. You are dealing with the mon- etary side. I guess on our side we deal with the fiscal. What I am taking away from what you are saying—a very intel- ligent person who certainly has a much broader view of what is happening not only here but also in the world—is that you know of nothing today, you have no additional ideas legislatively or fis- cally for us to deal with other than GSE reform and FHA reform. You know of nothing else today other than the existing efforts by the marketplace itself to work out some issues between lenders and borrowers. You know of nothing else today that we might do con- structively to solve this problem. Mr. BERNANKE. Senator, I see no harm in trying to think about other alternatives, and there are things that have been suggested. But at this point, I am not prepared to support any additional Senator CORKER. I am all for us thinking. I am a little worried there is a package that is actually coming to the floor, and that moves something into law. But I just appreciate your testimony, and I want to say that just in general I do think that sometimes when issues occur here, our hair gets on fire to act in ways that I think can actually create other problems down the road. And my 40 sense is that what you are saying is we are doing the things that we know to do today that make sense. And I hope that what you are also saying is that before we take any other action, we will think about those fully and look at the long-term implications of the market, not just trying to deal with something in the short term. I think that is what—thank you, Mr. Chairman. Chairman DODD. Thank you very much, Senator, and I appre- ciate that, and I appreciate the Chairman's response to your ques- tions as well. And as he points out, and I pointed out, back a year ago we—in fact, I feel very strongly that the best line of defense is exactly what the Chairman has said, and that is, hopefully the servicers and others can work out things here so that you do not have to engage in extraordinary steps to try and minimize these problems. And that is the first line of defense, and we are very hopeful that will produce some results. I also just want to point out quickly to my good friend from Ten- nessee here, Residential Fixed Investment, the GDP component that includes spending on housing, plunged by 25.2 percent in the fourth quarter, a bigger drop than the earlier 23.9 percent; third quarter spending fell by 20.5 percent. To give you some sense of proportionality, that is the worst plunge since the fourth quarter of 1981. This is a larger issue than just a correction problem. I say that respectfully, but I think it is bigger than that is the case. Senator CORKER. If I could respond to that, I would say, too, that is coming off of an extreme high. I mean, we have had an exu- berance in the housing market, and I think we should measure those drops off of a mean, if you will, versus a high. I think that the housing industry has enjoyed extreme free credit for many, many years. We have had an exuberant market that we have known for some time—as a matter of fact, I would say that actually a few years ago we were concerned in California, for instance, that housing prices were going up so rapidly. And so I would say that that drop is off an extreme high, and I thank you for pointing that out to me. Chairman DODD. Let me, if I can, Mr. Chairman, I want to raise a couple of questions, if I can for you, and some of them have been touched on. I do not want to take a long time here with you, but I am just intrigued by the correlation of some of these issues. Sometimes we cite a bunch of statistics and wonder what the cor- relations are between them. There are two factors that I want your thoughts on, if I can, that contribute to this huge run-up in commodity prices that we heard Senator Tester talk about and others. Oil is the first thing I think about, but obviously, if you are a farmer or a baker in Rhode Is- land, it can be the cost of wheat and others. The first is the in- crease in the demand for these goods. That is obviously one set of issues. The second is that these goods are priced in dollar terms. Sometimes we pass over that idea, but we talked about the price of oil a barrel, it is in dollar terms. And to what extent is the de- cline in the value of the dollar driving this? And beyond that con- cern, is that decline in the dollar—does that decline represent a de- crease in confidence in the U.S. financial system? As the Fed report indicates—and I mentioned this at the out- set—there was a net sale of U.S. securities by private foreign inves- 41 tors in the third quarter of 2007, the first quarterly net sale in more than 15 years. And I wonder how is that loss of confidence in the U.S. by foreign investors leading into a decline in the dollar, which leads to the rising commodity prices. I am trying to connect these questions, if at all. I was talking to a friend of mine in Europe this morning who is involved in the financial services sector—a totally different mat- ter—and I told him I was going to be having the hearing this morn- ing with you. And he was saying that one of the problems we have got is the fact that Europe is not cutting its interest rates at all, and so you are getting that comparison as well, which probably ex- acerbates this problem to some extent, at least in that market. And I was curious, because we have had a lot of questions of you—and I will come back to this in a minute—on the sovereign wealth funds, and I was trying to get some sense of proportionality about private investment versus sovereign wealth funds. And I do not minimize the importance of the sovereign wealth funds issues, but I asked staff to give me some sense of the proportionality of numbers. And out of the estimated $150 trillion in global capital stock, $2.2 trillion is held by sovereign wealth funds. And while sovereign wealth funds are about double the size of hedge fund as- sets, they represent less than 5 percent of global assets. And while China's sovereign wealth fund hold is about $200 billion in assets, the size of China's foreign exchange reserves is about $1.3 trillion. And so you have got—putting aside that for a second, the private investment sector here is an important one, and maybe I—am I making too much of this bar graph I saw in the Monetary Report Fund where you see for the first time that looks like a selling off here? And I noticed in your response to one of the—I forget who it was raised the question earlier. At least I thought I heard you say this was not as—that foreign investment is still coming in and that is a source of some confidence here. Anyway, could you try and connect those things for me? Is it a false connection? But I am curious how that relates to the decline in the dollar, the rise in commodity prices, and whether or not there is some connection here. Mr. BERNANKE. Well, I do not think that foreign investors have lost confidence in the United States by any means. The data you are referring to shows some desire by foreign investors to shift out of corporate credits and other credit products and into treasuries. That is the same shift that American investors are making. They are getting away from what they view as risky credits toward the safety of U.S. Government debt. And, indeed, U.S. Government debt is still the safest, most liquid, desired asset in the world. There is some effect of the dollar on commodities. Oil and other commodities are traded globally. You can think of the price as being set by global supply and demand. If the dollar depreciates a bit, then you would expect to see commodity prices rise to offset that depreciation. But it is important to understand that, for exam- ple, oil has risen in euros as well as in dollars. I mean, it is not simply an issue of currencies. It also has to do with global supply and demand for the commodity. So the European Central Bank is concerned about food and energy inflation as well. 42 With respect to the sovereign wealth funds, that is just another indication that foreigners have not lost confidence in the U.S. econ- omy and that there has been a good bit of inflow. In particular, about something close to half of the capital that financial institu- tions have raised in the last few months has come from sovereign wealth funds, from other countries. I think that, in general, that is quite constructive. If we are con- fident, as I think we are in this case, that the investments are made for economic reasons and not for political reasons or other noneconomic reasons, and there is no issue of national defense, which the CFIUS process takes care of, then that inflow of invest- ment is good for our economy and certainly is helping, in this case, the financial system. At the same time, allowing inflows of foreign capital through reciprocity gives us more opportunities to invest abroad. I know that Congress is very interested in sovereign wealth funds, and you should certainly take a close look at it. Inter- national agencies, like the International Monetary Fund and the OECD, are developing codes of conduct. The basic idea there is that sovereign wealth funds should be as transparent as possible. We should understand their governance and their motivations, and, in particular, we should be confident that they are investing, again, for economic rather than political or other purposes. If we are con- fident in that, then it is in our interest to keep our borders open and to allow that capital to flow in. And I think it will continue to flow in. Chairman DODD. You raise a good point here and one I wanted to raise with you. This is a statement you made yesterday as well before the House Financial Services Committee, talking about it. And I do not disagree. It is quite constructive. And I think there has to be a sense of balance in how we look at sovereign wealth funds, and I think we run the danger of becoming a pejorative without understanding the value of it. So we have to be careful about it. And you pointed out, and you did again here just now, you men- tioned CFIUS, which, of course, we developed good legislation, I think, out of the Committee on that, the IMF, the OECD, and look- ing at these investments from their various perspectives in terms of these issues, which are a very legitimate point. But what is the Fed's role in a sense? I mean, this is, it seems to me, while all these other institutions have an important role to play, I would make a case here that the Fed also has an important role. They are investing in bank holding companies. This is the ju- risdiction of the Federal Reserve Board, and it seems to me you did not mention the Federal Reserve's obligation to be looking at these questions as well. And, obviously, we have had major investments here in bank holding companies. So tell me what you think is— what is the Fed doing about this, and what is the responsibility of the Fed in looking at this issue as well? Mr. BERNANKE. YOU are quite correct, Senator. I should have mentioned that. Well, first, of course, we are very involved with the banks them- selves, and we are very interested in their capital-raising efforts and making sure that they raise enough capital to meet the well- 43 capitalized standards and to remain safe and sound. And so that whole process is something we pay very close attention to. We have statutory responsibilities. If the investment by any sin- gle person or group, whether it is a sovereign wealth fund or some- one else, reaches certain levels that, imply a significant degree of control, then we have to look at that, make sure it is appropriate. Chairman DODD. Is that a sort of objective test rather than a subjective test? Mr. BERNANKE. I believe that 25 percent is the threshold. Chairman DODD. But I was looking and thinking—I am just curi- ous to get your reaction to this. And, again, I do not want to over- dramatize this point, but I was curious in one of these—and you will know which one I am talking about. One of these major invest- ment houses, when the decision was made as to who the new CEO was going to be, there was a flight I think occurred that went to a country that was making major investment to get the OK in a sense. Now, the amount invested would represent an amount far smaller than the 25-percent threshold. But clearly, at least, if you will, the visuals of going over and getting sort of a sign-off indi- cated that there was more of an influence than the dollar amount would indicate. I mean, does that trigger something? Or should it trigger something? Mr. BERNANKE. Well, I think if the investor is making that big an investment, they need to understand what is going on. I am not sure whether it was a case of their deciding who was the CEO or just simply being informed of the plans of the company. In the cases that we have seen, the investments have been sig- nificant in absolute terms, but small in percentage of equity terms. And in most cases, the amount of control—rights, board of direc- tors, membership and so on—has been quite limited. So there has not been any significant change in the control of these institutions. If there were, then the Federal Reserve would want to Chairman DODD. No, absolutely. I understand that. And, again, I am not trying to expand your portfolio here by suggesting an ear- lier intervention, but it would seem to me that there may be some signals here that may fall short of the 25 percent. I would rather have you taking a look at those things where—and come to me and say, "I think this is"—not to me necessarily, but to say we think we ought to take a look at this, it may fall short of that absolute trigger. That is why I say objective/subjective kind of analysis as to what this could mean, so look at that. Is there any chance, any worry you have at all—coming back to the first question I raised with you, the declining value of the dol- lar, the 24-percent decline, the lowest since 1973, compared to the six other major currencies. Is there any chance in your mind that we would watch something moving away from a dollar denomina- tion in these areas, in these commodities, such as oil going to the euro, for instance? Do you see any danger in that? Or is it—do you worry about that at all? Mr. BERNANKE. I know of no plans of that, but the denomination, as I said, is of second-order importance. There is some importance in the willingness of foreigners to hold dollar assets, which is a dif- ferent matter entirely. And as I said, I know of no evidence that there is any reduction in interest. 44 Chairman DODD. Would that concern you if that happened? I mean, is there Mr. BERNANKE. If there was a change in denomination? Chairman DODD. Yes, if they moved all of a sudden, went from the price of a barrel of oil measured not in dollars but in euros, what does that say about us and our economy? Does that have— I mean, it seems to me that would be rather a dramatic piece of news. Mr. BERNANKE. Well, it might be symbolic. It might have sym- bolic value. But from an economic point of view, it is a global mar- ket, and foreign currencies are traded all the time. You know, if I want to buy a barrel of oil, I can do it in euro or yen or any other way I like. So from a fundamental sense point of view, it is not sig- nificant. There might be some symbolic value to it if that hap- pened. Chairman DODD. I was going to ask you a question to follow up on Senator Menendez who asked questions about the housing issue. But I think your answers in response to Senator Corker were good ones in thinking about this issue. And I sense in your com- ments here today that this housing issue is a serious one. And I am not going to try and put words in your mouth again, but I real- ize you put an adjective on this, and that becomes the headline. But it is serious and warrants serious thought as to what we can do to minimize this and to try and keep people in their homes, min- imize this from happening again, and dealing with related issues. And I appreciate those comments. And we are going to continue talking with you about these various ideas that we have. And I cer- tainly appreciate, having been here long enough to know, that sometimes actions, however well intended, can have unintended consequences, and so you need to think through things carefully. And so we are going to want to be in touch with you during that process. But we also want to make sure we are not looking back and won- dering if we could have done some things here that would have minimized this from getting worse. So it is important. I will leave the record open for a couple of days here. Members who did not make it here may have some additional questions for you. You have been before this Committee a lot now in the last cou- ple of weeks, and we are grateful to you for that, and we will con- tinue working with you. The Committee will stand adjourned. [Whereupon, at 12:32 p.m., the hearing was adjourned.] [Prepared statements, response to written questions, and addi- tional material supplied for the record follow:] 45 PREPARED STATEMENT OF SENATOR JEM BUNNING Thank you, Mr. Chairman. The health of our economy and financial markets is a concern to everyone here today. Growth has slowed and we have been through a rough patch in the credit markets. Everyone wants to see stability and growth return. Congress has acted to restore confidence in the economy. The Fed has taken steps to thaw the credit freeze. We hope that these policy actions will head off further damage, but no policy can reverse the busting of the housing bubble and we are not going to regulate away problems in the economy. While I have supported actions taken to respond to our economic problems, I fear they will have unintended consequences. I am most concerned about inflation and the fall of the dollar. We need to think beyond what we have already done and take steps to encourage long term growth. Congress can give taxpayers, businesses, and investors certainty that their taxes are not going to go up. Congress can knock down roadblocks to growth such as artificial limits on our energy supply. Congress can make it more appealing for corporations to stay in the United States by easing regu- lations and lowering the corporate tax rate. Only with long term permanent policies can we ensure a healthy economy for our grandchildren. I look forward to hearing from the Chairman. PREPARED STATEMENT OF SENATOR ELIZABETH DOLE Thank you, Chairman Dodd and Ranking Member Shelby for holding this very important hearing today. Chairman Bernanke, I join my colleagues in extending you a warm welcome. Since last August, our financial markets have experienced tremendous uncer- tainty. Credit and capital markets around the world have struggled to comprehend the ramifications of the U.S. subprime lending and housing crisis. Fortunately, the Federal Reserve has been quick to act, lowering the federal funds rate from 5.25 percent to 3 percent. Congress also is working to help boost our economy. Several recent reports have highlighted ongoing economic challenges. Such as last week, the Wall Street Journal said that the "leading economic indicators" fell for the fourth straight month. Since its July 2007 high, the index has fallen by 2 per- cent, which is the largest 6-month drop since 2001. Additionally, for the week end- ing on February 16, the 4-week average of initial unemployment claims rose by 10,750 to 360,500, pointing to a softening of the labor market. Furthermore, by the third quarter of 2007, household debt rose to $13.6 trillion from $7.2 trillion in 2001, a 10-percent annual increase. Over this same time period, mortgage borrowing more than doubled. As a result, one out of every seven dollars of disposable income earned by Americans goes towards paying down debt. Fears loom of higher inflation and more "pain at the pump." The price of a barrel of oil has hovered around the $90 mark and recently closed above $100 per barrel. If these higher gas prices and inflationary pressures continue, coupled with the well-known weakness in across our housing sector, I—like many folks I hear from— am very concerned that future economic growth could be hindered. No question, the health of our economy is influenced by many complex issues and expected and unexpected events. That said, I would like to highlight a few areas where I am focused to help spur growth and job creation. I strongly support Trade Adjustment Assistance, which helps ensure that dis- placed workers have the ability to train for new careers. In recent years, my home state of North Carolina has undergone a difficult economic transition, as our state continues to evolve from a manufacturing and agriculture-based economy to a more services-oriented economy. In North Carolina and across the country, there is a need to address the growing gap between skilled and unskilled workers. Senator Cantwell and I have introduced legislation that would allow more workers to receive TAA benefits, including training, job search and relocation allowances, income support and other reemployment services. Additionally, with respect to current regulation of financial institutions, it has come to my attention that some smaller banks are overburdened by compliance with Sections 404 and 302 of the Sarbanes-Oxley corporate accountability law. Mr. Chair- man, these financial institutions are already highly-regulated, and it has become in- creasingly apparent that these regulations, while well-intended, only increase their costs of doing business. I hope this committee will soon consider legislation that would provide true regulatory relief for all financial institutions. Chairman Bernanke, thank you again for being here today. I look forward to hear- ing from you—and working with you—on these and other important issues. 46 PREPARED STATEMENT OF BEN S. BERNANKE CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM FEBRUARY 28, 2008 Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Con- gress. 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 sum- mer, have persisted; and pressures on bank capital and the continued poor func- tioning 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 contrac- tion of the U.S. housing market. In 2006, after a multiyear boom in residential con- struction 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 mort- gage 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 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 com- ing quarters. Homebuilders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will sub- tract 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 sec- ond 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 3 months ending in January, compared with an aver- age increase of almost 100,000 per month over the previous 3 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 de- mand 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 in- ventories aside from the overhang of unsold homes. And, as a whole, the non- financial business sector remains in good financial condition, with strong profits, liq- uid 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 eco- nomic growth abroad and the lower foreign exchange value of the dollar. Strength- ening exports, together with moderating imports, have in turn led to some improve- ment in the U.S. current account deficit, which likely narrowed in 2007 (on an an- nual basis) for the first time since 2001. Although recent indicators point to some 47 slowing of foreign economic growth, U.S. exports should continue to expand at a healthy pace in coining quarters, providing some impetus to domestic economic ac- tivity 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 in- vestors to bear risk, difficulties in valuing complex or illiquid financial products, un- certainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the finan- cial markets in recent months. To help relieve the pressures in the market for inter- bank 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 cen- tral 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 de- velopments closely. As part of its ongoing commitment to improving the accountability and public un- derstanding 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 cen- tral tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2V2 percent to 2% 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% 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 projec- tions 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 hous- ing 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. The risks include the possibili- ties that the housing market or labor market may deteriorate more than is cur- rently 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 in- creased 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 depre- ciation 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 per- cent and 2.4 percent (the central tendency of the projections). A key assumption un- derlying 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 per- cent, 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 re- main reasonably well-anchored and pressures on resource utilization to be muted. The inflation projections submitted by FOMC participants for 2010—which ranged 48 from 1.5 percent to 2.0 percent for overall PCE inflation—were importantly influ- enced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate and about the time frame over which pol- icy 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 slower-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 commod- ities 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 credi- bility 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 fu- ture. Accordingly, in the months ahead, the Federal Reserve will continue to mon- itor 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 in- tent of those actions has been to help promote moderate growth over time and to mitigate the risks to economic activity. A critical task for the Federal Reserve over the course of this year will be to as- sess whether the stance of monetary policy is properly calibrated to foster our man- dated 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 activ- ity and inflation as well as the risks to that forecast. Although the FOMC partici- pants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. The FOMC will be carefully eval- uating incoming information bearing on the economic outlook and will act in a time- ly 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 con- sumers who seek mortgage credit receive loans whose terms are clearly disclosed and that can reasonably be expected to be repaid. Accordingly, the rules would pro- hibit lenders from engaging in a pattern or practice of making higher-priced mort- gage loans without due regard to consumers' ability to make the scheduled pay- ments. 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 an es- crow 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 pro- posal 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 non- depository lenders. The agencies will collaborate in determining the lessons learned 49 and in seeking ways to better cooperate in ensuring effective and consistent exami- nations 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 expe- dite 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 pur- suing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue. In addition to our consumer protection efforts in the mortgage area, we are work- ing toward finalizing rules under the Truth in Lending Act that will require new, more informative, and consumer-tested disclosures by credit card issuers. Sepa- rately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards. Using the Board's authority under the Federal Trade Com- mission Act, we expect to issue proposed rules regarding these practices this spring. Thank you. I would be pleased to take your questions. 