Congressional Testimony

S. HRG. 110-855 FEDERAL RESERVE'S SECOND 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 JULY 15, 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 50-409 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 AMY FRIEND, Chief Counsel DEAN V. SHAHINIAN, Senior Counsel JENNIFER FOGEL-BUBLICK, Counsel JULIE CHON, Counsel AARON KLEIN, Chief Economist JONATHAN MILLER, Professional Staff Member COLIN McGlNNIS, Professional Staff Member NEAL ORRINGER, Professional Staff Member DREW COLBERT, Legislative Assistant BRIAN FlLIPOWICH, Legislative Assistant MARK OESTERLE, Republican Chief Counsel JlM JOHNSON, Republican Counsel PEGGY KUHN, Republican Senior Financial Economist ANDREW OLMEM, Republican Professional Staff Member MARK CALABRIA, Republican Professional Staff Member BRANDON BARFORD, Republican Legislative Assistant DAWN RATLIFF, Chief Clerk DEVIN HARTLEY, Hearing Clerk SHELVIN SIMMONS, IT Director JIM CROWELL, Editor (ID C O N T E N TS TUESDAY, JULY 15, 2008 Page Opening statement of Chairman Dodd 1 Opening statements, comments, or prepared statements of: Senator Shelby 3 WITNESS Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System 4 Prepared statement 38 Response to written questions of: Senator Shelby 42 Senator Bunning 44 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Monetary Policy Report to the Congress dated July 15, 2008 46 (III) FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2008 TUESDAY, JULY 15, 2008 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Committee met at 10:09 a.m., in room SR—325, Russell Sen- ate Office Building, Senator Christopher J. Dodd (Chairman of the Committee) presiding. OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD Chairman DODD. Well, good morning. Let me welcome my col- leagues and others to this very important hearing this morning. I want to thank the Chairman of the Federal Reserve. Today we are meeting in the most unusual and extraordinary moments in many ways in the recent history of our country. Let me tell you how we are going to proceed this morning. This is, of course, a scheduled hearing with the Chairman of the Federal Reserve on Humphrey-Hawkins and dealing with monetary policy, and over the next hour or so, we are going to focus on that and give the Chairman an opportunity to give us his statement this morning on that statutorily mandated requirement to appear be- fore the Committee and share his thoughts on this issue. And then, as I understand it, we are due to have a vote around 11 o'clock, and my hope would be that we would recess for a few minutes for that vote, and when we come back, the Secretary of the Treasury, Hank Paulson, and Christopher Cox, the Chairman of the Securi- ties and Exchange Commission, will be with us to engage in a dis- cussion of the financial services issues that are before us. I want to thank Senator Shelby and my colleagues here for waiving the normal requirements of having several days of notice before we actually have a hearing like this. But I think all of us recognize the significance of the issues that are going on in our country at this moment and the importance of having the Secretary of the Treasury and the Chairman of the SEC as well as the Chair- man of the Federal Reserve to be with us this morning. So I am very grateful to you and to the Secretary of the Treasury and Chris Cox. So the first hearing will be to receive the Semiannual Monetary Policy Report from the Federal Reserve as previously scheduled, and after the conclusion of that hearing, we will convene a second hearing on Recent Developments in U.S. Financial Markets and Regulatory Responses to Them. The second hearing was noticed yesterday with the consent of Senator Shelby—and, again, I am (l) grateful to him—due to the special and exigent circumstances in our Nation's financial markets. I want to thank Chairman Bernanke for testifying at both hear- ings. I also thank Secretary Paulson and Chairman Cox for agree- ing to appear on very short notice at the second hearing. In def- erence to them and the importance of the matters at hand, I will provide a brief opening statement. I will ask Senator Shelby to do likewise. And then I would ask my fellow Members here if they would reserve their question period to make their opening state- ments. All statements will be included in the record as if read so that we can get to the statement by the Chairman of the Federal Reserve and then get to the questions as quickly as we can. In considering the state of our economy and, in particular, the turmoil in recent days, it is important to distinguish between fear and facts. In our markets today, far too many actions are being driven by fear and ignoring crucial facts. One such fact is that Fannie Mae and Freddie Mac have core strengths that are helping them weather the stormy seas of today's financial markets. They are adequately capitalized. They are able to access the debt mar- kets. They have solid portfolios with relatively few risky subprime mortgages. They are well regulated, and they have played a vital role in maintaining the flow of affordable mortgage credit even dur- ing these volatile times. Another fact is that the subprime lending fiasco was preventable. In this Committee, 18 months of exhaustive hearings have docu- mented what I have called a "pattern of regulatory neglect." The previous leadership, along with other financial agency leaders ap- pointed by this administration, in my view ignored the clear and present danger posed by predatory lending to homeowners, to fi- nancial institutions, and to the economy as a whole. The result of this neglect is that the American people are experiencing unprece- dented hardships and uncertainties. Foreclosure rates continue at record levels. Each and every day in America, more than 8,000 families enter foreclosure. For those lucky enough to keep their homes, the value of their homes has dropped by the greatest amount in some cases since the Great De- pression. Millions more are paying record-high prices for gasoline, for health care, for education, and even for the food that they put on their tables. They are watching the value of their pension funds and 401(k)s plummet. And they want to know when will things start to turn around, when will America get back on track. Chairman Bernanke, you are to be commended, in my view, for your efforts to bring greater stability to our financial system during an unprecedented period of volatility. You also deserve credit for your willingness to address some of the unsafe, unsound, and pred- atory practices that proliferated over the last several years in the subprime mortgage market, as well as in the credit card lending. And we look forward to hearing from you today about the outlook for the Nation's economy and what can be done to improve it. Certainly, this Committee has worked diligently in that regard. On Friday evening, the Senate passed, with an overwhelming bi- partisan majority, a bill that we believe will assist homeowners at risk of foreclosure, establish a new, permanent affordable housing fund, modernize the FHA, strengthen the regulation of the GSEs, and help restore confidence to the mortgage markets as a whole. It is certainly my view that this legislation deserves to be enacted as soon as possible, and I hope that will occur. In addition, we are all by now aware that the Treasury and the SEC as well as the Fed made important policy announcements this past weekend, which we intend to examine carefully in the hearing later this morning with you, Mr. Chairman, Secretary Paulson, and Chairman Cox. I think I can speak for everyone, I hope, on this Committee in saying that we all share a common desire to promote the common good of our country, and I think we all certainly appreciate the spirit in which the Fed, the SEC, and the Treasury Department have acted. But we do them and the American people a disservice if we do not examine very carefully the proposals that are being put forward. That is particularly true of the Treasury proposals. It is in many respects unprecedented. Although limited in duration, these proposals would give the Treasury unlimited new authority to purchase GSE debt and equity, it would exempt those purchases from pay-as-you-go budget rules, and it would grant to the Federal Reserve considerable new powers in relation to the regulation of the GSEs. These new powers could have the effect of crippling the efforts of virtually every Member of this Committee to create a true world-class regulator for the GSEs. These proposals raise serious questions—questions about the na- ture of the economic crisis facing our Nation, about the ability of these proposals to address this crisis effectively, and about the bur- den to the American taxpayer potentially being asked to carry. These questions deserve serious answers. Above all, this is a time to act on the basis of fact and not fear, as I said at the outset of these remarks. For too many years, lead- ers have shirked their duty, in my view, to protect the American taxpayer and to promote the American economy. At this critical moment, we must not flinch from our duty to do the same. With that, let me turn to Senator Shelby. STATEMENT OF SENATOR RICHARD C. SHELBY Senator SHELBY. Mr. Chairman, I ask that my whole statement be made part of the record. Chairman DODD. Without objection, it will be. Senator SHELBY. Chairman Bernanke, we again welcome you to the Banking Committee. We know this is a stressful time for our country, for our banking system, and perhaps for the Federal Re- serve. We welcome you to deliver the Federal Reserve's Semiannual Monetary Policy Report, as you are required by law to do. I will keep my remarks brief and wait for Secretary Paulson and also SEC Chairman Cox to join you. But we are all interested in your views on the economy, where the economy is going to go, more than the specter of inflation, but other issues, related issues, such as the GSE situation. A lot of us—and you have raised this issue, your Chairman raised this issue over 5 years ago in this Committee. A lot of us realized that the GSEs were not properly regulated and were thinly capitalized. We have seen this come home now. They were fears that we hoped would not come, but they are here today. I guess the situation is some said always that the GSEs, because of the implicit guarantee of the Government, with over $5 trillion of debt, exceeding that of France and the U.K. combined, that it was a ticking time bomb. Well, someone has started the fuse burn- ing. I hope it is not too little or too late. But I believe this is an opportune time to rein in the GSEs. Senator Dodd has talked about this a lot: We realize they are im- portant to our housing, they are important to our economy, but they have to be capitalized well. They have got to be managed well, and they have got to be regulated. And I hope later in the morning we will get into that. I think that is one of the topics of the day after your monetary policy report. Thank you, Senator Dodd. Chairman DODD. With that, Mr. Chairman, we welcome your comments, and your statement in full will be included in the record. STATEMENT OF BEN S. BERNANKE, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Mr. BERNANKE. Chairman Dodd, Senator Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. The U.S. economy and financial system has confronted some sig- nificant challenges thus far in 2008. The contraction in housing ac- tivity that began in 2006 and the associated deterioration in mort- gage markets that became evident last year have led to sizable losses at financial institutions and a sharp tightening in overall credit conditions. The effects of the housing contraction and of the financial head winds on spending and economic activity have been compounded by rapid increases in the prices of energy and other commodities which have sapped household purchasing power even as they have boosted inflation. Against this backdrop, economic activity has advanced at a slug- gish pace during the first half of this year while inflation has re- mained elevated. Following a significant reduction in its policy rate over the second half of 2007, the Federal Open Market Committee eased policy considerably further through the spring to counter ac- tual and expected weakness in economic growth and to mitigate downside risk to economic activity. In addition, the Federal Reserve expanded some of the special liquidity programs that were estab- lished last year and implemented additional facilities to support the functioning of financial markets and foster financial stability. Although these policy actions have had positive effects, the econ- omy continues to face numerous difficulties, including ongoing strains on financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other com- modities. Let me now turn to a more detailed discussion of some of these key issues. Developments in financial markets and their implications to the macroeconomic outlook have been a focus of monetary policymakers over the past year. In the second half of 2007, the deteriorating performance of subprime mortgages in the United States triggered turbulence in domestic and international financial markets as in- vestors became markedly less willing to bear credit risks of any type. In the first quarter of 2008, reports of further losses and writedowns by financial institutions intensified investor concerns and resulted in further sharp reductions in market liquidity. By March, many dealers and other institutions, even those that had relied heavily on short-term secured financing, were facing much more stringent borrowing conditions. In mid-March, a major investment bank, the Bear Stearns Com- panies Incorporated, was pushed to the brink of failure after sud- denly losing access to short-term financing markets. The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy. After discussions with the Securities and Exchange Commission and in consultation with the Treasury, we invoked emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by JPMorgan Chase and Company. In addition, the Federal Reserve used emergency authorities to establish two new facilities to provide backstop liquidity to primary dealers, with the goals of stabilizing financial conditions and in- creasing the availability of credit to the broader economy. We have also taken additional steps to address liquidity pres- sures in the banking system, including a further easing of the terms for bank borrowing at the discount window and increases in the amount of credit made available to banks through the Term Auction Facility. The FOMC also authorized expansion of its currency swap ar- rangements with the European Central Bank and the Swiss Na- tional Bank to facilitate increased dollar lending by those institu- tions to banks in their jurisdictions. These steps to address liquidity pressures, coupled with mone- tary easing, seem to have been helpful in mitigating some market strains. During the second quarter, credit spreads generally nar- rowed, liquidity pressures ebbed, and a number of financial institu- tions raised new capital. However, as events in recent weeks have demonstrated, many financial markets and institutions remain under considerable stress, in part because the outlook for the econ- omy and, thus, for credit quality remains uncertain. In recent days, investors became particularly concerned about the financial condition of the Government-sponsored enterprises Fannie Mae and Freddie Mac. In view of this development, and given the importance of these firms to the mortgage market, the Treasury announced the legislative proposal to bolster their capital, access to liquidity, and regulatory oversight. As a supplement to the Treasury's existing authority to lend to the GSEs, and as a bridge to the time when the Congress decides how to proceed on these matters, the Board of Governors author- ized the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac should that become necessary. Any lending would be collateralized by U.S. Government and Federal agency securi- ties. In general, healthy economic growth depends on well-func- tioning financial markets. Consequently, helping the financial mar- kets to return to more normal functioning will continue to be a top priority of the Federal Reserve. I turn now to current economic developments and prospects. The economy has continued to expand, but at a subdued pace. In the labor market, private payroll employment has declined this year, falling at an average pace of 94,000 jobs per month through June. Employment in the construction and manufacturing sectors has been particularly hard hit, although employment declines in a number of other sectors are evident as well. The unemployment rate has risen and now stands at 5.5 percent. In the housing sector, activity continues to weaken. Although sales of existing homes have been unchanged this year, sales of new homes have continued to fall, and inventories of unsold new homes remain high. In response, home builders continue to scale back the pace of housing starts. Home prices are falling, particu- larly in regions that experienced the largest price increases earlier this decade. The declines in home prices have contributed to the rising tide of foreclosures. By adding to the stock of vacant homes for sale, these foreclosures have in turn intensified the downward pressure on home prices in some areas. Personal consumption expenditures have advanced at a modest pace so far this year, generally holding up somewhat better than might have been expected given the array of forces weighing on household finances and attitudes. In particular, with the labor market softening and consumer price inflation elevated, real earn- ings have been stagnant so far this year. Declining values and eq- uities in house have taken their toll on household balance sheets, credit conditions have tightened, and indicators of consumer senti- ment have fallen sharply. More positively, the fiscal stimulus pack- age is providing some timely support to household incomes. Over- all, consumption spending seems likely to be restrained over com- ing quarters. In the business sector, real outlays for equipment and software were about flat in the first quarter of the year, and construction of nonresidential structures slowed appreciably. In the second quarter, the available data suggests that business fixed investment appears to have expanded moderately. Nevertheless, surveys of capital spending plans indicate that firms remain concerned about the economic and financial environment, including sharply rising costs of inputs and indications of tightening credit, and they are likely to be cautious with spending in the second half of the year. However, strong export growth continues to be a significant boon to many U.S. companies. In conjunction with the June FOMC meeting, Board members and reserve bank presidents prepared economic projections cov- ering the years 2008 through 2010. On balance, most FOMC par- ticipants expected that, over the remainder of this year, output would expand at a pace appreciably below its trend rate, primarily because of continued weakness in housing markets, elevated en- ergy prices, and tight credit conditions. Growth is projected to pick up gradually over the next 2 years as residential construction bot- toms out and begins a slow recovery and as credit conditions gradually improve. However, FOMC participants indicated that considerable uncertainty surrounded their outlook for economic growth, and they viewed the risks to their forecast as skewed to the downside. Inflation has remained high, running at nearly a 3.5-percent an- nual rate over the first 5 months of this year, as measured by the price index of personal consumption expenditures. And with gaso- line and other consumer energy prices rising in recent weeks, infla- tion seems likely to move temporarily higher in the near term. The elevated level of overall consumer inflation largely reflects a contin- ued sharp run-up in the prices of many commodities, especially oil, but also certain crops and metals. The spot price of West Texas in- termediate crude oil soared about 60 percent in 2007 and thus far this year has climbed an additional 50 percent or so. The price of oil currently stands at about 5 times its level toward the beginning of this decade. Our best judgment is that this surge in prices has been driven predominantly by strong growth in un- derlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded at its fastest pace in decades, leading to substantial increases in de- mand for oil. Moreover, growth has been concentrated in developed and emerging market economies, where energy consumption has been further stimulated by rapid industrialization and by govern- ment subsidies that hold down the price of energy faced by ulti- mate users. On the supply side, despite sharp increases in prices, the produc- tion of oil has risen only slightly in the past few years. Much of the subdued supply response reflects inadequate investment and production shortfalls in politically volatile regions where large por- tions of the world's oil reserves are located. Additionally, many gov- ernments have been tightening their control over oil resources, im- peding foreign investment and hindering efforts to boost capacity and production. Finally, sustainable rates of production in some of the more secure and accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long-term oil supplies have been marked down in recent months. Long-dated oil future prices have risen along with spot prices, suggesting that market partici- pants also see oil supply conditions remaining tight for years to come. The decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices. The precise size of this effect is difficult to ascertain as the causal relationships be- tween oil prices and the dollar are complex and run in both direc- tions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar— notably, shifts in the underlying global demand for and supply of oil—have been the principal drivers of these increases in prices. Another concern that has been raised is that financial specula- tion has added markedly to upward pressure on oil prices. Cer- tainly, investor interest in oil and other commodities has increased substantially of late. However, if financial speculation is pushing oil prices above the levels consistent with the fundamentals of sup- ply and demand, we would expect inventories of crude oil and pe- troleum products to increase as supply rose and demand fell. But, in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term. Although the inflationary effect of rising oil and agricultural commodity prices is evident in the retail prices of energy and food, the extent to which the high prices of oil and other raw materials have passed through to the prices of non-energy, non-food finished goods and services seems thus far to have been limited. But with businesses facing persistently higher input prices, they may at- tempt to pass through such costs into prices of final goods and services more aggressively than they have done so far. Moreover, as the foreign exchange value of the dollar has de- clined, rises in import prices have put greater upward pressure on business costs and consumer prices. In their economic projections for the June FOMC meeting, monetary policymakers marked up their forecasts for inflation during 2008 as a whole. FOMC partici- pants continue to expect inflation to moderate in 2009 and 2010 as slower global growth leads to a pooling of commodity markets, as pressures on resource utilization decline, and as longer-term infla- tion expectations remain reasonably well anchored. However, in light of persistent escalation of commodity prices in recent quar- ters, FOMC participants view the inflation outlook as unusually uncertain and cited the possibility that commodity prices will con- tinue to rise as an important risk to the inflation forecast. Moreover, the currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation. If that were to occur and those revised expectations were to become embedded in the domestic wage- and price-setting proc- ess, we could see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policymakers is to prevent that process from taking hold. At present, accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant chal- lenge for monetary policymakers. The possibility of higher energy prices, tighter credit conditions, and a still deeper contraction in housing markets all represent significant downside risks to the out- look for growth. At the same time, upside risks to the inflation out- look have intensified lately as the rising prices of energy and some other commodities have led to a sharp pick-up in inflation, and some measures of inflation expectations have moved higher. Given the high degree of uncertainty, monetary policymakers will need to carefully assess incoming information bearing on the outlook for both inflation and growth. In light of the increase in up- side inflation risk, we must be particularly alert to any indications, such as erosion of longer-term inflation expectations, that the infla- tionary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process. I would like to conclude my remarks by providing a brief update on some of the Federal Reserve's actions in the area of consumer protection. At the time of our report last February, I described the Board's proposal to adopt comprehensive new regulations to prohibit unfair or deceptive practices in the mortgage market using our authority under the Home Ownership and Equity Protection Act of 1994. After reviewing more than 4,500 comment letters we received on these proposed rules, the Board approved the final rules yesterday. The new rules apply to all types of mortgage lenders and will es- tablish lending standards aimed at curbing abuses while pre- serving responsible subprime lending and sustainable homeowner- ship. The final rules prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher- priced loans, lenders now will be required to establish escrow ac- counts so that property taxes and insurance costs will be included in consumers' regular monthly payments. The final rules also prohibit prepayment penalties for higher- priced loans in cases in which the consumer's payment could in- crease during the first few years and restrict prepayment penalties on other higher-priced loans. Other measures address the coercion of appraisers' service or practices and other issues. We believe the new rules will help to restore confidence in the mortgage market. In May, working jointly with the Office of Thrift Supervision and the National Credit Union Administration, the Board issued pro- posed rules under the Federal Trade Commission Act to address unfair or deceptive practices for credit card accounts and overdraft protection plans. Credit cards provide a convenient source of credit for many consumers, but as the terms of credit card loans have be- come more complex, transparency has been reduced. Our consumer testing has persuaded us that disclosures alone cannot solve this problem. Thus, the Board's proposed rules will re- quire card issuers to alter their practices in ways that will allow consumers to better understand how their own decisions and ac- tions will affect their costs. Card issuers