50 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKE Q.I. Increases in the GSE/FHA Conforming Loan Limits: The stim- ulus bill recently passed by Congress includes an increase in the conforming loan limit amount for mortgages that the Government Sponsored Entities (GSEs) and the Federal Housing Administra- tion can guarantee. Do you believe that increasing these loan amounts adds to the systemic risks associated with the GSEs' operations? While these increases are only temporary, some have raised the idea of permanently increasing the amounts. Are there additional risks associated with a permanent increase? A.1. Temporarily raising the conforming loan limit allows the GSEs to securitize an expanded range of mortgage loans and likely would increase liquidity in the secondary market for loans covered by the expansion. The GSEs should be strongly encouraged to rapidly use this authority, even if it requires that they raise substantial amounts of capital. Over a longer horizon, it is important to realize that raising the conforming loan limits extends the implicit government-backing of the GSEs into a larger portion of the mortgage market. While the jumbo mortgage market has experienced substantial liquidity prob- lems during the past year, this market historically has operated ef- ficiently and functioned well without GSE involvement. Moreover, prime quality homeowners who use jumbo mortgages are, in gen- eral, the highest income and wealthiest members of our society. Ex- tending the reach of the GSEs to these borrowers would do little to expand homeownership or to extend mortgage credit to those that cannot obtain mortgages otherwise. Thus, raising the conforming loan limit involves the larger ques- tion of how far to extend government guarantees, either explicit or implicit, to resolve short-term liquidity problems in secondary asset markets. Temporary expansions of the safety net, such as those un- dertaken by the Federal Reserve, can boost short-term liquidity without distorting private market credit analysis. In contrast, per- manent expansions of the safety net, such as raising the con- forming loan limit permanently, may well cause greater problems in the long-run. There are many reasons for the recent breakdown in private market credit analysis, but it is not clear to me that the best approach to rectify the current situation is simply to sub- stitute implicit government guarantees for much needed private market discipline. If private markets are unable to provide a sec- ondary market for some assets, we should first endeavor to under- stand why this is the case rather than immediately turn to a broader expansion of GSE guarantees. Any permanent expansion of GSE guarantees must, be accom- panied by comprehensive GSE reform to mitigate further systemic risks. In particular, capital standards for the GSEs must be signifi- cantly toughened and clear and credible receivership procedures for the GSEs should be established. Moreover, the role and function of the GSE portfolios should be clearly articulated by Congress. As has been evident in recent months, this portfolio is managed main- ly to meet needs of GSE shareholders and not to fulfill public policy objectives. 51 Q.2. International Liquidity Coordination: Chairman Bernanke, as of the minutes of the last Federal Open Market Committee meet- ing, the Federal Reserve reaffirmed their commitment to working with foreign central banks to coordinate international monetary policy. Please describe for us the details of the Federal Reserve's agree- ments with foreign central banks, such as the European Central Bank and the Bank of England for exchanging assets into dollars. Why have these agreements been made and are financial institu- tions using these tools? A.2. The Federal Open Market Committee (FOMC) established swap lines with the European Central Bank (ECB)and Swiss Na- tional Bank (SNB) in conjunction with the establishment of the Term Auction Facility (TAF) on December 12, 2007. These swap agreements were requested by the ECB and SNB and allowed them to draw a maximum of $20 billion and $4 billion respectively, for a period of up to 6 months. Under the agreements, both central banks are allowed to purchase U.S. dollars with their foreign cur- rencies based on the prevailing spot exchange rate, and they pay interest on the foreign currency received by the Federal Reserve. Given the strong financial position of the ECB and SNB, the swap lies involve virtually no credit risk to the Federal Reserve. The Federal Reserve has also maintained longstanding swap facilities with the Bank of Mexico and the Bank of Canada as part of the North American Framework Agreement. Those facilities amount to $2 billion with the Bank of Canada and $3 billion with the Bank of Mexico. The agreements with the ECB and SNB were established to allow dollar funding problems faced by European and Swiss banks to be addressed directly by their respective home central banks. In the absence of such agreements, European and Swiss banks were believed to be more likely to seek dollar funding in U.S. markets, potentially increasing volatility and adding to term funding pres- sures in U.S. markets. By providing dollars to the ECB and SNB to use in their efforts to address term dollar funding problems abroad, the FOMC believed that it would assist U.S. credit mar- kets. Both the ECB and SNB have used their swap agreements. The first use of these swap lines was on Monday, December 17, when the ECB drew upon $10 billion and the SNB drew upon $4 billion for a 28-day period. The two central banks used the funds to auc- tion dollar funding to their eligible depository institutions; the ECB offered funds to its eligible depository institutions at the 4.65 per- cent rate set in the Federal Reserve's TAF auction, and the SNB auctioned $4 billion at a weighted average rate of 4.79 percent. The ECB drew upon a further $10 billion on Thursday, December 20, in conjunction with the second TAF auction held by the Federal Re- serve. At the expiration of its first use of its swap line, the ECB renewed its draws in conjunction with the January 14 and January 28 TAF auctions, offering $10 billion in 28-day dollar funds both times at a rate equal to the rate set in the TAF auction. The SNB also renewed its draw of $4 billion on its swap line to participate in the January 14 auction of dollar funds. On March 11, the FOMC announced that it would increase its temporary swap line to the 52 ECB from $20 billion to $30 billion and its line to the SNB from $4 billion to $6 billion, extending the swap lines through Sep- tember 30, 2008. Both central banks have signaled that they would draw upon the lines to offer 28-day dollar funding in auctions to be held on March 25. Q.3. Sovereign Wealth Funds and Systemic Risk: Chairman Bernanke, recently we have seen an influx of capital into our do- mestic financial institutions from foreign governments, specifically sovereign wealth funds. Previous foreign direct investments have usually been in smaller quantities and from private investors, rath- er than governments. These investments may be under the thresh- old of control for each sale, but collectively could represent a large proportion of U.S. financial services firms. Is there a danger of systemic risk from one or more Sovereign Wealth Funds holding noncontrolling stakes many financial firms? A.3. The recent prominent equity investments by sovereign wealth funds in large U.S. financial institutions permanently increased the capital of these firms, enhancing their soundness and the sound- ness of the U.S. financial system. These investments also support the ability of the financial institutions to provide credit to busi- nesses and consumers. It is difficult to envision circumstances under which non-controlling equity stakes in financial institutions, could increase systemic risk in a financial system. Sovereign wealth funds have been relatively stable investors. The funds generally are neither highly leveraged nor exposed to liquid- ity risk arising from investor withdrawals or redemptions. Sov- ereign wealth funds often use professional private fund managers who are tasked with seeking higher returns and greater diversifica- tion—relative to official reserves—for a portion of a country's for- eign exchange assets. Because sovereign wealth funds are government owned, there has been concern, however, that these funds have the potential to be motivated by political reasons To the extent these funds make only smaller, noncontrolling investments, the ability of a sovereign wealth fund to have an effect on the operation, strategic direction or policies of a banking organization are minimal. If two or more companies with noncontrolling investments in a U.S. bank or bank holding company were to agree to act together in an attempt to influence the operations of a U.S. bank or bank holding company, the Federal Reserve has the authority to combine the companies' shareholdings and treat the group as one company (an "association") for purposes of the Bank Holding Company Act (BHC Act). If the combined shareholding were significant enough, the association could be treated as a bank holding company subject to the requirements of the BHC Act. To date, the Board has not found that sovereign wealth funds from different countries have in fact acted together to control a U.S. financial institution. Another important safeguard applies to the U.S. banking organi- zation itself. U.S. banking organizations themselves are subject to the supervisory and regulatory requirements of U.S. banking law. For example, federal banking agencies are required under the Fed- eral Deposit Insurance Act to establish certain safety and sound- ness standards by regulation or guideline for all U.S. insured de- 53 pository institutions. These standards are designed to identify po- tential safety and soundness concerns and ensure that action is taken to address those concerns before they pose a risk to the De- posit Insurance Fund. Thus, the Federal banking agencies may monitor and require action by the U.S. banking organization to maintain its financial health regardless of the owner of the bank- ing organization. Q.4. Is there a Bernanke "Put"? Chairman Bernanke, some econo- mists speculate that market participants became willing to take greater risks because monetary policy under Chairman Greenspan protected investments by cutting interest rates in response to eco- nomic shocks. This phenomenon came to be called the Greenspan "put"—referring to the financial instrument that guarantees its owner a certain return if prices fall below a specified level. Now critics are wondering if there is also a Bernanke put, given the re- cent significant drop in rates. How do you respond to these observations? How do you balance responding to slower economic growth while at the same time al- lowing the market to follow a normal business cycle? Do you have any concerns that the 225 basis point drop in inter- est rates since last August creates moral hazard for market partici- pants? A.4. In conducting monetary policy, the Federal Reserve is guided by its statutory mandate to promote maximum employment and stable prices over time. I do not believe that monetary policy ac- tions aimed at these goals are a significant source of moral hazard. To be sure, in carrying out its mandate, the Federal Reserve takes account of a broad range of factors that influence the outlook for economic growth and inflation, importantly including financial asset prices, such as the prices of equity shares and houses. Finan- cial asset prices are important for the economic outlook partly be- cause they affect household wealth and thus consumer spending on goods and services and therefore ultimately influence output, em- ployment, and inflationary pressures. Depending on overall cir- cumstances, declines in asset prices may adversely affect the out- look for aggregate demand, and consequently the stance of mone- tary policy may need to be eased in order to cushion the effect on aggregate demand. It is important to recognize that such a re- sponse of monetary policy is not designed to support financial asset prices themselves but to foster overall economic growth and to miti- gate the risks of particularly adverse economic outcomes. It is also worth noting that past Federal Reserve efforts to buoy economic growth in the face of declining asset prices have not insulated from substantial losses investors who made poor investment choices. This point is evidenced by the very large losses suffered by inves- tors in the tech sector early this decade despite considerable mone- tary policy easing, and by the losses experienced by investors in many subprime-related mortgage products more recently even as the stance of monetary policy was eased. Q.5. Term Auction Facility: Chairman Bernanke, the Federal Re- serve created a new Term Auction Facility to help ensure that American banks have adequate liquidity. 54 What has been the response to the auctions thus far and for how long will they continue? What type of collateral are banks posting in these auctions? What happens if that collateral, particularly AAA-rated mortgage backed securities, is downgraded? A.5. The demand for TAF credit from depository institutions has been ample. All eight auctions conducted to date have been over- subscribed, with resulting interest rates in each case above the minimum bid rate. The Federal Reserve will continue to conduct TAF auctions for at least the next 6 months unless evolving market conditions clearly indicate that such auctions are no longer nec- essary. TAF borrowing is collateralized by the same pool of assets as pledged against other types of discount window loans. For all types of discount window loans, Federal Reserve Banks will consider ac- cepting as collateral any assets that meet regulatory standards for sound asset quality. Commonly pledged assets include residential and commercial real estate loans, consumer loans, business loans, and a variety of securities. The standards applied to each type of collateral are available on the Federal Reserve discount window Web site at www.frbdiscountwindow.erg. Collateral that is down- graded below Federal Reserve eligibility standards is given no value and must be withdrawn. The likelihood that the downgrade of a portion of a depository institution's collateral will affect a TAF loan is reduced by the requirement that, at the time of bidding, the sum of the aggregate bid amount submitted by a depository institu- tion and the principal amount of TAF advances that the same de- pository institution may have outstanding cannot exceed 50 percent of the collateral value of the assets pledged by the depository insti- tution. Q.6. Value of the Dollar: As you know, the U.S. dollar declined against most major currencies over the past year. The dollar has lost 10.4 percent again the Euro and 5.7 percent versus the yen in 2007. What does it mean for our economy if foreign countries turn away from holding the dollar as their reserve currency or even if they diversify, which has already begun? Are there dangers that we will be more constrained in the ac- tions we are able to take domestically, including selling Treasury securities, to finance our deficit? A.6. The dollar's status as a reserve currency reflects investor con- fidence in the sophistication and liquidity of U.S. financial markets and the relative stability of our macroeconomic environment. To date, there is little evidence of a shift in foreign official holdings away from dollar denominated assets. U.S. data show further growth in foreign official holdings of U.S. assets. Data reported to the IMF also show continued growth in dollar assets in foreign offi- cial reserves. While the IMF data show a decline in the dollar share of reported reserves, this decline is entirely attributable to the depreciation of the dollar, which has raised the dollar value of the other currencies held in the reserve portfolios. In response to a private survey conducted by the Royal Bank of Scotland, several reserve managers indicated they planned to increase the weight of 55 non-dollar assets in future investments, but there was again no evidence of a general shift out of the dollar on the part of these re- spondents. In principle, a shift in foreign appetite away from U.S. securities toward foreign securities might be expected to lower the value of the dollar and to raise U.S. interest rates; however, these effects are difficult to measure and appear to be modest. Furthermore, while it is true that foreign official institutions hold a significant fraction of U.S. Treasury securities outstanding, it is important to note that these holdings represent less than 5 percent of the total debt outstanding in U.S. credit markets. As such, U.S. credit mar- kets could likely absorb a shift in foreign official allocations away from dollar assets without undue difficulty. In the event that such a shift were to occur and put undesired upward pressure on U.S. interest rates, the Federal Reserve has the capacity to increase available credit to maintain a level of short-term interest rates con- sistent with our domestic economic goals. Any effect of reduced for- eign demand on the term premium between short-term and long- term interest rates could affect the cost of long-term borrowing by the Federal Government; however, this impact is likely to be rel- atively small and is unlikely to materially constrain the U.S. gov- ernment's ability to finance its deficit. Q.7. Slow Growth and Rising Inflation: Mr. Chairman, there is some evidence of contradictory forces at play in the economy right now. In the middle of the present economic downturn, commodity and food prices have increased. What do you judge to be the threat of slow growth continuing, with inflation remaining above the Federal Reserve's comfort level? A.7. The FOMC, in the statement released at the conclusion of its most recent meeting on March 18, noted that the outlook for eco- nomic activity has weakened further in recent weeks and that downside risks to growth remain. At the same time, inflation has been elevated, uncertainty about the inflation outlook has in- creased The actions taken by the Federal Reserve since last Au- gust, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, the Federal Reserve remains attentive to the risks to the outlook for activity and inflation, and it will act in a timely manner as needed to promote sustainable economic growth and price stability. Q.8. Capital: The ongoing turmoil in our financial markets vividly demonstrates the wisdom of prudent capital requirements for our financial institutions. If our financial institutions hold sufficient capital, they are much more likely to weather the inevitable eco- nomic storms that occur as part of the business cycle. Because a healthy banking system is one of the best defenses against a severe economic downturn, one of the most important responsibilities of our financial regulators is ensuring that financial institutions are adequately capitalized. Chairman Bernanke, what is your assessment of the current cap- ital levels in our banking system? As part of your answer, would you explain the steps your agency has taken over the past year to make sure that our banks are adequately capitalized? 56 A.8. As you how a bank is deemed to be well capitalized under Prompt Corrective Action rules if it has a tier 1 risk-based capital ratio of 6 percent or greater, a total risk-based capital ratio of 10 percent or greater, a leverage ratio of 5 percent or greater and is not subject to any written directive issued by the Federal Reserve Board. As can be seen in the summary table below, the majority of U.S. commercial banks have substantial buffers over the well capitalized requirements (as of year-end 2007), which should prove helpful during these difficult times. However, capital ratios in banking organizations can erode rapidly during downturns, de- pending on the rate of increase and amounts of write-downs and additions to the allowance for losses and the extent to which these cannot be offset by the retention of earnings or raising of new cap- ital. Summary Average Data for Insured Commercial Banks Ratios Avg. 1997-2007 2006 2007 Equity Capital/Assets 9.2 10.2 10.2 Leverage 7.8 8.1 7.9 Tier 1 Ratio (Risk-Based) 9.7 9.8 9.4 Total Ratio (Risk-Based) 12.4 12.4 12.2 % Deemed Well Capitalized 98.3 99.3 98.9 Source: Summary Profile Report, Dec. 2007, BS&R, Federal Reserve Board of Governors. The Federal Reserve Board, together with the other banking agencies, is currently reviewing several elements of its regulatory capital requirements to ensure that banking organizations have sufficient capital levels to weather losses during difficult times and to ensure a high standard in the quality of capital (i.e., its ability to absorb losses effectively) being issued by these organizations. In addition, our ongoing supervisory activities include monitoring banking organizations' asset quality, market exposures, quality of earnings, capital management plans, effectiveness and adequacy of provisioning, and valuation policies, all of which directly impact the banking organizations' capital standing. In December 2007, the Federal Reserve Board, together with the other banking agencies, approved final rules implementing the Basel II advanced risk-based capital rules—for large, internation- ally active banking organizations—that more closely align regu- latory capital requirements with actual risks and should further strengthen banking organizations' risk-management practices. The improvements in risk management under Basel II will be valuable in promoting the resiliency of the banking and financial systems. Under the Basel II rules, banking organizations must have rig- orous processes for assessing their overall capital adequacy in rela- tion to their total risk profile and publicly disclose information about their risk profile and capital adequacy. We will continue to assess the Federal Reserve Board's capital rules to ensure that banking organizations' capital requirements remain prudent. Q.9. Role of Credit Rating Agencies for Capital Requirements: Many financial institutions and pension funds are only permitted to hold assets with an "investment grade" rating. Chairman Bernanke, what steps is the Fed taking to ensure that banks monitor the quality of assets on their balance sheets and 57 that financial institutions are not outsourcing their due diligence requirements to credit rating agencies? A.9. Many investors and financial firms relied too heavily on rat- ings assigned by credit rating agencies in their risk management activities, particularly with regard to structured credit instru- ments. The Federal Reserve has long stressed to bankers the im- portance of proper due diligence and independent analysis in mak- ing credit risk assessments. A recent analysis of several global fi- nancial institutions by supervisors from the United Kingdom, Ger- many, France, and the United States—including staff from the Federal Reserve—demonstrated that principle in the current envi- ronment. Those institutions that had developed robust internal processes for assessing risks of complex subprime-related instru- ments were able to more quickly identify declines in value and the heightened risks of these instruments. Accordingly, these institu- tions were less vulnerable to the underestimates of risk made by the credit rating agencies on these instruments, less likely to un- derestimate the volatility of these instruments, and better able to analyze the effects of changing market conditions on their credit and liquidity risk profiles.1 We are reminding institutions that they should conduct inde- pendent, thorough, and timely credit risk assessments for all expo- sures, not just those in the loan book. Their processes for producing credit risk assessments should be subject to periodic internal re- views—through financial analysis, benchmarking and other means—to ensure that these assessments are objective, accurate and timely. Supervisors are also redoubling efforts to ensure that institutions do not rely inappropriately on external ratings. We continue to emphasize that for any cases in which U.S. banks rely on third-party assessments of credit risk, these institutions should conduct their own assessments to ensure that they are sound and timely and that the level and nature of the due diligence should be commensurate to the complexity of the risk. In addition, the Federal Reserve and the other members of the President's Working Group on Financial Markets (PWG) have rec- ommended a review of existing regulations and supervisory policies that establish minimum external ratings requirements to ensure they appropriately take account of the characteristics of securitized and other structured finance instruments. The PWG also has en- dorsed plans by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions to recon- sider capital requirements for complex structured securities and off-balance-sheet instruments that are keyed to ratings provided by credit rating agencies. The PWG further has recommended changes in the oversight of credit rating agencies and their required disclo- sures to improve the comparability and reliability of their ratings, and expressed support for recent initiatives by the credit rating agencies to improve their internal controls and ratings for struc- tured finance instruments.2 1 Senior Supervisors' Group, "Observations on Risk Management Practices During the Recent Market Turbulence," March 6, 2008. 2 The President's Working group on Financial Markets, "Policy Statement on Financial Mar- ket Developments," March 12, 2008. 58 Q.10. HOEPA Rulemaking: During this period of correction in the housing market, I believe it is incredibly important that we do not overreact and restrict access to credit to individuals who need it the most. In December of last year, the Federal Reserve produced a proposed rule under its Homeownership Equity Protection Act (HOEPA) authority. That rule is currently out for notice and com- ment. Mr. Bernanke, can you comment for the record on some of the steps that the Fed took to ensure that an appropriate balance was struck between eliminating many of the mortgage market excesses that created many of the problems we face today while ensuring that borrowers have adequate access to credit? A.10. Our goal in proposing new regulations under the authority of the Home Ownership and Equity Protection Act (HOEPA) was to produce clear and comprehensive rules to protect consumers from unfair practices while maintaining the viability of a market for responsible mortgage lending. To help us achieve this goal, we gathered substantial input from the public, including though five public hearings we held on the home mortgage market in 2006 and 2007. We also focused the proposed protections where the risks are greatest by applying stricter regulations to higher-priced mortgage loans, which we have defined broadly so as to cover substantially all of the subprime market. As an example of the Board's approach, the rules would prohibit a lender from engaging in a pattern or practice of making higher- priced loans that the borrower cannot reasonably be expected to repay from income or from assets other than the house. The pro- posal is broadly worded to capture different ways that risk can be layered even as the practices that increase risk may change. It would not set numerical underwriting requirements, such as a spe- cific ratio of debt to income, but would provide some specific guid- ance for lenders to follow when assessing a consumer's repayment ability. For instance, creditors who exhibited a pattern or practice of not considering consumers' ability to repay a loan at the fully- indexed rate would be presumed to have violated the rule. Another proposed rule would require lenders to verify the income or assets they rely on to make credit decisions for higher-priced loans. Creditors would be able to rely on standard documents to verify income and assets, such as W-2 forms and tax returns. How- ever, to ensure access to credit for consumers, such as the self-em- ployed, who may not easily be able to provide traditional docu- mentation, the rule would allow creditors to rely on any third-party documents that provide reasonably reliable evidence of income and assets. For example, creditors could rely on a series of check cash- ing receipts to verify a consumer's income. We believe these proposed rules will help protect mortgage bor- rowers from unfair and deceptive practices. At the same time, we did not want to create rules that were so open-ended or costly to administer that responsible lenders would exit the subprime mar- ket. So, our proposal is designed to protect consumers without shutting off access to responsible credit. 59 Q.ll. Housing Market: Chairman Bernanke, the current downturn in the housing market is not the first that we've seen, and is un- likely to be the last. What has been the average length of time from peak to trough in previous housing market downturns? How does the current downturn compare to previous ones? A.11. Although there are considerable differences across episodes and measures of housing market activity, the trough usually occurs between 2 and 3 years after the peak. Thus far, the current down- turn in residential investment has lasted eight quarters, similar to the average of previous downturns. As measured by single-family housing starts, the decline in activity so far in this cycle has been greater than average, although not quite as large as the contrac- tion that occurred in the late 1970s and early 1980s. Q.12. Home Prices and Inflation: Chairman Bernanke, a commonly watched measure of inflation is the core-CPI. Housing constitutes almost a third of core-CPI. To what extent has the recent decline in housing prices mod- erated recent increases in the core-CPI? What would be the trend in core-CPI if house prices were ex- cluded? A.12. The CPI for owner-occupied housing is not directly affected by changes in housing prices. The Bureau of Labor Statistics (BLS) uses a rental equivalence approach to measure changes in the price of housing services from owner-occupied units. This approach defies the implicit rent of an owner-occupied unit as the money that would be received were it to be rented out (that is, the opportunity cost of owning, as opposed to renting, the unit). As a result, the BLS uses observations on tenants' rents (after making adjustments for landlord-provided utilities) to construct the CPI for owner-occu- pied housing. It is reasonable to expect that tenants' rents should be related over time to the affordability of owner-occupied housing, which would depend in part on home prices. The BLS does not pub- lish an index for the core CPI excluding owners' equivalent rent. However, one can gain some insight with regard to its limited con- tribution to core CPI inflation of late from the fact that the CPI index for all items less food and energy rose 2.3 percent over the 12 months ending in February 2008, while the index for owners' equivalent rent of primary residence increased 2.6 percent. Q.13. Housing Wealth: Chairman Bernanke, the recent decline in home prices in many parts of the country followed several years of extraordinary home price appreciation. What has been the overall impact of the housing bubble, and its burst, on household wealth? Is a family that purchased a home in 2002 or 2003 still better off? Of those families who purchased homes earlier this decade, and have seen substantial overall appreciation, how have their spend- ing patterns been affected by the declining market? A.13. Nationwide, according to the Office of Federal Housing En- terprise Oversight (OFHEO) purchase-only house price index, house prices peaked in mid-2007 and have since fallen about 3 per- cent; according to the more volatile S&P/Case-Shiller house price index, house prices peaked in mid-2006 and have since fallen about 60 10 percent. Both indexes show major regional disparities, with house prices peaking earlier, and falling more, in California, Ne- vada, some New England states, and Michigan and Ohio. Indeed, according to OFHEO's measure, home prices in Michigan have fall- en, on net, since 2001. In all other states, families that purchased their homes in 2003 or earlier continue to have seen a net appre- ciation in their home's value. According to the Federal Reserve's flow of funds accounts, hous- ing wealth peaked at $20.3 trillion in 2007:Q3 before falling about $170 billion in 2007:Q4. Estimates by academic economists of the direct effect of housing wealth on consumption vary widely, from as little as 2 cents on the dollar to as high as 7 cents on the dollar. These effects tend to be spread out over roughly a 3-year period, so that current spending is still being supported to some extent by earlier house price gains, and the effects of the current declines will only be fully felt over the next couple of years. In addition to directly affecting spending by reducing family wealth, falling house prices may affect a family's spending indi- rectly through credit market channels. Borrowing against home eq- uity is often the lowest-cost form of finance available to a house- hold; falling house prices can decrease the collateral value of a home, forcing borrowers to turn to costlier forms of finance, such as credit cards. These indirect effects, which are extremely difficult to quantify, probably are a factor that has increased the size of some of the larger published estimates of the effect of falling house prices on consumer spending. Q.14. Covered Bonds: Chairman Bernanke, recently FDIC Chair- man Bair indicated that covered bonds were a "front burner issue" at the FDIC as they continued to look for ways to improve liquidity in the mortgage market. I understand that Europe has a mature, $2 trillion covered bond market. Do you think there could be a benefit to fostering such a market in the United States? What distinctions do you see between the European market and the status of the U.S. market? A.14. As long as banks and their counterparties are safe and sound, efforts to provide more financing opportunities to banks and bank holding companies, particularly under current market condi- tions, should be taken seriously. Such actions may make it more likely that the financial markets will be able to provide the nec- essary credit to sustain and enhance economic activity. In general, the European markets appear to be useful additions to their finan- cial markets, successfully providing liquidity and credit for some assets under most market conditions. Covered bonds have been available in Europe for many years, and such programs differ greatly across countries. Much could be learned by studying the merits of each country's program and ap- plying these lessons to creating a unique program in the United States. Creating a covered bond market in the United States, how- ever, may be difficult without Congressional discussion and legisla- tion. Covered bonds raise many issues related to the safety net pro- vided to banks in the United States, including issues related to the bank deposit insurance fund. The legal structure provided for cov- 61 ered bonds in European countries resolves many of these issues. With regard to creating a covered bond market in the United States, all parties should seek to distill the best practices from the European markets and work towards the establishment of a robust and well-designed covered bond market that includes safeguards to ensure that the safety net provided banks would not be measurably extended further. 62 63 Monetary Policy Report to the Congress Submitted pursuant to section 2B of the Federal Reserve Act February 27,2008 Board of Governors of the Federal Reserve System 64 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 OR REPRESENTATIVES The Board of Governors is pleased to submit its Monetary Policy- Report to the Congress pursuant to section IB of the Federal Reserve Act. Sincerely. :ti Bemanke. Chairman 65 Contents Part1 ] Overview: Monetary Policy and the Economic Outlook Part 2 3 Recent Economic mi dFinauci.nl Developments i The Household Sector 3 Residential Investment and Finance 7 Consumer Spending and HotiselioldFinance 10 The Business Stttoi 10 Fixed I m 'e 11 Inventory I m 'e 12 Corporate Profits and Business Finance 14 The Government Sector 14 Federal Government 1( Slate and Local Government 16 National Saving 17 The External S«lor 17 International Trade 15 The Financial Account 1° TheLaboi Market IP Emplopnent and Unemplownetit 20 Productivity and Labor Compensation 21 Prices 23 Financial Markets 23 Market Functioning and Financial Stability 29 Policy Expectations and Interest Rates 30 £j)iM itarteis 30 Debt and Financial Intermediation 32 Hie M2 Monetary Aggregate 32 International Developments 32 International Financial Markets 33 Advanced Foreign Economies 34 Eifietglng-Marker Economies Part 3 37 Monetary Policy in 2007 and Early 2008 Part 4 41 Summary of Economic Projections 66 Part i Overview: Monetary Policy and the Economic Outlook The U.S. economy ha* weakened considerably since titie> backed h>itich rftorl|^i^fr&. The loss of confide IK« Itisl July, when tin: Fedcrji Reserve Board submitted it> reduced invciiors\ivcfall willingik^s to boar nsk and previous ^f(tIWf^$n' PtfUcv R^pa>rtU* it,'t* Ctwytrcsx- Sub- cattaed them to icnsscss the soundness of the stntcturcb SCSfllial -steams have emerge*! in financial markets here of other fiitanciul producU. Thai reasse$i.ment was jnJ .ibrc«:.i J, and liuLihii.iL;-n-LiK*J activity lui.-. i:on(i im^d accompanied by high volatility AND diminished liqjUidity to contract, AJso, further ilKMMBS in the price1? of etude inn number of tin.mesal cnarkeis lucre*indabroad. The oil LuiJ wine other commodities have eroded the real pressiJiiK in financial niarketfi W0H9 reinforced by bank&* income?* of US households and added to business, conums nbout ucluul und potential credit lavn In cosb. Ovotafl economic activity held up reas onably LidJiuoti. biiiik'i recognized that they miglu need to take well into ihe autumn despite tho*e adverse develop- a larj!,e volume of assets onto tlwir balance sheet*— ments, but h decelerated sharply in the fourth quarter, inducing levctiig^cd loam, some types of mori^uge-J, Moreover, the nutkiDk for 2008 ban become less Favor- and a&sefs relitii n to -••.•-!••'!••.! ••!-•!•:>.! paper able since last summer, jnd •consii.kjdN- dmvtrtidc ri-:k.-- program.1;—given iheir rc£i£tin£ commitments to cus- lo economic activity have emerged, Headline •.>\r'ii tomwns and the irncreased rvsistjnce1 of invtf>iors lo put- price inflation picked up in 201(7 as n result fffi&aMt chasing 1.0-niii securitized products. In response to UIOM increases in energy and food prices, white coiv men- unexpected UB UQij baiiks btxsme more conservative tioti (which KnhfiJH the ctirct leffeciv of m&vemcniA in in deploy m$ their liquidity and balance sheti capiicit>r. energy and food pwtjKli WQJ., en balance, a little Itswcj- Icj.fn^' tn lidi-rc-r credit conditions for ionie businesses rhan in*00(i. Nonetheless, with tnrlarion expjctatioijs LUIJ hott sehokte. The combinprion of a more negative untiejpnted to remain reasonably well anchored-euarj^y ecanofnic outlook and a reaisc-isnien! of risit by mves- an J i-tlK'i r-imii'-i-dji)1 prices expected to flatten out, Jild [«•>]-: precipitated u ^teep fal] ui Treasury yields n 4ub- pic^^urcs on (nflOM iikcly lo caw. moneuiry policy sujiMnl widening of Kp»ydv on both invesunont-gmde niukors generaUy luvo expected iiwlation tu moderate and speculative-grade corporate bt.tn<bt and A sizable scm?whnl in 2tXt*i a»j 20fm, Under those cututn- net decline inequity price*. stnnces, tiic Fedenij Reserve has cased the siunco e>f inonot;IJ v polky •nb>TJ!ili:i!ly >iin:c July. Initially, ihe spiJI^rcr from the problems in (he hou.^in^ :NLJ fiiunciiil irui kd * lo ••>t\\-jY %<.-^ IOL . of (I>• The turmoil in litmnci^E markets tiiat sincr^cd laM economy WAS limited. Indeedb in the third quarter, tedI summer ivai triggered by a> sharp increase in Jclinqucn- .i••' domestic product {GDP) rose at an annual rate eicsund defaults on iubprimi' morlgag^s. That mcteast ofneatly 5 percent in part because of foiid ^in^ in nAatoUll^ unpaired (lie funclionmgcf Ihe seciHidafy consumer spending, busmess investment, and exports marked for smbprime and nontRdilifiul rtsldtntial In tlw fourth qiiiarter. however. rv&\ GDP increased only mortgagee which in turn i:h>ntnbtiEed ic o rLLdudioii in slightly, and the economy seeim to have entered 200S the qv;iilnt>ililyof such mortgageeio hciiKhold-s. Partly with Ijrile momenitim In the labor market* gfowlh in as Q rt'sull of these developments as weU as continuing prrvatf-wctor poyrolls slowed markedly in late *007 concerus about prospect for linDoite prices, (he demand and jjciujn' 20UK. The sluggish pace of hiring, .ilon^ for hciusing dropped furilier In r^spDiist.' to wvak with higher vturtgy prices, lower «qtiity prices* and soA- d^mnikl und liifh inventories of unsold homo:., hcimc- ening home values, has weighed on CDibumei rfiitiiiiK'iiil buildcn; coiumucd to cut the i<•••->- of t-- ••• cotusifucticn und spending of tote. In addition, indicator* of business ni fba amujd half of 2007, pushing the level of single* investment have becanic less fovotabk recently How- family stiuta in ihc fourth quurtr more than 50 peirafti everx continued expansion of foreign ccanoniic activ- below r he high »aclied in the tirsl quarter of 20i>6. iiy and a lower dollur kept U.S. exports on a marked uptrend through the second ha lf of lust venr. presiding Aflvr midyear, as lasses en Mibprinw mon,gagtf5 ond sonvc offset to the slowing in domestic demand. relatedstructured invtfsuneut piWutis continued in mount* unx'siws became iticre-jsingly skcpucut xibout Ownill cortaxi iiiee price inftattaii. as nujsurfd by the likely credit jwfonnanei" of even highly rated «cu- the price index for personal consumphon expenditures 67 2 Monetary Policy Report to t he Congress • February 200*8 (PCE h stepped up to 3V; percent over & e four quarters ruptions in financial markets. The Committee reduced of 2007 because of the sharp increase in energy prices the target 25 basis pointsat ils October meeling and did and the largest rise in food prices in nearly two decades, so attain it the December meeting. In the weeks fol- Core PCti price inflation picked ^RmMM in the lowing lhat meeting, the economic outlookdeteriorated second half of last year, but the increase came on ihe further, and downside risks to growth intensified: the hee ls o f some unusually low readings in ihe first ha lf; FOMC cut an additional 125 basis points from the lar- core PCE price inflat ion over 2007 as a whole averaged get in January—75 basis points on January 22 and sli ghtly more than 2 percent, a liltLe less than in 2006. 50 basis points al its regularly scheduled meeting on The Fed cm l Reserve has taken a number of steps January1 29-30. since midsummer to address, strains in short-term fund- Since the previous Monetary Policy R^porSt ihe ing markets and to foster its inacroeconomic 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- em] Reserve's initial actions when market lurbulence tions were released with the minutes of ihe January emerged bl August included unusually large open mar- FOMC meeting and arc reproduced in part 4 ofthis ket operations as well as adjustments to Ihe discount report. Economic aciivity was expected lo remain soA te and to procedures for discount window borrowing in the near lerm but to pick up later this year—support- and securities lending, As pressures intensified near the ed by monetary and fiscal siHimIus— and to be expand- end of the year, the Federal Reserve established a Term ing at a pace around or a bit above ils long-run trend by Auction Facility to supply short-term credit to sound 2010. Tota l inflation was expected to be lower in 200S banks against a wide variely of colhieraL mnxMidaB* it than in 200? and lo edge down further in 2009. How- entered ink* currency swap arrangements with two oth- ever, FOMC participants (Board members and Reserve er cenlrat banks to increase the availability oftermdoU Bank presidents! indicated lhat considerable uncertainly lar funds in their jurisdictions. With regard to monetary surrounded the outlook for economic giowih and thai policy, ihe Federal Open Market Committee (FOMC) they saw ihe risks around that oulLook as skewed to ihe cut the target for the federal funds rate 50 basis points downside. In contrast, most participants saw the risks at its September mccli ng lo address the potential down- surrounding the forecasts for inftalion as roughly side risks to the broader economy from ihe ongoing dis- balanced. 68 Part 2 Recent Economic and Financial Developments AUhough the US economy had generally performed in the chain-iype price index for personal well in the first half of2007. the economic landscape mpt ion expe nditures. 2001—07 was subsequently reshaped by the emergence of sub- MamLj] sii;ii[is Jd TiiUiiLizil itmkcls in tit United Slacks and abroad. the intensifying down:urn m the housing market, and higher prices for crude oil and some other commodities. Rising delinquencies on subprinu' mort- gages led lo large losses on related strucluied credil products, sparking concerns abou! the structures of other financial products and reducing investors' appetite 1»ftftfti for risk. The resulting dislocations generated unan- iKip.iied pn-^ujcs on bank balance ^ru.vi>. .and ihosc pressures combined with uncertainty about the size and distribution of credit losses lo impair short-tenn funding markets. Consequently, Ihe Federal Reserve and I'ENL-I rvnti.il hankN unowned loMippon liquidity and functioning in those markets. Amid a dete riorati ng rf Coar<nxr BUKJU rf Econonk AIUIJYIL. economic outlook, and with downside risks increas- ing. Treasury yields declined markedly, and the Federal Open M nkci Committee cul the federal funds rate SUB- invcslmera. ande\pons more than offset Ihe continuing stant ially Meanwhile, risk spreads in a wide variety of drag from residential investment. In the fourth quarter, etcdil markets increased considerably, and equity prices however, economic activity decelerated significantly, tumbled. and II K economy seems to have entered 2WW with linle The financial turmoil did not appear to leave much c I- o >I n A d i R ti D o n m s o f m or e n h t o u u m se . h In o ld p s a n a n b d e c b a u u s s in e e o s f s e lig s, h I t h e e r c h r o e u d s it ing of a mark on overall economic activity in the third correction has deepened, and capital spending lias soft- quarter. Real GDProse at an annual roteofnewly 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 Changein *al CDP. 2001-07 sharply in late 2007 and January 200K. Tlie increase in the price index for total personal consumption expendi- tures(PCE) picked up to 3M percent in 2007 as a result of sizable increases in food and energy* prices. Core PCE inflation, though raven over the course of die year, averaged a bit more than 2 percent during 2007 as 3 whole, a little less than the increase posled in -^x- lilli, Tilt1 j tial limslmen iand Finance Economic activity in the past t wo years lias been restrained by Ihe ongoing contraction in the housing sector, and thai restraint intensified m Ihe second half 3X|t ^(54 3W5 jit» awT of 2007. Homesales and prices softened significantly rComnrrc. Bwoai of Ecowk Aiul) further, and homebuilderscurtailed new construction 69 4 Monetary Policy Report to the Congress D February 200& Private housing starts. 19W-2OO7 rates. 2001-08 — J — 4 AJ|Mt*krJ» SoiVt Fvdirri tkot LOM Mn^qt CocpwAoa in response to weak demand and elevated inventories. many hcrnebuyers apparently expecied that home prices In all, die diehnc in residential investtnent reduced nw would continue to rise briskly into the indefinite future* annual growth rule of ml GDP in the second half of thereby adding a speculative element to the market, tn 2007 by more than I percentage point, and the further addition, tow A rd the end of the boom, housing demand drop in dousing starts around Ihe rum of the year sug- was supported by an upsurge innonprime mortgage geststhat the drag on the growth of real GDP remains lending—in many cases fed by bx lending standards.' substantial in early 2008. By the middle of the decade* house prices had reached The downt urn in housing activity followed a mulli- very high levels in many part* of t he United States, and year period of soaring home sales arid construction and housing was becoming progressively less affordable. rapidly esca lating home prices. The earl i e r strength in Declining affordability 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 rales. Another was that weigh onthe demand for housing, t hereby causing SALES to la11 and the supply of unsold homes to ralehel up ret- alive to the pace of sales. Against this backdrop, prices Change in prices of existing le-fjrni])1 houses. began to decelerate, further damping expectations of 198K- 2O07 future price increases and exacerbatingt he 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 Usi year. For the nation as a whole, IhcOFHEO price index declined in PV second haIf of the year after rising modestly in the first half; that measure had risen 4 percent in 2006 and about 9'/i percent in each of ihe two years before that.; In the ma rke t for new homes, ihe cons tant-quality index of new home prices fell Vk porcent over ihe four quarters of 2007. Moreover many latge homebuilde 19» IMS iprttt ^ J UJ near-pnme lo «»(tb of p Nun. Ilk iMJ if* 4*iTfc(K Mid r\Md f )'k»riJcj ttun j^t-s. I key nu> •c^nr-c- Im- T rwrtr*iino(ul Jitwd i uih^n •wE^Kft ill nVl<nfh r high IOI r be nud? o B*fcB.Lfc DwpL ^ i be 2 . r ^ 1 c b j e - i t n n & th n * . c ii t l \ t O c C i M v j p ao rm Ai l t l n y da iot -ex. tcltn^ dbbOfIkf Fdk H P 70 Board ofGovernors of the Federaf Rtjunv System 5 reportedly have boon using not only price discounts Even sos spreads between rates offered on these loans but also nonprke incentives ( for example, paying CL os- and conforming loans remain 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 IILWHTUCU; i of subprimc mortgages. The deicrioraiic-n was rooted Inall, 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 ihc assumption that house prices would cut production in response to the downshift indemand: continue lo 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 S26.00Q able-rate mortgages (subprime ARMs) with tow initial units—less than half the quarterly high reached in early rates' of those Inns originated in 2005 and 2006, a 2006. Nonetheless, the ongoing declines in sales pre- historically large fraction had high loan-to-value ratios, vented builders from nuking 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 haveclimbed ratios on their loans were unable to build equity in their sharply relative to sales. Measured relative lo the homes, making refinancing more difficult, and also average pace of sates over the three months ending in faced the prospect of significantly higher mortgage pay- December, the months' supply of unsold new homes at menls after the initial rates on she loam reset. the end of December stood at nine months, more than mice the upper end of the narrow range thai had pre- vailed fiom I«7 to mid-2005. Mortgage delinquency rate*. 2001-07 The contraction in housing demand and construction was exacerbated in me second half of 2007 by the near elimination of nonprime mortgage origination's and a tightening of lending standards on all types of mort- BO w gages. Indeed, large fractions of banks that responded to the Federal Reserved Senior Loan Officer Opinion 12 Survey on Bank Lending Practices reported that ihey had tightened lending standards over (his period. None- theless, interest rateson prime conforming mortgages have declined on net: Rates on conforming thirty-year fixed-iate loans dropped from about 6V* percent last summer to just above 6 percent at year-end. This year they dipped as low- as 5l; percent but have recently moved back up to about 6 percent within the range that prevailed for much of the 2003-05 period.' Rates on conforming adjustahte- rate loans have also fallen sig- nificantly over the past several months and now i md I J I I I I t L I I at their lowest level since the end of 2005.Offered rates on ti icd-ialc jumbo Loans* which ran up in the second half of 2007, ban recently declined somewhat, on net,J A^uttUrnb/ — J. Coifaminf f f p y nk Mat il il c: ihc>- nu4 be t^^Jrrt in mJt io i priTK h ai w> [KT« I t t«n-to-Ml«c rjtio. tml they <»IH( ncccd UK cnlorxuif IQJTI tintl. The ECOKVIK SdmtiiArt ol It I I I I I J I I . MfncJ inio 11* on ftktmr\ \$.t*u-.-*.ii:*l; ui<f J tlr •-• n- n-O2 2004 2« M 200 2QK 2<X inf kai limit for i fwst moiigipc «i i wnf k^fjmS hone in ihc bgKiui LHiitd SIJ& riocn J41 •?,!>*> lo 125 pcrccif oTlW mrdui Ncm TI* Jjt* art- aodU^ Kof Hitfvuv. pnaf. isd attt-f w. with jn wtfiLUjpaf S7?9n75o. Then?