would be prohibited from increasing interest rates retroactively to cover prior purchases, ex- cept under very limited circumstances. For accounts having mul- tiple interest rates, when consumers seek to pay down their bal- ance by paying more than the minimum, card issuers would be pro- hibited from maximizing interest charges by applying excess pay- ments to the lowest-rate balance first. The proposed rules dealing with bank overdraft services seek to give consumers greater control by ensuring that they have ample opportunity to opt out of automatic payments of overdrafts. The Board has already received more than 20,000 comment letters in response to these proposed rules. Thank you very much. I would be pleased to take your questions. Chairman DODD. Well, thank you very much, Mr. Chairman. And let me just briefly say I appreciate the efforts of the Fed regarding both credit cards and the things dealing with predatory lending practices. We welcome those rules, and we welcome the suggestions in the credit card areas, and a future point here, we will maybe have more discussion about that. But I wanted to at least reflect 10 my appreciation of what the Fed has done regarding those matters, and we appreciate it very much. I am going to put this clock on at 5 minutes so we can give ev- eryone a chance to raise any questions they have on the monetary policy issues. Some of the questions may overlap, and at the conclu- sion of that, Secretary Paulson and Chairman Cox will be here to have a broader discussion about the proposals being made by Treasury over the weekend. Let me, if I can, jump to the economic projections for 2009, the concerns about economic growth that you have raised in your state- ment here this morning. Given the fact that we have, as you point out, acknowledged the risk to your forecast for economic growth are skewed to the downside, to use your words, and given the fact that the stimulus package is about to—the effects of it are going to run out by the end of the year. The housing crisis continues, obviously, as we all know painfully. Gasoline prices, as you point out, are at record levels, costing consumers tremendously. The issues involving the weakness in the labor market are significant, 94,000 jobs lost every month for the last 6 months on a consistent basis. Inflation, as you point out, while it may abate in the coming years, it cer- tainly is going to be with us for some time. What suggestions do you have for us in all of this? And I realize you may want to reserve some final judgment on the effects of the stimulus package and will not know the full effects of that until maybe toward the end of the year. But as we look down the road as policy setters here in the Congress looking at ideas, including a possibly a second stimulus package, one of the suggestions we made to increase productivity is to invest more heavily in infra- structure, the infrastructure needs of the country. I wonder if you might just share with us your views as to what ideas, as a menu of ideas, without necessarily embracing one or the other, but what you would be planning to do rather than just sort of waiting out the year and a new administration coming in, we will be leaving here, adjourning in late September, early October, maybe coming back, maybe not until after inauguration of the President late in January, it seems to me this would be an oppor- tune time for us to be considering very seriously policy consider- ations that would provide for greater economic growth and oppor- tunity than what we are presently looking at. Mr. BERNANKE. Mr. Chairman, I think that the central issue in the economic situation right now is the housing market. It is the continued uncertainty about house prices and housing activity which is creating financial stress, is affecting consumer wealth and consumer expectations and causing the stress we are seeing in the economy. So my suggestion would be in the near term to focus on issues related to housing. I understand that you have already passed a bill that would address, for example, GSE reform. We need the GSEs to continue to be active in supporting the mortgage markets, as well as FHA modernization and other steps that Con- gress determines would strengthen and support mortgage finance in the housing sector. I think that is the most critical central issue we face. On a second stimulus package, my own sense is that we are still trying to assess the effects of the first round. It appears that it 11 does seem to be helping. But it might be a bit more time before we fully understand the extent to which additional stimulus may or may not be needed. If additional stimulus is, in fact, invoked, it would be important to find programs that would be, as in the first round, timely, tem- porary, and targeted, in particular, that would take place quickly and would put money into the economy relatively quickly. In the case of infrastructure, it is often well justified on its mer- its, but one would have to ask whether the flow of funding would go into the economy in a relatively prompt way, or would there be long delays associated with the planning process? Chairman DODD. But your objections or concerns, they are not about the effects of that in the longer term but more the near-term benefits of it. Mr. BERNANKE. Addressing the infrastructure issue in the United States is very important since infrastructure is a critical part of the economic underpinnings. But except for those cases where the in- frastructure spending would have immediate impact on total spending, I would suggest that those projects be evaluated on their own merits in terms of their ability to contribute to the overall strength of the economy in the longer term. Chairman DODD. I have a last question for you dealing with gas- oline prices, and, again, let me first of all commend you because you did something different than your predecessor. In the past, we have excluded in the consideration of inflation gasoline or energy pricing and food. And if you do not drive a car, heat your home, or put food on the table, I suppose that has some relevance here. And I understand the macroeconomic value of excluding energy and food. But for average Americans, excluding those two neces- sities hardly reflects real inflation. And so the fact that you are now adding those to real inflation is very welcome, and I thank you for it. I wonder if you might comment briefly on the notion, how is it— and I understand your points about demand in the country and around the world and supply issues. But it strikes many of us here in the speculation area, and you said the need to look at trans- parency issues and the like are warranted. But it seems to me in 1 year's time to go from $60 or $70 a barrel to this morning I think it is hovering around $150 a barrel has to be explained in terms other than just normal economic pressures that it created. Does it concern you at all about margin requirements, for in- stance, in the area of speculation where the margin requirements are somewhat different in the area of energy pricing than they are for other commodities that there should be some leveling of the playing field when it comes to margin requirements, as an example of what might come as a response? Mr. BERNANKE. I would just like to comment briefly that the Federal Reserve and the CFTC are part of a task force which is gathering data analyzing these issues and hope to bring some more explicit recommendations to you later this summer or early fall. Margin requirements serve two purposes. They can affect the cost of credit, but they also are a very important part of the counterparty risk management process for exchanges. And so we need to be careful in changing margin requirements that we do not 12 interfere with these other important functions or that we do not unnecessarily reduce the liquidity in those markets. But we are certainly looking at these issues, and we hoped that they would bring to you some ideas. Chairman DODD. You will be looking at that one specifically, the margin requirement issue. Is that Mr. BERNANKE. We will be looking specifically at the whole range of issues about transparency, practices, positions, and so on. Chairman DODD. Thank you very much. Senator Shelby. Senator SHELBY. Mr. Chairman, I have a number of questions that I would like to submit for the record dealing with monetary policy. Chairman DODD. That will all be done, by the way. Any ques- tions people have and they do not feel they have enough time on monetary policy, we will make sure the Chairman gets them. Senator SHELBY. Chairman Bernanke, you are also a bank regu- lator, the Federal Reserve, and I know that you are not the pri- mary regulator of IndyMac, which was the largest bank failure since 1984, Continental Illinois. Why did that bank fail? And could it have been prevented? What is your take on it? And is that just the beginning of a number of bank failures that you should be con- cerned with and we should be concerned with in this country? Mr. BERNANKE. Well, Senator, as you point out, we are not the primary regulator of that institution, but we were involved in Senator SHELBY. Absolutely. Mr. BERNANKE. because the Federal Reserve Bank of San Francisco was attempting to assist in the wind down, and we cer- tainly had extensive communication with the FDIC and the OTS about that bank. My assessment of IndyMac is that it was particularly weighted down with low-quality mortgages, subprime and other exotic mort- gages, and those losses created a capital hole that it was unable to fill. So in that respect, I think its failure, barring acquisition by another firm, which did not occur, was inevitable. So, again, I think it was basically the asset quality of the bank that had that effect. Of course, all banks are being challenged by credit conditions now. The good news is that the banking system did come into this episode extremely well capitalized, extremely profitable. I do not have any forecast to make. I think Chairman Bair gave a good dis- cussion yesterday about the pressures that banks are facing, and she discussed her list of problem banks. I suppose it is a bit of good news that most of the problem banks that she had is a far smaller list than we have seen in some epi- sodes in the past, in the 1990s, for example. Senator SHELBY. Overall, looking at our banking system, could you say today here in the Senate that you believe as Chairman of the Federal Reserve that our banking system is stable and capitally strong? Mr. BERNANKE. Our banking system is well capitalized. They came in with strong capital. We are watching the situation very carefully. My concerns have turned less on the solvency of these in- stitutions and more on their ability to extend the credit that our 13 economy needs to keep growing, because in many cases banks are deleveraging or shrinking or are reluctant to raise the extra capital needed to take advantage of business opportunities. So that is more my concern than solvency concerns. Senator SHELBY. Let's briefly, because I have just got a couple of minutes, focus on the GSEs, and we will get into it more when the Treasury Secretary gets here and the Chairman of the SEC. Is this just a stopgap measure or is this a real approach to fundamen- tally reform the GSEs? A lot of us, you included, have been advo- cating that right here on this Committee for a long time. We did not have a lot of help from certain people, some of our friends, and Fannie Mae and Freddie Mac have some of the most powerful lob- byists, believe me, in Washington. And I do not believe that they are going to like some of the things that I believe we have to come forth with now. But is this just a piecemeal deal? Because we have got systemic risk here. Where do we go? Will this do it, in other words, or will this just be postponing the inevitable? Mr. BERNANKE. Well, Senator, our goals at this point should be to protect the financial system, to protect the taxpayer, and to strengthen and support the housing market. There are a number of steps that we need, but I think a critical step would be Senator SHELBY. What are the three most important steps? Mr. BERNANKE. The most important step will be to get a strong, bank-like, world-class regulator that will be able to provide assur- ance to the public, to the taxpayer, and to the investors that these firms will be well capitalized and able to maintain and support their core mission, which is to support mortgage financing in the United States. So I would say that is job one. Then we need to think about what else is needed to make sure that they are, in fact, strong enough financially and there is enough confidence that they can, in fact, carry out their mission. And, again, the taxpayers' interest must be protected. Senator SHELBY. Thank you, Mr. Chairman. Chairman DODD. Thank you. Senator Menendez. Senator MENENDEZ. Thank you, Mr. Chairman. Thank you, Chairman Bernanke, for your testimony and your successful. I want to visit with you on the housing issue. In March of 2007, you said that, "The impact on the broader economy and financial markets of the subprime market seems likely to be contained." And I assume you would want to change that statement today some- what, amend it, with the ability of 20/20 hindsight. What do you think in the housing crisis, do you see it hitting rock bottom this year? A year from now? Because this is one of the significant challenges within the economy. What do you see on the horizon? Mr. BERNANKE. Well, first, of course, I would like to revise and extend my remarks from March of 2007. The issue was that the subprime crisis triggered a much broader retreat from credit and risk taking, which has affected not just subprime lending but a wide variety of credit instruments. And that is why it has become a much bigger element in the situation than, frankly, I anticipated at that time. 14 The housing market is still under considerable stress and con- struction is still declining. I do believe that we will start to see sta- bilization in the construction of new homes sometime later this year or the beginning of next year, and that will be a benefit be- cause the slowing construction pattern has been subtracting about 1 percentage point from the growth of the GDP going back now for some time. So that will be a benefit. House prices may continue to fall longer than that because of the large inventories of unsold homes that we still face. And then I would have to say that there is uncertainty about exactly what the equilibrium level that house prices will reach is. Unfortunately, it is that uncertainty, which is generating a lot of the stress and risk aversion we are seeing in financial markets. It is for that reason—the need to find a footing, to find stability in the housing market—that I do think that action by this Con- gress to support the housing market through strengthening the GSEs and FHA and so on is of vital importance. Senator MENENDEZ. Let me talk about the other major driver, then, of what is happening to our economy, and that is the whole question of energy prices and oil. You know, I appreciate in your answer to the Chairman and in your testimony, because we have had testimony before the Congress by all executives who say that the difference between supply and demand over the last 2 years would largely lead us to a concern that, in fact, speculation may have driven the price of oil up an additional $50 a barrel. You have the view that that may not be the most significant thing in prices, but you do take the view that useful steps can be taken to improve the transparency and functioning of future markets. Are you ready to say to the Committee today what some of those useful steps are? Or are you still depending upon that Committee that you are meeting with to look at that? Because we do not have a lot of time here. Mr. BERNANKE. Senator, this is really the CFTC's function and responsibility. We are trying to assist them, and we are trying to work as quickly as possible to gather information and try to make some useful recommendations. Senator MENENDEZ. Well, many of us believe we need to pursue market speculation now as a critical element of helping to drive down particularly gas prices. Let me ask you this: There is one thing squarely within your realm, and that is the question of a weaker dollar. In 2000, we ran a budget surplus. Ever since then, the Federal Government has been running up larger budget deficits. We added to that a $1.6 trillion tax cut and a $700 billion war that would generally contribute to a larger budget deficit. And if you look at that and you look at the twin deficits of both trade and the budget in combination, you have a low—with a low domestic savings rate, you have all of the makings of a weakening dollar. In 2002, the barrel of oil cost $23 and 23 euros. Now it costs— well, the Chairman had even a higher figure than I had. I had $145 and 90 euros. I am sure it just changed overnight. Do you agree with the Commodity Futures Trading Commission and others that the weakening dollar has contributed to the higher price of oil as an elemental part of our challenge? 15 Mr. BERNANKE. I do agree, and I said so in my testimony. It should be noted that the decline in the dollar from 2002 reversed an appreciation of the dollar that had taken place from the early 1990s until that point. And it is related to the dynamics of our trade deficit, as you alluded to. In the late 1990s and early 2000s, strong capital inflows drove the dollar up, but that made up less competitive and created a trade deficit. Some of that has to be unwound to bring us back to- ward a better balance of trade, and, in fact, we had been seeing considerable improvement in our balance of trade as the dollar re- versed that increase. But we also import a lot of oil, and because we import it, when oil prices rise, that also works in the other di- rection. It tends to hurt the dollar. So there is really causality going in both directions. Senator MENENDEZ. Thank you, Mr. Chairman. Chairman DODD. Senator Bennett. Senator BENNETT. Thank you very much, Mr. Chairman. Welcome, Chairman Bernanke. I have the same kinds of ques- tions everybody has with respect to the deal made over the week- end for Fannie and Freddie, but I will save those for the next panel. Let's talk about your forecast. The GDP for the first quarter was originally forecast at six-tenths of 1 percent and then nine-tenths of 1 percent and then at 1-percent growth. It has always been raised as the data come in. We have had a bear signal on the Dow theory. I don't know whether you follow that or not, but there has been a lot of that in the newspapers, which I know you do follow that. Whether you believe the Dow theory or not, you follow it. I don't know whether you believe it or not. That is a separate issue. But, nonetheless, we have got a bear signal that says we are now in a bear market, which historically lasts for anywhere from 18 to 24, 30 months, something of that kind. The blue chip forecast for the second half has always been for growth—slow to be sure, relatively low to be sure, but for growth. And in your previous appearances before the Committee in this kind of a context, you have pretty much been in that same terri- tory. Are you still there? Mr. BERNANKE. Well, as your point about the first quarter makes clear, even after the fact, it is sometimes hard to know exactly how much growth there was. Yes, our forecast calls for growth in the second half, but relatively weak. Part of what seems to have hap- pened is that perhaps the fiscal stimulus or other factors—some of the growth that we anticipated—has been pulled forward into the second quarter, which looks to be doing somewhat better, frankly, than we anticipated. So our forecast Senator BENNETT. YOU mean pulled forward into the first quar- ter? Mr. BERNANKE. NO. TO the second quarter, the current—the quarter that just ended. Senator BENNETT. Oh, yes. All right. I am second half so that is—OK. Right. Mr. BERNANKE. SO the second quarter appears to be actually bet- ter than expected, and, therefore, our forecast for the entire year might actually be stronger than it was earlier. But with that 16 strength having been brought forward to some extent into the sec- ond quarter, we are looking at the remainder of the year as being probably positive growth, but certainly not robust growth. Senator BENNETT. The one thing the markets hate more than anything else is uncertainty, and I have the feeling that that is part of the problem with respect to oil prices and part of the prob- lem with respect to the housing market. Now, you have suggested that the housing market might sta- bilize over the next 6 to 12 months so that people will begin to say, OK, we have now reached bottom and we are starting to build back up again. Do you feel that the deal that was made over the week- end with Fannie and Freddie can help eliminate some of the uncer- tainty and cause people to have a greater degree of confidence that the timeframe that we have been talking about will indeed come to pass? Mr. BERNANKE. Well, Senator, no deal was made. All that was done was a proposal was made to bring to Congress Senator BENNETT. I am using newspaper talk. I realize that is always a mistake. Mr. BERNANKE. But as I said earlier, I think the housing sector, together to some extent with oil, is at the heart of the current un- certainty, the current situation. I think were it to happen that there would become a general view that the housing situation had stabilized, you would see actually a very strong bounce-back in the economy and the financial markets, and it is the uncertainty about when that happens that remains a problem. Again, it is the Congress' prerogative to decide what to do about the GSEs and other housing-related legislation. But as I tried to indicate before, I think the best thing that we can do to remove this uncertainty and to speed the recovery is to make sure that the housing market and the mortgage finance markets are functioning as well as possible. Senator BENNETT. Yes, but very specifically, taking away the word "deal"—and I agree with you that even though that is the word we have seen in the press, that is probably not the right word. But the structure that you have agreed to in terms of some kind of a back-up for the GSEs, should they get in trouble, do you have the feeling that the announcement of the terms of that struc- ture should remove some of the uncertainty with respect to their future? Mr. BERNANKE. Yes. I think right now that, in fact, part of the reaction in markets has to do with the uncertainty about exactly what the deal, as you call it, might look like. So if there is clarity which provides assurances that the GSEs will have the financial strength they need to support the mortgage market, and, second, as Senator Shelby emphasized, there is also a very strong regulator that will protect the system and protect the taxpayer, the combina- tion of those two things would be very constructive. Senator BENNETT. I think we know about the regulator. It is the other thing that people are waiting to find out about. Mr. BERNANKE. I think so, Senator, because right now the GSEs are a very big part of the U.S. mortgage market. Senator BENNETT. Thank you very much. Chairman DODD. Senator Casey. 