* (on- forniAf linii ttJlteinvffci ihmfhirccnJ^^H^. A. Junbo nortf^gcv jrc thov ihui c^coeJ the nu.vmun iue DTI a jdt-A pooh, rrfw to V-it r rito ii Uv pwcool <4 km* a i. i>ii«ni ny Eoji, thqr w typiqJI> e uenJnJt oh onwen mitfc re b- tii d >• 4n«f credi E tiri 71 6 Monetary Policy Report lo the Congress • February 2008 Cumulative defaults on 4Ubprlme 2/28 loam, often carry adjustable rates—have crept up slightly by year of originat ion, 2 00 from very low levels. The credit quality of loam that were securiiizcd in pools marketed as "alt-A" has declined considerably. Such LOANS are typically made to higher-quality borrow- era but have nonttaditional amortization structures or other nonstandard features. Some of the loans are eat- 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 stands a t almost 6 per- cent, far above the rates of less than I 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 lo a rising number of initial foreclosure filings; indeed, such filings were made at a record pace in the third quarter of 2007. Foreclosures averaged d •f r o fj e u * l t t o q d i f t* * v f» b rfc c ifc i c n d ri h w -J i l K ft 4 ] n V f n | t a i » p i t o . f i k f v n i r k u h m j n p l H f. e p is u f f c b f * r * d b y t ™ vu n te tc i t b * a f d JLI about 360*000 per quarter over the first three quarters of 2007. compared with a rate of about 2J5.0O0 in the cor- • K in HI r to tw 1} t n « a a f r < 2 » C « 0 K 5- } J - P f-w m F » t > a f t l i f d ti n 0 fc 1 l B T K V o a U ip d t a F f H d K a u b lu . c A i l 2 -x /3 r tw ta H n im u i responding quarters of 2006. As was the case in 2006, >->*,• 1 ^™ »irh J litJ rj11«rbc Inn t*o s«J» «hl«adjwttMf 14 more than half of (he foreclosure filings in 2007 were kr S O A LT r CE: Stillcak r il f ddi Cco Futi AIMK subprinn? mortgages despite the relatively smaller share of such loans in total mortgages outstanding, In some cases, falling prices may have tempted more- Subprimc ARMs account for about 7 percent of aII speculative buyers with little or no equity to walk away first-lien mort£&gc£ outstanding. Delinquency rates from their properties. Foreclosures have risen most in on subprimc ARMs bogan to incrcas? in 2006, and by areas wrhere home prices have been falling aftera period December 2007, more than on e -fi ft h o f i h« c ^f loans of rapid increase: foreclosures also have mounted in •ACK seriously delinquent (that is, ninety days or more gome regions where economic growth has been below delinquent or in foreclosure). Moreover, an increasing the national average. fraction of subprime AElMs in the paat few years have Avoiding foreclosure—even if il involves granting become seriously delinquent SOON after they mm i>ngi- concessions to the borrower—can be an important ten- nated ond often well before the iniiial rale was due to mitigation strategy for financial institutions. To limit reset' For subpriinc ARMs originated in 2006, about the number of delinquencies and foreclosures, financial 10 percent had defaulted in the first twelve months, institutions can usea variety of approaches, including more than double the fraction for mortgages originated renegotiating the liming and size of rate resets. Aeom- in earlier years. Furthermore, the path of the default rate pltcation in implementing sgch approaches is that the for subprime ARMs originated in 200? has run even loans have often been packaged and sold in securitized higher. Forsubprime mortgages with fixed interest rates, pools that are owned by a dispersed group of investors, delinquency rates have moved up signihcjnlly in recent which makes the task of coordinating renegotiation months, to the upper end of their historical range. among all affected parties difficult- In pan lo address For mortgages made to higher-quality borrowers the challenges in modifying securitized loans, coun- (prime and near-prime mortgages), performance weak- selors, servjecrs. investors, and other mortgage market ened somewhat in 2007b but it generally remains fairly participants joined in a collaborative effort, called the solid. Although the rate of serious delinquency en ARMs Hope Now Alliance, to facilitate cross-industry solu- has moved uph lhat on fixed-rate loans has stayed low. tions to the problem.* Separatehy*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 & TbcintluJ L-M-ralc px^i-xJ fc* raort MbfxHncARKU<ripidod iitKc penal from 2005 (DJOO1? wu Iwntiyrf ourn orthi Rixj£hK I' J million Aifcftrinc ARM* UK %chcJukJ \o undcrv^ tbdc fim nic A The Mope No* Alliance(www.fct i * revt in Z1 HIM E^cnuiU^tbc Kccnt Joclinrh in nuii^t iatcrnt raits, J n en and to ptjy J" rtoitb4cfrurtjonof tb<rKHtbfHmc ARM*areKW^UIH¥>re*ct ba ii» n-ilc in Ufc^nlini •$ ihc PUKC*1* f>f rcHunciif and nviJih in hif bet infcfcH rjlc. iubfriro* ARM*. The Alliance *ill A d h H Board of Gowrnors of ike Federal entitled "The Federal Reserve's Responses to the Sub- prime Mortgage Crisis ") Most commercial banks responding to the Federal IflJ- M (Hfi.tO Reserve's January 2008 Senior Loan Officer Opinion Survey indicated (hat loan-by-loan modifications based IJ" • — 110 on individual borrowers"circ umstances were an impor- tant part of I the ir loss-mit iga t ion strategic*. Almost two- i:v. •- — 1> thirds of respondents indicated lhat [hey wonid consider v*n. refinancing the loons of their troubled borrowers into I**- • 1 — 100 other mortgage products at their banks. About one- r third of respondents said that streamlined modifications m • e o im f p th o e r t s a o n r t t t p o r o th p e o i s r e s d tr a b t y e g th ie e s H fo o r p e li m N i o ti w n g A lo lH ss a e t s e . am <••'. i — « A]1 of the factors d iscussed above—ihe drop in home I i i 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 sales, softer home prices, and lighter lending standards L*J6 LM^JL ^LlJ ;oce xu ^M6 MS |especially for subpnme and alternative mortgage Han O^HKV B*MJ Jlli IH naarit Mil products)—combined lo reduce the growth of house- "' ** «»«*J *J . .j,..in.-.jir,, hold mortgage debt to an annual rate of about bout If U*l*M S« IVi percent over the first three quarters of 2OQ7H down from 11l /* percent in 2006,Growth likely slowed further in Ihe fourthquarter. have slowed lately, household wealth has been damped by the softening in home prices a& well as by recent Con Uifttiw Sifwttdittf; declines in equity values* and consumers* purchasing and tti>n\i-h(fU FlBOTTI power has been sapped by sharply higher energy prices. Moreover* eonsumer sentiment has fallen appreciably, and aIthough 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 solid gains in aggregate wages and salaries as well Real personal consumption expenditures (PC E) as by the lagged effects of tile increases in household increased at an annual rate of 2% perccnt in the third wealth in 2005 and 2006 However, other influences quarter, a little above the average pace during the first on spending have become less favorable. Job gains half of the year: in the fourth quarter. PCE growth sloped to _ percent. With the notable eiceptton of ttitiinf ru [Kful ncttrafc n> CCUKI bondmen and refer ihtm to pv- Change in real income and consumption. 20OI-O7 — 5 — 4 I I I I I I I I t I I I t I I I 1 I I I M I I I I I IW? IWI 1W* 19» XDS JOtlJ Nan. Th( HitL «f g«J«ie(1ir MJ &H*3 9*t<*$b JBTyt Tb* *+Jl tUf WH< ef C Bunnof Ecfltwmt AWTJ^ far****** ** fi 8 Monetary Policy Report lo the Congress • February 2008 The Federal Reserve's Responses to the Subprirrra Mortgage Crisis The sharp Incraass*in iubprim& mortgage avoid forectosure. Staff members throughoL* ihe In VIM ((dlllXjLHIK H-\ ,)l:.| fora I' '.!•'".. DIM llf Federal Reserve System are working lo identify past year have created personal, economic, localities that are likely lo experience the high- and social distress for many homeowners and est rales of foreclosure: Ihe resulting informa- communities. The F&deral Reserve has laken a tion is helping local groups to better locus their number of actions that directly respond to these borrower outreach efforts. In addition, the Fed- problems. Some of Uw efforts are intended to eral Reserve actively support. NeighborWorta help distressed subprime bOCTPWBW and limit America, a national nonprofit organization that preventable foreclosures, and others are aInwd has been helping ihousandi of mortgage boricw- at reducing the likelihood of wjch problem; in «n facing current or potential distress. Federal Ihe future. Reserve staff members have worked closely Home Iraws trough foreclosure canbe with this organization and its tocal affiliates on reduced if financial instiiutions 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 odlgahom. foreclosure on its board of directors Other contributions cannot always be avoided, but in many caies include efforts by Reserve Banks to convene prudent loss-mltlgallon techniques thai preserve wor kshops for uafceho Iders to deve lop co mmu- homeownership are less coaly lo lenders 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 lenders and mortgage service re lo pursue pru- ste ps aimed at avoiding future problems insub- dent loan workouts ihrough suc h measure as pfime mortgage marked while still preserving modification of loans deferral of payments, responsible subpr ime lending and sustainable extension of toan maturities, capitalization of homeownershiip. In coordination wrlhether delinquent amount*, and conversion of adjust- federal supervisory agencies and the Confer- able-rate mortgages (ARMs) into fixed-rate mort- ence of Stale Bank Supervisors, the Federal gages or fully indexed, fully amortizing ARMs.1 Reserve issued principles-based guidance on The Federal Reserve hasal so collaborated subprime mortgages last summer.-1 The guidance with community groups to help homeowners is designed lo heIp ensure thai borrowers ob(aIn I. Bura«GovtmonotT*FHITMR*wntSymm I2CC'J1. "WxthgwWi HoflgageBofrowwi,' UMibior ifi OJ* (Apf» "j. W "SuttfW* en LMJ W (200Tp. "Suwntn en Sixp im* Monpgt LffMmg," Dtvtucn tf Yieefi of RtiWendal Mcrtqajei. or fiwUig Supffvhtjn vtf fiojuWtrv SopwvhUxi and ft*ju- 7 • It |S#fc*mter &| \a\on l«« SBOMS M 21 outlays for new M^hi m*>tL>r ndishi (tjrs. •ipott-utjlitv1 tivity. For example,, average hourly earning 5 measure vehicles, and pkkup trucks)—-which were well main- of wag« for production or nonsupcrvisory workers, [;LHWJ through year-end—thedeceleration inspending increased only V: percent over the four quarters of 2007 in the fourth quartet was widespread. PCE appears to after accounting for the rise in the overall PCE price ha\"e entered 2008 on a weak trajectory, as sales of light indei. Moreover, for some workers, real wages actually vehicles sagged in. January and spending on. olhcr goods declined: Real avenge hourly earnings in manufactur- was soft. ing edged down about V* percent last year* while for Growth in real disposable personal income—that is. retail trade—an industry that typically pays relatively aftar-tax income adjusted for inflation—was sluggish in low wages—this measure of real wages fell about the second half of 2007. Although aggregate wag« 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 gainwas in good shape in 2007, although they weakened late eroded by Ihe 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 quaricr. as increases in in real Tft-ages over 2007 as a whole were modest* once equity values more than offset ihe effect of softening again falling short of the rise in aggregate Labor produc- home prices. However preliminary data suggest that 74 Boani af Goventurs of the Federal Jtaarw System 9 g pf«*di adjust ab l e -ra te mortgages that they c;3n afford testing of Ioan dis dosure documents. After a to repay and can refinance without prepayment similar comprehensive analysis of disclosures penally 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 similar guidance on nontraditional mortgages in May 2007 to require such disclosures to be 2006.* clearer and easier to understand. Like the credit The Federal Reterw is work ing to help safe- card review, the review of mortgage disc losures guard borrowers in their interactions with mort- will be lengthy given t he critical need for field gage lenders. In support of this effort, in Decem- lesiing but the process should ultimately l»1p ber 2007 t he Federal Reserve used its authority more consumers make appropriate choices under the Home Ownership and Equity Pro- when financing their homes. tection Ad of 1994 to propose new ru les that Finally, strong uniform oversight of all mort- address unfair or deceptive mortgage lending gage lenders is critical to avoiding future prob- practice*. ThIs proposalI addresses abum rotat- lems in mortgage markets. Regulatory oversight ed to prepayment penalties failure to escrow for of Uw mortgage industry has become morechal- taxes and Insurance, problems, related to stated- lengingasthe breadth and depth of the market income and low-documentation lending, and has grown over the pJ3 docadaandas the rote failure to gh/e adequate tonskieration to a bor- of nonbank mortgage lenders, particularly in the rower's ability to repay. The proposal includes subprime market, has increased. In response, other protect ions as well, such « rules designed the Federal Reserve, together with other federal tocurtail 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 lime when the Informat ion is likely TO Lory tenders with significant subprlrrw mortgage be the mow uwful to them. operations.J The program will review compli- The Federal Re-serw is also currently under- ancewith consumer protection regulations and taking a broad and rigorous review oft he Truth impose corrective or enforcement actions as in Lending Act, including extensive consumer warranted. 4. Th* «h*t AO4AC H4 M tM C4ftl*«tftt+41 $ut Gtn nd Ht&Juuan Uow y! 06-t4 (Odctw 10). FVrsonaJ uvin| raic. I9S4-2007 (ho vdluc of hou<-t?l»lJ wo-jlth loll miEio I'ounh ^turd.1! and a^ A re sult the ratio of Iwu&cliolJ wealth todispoi abk? incoinio—a key influence on eosisumcr spending— ended t he year well be low its level a t the end of 2006. Nonetheless, because changes in net worth tend lo influ- <?mx cOiVmmplion wuh ;i Lig. the incrcniiev in viv^hh during 2005 and 2006 likely helped suMiuis spending in 2007. In the fourth quarter, Ac personal saving rale was just a shade above zero, about in line with itA average value SINCE 2005. Overall household debl increased at an annual rale of aboul 7W percent through the ihird quarter of 2007, 9 notable deceleration from the I O'/4 percent pace in I I I I I I I I I L I I J ] 2006; household dcbi hkely slowed Further in Ihe founh quarter. Because; t he growth of household debt :ibom Hon. Tb* tLu 4** qu* u I > J*J *il**J ihrujch "DO7.Q*. matched the £rowlh in nominal di^po^able personal 75 10 Monetary Policy Report lo ihc Congress O February 2008 Household financial obligations ratio. 1992-2007 Delinquency nfinon consumer Eoans. 19Q&— 2O07 I I I I I t I I I I I I I II 1 1 I i i 1 1 1 1 I | | »J l«* IW tW* M01 XflJ MM MOT !•'•- »OT1 Km 1 P-Qi T>ta n*utft* til Ei nh • ID..II.I .*i|.-!xi ad o***r'# umcf. tod pfoprrty UHL *• divided by dsponMt [vnoul R«poA rf Gondboc ud Inrorar f Cil Hrpxt). iaooAf. SAia R4»l tow* Bond. rupicy law implemented in late 2005, the bankruptcy income through Ihc third quarter, and nci changes in niiv rose modestly over the first nine months of 2007. interest rates on mortgage debt TO (lut point were; small* The issuance of asset -backed securities (ABS) tied to Ihe RATIO of fina nc i A l obligationsto disposable personal credit cord loans and auto loans {consumer loan ABS| iiitromc wJS ;iboul H.n. has remained robust Spreads ofyields on consumer Consumer (nonmonp^ | borrowing picked up a bit loan ABS over comparable-maturity swap ra(e> have in 2007 i&$'.i percent, ptrhjpn fcflecurtg ^orne sub^iim* moved up considerably na July, the rise pushed lion nKiHisiiiiKT credit for monkUi^i? Jobt. Tho ptfay spreads on two-year BBB-nited consumer loan ABS in consumer debt IH mostly attributableio faster to almost double their pnvkxn peaks in late 2002. tro\Mh III ILVOIVII]^ CILJ][. .I p:itli-rt LOEISLSI^IU with tilt- Spreads on two-year AAA-rated consumer loan ABS results of the Federal Rcscnie1s Senior Loan Officer jumped to be[ween 60basis points and 100 basis pomIs Opinion Survey, Banks, on net. reporled easing lend- iifier iLLLving been near zero for most of the decade, ING S tand A rds on credit cards over the first half of 2007 |Vrh:ips in p:irt LIS :I result of investor*' jjjeilifml tv;i--sL's>- and reported Little change in those standardson net over ment of the nsk in structured credit products. I he jwond hiilf of ibe year In tontru.^. sL^tntitMnt ff^c- Iions of respon dents, in the second halfof 2007 reported ihat I!KV h^J lik^htcneJ sinjid;irJs and lemi% on olher I ho HlJ\llUaHS Svctcir consumer loon*. ;i i-limi^c ib^l may b»\x comribntcJ io j slowing in the growth of nonrevolving loans over the Fixt'd Investment final monthsof 2007, Average intercM mtcson credit cards generally moved down in the second halfofthe Real busmen tk^-d nUcsUih:nl I (It'll rose JII :m aiuui.il year, but by less than the short-tunn nurket interest rate of 8'/i percent in the •second half of 2007. largely rates on whichthey on often bused. Inleresl mte?: on because of a double-digit rise in expenditureson non- new auto JI.MII-. si KitiiL;, :niJ .it auto liitiiice conipstiiei J'.'MiJ.lUkll k.-Oll^[riX'llOll \\1\ : itil 1U111 UL-.'I.|IIJ|'J1J-.I|L ^lllil have also declined some in recent months. software (E&Sh which hud accounted for virtually all indKalor^of the credit <|iolily of coi;stiiner Urhin\ of the growth in real BFI from 2003 to 2005. has been -.ii^^.'-.c [||Ln it li.r. v.*.,iL.-JiL J but kit-ni:r:iIK ruiitLiii)s erra lic since early 2006 but* on balance, has decelerated sound, Oier thc second halfofthe y ea r, delinquency ii'iu.., .\\i\\ *• »n Mii. v\ 11• • I..-_ IJIL •. •. ^in-nm. .• 11-.11 tj111•.-_ i_iI rates on consiinKT In^ni ateonimcTfial I-JIA^ IIK-E^.I^^I, conditions lli.n influence capilai spending were fairly but from relatively moderate recent levels. Meanwhile, favorable in mid-2007, but they subsequently worsened dehiK)uency rates at captive auto finance companies as the outlook for sales tmd profits soured tmd ?s credit increased somewhat but are well below previous high* conditions forsome borrowers U^hiened A bright spot, Although household bankruptcy filings remained lovv however, is that man)1 H ms su ll have ample cash on rebtive to the level* seen before the changes in bunk* hand to fund potential projects. 76 Board of Governors of the Federal Reserve System 1 1 Change in real business fined investment, 2001-07 Meanwhile, real outlays on nonresidcntta! construc- lion remained on a strong uptrend Some of ihe rcccm strength likely represents a catch-up from i HC prolonged weakness in this sec lof in I he lir>t ]i.i|f nfthc- decade With the nolablc exception of die non-office commer- cial wctoi v Amn pending has been about flat since mid-2007—all major lypes of buildmg continued to exhibit considerable vigor in the second half. In gen- ERAI. the non financial fundame ntals affeeIing DMmsi- Jo nl i.i I c on.^ntci ion rcnuin favoubk?. Vacancy rales for office and industrial buildings have fallen appreciably over ihc pjsl k'\\ yC'ir^ dcApile the oddmon of a ]£OoJ dc.il of avaliable space: and. jllhou^h tlv vacancy rate for retail buildingshas moved up somewhat of late, it remains wclI below i1$ cyclical highs in 1991 and 2003. However, funding has reportedly become more diffi- cult to obtain in recent months especially lor specula- (IH.H_- projecls. ,niJ the slowing jn aj^fro^atf outpul and employment is likely to limn the demand for nonresi- dcntial space in coming quartern Meanwhile, real out- law's for drilling andm ining structures have continued Although inventory imbalances had cropped up in DtfHrtml rf I ol Ectonv Autyw. a number of industries in late 2006, overhangs were largelyeliminatcd in ihe first half of 2007, and firms On nverageh real outlays on E&S roseat an annual generally continued TO keep a tight rei non slocks in the rate of 5 percent in ihc second half of 2007; in ihe finJ i^eonJ half. In I ho inmoi wliKk- &ector+ manunictunfrs half, these outlays had r isen just 2H pefcent, in part pursued &n aggressive slratcgy of production adjust' killl <• ...t'.i ^^l.llj^ Ji.^Ml-.'-MIIJ IN ulltl IV S "II ICL..kl menls Eo keep dealer slocks reasonably well aligned vehicles,7 Real investment in high-technology per- with sales. En December 2007* days1 supply of light I'ufnivJ well in the second half, with further increas vehicles stood al 3 comfortable sifcty-four dap—though in all major components (computers, communications 1t licked up m Jamuary beca use of the drop in sales equipment, and software). Real outlays on equipment otherlhan high-tech and inm^pt^rmiim (u broadcat- Changneeirbalunsiesnsiveneo2tsir0.01- Change in real businessin^ve inntoventories. 2001-07 egory thai accounlsior nearly half of mvohncnt in E&S when measured in nominal lerms) posted a solid gain in thethird quarter However, ihov outlays edged down in the fourth quarter, and ihe relatively do* pace of orders, along withthe downbeat lone in recent sur- veys of busi ness conditionv suggests that the softness 1 11 in spending hasextended into early 2003. — 30 7. in bniocu o l ntabf ^ m the fir I c tuge Uuc la. Mo tf*C« al (he Hut cf 3007. y h>nu h*J i« t« of wxh U»cki info 200^ IJK) ikui ±TOB) #K hi^h>rtH^^jfI nux;uttj thill ik j U i n»l« vriiKlei c** modtcdy. ot act, in (he -m-end kitf of the yat. 77 12 Monetary Policy Report to ibe Congress O February 2008 noted MztiK Apart from motor vehicles, re;il nonlarm ed lo have been negative, primarily because of uivcnlory investment was a modes! SlO billion {annual asset writedowns: m contrast, earnings pershare of rate) m the fin>l halfof 2007; it slaved around ( hat rate I he nonfinancial firms appear to have increased about in the third quarter and appears Io have rcmuincd MOD- 13 pcrcenl. est in I he fourth quarter as manufacturing firms adjusted Nonfinancial business debt is estimalcd lo have production proniplly in response to signsofsoftening grown nboul 11 percent in 2OO7h buoyed by robust ..!-III.!LI.| Wilh only a few exceptions—mostly related to merger and acquisition activity. Net corporate bond the ongoing weakness in construction and molor vehi- •••001 was .strong throughout the year, although high- cle production—book-value inventory-sales ratios in yield issuance declined after midyear, as yields on such December seemed in line with historical trend* More- bonds increased and spreadsover yields on Treasury over, businesses surveyed in January by the Institute for securities of comparable maturity widened lo kveU not Supply Management reported that their cuslomer* were ^een since laic 2002- The amount of outstanding non- general ly satisfied with their current level of slocks tbanc ialI commercial paper was aboul flLiU on net. owt 2007, held down mostly by runoffs of lower-tier paper in ihe second half of ( he year a£ ihc market forsuch Corpttrato 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. I he first halfof 2007h issuance declined considerably corporations came in at about 2 percent in the ihird in ihe second half of the yearh when demand by non- quarter of 2007. valh the entire gain attributable to a bink inveslors for IIH^L ]n;ins 1LII • • tV. L onBMBnl large menxtso in receipts from foreign Mibsidiarics. The and mdusin^ (Celt) loans at banks expanded briskly share of profils in ihe GDPof I he nonfinaneial sec tor in 2007 as underlying demand for hank-intermediated peaked in tlw third quarter of 2006. ne;ir Ms previous business credii seeuvd to remain solid and bank*, look highreached in I997X and has SINCE receded- ForS&P onto iheir balance sheets loans thai KAJ been intended 500 firms, o perating earnings per share i I he ihird for syndication. In the Senior LOAN Officer Opinion quaricr came in about 6 percent below year-earlier Surveys taken in October 2007 and January 2008. con- levels.* Daly front about SO pcrccm of t hose firm* and siderablc ncl fractions of banks reported charging Wider analysts' estimates for the rest indicate thai operating spreads on C&[ loans—the Eoan rate less ihe bank's earnings, per share in (he fourth quarter fell more (han cost of funds—(he first such lighlemng in several years. 20 percent from the fourth quarter of 2006. Earnings Large fractions of banks also indicated t hat they had per share among the group's financial firms are estimat- . IKc diffe icnce between e<M*«tiic ily 1 tbc ctleublHi bfecotdrnk ptafrt but *n iKluJcd »tncvwc in mn^ ptr rfwie of £HK»I Amu. Before-lax profits of nonfinancial corporations u a percent of Mckx GDP, 1979-2007 Selected components of act financing fornonfinancial corporate bininesv s. 2003-07 UE> M Ltln. Mid ntr — u — 12 — 10 — K I ... I I ofC i onmHX*. BurccoofEcvacnJcAmil Tb S * C d A s I t C i I f . o F r * M ih W rj l Q V J M * t f m H Doof A flow rf f 78 Board of' Governors ofthe Federal Reserve System13 S'i I •,V,i. ', .;l.-.v..- i'1 J- • 11K -\ IL l\L-lk^ (L^lTi J11 n J • eon outstanding corpora* bonds. 1992-2003 jnJ inoiv^iinf spre:*l\ m commercial ;mJ InJuslrLj loan*to large JTKI mcJtumMJxJ borrower*. 1992-2003 I II i ll t i i i i i i i i i I San: Tlv diki Mt nomkh J*J tiknl An^ JJMUR MS Tb r Kent: TW djti nt ilrm-o Tron A vnn j<t*fral) coodKirdf cur( In. rtl j *nul iilo'< Alesser fraction- about one-fourth—cited concerns Sfflirt Lno Ofliotf OpWoo Sw**y <» about the liquidity or capital position of their own banks •tmBi fortightening. Gross equity issuance picked up in 2007 on an UK-IL-LIM: in UK- paCti ur^fd.^Jihrtl OJTvfuljp. NHJIKTIdvkr>\, record ^luines of share rvpiifcki^cs jihJ ta-J>fin;ii>ceJ ding standards- MOST of the banks that mex^en und requisitions pushed net equity retirement t d ig o h n t e e n s e o d i n le r r e m sp s o a n n s d e s to la n 3 d l a es rd s s f a in v d o i r c a a b te le d o th rm at o t t h v e y u n h c a e d r- even higher in :"<•" Ihun in 2006. The credit quality ofnonfinancial corporations bun economic oullook and a reduced tolerance for risk- remained strong. The six-monih trailing bond default rale stayed near zero through January 2008. The delin- Financing gap and NET equity retirement quency rate on C&f loans at commercial banks at the a ncnfiniuicial mrporauon s.1992-2007 end of 2007 remained near t he bottom of its historical Uiwrilibn raxi£ch but it trended higher ovof thf ycm. t'hac^;^-olT\ on C & l loans at ban ks a lso increased in 2007 . particu- larly in the fourth quarter. Rating downgrades of corpo- -.P. rale bonds, were modest ihrough the fourth quarter, and :ip. ov« tho \varihc fraelion ot'dobt thit vyj.% down^r^d^J roughly equaled the fraction that was upgraded. For HI' public firms, balance sheet liquidity remained at a. high :••• level through THE third quarter of2007* and leverage i siayed very low despite robust borrowing and surging ii rehrenienlst of equLt\. t.c i.i,t; [j|> ' Commerciul red ctcatcdcbi continued to npvnd briskly in 2007. reflecting in part strong investment in 1 nonresidential structures, but the oven 1l pace tapered off some in the second half of the year. A* noted above, The i H IA TT IV K C li i * s i* H a i i I $ t r k c p t i i p v « n v a E readings on some market fundamentals for existing p d iriiruU} fttrXd tmt&i. tdjuslrd for mni*Y) structures—for example* vacancy rites and renl>— M •c r i t n « rd |i( t I u V A . r r -d in on f x x - r ri t k b c u t f k c - i r T Lu r< ac n A K J « n t c v i M jf r l n \ i c c f q l u o h n i r g rt i ircd AK ol" l: S. remained solid. Similarly, the latest data for commer- linu mdtqiity tuud h> docH-vtx" ti.m^-inii'-1. in pabk cial mortgages held by life insumnce companies or iiock option frocradj. bj' issuers of commercial mortgage-backed securities (CMBS)—mortgages that mostly financeexisting strue- 79 M Monetary Policy Repot to the Congress • February 20GS Ne tinterest paymenls of noafinanc Lal corporations sp f ten -year investment-grade commercial morigage- as a percent of cash flow* 1975-2007 backed securitie s over swaps, by securities rating* 1997-2008 I I I I I I I I I I The Ji|i«f irttl) NkJ BJcomt Hires—show lilile change in delinquency rates in recent In contrasui hc delinquency rate on commercial mortgages he ld by b;inks about doubled over the course of 2007* reaching almost 23/* percent. The loan perfor- mance problems were the most sinking forconstruction anJ land development loans—especially for iho;,e that ttn^rtce re^idcfliiil d^velopmcnl—but^ome irKrcvMf in ikUn^uency nte.\ «?*!• JI1^ jppuent for Loan* booked by nonfarm* nonresidentlat properties and multifaintly properties. In ihe most recent Senior Loan Officer Opin- ion Survey, large fractions of banks reported having lightened .i.iml.nJ^ -uuj ILMN-. on coniniercul JL-JI c^Ule Delinquency ratesoncommercial real a tiale loans at banks, 1991-2007 MM \ ShfciJi ^-^ (Hf vr nonttHikilul — \ V^ — 1 .., MLlPl,..*J -^ 1I II11 1 1 1 1 1 1 1 1 1 1 1 1«1 1"W> 1V>J IV)'i msH : Son: 1>K JJ< J M^ ijuiiii i1 IL H. j]jJu.(V»1l MM loans. Among the most common reasons cited by ihose that n^htcivd credit conditions were a less favorable or more uncertain economic outlook, a worsening of com- mercial real estate market conditions inthe areas where the banks operate, and a reduced tolerance for nsk. Moreover despite llic generally solid performance of commercial morig^c* m secuntizcd pools, spreads of yields on BBB-rated CMBS me comparable-maturity swap rates soared,, and spreads on A A A-rated Ir anche s of those securities rose to unprecedented levels. The widening of spreads reportedly reflected heightened concerns rc^ardjm; me underwriting slondards for con>- mercial mortgages over t he past few years AND likely LILso investors' general wariness of structured tinanee product: Issuance of CMBS in 2007 topped the pace of 2006. 1t WU fueled by leveraged buyouts of re a l estate invest- ment trusts in (he firs) half of ihe year, butissuance slowed to a trickle over (he final four monthsof (he 21 year cm tighter undcrunlm^ standards and (he hijjltcr |N required >-ields. Nonclhctcss I IK still-sicady growth H of commerc ia l real estate dcbl indicated lhaU thus far, borrowers hive found altcmalivc runding source* for i: pnjwtt. — — (Governnu'tit Svciiir Federal (ittt'er/titn'tif 1 Piit >JOJ 3007 The deficit in the federal unified budget stood al i fat dfct « ut vci M<C billion m BscaJ year 2007. roughly S250 billion below the recent high reached m fiscal 2004 and equal xio* Council. Co*uli( to|ust I 1--*percent of nominal GDP. However,, growth Bimti nf Gamvon of Ike Fali'itil &Bmna Sy.iirm I $ J efcptndilbi^, IQ8J-3J Ctanga is real govakniGni ^qK^diuav OS L'iiiMiinplii.iil and InvefiLnienI, 2601 -1) Q ItJrral P Sin Tbrs«L-ipl*QHiiL'ipemWi>iviaii.i dvirn < iini rini-hu.t£n twsi* pml -nrn an: in)) :IJCH 21m sm J»T MKIV rmrnl jv»» ICWlntirF lliiT*(h V|Hrh«*n. 0111' >« rw »r»c li -Inr q irr* SM »< i OvTs.iiiikati ^ Cknaaon Butwii ai BeooAnle AMQAfe dntJmj III Q.V SilAil I mice nl Mwwgenwi* .H)J nu.Sg«_ As measured in the national income and product ill revenues has stewed since last summer, ami gnwili accounts (NIPAh real federal espendittu'cs on eonsuinp- in outlays HAS quickened Given IboK developments. tion and gross mvesuncni—the pan of federal spending lie deficit dsitus fc» 1'ir^i lour montiis affiscul 200S thai is a direct componentofGDP -rose at an annual (October 21107 la l.iiiu n i 2m is i was l.u LIT than it hud rale of 3'j percent, on average, in the second half of been during the comparable period or fiscal 2(107 Over calendar 2007 after having been unchanged in Ihe first Ihe remainder of fiscal 2008. a slow pace of economic Iwl f. Ihe step-up was concentrated in real defense Mth iiy and ibe revenue loss ussot'inleil vMlh Ihc tco- spending, which tends to be crmlk from quarter tu nomit Slimlilus Act of^OOS ure Otp<K»d la bdOfl tin- quarter and rose At an annual rale Of 4!r4 percent in the ikiicil. second half, somewhat above its average pace over Ihe Nominnl federal iveeipis hove dcraleraiMi s pust three years. siiitv |Kwling ilouble-digit tdvanoes iti fiscal yean 2005 Federal debt rose at an annual rate of almost 5 per- LIIIJ fl0& Nity rose less than 7 petueiit in liscal JIHI7 cent over Ihe fnur quarters of calendar year 2007, a bit mid Imvt: flowed subslanlially Turlhcr llius far in fiscal taster than the roughly A percenl increase in 200i> , Tile 2CM)S. The dtfcclcralii.in has tven mnsl nrennunced in ralio of federal debt held by the public to nominal GDP <:rirpk>ratc rcccipti, which batvly increased in fiscal 2<K)7 remained in ihe narrow range around 36*j percent seen •Set Iliree years ofexcept!mmI growth and hnve follen well below year-earlier levels so far in fiscal 2006: Ilie itownlum has reflected the rutcnl softness in corptjriitc Federal government Ml IKU hy Ik- puhlii;, prntitfi. In addition, growth in individual income \a\ icccipu; has moderated from Iht rapid rates seen nmttiut i he rim I ilk- of the dnads N'oneilieless. ujial receipls gn:« faster than nominal OOP for die Unrd year in a row in fiscal 20t>7 and reached IDS pcrtcni nl'GDP, •.lijliily abovt the average of t!ie past forty yiiari. Nninnral federal outlays rose less lhan 3 percenl in BtMl 2I.HJ7 oner having risen obnui 7H pereenl in each of the twa preceding yean, In large pan, the slowing in 2OU7 retleeleJ a number ofiransilnry fiictors—roosi notahly. the tapering olTofexpenditures for flood insur- ance and disaster relief relalei lto Ilie 2005 Gulf Coa.il hurricanes, which had produced a noliceabk hnkv in jpeoiing in risen! 2006- So far in fiscal 2U0S. sharp intrcases in uutlay.s for defense and IK-1 inlercsl liave m Tte cLua Its M* im&al Moi-e&L [IK i4»L'ivaiu^i tut VMTJ ll llclpcd push spending 8 percent above its year-earlier ir. Xttc eonapantfiv MIHH W ti\H' wt \<r* 01 J IDI VBSA r level. l ». nmili 16 Monetary Policy Kepon 10 the Congress i l;cfcntary 2(HJK in rc£imtycar*L The Trmury's decision in May tndis- kvdi prmpeny tax receipts apparently were tolBlcrcil rarriiauer actionno nhree-year nominal ticrncs clieiled m 21K17 by Ihe ejirlicr n»i-»p in KJII eslutc VAIUBS, tun •iMl., reacturn in in ••i.-n niarktis. I i_- ireasiiTy .! • ihc JL Lateral ion in house prfca will likely sfmv ihe nse tnii nin'd some LLUCMOFI gffids TOT a u~>*. uiber • •• >}•• >u in ta$d t$Vtatt*93 dn-unrtu: m;id. Moreover, many stale sccurtiie* over the first thw quanores of the y^u- as ft* tnul Irttfil governments expett to fate ^g/llftc«tt *iiuc- narrower dtficii reduced borrmving needs. Dhuta suggest iiji'al nnlxilanccM in (heir hudgidts in naming yeafh ai> a [inn iiit fux)|.wrtH]ii L>rnciiiKuil Btwpon Mjeurittets pur- rwnli of the niifiomr pressures Irotn Mcdtcaid fed tibe chased ;» Treasury auciions by fbri'ign oifieial ssislitti- need ti> provide pcraamu and healfli care lo ihcir tutlwJ tinm* edged ilrwn over rhc second hnlf af 2007. bill Ihe employees. proportion ha* changed little, on net, iincc miii-241115. \ccordine to 'htf NIPA, real exptrdiHircs mi cdn- iumptiLHt and yrais investment by SEBIL! iind lot^l gov- ertiments cmiHrnscd iu expand briskly in Hie seamd State and Local Government haU uf2007, Much of the strength was in construe!ion sptnrfiTiji, which picked up ipmd curly last year lifter n»c riM\«l i nudHum of mate and local governments having been WWJltiaUy Hal bctweeti 2W2 and 2{HKi, appeal* to have hwi BOSK htsicr in -M7 after improv- MLiinwhale, real tuitlays fbreunrcnt opcralJLins remained on the nnhJer.nc uptrend that lius been, evident AHWH nid 2IKJ6. Indeed, for the sltlc ;ind luc.il suvtor OS Q v^liuL1. nvi saviiij! as meanured in line NH^A, which fioosicd by Nptrnding oin rdutation and nnlnsiri.il aid, is broadly simiLur lotiw surplus in anope mting butt- hUTTO^inji, for new mpiUil expend)turcs by stale nnd E£d. tell Iroim a receni I-.I-:I c>rs2? biilitm tncol governmontii wus vefji *!rni]^ in 20f]7. ltet\j.ndiiny^ roughly zero, on average, Uuring the firsl ihrcc q in idvaBHuf rciirtinents were brisk m the(SJtly |\in or' 21(07. The downshift occiLnvd: us revenue i OIISIL- \\-,u Ay, \-.-,s\\ i:\-~. Uukol in k»w HUL'^SI ITIIC*, bm tailed: nrT.irtL-r ;i perniJ nl'licrty jsiins and n* noinlsad rchsndings *iiibimicd in lhcs«ond half as n result t:\rKiudiiijres cspLtmlly OR encryy and henllh care— oThiyher vnnlatilrly and ruthieeil liqurdrly in Ihe munics- row -h-Lipi\ i'...•..-,. in mi,111,1.1111.11 t'roiti niiiivlnhtul --.MI«,••-. juril h»»nj market- By cnnlrast, slwn-icrm horrnwinji o.i lo J gtHid deal of tincveniwss in turrcnt budget picked Up J hit during rht sectfnd half ufihe ycarH pos- i—csptvLpllyi [lime irt grieul- sibly beeuu*e of wine deterioniFicm in untc and local regions—continue ki enjoy budgets. M"n .f tsCalip ii-.iv. ••>. OUscri. Imwcvtir, iirt? rtpL^rting Municipal ISSIIIERS arc htfiwtiLing from lower iniercsi tiii^iihlc shortfalls in revenues, in pud httiisiw s&to) lux rates, as bond yIfIds have dec lined *ome since nudyetir. s arc being hit tmn1 by the wcsknE** in p»i- However* investors reportedly Imvu beeorntr increas- es ol'linusinu.-relii^d flcms. In ificsc cin:urn:sLanccs, ingly comHOHd about Hit wraktr llscal ouilooks for c states Frtay have tt cm spondliag or raise BUOS io niimy stale and local gamnmeols and Ihc condition t mquireivumn. Alt orninnicipyi Ixtnd insurers. Partly as a result of lt)P>e developments.f ltCn iliu 6faU index ohmumtipal hood yield*- lo ihe yield on eampurahle-niaiuriiy Irvusunei Slant attd bod pneotraan us sating i*)B7-2i has trlinibed foflw top end flf ift historical ningc. Some ittiiicfiiors of credit quality m the munitipal bond BSe&T h&vg begtan pcsiniiny to greater we in tueem muniIii. Rating! up^rudc.^ hn\e tilowed u luk- doy^ngradci have risen- A snbstanETuI nujvthcr of rev- enue haa&i far pfqJK&l in&urcd by a subsidiary of a major invi-stmciu bank were downgratted in October In January another group of bonds was d because of ihc itowngrudu of their insurtT, Toifll nt't national saving—thni is. llw saving l>t>lds, bu5inew.es iind govurnmento excluding deprv cfatiuiTi cliargtr* nm$ equal to jhout I1 - percenr of P, on tivenigc, during ihe tirsi three 82 Baanl f Gweruorx of the Fithrat fteiserw System 17 sizable increases lorulltomohik-s, ugriLrtillnral and capital goods, especially aircraftG spnrtsof sa- •• vices rose rn MB? bu tal a slower pace than in the pre- vious year. The value »r e\f«is to China, India, Russia. South Anietioi, and the members of OPEL rose quite suhstDnijaEiv, and gains forcxpon^ lii Canada and west- em Lurupe were also sizable, txpmtt |o Mexico and Jiipmi Inerniseu at a Mmewttut slower pucs. A slowd own >i in real imports was also a factor in the posilive contribution of so! espans lo the growth of real C1DI1 last year, I lie growth of real imports ofgoods •nJ wrviues decreased to about i K percent in 2007. down from a 3a percent nsi in 2(W, in part tecauM ofa slowdowni n U,S. domestic demand and the depre- IW7 mg IBB !OI1 ciation of fte dollar. Although real imparts oTeapilal V'ti' I he si«ik m '^intily '<lht CMcmd iliHtugli 3J07.OJ. wi goods am strong, ihe growth of most other major CAT- •BflQ <» Ifcr « t" [wnwul nirul n*T AHMINU »ilfi.it **l the (nil m egories dec lined. Despite Ihc moderation in the growth li S fe » J i t m LT i hu P nt u p Y H s l m ill m lll t i e i t - t l * QHMHI KMDIHI M ofimports uvcralL ihe vidue ofgoods Iexcluding oil ! imported from western burope. China, and M«ico still 7, T he drum an national sin-ing from the federal rose atsolid rales. delieil Vf& smaller lliiin tl liiut k.vn LL ffe* years Given those movements in exports and imports. irller. 1 lowcver, rwl business saving receded somewhat along with somewhat higher nei investment Income, from tho relatively high levels of the preceding Few the U.S. curren tnccouni deficii appears likely to hove years, etd nmunal saving was v<rry low for ihc •' >• shrunk in 2on on min nnual basis lor ihe lirtt lime since 2001 f, The current account deficit nnmiwcU fr*«m *>L-L i:.nsi-.M-..ii saving Tell !|<i'iL'(.-c'.i-h. as a su-i'. ::m IJL- SSI I billionin200fttoanaverage»rS753 bill ion at 6fQOP bdWMn tliv Ink1 IWOfi anJ the early part of ihit an annual rale, or around Si* pcivenl of nominal GDP, dctfldt; ifiai ntfO ftiU changed titllu SIIKV 2lHJi2 (a^J^ in [lie firs'i llaec qLnqrters of 260? (the lulesiavpibble from Ihf Ihird quuner of 2005. which «'AS nlartied by datnj. However,, its largesl component, Ihc trade deli- sizable hurrioiiw-nilHtcd prupotly losses). IT mil boosl- mit, uideiiixi in ihe fourth qmtttflj ftfewae ofaaaqi til over ihe longer ran. pefwitell low levch of na tional increase in tilt? price of im|»orted oil. saving ^vill hj ji^socinled ^ uh etlbcr slower capital The priLC ofcrude oiF BQwed on world markets fomuiiofl or coffflaued hotvy borwwtng ivom ibtcad in 2007 Trie spot price of West Texas t ntenneiiiale ijiihtr afwhich would reuird the nsu i» ihu sumda i of inereasen from around Son perbnircl ai Ihe cm! oi JiM living oT U.S. rcsktenis uvcr lime imd hamper Oic K) aboul S i (K> al present. The strong demand for oil ly Dfrtffi tiiHtoti to fflflo) the rcMircmeni nw^lsiifjm porntlahon. Change m real import** and tsjwrt."; of gwxLs. ami ^T1". EOfit, TM KiU'rnal Sectnr The exja i kai Bcol of I>I'i>v Wed sign i Rcsnl i uppoft M L.-ctinomic jetivuy in the second half uf last yfiir. Nei cxiwrts jiifdcd •Imofl I perceiUu^e poinl to U.S. C!DP . . I l ll growth ilnring thai period. tRording to the lotest CiRP release Tram the Eluraitt of UcunpiTlic Analysis, hut dnu epoeived since iiicn iq^psi u wmcwh* larger t»ssiivc coiurihudon, The c>«nitihiihh»n of'nei L'\fnnts wn:. Mjp- portixl by a rubusi expansion-— ahDjt 11 percent A ian umuil nrio—ofrsa] c^poriii of gtioJs and serribei thru I.I waa litlpvtl by stillrgofid gmwlh orfomsn eeanomies Bawd lite elTecit al'lhc pic I dL'preciat[t>n of the Jolkir. ami am? The bruad-bii^tfd rise in real exports uf goods includcii II-MH-- LVlhlllfip^iliil f 18 Monetary Policy Report to Uw Congress Februaiy 2(108 U.S. irulrunitciincrnd la nearlj S*5 per barrel and likely rellects a belief h} at] markei parEteipiints itii.ii the balance oE supply and demandwill tfiiniin ughi lor some limi1lo come. Brood indexes of non-oil eomimxlilics prices reoiaio elevnied, Althmigh ihcy fell back slightly over the second half of last year, prices hnve again risen since liie slart o£ 200S. Prices of a number of inelttls. which surged ID the spring on strong ylobal demand, relrealwl somehwhni during ibe latter half of 2007 as prodLittion increased and as users substituted into other nittlcriols. lowcver. more recently ihc prices of copper and alumi- num have moved buck up. Prices for food coramwlilics continue to rise steeply. Poor harvests in Ausrralis as well as in pans of i-urope ttnd Asia led to higher wheat prices. Tlte price af soybeans also has risen sharply IK 4«ianert> l\it the intJs jL-.-miiii. '\tc ikiin ido^ because acrtagu lias heen shilled lo com production, in part In produce biofuel, in uddition. the soybean harvest 5DVKI in (.'hina was down sharply from last year. Import price inflation increased in 2007, with live «V3t pQWBQil by the continued cx[unsiDM aftfae world depreciation of Ilie dollar providing an unpmUni impe- economy through 2007, ggpecmlfy in Lhc (Jc\eEop»>^ tus; liiglier ufi and FOOD prices also contributed. Prices countries. In addituiTs, d number a factua] and poJential uf imported gomJs rose about K* pereenl tn linn, inn disnjplions to supply have contributed Eo the surge in ;-v. udiiig food, oil, and nmuial gas. such prices rose oil prices. QPF.C members announced cuu* to oiE pro- 2V> percent: both rates were somewhat higher iltan in UULLIOII in late 20f)6. Decile refill ftgOtfWISflg ihat haVE reversed st>me of these LUIS, OPKC production remains, rcstiaincd. Tin; growth af produciioi> has also been liampefeil by SOME gDvemments' moves to iukt- The tmanviat A cemtiii conti-ol of oil resources or raise their share of rev enues. Geopolitical tensions in the Middle hast and instability Allhulteh the current account ddicil appears to have in Nigeria have contributed to concerns nhottt oil supply narrowed during 2007, it rvmains sizable and conlinuusi as well. The price of liic FAR-DATED NYMEX oil finurcs UJ require ii sienilicanl influx oflinriuciiijj Iram jbio[id. (cuircntly for delivery in 211Id) now has risen As in Env past, foe tidicil wus larjit'Sy tjnnnccd b>' for- uien net LKqui-sitions of U.S. sec unlies Price* 01 tild ei tmfisol o 1'hc global lin;.irK-iiil lurrmiil th»I began m ih*_- -um- mer left an imprint un the componentsof the U.S. U.S iwt rinnnriul i ft. 2003-07 MI,, „ m vm [ten : lit' >ui,i mi- mnubly. OK- IH Aur I •>•• in- all pA^ • jvtrwpn fin iVhnntry I (linnii];li F-cltfimry 2\, 3iftK TW rf'« "! «» L.-MnkuJtHL". « U'ltdi (Jtlttfljjl JuiiLidry l»in. the JII I jTicd it We vf«4 |H lt Wi>i TMM bflmfnedtint cnifc «'ii i iu- pflHso] iioiifltd wttmuwSiiei •r..:.'. ui i, rQ fhv |TMLi,iry^Mnn»JiJHj jinirV*. Sl«-IQ-- R»r tiki, llh' i"LiiniiMnl)t> RcH^in.1!! Mun'ioiF. I in noulu ! Ilk dfiui w c|?uwicrly r>i«0<:MfIH! ilin Haifa. iiiimwin<ii «i M«wy> F-"niw) ra btpHttftf eT Cwaneree, 84 Board of Gmvniors <ty' ihv Fettvrul Reserve Systtfti 19 V-i private foreign purchases oflong-term U.Ss,ecueitris. 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 I brisk pace for 2007 HI uhole. Outflows associated wilh U.S. direct investment abroad remained strong. The Labor Market Employment and Unemployment 1he demand for labor decelerated early last year and has slowed further of laic The average monthly gain in private nonfami payroll employment, which slid from about 160,000 in 2006 to 80,000 over ihe hrsi len months of 2007, was only 50,000 in Novcmher and SIITI: TW diu ttt quantity ind * wad ihrough i Sennet: DVpoflmnri rffw December, and private employment was nearly flat in January 200&. The civilian unemployment rate, which financial account. After acquiring record amounts of had hovered around 41; percent in the early part of U.S. securities in the first half of 20G7, foreign private 2007, drifted up about lA percentage point from May lo i I n v > es . t s o e r c s u s r o iti l e d s a i n si z th a e b l t e h i n r e d t q a u m a o rt u e n r t o t l h m e m fir - s T t r q s u as a u rt r e y rly e N v o e v r e t m he b e fo r: l l i o t w ro i s n e g a tw no o t h m e o r n W th p s e a rc n e d n t s a t g oo e d p a o t i n 4 t . , 9 o p n e n rc e e t, nt net sale of such securities in more than fifteen YEARS. in January. In contrasl, foreign private demand for U.S. Treasury Employment in residential construction has been securities picked up sharply in ihe third quarter as falling for about two years and now stands 375,000 global investors shifted into less-risky positions. On hclow the luyl ivcwdwd in early JiVMi 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 toial foreign pri- in ihe manufacturing sector, which have been on a vate acquisitions of U.S. securities recorded an unusu- downtrend for more lhan a quarter-century, have con- ally small net inflow lor 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 ihc hrsi half of the year. services and drinking establishments has remained Foreign private demand for US, Treasury securities has strong* and job uains at businesses providing profes- remained strong. As issuers of asset-backed commercial paper around the globe began to encounter diffic ulties over ihe sum- Nel change in privale payrulI cmploymerit, 200 1 -08 mer ,tionbank enlities that had issued commercial paper in the United States and lent the proceeds to foreign parents sharply curtailed those activities. As a result, those enlities reduced their claims on foreign par- ents, and net financial inflows from nonbank entities thus were sizable in the ihird quarter. Foreign inflows through direct invesfment into ihe United Slates surged in the third quarter, as foreign parents injected addi - tional equity capital inlo their U.S. affiliates. Foreign official inflows slowed in ihe third quarter, as Asian central banks acquired debt securities issued by government-sponsored enterprises (GSRs) but on net sold U.S. Treasury securities. Official inflows appear to have strengthened again in. the fourth quarter, with a 3002 300* 300^ 3HH MOfr 300? 3WS return lo moderate purchases of U.S, Treasury securi- IT. riW JJJ Jir nhinthN JOJ «xJcAl thri-uph ties, continued strong purchases of GSE-issued debt 20 Muneiury Policy Report TO the February 2(HJB Civilian unemployment oie. IIMIT>; it i-.:- cluM^i-'ti liitle, un net, UVLTIIIC pa^i couplc of yean after fulling appreciably aver the lirsi half t>f ilhe decide. Most other recent mdkfilors. also poinl lo some sottenirtizallabor murkc-t conditions. Initial claictis Ibr III.I iinl« '•• n M.'ii* li-iii. -ii.--.-. ••• I n I I .nl i :mrtined '^:l I- tively lovt ihrouuli ihe fall, moved up soinewhiH In ihe clLoiiiy niotuli^ (>r2<M)7; t1n>Ligh eirciiic fnaim week To wtMJkT ITICJ jippe-jr tt> liuve nsun Further in curly 2£H)H. MeiinwhiLv private surveys mj^^csi Uiai Jirma havtcul b,n.-k i m pluMb. far lurrny in Hit- nc;ir k-im. MOLINCIVOMS bsvoa^ffl beeome les» upkieai about the pro.npccls for the latwnismkcJ in ihe year ahead. ("•IK 2imK Productivity ttttd Labttr Compensation IkfinHri Output per hour in the nonfarm business ,sector rose StOtt F & Th l e * i I n n J c r u e v a l s i e n i i c n a f J o S b C l f e V s h s K ne S s s h a s v in e c b e e I e h n e s s l p z r n i h n l g c o & f > 2 w 00 e " l ? l. t% pereeni in 2U07 aflei1 averjgmgjuiit ] W percent per ycar ostr Ihe prccedinj! ihivt years Althoujih esitinnnle?! b«M been widespread across major demographic groups. ofthe underlying pace of productivity jirr^vih are o.ti In January I?00Kr unemployment rates for ITUJII and Lij.'ri..iiFi. Ihu pickup m measured productsit\ growlh women au,nd 25 years iind nkkr were bath about W per- in 2007 suggests Elmt ihe tundiinii'ninl Ibrccs Mippnrl- ccniagc point ubswe the levels uTIasl «prinj*. and aa my a ^ulid kiuderlyin^ (rend rtmuiu in pluee. TIKW lyjnculty occurs—rsics for teenag&rs jmd yoitfi^ adata linn"- include ihc mpiJ prtce of tcclinologjcul ch^n^e-fls showed Iflrgei' increjscs Anmnji the tnajof racial and well n& ihe ongoing efforts by firms io me information cfisne yrotips, uncniploynicni rates lor btackfi nod UN- technology lo improve User ef)icient:y ofthyir flpera' panics rase sfiTTiL'Vihfli DXMB lhan dkl nn^niployrniint tions. Increases in the umotmi LOFcapital pur worker mlcs I.OF whiU's. a dinVn:nu:i1 ulyo lypiuw] ol'r»Lhniids O^Hi ,ipric5rto be prtividing ;m impetus k^pruductivily MIKTI l.ihor nijitki'i1 CtirulllioiiH suttcn. Ajt kltCFMSC n« growth. Tlic number of unemployed who Iwd lost i hcir IEUI jobs (as mppo&ed to ihose who had voluntariiv left their jobs lltHirtv cojnfjensfltionr twcat a relatively moder- Or were new entranls lo tlie labuf fijrie) accounted tor wW rate in 2OU7 despite a pickup in overall consumer jihtiul luEfnf (he rise in live uvemll jublessmic Iwiween price iniljLion: i conlinued advnnct in labor produc- tl>e spring of 2!>07 und Jjinwiry 2IK>f(. The [nlwr foree tivity ami generally light labor murkefc. Theemploy- participation nitc stotnl stipJiily nbcivc 66 percent in JAII- Crum^c in i>ut|iiii (vr hour. l^JS 2iJfJ7 p;.uiPt'ir»aiiott raic. llll 11 * 1 j. 111 J I.JJ.I.Ji 411 i | i1 t_li 1. |1 > 1 1 |M N i- u*c i ;y . , n m aJ \ . | H & i u iln n - n lu i u p n u n t J s o f w M m K Sf a V t K U , e U f i i n ru n l p r j cu h . v ..f a i| x w «m Ik Mfiti [TB (tau .we \u\*w\A; and RMHIJ ITI»IMUII > y p I J^pttOM^-imil Ul*-, HHI^S. lUbM l>cpnHliHnll nl LJuif IIUT Botii-d of Ginvrtmrs of the Fet&itil Reserve System 21 Fchange in hourly Kimpe llw7- J(K)7 Chwigc in anil tohur a M IK I(Wft-3 * a 20GB 2lB.ll ffc il>i4 *v mwrinif mft rtml lfmni|Eli -ctmr The .'hnniM Nw l liiin. ilijutv u mi.:i tnur qiiiuwn, In qj Midi1*. (fDCfr. tl ••: i-O TWM M l**h< RHmbt i''ii1lihj.p in Ik' l*ii Rkc .loniJ.in hid)m> OCM* #trfMla fam iu I: i- ik- uxu- n« (|M BWrfHTW XIMIIV^ IBQIVriin IW^Ilfll ] pcrccni. Unit labw cosla roscatniut 2^ perceal jwr Ml v»io MM RSDdMoed (or Jsi* || t<l JBOUI* "W Itfi year, tin average front 2DW to 2(>06 dllei having been iiLMt.. UN-ftanntcm ..I La hit. llur-L-aii «i nearly flat over this preceding three years. iticjit cost index (ECU for private industry workers. ^|bh^cl^ measures bolh WBge»afld the coM orbenchts, incrta&cti S perwiil in mmnnnJ terms BVB ihc twelve Prices ii \:L i»f 2fHl7. aboui m lint.1 with ils pate in 2U0S and 2IJ06. Within Hie ECl, wage* und saluritii inoeawsd Headline consumer price inflation sl V/4 percent in 2(M)7. tJie emna as in 2006 bui ^ per- in die ihird t)imtier tif 2007, when energy prices hit a tcntagL" \witH above Oie incrctLStis in 21WH .nm lull after their first-half surge, but it moved back up in Mtratiwlnlc, mcrcdMis in tht coisi u the fourth qtiarfcr as energy pntL« el irnhed again. Over have flowed iiiLnkt-dly lit rcccnE ysan, in pari b^nuftc the yesr js a whole, the ovendl K'l; chuin-typc price njnipjiiyurtunlributiuns for health i index nvsQ 3VV percent, t \ pefet-ntiige: points more than 0 .Ikui I In.1 JITCrL'iJMJ i« btm hi-. •-•.-.!. L;I 'UN"1 i in 2tMjft, tore pnee in flation excludes the direct cfTecls imOntttod (o jusi 2W percent, was also held down by ofincreases in food and enerj^y prices; ihtrse increases u drop in anploy£rctmtnbulii)n:s kxJclincil-b^nt'rn were sharp Insl year. Like headline innation, eore PCh rttincmtnl plans in the firsl 4UAITCI. The lower contribu- in fbium was ticitveo from qunrtcr to quarter in 2t)(l7; tions appear lo have been fciciliiiUcd hy sevetsJ Hiuiors. overrhe four quEirters of llur>trat, itavcrayect ab il more inciufjhig i\ liigli level of employer cuiilrihufMHt over than 2 percent. In 2iV}bM tl>e eore index nwe VA pereent- lhe preceding few years and Ihe strong perrisnnance of Alilio«nrh dala for PCE prices in January 200S tire noi (he alock market in .'•u•< \vi availfiblc. inlurmalion Irom the eonanmer price According to prentninan1 14cte, nditinml uhtTnipcnsa- 'Mil -. \( I'ti Ill'l .'Ili.-i LiM:lu". -Ili-^'v:^:- lIlLU I'l'lM ..il.ll lion ptr hour in ihe nonOtrm btisin^s sector--dn dlkT- and core inflalion rcrnaincd on the high side early this imiivc measure ol honrly coitipensution derived from ycaraflcr having finned IN ihc fourth quarter ol 20lt7. (lie compensation dutu mtlieNlE]A iTise V.-'i pnaecd The FCT price inrfex Un energy mas nearly 2U per- in 21)1)7, Korticwhat fasler than the ECI, In 2tMt6, the cent over the four quarters of 2007 after hav ing lhlksn miiifatm business measure had risen 5 percent, wilh B3od£flt£y in 20llfs, The rvlaii price ofgasoline was up about 10 percent OVER [t& ycar ai a whole, driven higher an iip[):nvni hisi from a high level of bonuses dnd b> UH1 upsurjic in ihe cosl ofcrude ail, In 200R, gasoline sl(H;k oplion ejiercijtes. which do w$j reem lo have bven prices through mid-February were around (he high lev- repealled in 2tK)7/'lhe modemlion in this meijsure last •J\: • LCII laic last year. Pritej: of rtalural gas rose shnrpiy vL^ir. nbng with Ihc slcp-np mn measured prothiciivhy getTW'th. held Ihe intresse in irnil labor costs in 2(KP to '*. tncuiiK receivftl Uc»n ibe tfxvrcisc or*<tg«ti o^nifin* M i Inn iu.il in ibC BD klBBim nccovtNl rmra nwwt iy|»K »rhointrfi n I ifH BKHSt efhsorlf v*m(wift!inon m iiic munrnnii, hiiitn'h-. mem 87 21 Monetary Policy Report to ihe Congress February 24)1 in early 21*17, bin ihe_v receded over the second half of ^t- in GOffi COItUinKt priiicv the year as inventories reached their highest levels si nce the early 1990s, £e Tar in SdQfti natumi gas. pnees htfW d$QI notnbly a? inventories bjffvfl luSlen back mln line • Mntf [Witt irnk-i with seasonal nunns, Consumer pitas for electricity • 1 i..,ni.ni- ptm iHdU i..r.