17 Senator CASEY. Mr. Chairman, thank you very much, and, Chair- man Bernanke, I want to thank you for your presence here today and for your testimony. We have had the opportunity to question you on a number of oc- casions, I probably more than most because not only am I Member of this Committee but I am also a Member of the Joint Economic Committee, and we are grateful, again, for your testimony today. I wanted to review just some of the basic data, some of which you were kind enough to put in your statement today in terms of where we are economically in this country. It is, to use an old expression from the 1970s, a "misery index," a "tale of woe," but I think it is important to remind all of us kind of where we are. You cited on page 3, I guess, of your testimony the average pace of 94,000 jobs per month lost through June. If you look at it an- other way, just in terms of real GDP, the growth rate over the last couple of years—I had not seen these numbers until recently— 2005, 3.1-percent growth, "only" I should say; 2006, 2.9; 2007, 2.2; and then the first quarter of 2008, as was cited earlier, 1 percent. The total job loss the last 6 months, 438,000. You look at the trade deficit just with China alone, that went up even though the overall trade deficit went down. Foreclosures, 8,400 to 8,500 families per day, if you look at just weekdays, entering foreclosure. The projec- tion by Treasury for foreclosures for 2008 is at some 2.5 million. The prices report—there is a story today, a brief story in the New York Times, I guess online, sales of retail goods and food grew just 0.1 percent in June. Consumers spent a large amount of money on one product. Of course, gasoline we know, have heard an awful lot about that. But outside of fuel, sales actually dropped last month by 0.5 percent. All of that is background, of course, to two basic questions I wanted to ask you, one of which I have asked and you have an- swered over the course of many months in your appearances here. The first question pertains to the difference between the real world of the impact of this economic crisis on families versus the economist's definition of "recession." And I think, frankly, the old definition or the textbook definition of "recession" does not apply when it comes to what families are up against. And I think it was probably said best, not by a set of the data points I just read and not by any economist, recently in a story in the Centre Daily Times in Pennsylvania, in Centre County, Penn- sylvania, "Tammy May, a single mother of two in Pleasant Gap, Pennsylvania, probably said it best in just one line"—and I am quoting her. She is a single mother of two. "Pretty much we have reprioritized. The house payment is first, then day care, then we worry about gas, then food." Food is number four. So I would ask you, in light of that economic misery that I have just highlighted, and in light of your own testimony, your own work, and I think your own sensitivity to these issues, how do we deal with this question of what is a recession and what it isn't, and do we need some new definitions and some new terminology to bet- ter define what is happening to real families and real people? Mr. BERNANKE. Well, there is a technical definition of recession which has to do with behavior of employment and investor produc- tion and other things, and that is a determination that is made by 18 some economists after the fact. I don't know whether they will de- termine we have been in a recession or not according to these tech- nical definitions, but I agree with you entirely that whether it is a technical recession or not, the combination of declining wealth, weak job market, rising food and energy prices, foreclosures, tight credit—all those things are putting tremendous pressure on fami- lies and explain why consumer sentiment is very low. People are very worried. So I certainly would never make the claim that even if we were not in a technical recession that it was not a serious situation. And I just want to assure you that everything the Federal Reserve does is intended to try to promote the welfare of the average American, and that is our objective. Senator CASEY. Thank you. I think I am out of time. I will go to the next question on the second round. Thank you. Chairman DODD. I think Senator Bunning, I believe—no, excuse me. Senator Allard. I apologize. Senator ALLARD. Thank you, Mr. Chairman. Welcome to the Committee. I always look forward to hearing your comments, Chairman Bernanke. Business lending has—I want to talk about that a little bit, and a big aspect of business lending historically, I am told, has been that business plans and their ability to execute those business plans has been a big factor in assessing credit and whether they get a loan or not. I am told that in recent history that has been minimized considerably. First of all, I would like to know if that is true. And the other question, if it is true, do you think we could help confidence if we had provisions that somehow or the other brought more account- ability to the business plan aspect when you apply for a loan? Mr. BERNANKE. Well, there is a general tightening in credit and tightening in underwriting standards, you know, related to this pullback from credit risk in general. It has affected different groups differentially. For example, prime corporate borrowers are still able to access the bond market and the loan market pretty effectively. Riskier firms, smaller firms, are having more difficulty accessing credit. I think that I would encourage banks to continue to make sound loans, and we at the Federal Reserve will not penalize banks that are making sound loans. We want them to extend credit. In assess- ing how to make a good loan to a business, certainly there are many factors, including financials and personal relationships and many other things, but the business plan is certainly an important part and one that a good bank lender would look at. Senator ALLARD. YOU have assumed, meaning the Fed has as- sumed, a great regulatory oversight authority recently here. Are you comfortable with that? And do you anticipate that you may even take on a greater regulatory role? Mr. BERNANKE. We have begun to work with, as you know, the Securities and Exchange Commission, who are the primary regu- lator. We have been working with them to help evaluate and over- see the four large investment banks and the other primary dealers. That is because of the lending facility that we opened up after Bear Stearns. We have a responsibility to protect our loans, and I be- 19 lieve that the SEC views our participation as helpful in trying to make sure that these firms are sufficiently strong. It remains to be seen how the Congress would like to think through regulation going forward. I do think that the investment banks need a consolidated supervisor, but have not proposed a par- ticular agency to do that. The key issue is that they have strong consolidated supervision. The only area in which I have raised the possibility of additional powers for the Federal Reserve—in my tes- timony and in speeches—is in payment systems, which are system- ically important and where in most countries central banks have considerable oversight responsibility. I think it would be useful for the Congress to review how pay- ment and settlement systems are overseen and to ask whether, from a systemic point of view, they are adequately regulated and whether the Fed should have some additional role in that area. Otherwise, we are going to have to do a lot of thinking, all of us, and certainly the Congress, about how, if at all, the regulatory structure should change based on what we have learned in the last year. Senator ALLARD. Some of the discussions I have been involved in have said that if the Fed assumes a greater regulatory role, it could affect your independence. And I would like to hear you comment on that as acting in your current role. Mr. BERNANKE. Well, the way Congress wants to organize the regulatory structure is an important question that needs to be worked out, and I am not asking for any change at this moment. However, the Federal Reserve has a wide range of responsibilities, including not only regulatory oversight but also consumer protec- tion, payment systems, and other things. The independence, which is critical, is the independence vis-a-vis monetary policy. And I think we have been able to keep a good separation between mone- tary policy and these other areas. In these other areas, we are an independent agency, but we have no stronger claimed independ- ence than, say, the OCC would. It is only in monetary policy where we need to maintain a strict independence, you know, in order to make the right decisions. Senator ALLARD. I noticed on some of the projections into 2009 that they seem pretty positive—that they are better than what we are looking at this year, generally. What part of the economic sec- tor do you see will continue to struggle? And where do you see that growth to improve our economy as we move into 2009? Mr. BERNANKE. Well, first of all, there are some factors which have been positive and continue to be positive. Foreign trade ex- ports have been a very positive factor and have contributed signifi- cantly to our growth, and as that continues, that will be a basis to build on. I mentioned already the home-building sector. That has already declined quite substantially. It is very likely going to begin to level out somewhere around the end of the year. That leveling out will also provide additional strengths, at least in the sense of not sub- tracting from the GDP growth. As the situation begins to stabilize and credit markets begin to stabilize, then I think confidence will return to consumers, and we will see the beginnings of a recovery. But as I noted and as every- 20 one has made allusion to, the uncertainties of the exact timing of this are still great. Senator ALLARD. Thank you, Mr. Chairman. Chairman DODD. Thank you. Senator Tester. Senator TESTER. Thank you, Mr. Chairman. Thank you, Chair- man Bernanke. In your statement, you said the world economy was growing at the fastest pace in decades. I believe that is what you said. Do you anticipate that to continue or to decline? Mr. BERNANKE. I think that this year and going into next year, we probably will see some moderation but still healthy growth. Senator TESTER. SO do you think that those impacts, if it backs off some, will have positive or negative or no effect on our financial situation? Mr. BERNANKE. Well, it cuts two ways. On the one hand, it might weaken to some extent the contribution of exports and trade to our growth. But, on the other hand, if these other economies cool down, it might reduce commodity prices or flatten out commodity prices, which would be very beneficial. Senator TESTER. DO you anticipate overall negative, positive, or pretty static in its effect? Mr. BERNANKE. Sorry? Senator TESTER. I know it is a two-edged sword, but do you an- ticipate it will be positive, negative, or negligible? Mr. BERNANKE. I think it will be probably positive if it contrib- utes to a slowing in commodity prices. Senator TESTER. YOU talked about the long-term oil supplies are down. I believe that is what you said. Mr. BERNANKE. Well, not rising. Senator TESTER. IS that domestically, worldwide, or both? Mr. BERNANKE. Well, certainly oil supplies are declining in the United States. Worldwide, they have been relatively flat. Senator TESTER. OK. Senator Menendez talked about the dollar and the value it has on oil. Does the budget deficit have any effect on the value of the dollar? Mr. BERNANKE. Perhaps a weak effect, but I don't think it is a first-order effect. The linkage between the budget deficit and the trade deficit is there because the trade deficit does reflect our na- tional savings and investment imbalance. But, empirically, the ef- fect is relatively weak under most circumstances. Senator TESTER. And the value of the dollar has devaluated by about 40 percent—is that correct?—over the last 4 or 5 years. Mr. BERNANKE. NO. I think it is more like 25 percent. And, again, it has reversed a considerable appreciation prior to that peak in 2002. Senator TESTER. Are you comfortable with where the dollar's value is now? Mr. BERNANKE. I am looking for the economy to strengthen next year, and as it does, I think that will support a strong dollar going forward. Senator TESTER. DO you anticipate it—OK. That is fine. Is there anything that you see on the horizon that could impact the credit rating for the Treasury? 21 Mr. BERNANKE. NO, I don't. In the very long term, or even the medium term, we need to address these large issues of entitle- ments and the aging population, and there are tremendous chal- lenges involved there. I don't think anything in the next short pe- riod of time, including issues related to the GSEs, for example, would affect the credit rating. That is my understanding, for exam- ple, based on statements that some credit raters have made. Senator TESTER. And we will get into this in the next panel, but what you are saying is that even if we don't do anything with the bill that is being proposed on the GSEs, you don't think that could have any negative impact on the credit rating? Mr. BERNANKE. If we don't do anything? Senator TESTER. If we don't do anything, if we just let it play out. Mr. BERNANKE. NO, I don't think so. I don't think it would, no. Senator TESTER. OK. You stated earlier in your testimony that the housing is really kind of the root of what we are seeing, the housing contraction. From my perspective, we have kind of gone into a credit economy. Do you see that as being another part of this equation that is kind of a boat anchor on our economy, that we are making adjustments out of this? Or do you anticipate we are going to be in this, what I would say is a credit economy, from now on? Mr. BERNANKE. Well, a part of what has been happening—and this goes back to Senator Menendez's question about the role of the subprime crisis and so on—is that there was, if you will, a credit boom or a credit bubble where there was an overextension of credit in a lot of areas. There has been a big reversal of attitudes. Banks and other financial institutions are scaling back on their credit risk. They are deleveraging. They are raising capital. And that ad- justment process is part of what is happening now that is creating the drag on economic growth. So it is harder to get a mortgage, it is harder to get a business loan. And until we come to a more sta- ble situation where banks are comfortable with their credit stand- ards and their balance sheets, the leveraging process is going to continue and is part of what we are seeing here. Senator TESTER. And very quickly, because my time is over, do you—I mean, we have heard figures of 150 banks potentially going down because, I assume, of this adjustment that you just talked about. Do you guys have any projections on what kind of impact banking institutions going down, how many there potentially could be in the next year or do you not want to comment on that? Mr. BERNANKE. I think I would just refer you to Chairman Bair's list and discussion from the last couple of days. We don't have a projection. Senator TESTER. HOW many are on that list? Mr. BERNANKE. About 95, as I recall. As I said, I think the bank- ing system came into this episode with good capital basis and with strong earnings. Senator TESTER. OK. Thank you, Mr. Chairman. I appreciate that. Thank you. Chairman DODD. Thank you very much. Senator Bunning. Senator BUNNING. Thank you, Mr. Chairman. Since I did not give an opening statement, I want to give an opening statement in 22 all deference to Chairman Bernanke. I know we have a lot of ground to cover today, but I want to say a few things on the topic of this hearing and the next. First, on monetary policy, I am deeply concerned about what the Fed has done in the last year and in the last decade: Chairman Greenspan's easy money in the late 1990s and then followed the tech bust, inflated the housing bubble, and created the mess we are in today. Chairman Bernanke's easy money in the last year has un- dermined the dollar and sent oil prices to a new high every day, and an almost doubling since the rate cuts started. Inflation is here and hurting us and the average American, and it was brought out very clearly by the Senator from Pennsylvania. Second, the Fed is asking for more power, but the Fed has prov- en they cannot be trusted with the power they have. They get it wrong, do not use it, or stretch it farther than it was ever supposed to go in the first place. As I said a moment ago, their monetary pol- icy is the leading cause of the mess we are in. As regulators, it took until yesterday to use the power we gave them in 1994 to regulate all mortgage lenders. Then they stretched their authority by buying $29 billion worth of Bear Stearns assets so JPMorgan could buy Bear Stearns at a deep discount. Now the Fed wants to be a systemic risk regulator, but the Fed is a systemic risk. Giving the Fed more power is like giving a neighborhood kid who broke a window playing baseball in the street a bigger bat and thinking that will fix the problem. I am not going to go along with that, and I will use every power in my arsenal as a Senator to stop any new powers going to the Fed. Instead, we should give them less to do so they can get it right, either by taking their monetary responsibility away or by re- quiring them to focus only on inflation. Third, and finally, since I expect we will try to get it right to question the next hearing, let me say a few words about the GSE bailout plan. When I picked up my newspaper yesterday, I thought I woke up in France. But, no, it turned out it was socialism here in the United States of America, and very well, going well. The Treasury Secretary is now asking for a blank check to buy as much Fannie and Freddie debt or equity as he wants. The Fed purchase of Bear Stearns assets was amateur socialism compared to this. And for this unprecedented intervention in our free markets, what assurance do we get that it will not happen again? Absolutely none. We are in the process of passing a strong regulator for the GSEs, and that is important. But it allows them to continue in the cur- rent form. If they really do fail, we should let them go back to what they were doing before? I doubt it. I close with this question, Mr. Chairman. Given what the Fed and Treasury did with Bear Stearns, and given what we are talk- ing about here today, I have to wonder what the next Government intervention into the private enterprise will be. More importantly, where does it all stop? Thank you. Chairman DODD. Do you want to respond to that, Mr. Chairman? [Laughter.] 23 Chairman DODD. Senator Bunning just does not have any strong views on these matters. I wish he would be more clear in the future when he speaks. Mr. BERNANKE. Well, I think some of the problems with the GSEs that you allude to were pre-existing. I mean, the moral haz- ard issue, the Government implicit guarantee, those Senator BUNNING. We tried to pass a bill. We could not get it Mr. BERNANKE. And I agreed with Senator BUNNING. We passed it here. Mr. BERNANKE. And I agree with you. Senator BUNNING. And it got stuck between here and the floor of the Senate. Mr. BERNANKE. And I agree with you on that. As far as powers are concerned, as I mentioned earlier, I think we ought to review the payment system issue which is something that other central banks have. But I have not asked for any other powers. Thank you. Chairman DODD. Very good. Senator Reed. Senator REED. Thank you, Mr. Chairman. You indicated in your opening statement that in this economic turmoil the banking system is approaching it with good capital lev- els. Your estimate is based upon not just their balance sheet, but their off-balance-sheet arrangements. I understand there are new anything rules that will shortly be enacted that will require much more recognition of off-balance-sheet activities. Have you looked at the fully diluted value of the balance sheets? And can you still make that assessment? Mr. BERNANKE. I don't think we have done a full assessment. Those rules are yet to be clarified, and I think it may well be some time before they are enacted. At such time we will obviously think hard about how it affects those ratios. Senator REED. But you are beginning to consider much more, I hope, focus on some of these off-balance-sheet Mr. BERNANKE. Oh, certainly. For a long time we have been aware of those off-balance-sheet vehicles. There were some things we did not appreciate. I think one of the issues we did not fully appreciate was what is referred to sometimes as the moral recourse issue, which is that off-balance-sheet vehicles, which are not tech- nically owned by the bank, nevertheless the bank feels for reputational reasons it needs to assume them in a difficult period. We have been thinking about the capital requirements in those kinds of contexts. But we have certainly been quite attentive to off- balance-sheet vehicles, very attentive in particular since this crisis began in August. Senator REED. Let me refer to another issue in your statement. You indicated that one of the contributing factors to the present in- crease in oil prices is the lack of investment over the last several years. Now with oil at extraordinarily high prices, one would think in a simple market model that investment would be accelerating rapidly. Is investment in new drilling and new production and new refin- ing, is that taking place? 24 Mr. BERNANKE. In some places, but not to the extent you might think. Part of it is bottlenecks in the materials and manpower and expertise that goes into drilling and development. Part of it is the fact that a large share of the world's oil is controlled by national governments who may not have the same immediate profit motives as a private driller might have. In particular, some countries pro- hibit foreign technology or foreign investment in their oil produc- tion. So there are these political constraints as well that have been affecting the supply as well as economic bottlenecks and other problems. Senator REED. IS there a lack of adequate fields to exploit world- wide? Is that one of the significant factors? Mr. BERNANKE. Well, experts have some disagreement over this, but in terms of proved reserves, there seems to be adequate oil in the ground. It is really a question of exploiting it. Senator REED. YOU indicated that in terms of speculation, that was not a significant factor, but you are, with the CFTC, looking into the issue of possible speculation. And I am getting into dan- gerous ground. You are an economist and I am not. But it would seem to me this is a market that would be ripe for speculation. De- mand is highly inelastic. Price signals are blunted in many coun- tries because of subsidies. Is that your understanding of the mar- ket, that there is an opportunity at least for speculation in this particular market for oil? Mr. BERNANKE. Well, there is speculation, but speculation under most circumstances is a positive thing. It provides liquidity and al- lows people to hedge their risks. It provides price discovery. It can help allocate oil availability over time, depending on the pattern of futures prices and so on. What is really a concern—what the CFTC, for example, is con- cerned with would be manipulation as opposed to speculation. Senator REED. Well, I will use the term "manipulation" in the same situation. Mr. BERNANKE. And as I said, you know, transparency and data collection are important aspects of assuring there is no manipula- tion. But given the enormous size of this market, it is quite a dif- ficult market—would be quite a difficult market, I would think, to corner. Senator REED. Thank you. My time is about to expire. Thank you, Mr. Chairman. Chairman DODD. Thank you very much, Senator. Senator Dole. Senator DOLE. Chairman Bernanke, in December of last year Chairman DODD. Senator, would you just postpone for 1 second? What I am going to do here with Members, by the way, is several Members who have already asked questions have gone to vote, and they will come right back. And this way we will try and keep going. If there is going to be a minute or two before you get to question, I suggest you go vote and come back. We are not going to interrupt. I want to give everyone a chance to get one round in on this before we move to our larger panel. Senator Dole, please. Senator DOLE. In December of last year, Attorney General Cuomo of New York entered into an agreement with Fannie Mae, 25 Freddie Mac and OFHEO to create a mortgage appraiser code of conduct. While everyone appreciates the goals of this agreement, the code leans heavily toward inconsistent and potentially counter- productive regulation of the lending industry and, if implemented poorly, could actually increase costs of obtaining appraisals and slow down the process of obtaining appraisals. Recognizing that the current settlement recommendations are in- consistent with current appraisal regulations and guidelines issued by the FFIEC Subcommittee on Appraisals, what are you doing to ensure that implementation of the code of conduct does not further disrupt the current housing and mortgage crises on federally regu- lated banking institutions? What can you do? Mr. BERNANKE. Senator, as I understand, the agreement requires acceptance by the FFIEC, by the bank regulators, and so we are currently looking at it, and we do want to make sure that it does not prevent banks, for example, from using their own appraisers in situations where they need that information to make a good ap- praisal. And we want to make sure it does not impose excessive costs—there are already guidances by the regulators about how to do appraisals which already exist for banks. And we think those are pretty good, and we want to make sure there is no inconsist- ency. So we are looking at that, but we want to be particularly careful about some of the issues that you have just raised. Senator DOLE. AS you are aware, the FDIC gathers and monitors various bank performance data for its member institutions as part of its regulatory oversight, and this is on a quarterly basis, of course. Ending with this most recent data collection period, the end of the first quarter of 2008, the FDIC's data indicates that banks in North Carolina are on fairly good footing relative to its peer group nationally. But the report did show the number of unprofit- able financial institutions with a market cap under $1 billion in my home State increased from the previous quarter, while the national numbers actually improved. My question for you is whether the Fed currently reviews the performance of smaller financial institutions such as community banks as a proxy for the health of the local economy in which they served. And if so, how does this information factor into Fed policy? Mr. BERNANKE. Senator, we absolutely do look at community banks. We have a regulatory responsibility for State member banks, which include many, many small banks that we oversee in conjunction with the State regulator or with the FDIC. There are many benefits of our regulation of those banks in terms of what we learn, but, in particular, as you point out, small banks have their fingers on the pulse of the local economy, and they can provide us a lot of useful information about what is happening. And for the same reason, we are required to have bankers on the boards of the reserve banks around the country so that we can gather informa- tion from them and benefit from their insights. Senator DOLE. Thank you very much, Mr. Chairman. Thank you. Chairman DODD. Thank you, Senator Dole. Senator Brown. 