< rose sharply last rail, likely retains nflast year's higher prices of fossil fuel inputs to electricity generation. Last year's increase in the PCE price iniics for Ibod rI and bevemjps, .11 *H pcrccni, was ihe largest In nearly two decades, foiKl prices accelerated in response m slnmg world demandu nit high demand forcom for the production ofethanol- Taken together, prices lor meals, poultry, fish, and ejjgs row 5M percent, unj prices of dairy pruducts were tip a! double-digit rates. Prices for purchased mesh ani lbeverages, which typically art influenced more by labor anil other business unsls ir urn; Cifli*umi:r}ifiFi:imti. rVpniimmi ul I^ than by i'arm price*, also recorded a sizable increase last year. In eomitiudily markets, grain prices wared lo near-record levels in late 2007 us strong global demand outstripped available aitfpfy, and they have moved somewhat higher since tlw inm of the year. Mean- ^; apun from ;i dOWBW«t| hIsp m Itic im while, spot prices oI' livestock linve declined of late; 11 rcmaiuiuj there ihrouyli Jjnuar>' HVlR «nd spurtisl 10 the ilei-rasc ttluilld pruvidc seme otTscI to the llpWilrd y.'» percent in the preliminary estimate for February. In pressure from grain prices and thus help limn increases cunifssi, BUHl in^catow isu^gfsi rbat HKpecJatioCii for in consumer food price* in corning months. longer-run inflation kivc remstJtied rcusonably well CON- The pattern of core PCF inflation was uneven dur- tained .Ihe preliminary Febriia^ i^sull for median five- ing 2007. In ihc tim half of llie year, ewe inflation « f to ten-year inflaiion expectations in the Reutcrs'lJniver- damped significantly by unusually sort prices for appar- sity ofMicjiigan survey, al 5.0 percent, wns around the el, prescription drags, anct nonmarkci items (especially mitlillo oftbfl nurrow rnn^c (hilt 1ms prevjilU'd for ihc financial services provided by banks without cipUcii past few years. And according H Hie Survey of Profes- charge I, all of Lhese developments proved Ininshory and sionut ranjicuTiicr?;, caiiiJutii-'d hy (lie Federal Histrvc were reversed later in tile jtiir will liltle act etreet on Gunk of l]1i iIVuUphill, %xpWtJ8$Qtt8 uf CPt hiflaliun eyre inflation over the year us a wiiole. Meanwhile, SHI ilK1 BBX1 ic» ycui^ have wmaimd jrniund 2'^ pet- the rate of increase in thecoreCPI dropped from ceflti ii lo'.-l ihm \\&s been C 2Vi percent in 2006 to i'A percent in 204)7; Ihii main 1'jyK, Mcjinwhite. tcn-ycai i rcasun lor the nhtipa dccderalioii in the ewe CP1 than Bteasund by I|IL- uprCiieU ui yields on tionninaJ Treasury in the core PCI price nuk* is tliat housing tntis, vihtch svcurilies over those ontheir inlialton-pRiieciLid cunn- rose less rapidly in 2UII7 than Ihey hart in 2006. carry tfrpiirt^. 11.:-. •_ ii:uL:L. • I link', on biituTicc, staSE mid- much grenlcr weight in ihe am i'fl. 2007. More fundjinientally, Ihe behavior of core inflation in Lstsi year's sharp rise in energy prices also left an 2IKJ7 was shaped by many of Ihe same forces (hat were imprint on the price index for GDP, which rose a at work hi 2Wlft, The December jump in unemployment link' inorc than 214 (wnriint for Lhc .J.VI.I year tit a noiwitbsianding, resource utilization in labor and pB>d- IB% '• EUfitudiflB food snd energy prices, Ibe tocna&B ucl marked reniaincd tinrk high last yearT and increases in QDPpcicQs shnvetl fiwrn 3 pereeni in 2ft06 us 111 prices hbr energy aid other industrial commodities >; percent in 2007: significantly smnllcr increases contiiuied 10 aiW lo Ihe cost of producing a wide vari- in constnieETon prices accounted for mKli of the ety of goods and ier\ ices. Higher price* For nnn-tMl decelcnuiun imports also likely put some upward pressure on core inflation. Meanwhile, the news on inClalnm e.vpeclaliiins has been mi.Ved. Probably reflecting ihe higher rate of actual heudlinc nUaiiun. the median expectation lor year-ahead Inflation in the Iteutcrs/Universily of Michi- Hi TIK flFTcci r«f Cltflgy prk'Cs VH Or>l* pikTs MM mild *mi*HVT gan SurV'eyB oFConsun>CTS moved up from 3 percent wii IIMII on KT p»w«t T^w rcawn ii Ehm UMICII OFTIB en •• • •• ,-> u •• ill cailj 2007 to between 3Vu peicenl and J 'n percent ie iiiis*: w*ii iilin hyiuhjd ^ |lli< luiiliti piU-Vm umioti^d ml, irvhu'h is : IL u nml pun ci| sdmiL- Btxmi o/ GmvmarN of the Federal tteurvs Syrtem 23 MleiTOIIw measures urpncc dunce JOOI 07 around mady^r, us crcdil quuJily in ilwt SL'ci ucd to worsen and leasn mttunkiJ, investors (n:gan to •llM IKHIsiHr ., toop an rcirttH from slruclurcd urfdit producis and from mky iiBsyiB man:' generally. Strains began lo WPffl^cs m ijic ntaPWl X u it leveraged synttieuttd loan marktl in laic Juot: and then i vlauiinf 3nm• FL.I O«SV - KB !J t) 2.1 siirliited in the issyt-backijd SOflVitBftSJ pa|>i?raiid i'vn ts Q c T l k n . d i N wa ji w f w ix* n 8 1 : - • r, ii:nn hank fundmji gn;irki?t& in August Alter a respite m .). , •• - I1. u in i" late SL-ptemiwr Lin l d s e f v > e c r t a o l h c fi r n , a r n ^ c v r t a l ! ii l f i i i n i n n s s . o a f n d la a rg v e v r- e l u h fc u e n r - L'niwuBiCT i«nce i IS Ifl in t tt,n>iribuiL'd ki year-end pressures in rsfl.lUMI^Jw^ g iarkets lhas caurtfirtJaWd financial ^(raias and heightened market volatility, Finanuinl rmvr- Sffl H I fi" thmMype MUM UfpOASH »if CtanrfkBBb IWr«u nF kds remained volatile through nuid-Fehmary, in \yan I_V>K fat fi>*i-w*lj|hi mtswirc*. llqurn.i,1 i | •• i>.. . •• i 5auue& owing lu a fitnher downgrading of the economic out- look and prubtems al some firuineinl guaramuis. Sijrns of investor norvouiTics* about the mortgage Financial Markers iilUiiiion first uppewu'd in DtMJtnber 200G 4ind Thefl inU'ntilfed in btc Febniarj 2(H17H ai a time when sofkr- Dumcsiii: arid Eii!cmjtu»nj| fiiuintial niarkcts ttKfWri- Ihnn-cvpLxted L;.S. ccunomii.' data wem mliltrrjf lo riiEtr- ciictd iuhstnnicil siniins ami voljitiliiy in 2*107 ii\ai \Wtfl kct unLLTlainly. O\yr lli is period, mortgage companies .sparkL-d bj1 die on^ti ing duleriuratiort Pflh^subpnnit speuiah/iny in subpriniL" product* bek!,an to L'\peri' itttingagt sKLhu1 and lamciging worrits abcuji I|ILI noir- trnce considerable Llimltng pressures. Jint! man> lailed. leilii DUthwk lor U.S. tieniiomic growth. SuK^ianiiaf hecanse rising ilciinqucnck's on recently originated lossts nfi strijL'iu rLhd products Felii^ to *iiihpnirtir stihpnme mortgage}: required Ihovc nnns lo reptjrehaise muiiu3g.es caused irsarkci p;irttcipants to reassras the ifie bad loans from sccurifired pools. Financial inurket;* risks asswiatett wnJi :i wide range of Otter s'trucimred t i April, however, and liquiilily in mrytir mar- tirmrii-'inl MiisiniiMciH-1*., "1'hc result was ^ drying up of pofs remained jUTiple. In June, ratiny uyencics down- inurkcfr lor subprinu1 and nomniUilmriiil mon^ngc ign£?l at p»[ under review for possible downgrade the |M"oJutl> as well as a siutnlk-ani Hvipninmcnt of I lie mnr- trrcdil ratings of u large number a( securities rucked by kcti Tor Hbsel-bEick£d oaninicrciiil paper flnJ leveragtid ngagts. Shortly iheicaftcv, n lew hedge syndicaltd KMIIS riktsc dlbkx'utums ^-ncriUcd unex- nttduiu-\-d serious difTicullies 3$ a resuh of pected Inland" sheet prcssiirei at H*rTte inmur financiul in^lilulionb. and Ihu pressure* in turn c<mlnhnk-d lo Pnctt of indexes of credit dL'iauJi swaps on rest<Jen- sOVcR" sltiiins -in i-liuil-lt'rm hunk luniling mnrkflv Tlic liul nmngugL'-backcd stturiiics backed by s l-jilciul Ruiicrvc ri!sp(mjfd Lo 1hLL linari.ri4jf Litrmnil .ITILI iortgugcs- which hud alfL-ndy weakened over ilu* first iht risks to Ihc bmadtr L'conomy aloii^ tWa iTackis; II halfof2CP»7 lor *B tower-rated irunchcii -druppud iihA (i series efagtfOnfi (o support murk-v'L lu]nnlii\ and siLt'ptv in July for botfi lowtir-mtti Innctioiiing (pantv in cmirdtnEtiion with Itirvign ccnlnt) minchen. Suhsi'qiumUy, investor demand for batiks), and il castd nmnciary policy in pursuil of its hackLtl by suhprimc mid alL-A inongage potils dwin- macTflccontintic oh]eciivcs. AH a nanlH ol'ihc dowflwanl ilLJ, and iliL- ^curiiizutiLVii rnarkct for tho^.-1 li1.. -•. rCV ia i oci to ilw economic ouilook and strained fiBen- viduslly .shui down. Tfapse deVfltopfSfiQta ampli fied eia! tundilams, vieldais n Treasury wcuniies fell, risk credit and funding pressures on mortgage eompanies spreads widened aignificBfUly. eqitity prices dropped, specializing m snbnrimei nongages; with no buyers for aiuj volatility in nmnv Hnancinl markets irwrea»ci the mortgage* ihey originated, more of those linns wen: forced to dose or drastically reduce their operutituns, JI el subprimecrtfijTStiDB*Mowed to u crawl. OripnB- Murker Functuming mat I inant ial Stability tions of a lt-A mortgftgi-s- vvhich Und held up over the iirst halfofthe year —stlsu dropped sharply begtmring in The •-•••;:-- •!•>•• crijsion in lh*.H credit ^tmliiy olsuhprimc July, Ink-re^t rules on jtinibci loans hwafeawt hill insti- rcsidcniiaJ modtingcs. padicularlv mljualsblC'ralc i.iinii.- rli.ii had die opucity tu li.tUl-ui.lt testSOd iheii mortgagee hascxpofiod weaknesses in <nhcr tinancisl balance &l£t8& continued to \u\\ku them iivatiuble to markets and posrd chull^nges t« BnancioJ insiitniioiis- prime borrowers. In conlrasih ihe markfi ior conl'omiinu Ovw ihe first halfof 2007. probletns were moatly iso- mortgages for prime borrowers was afFccted relatively (latod wiiiiin Ihe sunpriinc mortgage market*. HMVVVLT. little. Indeed, the issuance of securities carrying gUBIBti- 89 Munelary Policy Report in the Congress Fcbnnuy 21108 i ce s wJexes of credit de limit swap EM loans. ULuJing velmnw we« rcponedly lor^c, but bid- ajiktid steads widened tilurply and prices, wWeh luui twen high in ihe first hiilf of HW, deelined inurkodly. fmpiicd spreads on yn index ofltwvonjy crwlii dcJbult KwupsfLCDXi ipiki.'d in July and re\n\uncti riavatad in August, Unable to distribute many levelled syndicated foflfl* ihj[ fe»y had rflpOftefly undcrwritttn- -a problem appurcnUy iiiftttinjj Btottt S250 billion of such toms in the Uiiiied Stales a Lone- hanks faced flie pinsptit:! of hringinj; Ihosi: loans onto their balance sheetsJ L, I|] under!yinu dea ls elost*U- Atthe end t>f July, Enrppeuni assct-baukcd tomi- in.- -. •.!i paper (ABCI1) and short-term funding matkels were miled by warnings of heavy losses associated wills commerciaf paper programs backed by VS. sub- prin>e mortgftg'Ss. On August 9. a nmjor European bmik anniitinced ituiT M bad frozen redemptions for lltrce of ptOTM TV- J^.i .in.- .taily inK-jeml HifiiufJi Fulwii.*n 31, JiMlH. Th,-« IRS invcsmicm funds, citing Us inability to value some of the mortgage-rriated securities held by the KUHfc. AHer thai Ltrtnuuncwnem, liquidity prubleimand short-ttriTi tunilint; prc^HORS intend lied in Kuriip*.1 and cmcrjicd in lees from Fannie Mac or Freddie Mac m« snmewhui in U.S. money rmrkds, Partly in r^wnde to tifiXftC dPi^t- Ihc m'ttnd hfllf of Ihc year. npnwnls. the Ft'dtrrbi Reserve and other central hunks The unprecedented decline in the value of highly took slt-pit lu foslcr sTiMH>thuT funL'tionin^ of short-lcnti rated tranches of mortgage-related secufdlioa led inves- fn:dii niiifkcis (refer to i hc box auuk-il "The Fcdtrnil tors lo doiibl their own ability, and ihtii of! he rating agenda, lo evaluate many other typiss of sltuc'lured ReserveTs Responses nn Financial Straios")h Spreads oh U.S. ADCP widened ton^idcrabty m in.«li umL'nr*. TI>L» Inss ofcDnfidoncc was njflcciL'J in ntid-Augusi. jiid the uiluine of ABCP LHitsiLtm 1 in^> sigmficiuiUy hrgncr spreads LMI the debt o r col latemli /ecJ bfu.ni] Q precipitous dctiiK- sis jnv^ten balked at row- li ii3i> obligations U 1.(Isj, .nn] Ehe i^Liaitee of ^uch debt ing over papxt Fur more tharii a Ctw dayt. OuiKiandinji weakened mitiee^My wver the summer- Because CLOs Europuiiai ABCPulau dticilntcd subsiajtiiahy, ami ihc hud heen Tin.- 1;iF^M purchasers of leveraged syniticateit tnaikcl fee Canadian ABCf no ^rx^iNored by bankA loans, the drop in issuance contributed to the dectinje in leveraged lending. In (he secondary market fortucli tiiiisv is^ttuncc of Atturitic1 am iSl mi (•SI -«n ee :«i tsu wo .1.1,1 o.^hd lliii.u.Dh I•L-hiu,irj li, MtH Eatti [ p i nil A (MAll . -nliliii^. wilh. hril-lUiii \vntln'muJ Nuirv Hu in Mt «ecn(Kkir> nurtiU hir kvi.-lil.lnJ h'lli; SOTBI (• "K:il vl> in<\U\if U 12, SOT. Ill ' 90 if Rewve Synt&fl ii OiiL--munlti Libifl" minus OIS rale 2DUT-4HI 1.., |»| _Srrei* - U» ...1 Ml MJ ,, i Milling "f'lrfair1 m _ GubiiiuulingL., _ r~S\ |llNI I-:, ^^ \ — 1J«»1 IM /*~vJ\)Ws mi la ^v/ tltoiiUfci! T Tjjj so— . - Mil I., an imjf* lit dnll> 'ndnli^M rajc%, ^ULII JS <EiiI eilKIJUS lcik>*-,ik IIJIKI'. KML • i Al lr*iunl>, I*" [s,nn-. oute h. IM-I e >•.•• -.1 2i'H 17 2(I(IK DEIWUHII [iwiUrtcrj.'ntc Mt^ti^i mitit^i »:crui*l ill lln- «i\fU mh-' 1 mhinrvi Of N ll O .L T . 1 Iiu ' lif H l£ i * t ii« « c b! E ^. m 3 . ( i t H » ll C v E i i. u 1 l ^ ji « I i I e E i l j fI F L u -H r n i u \A J - n L w ln i n x u t i 4 jh « n C !i - - L lr A * T -J IIJ if J t ) L ^ J [ K tr e* I ( H u f r t \ , :ktr S w b ^L tW OJ K « Lu B n f i; l > lI i U ln e . " i , t H .) E 1 h * f. l . ( • ^ j i . c B i- B it H ;n I ' E L W 1 n A l r — lw n ' f liin w lin .t y v . r ut I " ti i e ii f O c* I . S r t i l n e k . 1.IVrNm Jav JUI^IJIKC, b sMt fcA liiu I. .»Vf AA Miimijinniwl (nlc virtually COL lapsed." structured investment vehicles nn their funding capacity. Moreover, creditors found ISIVs) ami siiiglc-aellcr ABCP sonduits thai wen; heav- they Ltuild mil reliably delenninc the size oflheir cotln- ily eX|m«d lo securities backed by subprimc inortguiiw terpart Its' potemlal exposures to those market-., and cupcriiticed Ihe grcaiest difficullics. Unlike traditional concerns abom vuluution practice satUed to ihe oterall ABCP prngrams, SIVs IML very lillle explich llquitl- uneeriLiinty ki a result, banks beemne much less will- iiy support thim their sponsors. Asa resuJl. invcsiots ing lo provide funding lo others, including other banks, became particularly concerned iiboul the ability of especially lor terms of more than a fen day*. Spreads SIVs—even itiose with little or no exposure M vtsitleii- offirm federal funds rates and tern Ltbor over rales liitl mongages- M make timely pitymenu, and demand on uonirarable-maturily overnight index swaps wid- Mr Alii? issued h> SIVs IL-II sharply. Over ihe nost ened appreciably, and Ilie liquidity in Ihese markets few vveeks, some U.S. issuers inv oked their right to diminished (for the definition «f OVWntghl index swaps, extend tbt n^ilurity of their p:iper. Others lemrKlrunly refer lo ihe Hccoinnnnying figure). European banks drew on iheir bant-provided backup credpi lines, and u also waght to seeitre term funding in Iheir domeslic few issuers defaulted. The general uncertainty and lack currencies, md similar spreads were seen in term euro Of liquidity also led to sonic decrease in demand lor and sterling Libra1 mart;els. Liquidity in the foreign I..1...M.Ilei- unsecured nL>nnnanciui conmiLLreial paper escltBnge swap market was poor over this period, and especially al kinger maturilies and spreads in that European RfmS found il more difficult and cosily to use segment oHrie niarkel widened markedly in August i: the I'nreign esehange swap niarkel lo swap term funds well. Issuers of high-grade unsecured commercial paper denominated in euros W olher currenciei lor funds were largely unafteeled by tlie turmoil and cspcrijnceJ denominated in dollars- Temi funding markets in Ihe little disruption. Japanese yen and Australian dollar also cnine under At Ihe same time, term tnlerbank Euuding markets pressure as foreign insiiliilions atiempled lo borrow in Ihe United Stales and Europe came tujder pressure. in those currencies and swap the funds into dollars or Banks recognized thai Ihe dinkuhiL** in Ilie murker SU1TJS- fur ntQlgsgcs. syndicaltd loans, ajld commercial paper Against thai backdrop, investors fled lo ihe relative liould lead 10 subsmntiully larger-lhan-anlicipgled calls safety of Treasurv securities, particularly Treasury hills during mid-Augusl. For example, inflows inio money market mutual funds investing only in Treasury and f agency securities jumped in August. Surges of sale- n (ninhuok \GCP InJo liin haven demand caused Treasury bill rates lo plunge at 91 Monetary Polity Report to the Congress . Februa The Federal Reserve's Responses to Financial Strains In response ro the serious financial strains thai IL-VEI. (InrJcpd, de*pitr> hciijtiicmxt rjciFTi-inri for August, me Federal Reserve has iif|UKMy. tiifflrfecuue r^der^i lunds >ote ^ai en a number of measures lo foster Iho somewhat helowIhpl,srgal lor a tlirw In August normal funciniHmg Of Hn&TKftl inrirkels rinr) nnj KJTly J>cp[pmb?T, ris Gffnrt&tn Ji*?£rp ihe rrilt? thereby promote ili dual object ives ot uuiKimum near the [argti wnrs Fmmf>i*rE?cJ by ificttflteaJ FLi^- employment and price stability. lori urTd fkUhCW in^iket vcil^lHity] Afltfr ttw In mi d- AUGU st, the Federal Reserve, as wall Sqpu?ml?pr meeting of tile Ftidoral Open Market o> sever al foreign central har>ks. irx* actions CarnrTTHtBe. cunrjilhant m uvermqhl Punijmq rjsifgrved to provide liquidity and help y oblige rflerk?(5 trnfiroverJ furthef. The Julurne of loans markets. On August 9. the European Central todepository Institutions madet hrough the Bank (ECB) tiontjijctwl Ein uniichietlijletl i«n- (!•-.':(i^jnl WlndUW iHciK*snl Hi (irr»js INLIIN- tiEr opuc;]LJijn in naiionm lo ihofply <:Ffiv*ifr;(J fiF tui'm loyn^ tr) a re1fliivt»ly siriall iminhEir of invltUlHifw. but il mnitimed rj^ncraUy nndeiL ariran it rcpoiitrcti WVETJI more tinins lr> 5tJtJ' ate. Institutions may have been rnkinurn to use *et|Lnsrtl wpelv^. On Augnsi 10. •sinnluf strei«i (ht thy.'SurFt window, imbuy* rtdrirtg inaithBit umcjqorl in LP.S mnmey mjrkeiy ana Otc F(fd- horrnwlng woutd noccmo known jml would be eral R«fjrvb rtrJrjfrtJ tubM^nriak rewrves 10 meet soar by creditors and eaunleiparties as a sign of heujfueiitjcj cJenwiKJ for Fur-Kts Proin hanks. 'in.trn.jjil wHriknc^i—IF* ^u-calFmj *ilr[jrtiij |jrob- ShnrtLorni rnuTkcl^ inFTisincrt under ctinsulrf Icm. NonclherE55. coMtitnral pJarcd riy tj-inki <iU1« preii-ufF! ovei subsequent tfayb rje^pilf Lbf dl the discount window in anticipation ot pos- provision oT^nipto ^qi'ldlty pn ovcrmgN funrling sihirj hrflrnwinrj rose uli.ifply during Atrgusi and mockers J?y rnc Fetihfrai Rewfvt. the ECB. and Th 5c]3lernbor. whic'i ?ugg«i*?cf lhar sonne twnki Cdnirai bdnte orcrth^r nvijor inrJusumlirtd coun- viewed the discounl window a ta pniontlally tries On Augusl 17, the Fetidral Reserve Board .inriraiiiced a narrowing oftut spread betwutn Pressures In (tnandal marke inu Ftfjuriil fund^i rate dnrt I he dlhcoiint rate Trnm time in tne fall but rosrs again Inl^F r'n the yaw 100 l/jin. ijom^ ic 50 birti* prjiTit^ ijpkch ciTdnged On Novembei 26, theTederal Reserve Sank Of fJi^couFit WJnriow Ending prflcncr*i ro JHOW ibc New York announced some additional modest, provision of lerm financing tor as lomj as tturty (f>rri[i[>f;jry thiincjeii lothe SOMA secuMiitt tend- dayy fsrmwublH by Itie tjorrower. To ante p>ei- ing program that wera dtBlgrte uto runner relax SLut^ in HIM Trtaiujrv iTiafVei. [hu Fijtj^ral Restffvr? Wit llmQdtlMU on htKiowiny IMIIHUJJ TrfMSiuv Bank, of New Vori tannouncer) on August 21 seairities anb to imprtjv^ Nm functianinij of Mnv? temporary changes to the term* and con- the TiwtsLiry mflrttMi M ^ciclHrort. 1hR New Vbrk ditions of me System Open Market Account Reserve Bank SfUBH Wai the Open Morket Trsid- (£OMA) securities lending pratrram. ing Desk planned TO conduct A series ofterm Tim Federal Reserve ' Rtrtiru aiihiHued some npuechme *|feem^rni tliui wourd fix^jnti wvt oftna desired ff:MJhs The provision of increased ti.:< IT en id ^nd thbit H WOLIILT [MOVI;!^ sufFlmcnt llt|Lirrfiiv gftnefally ^ucccttJiEd in kcapmg Thn reserves to resist upward pressures on the federal ted&M furKfs rriio liorti FitkKj anuvi.' >ft mlt-ndisl funds rate around year-end. Dun on Derajmber 92 i at ii / Reserve System 27 12. the FptJwfjj* fti^t'»/•.'< niij SBVtfBl Uinjign <0WM tn iU** Innurhry nnd f »?btunry BUCIfOni Dflncral bank* dnnounnert ;• cmvdJnijyid cfrtwi Tht? lower ^yc.wj dpptwfrnriy rtjfiectntj somy to Inornate A return in more-narmiti pricingand iniprovcniBnl in bonks' accea to tRrm fujining Purn;liunmvj in lorn hnvUmi ffiarkoi'j As pflrl of •iNi.i me him of Eha yw Anrnjugn i^r>irmng UiJJi effort The Ferfffrjji Rcr*rvt flnncKjr»c«l the itm Impact of Bw TAF on Financial markOi ti creation or a temporary Term Auction Facility not easy, a declirw in spreads in term Funding |TAF) TO pTovldo wcurtd term 1uncling to eligible markets since early December pro^idm collie c1f.h|jraLl[ory iriitjiuttons ihroiKjh an mi! umi tividi?m:[> thiit iMo TAF may have had ftfflftftclnl rm?ihiiini*i'Ti buqinnirHj in Tnid-DtrctrJiibcr TIir: eFfocls on Financial markets. The initial expsri- Federal Reserve also established •iwup Nnei UF>I.O v^itn Uic IAI iuggcM^ThaT il mjy WGM be with me FCB and ih« SvHn National Bank •! LisififLih «orn[>l[!niynt \o irw discount wuKlnw in (SNB). which provided dollar funds that Those sonvdfGbnwancBt, ond (he Ferja^i R^str^r: COnirril UarikliCOiJlfJ lend m thOn-J<jrlKJiCLiQ«15 Dt^rd will coniidflf rriciking ii a pcrmanotn .Edi- At Ihr1 yirntr tirrnr, [Tin ftjinh c]T FnqlFwid iinrt Ihc tion to the FnrtcTjjl fieiicrvn'^ avoklnblu tn^lru1 Bflnk of Canada announced plans to conduct ments lor providine liquidity to Ihe banking airTiiitK tarn Tijnci^ operairjr^ in Ihtir own •£EtSfn The swap ama ngornonts with Forsign central brinks a l lawccl For up tG %2tl billion in currency auttiutts HUB tar, iwo of S20 uill ion in Decem- swaus wiih the ECB AND up to S4 Billion with ber, iwo ul S30 6lliion in Ipnuary. and Iwo of tin? SNB Drawing upon those lines, tha ECB HO C'IIIQIH m February, ^hf riuchtrns iiiirr>r:(Dd a cJuctJcmRO $1t) billion in drill or 'UPKIS O» l^ccem- i^rgej numtwr &i lt\iiti&$ Tht* r^titi nt the dollar bcr 17 rintl ynothfif 11(1 Million an DtH^fntMr value or bids TO Ihe amount oFfeiod (the bid-to- 20 in coordination with Ihe Federal Reserve's cover ratio] atthe1wo auction s InDecember TAF duL^JOrft. ThMj SMH aufiUoriod $i bllllcm in Was HUDtil 3. The auctions In Jnnuary and Febru- ftJnrj^ 0(1 December 1 ?. Thtj rjidtD-covrjr FHHOS ary wwtr iciTinwnol 'ewovcif^i.ibH".r»htfd. with at ths ECB and SNB auctions in December hkd-TD-tCVtr fdUDSO* roughly 2 on January M rjngc-d between 1% and 4%• the actions WORE Fetnuary 11. and February 25 and oT TK on tan> considered successful in helping togive foreign ouTy 2G Th'? lo**3 bftj-tO'CcrvOF niOos »n iruw; ffndnCriei instttutlont acvcsMu Additipn^r ctotlai akXiTitint irwy huvt* u$feevxi improved liq^idiiy Funding. The Dfi^omtwr loans were renewed by i a n n d la . d F r o n r F lh ir i t . i J d J ir a iy n u ii a u r a y i tt 2 e 8 b . a r u ' c •• ti - o n I a . • K • R • T •• A n u . n M te I/ r U M M m I - sl/tj.t b h ld e - t E o C -c O o v fi e n r d r ! a > t N io 6 s a r t a l n U g .r in .h g n r f r r . o m in 1 I. T m A u t m o 2 v V w t i T tJ h i e ty about ihfi monetary policy action dmt would ECB and SNB have not conducted BUOtBq in be laken at the January 29-30 FOMC: mooting. February: ECB officials have indicated tbal con- \he ipresd of llie inlwoM rjtc for thL- auc- sideration would be given la reactivating, dollar Htmed Tunds ovrjr Itiu itiinimuin tid ndB 0• "•• J .merums nr ounrjiticit^ ctppeur UwvCStf Uh •vL-rn ig IH -l ndex- swap rate correspondinq to :;•!• i • -1 iv i..lHn hi in- H.I i . i..-i 'i. if... 111 •,-,•• i . abuut S(l hiTsiii fK]inti In Dcjcurtilnfl bin was etary Policy Repor tlo the Congress February KIDS tFiiii'v unit I he MH^nL'nihlt' volalility in lluit in.jrfcvi ius all-A mon^n^e incite t> remain t:\M.'nh:iJly shullereJ. likely c.sacerbated in September by a seasonal reduction i."(}iidi[iHjnv tn ihc marfci'l for Icveru^ed syndicaled \oant- in bill MifTb r"Jid-;i>ked .spreads in tin.Ircisiirv bill htVd v L>rvt"iif J. and ilic fV»n^iirJ vnk'iuLir *.if <H.Him>itlcil murkei w]deik\l MibsliinliLilly >n ibis period dmls uin. ^ibsUiohnr Ki>k %r>Fi:odji oi> ctirpi^mkL rinanciiil condition* a.p|vn**d in iwprott: somc^h^i Kviils wuLiiwii ^iyoilicinily u\ Jjinury. •md eu.Uiiy in UH« SiipicmbiT und Ottorvr LIULT Hn- Idr^cMhan- prices dropped. VU'si rc»:ciilU, deii^md Uus eiaptiraieJ txpccttvi reduction n\ 5(1 basis pumt-f m lite ledcra] IL-IT .HJvlioJi-r.iiL «CUllliiM — llllljMcm) drftl {ntUCh n! funds i,iu- JI ihe Scpiejnbcr H)\1t" tuccim^ .md .s luw, uhtcli » mutucirul bonds>Awin Houim^ itilerbi rjies ciiirouragi tin rc|KMis on economic :Kliv}ly Spreads in lhat :IIV icscl Jt friM^ntrnl, rc^uJai .uiettuns Jiul incrrvhy nu[i\ ^IH'IMI'IMI funding in.nkt'lN pariiatly n/wc-ed tmposetf higher rules on ii-iULT* ami minccil liqutrlity ihi'i? AiimLitl run-up V UiJ-iisked spreroh in llu* mler- si'i •=11TT..'PIi holdtrv dcaler market fur Treainry hills werea hit les selevated In Jninitin =inJ rcbnuirv pn^kfii^ al KVWl linjin- ihuH (hoy hutfbeen in Aog^i. lt<ji ifceTtMMU}! hill ci.sl ^ii.ir^inTiiirN niten^iliud us rctiiny iiy^icic-- ;md mv^s- m.irku mripei] tJun. Lir'.si wU> vn ialdiik .ii mm roj> bnidoie more kJOiKcmcd diat ^uanutloTa' espttsilnc* lii Uie synd^utirtl lo^ui [u.irk^t. mipEicd L CDX ^[lu.nk t^ that hold asset-hacked p;inJv KVWMl their suinnnr jcurgc. .iiul BMBC rinilnbii- lioa- backed hy subprime rest- lion-ilol|nrdiMls were succt's^ftjMy pluct'd I;I tlif m:it V-ci. \k"hn:il :nn]iL|.j^L>i had uitpcf iL'd ihe jiu:imniorv" AAA However, unde rwriting banks ICR forced to take siz- T.ninu^ liulfCi], llic r.niHu .iuL"rivie•* (imvn^rLideil J lev abk*difi'ounls trum ptir v;ifhf 1u iinlli-cir in^CAliirs h> liniincial jiunmnlon: iinii pul vim: linns on Watch Icr purcrVjx: Iht- loanv. Jhd <hc> recoiu-d ^i^nifitant^1 possible do^ngnules: 1m»ni:ral jiU*ranli»rs'etjuily pntcs liirtcr-ilnm-mk-iidvd poriknb ofUmlsoii ihctrown bnl- declined, iiod^redii Jefaoll ^w>tp -j-iv.nl^ mu;i.i..l A ahkic ^1IL'^1> I tit.1 hmpnivciiifnls in in^rV^l funtUnnifiti nunrhcr *>f ^ujranlors iire undertaking cfTorts to ^flViff jirtHftl IB iv ^tiort [ncJ. in pan HL-CJUSC off fimhcr 0BB linnmujJ ritrcn^th. L\oisv?inti: in ihc uulliKilt l^i t\w inutMtiu sct'lor^nd F ni.ilKiHit tU,lfjnlors lij|^-c pLiyi.-il ;m lin|ioiT.ml TOlC J.WK-i a leti L-LTHLLCI ii n ulnnrt ^t^ihlcr^nii.s:is an hii:nu.Linl in EhL' nuiikijis lor mumei|iiul S>mU .unl fot some %tiucr- insliCuEions and ihc ctoiuuiis. I n r LM.1 linanee proditets by pjvsnlmu nixinmee a^iiin^L The btnnns in hri.rui.tl m-tiV^i^ <rHun>t1ii."il during default. Jlune fnarkctshavcalrvaily felt Jn'mi? c.fleets Novcmht-r jinJ DtvtinKt. Ilk- -jsndkMtal lir^ii mar- liruni ihe <\rv^ til Ihe linantial ^our.mtors ;mJ could Iv kci htjjiim ground <o :i luili_ iind spreads- on ihc I C\>X more substiniiiiilly sffecied hy uny ttuure downgrsdes. HLJL^L1^ moved up. Tim hoi^litoin^l uiKvnuinfi^s jnd The ilireci ovpuMucs nFL>\S- baflk^ ^.^ loi*» (TOH> onpumti financial lumioil, jlunj; toilh ihc d^m ot d^win^mdes of ^uajunuirs' reiir^s through bJiik-i' fin>;intLifll itHiLiuiioiu i*>sho» s.)kl Ltud ^i|itid u»tf* oti lK>h)in^.s ol niim iciptti \t* ••ml •> JIKJ cre^n proiecuon on tUuii ycar^nd HWnimiTtL ^L:ripened ^i^intig.ini yen- sinicmrcd products ,ip;vcjif lobe niod^rjite reljn^e lo end prtrshiircs in slmrt'lrmi hindinj? murals for the Ihc banVh1 iiipiial. LJni J-.IHIIC lut^c hanks aiul broker hm tinif HI srtcfii] years. Spn.Mil> on WK'-monlh Lihur dealers cotild experience signilicanl E'nmlrng pressures and Lerni lcdcr.il Rimly>li^l up m liUc Ny^mk-r whin from structured produels lied lo municipal bondsthat ihcir mnluriiics k-ros>t-d yc4ir-cntl. Similarly. spruMnl-- rni^ht return luihvir KITAHCC stBCTf ilLi:njrHirnor%aiv doHn^nidfd tal<vu ipct:hfit:d ihrvsh^ldvor if invc*- her over the penod Simhg demand tor toft chdostr UT ui>^ind their invc^inid^is m ddvjrvcc of s over year-enddrove yieldson shufi-^Cfl I;^i-iL:JV hilN iiLiUitin^ m cnrly ZiHK ut Juu- kvcis. ,niil Ahlioujjk IS HiNiiUviJil in.!ik-.'i?i LMUI inMilutKms liqnuliLy in lluil muricl uj-i mipitired Jt (nnf%. hati? eneoumenrdeon^idcnihk' ilrflKiilhcs over itic pj^l In mid-Duccinhtr, Ihc l'cdcral Rescnc nnnounL'Al several months, the linancial system entered thai period nvnlinulcd M\\un vyi\b ;i MlMIlllff OfOrtMf fWliltl ^iirsk^ niiili soitw Jistintl ?i<Fk"iiL[(Ii*. In (Kuiieuhir. inosl Lirj^e lo hdp liictlitLik- a rvMm to nu>nf-iivfnul pncinif JIHI liniiihrinl itisliULU0Fi^1ihii}slrt>ii^ Hipilul posiiionn. jnJ tuiK'liumny H> li^mi funilio^ m^rkebi- The lilTntTl^ i>f UILL ihc fiiinintini infm>lrueiurc v^ji rnhu^t AtlVtotjuti RUN cirnlral hui^k^ u^nbjnt.ti with Ihc piL<isufc of ycar-trnJ. Ijrye I[n,iin::JI Misiuuiions haxv e\j»ei k-»ted ^i/able jppvdiMil io Iwlp siCddy sluirt-tcnn hi^ncidl nurt^is |OSH% (he sector generally remains healthy. A number in caHy 200K- So Tar ihis >v:u, ctHnnu<xi;il puptt of ihc (inns iliiii btiic rcporicd si/jhlc unie-douns of spreads- both lor ABCI' and for lower-ncr unsecured asuLi ta\c been able lo mtsc aitilthonat tapiial. MnrtttM [\tpcr JIHI Lcnn hjinL riiiKliuc sprcjds have dmpped. inlitiMciiHitii" ILIr cleann^ and vellkmciiL perlunncd jhhnii;h ific> rvniinn nbove the IC^H_-|> ihnl profiled well over the year, even when volatility spiked and trad- before Inst Au^itfl. In n»nlm>l. Ii^uii1il> in ihc Treasury >u^ % olome$ WWI vtf y hir^c. hill market ii • Ivcn incon^isicni Ilicsuhpnme oi>d Mnr^weTT noi all ftwket* eKpcncncod 94 t iovvrtmrs t*( fhf I'vtk-nst Hcsvn-c M:\tcm 29 t. For instance. lh« invc.stmtnl-,gradc corpo- TlPS-hnwd intloiinn compegaaiiOT. 2l H I •• i Itg viiie bond :rnarfcei reportedly lunciiontrd well over rnosi of ihe period. nm\ (IK unsaMiivd lugh-gratk* commercial I paper rrtarkci appeared Mitle affected by (he dilTkul- tics encountered in oilier short-term funding rnnrktMs. The n of consumer Uwis and conforming residermal &afigtg-l£fi wu rubitsi. Despite a lew nn table failures, hedge liimls overall seenied ly hold up fairly well, jnd eounlcrpttriies of failing hedge 1'UIKI: did (lOI sustain materin) LOSSE Policy Expevtaifons ami htwrest Rate* turrcaii luryict fnr the federal Kinds rate, 3 percent MlK ht-l^w the lev«l tliut inviUiiiori expected j M W Hy 21. JWW. P#«lcq ut the end Of Jims 2007. Judging from iururcs quotes ,1 T <.tU 1 iipntiM P Xii 3 ut ri i k- ji l L-lil U c T u rve IMP (IL-I ^ VJ M IK tillUl«.in-rm«ltacvl «<<i.ur1|gtr» at that OfflGi nturiffil pur!ie(panK en;pceied the FOMf i I r-fJcra.IK.wv.: B ici shave al mosi 25 basis points troin Ihc fedora! funds niu by Fisbiuary 2U0K rytHier thuii Hie 225 basis pflitUB that lia>> been nialiifed. Invesiurs currenlty e.\peci ah,jut 100 bjMH |>cinLs of additaonai casing by the nf tbt year, and Ira-yem yields shed ahiwt K M) hsisia tfnd oI' 200S, UntWrttHIty about the path ofp(ilit:y bad points, rreasury yields fell signilicanily more in early been, VL*ry tow during tlier first hail'ofthe yual, bill u 200K, CSJ^CIJMV forshorteMenri sccuntics. as policy increased appreciably over Hie summer and generally t'xpeclationa shifted down in response to sigjts of fur- has remained unjiirid Its king-run hs^ioi'ical average ther weakness in Ihc economic oudmtk. As uf February since then. 2IH ihc Iwtt-ycjir yield was abam 2 pirrcenl, ani JiW kLn- Miln'U^li lu-miii^l Treasury ).\vkh ri*w somewhat ycar yield WH ubtiul 3 Hi pcrttnt. over iht (Irs-t half oFlasl vcar. rales subsequenlly FCH Yields on inflation-indexed TnJitsiiry BfiCQPties nhu sharply us the outiotvk for the economy dim med mnd as declined considerably in LIIL- second lutlf of2007 and market panicipants revised ilicir ejq&GtAfQtiS Jor m««n- inio 200H. TIIL' diffcrtntt; between thu five-year nomi- etary policy accordingly. Treasury bill yields declined nal Treasury yield and the live-year in(I^EIion-indexed lo particuliirly low levels ai liimcs l>ccuu*eol'inciTasctl I rv;i>nry yield - five-year in Mat ion uouipcnsutittn -- demand fi>r sa fe and liquid assets. On net, (wo-yc«r yield* fell rOlJfihi) I8U basis poihttin ihesecomJ half Spread".1* n!" em [Mriilc huHJ yltiliih *^t*i T yields, hy stfurittn rating IWS-2flfffi [steceri t&a m wltttcd Tir;ts«rjp 1 1, am : MB am UT an dlnwn HP* fk: !(1dA .«i kn.v^r hiwd* t ..! ltir.i..i;|.t".-;fi. r, ••.. i IKIIVIAI I I 95 epun in Nit { \ R:bn(nr\ 2 ed^i'd ildwn (HtT Ehal [vrnsi. ML'.in^hik1. I hi: [en-yejr inflation curapensatuui ISILM^HTV •_• 11in^cd lilllc, As im^il earlier, sun cy-hu»:d merlins t*r*hurMenn infl.uiwi fs[Hvi.nri'rT. rose u)mewhnl in 2'nl7 and emly ifhjw. prmtmnbly bccmuc <<f the tucrmic in IKMIIIHU- iiitta- (ii.»ti. Snrvt\ w Lin i ires ofl^n^'Menm Fi;f)mion i^vi-fri* lions changed oilty slightfy. Yield* itu ttirputtic hoikls tinned J b>i i>vcr the lbs) k»U »t'?<HJ"\ uiiil spreads oh hose yields over yu-JJ^oii eompjiable-iuttfunty Treasury sectuilia dumped Iml-.-. im net. Sin4:f JtniLh r yi^tds cm AA-rjtcJ Lrorp^rjU' IKIIKIS \i.\\\- dccrciiscil MiinvTM'halr on nci u-hiV Ihn^ on Hhh- rakd hands incteuscd stitjhlly: sprc;uh tm AA-naLtfJ und RHm-rdtiJ bond* lu\c nstitabcul *M| and l.iOhu^s ivmus a-spcdixcly. Murvi'vcr. yitkli ui^ ipwtiUl^c- L^nidk- sccuriito Itj^c incTCd&cd snbsranlidily o^tr rhc BOQB p^fimi. and their snnrart> Un\c shO< up altiuvu pushed hrimJ intii?\c<t iti^n uhoul W nchccnl. Equity Markets ilk- iidniinuoJ uttLvnuimy surruundin,^ the ulnnuiu bin:;iti(.1 di;itnbutifin ofljsscs from ^ubprin^-rfLitcd Urn iHui equity indeu.** lodged increases of around and oiht'r invcstnicm pfinlui'tii. us w^ll n> iht? poi^niuil 10 percent over the lirst IfcilFof^tfl? hut then fan trffevis of tli L' HiuLficuil luminil on ilic hin:nk'[ cirVtnniny. gmund over the second hull", they ended the \ LL,<r unli cnniribuicd \o Inyhcr volatiliiv in cqmiy m.irt.ijr- und yjins<*f .1 percent ti>(» pcrccui. The intrrczsc reilecticd A siwider equity premium. The implied volatility (if Ihe S&P 3lK>4 rti- ctlcniiiti-J thwii options prices KB* tiflflffi- tors. pjrttk.Lul:n*ly jnerjss, TWMC innioulv. jnd iccttnoi- •:.irnl> in ihe >etund JMII ••! .IIHT and r.Tii.im- •*•[.,•. ii.;.j ogv. By onllHt, •Zocftl indc^ci fin ihc fiitjiwi^i Kcctoi rite ml in ort^ol^o-month-rMrwiird i:\pvcioil enrnmgi Ml iihtnil H\ percent in ."UMi"1 H iiniMms rejclird io ill to equity priceiL ft>r S&.P SfMi fifnn bVRB0d9VtrdK lalinul It^cn the problems in the vith|prinkn unTtiiiijii1 -,-,.• 11.1 hrifof2007 nod iota -<"i.v while uu- tng-ian sector. So liar in ZOlW. ^nn^mi! corttfiiis iibtiut the ret real Treasury yield decreased. Ilk- dittertnce belween fifnnif oiiMi»k. alonp with aniU'iintcrnentb ofddditi^ri inesc nvij xjlueti ;i nicuiurconhe premium lii.ji subslanltnt K»s^Ci at Mime lirge rtiuintml linn*-, luiu- invcihtuns revutre Im liol^iri^ cumtj slvta, lus precipitaled a widespiiad drop IN equiiy prices (hat li rc--iLLhcd ijit:>»^ii end of its onge DVS ihc pusi tnenty n*iH> into trquil) ntnlusl funtls wen: hcivy early in Z001 bill slimed Mic^i;intinlt> LITXLT IIIC rirsl qiurtLrr fmlectl. eguil> lutids iliiil Utciih.il *<n dtmicsiTC holding CApencnLvd ^on^i^lcni net onMk<u4 hc^nmnii: in Ihe ipiing. fl> contrast, inflow•* into foreign equm lunj^ HLM up Through the end of3007 ik^pire die ^eakfie^s in many foreign slock markets in the Iciiirth quarter, estic and fore ign equity fands experienced K mMftnnc w JmiuHry n e^uuv fincv% imnhled ti1« kiv. run f1ou<v^ppcitrtn Imu1 *i.LhLli/v(l in Debt and t'watti'iaf Inlfrmtriliafifirt nit nnjl debt of the domctfic rhinim^ne^d scdon uppc^rstn luivii cxpuded JIVUII K percent iti 20^7. 4 Km nx i slightly dower riiic of gnmrlh ih;m in ^(HM>. [lie *|ow- 96 Board irf Oiiwrnitn ttf the Fmttntt Rex&w System 31 Clwilg? til MII) dnmostfc minliniiHLiiiJ *fcht, IQ*»l-2(Hr7 mcwhol fasLor in 2007 than in 2HW\ which is wn- i with StntM SuMtlruttOa of nurmnrlgajie crt-dil lor mortgage credit. To land THE rapid cxpiinsion of ihelr biiltiiwc >hocK coinincrciul banks nmmly LiLnud iii a Viiricty of oianiigcd Mobilities, Inctuding large lime dK^OShs anil advances Ir-oni f:L<d^ra3 Home Laao Bank^i. I): jiiJi. . a,t\ti ,IJ _I'L i,•= of litivign bank-s ulsn tapped ihcirpartnl instil un'ofis lor funds. The growth of bank - / \ V / j c o in r f u o n i M e v c i i l u s r L l i o 'T l w i O e ^ e s L d a J n I i d n in J r m a c n s o i u K tk a i ' r n y o ii t i h 2 i ( l e K ! r J n K k n x h > i r « n ig s c a d a ji t t e d e s g i n o |» h c y a e r t l 1 l i ; y n . a iu ff > a I( e ii i J i c gh o i n- IlinL profltj declined Aignilkiuilly in 2W? as- faliom - l frum (he stibprime mortgnye crisis and rebied finan- i | i | trijil dismtptions caused tr&diny income la plunge and tiUJ IW5 IW7IW IW7 IW'I 3KM 3«Ji n Mi^ BSfl \o& provisions to rnoir ihnn double from ihf previ- P» (frfa »iv MilhIMl =1h.lmHM«««ath iViv ofileaiwill!.,-.s pus ye-jr, OVCT the SfiOOdd hall "of 2007, thu reliim on N 4 Kitj» mi i»> nw k< • tinii in 'Ik- mmtniK \m, v*|w iur: $£&&& and (hi; rcliim on uquily btnlh dropped to lewis SMM I ledtMl Ke«rw hU-ml. ll^i, m ftah AH mil se^n since lite tEirly L99Q& Weak pFoltl^ or oitlriglit losses, along wiili significant balance iheet growth. ing rellecitrt! a deceleration ofl umsehold debt that wa n aha pui pre^suiv on napiiyl Mtros JI Kane Ofte largc-St only partially olfscl liy a etinsideniblc step-up in bor- y number of bunk ing rowing by h uM nesses and governments. HK^unLs OfQSW capital Commvrcin] bank credit && Hlli pirrtvnt kiai war. in tiw Kcccind halfnf 3KT? and early 2CH1S. Loan dclin- ii piukup from the '^< pfivL'nt •; • i• • in 2(N)o,17 The qucrtcy rates rose ooticreybly for many loan c accdcmlron of hank Ltcdil. 0S well as the diflVrcnccit but especially i'nr rc^idenMul moFiga^Cji, ctin tn growth rd(fs ft(9tea hank a^SL-t clLtwci. reflect U\ p^ti lion ami kind devdopmcni lojuts Hn.iiteing res^k-nlinl ife edfBOB of the financial inarkcl distress. As already projects, and other constinciion ami land development motet), commercial y]>J industrial (nans surgfll in 2(HI7 loans, because of ^Ktrem^lj1 rapit] yrowih in ifie vcirtuwj half (Hher types ofnnancinl iiistitmiions nl«i fatvJ sub- of ihe year that HI pan resulted from Ihc inability LM suiniial cliLillenjie*! in 2tX)7. As a resull Dffl&$K]$ttf£fi (6 banks tu syndicjitc leveriiyt'd loans. At various limus sniibpnmt: Incins sunn.* IhriJl instiluiions liad signilk-nn< over the second hutf of the yt;arh banks' balance jtlwm losscb, S^venil of the maior invcstmcnl banks und their were t)(xns.[L'(J by cMcnstotts of credit to lumbank IIULLM- fttiihnio booked lO88£$ on morlgage-rcFalfd products CKII itislJEutions. ii category iliiir intlinks ki:ins ut AHt'P ctnd olher exposures that weie large enough to lead programs Ilial were no longer able to inaue commertiol some nf them \o raise aiidiliortal equity cofjital- paper. I hiou«h the ilnrct ^tiartpr ol'2CJ07, ihc ^rnwlh In Uie thirtl quarter Fannie Mac and Freddie Mac inl'rcsidciilijil mortgages {including wvoiving home equity loans) was "lairly robusL Nil the ^aluc nl"such CoimiKTuijil burin profilabihty. ImnS on hanks' books cuniiTiu;l(.*d tn (he loiirth quarter The ivvcnjal Ilkclj slimmed from a 5tcppcit-np pace of iV«m I'n;Mill H'CUM i i/iii i<un of con funn ing mortgLi^cs stud n ^ of new orignvudon*! in response to the weaker I U •> I) ynd ilie lighlemnti of lending siandards reponed in One I )1 SenifH" Loan Ofliftir Opinifm Surveys covering the I ' M M eq K u o it m y J l o l a i n a > l > fo p f ic 2 k O t E hd J7 . u T p f i i e n g 2 r W ow F t . l i i ^ o n f i r c e u v l o u l r v ly in g la i l c io i i n ne the i i i ii V 17 year; bcciiLi^c i nk--; mi such lozin.s are generally lied to ' \ J Ml ithttrMenm nmrkci rales, which declined over i\K si-htoud : — halror20()71 ihn fomi ortiniincing may have bcwimir :V - relatively more attractive. Bank consumer Umns grew it I I 1 I . - i i J i .] - I 1 It . 1 * 1992 I'JftS 1WB X»t 3IM- aur? fur somt slulfcs ofasMU u •* % jILJ m a.nnuul unJ tiLriiJ |JI<HU[II 'JH* ? Jlli.l Hiiiill.jiil.\. •ni''Ui.tii i-' Ili-.!.1 idLiUiriL1 lr,im ,Tni i fannR] iii«iiuim»^> fiaBaimNM1 Joao It,QMMW ...M n L'-lmner. and a^si T-UII»I IS:1-, und SS H'.-|--ii ill i HI,I.I|M> | Illunin' •'< '.I I I'..; 97 nT Monetary. Policy Report to the Congress i Kebruary 20 M2 grimth rale. I fciuiiy indexes in MrlcfEeit wtvmicec) Gscfga cumatnilra. IJQ IOT i..KM gnu jwi aw :uii7 - The Jirj tK inmtnl on n fiMBih-quancr nwir fiiuni(i-i|Hrt»iL'< n»i»i.M'tufreik'j, imvflir'tetBiK JcnmiiJtlepotia. inii*i Lfa H*. tic lJuIll LKIl! M'L'L'klV. hit; lj?l lJ«-_'l%l*l,lf1H till iwh *<ni."S y 'Mi"fnjj**k'poili»( Iniiibdlni moiicit iimM *ltfpo«ti wtv-oihilti slowingj irowth weighed tin investor scnlunem, mm- cnch c^ptncncL'il si/;ihki losses on iht;ir morlgagt.' kol volatility ruse isubsiuntiiilly1 and oil »ti mosi major portfolios and on crcdil gicnraniitrt!*;. In response- f foreign stock mnrkel^ fell. Despite Ehc rocky end lo me Hrms raiscj .nM'inuul equity. The firms ntsn tighltnctt year, rnosi majoi' equity indexes in the advsinccd foreign Liiikk'nvriting slandards slightly anil intrciisa! flu- lets OBBttttnaeSt with the exception of Japfin, linisheti bi&hcr ihitl ihty churyf to purchase som^ upui ul' UuiTii. All on MI in lociil-cmTcney icrms coimpmred with die hegin- nisi? eqimf. ihcse chai^iis wuukl bt1 cxptrtitd in iiKTCwe ntn^ of 21KI7. However indexes ot the stock prices of borrower ccwtM fpr contormmg loans. niuMiriiil firms MI Iho^e QBBntiRM declined Hj pcrcettl iu Mi percent1 he firi3inti;sli turbulence had less clTed on ctjutiy prices in emerging marked, and MAST major The M2 Monetary Aggregate I:t|ii'iy ind T^irn;- in.,irkri L- M2 grew ill a SUIILI ru(L\ on '*i>\\ MILL1, in 2007 and ihi.' early part (iiL20fl&. Orowlh Wiis snpp<)rtt?<J by Ucclincsi in [he opponiintly TOST uf holding munty rclnlivu Eo olhcr finuEiciiil ^SSffls, The ciin«idcrabl£ growth of Hwni-y pnarktl innlLiul IbmLs gtso buiitslcd Vf2 a^ invi-slor^ -"""tifii the rcblivi: sjslc-ty ul ihust- MijLiid ssflO amid M. m the volatiltiy in vtirioui linaiittal murkcls. Tlie currency - toimponciH ofM2 dcceleratid rurshtr in 2EMJ7 from lite - r .ihi a N lr p e v a e d n y ib t c tp r i U d ir p o i u i« g li i n J a 2 n lM ua lf r t y i 2 t 0 d 0 c M iu , a p llv ro b co a i b V l t y ra c b T t i c ;d a u tr i o i i o n f - / a al reduceJ detnund from forcijin SQUcefc&, _ i -HI ^ "^ EjniLi}Ui\g AUD — n., International Developnitnts 1 1 AM at ittternaihttal Fititmvial Markets VIM niL. jn ^ ^^L^. tbc liW *»h*urvdiM.it |iV GaVtl «tne> ^ l|*f incfaicf ftif Mirtiur, IK il.inmid RAnwy -1 SHH I i- ii..- 1 .inn A .„, Global i is,. HI . ;l mariicts were calm DVtJ Ihc lirsi halt . L m 4] il h L .1 h .1 ll . J j [ l f i \t\\f B h a'*n I ' I < JI C iii » i> n t i p1 Il - k . - i- 1 M uli r (MU |D H | H ii. IJ H i 1 e L m K il U .'* i « A ¥ m iV c * t » w iu i< i « it • v tf m itr u i K lit e u i of 2007 except lor a. bnefpeuod in lute Ecbruarv when iu>' APIL'<UlliJ. Urii'«l Hulk'. . IV™ The finpiyiiij* Aaiali CL .-, jre pOM, llnHa, liiLilailcMii Milijsfe MdsalL blv Ci]uiE> marfceis were roik-d in p.irt by worries abpm U.S. 1 » Np| s -VIHIII K'wr-ii I'jiik*,llt, IIKI 1 ILJIII"M( -subprimc mortgage lenders, After niidyt'flr, ,AS ihe gldbai '•, WK1 1- 1 .'HI A run it i•lk.1 On£0H| Amu MlD*uj,ii Suntijt *\<\U< financial inrmoil began in faffiCSl nnd [he po^ibilily of Ini.in.iu.'. .1 ".V:; 1 i-i.:. •- >i4 riiuiii siiMivhui i:.in,|h..il. in 98 ttuttttt ufiftmrmtrx of tin' System 33 ivliti. on benchmark government bonds in iefcclrd tl.S.diillur t&fihaage niie j^u ^ LUK-UJ lord tin ppmwutfws 2UD4-04} scJeocd nmjar'eurrenciaf. 2Ot Ma Lliiil^l •i - ) - - < - — 3 /^ — 1 :H-.. •">: nun • thi' skua, •HlK'h on! U* Mr ^- ri.r mm MM WL'L-WV- ItK IIU.1 T ! i i i - e . J i i . il.it. ii *y I > II, aw, emery ing-market stock indtprea oLirneri'omnetl ihcir v and Jupan ended ihc year 20 to 30 basis cunnlerpnrts in IM mlranecd economies. So for in owcr4 wn nd. while they wore ahuil 10 basis stuclt mnrkcis in both advanced and emergiitg- points litgher in the euro ares than «( ihc siari uf the economy art; flown Further us wncerns .annul glohnl year. Yields on inflaiion-|>rolecicd long-lerm securities grmvlh have increased, followed utiinilitrpmuem; inflation compensation (he Lnng-lenn hirad vislds in the advanced foreign eeiin- difference beiween yk'ldi on nominal securiliei m<\ omitrs mwi ivcr Ihc firsl hall 'ol'2tK)7 but Iften reversed courst: as invesKM-s rcnctctl to signs in many countries in Cannda and rosi! slightly in ih t;cum area. Since Ihc oFdMtrforatfOg niirxici.il condition a, e SD!woiBgoe&. .-jiMIL1 or 200ST yields on nominal seL-uriliw in mosi nomic outlook, and e^ffiettljoi© for a tawcr future tconnmici hflvc declined; yields un indexed securilits •••"! •••-.- i i iv policy rates. All lold. iliu >iei changes have liillcn in [he euro area but have risen in Canada. were tiol iHrgc; ttiu^-tcrtu rates in Canudu, the Uniied IIIL' •mk-d Kingdom, and Japan. The Kedcral Reserve's broadest measure ol'lht noni- inal iradu-wcighted fqrcjgn tJSchange valiu: of th* dollar U.S. diitlnr nuniianJ c\c1niiige rait', hroail ind^s. 2OU4-0R has declined blbtnil 8 percent nn nei since the hei:iniiiu ii*'rekonJiiiuJii*' oI Qffl. Overthe same periods the major currencies index of 'lhf dollar has moved down a bil mure than 10 percenL Tin? dollar has depreciated ahciui 9V5 percenl against [he yen and slightly more Elian ID percent versus (he euro. The dollar Kas depreciated roughly 33! J ptFcenl iigainsl lite C'anttJijin dollar and in Novein her brielty Luuehed iis lowest kvel in decades against thai currency. The dollar lias declined &A pereenl iigainst the Chinese renminbi siiiLi tiIhe hejiinnirnji pf 20f>7, and the puce tif ilepreeiiitum accelemleiJ lute lusl year. Ailvuittcii Foreign Evmtotnies PTWtin for t-mh «WO i-"'-. • • -•• «• •;• i'T lYhmiirif Ifl ihrcmuli. ) < - I n t, ^ 3 ln 3G n R ) ll H w K U M JS b d a k l i u lb i t k r - t N g la n in ^ n v , I 4 lk j| 1 u 1 IW ih.i 7 1 C W H& ( I d n ^ ( i< n i b I r k ip - IH jr IV n * i L j > ) I i > iiJ Kconumic activity in Ihe inu.ior udviiiieiMJ. ffn^ign econo- lunnmiaiit ItJ. llsJ|i|£ |HiHn£n 1 lie tittle1* VtV.'ii{lllt\, Klimh dui^ mics postoU rebnvely sirong grcvwlh &V& the firsl three K «fLL 4fltwd Run u.v fiim ikim aid Itatn U S, jnj fore*int qiiajlfiK Of 2DQ7, and labor markets, tightened. Howev- er, evidence .--!'.• slo\vdo\vn has ijccumuimed since me 99 34 Mnnclary Pulicj Report to <lw CongTCff febniary JOUft -uinmtT ] JH.UVI.I! nurU'1 strains iippeur lu IK W^-I^IMUJ f>Etii.-i^lfr tjt^cu'd 11111.11x'i ntfp in Mrl on jmmih m ihc nuym rrnnnffiiir SurvayaaffeNhn have revcnlcd ;i tighieninj: of credit suiniiiifds fnrhaih households" nnd businoscv Uulh consumer jriit hiisi- hn&conlklcrK-c have >lrtl>inceAti£ti*l. 4ind rculirui^ from surveys ofeconomic activity have declined. Retail vik'\ hum Anvd. and housing n wrists in a number of ceuiirues iliui untili rtenlly had bten robust- including IrvL-iiiiL S^iani, ;iti(J ittc L'tiiitfJ Kingdom- liavc SLOIV cricil According lo mil in! rek'JiM'v real ClDP^rnvrlh tor (lit fourth quarter vhwed m ;i number of counlticv A)lh0llllll fi-irt l!i ill J.ip.m i u-l- •I.HILI*.'L1 HI UK- Untnli ipcnJin^ hous^Imld spending huv been rtlaiisrcly weak, und ilie *.j<>n^imuimti nctH h;is tven dqw^scd by Lli:siijif*. ki it^tiliinims cbjt hii^c it-'.itlk'ii in Ivitik-- necks m reviewing building plans. Ik-adlinc rak-h ul inllitioti lute c<vihnuctl lo rist in . Ik" v^ll HP.XW.I nK; jr*L t nind LrncriiV pnecs. Hici^chv-monlh uhnn^c in ton* •*:IIHLT ppdtt iri i^ic eun> Jifca wcttdtd 3 jvrctrm m Jjiiiuiry up fmiri Ic^s limn ^ pcrt/cni jiisi ;i ftn niinufi-. whai higher infljiMiir major lorci^n cenira.! hjnk^ cjrlk'r: aorc infLilion i^ IHLII excludes ilu1 L-ltjnu^s in either have cm adtciul policy i'atfsor have rctmnuied 'f^ ft 'L'IHTJIN <iniJ mi pn VL1 s"»otl l'(H*t1t lui4- im^cd on hold since f:ne ,(Wi7 a cli;iii^c ir^m tdrhcrmirkci up J clf. CannJi;in mfl^uivn climbed ITX>FI> 1O* itian e\pc^tiilioiiH t^l fiirlher nmr mcreaiers. The hank olt'an- I percent laic in 2fMX> {•> jh*>ui 2U ptTtvnt in ihe 96C- ,nl.i MI til (he Bank of l-.n^kwd Ifiwcjvd their lurycts lor umJ hultof 2IXIV: however, corv inHjiioti has rioiictl >n tlk-irfnpcchscovcmi^lit rjti-s<. Ihe iiuwpcjfi C'tiilrui rvcciU mnntlti. parily hccdiist; ofihccooiiuucJMnrnjjiih Bank mid iln- Bank of Japan have kept their policy rat& i>l'lhe t ansidun {lipllur. Alrfiough inlijnon in Jjpjn v,a\ .i4 J rvrvi-iiE ^nd 0.5 pcnvni n>y*«ti^i;U (Rirtlur Ji>- close lu /em fur nw&t nf^LKV?. Mn* rale picked up la cosMon t>f actionii by foreign centnil banks is in the boh roughly >r* pt-ivi-nl =it flic i-ml^Tlnc soar, u^ain ni;nnlv A vnmled '*The Ix-ilenl Rcsent*s (tcifptwisc* ii> financial result or the rise in cner&y prices. Slnnns."! Faced with aweakeroLitU-k for growth bui WJtt I:/ttt?ty»itif!-,\ftirlntt Ec ^bjwed m the teCQftd half of 2I.K17 but was slronj£. In China, yoicmnicm pt^icy H-.C.IMU..- bclpcd nwKknj^ the ^rovvih mic of rtal GDP m Uw sec- ond half. Todpmp loan un>\nih. the government in 2(K>7 ivpcaledly miscd the rvscrve rvqnirvment r.iiiu .unl ihc henchnufk rale at tsliH.li bnuka can lemJ lo Ihcirtuv [ontcrs. In iidilihoM. ihe ^Ltiemnicni iticteittl hnnks \u iVtv/c iliL-m bevfl) of lendJng over ihc limiL twumomhd of2IXIi7di ihc October level CIHIKM: jutiioniie* als*^ • v allowed I lie min)nhi\mic of jppn.\iaiion ii> Mcp up in Luc ^IK>". JTI(1 the People's Hjnk oft lima lU'lcd in i(s monvlur^ pulic) rerK>ri ui November lhal il ^tmld bv using the emchange rate as n (00] to light infintion. M itrtvliiTC m emer^iny AMU, gmmli ni^pcars l^havc stepped down to R more tempered pace in -icveral COITI]- ines MI the M>:OIH1 h-M of ihc yt'at. iho^i^h generally 100 UottrtS fV inventors of the tedervi ttrwrve Snta* 35 In nn \cty MThTrtfr tat fh in ihc (\r>\ half. One foclM Sup- pfr\<iitftji gri>ulh HI ilh-St ^ipuri 'ikpcndcni ^canomiti anil dairy pnea twt Ao iMmicd ti LnnMiuipi^i .ip^nir-n fi>\H itoiV i: • -J" 11 m MSOl IfiUviU ..i Uk1 irf ilna*: p<IJKJUCIS in ik'i tUipifl]f LOitiuriirNiu* ^D^H mi of HK-wiirltl. rjpiillv and at Uw ptitt of ininul feed nio*tl> tjoi In Moxknr nioipni grcittih WK rruktratt in 2007 tub rivn tnfUlhvi row during Zflti1™ m huny fnk.*rK <tnd rtiMowtl mi^hly (ho binic pultem A^ in ihv t'nKeJ •\*J4fl cconmnics. including Chhu, ulwnrthc hnlLili Si-ii^ Hk ^rrnvth^ro^onoinic JctiMlv excfAlAl ralo fr* Hie HACIW month* ending in Juniury Rathd ? ptirccnl diiniifj the llnrii t)iuuifr Nil ^IktHnl In } per- ccirt in ihc ti.>Lwi1i h|turlor In Brazil •iiMlottur l.,alin inlXiihHi wn ihc WL'ftthtliaH ut'lhv \CM MI American LT>unlri«. jiimth u *> mtiwi • luiJLCIiik. MCMCO. J*H1 VcnvzucEu- ThcnK i IptTiilM^ in the pTK«uf ffKK) JWl flKlCHfirifbLHrtl m Vcnczucb i*a> compounded by Aimnlaihc to JI nvin connMTkT nritc infljinw MI nwnytmerging- market nxflihun^ FYKV ffcJihic ink ami gom* HCH.L 101 Part 3 Monetary Policy in 2007 and Early 2008 i the first half (>r2(Hj7. the available infor- anil credit conditions hud become somewhatti rn,ii.uvi |>omiL\t U* 'A ijairriiHy favorable economic fbfiCOM htuis^holiiH ynd btaisetsu. ^inicipnnis in cmtlunk dt&pnc Iht: b>nyoii^ WBPBWfan in [ht hoLi^n>Li rOMt" niL'-cnDLL^ iHn.ird inttUlwn jnd ROSRVB Rank market ,Indicators of consumer and business spend- pivsidents) imlLiI thai.u lin-iiikiits in the housing sector ira^r v/ett -.-ii - --.^:i-:- uneven, bul iheir ^juii^Ny pusilive hnd ihc poletiEFsit to prove deeper and more prolonged traiFkrl-nrit?s sujyscsird ih-n ifiu MfiiiMHL1 ntartitM develop- MniEi bad SOBHMSd likely curlier in llie yunr. LLIILI J iVirlhei ments were, as yet, having link' cflcd (in thu1 hinder 11?iLI_• 11 -L"11 •."-u 111.1.11I_L'" in the huu^ini; are^i reprcnvntcd ft BIJI- ecoafiny. Net (GfpQift, spurred b) pun by u Mlhuji JDIIUT. HI 11•-.-_iiii dnungidi: rink U> Uic economic outlook, \IHK-- wOnt ptiiv i(li fjjj support to uton^miL jirovviti, Outside oT (huliss. iuctyrnin^ ilLita indicated tirM econonuc gruwih I hc subprime mortgage iafar ,financial conditions In bntl itrcniiilieneJ in EITI? .second ijuyner. its JI fUffl)(<T ^iLntrLil WQQ (iirly feCtiUfffltiodMiVfe Thf Fc-J^rul Open i\itt- ofbostiKSS Npcitdmjj olVsvt a JIOW^OWH in opn- Market t pjiinntitt cxptctfd ctirc intljition if> modfidM RQIMr DUthyB. PUtiCipttQM tvhfwd 11 ml I In." cccnnmy irorii die iputwbil ctcviiiu^ hvcj ilui Imd- prevailed A r.Lrn.-iiikLil Likely to exnurid JII :i uunkTuU' p.t-.v in HMMJI1.- 'I., skin -ii iii-: -,• ii. bul iirJ. nuwiCfl ulili^utik>n IILICJ qitmicrk. suprK>rled in ptirt l>y coritnmetJ jjniuih in busi- (he rnncnlifll io nutatti up^^rd pnssune oi> inflation. Ai ness ntvcstntcnl and J n.iinisi gkthjl AQOWRHy, AJtlnm^h u DCdQht during ihc HIM lulioliht' year, (hi; CoQUfllOce core inflation had moved lower since the siart of the '. • 111 -1 -1 •_• 1111 - u- ••r L1.1 in its -I^I^IMLMI ihat its prtdciminunl yoflft fwriicipjtlts ^erc ^lill concerned about so CM I pofcy cooBcra was thai inflation wonkl fnH io modera H; 11." r 11 r >—inn hiding a tonlinncil iii^h level ot'rtsiJLiT-ee as cvpccicd. Hosvcvurh in r;i:i ewlog lo a&ctikaru of iHiMAiiiLfM I tint ccuild OLi^int'nl inHalum f>rcsMirc>. nicriM^i^ wctiknirss in ihe liouving «citT. Hie Cnminii- I lv\ I>_• 11u.•'. id Muil J MKt.mui! in.'LII.MIIUH in IIMKL1 tM L-iii|>liii>i/L'd in il'.- IWifinteRH issuc-d at ik-.- GPIfelo pressures had yet to be convincingly demonstrated. situs nfitM Mctr-ch, Mjiyr nnct Jinn: mciiHii^s lli:tl ils A^ Li EVaiK, Hie FOMC dttided (t> lenve the k:r^fl fur fuiurc poEicy Hctiopa uouliJ Jepcnd mi i!> • evohittQfl I he r i • 1.1 ij ra I lund^ rnti? LinL'h^n^cd at S'1* percent nnd, despile SOMEWHAI greater downside risks to yrowlh. • •j ii./ .'I ill .'I Jtir • .'il- -.1 I i. I r... i i jJld .. .." • iteruled lhat the predominant policy concent growlh. rtnuin^d the? rmlt linn mfiiition UL^i,itJ i\\.i\ io W'liL'ii llkr (.Viflniiucc oiL'l on Ait^usl 7. hi^ncltil H^ ex peeled. niiirkus htid bftn unusLLtlly VUIJIIIL- Ibru ii.L^ nceks. wi r*wv3OQ5-CW MIL^ llnl.l i'Pi' ll.H-ll .IIILI CT^L'lul lLlP| 102 38 Mondury IMtky Report lo the Congress February 20OS lit Ihi! Jays following the August 7 FOMC meeting. Al Ihe lime of Ihe October F OMC mealing, Hie dala financial conditions deteriorated rapidly as market par- huliciiled Ihsil economic jen^vth liml hcon >v]n\ rn Ihc licipante Ivt.inK' LL^LUFIIL'J ahvul dunlerpuru credit ilwrJ quartLT. \ pieViii{t in efinsmntfr speiidint and dm* risk and ihcmiecc1* lo liquidity. After an FOMC con- tinued expansion of business invesunenl suggiKled Ihai ference cult on Aiky.Mii Ml to review \%<irII.JuiL-J ^it.un-. -spiilitvm frotti the turmoil m in? lumMiiji LMHI fiiM.i,-i.ii in nioircy .nni cmbi markfis, ihc Coininhtce lssiuda itiarkci> hud been Mmiicd M di:ii |vunt Ahhon^li ^c-r.ini-i slatcmcnE inilkntlin^ lluil the I cxlerut KCSA.T\C would iti Ii»iinijt.i1 MLi;LLLI". tidid LLJNC{I sinner hill r>n hjlaiun:r pr<mdc RnVa as neves^un mnutuh open markd lighter credil eiindilions WCfB LhtHi^rlrt hkel) K^slow opcrahons CO promote trailing in the federal funds mar- Ihe pace ofeconomic expansion over coming quarters. ket at rates close lo tile FOMC* target rate of 5' * per- rurthenrKiTc. Ihc dituiitum m rx->idenUul conbtruction tLi>i As conditions deicriomicd further, (lie Cnmnriiicc h:iJ ktce]tcnekl nrvd a^dilnhle nuliLjim>. p. unit'. L IO t mel ,I;_.!.II i MII \:j.-jij^i lo by conference call n> iji-.oi^- (urtlhr -.l.nvi 'IL:J m hoosin^ UkTtivity MI the near term. Ihe potential usefulness of various policy responses. FOMC meeting participantsnoted that readingson core The foltou-mp duy. ihc Z-'cikml Reserve mimikiiKcd iiiH.ii inn lud tmproi cU MHIIOI lut over Kic ye;ii mid changes in discount w nidnH- policies to l.ialii.nc I htr iiiticipjiml ihiii >omc t>f Ih^ nnHkraEton likely ^i-siki be tifJcrl> funciionin^ (i| slian (enn credit irLnkci1- Fur- smlanieil. Nmiclhckm, pidirtip.m^ expressed concern Ihcrmorc, Ihc I'OMC K-IUISCIJ A ^Icmcnl nuiit.HMij: abuul Ihe upside risks lo the outlook lormflj^ioni, MOn- lh«l iW Jo^nsttk i\*X\ \<> umwdi hud increased appiv- IHing in i^in from (he elTfc*> of recent increa^e> m eon- ciuhly nihl that HiL-t'n.niniM(<.-*.- ^.i- pn'pjrvd in ,ILI US modity pricesand Ihe sijmilieani d^vline m the toreisin d 1L> r II I t I J I I I k.- snKcf-.