26 Senator BROWN. Thank you, Mr. Chairman. Chairman Bernanke, thank you. Nice to see you again, and thank you for your public service. I appreciate the Fed has finalized its regulation for some prime mortgage lending. In my view, as you know, this comes, especially in a place like Ohio, several years too late. Hindsight, of course, is near perfect, but there were lots of voices and warning signals try- ing to get the Fed to act both here in Washington, also at places like the Cleveland Fed and elsewhere. First of all, I appreciate the refreshingly different approach you have to this job and to this issue than that of your predecessor. I think that is very good for our country. But there is a certain cyni- cism in the public at large how, when Bear Stearns gets in trouble, when Fannie and Freddie get in trouble, that you act, that Con- gress acts, the Treasury Department acts, but we do not act so quickly, neither the regulatory system, the Fed, the Congress act so quickly in protecting the public and the issues that Senator Casey, the story Senator Casey brought up. Tell me what steps we need to take, and you need to take espe- cially, to get the same rapid response for consumers, for consumer protection, that we have achieved, if you will, with Bear Stearns and with Fannie and Freddie. Mr. BERNANKE. Well, Senator, first, although I know it is not al- ways easy to explain, our actions, as I said earlier, with respect to Bear Stearns, with respect to Fannie and Freddie, with respect to the financial system in general are based on our view that financial stability is critical to economic stability. I think the benefit is more obvious to the average person from Fannie and Freddie because they, after all, are providing liquidity for mortgages, and people want to be able to have access to mortgages. So I just do not accept the distinction between helping Wall Street and helping Main Street. The actions we have taken are aimed at supporting the overall economy and helping the average American. With respect to your question, I agree that there was a delay in recognition of this issue. Once we undertook it, though, we had to go through a regulatory process that involves developing regula- tions, putting them out for comment, re-evaluating them and so on. There is a natural period of time. I think that is probably a good thing in the sense that we want regulations to be well thought out and so on. But to the extent that Congress wants to act more quickly or is concerned about the constraints on the agency's pow- ers given to them by their enabling legislation, Congress, of course, can act very quickly if they need to. Senator BROWN. While I do not oppose your actions on what we are going to try to do with Fannie and Freddie, and I think we did what we had to do with Bear Stearns, I think there is a perception, and probably a reasonable perception, a deserved perception, that our Government, whether it is regulatory process or the Congress, is much more apt to move quickly on Wall Street when we do not move so quickly on Main Street. Granted, you had to go through a process, and as I say, I think you are refreshingly different from your predecessor. But what can you do to speed that up so the pub- lic really can be assured that while it does make sense for the econ- omy as a whole, which helps everyone on Main Street, too, doing 27 the right thing with Wall Street, but it is pretty clear that when— and the Bush administration really did not seem to think there was a subprime crisis until it spread to Wall Street. When it was just Main Street, Mansfield, and Main Street, Zanesville, it did not seem to be much of a problem. Mr. BERNANKE. Well, we just have to do a better job, first of all, monitoring what is going on. The Treasury Secretary had an inter- esting idea. The mortgage origination commission, I think it was called, would be evaluating the quality of the State regulators to make sure that State-regulated institutions were being adequately supervised. So that is one possible suggestion. But in a way of keeping better tabs on what is going on, we need to be more vigi- lant, and we need to be as effective and rapid as possible in pro- mulgating good regulations. But, again, the legal process and our responsibility to do a good job means that we cannot produce the regulations in a month. It really does take some time for us to do all the work, including one thing we have done at the Fed, which is a lot of consumer testing, to make sure that people understand disclosures, for example. We think we get more effective regulation that way. Senator BROWN. Does the Fed have a mechanism to listen better to the regional—when the Cleveland Fed feeds you information about a problem that may come to Cleveland before it comes to New York or before it comes to Chicago or Los Angeles, do you feel like the Fed here is listening to places like Cleveland the way that you should? Mr. BERNANKE. Absolutely. The 12 reserve banks around the country were created to make sure that the Fed always had a na- tional constituency, that it always listened to the concerns of the whole country and not just the financial sector, and that works very effectively. We do have a lot of input from reserve banks and their boards, their advisory councils, their contacts. And related to my reply to Senator Dole, those kinds of contacts are useful in a macroeconomic monetary sense, but also in a regulatory sense as well. Senator CARPER [presiding]. The Senator's time has expired. When Senator Martinez returns, it will be his time to ask ques- tions, but until he does, I am going to ask a few of my own. Wel- come, Mr. Chairman. I was reflecting. How long have you been Federal Reserve Chair- man now? Mr. BERNANKE. Two-and-a-half years. Senator CARPER. Does it seem that long? [Laughter.] Mr. BERNANKE. About that long. Senator CARPER. Did you ever imagine in your wildest dreams that the Federal Reserve would end up being called upon to do the kinds of things you have done in recent months? I remember when you were going through your confirmation hearing, we focused, as I recall, on just what should be the right rate of inflation, kind of, if you will, the window or the limits for the rate of inflation. I do not think we ever asked you whether or not the discount window should be made available to investment banks. I do not think we ever asked you if the discount window should be made available to 28 Fannie or to Freddie. I do not think we ever asked you about trying to arrange the marriage, if you will, of JPMorgan Chase with Bear Stearns. All that stuff has just come along, and I want to commend you and those with whom you serve, those who you lead, for the way you have responded, and quickly, thinking outside the Box, and trying to help us through all of this. I thought you said a great truth in terms of where we want to position ourselves as we come out of this fall. We have seen this drop in housing values, and I think part of what is going on here in our economy today is the loss of confidence you have alluded to. We have seen a loss of home equity, and a lot of us in this country have treated the equity in our home as a piggy bank, and the wealth effect that we derive from that, and couple that with going up to the gas pump and spending $80 or $90 to fill up the tank of our vehicles—I think the two of those together has a dramatic negative effect on our con- fidence in this country and has sort of led to it. One of the questions you were asked earlier—and I want to fol- low up on it—was: Where do we want to be when we bottom out? Eventually, we will bottom out. There are a lot of people who are renting today that are not buying, but eventually they are going to want to get in. They are going to want to be homeowners. What are the things that we need to be doing to make sure that when they are ready to move, when they think that we have come to the bottom and prices are starting to go back up? Just say again, how do we want to plow the field, how do we want to prepare the field in terms of a mortgage market and in terms of housing markets? And you have said some of this already. I just want you to re-em- phasize it, please? Mr. BERNANKE. Well, of course, fundamentally the market will do it. The free market will do it. But there are things that we can do. The Federal Reserve has already tried to address, some of the reg- ulatory aspects of high-cost mortgage lending. We and our fellow regulators are also looking at the treatment of mortgages by banks and other lenders in terms of their capital and how they manage that. I think the banks and the private sector themselves are re- thinking the standards, the underwriting standards, the loan-to- value ratios, those sorts of things as they go forward. So, I anticipate that we will have a healthy recovery in the hous- ing market once we have gone through this necessary process. But it will probably be less exuberant than we saw earlier with some- what tougher underwriting standards, more investment due dili- gence, probably less use of securitization or complex securitized products. But I am confident that, with the appropriate back- ground—I probably include here the GSEs and FHA—the housing market will recover, and it will help be part of the economy's re- turn to growth. Senator CARPER. One of my colleagues asked you earlier about the drop in the value of the dollar and asked you quantify that. I will not ask you to do that again. But we have seen the dollar drop, whether it is 20 percent or 30 percent or some other number. We have seen exports, conversely, rise, but yet we have seen a contin- ued loss in manufacturing jobs in this country. I think the last 29 month I noticed maybe 30,000 or 40,000 additional manufacturing jobs had been lost. When do we see that turn around? And what do we need to do to turn it around, the loss of manufacturing jobs, that is? Mr. BERNANKE. Well, there has been an ongoing loss of manufac- turing jobs even during periods of growth in production because the U.S. manufacturing sector is enormously productive and its produc- tivity has been growing more quickly than the rest of the economy. And so even when output is growing—and we have some of the best growth and the highest productivity growth in manufacturing of any industrialized country—because of the high productivity growth, you need fewer workers to make the same amount of out- put. Now, one thing that has certainly been clear, and we have seen in the U.S. manufacturing over the last few years, is an increasing emphasis on sophisticated high-tech exports, including capital goods and so on. And what I hear from manufacturers is that they have plenty of low-skilled workers, but what they need are workers with high skills—not necessarily a college degree, but with skills, like welding and machine work and so on. And, in fact, the number of skilled manufacturing workers has actually been rising, not fall- ing. So I think the future for us is to continue to go to more and more sophisticated manufacturing products, but to support that and to make sure there are good jobs associated with it, we need to have the training and education that will provide the workforce that is consistent with that. Senator CARPER. The last question that I have deals with just to follow up on the drop in the value of the dollar. The hearings that we have had in this Committee and other committees that I have participated in suggest there are three major factors driving up the cost of oil. One of those is the laws of supply and demand. Nations are pretty much holding their output level. Demand is rising. There has been—we discussed the drop in the value of the dollar and the effect that that has had. The third factor that we keep coming back to is the role that speculation is playing. We touched on this at least indirectly here today. Just give us some advice. I think we are going to debate, seriously debate, probably before the beginning of next month, legislation dealing with speculation to try to curb the excesses that may be occurring there. If you could give us some ad- vice, it would be timely and much appreciated. Mr. BERNANKE. Well, as I said, based on the evidence that is available, I would not estimate that speculation or particularly ma- nipulation is a significant part of the rise in oil prices. That said, the CFTC and others are looking at the data and try- ing to evaluate that. These are very difficult matters. We do not want to do anything that will stop the futures markets from legiti- mate functions like providing liquidity and hedging. So, my advice would be to go slow and carefully and to take the insights that you get from the CFTC and others who are associated directly over- seeing these activities. Despite the concerns—and I fully understand the concerns about high gas prices—I don't think it is likely that you can have a big 30 effect on gas prices with short-term moves in the futures markets. And I would urge careful and deliberate action in this area. Senator CARPER. All right. Thank you, Mr. Chairman. Senator Martinez is next, and then followed by Senator Akaka. Senator MARTINEZ. Thank you, Mr. Chairman. Mr. Chairman, thank you very much for being with us today. I wanted to focus on a couple of areas. One was your remarks during your testimony regarding the fundamental issue in the energy situ- ation which you identify one of supply and demand, which makes sense to me. I wonder if you might dwell just for a moment on the speculation side as to why you do not see that as a fundamental part of the problem, but then also what we could do to be more helpful in the area of transparency and oversight. Mr. BERNANKE. Well, there are a number of pieces of evidence against the view that speculation is a primary force. I mentioned in my testimony the absence of hoarding or inventories that you would expect to see if speculation was driving prices above the sup- ply demand equilibrium. There are a number of studies which show that there is little or no connection between the open interest taken by non-commercial traders in futures markets and the subsequent movements in prices. It is also interesting to note that there are many commodities— or at least some commodities—that are not even traded on futures markets, like iron ore, for example, which have had very large in- creases in prices. So I think the evidence is fairly weak. That said, I think that transparency in futures markets, informa- tion available to the overseer, the CFTC, is a positive thing. And I expect that the CFTC will come forward with some suggestions in that regard. But I just do not think it is going to be a magic bullet to address this very difficult problem of high oil and com- modity prices. Senator MARTINEZ. In other words, well, it might be helpful and useful to have more transparency ultimately. The supply and de- mand equilibrium is only going to be impacted by more supply or less demand. Mr. BERNANKE. I believe that to be true, yes. Senator MARTINEZ. I want to commend you for the work you have done in consumer protection. I noted in your testimony in a couple of areas that I think are particularly important. I think that it is terrific to prohibit lenders from making higher-priced loans without due regard for a consumer's ability to make the scheduled payments. And I also think it is great to also include the escrowing of property taxes and insurance as an integral part of what we need to do in order to keep homeowners in their home. And, last, the area of credit cards as well, I think all those are very, very good things for consumers, and particularly at stressful times like this, it is good to have a reckoning of where we are and where we are going and include that in that help to consumers. I know in the next panel we will talk more about the GSE situa- tion. I want to talk about regulatory reform, if I could. Your prede- cessor and I had an opportunity to discuss this when I was Sec- retary of HUD, and I recall also coming before this Committee and testifying with Secretary Snow at that time, proposing a new regu- 31 latory framework for the GSEs. That was in 2003. I wish we might have done that. But at the same time, we are where we are today. We do have a piece of legislation moving its way through the Congress, which includes the creation of a new affordable housing trust fund. This affordable housing trust fund is funded by a fee on the GSEs' new business purchases. So, in other words, as they increase their book of business, this fund would grow at a percent- age of that. I wondered if you have a concern, which I certainly have, about this provision, particularly at a time when the GSEs are suffering such substantial losses and when we are, in fact, taking other Gov- ernment action in order to ensure their sustainability. Mr. BERNANKE. Senator, I think that is really a congressional prerogative. I really have not gotten into that particular issue. I think the really critical issue, as you alluded to, is that we have a strong and robust regulator that will restore confidence in the markets and will allow Fannie and Freddie to support the mort- gage market in the way they are intended to do. That would be my emphasis. Senator MARTINEZ. Thank you, Mr. Chairman. Chairman DODD. Thank you, Senator. Senator Akaka. Senator AKAKA. Thank you very much, Mr. Chairman. Let me add my welcome to Chairman Bernanke for being here, and my concerns in our country is to educate the people of America as well as to protect them and empower them in our financial system. Given the recent failures, I am concerned by the increasing lack of trust that individuals have in the banking system. When large numbers of depositors lose trust in their financial institution and demand their money back, the bank can fail as a result, and we know that. In addition, distrust of the banking system causes many immi- grants to miss out on savings, borrowing, and low-cost remittance opportunities found at banks and credit unions. My question to you is: What must be done to increase trust in the banking system among depositors as well as among the unbanked? Mr. BERNANKE. Well, Senator, you point to a legitimate question, which is that there are still many people, disproportionately immi- grants, who do not have a checking account, do not have a savings account, and these are the "unbanked," as the term goes. In not all but in many cases, those people would be better off with a banking relationship. They might be able to avoid high fees for remittances, for example, or high fees for check cashing if they were associated with a bank. To some extent, it is a cultural element. We encour- age banks to reach out to communities, to have people who speak the appropriate language. On the other side, as you know—and this is one of your impor- tant issues that you have been a leader on—is to promote financial literacy and to get folks to understand, how to manage their fi- nances and how important having the right relationships with fi- nancial institutions can be. So I think it is really on both sides. We have to get the banks to reach out. We have to get the public to understand and reach 32 out. Where necessary, as in the case of home mortgages, disclo- sures and regulation may be necessary to keep the contracts, clear enough that the public can make use of them. And in that respect, I hope that, for example, our actions on mortgage lending will re- store some confidence where there are people who feel that they got burned taking out a subprime mortgage. Perhaps in the future, they will see more clearly what the contract entails, and they will be more confident in taking out a mortgage. So it is a very important issue, and we can address it, I think, from a number of different directions. Senator AKAKA. Thank you. Working families, as you know, are having trouble paying for increases today in gasoline, groceries, and other daily living expenses while wages are not increasing fast enough and affordable credit is becoming harder to obtain. I am deeply concerned that too many working families are being ex- ploited by the unscrupulous lenders who give payday loans, and this is where protection, I think, is needed. I have been impressed by the work of the National Credit Union Administration, NCUA, due to a NCUA grant on the windward side of the island of Oahu in Hawaii at the Community Federal Credit Union at Kailua, and it has developed an affordable alter- native to payday loans to help U.S. Marines and other members they serve. We must further encourage the development of these alternatives so that working families have access to affordable small loans. My question to you is: What must be done to protect consumers from high-cost payday loans and encourage the development of af- fordable payday loan alternatives? Mr. BERNANKE. Well, again, I think that competition is the best solution, and I give particular credit to credit unions. They have done some especially good work in terms of providing remittance services to allow people to get money back to their families without exorbitant cost. But I think we should continue to urge banks and other financial institutions to reach out into underserved neighbor- hoods. That is, in fact, part of the Community Reinvestment Act to try to do that to give people the alternative rather than the storefront in their neighborhood. So I think that is a desirable goal, and through financial literacy education and working with banks and community development ex- perts, I think we can make progress in that direction, and I would very much like to support that. Senator AKAKA. Thank you very much for your responses. Thank you, Mr. Chairman. Chairman DODD. Thank you very much. Senator Crapo, you are next, then Senator Bayh, and then I be- lieve we are prepared to move to the additional panel members here. So Senator Crapo. Senator CRAPO. Thank you very much, Mr. Chairman. I want to return for just a moment—I know you have gone over this a lot already—to the question of speculation and the issue of prohibiting or aggressively regulating the over-the-counter deriva- tives. And, you know, I understand that measures to enhance the transparency in our energy markets are a very appropriate re- sponse to today's global markets. I am concerned, however, that 33 overly restrictive limitations on the number of speculative positions that can be held by individuals or other entities could have signifi- cant impacts on liquidity in those markets and naturally have the opposite impact that we would intend by those actions, namely, to reduce liquidity and actually drive the price of fuel up or petroleum up. Could you comment on that? Mr. BERNANKE. Certainly. First of all, OTC derivatives are not really unregulated in that the dealers and the banks who make these transactions are, of course, regulated in one way or another, and one of the things that the oversight regulators do is make sure that they are taking adequate precautions of a counterparty risk, that they are managing their positions in a safe way. In general, I think there is some reason to look for more stand- ardization where possible so that we could begin to use particular exchanges as ways of improving liquidity and management of counterparty risk. But I think there is always going to be some scope for over-the-counter products because they are the ones that customize to the particular needs of the other party. So I think it is important for us to maintain our oversight of the dealers and the banks. We need to continue to work to make sure that the clearing and settlement process works efficiently so there is no confusion or delay. There is some scope for working toward standardization in order to move toward essential counterparties or exchanges. But I think we are always going to have over-the- counter derivatives. They serve a useful function. They help with risk sharing. They provide liquidity to hedgers. And so, I am not advocating any major change in the way we look at those par- ticular instruments other than making sure we clear them and set- tle them properly. Senator CRAPO. If you take, say, futures trading in petroleum as an example, isn't it correct that for every transaction, there is a counterparty? In other words, every time there is a buyer, there is also a seller. Mr. BERNANKE. Yes, of course. With almost no exceptions, specu- lators in commodities never take delivery. They have to sell their position when it comes due, and so they are not in any way using up the physical resource that underlies the contract. So there has always to be two sides to every transaction. Senator CRAPO. And the liquidity that we are talking about, am I correct, is primarily being provided for those who are not actual users of petroleum. This liquidity is primarily coming from pension funds. Is that not correct? Mr. BERNANKE. Well, it depends which side of the transaction you are on. You have people on both sides who are trying to make a bet essentially on whether oil prices will go up or down. But, clearly, one of the major economic functions of futures markets is to allow those who want to lay off their risk, like an airline, the opportunity to sell or to buy forward the fuel so that they will not be subject to the risk of price fluctuations. And it is the activities of speculators in those markets that provides the other side of that transaction and makes those markets liquid and allows them to serve that function. 34 Senator CRAPO. The airlines are a good example. As you know, a number of the CEOs of a number of airlines have maintained that the price of their jet fuel is being forced unnaturally high be- cause of market speculation in the futures market. Do you believe that they are correct in that? Mr. BERNANKE. Well, as I have indicated, I think that it is worthwhile making sure that, there is some transparency, that we are doing all we can to make sure these markets are as liquid and as efficient as possible. CFTC has the primary responsibility for that. We are happy to work with them and try to support that. So I am not saying there cannot be improvements made in these markets, but my best guess, as I have indicated a few times now, is that I do not think that speculative activity per se, or particu- larly manipulation, is the principal cause of the increases in energy and other commodity prices that we have been seeing. Senator CRAPO. Thank you. Chairman DODD. Thank you, Senator, very much. Senator Bayh. Senator BAYH. Thank you, Mr. Chairman, and given the nature of our having to leave to vote and then come back, I hope that my questions are not redundant. It is an occupational hazard. You mentioned that the housing turmoil is sort of the crux of many of the challenges that we are currently facing. Have there been any analogous episodes in other countries previously or in our own that might give some guidance as to—or further guidance as to when this might bottom out? Mr. BERNANKE. There have been similar episodes in the U.K. and Australia, for example. But it is hard to draw strict analogies. One reason is that the financing systems are different in the different countries. Clearly, in this case, the high loan-to-value subprime ad- justable rate mortgages, those sorts of instruments were particu- larly sensitive to the decline in house prices that we saw, and the effects, therefore, on credit quality and on bank balance sheets were stronger. So there are other examples, and we have looked at those. Most of them suggest, which is something which I am sure we are all happy to hear, that eventually the new equilibriums is established, the housing market comes back into balance, and the negative effects of that are ended, and you begin to see more stable growth again. I am sure that will happen here, but there is not an exact analogy. Senator BAYH. Well, along those lines—and I know you are reluc- tant to offer advice to the legislative branch of Government, but I am sure you have followed the bill that passed out of the Senate last week. Going over to the House, there may be some marginal adjustments, but probably not more than that. Is there anything else we should be looking at doing here in a timely fashion to ad- dress the housing challenge that has not been included in this leg- islation? Mr. BERNANKE. NO, I do not think so. Not that I can think of. Again, as this next hearing will reveal, of course, you now have a set of issues and questions to answer relating to the GSEs, and, of course, that fits directly with the elements of the bill that already include a stronger regulator. So I think that is going to be a very, very important issue in the next weeks and months for the 35 Senator BAYH. And that is going to raise the topic of borrowing from the discount window, which I would like to ask you about. What currently is the amount that has been let from the window as we gather here today? Mr. BERNANKE. Well, the loans are short-term loans, and they are rolled over. So I could not give you Senator BAYH. We do not know the Mr. BERNANKE. Several hundred billion dollars outstanding at any given time. But I Senator BAYH. Several hundred billion at a time? Mr. BERNANKE. At a given time, yes. Senator BAYH. IS there any limit to the amount that can be uti- lized through that mechanism, any practical limit? We have the in- vestment banks partaking. If we get the GSEs partaking, I am just wondering how much more there is to be had from that mecha- nism. Mr. BERNANKE. I think the Federal Reserve's balance sheet is about $900 billion, and even if we reached that level, which I have no expectation we would, there are other things we could do to ad- dress that. Senator BAYH. I read here recently—I think it was the Econo- mist. I cannot recall the source of the data, but it caught my eye, and I would like your reaction to it. The assertion was by some an- alysts that of the stimulus checks that had been sent, 90 percent of the amount had been saved. Do you have a reaction to that? Mr. BERNANKE. I do not know how they would know that. The historical experience, based, for example, on the checks that were sent in 2001, suggests that people spent something on the order of 40 to 50 percent of their check within a few quarters. The rel- atively strong consumer spending number, as we saw recently, could be due to even a higher propensity to spend out of those checks. So to my way of thinking, so far it seems that they are hav- ing an effect, but we will not really know for sure until we see how things play out over the next two quarters. Senator BAYH. Just two final questions, Mr. Chairman. Chair- man Dodd asked you about the prospects of a second stimulus package moving through. My question is: If we are really looking at trying to buttress the consumer at this fragile time, doesn't in- come and wealth level, don't those affect the marginal propensity to consume? Is that an accurate statement? Mr. BERNANKE. That is generally thought to be the case. Senator BAYH. And should that not lead us to focus on those who are more likely to consumer, you know, the more middle-class, lower-middle-class level, if propping up the consumer is our aim? Mr. BERNANKE. AS I said when we were discussing the first stim- ulus package, one of the criteria was to be targeted, which means to go to people who would be more likely to spend in the short term, and, generally speaking though it is not uniform, there tends to be a higher spending propensity from people of lower income and lower wealth Senator BAYH. My final question here as my time expires: There has been a recent increase in the price of credit default swaps on U.S. Treasurys. What do you think accounts for that? And should 36 that be a matter of some concern in the message the market seems to be sending about their confidence? Mr. BERNANKE. There has been a lot of movement in a variety of spreads, for example, the spreads between newly issued and pre- viously issued bonds and so on. I would not read too much into that. It is a very small change. I think it has more to do with li- quidity in markets and other risk aversion—other types of behavior rather than any sense that there is a default risk. That would be my guess. Senator BAYH. Thank you, Mr. Chairman. Chairman DODD. Thank you very much, Senator. We have one additional question from Senator Schumer. Senator SCHUMER. Thank you, Mr. Chairman, and thank you for being here. I had two. One is not about the Fannie and Freddie rescue per se, but just about the criteria. There is tremendous focus on the stock price, which we all know has sunk a great deal. But it seems to me that of much greater importance to the economy and to the markets and even to the stability of Fannie and Freddie is the differential that Fannie and Freddie have to pay for their bonds and, say, the U.S. Government has to pay for Treasury's. Do you agree with that, and could you give us some indication of how the bond spread is going? And how does it measures in terms of Fannie and Freddie's sta- bility? Mr. BERNANKE. Well, that bond spread opened up last week. It has generally come in since Paulson announced these actions. I think that is very important, both because Fannie and Freddie obli- gations, both MBS and corporate debt, are held all over the world, including large amounts by banks, so that is very important. And, second, that determines their marginal cost of finance for mort- gages, which ultimately we want to make sure that mortgages are available at a reasonable price. So the announcements have been generally good for the debt be- cause of the sense that the Government is going to become involved in these agencies. The stock prices are also important because they affect the ability of Fannie and Freddie to raise capital. And I think at this point, there is probably a lot of uncertainty for share- holders as to exactly what is going to happen and to what extent that will affect the value of their shares. Senator SCHUMER. One final question. There has been a lot of talk now about somehow limiting short selling, particularly in fi- nancial companies, because of all the problems. Now, a while ago we had something called the uptick rule, which provided some measure of restraint on short sellers. When we changed from sell- ing stocks from eighths to hundredths, an uptick of one one-hun- dredth does not mean much. But I have heard some ideas re- cently—I have been toying with it—of recommending that we go back to the uptick rule and say you don't need a one one-hundredth uptick, but you need 12 upticks, and you get back to the one- eighth. Do you have any thoughts, preliminary thoughts, on whether that would be a good idea and, in general, your view on short sell- ing as it affects the markets here? 37 Mr. BERNANKE. Well, I think you do not want to rule out short selling as a general matter. That is a way for markets to be effi- cient and for people to take a view on where a stock price ought to be. There are already limits on so-called naked shorts without owning the stock, and certainly we want to be very careful about situations in which a potential short seller spreads unverified ru- mors and so on. I think I am in an excellent position here to answer your ques- tion because Chairman Cox is going to be sitting next to me in a few minutes, and I think he could give you a much better sense of where they are at the SEC on this issue. But my short answer is that some limits on short selling are probably appropriate, but we want to make sure that legitimate short selling remains part of the market. Senator SCHUMER. I agree with both. Thank you, Mr. Chairman. Chairman DODD. Thank you very much, Senator, and with that, we are going to take a couple minutes' break, give the Chairman an opportunity to take a few minutes, and we will invite Secretary Paulson and Chairman Cox to come into the room, and we will begin the second phase of this hearing. So we will take about 5 minutes here. [Whereupon, at 12:09 p.m., the hearing was adjourned.] [Prepared statements, response to written questions, and addi- tional material supplied for the record follow:] 38 PREPARED STATEMENT OF BEN S. BERNANKE CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM JULY 15, 2008 Chairman Dodd, Senator Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. The U.S. economy and financial system have confronted some significant chal- lenges thus far in 2008. The contraction in housing activity that began in 2006 and the associated deterioration in mortgage markets that became evident last year have led to sizable losses at financial institutions and a sharp tightening in overall credit conditions. The effects of the housing contraction and of the financial headwinds on spending and economic activity have been compounded by rapid in- creases in the prices of energy and other commodities, which have sapped household purchasing power even as they have boosted inflation. Against this backdrop, eco- nomic activity has advanced at a sluggish pace during the first half of this year, while inflation has remained elevated. Following a significant reduction in its policy rate over the second half of 2007, the Federal Open Market Committee (FOMC) eased policy considerably further through the spring to counter actual and expected weakness in economic growth and to mitigate downside risks to economic activity. In addition, the Federal Reserve ex- panded some of the special liquidity programs that were established last year and implemented additional facilities to support the functioning of financial markets and foster financial stability. Although these policy actions have had positive effects, the economy continues to face numerous difficulties, including ongoing strains in finan- cial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities. Let me now turn to a more detailed discus- sion of some of these key issues. Developments in financial markets and their implications for the macroeconomic outlook have been a focus of monetary policymakers over the past year. In the sec- ond half of 2007, the deteriorating performance of subprime mortgages in the United States triggered turbulence in domestic and international financial markets as investors became markedly less willing to bear credit risks of any type. In the first quarter of 2008, reports of further losses and write-downs at financial institu- tions intensified investor concerns and resulted in further sharp reductions in mar- ket liquidity. By March, many dealers and other institutions, even those that had relied heavily on short-term secured financing, were facing much more stringent borrowing conditions. In mid-March, a major investment bank, The Bear Stearns Companies, Inc., was pushed to the brink of failure after suddenly losing access to short-term financing markets. The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy. After discussions with the Se- curities and Exchange Commission and in consultation with the Treasury, we in- voked emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by JPMorgan Chase & Co. In addition, the Federal Reserve used emergency authorities to establish two new facilities to provide backstop liquidity to primary dealers, with the goals of stabilizing financial conditions and increasing the availability of credit to the broader economy.1 We have also taken additional steps to address liquidity pressures in the banking system, including a further eas- ing of the terms for bank borrowing at the discount window and increases in the amount of credit made available to banks through the Term Auction Facility. The FOMC also authorized expansions of its currency swap arrangements with the Eu- ropean Central Bank and the Swiss National Bank to facilitate increased dollar lending by those institutions to banks in their jurisdictions. These steps to address liquidity pressures coupled with monetary easing seem to have been helpful in mitigating some market strains. During the second quarter, credit spreads generally narrowed, liquidity pressures ebbed, and a number of finan- cial institutions raised new capital. However, as events in recent weeks have dem- onstrated, many financial markets and institutions remain under considerable stress, in part because the outlook for the economy, and thus for credit quality, re- mains uncertain. In recent days, investors became particularly concerned about the financial condition of the government-sponsored enterprises (GSEs), Fannie Mae 1 Primary dealers are financial institutions that trade in U.S. government securities with the Federal Reserve Bank of New York. On behalf of the Federal Reserve System, the New York Fed's Open Market Desk engages in the trades to implement monetary policy. 39 and Freddie Mac. In view of this development, and given the importance of these firms to the mortgage market, the Treasury announced a legislative proposal to bol- ster their capital, access to liquidity, and regulatory oversight. As a supplement to the Treasury's existing authority to lend to the GSEs and as a bridge to the time when the Congress decides how to proceed on these matters, the Board of Governors authorized the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac, should that become necessary. Any lending would be collateralized by U.S. government and Federal agency securities. In general, healthy economic growth depends on well-functioning financial markets. Consequently, helping the fi- nancial markets to return to more normal functioning will continue to be a top pri- ority of the Federal Reserve. I turn now to current economic developments and prospects. The economy has continued to expand, but at a subdued pace. In the labor market, private payroll employment has declined this year, falling at an average pace of 94,000 jobs per month through June. Employment in the construction and manufacturing sectors has been particularly hard hit, although employment declines in a number of other sectors are evident as well. The unemployment rate has risen and now stands at 5V2 percent. In the housing sector, activity continues to weaken. Although sales of existing homes have been about unchanged this year, sales of new homes have continued to fall, and inventories of unsold new homes remain high. In response, homebuilders continue to scale back the pace of housing starts. Home prices are falling, particu- larly in regions that experienced the largest price increases earlier this decade. The declines in home prices have contributed to the rising tide of foreclosures; by adding to the stock of vacant homes for sale, these foreclosures have, in turn, intensified the downward pressure on home prices in some areas. Personal consumption expenditures have advanced at a modest pace so far this year, generally holding up somewhat better than might have been expected given the array of forces weighing on household finances and attitudes. In particular, with the labor market softening and consumer price inflation elevated, real earnings have been stagnant so far this year; declining values of equities and houses have taken their toll on household balance sheets; credit conditions have tightened; and indica- tors of consumer sentiment have fallen sharply. More positively, the fiscal stimulus package is providing some timely support to household incomes. Overall, consump- tion spending seems likely to be restrained over coming quarters. In the business sector, real outlays for equipment and software were about flat in the first quarter of the year, and construction of nonresidential structures slowed appreciably. In the second quarter, the available data suggest that business fixed investment appears to have expanded moderately. Nevertheless, surveys of capital spending plans indicate that firms remain concerned about the economic and finan- cial environment, including sharply rising costs of inputs and indications of tight- ening credit, and they are likely to be cautious with spending in the second half of the year. However, strong export growth continues to be a significant boon to many U.S. companies. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared economic projections covering the years 2008 through 2010. On balance, most FOMC participants expected that, over the remainder of this year, output would expand at a pace appreciably below its trend rate, primarily because of continued weakness in housing markets, elevated energy prices, and tight credit conditions. Growth is projected to pick up gradually over the next 2 years as resi- dential construction bottoms out and begins a slow recovery and as credit conditions gradually improve. However, FOMC participants indicated that considerable uncer- tainty surrounded their outlook for economic growth and viewed the risks to their forecasts as skewed to the downside. Inflation has remained high, running at nearly a 3V2 percent annual rate over the first 5 months of this year as measured by the price index for personal consumption expenditures. And, with gasoline and other consumer energy prices rising in recent weeks, inflation seems likely to move temporarily higher in the near term. The elevated level of overall consumer inflation largely reflects a continued sharp run-up in the prices of many commodities, especially oil but also certain crops and metals. 2 The spot price of West Texas intermediate crude oil soared about 60 per- cent in 2007 and, thus far this year, has climbed an additional 50 percent or so. The price of oil currently stands at about five times its level toward the beginning 2 The dominant role of commodity prices in driving the recent increase in inflation can be seen by contrasting the overall inflation rate with the so-called core measure of inflation, which ex- cludes food and energy prices. Core inflation has been fairly steady this year at an annual rate of about 2 percent. 40 of this decade. Our best judgment is that this surge in prices has been driven pre- dominantly by strong growth in underlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded at its fastest pace in decades, leading to substantial increases in the demand for oil. Moreover, growth has been concentrated in developing and emerging market econo- mies, where energy consumption has been further stimulated by rapid industrializa- tion and by government subsidies that hold down the price of energy faced by ulti- mate users. On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of the subdued supply response re- flects inadequate investment and production shortfalls in politically volatile regions where large portions of the world's oil reserves are located. Additionally, many gov- ernments have been tightening their control over oil resources, impeding foreign in- vestment and hindering efforts to boost capacity and production. Finally, sustain- able rates of production in some of the more secure and accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long-term oil supplies have been marked down in recent months. Longdated oil futures prices have risen along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come. The decline in the foreign exchange value of the dollar has also contributed some- what to the increase in oil prices. The precise size of this effect is difficult to ascer- tain, as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar, notably shifts in the underlying global demand for and supply of oil, have been the principal drivers of the increase in prices. Another concern that has been raised is that financial speculation has added markedly to upward pressures on oil prices. Certainly, investor interest in oil and other commodities has increased substantially of late. However, if financial specula- tion were pushing oil prices above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum prod- ucts to increase as supply rose and demand fell. But in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term. Although the inflationary effect of rising oil and agricultural commodity prices is evident in the retail prices of energy and food, the extent to which the high prices of oil and other raw materials have been passed through to the prices of non-energy, non-food finished goods and services seems thus far to have been limited. But with businesses facing persistently higher input prices, they may attempt to pass through such costs into prices of final goods and services more aggressively than they have so far. Moreover, as the foreign exchange value of the dollar has declined, rises in import prices have put greater upward pressure on business costs and consumer prices. In their economic projections for the June FOMC meeting, monetary policy- makers marked up their forecasts for inflation during 2008 as a whole. FOMC par- ticipants continue to expect inflation to moderate in 2009 and 2010, as slower global growth leads to a cooling of commodity markets, as pressures on resource utilization decline, and as longer-term inflation expectations remain reasonably well anchored. However, in light of the persistent escalation of commodity prices in recent quarters, FOMC participants viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast. Moreover, the currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation. If that were to occur, and those revised expectations were to become embedded in the do- mestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policymakers is to prevent that process from taking hold. At present, accurately assessing and appropriately balancing the risks to the out- look for growth and inflation is a significant challenge for monetary policymakers. The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the out- look for growth. At the same time, upside risks to the inflation outlook have intensi- fied lately, as the rising prices of energy and some other commodities have led to a sharp pickup in inflation and some measures of inflation expectations have moved higher. Given the high degree of uncertainty, monetary policymakers will need to carefully assess incoming information bearing on the outlook for both inflation and growth. In light of the increase in upside inflation risk, we must be particularly 41 alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process. I would like to conclude my remarks by providing a brief update on some of the Federal Reserve's actions in the area of consumer protection. At the time of our re- port last February, I described the Board's proposal to adopt comprehensive new regulations to prohibit unfair or deceptive practices in the mortgage market, using our authority under the Home Ownership and Equity Protection Act of 1994. After reviewing the more than 4,500 comment letters we received on the proposed rules, the Board approved the final rules yesterday. The new rules apply to all types of mortgage lenders and will establish lending standards aimed at curbing abuses while preserving responsible subprime lending and sustainable homeownership. The final rules prohibit lenders from making high- er-priced loans without due regard for consumers' ability to make the scheduled payments and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher-priced loans, lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regular monthly payments. The final rules also prohibit prepayment penalties for higher-priced loans in cases in which the consumer's pay- ment can increase during the first few years and restrict prepayment penalties on other higher-priced loans Other measures address the coercion of appraisers, servicer practices, and other issues. We believe the new rules will help to restore confidence in the mortgage market. In May, working jointly with the Office of Thrift Supervision and the National Credit Union Administration, the Board issued proposed rules under the Federal Trade Commission Act to address unfair or deceptive practices for credit card ac- counts and overdraft protection plans. Credit cards provide a convenient source of credit for many consumers, but the terms of credit card loans have become more complex, which has reduced transparency. Our consumer testing has persuaded us that disclosures alone cannot solve this problem. Thus, the Board's proposed rules would require card issuers to alter their practices in ways that will allow consumers to better understand how their own decisions and actions will affect their costs. Card issuers would be prohibited from increasing interest rates retroactively to cover prior purchases except under very limited circumstances. For accounts having multiple interest rates, when consumers seek to pay down their balance by paying more than the minimum, card issuers would be prohibited from maximizing interest charges by applying excess payments to the lowest rate balance first. The proposed rules dealing with bank overdraft services seek to give consumers greater control by ensuring that they have ample opportunity to opt out of automatic payments of overdrafts. The Board has already received more than 20,000 comment letters in re- sponse to the proposed rules. Thank you. I would be pleased to take your questions. 42 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKE Q.I. Inflation: Mr. Chairman, I have great concerns about inflation. Inflation degrades consumer's purchasing power and reduces the value of many investments, including people's homes. Additionally, continued food and energy price increases can have negative effects on consumer confidence and potentially unhinge inflation expecta- tions. How large of a shift in expectations would the FOMC have to see before it began to tighten the target for the Federal Funds rate? Please comment on whether you have observed a pass-through of higher input prices for commodities and energy in the form of high- er prices for finished goods? A.1. The inflationary effects of the sharp increases in oil and agri- cultural commodity prices earlier this year are clearly evident in the retail prices of energy and food. In particular, the PCE price index for food and beverages increased almost 6 percent over the 12 months ending in August 2008, while the PCE price index for energy moved up 28 percent over that same period. The accelera- tion in the price indexes for these two components of spending ac- counted for much of the pickup in the 12-month change in the over- all PCE price index to 4.5 percent in August 2008 from 2 percent over the 12 months ending in August 2007. It appears that, to some extent, the earlier increases in the prices of oil and other raw materials have been passed through to the prices of non-energy, non-food finished goods and services. Prices for consumer items that have a high energy content—such as air- fares and other transportation services, housekeeping supplies, and household operations—have moved up noticeably this year; more- over, energy and other basic input costs could well have pushed up prices for a range of other items for which the direct effect of com- modity prices is more difficult to identify. In the aggregate, the PCE price index excluding food and energy rose at an annual rate of 2.6 percent over the 12 months ending in August 2008, about one-half percentage point faster than over the 12 months ending in August 2007. Thus far, however, we have not seen the sort of run up in labor compensation and inflation expectations that could lead to a dete- rioration in the longer term outlook for inflation. In particular, al- though some indicators of inflation expectations have increased, long-term inflation expectations still appear to be reasonably well anchored. Indeed, given the recent sharp declines in the prices for crude oil and other commodities and the weakening in economic conditions, the FOMC believes that inflation is likely to moderate later this year and in 2009. Of course, the Committee will continue to monitor the incoming information on inflation and inflation ex- pectations carefully. Q.2. Update on Bear Stearns: Chairman Bernanke, the Federal Re- serve created a limited liability corporation (Maiden Lane LLC) to acquire and manage certain assets from Bear Stearns, with the goal of maximizing repayment of the original loan back to the Fed- eral Reserve Bank of New York. We all hope that this loan will be repaid in its entirety through the sale of these assets over time. 43 How has the value of the Bear Stearns portfolio changed over time? In the few months since this transaction occurred, has anything changed that would lead to a reassessment of potential losses? A.2. As indicated in the Federal Reserve's weekly H.4.1 statistical releases, the fair value of the net portfolio holdings of Maiden Lane LLC was $29,816 billion as of March 14, 2008, $28,893 billion as of June 26, 2008, and $29,018 billion as of June 30, 2008. The Fed- eral Reserve will publish in the H.4.1 statistical release an updated fair value of the net portfolio holdings of Maiden Lane LLC as of the end of each calendar quarter. The fair value of the net portfolio holdings of Maiden Lane LLC was $26,979 billion as of November 26, 2008, which reflects valuations as of September 30, 2008. As more fully explained in my testimony before the Committee on April 3, 2008, the Federal Reserve decided to finance a portion of Bear Stearns' assets to facilitate the acquisition of the firm by JPMorgan Chase to address the severe consequences that likely would have resulted from a disorderly liquidation of the firm in the unusually fragile circumstances that then prevailed. In taking this action, the Federal Reserve consulted closely with the Treasury De- partment. In order to maximize the returns to the Federal Reserve and the taxpayer, the Federal Reserve has engaged an independent port- folio management firm to professionally manage the assets held by Maiden Lane LLC. The assets will be managed with a long-term time horizon of at least 10 years. Although the value of the port- folio declined between March 14, 2008, and June 30, 2008, given the long-term time horizon for the portfolio it is too early to esti- mate what, if any, net losses might result from the eventual liq- uidation of the portfolio. Importantly, as previously announced, JPMorgan Chase will bear the first $1 billion of any losses on the collateral pool. Q.3. Negative Real Interest Rates: Chairman Bernanke, real inter- est rates appear to be negative at present, since the nominal short- term rate is lower than inflation. Does having a negative real rate of interest during a period of increased inflation harm the Fed's ability to work towards main- taining price stability? For how long can the Fed run a negative real interest rate