\.n rll^T-h n"i ihc cc^Tinniy. exchange value ofthe dollar. Against that backdrop, the xrt cnutlkSl "The J'cdLtal Kt"scr\c's R«|hniM-.'i Commitiee decided lo lower the mr^i for ihe federal u) I "iitaiic^i I Mtjms" |m>M tk'* jdilitioiul dcu»l nti die fumk rflte :.S it&tAx pomiH, i^4'> pervcnL Jiid judged milCOfnct uf ihLW LtJolirrtfTuri! tJilts untl olhci measures lh:il ificr upside iidk^ lo inllihon toii^hly h:bl:inci\l tlic taken h> ihc l-ctlcrul Hc/wrvc \o liicihljitc the imlcrty [luwnsuJc hskh togrowth. fuhcliimiriji of financial murkclb uvcr Ihc sctvnd hjil1'i>r ALSOAL the Oetohcr meeting, IheCommittee contin- ttie year, mcluillng atordinalcJ aciiom uiih "ihw otft- ued ilh JIM: unions nrga/Jin^ commumc^liun wiih Ihe public. Parti CI pan ts reached a consensus nn increasing At the lime ofIhe September FOMC OKXHUS^ •he lrL\|Ucoc> and c\fv;inding ihccoMtcnl of iheir pen- Fiiuncitil mu/k^ls rcn^iin^d •-i^mL- I kumlns in sht<rt- iniit (COnonia projcviiiOi*- l-nikf ihc ftsfw prnvtr*uirc. icrm LinJuiL! markets MW M|:nilkdiUl> iihpuircd jmid which TAJS Luintrunced oil \itvtrrtbct 14* tiic FOMf' fJV111nciLf^ mvcxior iinc;iMf uboui cxixv^ure^ n» nb- iiiuipili^ ,]mj nrled^esthc prt>jcciLonsiiude hy ihe pnriiv mtvtiptjrct jitid lo Mmchirtd credit pnHlvris more r-^k-Mt Kcscnc Governors mid Rtwrvc Bank pr«i- hffjcidly, f TL'I.III .VIILT.I]!1! rcmatned ,w Jilnl^i.1 fnrnidsL Uems tour limes each year JE jippmviumicH' qiLrinerly bun nesses and hmi!iehold&. bul ihc i. nmnudCh: Doled itik'niiU. ralnerihan t^viee canh \ci\r. as had been ihc Itul Ific MdiU-r LFWIH iMntlillun?- forulher imunOWOTi practice since 1^7**. In LiJihn(>n4 ihc projeclioii hori- had the potential lo restrain economic growth. INCOM- zon hdf been c\tciidc^l from twoyc^r> to lurev yarn. "ly k-L^fiMinit diiia hciv mixed: CotOVM ^pt.LMilirig t'OMt" nwdHrts particijKiutv provide prLTjeviion* r"Of J u* hn\-e sirei^ihefkcd Tnim iia. -;uhdkied scu^Kl- Ittc iii\fc(iH: in ihe pnuc intkx lor Ml<d pcr^oiul con- bu< a lunlinr nitcnMiicaiiLiii ol ihc htniMm^ ^utiiption cxpendilom (PCEjus ivcH a* ptoictiioiii for real UDP growIII, ihe unemploy ment rate,and core ii weaker evtmtunie uiiLfdnli. Kmk'ipjnts nott'J lhai t'O. puce mflaiion. S LIITIUI.IT ics ot'Lhe pEi>jceiioim4ind incoming dala on core influiion continued lo iv favor* an accompanying narrative arc published along with nHc jnd ihjit (he iln^nw;irJK fcMscd rtuhumk- DUttMlt ihe nimnlcj of ihc I-ONU" meclmu a\ ulilch ihcy ivere implied ^me {e^M>nm^ ofprotfireson mounccv. bui Jistiti*ed. rle^inmn^ w+lti the prvsenl rvporl+ Ihe pm- ifiey r?mai nvd t-^HHvmcd ;iboul possiMe Li|i^nl: n-.i, •, jectifri-t made in Jiu>uan' are utrlwk'd JII ihe f^brujiry In infkilion. To forestall some of theadverse Macro- \tf»wlan P**lUv finfHtrt httftf (iHigvca*, Jnd ihe pn>- •'••Mimin:-. eJTecis Hut ini:'Ni oihcr*use an>*e From the jcciiofis iTiatJc in Juiicdiv intluikd m Die July rupon LiiMrtij>tiLi-n.v m luuiiei^l rivLrket> Ami to prmn[>tc intnJef- In a uonlfrtiHjc tL:ill on Dccenibcr <T, E^Mtrd menitters ule ttnuwth DWf tune, ilie Jrl>\it tinkered I he Uir^el fur ,\nt\ He.terve Dunk ^re^idents re^ieu-L\l eondihous in ifiL' kdunii funds rule ^> HJISIS pornls, DD4H pcrtcrH domestic and foreign linancial markets anddiscussed TheCommittee also nnled that recent developments Iwo proposals a nticd a I inlpmvin|: ni:irkcl liincE;onin]:. hud n^n-.iseJ I he Miicertamtv Mirr^innJrni; TIK cv^momik: The HI ••i prop^tfHil Htf J"i ihc e^.tbli^hiiieiii of a temix^ LMiif.KhV .ind staled th,it "n u.iUIJ ;^i M ncx-ilAl ii - f rary Term Auction Facility (TAF ), which woudlprovi price itabiliiy and suvUHtthk cvtMU>rnic jjrro^ y Ihrougll an auction mechanismto 103 t tif (jnrt'fmwx ttffhtt Fintt'tat fir-xet-vc Synierti iinn, iiisMULtnns-, n^mist \t hnudiT rait^e ufctd- c\charij:e S*JJJ lines wilh 1\K KmopujTi Cnei;lrul Hank d lhan lhai us^d for open rnurkci t'jn.-r.il i mi1*. I hc and the Swpi Hriiaoftl Bank. propi»ftl u^fr fo sel up u foreign c:<ich:in£ir swap Jn ii a}riftfai£t call ir>n Janiuir> ^. the CbnatdUcG .in iiiLVink-nr iviMl Hu: HHA<|HHUP Qffltf] KmV lO:uldn:&> (^viewed asmni fiOteontk Jaiy jfid finuncLBl myr- elevated prc-isturcs • #• short-lenn dollnr funding n>urkoi>. kt'l Ji'vcKjpmL'nis. The information, which included \i the CI>IK'TUAI«I> *.**•'the Ji>cu^smn. the ("ommiuee WflAflHftilUllpMtBd daHii Dti home %jlcs and employ- Voted SO ftrtd i Uic (\\Ural Reserve Hank oFNew York mcnl for L^eceinber, AS well as a sharp decline in equity roosluhlisli HITUI mmniain A reciprocal currency i>vsHp> prices sinn: llie hL'^inuiny al'llie ycjr, fitggSSted lhal im^ngvmeni r'm the SjMem Open M;irVcl Account ihc duwnside riiks ti> growth had increased siyniji- with I he |:iirop<Mn t emr-jJ llanV ': The flftaM ui Gnv- canEly since Ihc lime of five tXxeinber FOMC meeting. entars ;ipproicd ike TAT viu IH>MI i. .n VObE on fAccem- Moreover. |-«_ :•.-.•.• - cited concerns "l-.ii ihe slowing ber 10, of economic ^rnuilt coul<i k'tnJ to =i junher u^hccDiiifr AI the Cwmmlkt'^ meeting CM; [X'CLinlvr 11. par- jf linunciiil LitmJiuoiu, winch m itim coyld rvmlorev iit:ipj{iis noted ihdit tuctfininj! uiloni>:Hn>iT sug^mctl the ifcojiuniic slowdown. Howu^'er, pitHLCip:mL>i noltd L'LtHih>nHLL LLciiviiy huil deceit™i^J ^i^nilicnnih1 in ilic ihtit con? mt^itjoi) IKIJ ed^cd up in recciM pnonih^ .tm\ ti.njHh LjLLiner The housing cnninictiwi hntl sleupeiLLrd '• • '••• • • 'i thai oomidsodAs imcenatnty summndoti Jhe ludlurr and pjiriieip^iiLi agreed ihiii ihc -wttor *n i n J1. 11 ion am iontk.. i'n n ic ipu nis wert ^senerjl |y of the ttcukcT lit;in luitl htvii i:\pcuiciJ HI \hc in-hi-L- ofifieCDQV- ViCW Ml. 11 -'lihiKllill.il .Uklitiitn.il ]iillL'\ ^^lILt IHIJIJI innltv'> prviiOihrnK.-clm£. MUH'I^^I spilluwri frnlli LVLII be nei^essiLry ta snppt>Fi eeunomit: LinEivity .m..i Jimt-inu to oiherprniborilifirLiirKmiy Itid K'i'mi IO i"..,ii:i":.- Ihe downside riiilu io yrtf^lh. [»mj they discussed emerge: C 'omumplinn spending apjwnrcd w he soJten* the possible liming oTsTich W3tem in^nuvc lhan lud bcfir arutipalcd. ttnd cmp^ciymcul On imiuury ZL ihc Loinmiitec \\c\i\ uJiutliLT eaoftr- g ev a i m de x n : c ip e |> o c l ; h irc ir il t l m w r h e dc ^ it k :m > > ^ r L < i m i^ < P w i in m iu d ip ic im cr i e s d n n u i g c i J u l l h u n ^ i RKC . •' ; I"- -••-_ i--» «•- in ::i • cull 11! .•.. i:•=• • ntruu^s m —-• •• i. i - !:;i.,l- i:i. \.\.\A . L- 'i.i.l :iiL.-|.'ll..-\! .Hi,I ll.;1 l| ( • li 4>fnion^ii2!Ch and oilier Joims (o hoiiselx^lds appenrcd ii- evtdonee luid rcinlbitcd Mtt view i:i n m.1 • 111!• •-•••-. lo lv ••purnrii; Itrndcrs lu InrlEkT lighten iht: lL'rm> un for economic :teiivjty wus ^v^jik. l^prticipsnt*) t>b*iyi"ved FH:^ i:xicii>ioi]i> ol crvdi I for J wiiktitiiL: Taii^e oftivtiii ihiii uivt'itiK.'i uppLipemK WCK heeonim^ incrcasiii^Ly ptfhlticls. lirtJiKul market t:ondilioii^> had uiifeened concerned abnul ihc economic ouEloak and Ihot ihesc vT^iiilicuHlv, Tht litiHiocint ^truin^ ucrc cx^ccrKilcit h> • '•. •:'|iiriuiii> could lend to ait e\ccvsi\e pulLbjck in c(>ni:cnis rcl jLtrtl \w ytvir'triJ pren>iircs in ih(*n-kTtn •jfL'iin jv.iiliilnltiy \L',LIH^I I1UI1 Iwctground. tneiTibei?i lunding riKirkcr;.. uhd similar Hlrtsbt-ii-wtrc L-vuk-nt liklued IJIHI iL SLihslunlEjl e^isin^ in poliey wqn nppropn- in ihi" linnnciHi nidfktts^rrn;ifi>r lurci^u cvonoinio. Allhougli M surge in energy prices pushed up headline nte to tbslcr mixlerale ccunornk ^row 1h nntl rethicc I he cx^nMimer price inflaTj^n during £qpicmher<ind Ottob*.T, downside risks in economic uctivily. The C\]mrnitlee i'mmiuIttif mtrmlvrs j^rwO ihnl tho inflmion situiatjon dceided to lower the ui^el for the federal lunds RUC had changed I idle fn^m IJIL" time of the previous mtut- 75 hois p^nnts. lo V'i percern, ;nnl slaled Ihhit wppn.1- ing, loihcs^tiroimMiinccs. theTOMC ImicmJihc dable downside fisk» io yrowih rviiiitincd- s iii •. --I:-I- liif^-i for iho fcit«a| fund» rau* o iiinher ?5 hs^i-s rwhitK infialion was expected to edge tower over the course of ht J'.x pcrccni. iind, ^I\L'II I lit? ticighicm'd unctfimnity. 'illl^. 11:n 1 u-• p:1111-• uii'lLT-.v-i'-u'.l lli.d I?i: —- HVM."\MT1I;II1 V. ii ihc (\uti]nitlA.L decided To re Trim from pto\' tiling dn condiiioncd irpmi inftLiiioM expecurJoos reniftining well •J-'-PIKII ;L^vcs%mcnt ofltie IMIHIWV ufrtiks. The Cnm- anchored and sikesscd that the inflation siiuatlon should mulec JIMJ mdi^K-d ihjt H u<>uld «miniiic io dVHtsu continue to Kr nmnilf>rud cjiiviully. Hie irlKiv^ of |iii;inci^il jn^^hcrde^i;lopineiiisoii MO- The JjiM rtviL'Ued yi the rcyuhrly .scheduled FOMf nomic pro«ptxis mul iiti »s net'oVfl Ui fiwtei price sm meeting m Jiinuarj121* .ind 3d DuUtanad J *lidJ"r d^Ljel- hihiy .in. I -.ii-i.iiii,ihk- BC^Htntlc gnnrfh. In uddinon io tuition in etoitomie growth during itic fourth (|uunvr oi limt policy move. Ihe Federal Rfst'nc and several oiStrr 2f>H7 and omimufd u^hienm^ 0fftn>QWl cotiditinns. central Kuil.'. .iniu-m:i-i-iJ on Dccc^nhef f ? ihe nitMSiires Wuli [|>e eonimciinn in ihc hou&ing s^cior inien^ilyink; lhtf% were inking n> address ulcvjik'tl pICSUiS ui sliort- .••ml ii range Qfjmxbd 'ii.nk-.-K rciniiinin^ inukT pres- leim funding nuifittis. The 1'^tcnl fctneiTfMPUBCal snreh pMrntipiini^ LLeiiei;ill\ expected economic ^ruuih lh< crcaiiiin nrihs TAl iutd Ihc cslahlishmefii ofR>rci»n It) rcinjitji mgfe ii> the (u-i h.-M nr .^uO"-< ii.-Unv picking up sirenyth in the second half. However, the continu- lii^ HtuftpTUff in home sales :ind hoose priflBB, Hi well its die ii^hieni»^ oTurcdil condiiions for ImuKtholds ;md businesses, were seen AS pttfing downside risks to IhettOMenaouUoBli for teoiMtaic growth, Moreover 104 4Q Monetary Policy Report lo the Congress • Februpry 2(J many purticiputits cited n-V.^ regarding iiu- |wicmiyl injtunc believed IMJL LI Knunind Kccsssry in numiLur Rir wivejit Feedback (xrtween ihc Fin;mdnl niiirk^-t^ jtidtiiioii devdopntatti esnftilfy Aydnsl IJUL hut^Jriip, and ihc eoojiomy l^mcipEinis uyprt-SM^J •.ITK- UUICLTTI lia I-OMC Jecitk^l to Iowa the target Bar the Ebdenll Lihoin The disypfwirninp. inMaiiim iLmt ri.i:t'ivc(J owff fund^ rutc ^11 Ni-MS rH>ii)U, to ^ percent. The Com mi (toe •in- tastb pun MT2007. Although ninns cnp<?cicU ihut u helped ihut [he puiii-y ootton. couibiwl uuli iln»w Icvt'linv (Hfl bfpritol Tor LTicnjiV and oilier ONitnujJi- lykcn L-urlitr. UnuM liclp pn.»nio(c moderate jfr^vch lien, mich as ihnl cmhvtkicd in luluftrs nuikel*. uiid a SVCf imit nnd nin^j.Lk- ihf risili^ lo OJAKMDk SCtiV- pt-noiJ pfhclow^4fCllJ jjioivih would cotiti ibulc tD some itj. UoWeVttC rn^:rilhvr^ indeed lEiaL du^n^idc risks lu miHlcratioii in itirluiioii pressure «vcr limch Ihi: torn- »in\vf!i rem^ineii 105 Part 4 Summary of Economic Projections fin- fatknvftig material Hpjratrvtt ai un ttthkmium stt I. Economic proji;etitnns fill tmiuth* tff tht January 2V M 2008, mvtma tif the tidertit O/H'ti X-fwkt'f Committee. n In conjunction wiili lhe January 200N FOMt mi.vl- i p n m t: s . K I t b oQ f K im o em f i b h e e rs F o e f d i t h sr u a l B R o e a s rd er « ve f t B jm an e k m s* o a rs lt a o n r d w I h li o u m i I• ia •••I. ?l ulT r ;. f s t i i i i7 jn ff participate tn ihe deliberations of nV F OMC . provided 1 >ni»il|ihi)-nit-iu rtiLo pn ijcciions- Ibr economic growth, unemployment, and 21 (0 :.j n»!» influtian in 200K. 20(>9, and 2010. Projections tare. I Km.1 i UN.: II 1.6 M I • \r,i:>.\l on inlVnTn,i1inn nvnileihk- IhrnujLh [he uondusion l,fuO Mum 1J l >1 i^l'the J,i?iu.ii\ meeting, on eaeh participanrs assump- lions regarding J range of factor* likely in a fact eco- .iMhiiuHimlom' ' UltU nomic outcomes, und on his or her assessment ul Appro- • • priate monetary policy, "Appropriate monetary policy" ini O i ctal* <t iHittceliuih ... M• 41. h." II 4> m • II is ikliiK-i.) as lhc IVilure poHc> that, based un current l\I- intttiim infoftnaiion. tfi dfrcmed must llkcl> to foster owoimcs for economic at-tiviij und inflmum Mint ht^I MJtcsly thu l IHCII 1 IHtblltM i -i.. :M participjnl'i ink'rprctalion ui"thf ftdcraf Reserve's dual objective!* ol'maximunn einpkn mem tifid price sEabilily. lit- mflMNfun paaeM ii RUM (hwi I'K Hwflb^pMiiisi BfiSi i-. •••< • MTW Ihe pppfettioos, which art summarized in table i I»-J rn..nli riLMn^r ni .il* -...-Ht UHlltnUb! (SI; mJUm-i .mil BH K1 iF&tfan Ml and chart 1. suggest lhai FOMC p*rticfpams expected * t . h o e n t p n B ui T )H ff n fi ; m i« n i i ^H m K e W * l n lA f K f M IPK IIJ .n J? n l i n 1 , t lr n ! p i[ n xV u- » H IIH -U JD , H H i f e > ir p r ( w M d I I I H IK l J l C C I O r,i W r |«fW I' M ll- u " l Ihm ouipui would grow «l a pace appreciably below Us nrenilinnf- -rt^liiJir^ r«iU .mil cnri*j. fnjnk^ Lur Hw uFWifiplnyinum rn« trend cote m 2MS.OWing primarily to a dL*cpcning of f n ie d l « ff m lw U l H i r f w fti jt f e ir i« * m i* .i i p tm «i, i u '. B p a n fi f p M hm M n n w i n m w e b m • n d • o ( n M i R ii< s o w tf i i I x IU n M • ^U nr iv »> Lie housing contraction an4 a lightening in Iheavail- ftfifupriiikL- n«tKtir> ptrflcy I. nw ceiilral fcmkiKV ewludm ifcpUffW higlw*i * ability u f hou&rhuld itnd busmen credit, and lhat lite KM gMtl l«i«Mc Id M Ii pMC unenipioyrnenl rate wuuU inncjise siomew ha< Given 7 r*ip ciRut I'flr n vunutik m it utven \SM in- luifcr M lr.«n fora* m tn-ishcM. IIH i1ui vanable ITI il-nl year. Ihc substantial reductions in the lurgct Icdeml funds rale through Ihe Jatntary FOMC mecUn^ as wdf as ilit a>siLmptfupi i%f approprmle policy going forward, output crjibty lower than (tic ttntrnl lefndBEtcy of the pK$BS- growih lurthet ulteod wa* projected lo pick up u- ii pinr tiuna provided in, coiijunction with tlt erki tobtr FOMC around w a bil above its long-run trend by 2010. \nfta- meiTEimsi, which was LBlii2.5 pertrcnl. The?icdowM' liun w;ii SJtpwtaJ 10 decline in 200M and 2<X1^ from ward rcvtstotii 10 \\i-.: lliOV outlutik -,••• ..\ •..•: from u its tetent cleaned levels as ei>crgy prices leveled oul uuMibctdf factors, including a run her inlcnsifkalion oi and cconomio slack contained cosl and price incrctiev tht huuEhing fnarkei t'orrcciiyn. tighter credit condiiioiiN Mo& participants judged Unit constdcniblc uncertainly jinnJ IIII.IV.I---AI BomaHRBS^oy] credit i|imhiy ^md ongo- surrounded their projections Ibr output growth and viewed the risks (o tlieir forecasts as weighted to the ing liinnoiE tn finanirial nuifkces,, ami higher oil prices. However. &Mm-parndputfis noicd that a h.^-.ti stunu- dnvH,n>itle ^ majority of panicipiims viewed ihe risks to Ins gwkagc would likely prnvide-^i Uaspoaty hooM (he Hi 11,11 IOO outlook us hroadly Halancetl. hul n nur^hcr to dfiQKtijc demand in ihe Kcend half t>f tins yciir. of participants saw the risks to inflaiion at skewed Beyond 2EHJK, a nuiflher tif fuctdrs were projected lt> buoy eetimmiic gruwih, mcludinga gntduHl uiriinrinuitl in housing nmtlk'v^ lower incerest t.iw- assocuited with the sub>tanliut easing of monetary policy to &AK and appropriate adjuslnit:nis to policy guing forward, and an Tlw central tendency nfparticipaiiEs' projectLt>ns for r anlietputed roducnon in ftiuuiciLiI markcl stnunK- Real iDi> growth in 2NIK at 1.3 to 2.0 percent, was ccmsii GDP was t'speded 10 aeceJtuslc somcwhai in 201)9 and 106 42 Monetary IVlkr> K^p<*t ki flic ITijni^ri^ss . Fcbruury 21IOS Chart I: Central tendencies and ranges of economic projections Ki.il < — ^B Caitnl mhlatcr — s - 5 - J — 3 - 2 — 1 I znu _-i H I -. :>* I ''.;*]' -ii • -- :M-. :n rare - t - 6 :IHT : » wn un aim P( t in Hal M anw MBS 2007 aw Core PCE inflation — 2 — I :om .IRK. apt JWM 107 l >>! Oo fS ttfllte Fcdenil Re.it'n'i' SyMcin 41 by 201 Ct lo expand al i>r a ti3ik above participants' csli- risks it} their projiKliuiw or uiicmploymcnl as tilled mates of tin taic al trend growth. to the upside. Tlie possibility thai Imuse prices could WiUi ouipui growth running below trend avm th» deeline more slcep ly than anI id paled, further minting nest year or M, most participants expected that the hoiiKcliiiliis' wfiilih and access lo credit, was perceived unemployment rate would edge higher. Tin;e ciiiml Icti- us a lignilicnni risk lo Ihc central millook for economic deney of partici pants' projections for me average r.ue growih and craployincnl. In addilion. despite some of unnnpioymtlS in the fourth quarter ofMOS was 5.2 recovery in money markets otter the mm of the year. to 5,3 pweeat. above the 4.8 lo4*J pcrtcnl unemploy- financial market conditions continued In be strained ment rate forecasted in October and broadly suggestive slock prices hud declined sharply since Ihe December oC some stack in labtir markets, 1 he unemployment matting, concerns nlioui further potcntinl losses si rale was generally especial in change relalivcby link' in ninjor finnncinl lmililuliuiu liad mounted amid mimes ZW) and ilien w edge tower in 2QI0 as wapiti growth ahom Ihe condition of financial jjuntanlprs, and credit pieks up, iitlhouuh in bolli years the tincrnpluymenl rale conditions had lightened in general Ibr bolh houschoMs was projected lo be a link1 higher than liad been antici- and firm*. The pntenlia] for adverse iuLcniL-lions, in pated in October. which weaker economic activity coulil lead In a »UB- cntng of linancial conditions and a reduced availability The lugheMhfln-expeeted nltes- ofovendl and core of credit, which in turn eon ld further damp economic iullalii.n since October, which were driven in pan iirnwil i, was viewej as an especially worrisome pos- by liie steep run-up in uil price?, had caused partiei- Mhllny. pants lo revise up somewhat I heir ptejootfOBJ tor infla- tioii In Ihc near term. The central lemlency of partici- Regarding risks lo the itiflatinn outlook, several pants' projccticflis for core PCE InflaliDH in 2(XW was participant* pointedl o ihe possibility that real activiiy 2.tl to 2,2 percent, up from the 11 IP 1 .9 pereenl cen- eould rebound lest vigorously lhau projucled. leading to tral tendency in Ociober, However, coreinflaiinn was more downward pressure on costs and pnees tliari aalie- expected la miHlerate nver uV neti iwo years, reflecting ipalcd. HL>wevcr. parlicipanls also saw a numher of Diuied pressures on resources and lairly vvell-aiK-hnred upside risks lo inflation. In particular, the pass-through [iillati.jii expeL-latlon-l. Overall PCE iilllailoll was pro- of recent increases in energy and commodity p ri ces LL S. jiicled to decline from Its turrenc elevated raLt ovef well AT, of past dollai depreciation to consume* prices tin ?cuming year, largely reflecting the aBNUinpiion ihul could be greater ilian espccied. In addition, partici- energy and Ihod prices wtuild flatten mil. Ttiercalkt, pants recognized ! risk that inflaiiini espeelalums could iivctall PCE inflariori was projeck'd to move largely in become less firmly anchored ifihe currcnl elevated slup with con; PCt" inHiHimi. rales ofinflation persisted for longer than anticipated Parlicipanls'priijefiuins Tor 201(1 were iuiptinnnlly or if the recent sutoianlial casing in monetary policy inHucii«.-il by ilieir jiulginenn abiiiil Ibe measureil rales was misinterpretedB E. rcReciing less resolve among of inflation coi!*iwnl wilh Ihe l-eilei;il Rcservt's dnal L orainirtee members lo maimoiti low and stable infla- tnatntale lei promote mammiim employment and price tion. On Iwlanec. a larger nunibcr ol' partieipanls than stability and about Ihe tini fI'ranie over which policy in Ociober viewed the risks lo Ihcii inflation forecasts should ami Brands those rates given current economic ns hmaUly balanced, although several participants con- c iv o c n c d n i l i i i o & ns n - ss M a a s n h y o c p k a s n t i o c i h p a a t n h l s a j g u g d r g e e g d a te th d m e , m g a i n s d cn a n td d c t s i k n e u w i'd e d l o 1 0 in t d h i e e u u l p c s i i h d a e l . their inflalion project ions uc rv inflation, poliey would he able to loster ynly a gradual The onyoing linJincial market turbulence ,ind ticlil, rctun ol key miscroceonfjmic \arinble^ lo their longer- ening of ervdit conditions had incrvnsed participants' run suslaimibk or uplifna! levels, Consequently, ihe uncertainly about the outlook for economic activity. m[e or unemploymenl wiis prLijected by Mime partici- Most participants judged Ihat the uncertainty al tending pants lo remain slighTly iibme JH loneer-rtm susiatnable Ilieir Janunry projections for mil GDI' growih and for tevel even in 21)1(1. und mllalion was juiiged likely Mil Ilie unemployinenl rale was above typical levels seen to be a bit abuve levels llial some participants judged in the pit-it, (Tnblc 2 nrn\ ides .in estimate ofaverage would be consisletil with Ihe Fedml Reserve's dunl ranges of forecast uncertainly for OOP growth, unem- inundate. ployment, and inflation over the pail evenly yeais.") in contrast, ihe uncertainly atmched lo participants' Risks to the Outlook rii-'ht]^ "I niLLjhf ljut>.ftinn[y~ at Hit; end ol 11 us luramni) MDBI participanls viewed Ihc risks lo their GDP projec- ^ a a U n IL it - L W - U vp J l L a I i 1 t , t - u n H i i t t 1 U ii a p l p ^ m rt iw ta ih ll P U D M S L J rJ I ' n u n a c s e s n e u « t o Ih t> e u in n c t e c r t t t a n i u n m ly i c anil tions as weighted lo the downside and ihe associaied 108 44 Monetary ESdicy Rt-pun ru I he Congress Ithrunrv 2(Kl8 e 2. Aicragc hMonca] thaw in Ihe forccuisls submiUcd in October, ^hich m tunl wen ciMisidcnihty more diverse ih;m those >ubniilted iti .•i'iiiiLMiLi^:i v. u|i llit June rOMC mcelin^ ,n:ii dk-ltulal in An: Ui*ani\ Ata/u'lury Pttticv Report tit thv t'cinjijit'jfv 41-0 tfla • it July. Mirrormjj! (he tncrLJsc w\ divcrsiiy of views On real GOPgrowlh, the d>>per&ion ofpurtieipaiRs" I:r*i4 luff* JP#»II JK ivjiuffll *•• plu* «f ininu ik rfwr fp mic*t«K ibl wm ftln*hl M I he wmtf torn l pfujeeUoi^ for Ihe ffiie of Lneinploynitiit ,ii -.. • v. idencd nt^hly. ppinkuinrly Ibr2009od 20in. Uisdfapa^ awn ofpmiet:uoTi> for oulptii ;mJ emplovmenl sccmi'd largely En reflect UikTcrin^ a&ses*menl& nf ihc cfTecl \*\ i, <> Htfif •**• t trtr»<f"f o< the rirhincrial mnrkcl cond>lionti on TCA) activity, ihcspL-cd wilh uhich trrcdil t'oiidilinnb iniulit inipn^c, Jtiil ihr ilcfUh iiniJ JuniUoji nf t!>LL htmsiiikr market uoninictiui). « ip*Jmiat Tlw dispcriion ofpurticij*jn(s' li>nLtLT-lem> pivjecuons WHA n\io directed to some degree by differences in their |ndi;moii^ jhtmii Mix ccuntHny'^ ire ml t;rwfh rj[f aeut l} I-*H1 in p»fnviLT| f ihe nnt.in>ploymciii rale Ihn would Iv c»n%isuinl over the ^whS i]nartb> irf H time with maximum employment. Views also differed nlUtkrvi it ihv Mhit ynH k\MH|tiriJ *rih hw 1hT E jiboul Ihc puce at whfch milpul and employmenl wtmld > iV HMN ikf uptnf i |pftiri\*d Mnyk ix n<H Mr O I •( itnv -M nBBPWT lounrd iJiusc Icvtkovtr IKL' fovtwL^i horttmi mid Iwond, LJIVCII ^pprHpfiiilr mont'tary ptility. Tht" ttispcfswn of ihc projections f«T l*f'(: mtlai IOI> in il<c inpialiun pfo^txlUins was gcncml^y vimvcd a* being near lemn partly reflected different view* on the extern bnurfly in line wilh pjsl experience, atlhoiig.li se>entl N- w>in:h netvni irtcre^rfi in <Mictj;> 4ind oihtT ^omnuiJ- p.irlicipjnis )ud^cil th;il ihf dfgrcc ol'uiiLi:n;iihly atxpui ii\ pnee* urpidd p.iis ilirmi^h mio hiyher L'oiiMLiiier inJI^iion s higher lhan notrnul. prices und on the indiicntv thjl inllalion e^peclalions would exert on infbiion over Ihe short AND medium run i'jnicipiinis1 mlliiiuu pmjL'dKms JurthfT nut wurr miTu- Diversity or Participants'' Views enctrd hy ihctr views nflhi: rale oJ inft^Mtm ctmsiftL'iiL with the Foiicra! Rcsjr\L"\ dual i>hjccti\c^ nnd tht.L unit; it K'oulJ take lo achieve these i^oid> MMU eurrenl BPO- Chart* 2<p>and 2£h> provide mrirc dcmolitlihed i nomic conditions and appropriate policy. i[>Hinu" ^K'US. The diip*rr>ioiu 109 ots ofthe feikrut Rwcrve Sys 45 Chart 2(a): Distribution af participants' projections (percent) Unemployment rule II,,* Jinunry prejftijuru - 1* - M - 12 - 10 - • - M- 22- 11- -0- V U '-' 1.7 JJ 2KB I 1 J.B- u •'I— _ 201O '- •>• iM- la- 12- j* 4.A - 4.H - 5D- 5.1 110 <ffi Mum-un Policy H..-J«III IU (lie t'ongrea Chun 2(b): Disiribtuion o f partic i pan ts' projections (percenl) PCE infliltinn Core KB indBlion _ 20•0•9 y - 16 ••HIX Jiniurr prorcciiixLi — — • October - H - I! - W l^. 1.7- is- if. if. Lt l.« JJJ 2IHW MOT , 1 1 1 1 1 1 I—n 1 : : ,1 1 ! 1 I.N 1- 1 2 . t V t - M 22 3 2. . f 3 t - IJ-l. 1 1 J t . \ 1 1 .7 > . M !•• l ;' \&- • . i r>l r.n^ifxak 2UIU - It - n - IU IJ- 1.7. 1.9- 11- IJ- U - '<. !1 2 A Ill a! itf tin.* /-Wfrtr/ flwrnr System 47 Forecast Uncertainly Ttiu Qconomf fTcjprriKins pf<:*V«MI by iPn*m»rfn- ptoi and man ben of the Baud oP GovaiHH^ JHKS itw prmi' broadly luilaoccd. mn number* reported +ri lobls ik^bt^ uf flu Fedorji tji.'icjve Boi'iVi huip .ttidpo 2 mini it JrnpLy a [jfoti^l^J hty of 4boul 70 i)fct*nt monetary policy and cannici public undeislund- ihnt actual GDP would p*p*id brtvr'1 ing of the b#m for polity actions Com'CK.vabte ceni \f?4 Z {Wcem in iin; civrgni yvat dnd tKKCr(nin1y iillcnth Mw p'njcctiri'nf. Px*wcvcr 1 rj ntwrijfil In 4 4 pyfC'^nl m Ihc >0<t>nr} HIVJ the fKOiwinLc A*Mi 441 FUiui fnocldh jmi tka- mwd yttir^ TtH> totn^porwtirrtj 70 pcri:«ni ccnifk' IIOrrtl>tfr> iJV-^l 10 'KJlp iNOOuct* tftQflOmc hJrC- (JW*Cth I'UCfVJts for uuuMH iriJla1io>i would bt ttiiui jre rMKP^dr^Ey iinperfiKHdAcrl^JUDnqof I percent lu ipwccol inilvciprrant aid second Iho rnil wmId. And tno fuluro j>olb of tnc L*xmo> yoiK^r and 1-1 pon:cfH(D 2 9 percwn m ihc Hind my can bo uffmitod by ntyriad nnforopen iHrveh ymr opiittvitb \yit$ flvenii Titi*s in -joiiing ihrj startc-e B^CituW ci>rt4KH cotKliEiAr^ iTif^y differ ftntn oTroonciafy padcy, [Kiaicipmtts ron^nclw not HmelTml pf*^airivj on Hivn^1 0*"* hisli.vy. only whsl apptii'^ to On Ihp nvxn lihdy ccDnoni- iNirlic^Ktnh ivnvpctajucJgniarii^ AA to whether ttte ic oiHoome a^ omnodtcd in iheii prnjeclioos, »jncerMuiiy ^il^ched |D ilie^r fnojetiiinVb o* isttn bitt fliv> ihn iai>q*" oV nliinniiiL^^ puvuinUHP*. ihe vHnaWfl <s i)f«rftiof tfifln. umHd lhan or tiruwJiy m OLtufikHi gp>d iho potvtHtAk urinfor loiypicni levels u4 focxnu uncenainty o ihfl (Ki-f^KXity should iPwy occur In lit pitsi *i shown In idbic. ^ PrtFiicip»in|s ilo ? Miinmiv^TfK dw nwroqc hiyorical nlw ivovxtn ii«JgiT¥>nis nsfo wtwrhcr Ihe ri4kv cy of a range of Forecast*. incluOin/) uvsc lo Ibrar projedions are wepqiilen lo fne up4iQ>>. Hi in pastMundaiy Poury RcftoiU jnd fluwmlde. fir an; tvKHlly UnnVK^d. 1\na h, [av- n pf ITHN<Iirigs til ifw fimlm.n Qcxn Mnckei likely 10 ix? nihovis or twiowtiwir p<oj«:|ion& of projWlion effof ranges ^hown ihu mosl KKcly outcome. Thtse }udnmenl& abotJi in ihoraliio ^Pluurotc Ihc coniovawc vncur ihp unctd-iinty ;ind thp risks attendUM} ooctt Idinty a^ncidied wtih cfonoinlc torecjdis For pudjcipunrs projecbons aro rimfncl from the (?armipic. fupptrtcd paFiicipinl projotis Ibal rocir dwcrsfly ot pnpuciponis VJOV^ itboul I in? mosl COP iimi toial conujnm prices will rise stearliiy Uknly oulcornc* FOTRUK( uncnrtnlnty w enn^ 11 iinnuol falcs of iCSpedrvety. ^pcrccni tpnf| i;t*n«| |MV IV ^isttv dv»OCijlie<l wilh D |Vu|k:ulAi ?pcfG£nt. If Ihe uncwiamty otlRmliiij itwse pm- projeciKXi. •••Ehf.i rPiinn jGdinrts is^kmiHj taUui cxperiencArj inmt number of d^ffuvnt pro

Ben S. Bernanke (2008, February 27). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_20080228_chair_federal_reserves_first_monetary_policy

@misc{wtfs_testimony_20080228_chair_federal_reserves_first_monetary_policy,
  author = {Ben S. Bernanke},
  title = {Congressional Testimony},
  year = {2008},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_20080228_chair_federal_reserves_first_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}