before inflation pressures grow to dangerous levels? A.3. The FOMC has judged the current level of short-term interest rates as appropriate in light of its statutory objectives of maximum employment and price stability. Relatively low real short-term in- terest rates are currently necessary to counter the adverse effects of the broad range of factors restraining aggregate spending and output. Such factors include severe strains on financial markets and institutions, tight credit conditions, the ongoing housing correc- tion, and elevated energy prices, which reduce households' discre- tionary income. As such, we do not believe that the current low level of real short-term interest rates is likely to have an adverse effect on the economy. Clearly, the highly accommodative stance of monetary policy cannot be maintained indefinitely. But, in view of the expectation for inflation to decline, such a stance is appropriate 44 for a time to help foster moderate economic growth in the face of the range of factors that is restraining growth. The Committee be- lieves that inflation is likely to moderate later this year and during 2009 as the effect of recent sharp drops in the prices of energy and other commodity prices shows through to broad price indexes and as slack in the economy resulting from slower economic growth re- duces pressure on resources. Q.4. FOMC Statement Bias: Mr. Chairman, in the FOMC's most recent statement, the Committee seemed to shift its bias away from concerns over slower growth, towards concern about inflation and inflation expectations. Would you elaborate on what this shift means for future policy decisions? Additionally, how long would inflation rates have to stay elevated for the Committee to display unambiguous bias towards alleviating inflation concerns? A.4. In conducting monetary policy, the Committee carefully mon- itors ongoing developments in the economy and financial markets that influence the outlook for the economy and inflation. From time to time, the Federal Reserve adjusts its policy stance in view of the evolving economic outlook and risks to the outlook. After each meeting, the Committee issues a statement that explains any ad- justment to its policy stance and characterizes the outlook for eco- nomic growth and inflation. In the period before the June meeting, incoming economic data had indicated that economic growth in the second quarter was stronger than had been expected. Also, finan- cial market conditions appeared to have improved somewhat, al- though markets clearly remained under stress. Meanwhile, oil prices had increased further. In these circumstances, the Com- mittee judged at its June meeting that the downside risks to growth diminished and the upside risks to inflation had increased. An important uncertainty in the outlook for inflation is whether the current elevated level of total inflation may lead to upward pressure on longer-term inflation expectations. At present, al- though some indicators of inflation expectations have increased, long-term inflation expectations still appear to be reasonably well anchored. However, the Committee is monitoring inflation and in- flation expectations very carefully. RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM BEN S. BERNANKE Q.I. The number and severity of credit rating downgrades from credit rating agencies in the last year casts doubt on the reliability of such ratings. What is the Fed doing to verify the credit rating of the collateral you are accepting at the various Fed facilities? A.1. The Federal Reserve regularly updates the credit ratings of as- sets pledged as collateral and uses multiple ratings rather than just one. Assets are regularly marked to market and haircuts are applied to provide adequate protection against market, liquidity, and credit risks. In cases where ratings are less reliable, we re- quire a higher rating than we would otherwise. It should be noted that the entire pool of collateral pledged by a depository institution 45 secures any loans to that institution; moreover, the Federal Re- serve has recourse to the borrower under all of its lending facilities beyond the specific collateral pledged. Although credit ratings are one determinant of the eligibility of collateral pledged to Federal Reserve liquidity facilities, Reserve Banks also perform independent credit analysis when receiving col- lateral and especially when extending a loan to a depository insti- tution. That analysis is based on publicly available information as well as on supervisory information on both the quality of the collat- eral and on the financial condition of the pledging institution. Q.2. In 2006, Congress passed the Credit Rating Agency Reform Act, which created a formal process for recognizing and examining credit rating agencies with a goal of increasing competition and rating quality. Under that law, the SEC has now recognized 10 Na- tional Recognized Statistical Rating Organizations. However, the Fed only accepts credit ratings from the three largest rating agen- cies for collateral taken at the various Fed facilities. Why does the Fed not accept ratings from the other approved agencies? Are there any plans to revisit that prohibition? A.2. The Federal Reserve accepts a very large volume of collateral, and it is critically important to be able to access credit ratings and other information on a timely basis in a fully automated fashion. The Federal Reserve is open to utilizing credit ratings of all NRSROs consistent with this basic requirement. Q.3. Given the concerns about the government-sponsored entities that led the Fed to grant them access to a lending facility and the Treasury Department to ask for rescue legislation, has the Fed changed its practices on accepting GSE-backed securities as collat- eral at the Fed facilities? Have you increased the collateral re- quired when GSE-backed collateral is posted? A.3. Securities issued or guaranteed by the GSEs remain eligible collateral at the Federal Reserve's various liquidity support facili- ties. The market prices of GSE securities pledged as collateral are regularly updated and the haircuts are determined to provide the Federal Reserve with adequate protection against market, liquid- ity, and credit risk. The haircuts applied to collateral pledged by depository institutions to the discount window are regularly recali- brated by the Federal Reserve, and it has not been necessary to change those applied to GSE-related securities. Haircuts applied to securities pledged by primary dealers for repurchase agreements, the primary dealer credit facility, and the term securities lending facility are chosen to be consistent with, but slightly more conserv- ative than, market practice. 46 For list ;i 10:00 a.m., EDT Monetary Policy Report to the Congress July 15, 2008 Board of Governors of the Federal Reserve System 47 Monetary Policy Report to the Congress Submitted pursuant to section 2B of the Federal Reserve Act July 15,2008 Board of Governors of the Federal Reserve System 48 Letter of Transmittal BOARD OF GOVERNORS OF nn FEDERAL RESERVE SvstBM Washington. D.C.July 15. 2008 THI PRESIDENT of Tilt SENATE THE SPEAKER OH THE HOUSE OH REPRESENTATIVES The Board of Governors is pleased to submit its Monetary' Policy Report to the Congress pursuant to section 2B of the Federal Reserve Act. Sincerely, en Bernanke, Chairman 49 Contents Part 1 I Overview: Monetary Policy and the Economic Outlook Part 2 3 Recent Economic and Financial Developments "\ The Household Sector 3 Residential Investment and Finance 7 GRBSUMF Sjjending and Household Finance 10 The Business Sector JO Fixed Investment 10 hi ventory In vestmen t I1 Corporate Profits ami Business Finance 13 The Government Sector 13 Federal Government 14 Federal Bom>iring 15 State and Local Government 15 State and Local Government Borrowing 16 National Saving \h The External Sector 16 International Trade 17 The Financial Account 19 The Labor Market 19 Employment and Unemployment 20 Productivity and Labor Compensation 21 Prices 23 Financial Markets 23 Market Functioning and Financial Stability 25 Debt mid Financial Intermediation 28 Eqttitv Markets 29 Policv Expectations and Interest Rales 30 Monies and RtMt'lW 30 International Developments 30 International Financial Markets 32 Advanced Foreign Economies 33 Emerging Market Economies Part 3 35 Monetary Policy over the First Half of 20(18 Part 4 39 Summary of Economic Projections ii Tie Out look 41 Risks to the Outlook 42 DiversIly of Parllclpanls' Views Boxes ft Kccent Federal Reserve Initiatives to Address Problems in the Mortgage Market IK Commodity Prices 2(> The Federal Reserve's Liquidity Operations 45 Forecast Uncertainty 51 P&rtl Overview: Monetary Policy and the Economic Outlook The U.S. economy remained sluggish in the first half of pated to remain reasonably well anchored, with futures 200H. and strep increases in ((HMIIUHILIV prices fmxr.lt'ri markets iiiclicaliu^ thai CHIUCIHHILIV pikts art- rxpcuHtl L iHI-.iLiin-t pin i- Jntl.iti-iji I he riiiH\iii_i3 iiuirkfC L Niiiin to flatten ciul. and with pressures on resources likely ued (o contract, weighing on overall economic activity. toease, inflation is projected to moderate appreciably Against a backdrop of mourning losses incurred by in 2009. FOMC participants indicate that consider- major financial institutions, financial market conditions able uncertainty surrounds Ihe outlook for economic deteriorated sharply furlher toward the end of the first ^mniti ,<nd thai ihey see ilu- risks arciuud Midi Quilaok IJIL.LIIIT .! LJr\rlif[jnu"iit llul Lliffiilcju'd lc> y\Ebrrt\ a% skewed en 131L- liiiwTisiitr. ~YUv\ <ilsci WT prcispc^ris fur impair the funitinning nf (he overall financial system inflation as unusually uncertain, and they view the risks and lo hinder economic growth. In response, (he Federal surrounding, their forecasts Tor inflation as skewed to Reserve undertook a number of significant actions lo I he upside. address liquidity pressures faced by banks and other In the second half of 2007 , ihe deteriorating perfor financial institutions, thereby aii^ineiiEiu^ ilu- lnjiin.kr. mance of subpritne mortgages in the United Stales trig- fiiliiirnLiifj measures implemented in the second half gered a reassessment of credit and liquidity risks across of 2flO7r Taken together. these measures fostered some a broad range of assets, leading to widespread strains improvement in the functioning of financial markets, and turbulence in domestic and international financial but considerable strains persist. In view of ihe implica- markets. During the first quarter of 2008. reports of tions of thesubstantial reduction in credit availability further losses and wrlle-downs at major linancial insti- and Ihe continuing decline in housing act ivity for the mricms incrnsttHtl concerns .LJUMLI cretlit JJUI lic|LIiili[^ eronmhir oulitmk. The KEilerd lOpen Market Committee risks and resulted in a further sharp reduction of market (FOMC} further eased the stance of monetary policy. liquidity. Risk spreads—particularly for structured cred- After cutting the target federal funds rate 100 basis it products—widened dramatical l y, and securilization points in the second half of 2007, the FOMC reduced activity ail but shut down in a number of markets. By rates another 225 basis points ov ER the first four months March, many securities dealers and other institutions of 2008. Tiie further easing of policy was seen ascon- itiiil had rrlii^d !iejivilN' {in shcirMemi tinancing in mar sistent with fostering price stability over time, given the kets for repurchase agreements were facing much more Committee's expectation that a flatten !ng-out of energy stringent borrowing conditions. prices and increasing economic slack would damp infla- In mid-March, a major investment bank. The Bear tionary pressures. Steams Companies, Inc.. was pushed TO the brink I Jn- iiuAt PM9BM etmioEhif projeciioi^ H_• I jh.ir i i•_ J i.hi faiE URE after suddenly losing access to short-term p;iii|% in l-£)Mt meetings (l^Uniui IIH-IJIIHT^ and Rrservr financing markets, "file Federal Reserve judged Ihat a Bank president) are presented in p;ir[ A of Ihis repurt. LIIVIIILIITK Liihirr MF \U\t\ S[pjims wntiU\ 11.1-4.L- threat According to these projections* the economy is expected cued overall financial stability and would most likely to expand slowly over the rest of t his yea R. FOMC par- have had significant adverse implications for the U.S. ticipants anticipate a gradual strengthening of economic economy. After discussions with the Securities and growth over co mi ng quarters as the lagged effects of ii.ifliiiuge (]cinuThssiun and in Hinsullalicm willi l)ie |his| mnneijry p»liry acijonv umicl gr<tcltiHiUv jmprtiv- Treasury, the Federal Reservedetermined THAT it should ing financial market conditions, begin to provide addi- invoke emergency authorities to provide special financ- tional lift to spending and as housing activity begins to ing lo facilitate the acquisition of Bear Steams by stabilize. FOMC participants marked up their forecasts JPMorgan Chase & Co. The Federal Reserve also used of inflation for 2008 as a whole, reflecting the upward emergency authorities lo establish the Term Securities pri'ssurp mi in Hill inn fruni rising c oiuiiiiMliiv pritW, Lending Fac i lity and the Primary Dealer Credit Fatality However, willi louderrun inJlaiiori expectations anliri- lo support Ihe liimidily nt |»riiii.i[\ dealers and financial I 2 Monetary Policy Report LO ihe Congress July 2008 markets more generally, which would bolster the avail- purchasing power of those nominal gains was eroded ability ofcredit lo the overall economy.1 (See the box by ihe rapid increases in CONSUMER prices. Declining cmIIled "The Federal Reserve's Liquidity Operations" employment, stagnant real wages, and lower eqully in pad 2. page 26.) Other sleps taken by the Federal and home values weighed on consumer sentiment and Reserve in recent months lo address strains In financial spending. In addition, amid falling house prices and markels Include a furt her easing in t he terms for bank rising foreclosures, activity in ihe housing sector con- borrowing at the discount window and an increase In tinued lo decrease. The resulting softness in business the amount of credit made available to banks through sales and profits also made the environment for capi- the Term Auction Facility. The FOMC also authorized tal spending less hospitable. The weakness in overall increases in its currency swap arrange ments with ihc domestic demand was partly offset bv strong growth of European Central Bank and the Swiss National Bank to export which were supported by a sustained expansion Facilitate an expansion of dollar lending operations lo of foreign activity and a lower dollar. banks in (heir jurisdictions. The substantial further rise this year in the prices of Over the second quarter financial market condi- many commodities, especially oil and agricultural prod- tions improved somewhat—credit spreads generally ucts, largely reflected strong growth of physical demand narrowed, liquidity pressures ebbed, and financial that outstripped supply in these markets, Although institutions made progress in raising new capital. St ill, weakening economic activity and rising prices have asset prices continue to be volatile, and many financial tempered demand lor com modi ties in many industrial- markels and institutions remain under considerable ized nations, demand has continued to grow in boom- stress. Very recentl y, the share prices of Fannie Mae ing emerging market economies However, supplies of and Freddie Mac dropped sharply on investor concerns commodities have generally nol kept pace for a variety about their financial condition and capllal position. The of reasons, including political tensions In some oil- Treasury announced a legislative Initiative lo bolster the producing nations, higher input ants, lags In ihe devel- capita], access lo liquidity, and regulatory oversight of opment of new capacity, and more recently, Hoods in the government-sponsored enterprises (GSEs). As tin- Miihu"i( I" '..imii.1-1, fli-Linw I In.- iru.jhin.L1. iiu rt^i s a supplement to the Treasury's existing authority lo in materials prices have passed through into retail prices lend lo the CSEs, ihe Board of Governors eslablishcd of energy, food, and some other items. a temporary arrangemenl that allows the Federal Overall consumer price inflation, as measured by Reserve lo extend credit to Fannie Mae and Freddie the price index for personal consumption expenditures, Mac, if necessary. remained elevated in the first half of 2008, largely The sluggish pace of economic activity in the first because of the sharp increases in the prices of many half oF 2008 was accompanied by a further deterioration commodities. The decline in the foreign exchange value in the labor market. Private-sector payroll employment of the dollar has boosted import prices more gener- declined al an average monthly pace of 94.000, and the ally and thus has also put upward pressure on inflation. unemployment rale rose to 5'6 percent. Moreover, real Nonetheless, increases In labor costs and core consumer labor income appears lo have been flat in the first hall prices (which exclude the direct •effects of movements of Ihe year. Although wages rose in nominal terms, the in energy and food prices) have remained moderate. The rapid advance in nverall prices has bomled some measures nf inflation expectations: Near-lean inflation expectations have risen considerably in recenl months, I. Pftnury Uc-jtm UP fuim lhal Iradr- in (J.S. pm rrnutriri wniri- am] some indicators of longer-term inflaiiun expecta- l F in n l H m il l h k Ih n r m F r c d S m >U l r J r t n n . t I n b r e f N ii M ri k Y D a T t L N M ™ O V n O r p i. m O M n b v r k f c u i I D f t o > f 4 lltr tions have also moved up—a development that will uch Iradra ID imptnnml ntunrlarv pclkry. require close monitoring in The period ahead 53 Part2 Recent Economic and Financial Developments The growth of economic activity, which slowed sharply an the chiiin-type price in Ilu1 fourth (|Uiiiitrr ul 2007, u'liiainrd sijbji.ir in ilu1 lirst half of 2008. Although ihc reslraim on activity late in 2007 was concentrated in thr housing sector, spillovers to other areas of the economy began to show D Tc* through more clearly in the lirst haiF of ZOm Mean- while, consumer price inflation has remained elevated Ihis year primarily because of steep increases In the prices ofmany commodities Probably in response to ilu1 \iAiMi- rise in headline price indexes, sonic i tut it .L Mill tors of longer-term inflation expectations have risen in recent months. However, increases in labor costs and core prices have own fairly stable* reflecting in pan ihe softening In aggregate activity. I iiLiiK i;il markei stirs* \\MH \Y,H\ i\vxv]ti\wi\ OVIT MICJ second half of last year intensified in the first quarter of this year. Increased concerns about the possibility of Sulk, rhruujjh SJO?, kludge I Lktcfrtn cu Unmrdvi. f a global economic slowdown and a generalized flight tKmgt a tram Ikormht M MJJ from riskier asset s cont ributed to sharply wider risk spreads heightened volatility, and impaired liquid- ity across a range of markets The Federal Reserve somewhat In the wake of these actions, but significant responded 10 (hesrdevelopments and their jHiientLiI Mraius remain Wtlh (rcclil rnnclilicms li^lil. «tuit\ JIIH! adverse implications for the economy by aggressively nate valuta falling, and rafiidly rising comnnHlily easing the stance of monetary policy and by taking a prices boosting costs and ronsunier prices, growth of number of steps TO BOLSTER liquidity and enhance market household and business spending appears to have been functioning. Conditions in Financ ial markets Improved sluggish over ihe lirst half of the year. Change In real ojou domestic product, 2002-0 The 1loLischttld Sector Residential Investment and Finance Housing demand, residential construction, and home prices have all continued to Fall so far this year. Fol- lowing a decline at an annual rale of 43 percem In (be M=I. nd half of 2007. sales of new ho tint's dec reasEKl at HEI annual rait' of 32 permit in the first five months of 2008, However, sales of single-family existing homes, which dropped at an annual rale of 26 percent in the second half of last year have been about unchanged this year. Moreover, pending home sales, which pro- virie it glimpse til llie |KK f nf exisEin^ humr ulcs in ilu1 2HQ 2DM MOS J006 TOOT 2D0H uioncbs ahead, mi ne[ kvrkt] nut in the spring, hinting al some stabilization in transactions in ihc resale mar- d h mnmd to ib Oral (furtrr from hr flail qwrirr cf I ket. Siill. for [he overall housing sector, the challenging p mortgage lending environment and the concerns of Stmci. DepMiii • <rf Ca«iiwcf. Btwu of 54 4 Monetary Policy Report lo ihc Congress July 2008 prospective humehuver* about further dedinev in hoiis** (/hongc in prices or'c.tistm^ singlc-fimiiv IHHISCS, prires arc likely runiinuing [o depress tinusing lEeitLincI. 19K8-2OOS As new home sales have continued to Aw lim-. hamenuildcrs have siniggled lo work down iheir sub- stantial ov erhang of unsaid houses. As a consequence, residential construction activity has been pared further this year, [n the single-Tamilv housing sector, new units were started at an annual rale of 674.000 in May— dow n more than 13 percenl this year and roughly 60 percent sin ilit' pOdk reached in the first quarter *>\ ^UOti. Despite [hcM- tin-ft pindui litm CUTS, ilu1 slink V of UNSOLD homes has moved down only 20 percent from its n. i ini.l 111:-.11 in i..!: I1. XiIIil> \\ 11• -• • i \ .iln.ui"! M I.Hr. r tol ite three- month average pare of sales, the months' — IJ supply 4it uiiSHilcl IIL'U IIDIIILA ILLS (cuiliniifd [o rise .unj I I L I L J I J I L i L J I I I I I i I L I I sloodal 1(H* mmiriis in May. I" the milIlitarnilv seciox. starts averaged an annual rate of about 320,000 units HII: J0Q8 pi: tk^gn MK during the first five months of 2008. a level of atlivity Ijvm one al Ihe lower end of its range in me past several years. wily. TheS* AIL told, ihe decline in residential investment (rimmed Hin^lrltiitrt in 11k." the growth rate of real gross domestic product (GDP) about I percenlage point in (he first quarter of 2008 and . FM Itpm U-jrt\*.-TM>fiv -tHIkt uf hnklal llnuutig t; bf SAP t"ue-ShilbT.C1iKJ«9Mcrh.-JKhk lAdunp: appears to have held down the second-quarter growth rate by about the same amount. single-family homes sold—which does not control for Mouse prices also have continued lo fall. The month- changes in the mix of houses sold but is available on a ly price imlex pulilisheil liv ihe tJflicf ol h'ditnil Kunm- mint' murk h,\\i\ ULI\ JIIKUII 71: |nn iiii IM-1IIH MI,I[ ing Enterprise Oversight dropped at a 6 percent annual [jf a year earlier. Although lower prices should eventu- rate in the first four months of 2008 (the latest available ally hrlp holster housing demand, survey and anecduia! data), a slightly faster rale of decline than in the second reports syggesl lhat ex pect at ions of further house price half of 2007/ In Mayh the average price of existing declines are quite prevalent, a consideration t hat may make potential buyers reluctant la purchase homes until 2.. thK JIWVJ, KtW1 pmtw^Hil> ^mkmof tkrirprat- prices show signs of slabili/ing. \ion\ prtrr indn for raining \\ng\t-family hoiqn puhliihnl hy The rising volume of foreclosures likely has con- tributed lo falling house prices. Continuing the upward b-end that began in late 2006. about 550,000 loans Private housing surts. | began the foreclosure process In the first quarter of 2008-m ore lhan double the average quarterly rate fmni 200:1 u> 2005. Ihis rise in furecltKiiire iians v.ill iucriMM1 ihe sunph1 cif IHHIWS for \ale iiiilevs lnjirti\',ri v i JIII [nuke ii[i [he Jiiissit! |uiyjneut% «r arrange wilh |he lender* or rnrcrlgagt* servkers to have their loan^ modi fied- J Lenders and mongnge vrf\rirenp have inrreas- ingly been working with borrowers io modify loans lo allow borrowers lo remain in iheir homes. However, some borrowers may not be able lo afford even reduced month]}r payments, and other borrowers may nol wish lo keep their properties in an environmenl of falling house prices. Thus, the share of foreclosure starts that . A loan nun '^ modiltrd h\ irdurinf; ihr principil tulanrr, lkiKiqn tor Apnl wd MJ>. ihe imnnX rale, or rxlcnlir^ ihp Inm w a\ lo nuVr munlh - h juyn Tdhk BoardofGovernors of the Federal Reserve System 5 ultimately result in t he loss of a home serins Hkety to be ivc dcJaults on subprimc2/2Sloans2.S loans. higher in [he rurrent episode than customarily has been of originalion, 2001 07 lie case. {See the \MX emitted "Recent Federal Reserve Jniiiaiivps lu Address PmiiLeins in tin- Montage Mar ket" on page 6.) The rales of delinquency continued to rise in the mm — s \\\\{ \\-\\ 1\H>I\\]\\ Lh| i'llUH .IL l(t\\ ,t|| I .Ik^UILCS 1)1 JIL.lK (M gage loans. Problems remained espetially severe for - M07 / / — 20 sub prime loans. However, the growih rate of iubpriinr delinquencies has, slowed this year while that of prime - IMIJ '!j — l> and near-prime delinquencies—part icularly on // / adjustable-rate loans—has picked up. Credit quality - — 10 is sir ongly related to the originalinn date of mnrlgage — J bans, with ILMTIS originated in 20Uti ami 2007 much more likely to experience delinquency and default than i i J | loans originated in previous years. The poorer perfor- q a » >) mance oT the more recent loan vintages reflects 3 gener- l..»o lie Imon* aldeterioraltnu in uud^nuJmigsEniiHLird*, chrou^li tinr]y ) d»(3 IIIFOUVII «wk tm I JKII <mt 2007 and Il irdec l inein house prices since 2007, which J hi Hie ii ! iU o fJ f t In iu m th W HK . I^M r~ U IA c I u m 1*1 p l l e h . c n I ^ h s d b K ty il n S l P > C V T a T< i O L I i u n ) f l ? u l t l l ii.i-. increased Ihe occurrence of negative homeowner ^ inn: in Lht yms Mrt] |p ZdtH hod tkbulicd by tin Ibirw 1lw> MR M mnnlhi LIILL TV LiJ V prniili u[ tbo BROI J« -""^ hqh :INIT DK tuMAJ (Mi irwwiipHc Jiu. A 2 JR hun i* i KKyMr Ion cy ntn. 2001 OK ttyy J flint role InMhc ftrJ J ycaft irtd LHI mlju^Uhk-TJIL lur II>L' rLnLJIIIinu- 5auwx Fir e[|ulEy for houses purc hased near the peak of the real BBHl market. New subprime mortgage loans remained largely unavailable in thefirst half of 2008. and borrowers with higher rrerlil ri^k lt;ni m mm ui governmenl ^usr^iiirp pragranu. such as Ihat u( \W Federal Housing Admin- ]slraeEon, to obtain mortgage loans. The availability of — ID prime mortgage credit has been held down by a further X lightening of lending standards at many commercial — 6 hanks, according tn ihc Senior Loan Officer Opinion — A Survey on [Junk Lending Prac tices conducted in jinmi — 3 aryand April. Securllizalion of mortgages by the gov- ernment sponsored enterprises {CSEs)h Fannie Mae and Fr«lriie Mae, was robust through April, although the CkSEs lighlcne<| siand'irtK and Increased ^iLinnlee fee^. - All-A pools for prime loans, iutereM rjtes on < uniontiLii;.^ h vi iL rale mortgages were up slightly, on NET, over the tirslhalfof 2008 after declining ntoderalely late East year.1 Rales on conforming adjustable rale mortgages dropped inJanu ary but have since reversed a ptirtinn of that decline. Offered vain on JUMBOFI xed-rale loans—which ran up in the second halfoflast year as the sec urilizallon 4. Lonfnnnlni; iibortpaflp* afr ihow rli^lbir tot purchjM1 \n l-an • in- M.:i ..i .I: n-iI-11-- Mar; chry nnhl brNt^lvalrni in li^k lo.i |<iiiM, inwtRjRr nidi aiSD prfa-nt Itun-ED-vuEur riHlo, .imi Ibrv f Jniwl f xfore! chf caiiftrfm1ii£ lain IhiiJi. 6 Monetary Policy Report to the Congress July 2008 Rvamt federal Reserve Initiatives to Address Problems in the Mortgage Market The hifih rate of mortgage foreclosures is Creating at high risk of foreclosures. With this informa- personal, economic, and social distress for many tion, community leaders can target their scarce homeowner* and communities. The Federal resources to borrowers in need of counseling Reserve is collaborating with olher re.R,uf.ilors, and other interventions that may help prevent community Brou05., |H>[icy organiza tions, finan- unnecessary foreclosures. One example of this cial institutions, and public officials to identify effort is the online dynamic maps and data that solutions to prevent unnecessary foreclosures illustrate nonprime loan conditions across the and Their negative effects. The Federal Reserve United Stales (available aE www,newyorkfeci.org/ also has taken a number of regulatory and super- mortgagemaps). In addition, community affairs visory actions to reduce ihe likelihood of such n.llii :•- ,i, r,,sv lh, fcdt7.il Rrvrvr Sy^tE/ni li.ivi' problems in (he future. sponsored or cosponsored more than 75 events tn 2007, the Federal Reserve and olher bank- Maletl to foreclosures since January 2007, ing agencies called on mortgage lenders and reaching more than 5r800 attendees including morlRG,Re servicers Eo work closely with borrow- k-ndrrh. r cmnylnrv r rfIiiniuriitv drvrktpmi'nl ers who flfr having difficulty meeting Their mort- specialist and policymakers. gage payment obligations. Foreclosure cannot The Federal Reserve alsois helping to address always be avoided, hut pnjdent loan workouts the challenges Chat foreclosed homes present, and olher fosvm it Ration techniques that help such as decreased home values and vacant troubled borrowers can te less cosily lo lenders properties that can cEetefiorjte from neglect. than foreclosure. Toward thi& t*tv}r the Federal Reserve entered into The FiiJvr.il KI-M'FW'K HttniftUVrtiiship ,mr| a partners hip this spring with MeighborWorks Mortgage Initiatives reflec ta comprehensive America, a national nonprofit organisation, to strategy across rhe Federal Reserve System to work together in identifying strategies to mitigate provide information and outreach to prevent the effect of foreclosures and vacant homes on u m n u n n e i c li e e s v s a U ry n d fo e r r e c th lo i' s s u ij re i n s i l a O n l d iv t e o s , s t t h a e b il F iz e e d e c r o a m l - c b o eg m a m n u h n o it s ie tin s. g I a n s J e u r n ie e s 2 o O f O fo 7 r P u t m he s F in e d s e e r v a e l r a R l e c s i e t- rve Reserve has been providing community coalt- ies acrnss the coon Cry to examine the effects lions, counseling agenc ies, and others with that tbreclosures have on neighborhoods in detailed analyses identifying nei ]xjlh strong and weak housing markets aitd lo market tor such loans dried up— remained elevated in the fiRt half of 200£> and spreads between rales offered on these loans and oit conforming loans stayed unusu- ally wide / To support the market for larger loans, the Congress raised the conforming hmi limit temporarily fur Z(IOHr which allnvv^l lUv t,Si\ m lack Ihi-sc mori gages. HoweviT. bflOBSt the |n"i'piiyn^'nt i hararleris- tics of jumbo mortgage borrowers are different from !^pt\: those of other borrowers, the GSEs and other market p.si ri< ijmtiK 111 -1 i(kd in tr \u fmol \\\vw "jmiilr" i [niftuni inj;" murlgd^es with olhrr mortgages \\\w\i tTfitlin^ riii i-r t; •_• i:";i• IMU ki-il \efurities (MBS}. As n result, tin1 .-• — * secondary market Tor such mortgages has thus far failed to thrive. Concerns expressed by public policymakers piTMiatk'd Fannie Mae and Freddie Mac lo make greal- l«p. I«J1 2000 The JiU. ^hurli wv MtUy ind tUnid Itirmigh July •, ZOW. uv I... ^.' i •' < ll." • '^' I • • 5. Juitvbu inongagn arc ihtwibai txend ihr inaxiiinjin size of J HmrofttiIflfi loan; ilK-y it? UpJiJlK rxirikkil ro burroivtrs\Yiihrfl£< EtVrly MrmlR rmtll htiLDfin. Baani of Governors of the Federal Reserve System 7 assess the t[Mili. niVdiiliilik' ED local f.oniniunilie*; to i IOI Kii 11-:^iUti\ li• i11U-1v \>. iM -ni-i 111 N ,i11r M ii ifrrir111- address the consequences of foreclosures. nlnrlK-iKC opHT.11 •- The Federal Reserve is committed m fostering In E>etember 20O7, ( he Board proposed new an environment that supports he homeown- rules under the Home Ownership and Equity ership goals of creditworthy borrowers with Proteclion Actt o ban unfair and deceptive mort- appropriate consumer protection and respon' gage tending practices. The Board received about sible lending practices. El is usingit s regulatory 4,500 1 r./iirn.-iil-, i.<ii ll«- Fmij-u'-.Ll .intl l.ikint; inlti and supervisory au T horit ies to help avoid future comjderdiion ihes# commentsr issued new ruf f?rol)tpm& in montage* markets. In coordination rn |uEy. For con^umere ^eceivinK higher-priced with other federal supervisory agencies nd the mortj"agesr the final rules prohibit lenders from Conference of Stole Bank Supervisors, the Federal extending credit withoul regard to a borrower's Reserve issued principles-based guidance on spe- ability to repay, require lenders to verify income cific typesof adjustable-rate subprime mortflafles . IIT I .I-^H;V ihr-v rrk LJJMHI in IMAIIIL: II ..HI-. in June 2007. The guidance b designed to help nequire lenders lo eslablish escrow accounis iw ensure llvt borrowers who choose an adjustafole- taxes and insurance, and prohibit prepaymenl r.ite ninnrr^,b|jit» w\ s loLm ihjl lht»y can afford to penalties unkss certain conditions are mel. In repay and can refinance wilhoul prepayment addition, the rules also are designed to curtail fH'n-UK rrn .! IIM--IIII,I|III 11.nih| Ni-iim t'i.- rn ,- deceptive mortgage advertising and to ensure interest rale reset. The Federal Reserve issued thiH t [nisunscr^ FLJ[ i-ivr nVMt^j^i- [Jim krturt^ .il sirtliLif jiLiitLbfict1 tjri rUjillr.idtlif]i>j\ nictrtHAftrt in .1 [inir w\wn I hi' inlnrnT,itinn is likely I" IK1 mini 200b. uwful lo them. Strong uniform enforcement of Ihe consumer Finally, Ihe Board also is undertaking a broad prolectton regulations that govern mortgage lend- and rigorous review of the Truth in Lending Act, ers is critical TO avoid future problems in mort- which involves extensive consumer testing of g^ffi markets. Together with other federal and riUirl^'iK'' (li^'tctMJfL' (JocuriUMlK. CIr;trt-r .ind stale supervisory agencies, the Federal Reserve iMSM'r-io-understand tli«.l»iurE.i!» hiicmJrl help con- 1 p ,1 r 1 o 1 le n t t ii h o e n d c h o i m \it p \t l H ia n j> c n e ^ j M nd n i im |tj p r o t s ^ t v . i 1 t 'w co m rre m ct u iv m e i o 'i r s to u m th e e r m s b a e n ll d e r t h e u v s a m l u a a k t e e I m be o r l e o - a a n p s p r th o a p t r ia a l r e e c o h ff o e ic re e d s enforcement actions, as warranted, at selecled when financing their homes. CTffToru iujump-Kt<irt trading in the market for jumlxi i bsngf to r cnnRirming kuin^i. and the CiSE-.s \I~A\C rrct'cilly laken •:• variety of act ions lo encourage THE development ofthat market. pennut HKSW The weakness in the housing market was associ- 'urn ctpcnliliim ated with a sharp slowing in ihe growth a( hnuscholtl riHirt^a^e ittLhi 10 an annual r4iir of !i pcrcnir in the hrsi quarter nf .-iIHJH. dtiuu from l>' i percent in ^007 Jnd 11 '/i percent In 2006, The available indicators suggest (hat mortgage debt likely slowed further in Ihe second quarter. I Consumer Spending and Household Finance The growth rate of consumer spending slowed some in ihe tirsl half of 2(308 from its solid part1 in the sec- ond half of 2IHI7 The slmvinj; reflected a number of restraining infl uences. The growth rate of real labur urras labor market conditions have weakened and income has stepped down subsEanliaily since last sum- as rislii" prices for food and energy have pui a sizable 8 Monetary Policy Reporl to Ihe Congress July ZOOS Consumer unlimcnt. I real terms. In the past couple of months, par tof the uriijii on liiniM'lntli] im nines t jiusni \n i3n- ^i.i^:i.niuii In real wages was likely alleviated temporarily by the tax rebates tha t were paid out In May and June. As a result of these relates, gmwih in real disposable per- sonal income (DPI)—that is. afirr ia\ income adjusted for in Hal ion—which was subpar in Ihc fourth quarter of 2007 and ihe firsl quarter of 2008. likely jumped in ihe second quarter. Despite an increase in transfers reflect- ing [tie recently passed extension o f unemployment iiiMii.irn i- liTTii-liis. real DPI is liki'ly lei fall 1ML k in ihf third quarter asthe disbursement ofrebates slows con siderably. After several years of providing an impetus lo spend ing. household wealth has been a negative Influence Vn-: The {'iififcmiKC [kuni JJIJ afr tlWMftlt JinJ C"itt1kl [hfruyft JiAc thi% year. Cluiigrs in ImuM-liold nd \untU ii'iiil lo inrln JWK. The Ktufrr> L mi crHi> of MKhipJn 111* we n»n(hl> MMJ «md ITH v i nriMirin'c v|>i• n-iti• i• ^ innM Eicas ih u\n ,i [HTIIK] th S ru O sh U m J i»f r 1 * 1 c m C i ' i u u f r i > fc t o rt l M in s u B lf u 1 al i d * J * u > l> d ^ R O f C i n * t ct\ I nn rt\rtV flT Micfaifllt Si*. of a year or two. Accordingl y, the drop last year in the rey* ofCo ratio of household net worth relative to income prob- ably weighed on consumption outlays in the tirst half ot2008. Moreover. Ihis year's din lines in residential real estate values and in equity prires have exacerbated denl In consume rs' purchasing power. Al (he same time, the situation. Flagging wealth has likely left house- household wealth has been reduced by declining values holds less inclined to raise their spending at a rate t hat uf Ikjlli if]uitii>% and huuw In addition, twrriiwing exceeds Income growth, and the personal saving rate al kinks iLJ liiMim- oullays liiis ln'c LIMLC Tmm1 diflicull has flatteited otit over the past few quarters. In May, the asterms and standards on consumer credit have been saving rale jumped to 5 percent, as the immediate effect li^liiL'iu'il. Alihuugh [In- tax relates lhat liciu%eholds of tax rebates in many households was lo boost savings. began receiving in ihc spring an? MkrU cu%hi{>ning Overall household debt increased al an annual rale of these effects lo some extent ,consumers appear lo be HIFHHII '.\ui JHT-C i-Fil in llw tirM quarter (tf 'HHVA. a iHiL,iL!r quite downbeat. Measures of consumer confidence, cle< eli'Mttmi Ironi the U' i \H-U t-nt .id\,ii« *• m 2007 which had dropped sharply in the second hall of Jim? , Household debt appears to have slowed further in the plungrtl fuhhi-r in Ilk1 rirsl hslfoTikis y^r^nd novv MHIHI 3.1 cir EM'IOU" liir Itiw Irveh rcat ln"i] in tlir thjrl\ 1990s. Real personal consumption expenditures (PCE) rose at a modest annual rate of 1 percent In the first quarter. The available data suggest that spending picked up in llu1 srrcHitl f|iurlrir, ri'|M)Hi'ill\ iHrnslnl h\ ui\ nhb;]li's. Spending on light motor vehicles was lackluster in the lirsl half of the year, as high gasoline prices curbed demand for sport utility vehicles and pickup trucks. Outlays for other types of goods fell slightly in the hist ijudrl^r IHJI appear lu liavr tunk-d bark up lit recent months Spending on service hj\ held up well in recent quarters. Following a sharp deceleration in the second half of last year, real labor income has been flat so far this year, as numinnl wage gains have IHTH emded by rising muMiEitrr |]rice\. .V LT..IJ^L l«mrl\ t'Lirniiif's. A mvasinv TV iliUn qiurteily utd nlcnJ Itwnifh 2W»OI The of wages for production or nonsupervisory workers, nr rj(x> n the tMm nf bm«facild nd vntlk •» i^ roseat the same rale as the PCE price index in the live Rcxr* Dcwd. fim of Funtk months through May: thus, wages were unchanged in 59 Board of Governors of the Federal Reserve System 9 first halt of this year but by less Ihim short-term markei interest rales. t)viTjll rreilit {jitnlily DF ronsnnirr ]UAT\S WAS ilflcrki- rated soiiie^'luii in rcctnt ciuiriilis. D{LlLiH|UEbni:y rates {in O0QBIBW hiaiix at roiiuiienial banks ami cu\ii\ ve Juki finance companies rose in ihe lirst quarter but stayed within the range experienced over ihe past I D years. Although household bankruptcy tilings remained low relative to (he levels seen before the changes in bankruptcy law implemented in late 2005. the bank- ruplty rate rose modestly in the tirsl few munltis of 20O8. Srcoiuhirv1 [iiark[Lt i\Ma Mif^esi ilun Funding for rn'ilit ["arc! LIIIIE iiuici Etians lus tici'ii -A i-l I Mi.iiiii.iiiiii: in recent MONTHS. Notably, issuance of asset -backed Nan: TTK dau arc qujrwtly and tuieiid lh h 20O8:Q2; Hie reading for securities (ABS) tied LO credit card loans and auto loans :tKJS:(j; »the avenyc Tor ^jwil KHJ MH) has remained robust despite spreads of yields on these SoUKK tltiunnwriL nf L'tMnmtftt. UtiFL'j securllies over comparable-malurity swap rales Ihat continue to be near historically high levels. In contrast, pressures in secondary markets for sludent loan ABS second i|n,]il«i. ]ic(.LUM' ihcgmwlhol I M-hciliIdetM have reportedly afreeted I heavaiIdhiIiiy «fsuth credit was slightly less than thegrowth in nominal DPI in the The rcuuhnrsenient funuuEa For government-guarantffld rirsl quarter and Interest rales on mortgage and consum- Mudei^E Iciaiu did not adequately compensate lenders erdehl ili'cliiifi.i ;i bit, rln- ratio nt financial • ^l • I i•;. • i i• • • • -^Ffir liie higtiiT luiidiu^ ecjsi in wKLiriii/jniiiu nurki'Ls, lo DPI us k. d town. and issuance of guaranteed sludent loan ABS dropped Consumer (nonmorlgagc) dcbl expanded al an annu- sharply early En 2G0&. Legislation enacted in May gave al ralu ol S-^ percent in the first quarter, aboul the same die Department of FduraMon ;md the Treasury (he pace as in 2007. Lurtsumrr drlit ^niwili tn-ld up ilt^piU' • :ill.i:i M1-. ii; provide \!m:l •: -1 -1. 11 • 11! i • 11:'-. Hi i;r I: '< ;| n n •. a njf)t>f(wl [[^lUiiilngof lending terms and standards at llut leiul to MutlfiLls. ;IJL[! Liv;iiljl)iLlv til slndent loans banks. In pan, this pattern may reflect some subslitu- appears lo have improved. However, concerns persist Mon away from mortgage credit. Also, interest rales on .: bo ut access to loans by students at community and aulo loans and! on crcdil cards generally declined in the career colleges, as these loans tend to be less pro.1liable for lenders. Household financial obJigaiions rjiio, 1 NOT IlitihU art LJILJFKTIJ Jisrf*\lflkl ihronjiJi ~<MK:OI. Th :iHM 200b • >hli;._i• • •_• i-- i.ili>• »'i|i .1! 111. --.1:1- • • I [L~L|LJhrcL] pj\irk:nli • > 1 • 1.1<>iI-.•.:^> Lmnci'-. iniiirjrt.1*, and (Kiificfly Lu^i, jll nEiiulod by dufuiubli h • 11 • IK*- M r i v ." r i 1 A 1. i iv i! .1 i i1 ;IT 'k L- u n L| > L i. 5 ir 0 lL T d ; j V > -> jn o d rn L w '^k re "i iJ p a L n JI i I L d H i J > | income. SiHUi. J«L-rjl JlfwM ttuufJ. L0 Monetary Fottcy Report us the Congress July 2DOH The Business Sector rale tjF J1* percent in the firs tquarter after a smaller Fixed Invest ment c11"c 3iin.• in I]11' previ^TLis i|UiirdT. Ihr ^i•--_i11 • 1111•= - :i:>.I:• .11-.•: . Mij^:;i^t (finii 1-4ipit.1I s|K-iiL]iiij; nn rtjuiipmr-ii A\H\ \uh ware felt In the second quarter: Business purchases of After having posted rubust gains in the niulili*' oftasi new motor vehicles reportedly slipped again; shipments year, real business fixed investment lost some steam in of nondefense capital goods (adjusted to exclude both the fourth quarter and eked out only a small advance in iraTisjKjrlaliuTi lirnis nm\ gtmds thai wrre M-III abroad) the first quarter of 2008. Economic and financial condi- were IciviiT. cin JVITI^I1, iit April .ITHJ Mnv ih^n in [fir tions Ihat influence capital spending deteriorated appre- first quaner; and the lone of recent surveys of business ciably late last year and early this year: Business sales conditions remained downbeat. <iiuwed, E'mpmalr pmlils fell, ami cnnlil roiuliliuTis Fur Nanresidenllal construction activity, which exhibited \-mn- Ij-cinowers lighiened. Jn jddiiinn. Ihp brightened considerable vigor in ZOOtiand 2007. slowed appre- concern about the- economic outlook may have caused ciably in the lira quarter of 2008. Real oullays Tor some firms to postpone or abandon plans for capital 111 • •.-. i • • r i: 111 • • i •= i. 11 l:iiiMni!'N ilii Inn il -11.11 |iK in ihe ". i -' expansion thisyear. quarter, and increases in oullays for most other types of Real business outlays for equipment and software Lwildirit* MC|)]N-(| dnw n Morr-recenl <lala on construc- iverr ll :LI in I In1 lirM quarter {*rm\lh in rrjil ^|Hhiuliii^ on tion Expenditures suggest that spending on nonrestden- highlech equipment and software slowed to an annual tial struct ures may have bounced back in Ilie second rale of about 10 percent, down from the 13 percent pace L|LJiiriLT Hciive'irr, di'tiTinrtKiti!1 ecom>mir anil tlnanrial recorded in 2007. in addition, business spending on conditions indicate t hat this rebound may be short- motor vehicles tumbled. Inv estment in Equipment other lived. In addition to the weakening of business sales than high tec h and transportation dropped at an annual and proIlls, vacancy rales turned up in the lirsl quarter (the latest available data). Moreover, the financing i-iw iTnriiiu"ii[ lias rpinained cliftiruli: liank lrmling t*i\\ in real business fixed UWMtuawa, 2002-0 cers have reported a significant lightening of terms and standards for commercial real estate- loans, and funding llirnugh (hi* commercial cnuriL^jge lurked M-^U lilies (CMBS) market has continued t OBE extremely limited. Despite sluggish rural sales. Inventories declined again in the first quarter of 2008 as firms acted promptly to Change in real business inventories, 2002-0 ._. I lifh.iM-hf t|mpmrn(1t ad M^UT, JUJI I_J I I I I I I I_J ~upcr Hish-Cfch cV"TimCTd ffMrv^1 SmiHi. Drpor&ncnl of-t'cfnmnvr. Ehire-Mi-or DcpMtmrni of t'oflweferr Buna -rf ho 61 Bikini of (JmvrnuFi of flit' Fttffnil Rt'.vm- System 11 prevent invE'iniiry inihuLinn^ from arising, Antnmak- ery which ti-id worked to bring days' supply down (o a S a pcrccnl af scclur gross domestic prwlutt, I sustainable level lasl year, have moved aggressively to keep product ion aligned with demand in recent quar- ters. Excluding motor vehicles, real inventory Irtvesl- menl fell in dtp fourth quarter of 2007 to iis hmesi Ivvel in KVCnl years and then InmEii negative in ihc first quarter of this year. According lo the limited avail- able, data, nonaulo businesses continued lo liquidate real inventories early in the second quarter. Business surveys suggest thai companies are generally comfort- able wilb llieir (lirircil Mm k levels. Xuriellu'less. .i few industries, most notably those pirnlm in^ 1 UIKIMK InIM supplies, are showing some tVfthttOt of inventory overhangs. i f h 2DW:QI. CnHlc* Corporate Profits and Business Finance UM *l|'i *)| ^Mv [7iu iM' Economic Aiuryti*. The sluggish pace of business inveslmenl in recent months is (IIJL1 In part to ilu* ^^ E-Lik-L-EiLn^ of domestic quarter of 2008: the available data point lo a further protitnhilllv mid the lijjnn crnJLi conditions I ••• i-ii deceleration in the second quarter of this year In ^iiNLe Inisinrssc, tn t\v lijsi CJLJ:JI-|L^E M( MttK. im.il On balance, the composition of borrowing by nonfi- economic prortls Tor all U,S, corporations were down nancial businesses has shifted this year toward longer- slighlly from their level four quarters earlier; a nearly niiUmiK debt. Net bond issuance by iitinfniaitcial firms 20 percent rise in receipts from foreign subsidiaries was has been strong. Speculative-grade issuance, which nci| Miliificni in ullu't A Vh. percent fall in dcirnesiic:jlly droppetl sharply lale last year and was practically nil generated profits. Although profits as a share of output in ihe first quarter, rebounded markedly in the second in the nonlinanrial corporate sector have declined in quarter while investment-grade issuance has continued recent quarters, they remain well above previous cycli- to be robust. Spreads between yields on investment- cal lows. For companies in the S&P 500, operating :iiii speculative ^j.nir fminK iind diose on I'oiurjarjhle earnings per share fell 17 percent over the year ending maturity Treasury securitJE's c:limbed in January and ici the : i i -. i I|IL-.HUI. This dibtnline was i : ilun dfTOLini • then surged in March, After narrowing in April and ed for by plummeting earnings M financial linns, whirh reported large wrile-downs on leveraged loans and mortgage-related assels.n For nonttnancial firms in the i:\.\iti LLHUfWDcnls i>f rwi liii:Ltti:in^ (or rnji)t1njn*.Li orate businesses, 2O03-Q& S&P 500, earnings rose nearly IL percent over the four quarters ending in the first quarter of 2008; energy- SBCtOf lim;s \\w\\ J Mmng 31 prrri'iu increase in eam- ing, whereas earnings at nther ncritinanrial firnjs rest1 Alh percenh Although credit has remained available to the busi- ness sector, yields on corporate bonds Increased signifi- cantly over the h'rst half of ihe year, and banks reported 11;•,!• ii-i terms .iml sunidcircK on rommerrlal and iuduv trial loan^ and cm commercial real estate loans. All ut!d. [he growth rate of the debt of nonlinanrial businesses fell from \\V\ percent in 2007 to 914 percent In me firsl an] ion 6. Auii UTilF-tluwm anJ capital lossri arr ^rmnil ly vtcv I Jtlttt Si HI The ilatD iif I nmp^ncnb t\<cnpt bond* m fmni ihrcjiculallon nf «-£HiLHiik |»r»MMju1 arr me luclril ;LS JII The dH* fPF 2(KH Q3 o rxppfiv In Ibr op*TiilInppanilng\ jxv sturruflnuitrl.il lirnm f Ikidftl, rlirtujf fundi lina \'l Monetary Polity Report lo the Congress July 2008 May. band spreads jumped again In la te June. Ou island Components of net equity IssoaftCt, 2<nu 08 III '. i iMinin M i,U |)Li]Hhr (I'H fur ucuitithinujl firms hus bwn Illllr rliHiigpri, on nrl. this year. YiMck mi n-cinh nancial CP have moved down si nce Ihr ginning of the year, roughly In line with other short-term interest rales, although spreads between yields an lower-rated nirid lii^fn'r inwt\ rnuiiiihnir i;d CP remain \w\\ ,ilimi- IIM1 leveh fnrrv.i ii i ii L; fie En re thi" imsel of I lit1 liiiiuirijl cljf- ficulties last summer. Commercial and industrial (C&l) loans at banks • PuHi expanded briskly in the lirst quarter and then slowed • Private- iiauante markedly In Ihe second quarter. In the Senior l oan Offi- I KrputvhiLiC* CB Opiniuii Survey i.ik'-n in I n.ii.:r i .ml April, • •:•! — Trtal sklenihLV lie I h;Hli(ni^ <tf Iwriks reported iluic iheyhaiJ tightened credit standards and boosted spreads on C&l loans. According to the respondent banks, the move iwe C- hiu to a more stringent lending posture mainly reflected a urkein and e y relired through less favorable in nmrr uiu I.-EKtin rt ruininii iI-LIIUKIK H.-.I f'jikh imeMnl by prwiit equity • i nx!in ill (nlciiirn i- Utr risk; J *-. i • M i j j • • .ml tr.n limi ,ikii Ki proceeds. i: Etianl. |lnw i»r lumJ* Jad noled concerns about Ihe capital position of their own bank as a reason for lightening standards. The second- ary market for syndicated leveraged loans remained led to a notable reduction of net equity retirement in the relatively weak, but loans associated with some promi- lirsl I|I ..iii-i EICTII hiiVuuK were vhl. .•Ifuii at a distouTil. Jin1 rrrclil (|Uii!iu cif rnjiiliiLiiLL iiil uirjKirtilifJiiN f;en i,T»\\ {fjitily isMjaiHT hy iitintin,inrial firms [tippi-rE cr.illv h*\s ri• 111.i irii--iI M'llid I he M\ iLimtlii ir;ii]ing \xnw\ in I lirsf (|Liiirter and rehounded in the second quarter. default rate was very low despite a small lick up in A '. i i : r 11 i "-.-•: I i r 11 - in * -11. i r * • repurth^si^ LI I I-LI rash nuTfji1^June. Thr [JHmqiu'iuy rale mi (.!JtI \n$n\ .H criniiTien MI banks continued Ihe mild increase that began last year. but it remained subdued by historical standards. Rat- Ings downgrades in the iirsl five months of this year Nel percentage ofdomestic batiks lightening were niodral. only sliglitly exceeding upgrades. Balance ami intr^jsing jiprva^Js t>n t^rrtrncrvinl nrrd iTuInMri kwu U) Urge and iiU'tiium-jii/t'J bOBKHWl. 1992 slice! ItijuidJiy ai imnfiiuTirial furpiirdtioiis remained IK-Nuill rUDOa nulMamtinjj t'nrptfralt- boiul^, 1992-2008 I-M- !••:•• Null I he djlj JJT iliswn Tnjvti J MJhi^v lifrwr.illv LmidLiLEcd II"HLI Ermcr per yoa-r (he last obHnotion n froni IIILL Apnl 3O0R BHQ. mliiLli (own 24MIK (Jl. \rt pfrvenlJ|K i*t fwi w-tmlnpc ufhaiih^ TVf*.irtiJij 3 h^litcriinji. (i( ilambnli at V taOBH In vf«jJ\ I fin Ihr pcatnUfT nrfunint Jn cnMf. nt 1 dtfrtw. SpmdA jrt imuinhl 1* the hun raw ltu ihe haul t L«I ul S" 'ii lbc dnEn arc Tunih. The JcfiniUnn Tor firm FVC wfigeslcd For. ltd ijOKnlL> used hy, Itufli nuiih if ihe f of farads true de-fjullAl in Ihr ftb imHiltn limey nry^iiHkiili 11 [haE Ltffr ami n^iliuni-ii^fd llnrs hj1. c jnimj.1 uki nl ..:iiln ,: MI inn I-IN••-•• I-. -j by 2 lo -1.1I --.- Ihe ik-i •••!:. and 1hcn SS mlltti dniii,:Ll by Uw [We VJ bnoj\ HHUIMJUJIIT^ al I ho *m] oM Ik: vak-ndji i DosnlL Scnkv Ixun (Mikfr Sun'ey c ijiiirm MtiriwdiJieK pr^tili n u lhf -^ Snoa Mhvdy'h ln\ olnn Serv 63 Bonn! of Governors of (he Federal Reserve System uency rales on eommureia] real of 10-year irt^ L^lftUill-^ i; -Kn;t in! swuniio«n;r by securiiics rating, I947-2UO3 — ID J ~ \ — 1.400 — SO — «0 — -BO — job I I 2000 2003 I99J IWi IWfc 2000 ZM »0* 300* 30* widening of spreads reported! v TPtloclo c an* for nwmmil boti ml hfc • concerns regarding standards ftir nrKifruTitingcommer- HI nlcul iWwqk J^tKH.^I. Ik JJLI Fat Klcd ^uvunUn KAJHSt we mmnMj wd ctmd ibiniffc f ^Lil ninrt^i^r% ov(T llir pasi Fi^i' vf-irs and likely a\vt 2Q0&. The d fa I IJAJ ntl< ' M IIS arr ibr pfii III\L-stms' MjrinfU of MnicCun^l liiurni' PFUKILULES murr i 34 0 V PQl f Th generally. After hitting a record level in early 2007. p K ibe- pawn aT koiu W y in; ra not mftpig MfRil Issuance of CMBS dropped sharply late lasl year and SOIMI: For HHIIMLIII bootiv Faknl KIUIKUI slowed id a trickle so far t his year t.uoviAn <IHEK'II, T rntrlhianl Rcfufli ul I'tifelrUafi dUI I V fdf llfc The Government Sector Federal Government Jii^h ihrciujih Uit> lirst t|ujrlt'r uf2U(ISr .mil li-\i1 riifif The deficit in ihe federal unified budget has widened slaved very low. during Ihe current fiscal year after having narrowed in In the April 2008 Senior Loan Officer Opinion ihe preceding few years. A substantial poriio U ofihe Survey, a large frarlion of hanks reported having iighl- rebates authorized by the Economic Stimulus Act of i-jinl crc-flJl s-EiiiLd.iiL!> UII A iiiiinien i.il rral rcMlr ln.ins 2008 was distributed in May and June, which caused Drliru|uency rales cin cummcTtia! rral I'MJCI1 luan\ tur a significant widening of the deficil. In addition, the construction and land dewlopnienl projects extended growth of receipts has slowed in response la the weaker by commercial banks moved sharply higher in the first pace of Economic activity, anil ihegrowth of ouihv s quarter of 2008 aflef rising noliceably lasl year. In has stepped up. Over the first nine months of fiscal year ronlravt. clrlin[|urnr>' rates cm lumk loans llial finance 20O8—from October through June—(he unified budget gcon mierc iaE properties moved up only slightly. recorded a deficil lhal was SMS billion grealer lhan dur- Delinquency rates on commercial niorlgages held by ing the comparable period ending in June 2007- When life insurance companies and t hose in CMBS pools, measured relative lo nominal CJDF. the deficit moved up which mcislly linamc enisling tonnnrrcLil properties, from I'/i percent in liscal 2007 to 2l k percent during ri-mained low. the 12 months ending in June 2008: a continued slow Despite the generally solid performance of com- pace of economic activity and additional revenue losses mercial mortgages in socurlESzed pools, spreads of associated wilh the Stimulus Act are expected |o widen yields on CMBS over comparable-maturily swap rales ihe detitil further in the final three months of Jiscal soared to unprecedented levels early in 200R. In retenl 2008. TEillis. these spreads haw narrowed somewhat, hut The Economic Stimulus Act is estimated to result in ihey remain well above levels seen before this year. The about $1 15 billion of rebates being seni lo households 64 14 Monetary Policy Report to the Congress July ZOOS Federal receipts and tttpendilfflM, C'hangc in real pjvemmcnl expenditures on consum^lton amd inveslmeBtt 2OW -O8 • fafcnl • Sukud KM _1 J | L_ Noit f fod-tadlprt proAtci {HDP} ki fH Ibe fvtii ipurtrr> tfklmtf m V* I nf ;rjm. rcrapt , IfdrJU vt \ ir<*iintitf •\hjJ>'-iv nprnklim-vr kxihc I' nxoih^ ndmp m Anc i-~l (JDPntfu wc 1007:01 **l *m.Ql SULUI: Office of in hu iMiiLni|)lr^ nii.-iii iij-Miiiiurr iH'iii'tiis Lti indn idiuK who have exhauslei! their benefits. As measured in Ihc national income and product in 2003 and 2009. The rebates began lo bo distributed accounts (NIPA), real federal expenditures on consump- In t he last Tew days of April, and by the end or June, lion and gross Investment— the pan of federal spending approximately 580 billion worth of rebates had been lhat is a direct componenl of GDP—increased at an disbursed, accounting for more lhan half of [ he widen- annual rale ofi% percent In Ihe first quarter, a contribu- ing of Ihe budge! deft* In the lirsl nine monlhs of fiscal tion of 0.3 percentage point to real GDP growth. Real 2008 rdattve lo die same period in fiscal 2007. ilclVnw v|K-ii(1iiii; ,14 rniniLrd Un ahiuiM I ho mini1 risr. Ilii- slower (HH' uf {^oiiumic diliviiy IMS nil intu .r. !•• • 111 r^ -11 - r i •-. i - null.i1. ^ MIII', i -11 - -J --= i uy. tn iin- M' • • i • • I receipts. Excluding the budgetary effects ofstimulus 4) 11 LLI NT. (li-irllNI1 ^iHTlilllI1! .l[i|n\;r - Til ill1-1 |;: I-'-.I ii rebates, federal revenues in the first nine months another sizable increase, and given currently enacted of fiscal 2008 were only 2 percent higher lhan in the appropriations, it is likely to rise further In coming same period in fiscal 20(17. down from a riseof quarters. 6^i percent in lineal 2(XJ7 and cansldtrablv smaller UIHIEI [lir clnublc fli^il ji^itis n-ccirdnl in lisral Z005 and fiscal ZOOS. The slowdown in federal revenues has been al Borrowing most pronounced for corporate receipts, reflecting the decline in corporate profits since Ihe middle or 2007. Federal debt rose at an annual rate of 714 percent in the Individual Income and payroll lax receipls—excluding first two quarters of fiscal year 2008—from October the stimulus rehale.salso haw slowed, likel; lii'iwse llmiugh Marc h—a notable step-up from the Wt pcrcenl »f [In1 MiMlhbr guin% in fwrMjujI inrnnic1 during thr rur- pace in fiscal 2007. As of Ihe end of March, the ralio ren! fiscal year. of federal debt held by Ihc public lo nominal GDP Nominal federal outlays in the first nine months was about 37 ptrcenl, slightly higher lhan in recent of fiscal 2008 were 6tt percent above their level in years. the comparable period in fiscal 20D7. a faster pace of The deterioration in Ihe budget position of the feder- increase than was recunJiii in ti«al 'HK17 bul geiwtally al guvcnimeiit k-d thr Treasury lo rrinirwiutr ihr one- Ik'hm Die rapid increases seen in fiscal 2002 through year Treasury bill, which was last issued in 2001, I The 2006. So far this fiscal year, thegrowth of outlays for initial auction on June 3 was very well received, wilh a defense has stepped up ?elalive to llscal 2006 and 2007. bid-locover ratio above 3. Issuance also increased for and spending has continued to rise apace In mosl major both shorter- and longer-maturity Treasury securities. iKHidcfi'iisf tLai^ories. Inllienmnllisahfadr oullass I he proportion of nominal coupon securities purchased will In1 tiunijH'd up furtlitT by the i viiiismn cif i-ligihil at Treasury aurlions by foreign investors changed litt Board of Governors of(tic Fntentt Reserve System 15 SEatt and li>ca! iio^-inmcni net savin];. I*JHN ^HhN rvi, : J. imp K i r H.II: _ — » -I r \ - \ / v—- • / — 50 — 23 — M I ll i i i 1 1 1 1 1 ion 14U I4H 300S I •"••HI 1'rt.i l-^i. l'^w 3H2 ?IN-5 JI/I.N K<PII: TV ill, khit'-il jfr Hfu^UiHy. n(r Lift • rulmtul iiKiinkf arid |Krak>.1 Horn: TIK tlita c^ntd Umnifh 30OK:QI. TtacdiU fm AN Ihrmiffa HW7 IK M\ [lf| 111 l flo hE n l .•-• 1f • H 1 A l jhcdu ill" E^OfluttlH: AlUJyui H.I«'|Jri=hi i.n .n Jii .nil,ILII r.r.1 ihi- 11 ,i 11 • n.Tl...,II-.I I.ILI. • ,-*.t i jn -r r t m i > j.1 > n r k :mfc I Q \L l I » U « J K O l I iK M - M ..•n •:L•• iir*:- .Iwi:l ldI .• J\. in1 iL.-^l , M •1 K. i , : I | I - p - ? ,. : ii k r - . . . t r r .il : | \ m *n\f h\|lUP|t s. ,• .-. , 1 LJcrul fa•'-.•i •,.: BuoftL Ikiw ul" fm*!-• I'JI.L t)n ihe uniEays sitle of i he aecouuEv. nominal spend- jn^ hd1! lonlinijetl tit rL%f. pnriiruiarlv for t"X|M• II• II:•:I:— on health care and energy items. In real terms, expendi- over the first half of 2008 ami remains in the rang? of tures on consumption and grass investment by slate and 10 perreiH lc> ^5 pprrcnl cp|}\ervpd itvpr llir pasl %rvrral local gavenimE'nls (as measures] in the NIPA) rose only years. However, holdings of Treasury securities by .L II-JI in llir MM quarter, JS ini"reu%fs in ibx[Mbi]dlEunis {in iiinr L-iu;ii nplVi.il iiisiiinri[iris nil i31 •• I - E -• I • • i. • L l<rvn\r I L.tnktuin-ni {ip^fiiliuiis werr largely «fFvh[ [jy A tin line in of New York increased! more rapidly in the first half of outlays on structures. However construcMon expendi- 2008 than over any nf ibr previous three1 ypafs. ltures fire voEniite from quarter |o fuiarUT, and ihe dai<i if i;'l: M.LV ••ni;".rs[ EIL.IE rt\L] ^.e.iiL- .iiu! UH .it \-\\M-\I dilutes fur Mrut tures picked up in Ihe second quarter. State and Local Government Mi.-.invJiili-. state jnd lu< ,il MiiiiiL- remained elevated through June. The fiscal positions of slate and local government began to weaken lns( year and have <qn[inned io drie- ritiran1 in 200R. Afitir having Improved si(iiiLji('anLlv State and Local Government Borrowing from Z0U3 to 2006. net saving by tlie sector—which is broadly similar to the surplus in an operating budget— Bond I ^siu ntru by stale and local governments slow ed turned slightly negative in 2007. and this measure moderately in the first quanor of 2008 as the cost of moved further inio negative territory in ihe firsl quarter borrowing rose. Investors demanded higher returns, in tif200S. Tlic clek'rinrjuifiii in hucl^el r^uiclilidiis \*a\ pan Ixrause of concerns ahoyI the strength of linancial (HirujTfd its iiHTi'Jirf's in ri'Vfnufs Unw s\u\vn\ while gliiiranlors iluii Insure many ]iiniiiri|uil Ivinds iuid in nominal expenditures have risen 31 a brisk pace. The pjn IM^-HJSI.1 [if tuncems aboul ihe effect ufd poienlial slnudfpu II in slate tnoBBt En minimi bn Kdknnd i economic slowdown on state and EocaE government rev- pallem similar to ihe one lhal hasenitTged al Ihe federal enues/ Beginning in February, these investor appreheu- If.vel. Cnrpnrale receip|% have rli-c linrcl. .mil iln- rise in individual income taxes hiis lHjt(niic niun- SLIIHIUIKI. AI ihe same time, state receipts from sales taxes haw soft- e p n ri e ce d s m h a a r s ke n d u E t y y r e A l t l i t e h g e u l n o c 1 a 0 l r l t e ir v h e l l , o t c h a e l d p e ro c p lin e e rl y i n ta h x o u r s e e v- t^P 7 ii . i n C u n n m l t - U rr / i v h , H jtw flr u a l t P ll C tr N ( in d i i u d c n i u jl n ^ u u j t M ru i r N u u i r t h ll i l u r u o M th - i ib n i i £ -y 0 r 0 iu 7 . , b In u t Juor. Moody 'i iihJ Si Jlhldl d A P«f 's JewTiftfakil M HI A and Arlilmc. IWJ i-mn-s..11• |ici--: i;ilih. ln.il im iLL;IM-S in Leu .il iL-Li-ijn^ IHJIH oTihr- \vf?"4 fjfavM\ii.H\ frwn AAA lo AA <* lowtr. Ni-*i- IXMHI lutur ihis s(hLirc:p u>fhii^ liki-lv tu slow more Eioiirrahiy in the :• ik< c- liuiiih'\i Iu'. ish:inil en HM.1 mii etui .ift' t|rw«t« rljLiih-Jally nexi few years. •MtfK, Jnd UN niunlcJpialirin luvi' staU>d ttirkr inlrnlicMi lc» dJ%- pHHVttfpWHIDaad kntlll lhL'Mn.'nj^Lh nl'Ihciruwn ralirRS. 66 Monetary Policy Report lo I lie Congress July 2008 sionsalso led lo widespread failures of rate-resetting widened, the fiscal positions of slale and local govern- auctions for andion rale securities (ARS) issued by ment deleriorated. and business saving decreased. stale and local governments.* Pressures In the- munici- Accordingly, lotal national saving as a share of nominal pal securities market eased somewhat In the second GDP. which has been declining, on balance, since the ijii-Hin. ciIci-rI,L» with the broader relaxation ul linaiii i.t! Luc 11IEHK. \KKI l,ilkn HI LI hi slum Imv NIELLI L Iruni iluh market slrains. [n addition, ratings upgrades ofmunici- third quarter of2005. whic h was marked by sizable palilies greatly exceeded downgrades in the second hurricane-re lated property losses). Ifnol reversed over quarter. Since March, municipal bond Issuance has the longer run, persistent low levels of saving will be rebounded, and a significant Traction uf Tailing ARS associated wllli either slower capilal formation or itm issues have IJHMI paid down with the proceeds of stan- liiim'd heavy borrowing from abroad, either of nhiili i hi 11 ITOEUI I-AIH-1. would n-IunI [hi1 rise in (luh Miiinl^rtl of livini* ri( U.S. residents over ijiTie and |urn|H'r the iibilify of llir IUUEIII tomeelt Ihe retirement needs of its aging population. National Saving Total nel national saving—lhat is, the saving of house- The External Sector holds, businesses, and governineitls excluding depreci- ation charges—dipped below zero in the tireI quarter of International Trade 2008. After having stood al an already low rate (if IS IIL-ii • -111 cif nominal (iDP in lite si"f mid quarter of 2007r Foreign demand has continued lo BE an important the national saving rale declined steadily over the source of strength for the U.S. economy. Net exports subsequent three quarters, as the federal budget deficit contributed % percentage point lo Ihe growth of real GDP in the first quarter of 2008 after adding a similar amount to grmvlh in 2007- H ie growth of real exports K ARS iic Sodg-lrnn sccurii It* whu^c imitrM Mir^dn- cni'i cif ^EHHIM and services I'KpanEk^l at a. 5'.^ [irnnit fjace in 11 .1 • i- _• • I. •• I -. •! 11: al-ili --• .i M i MU i-.. tvpiral ly tvrty 7, 28, Err the lirsi quarter, mmleraling from the Wh percent surge 3 L S iil d tr a t v l s S . u A li s 's u w ri a h s t ' a f b n o d u o t f 1 2 3 W 30 7 . b i J h lll o u s ii i . / i t b u o C u l l h h e a A lf R o S r i w ns lt T ld k i r i w I a n s tin1 \n rudc-d in ilit1 second linill oi 2M>t \L\port growth afiTHinMtl furtiy muniiipd] rtTWttW AnHJ^HTItfWI hiK wtlrrt in the lir\t {jiiartiT was su|][iorlrd li> higher r^jKirls ol i in rMnri (h i nol tiiii fnrlltr rnlin- iBWM an iirirmC nEE-Irtiiw 1 hi- agricultural products, consumer goods, industrial sup cnnlriH'4 imxLnmni. t IH^EI durlirxi rjitLirr. lhci3%Mil h(Mnrr\ircni brf«rc llx1 aurLinn rMa I n nwwrcHiKif ihe Mfurlrt^^nd rerrlvr ji plies, and services. In contrast, exports of both aircraft lii^ hnirmi rai*1-. whJrh K usually, lnn JMH net f^.trik. and automobiles moved down after rising rapidly In l Lu the maximum hW nlr. the second half oF £007, Exports to Europe and Latin America rose robustly (in current dollars), whik Net anna, (."haniio in ri]al imports and*]X|wrts ofuoods arnl MC I,H M|. f^^ ^•'.Ili- 2(KI0 -0S — t • Import* r. • ' •i- i — J V LfliJJj i ..I • / \ — i h — 1 1 1 1 1 1 1 1 1 i i I i i i i i 1 1 1 1 1 4I ' III \t** |W2 I1N6 2000 iiv 4m) f^trnj IhnHjfh 2D0H;Ol Nc Miliri|f il lht MilTI i\ (VfuMUldlhl ftt[ hrHftft* >Jvm^t n ..i i ii - i:.:jvtmt of stibe ind hx-il gDvcmirKfiCv S"r F. i |lfI»r1irwiilLi1-[[H 67 Board ofGovernor* ofthe Perietal Reserve System 17 U.S. trade and cuirvni j balances. 2000 08 in Man:h, imports relHiiintliil. on avsragK, in April and \hi\, A\ i[]t|Hirls n\ ( a|nLil ritnifirnrnt iirnl I'DIIMI itn-r goods increased strongly. In the first quarter of 2008, the U.S. current account deficit was S706 billion at an annual rate, or 5 percent or GDP, $25 billion narrower titan its level in 2iW\ the narrowing largely reflects higher net investment tin fHiic. A targe iniprn^Tinriii in ilie IHJIMHI iMcle clelicit wasoffset by a sharp increase in the bill for imported oil, which resulted from Ihe jump in oil prices. Compared with 2007, prices for imports of both m.iti'ii.il inti'rm^E' ,ind iini^lx d IMMH^ .IrH• \m rfM\in» nr nun ii foster I,IN-S sti t,\t Ilii% ycjr. Alltiougii impcin priri1 increases also reflect the depreciation of the dollar, ris- ing commodity prices (discussed in more detail in Ihe box entitled "Comnuxlilv Prices' mi pi"r IB] have sij> nilirantly Ixiostetf the- rale of inipiirl price inllation. In the NtNL IJIMTIIT. prices of ini|Hirtecl guods r.\( lmlin» nil exports lo Canada and to OPEC countries fell back. a c n e d n t n , a a t u p r a a c l e g m as o r r e u v th a a n t a tw n i a c n e n t u h a a l t t o a f l e t h o e f a p b re o v u io t u T s i y p e e a r r - . Data KM April and May suggest thai Exports continued Available data suggest that Import price inflation was (u expand in thf srtomi ijudrtrr. wilhexpuris uf indus sharply higher in Ihe second quarter. trial supplies showing particular STRENGT The positive cortlribution of ncl exports in thr first quarter reflected. in part, a ¥i percent decline in real The Financial Account Imports of goods and services. Imports of automotive products and consumer goods fell in line with slowing U.S. domestic demand, more than offsetting higher real In late 2007 and the first quarter of 2008, Ihe U.S. cur- imparts of ail and a slight Increase in imports of capital rent account deficit was financed primarily by foreign goods. Imports from China ami Modes declined (in purchases of U.S. securities, as has BEEN the norm in < 11r i • m i|n!|.![M ivInTt'as iinjHirls from { JIIHKI.I, |,i|) HI rcc thn[ \CAT\. NIP glrfial liujnc fril luniHiil \YA\ {uniiimed .•ml OPI-T rciururies r\|i.iTidEiiJ. After t.ilim^ ^fLbr[]^ lo leave an imprint on both Ihe sources and composition of cross-border financial flows, including a net private outflow in the first quarter. Meanwhile, foreign official inflows provided all of the financing Emm alirodd dur- Prices of oil and nuntuc! commmitlics, 2 ing iln= IMM i^iiiir ICI. driven lt\ rwi [Jiinthisrs til LJ.S. asury and agency securities by Asian institutions. U.S. ncl financial inflows. 2003-08 JOO7 JOOB llW iliLi jrc iminllil> Thic tnl JTKC is Ihc ifHri priic of Wpl Tf MI naic ixl. JF*J ihc Lbi ohcrhHnm t% tht d^engf TH1 Jdly I -4, The [*KC yf mFurl twnmndrtws n m indn nf 45 .^munnJUi fmccv and?*lci«ti Itawifh May 20OL x VM L-ITI. LJW CHwiudMy KAevefa Bureau; fof nHtfud iutinul Mondanr Fund. 68 IS Monetary Policy Report lo fiu Congress July 2008 Commodity Prices Prices lor crude oif and many other com modi ties such as ongoing tensions i-i the Middle East and cuiiijruin lto soar through the ;\t^ half OF 2006. ir|,1,|li|:i|\ in Si^i-r:,]. £ h\- f>r;, r i H HuMi •• \,\t< <. i After shooting up about bU percent lost year, NYME X oil futures contract (currently for deliv- thespot price of West Texas intermediate i rude ery in 2016] has also risen to about S140 per oil -has increased an additional 50 percent ihus barrel and suggests that the balance of supply far in 2008, climbing from S92 per barrel in and demand is.expected to remain tight for some December 2007 lo about ( 140 recently. While time to come. weaker economic growth and the high level Nearer-term market pressures have been of prices appear tobedamping oil demand in retleeled in domestic inventories of both irnliMii.iim-d R&ionSj dr-uund from emerging crude oil and rMined oil products,, which have market countries remains robust. The continued dec lined notably in recent monthsand stand strength in emerging market demand reflects, in well BELOW year-eariter levels. Inventories also piM, [iijifrnmynl Sulfetdies thdt limit I he pvsv appear lo be tight in other countries (although t a h n r d o u th g u h s o m f u h i l g e ( h e h r e c r r e u s d po e n p s r e ic t e o s h to ig h re e t r a i p l r p ic r e o s d .. ucts d co at u a n a in re e s le k s l s e c d o n m i p n l v e e t n e t o fo r r ie e s m in e c rg re in a g s e m t a h r e k e v t ulner- Furthermore, on the supply side, incoming ability of petroleum markets to any disruptions in information since (he beginning ot the «M r has pruduttiun. (rjnspuUdtinn, ,^rt<l rtTinini;. \v\i\i fi been decidedly downbeat, with non-OPEC pro- is ol particular concern during hurricane season. duction continuing to fall short oi expectations. The tightness of inventories suggests that the Despite addilionjl investment, oil production recent increases in oil prices reflect near-term capacity has not risen at a pact' commensurate demand and supply pressures, rather than specu- with the growth of global demand. The lack of lative hoarding. ifMff capacity has led, in turn, to heightened sensitivity ol oil prices lo political developments. Prices of nonfuel commodities were quite volatile in the first half of 2008. Through early Unusually large nel purchases of corporate securi- Foreign private demand appeared lo remain robusl ties also contributed to foreign official Inflows, likely for the safest U.S. investments—net private purchases reflecting sovereign utdkh fund activity, of U.S. Treasury stvuriliey wliirfi surged hi the third [jiiiiTdT of 2Of)7 whrn llir tLinruill IH^JEI, rrmiiiued j[ Ntl private f purchases of U.S. near-record levels through April 2008. In contrast, cor- porate bond purchases by Foreign private investors have been weaker in each quarter of ihe turmoil than in any previous quarter since 2002. Corparale equity purchases liave i\m MIMTI \VT\ wt-ak in 2(H1H lliruiij;h April aflrr i Mronji rebound in thr Runili t|ii;irErr nf 2007. O^crjll. total inflows from foreign private acquisitions of U.S. securities were well below average in the first quarter of 2008 but slightly above the nine-year low set in the third quarter uf 2007 as ilk1 lurmuH IK'^JTI. Inflows Imrii pm,Hi- pim IJ.ISHX tjf L..S. sriuriliths in the first quarter of 2008 were offset by strong outflows associated with U.S. direct investment abroad and by Interbank Hows. Somewhal surprisingly given the global financial turmoil the strength seen In U.S. direct NOB' Ottm U S wembn totludt nvp«mc cqwDn wd bcnK i investment abroad En Z007 penisted Ihruugii the fourth t S^ [jiiartrr and into [he llrsl quiirH'r nf i?(W)ft. In additim;. nel lending abroad by U.S.-residpnt banks, which 69 Boaid of Governors of {tie Federal Reserve System March, prices of many commodities rose sharp ly, includ- tributing to the rise in commodily prices in recent years, ing (hose for &on*e foods (such as corn and wheat) a net in-, h.ii: IL: ili:>rL£ i.iiiort of ihf (hjll.ir Aw,i lower interest melata 4in [MrtiiuLir, copper and ,1 In minimi. This broad- rales. All els ebeing equal, # lower value of thedollar bawcl price increase appears to have been driven mainly Emplfes A higher dollar price «i conirnodiUesr but (he by growth in GLOBAL demand. More recenlly, however causal relationships between the exchange value of (he price movements have been less uniform, and com- dollar and commodity prices are complex and run in modities such as wheat and nickel have seen sharp price both directions. The fad that commodity prices have fll-t I Mill. S-'ViTtllHi ^ - • ,M.||[ hrti-l i .HMIIHj.hr'. ;.;•.• risen significantly in termsof all n>aj[>r<ufrt?nci^ WBgBb es hdYe continued lo sojr, particularly tht* price of corn, 1h,n iaclurs other ih,m ihe depreciation ui thedolbr have which hai been directed by weather-related concerns, Iseen jmpoMan tcause? of the rise in prices. SimilirK iii including the recenl Floods in ( he Midwest. The price of relationship between interest rates and commodily prices rice has also increased sharply (his year, which has led a may depend on what is driving changes in interest rales. number of rice *producinR cou ntries to enact export ban?, For example, to theextent that lower Interest rates reflect -•• Idin^ In ii|iw.if[J prr^hiift- on KIOII.II |irii n^. NinniL-.h L <-i\ .1 rrl.itivrk v,<-.\k it thnomy .intl IhuSSAfl^f demand foi cos)*., increased grain price aJ*D have been reflected in - u nimod IIIES inEereft rales and commodity prites may higher prices for meal and dairy products tend to move in the same direction. And irrespective The supply response of farm crops lo price increase* of their cause, lower interest rales might also lead lo a typically has had a relatively short time LAG, usually buildup in commodily inventories—AS a result of reduced through increasing land under cultivation. Although n INANC in g costs oi holding inventories—potentially put- increases in acreage devaiod to one crop Ktvv mctntrv ting upward pressure on prices. However, inventory levels < tirni' .it ihc fwptnw t*i mhur trops, yields have risen and of key commodities have not risen Ihis year, a foei that should conlinue lo do so fts more-advanted seed varieties is at odds with such explanations of price increases that and cuJtivalion techniques Are employed. emphasize the role of interest rates. In addition to supply and demand conditions in the physit.iJ niH^rkrih, irthrt i.u tors have boon cited s^can- lends in Ix- (JLILU1 volatik1. lus increased with LIIILIMLL] Hl'liliiiLrs. wen1 [JJII1 ic'LikirlV lar^Eb in Marcfi as consisEency since the turmoil began; ihesc outflows, in U.S. and European Interbank Funding markets primarily front foreign-owned hanks lo their European ro-iiitonsMied. Nd change in private payroll employment. 2002-08 The Labor Market Employment and Unemployment The demand for fo\nn has hern {cintrartlnR this yesr. III After having increased 5 !.000 per month, an average, in the second half of 21)07. p r • i va t e1 - - payroll employment declined at an average tnonlhly pace of 94.000 in the ll first halfof2008. Over the samp period, (he civilian II nLjitnvm.rni rate mnverl up more than ^ prrcrnfage potnt. to SW percenl. Job losses in the first half of 2008 were concentrated rji y; in I lie const ruction and manilfarHiring sectors. Although — 1M businesses in ihese induslrirs have bprn trimnting iota ion 2«H < f I I payrnlts lor moir than i^n yrarv, the downwing II.L\ i;Hf[iii]ii'd during the past several immths. In addition, HOT) S-.inr.inii huun^u * STH-PH: IVparttiKin.if I j job losses have begun to mount ihls year In the whole- 70 2U Monetary Policy Reporl lo Ihe Congress July 2008 Civilian unemployment rait. I jtj[>s (JS op|Ki\rtl CM those wlm YoluuMrilv \vU ilirir jcilis or were new entrants lo Ihc labor force) rose, on net, this spring. In addition, the percentage of persons who reported that they were working par tlime for economic reasons Increased sharply. Thus Tar. the labur forte par licipaiian rate, which typically falls during pe riods of taljor riKirkei weaknesv ha\ rrmaiiufl %lea<ly and Mcim} at 66.1 percent in June, near the middle of the range that has prevailed since early 2007. Oilier indicators also point lo further deterioration in I.ihnnr niiitkrl i (Hulilimls rliis u\ir. \'\\\,\\f \n\\i\\ (ii ImsiTicsses Mij!^n,i">i iluic ItriTis pljn m cciniinui1 rui urn; hiH k DM hiring in I In1 ncjir itJtn \| ihr wnw1 lime, according to surveys of consumers, assessments of labor market prospects in the year ahead, which had Ndfl The Jail Jrf mucilhlj ind worsened late last year, slipped furt her in the rlrsi half Snaoc Dqummw of Lahut. sale and relail trade sectors and in the professional and Productivity and Labor Compensation business services category. Even among the many sec Lnis in uliirh [),i\ml]^ \IA\P lonliniitfl I-CJ fx^iiiicl. MIC:II Gains in labor productivity \u\\v muved up significantly as lerhnical ^r^'ices providm ami rjitLn^ <nul i\\ inkin« of late. According to Ihe latest available published data, establishments,job gains have been less robust so far output per hour in the nonfami business sector rase this year than In 2007. A notable exception has been ,'il-i percent during Ihe year ending in Ihe first quarter hiring by providers of health and education services, of 2008, up from the ft percent increase recorded over which has remained strong. the preceding four quarters. On average. Ihe rise in pro- The unemployment rate, which rose Vi percentage ductivity over the past twoyears, although less than the poinl in 2007. increased another Vi percentage point in ouEsi/ifl nu ww\ |K)MI(I earlier in ihr [Irtdcle, suggesl [hi1 lirsi h-jlf oT ili^ year. 1 nil id I f l.imi\ IOT unnii^iloy- lhal the fundamental forces that in recent years have ineni insurance am! ihr iiLiriilx^r o! inclivifluii!% receiving supported a solid uptrend in underlying productivity unemployment insurance benefits moved up consider- remain in place. Those forces Include the rapid pace of ably over Ihe six months ending in June; accordingly. technological change and the ongoing efforts by firms Ihe share of uneitiployed workers who lost their last Change tn outpul pw hour. IWK itiW. Labor force participation rate, I975-2OOB It J I I I 1 I I I 1 I M J 1 1 L I I J I I I J L I M 1 L M 1 L I M I <i] i Kurtbdirt hiuim^ HIM. The dill Mr ifuMUrK jnd cilcnl t*>7$ tttt I'm 200* L^I Chuge-iimtr Towtfiunen. S«P«I: DefkHinml of I jhw. Uurmi rf Litar 71 Bonn} ofCovfmon afllir al Reserve System 21 Measures of change in hourly compensation, 1998-2008 en* of providing henprtts, rose 3]^ prrcfnl in nominal [crms bclwccn March 20fl7 and March ZOOS ((hp Litest available data), [he same gain as was recorded over the preceding 12 months. Although the increase in the wage and salary irjmpunriit uf ihe HCI vtigctl duwn. thr riit' in iM'in'tils t'ir\l\ [lukrcl 1 • | :• ni.iikcdlN. HITIHI[\ msl.s wen1 pushed up by a shisrp ris<= in emplnyET comrihu- [ions to reciremenl plans, which likely rrHetEed. In par), the weak perfoimance of the slock market and an atypi- cally small increase in employer contributions in the According in prrLjniinary rhu^, rficnpriis^iiun prr hour in the rmn|.irm EHisinpss {IVFB) settnr—an aliema- [ive measure of hourly compensalion derived from ihe data in the NIPA—rose 4 percent over the year ending None Tlw tkria i in the lirsl quarler of 2008, down from a 5 percent gain in 1 In- previous year. t£et'ju\e ni i11 • - slnwET^rcjwth in T. The (KwCanii fruiiiY*.t »«i u H i h iK a t L a - nd fa m r ^ im in . £ i i h -i t v c U m iC n« n [ t » m l. ith r o n n l p < ro .'* r .• il h NFB hourly ["mnpiiiisaM«n iinrt I lie f^sirr grcjwili in pro iihiii> .mil t x.h.M. r i^ . LLi-bLTOI! b; lb? 1(1 U--LII h-LiL ii [he duclivily over the period, unil labor cosls rose just Vi percenl over the year ending in Ihe first quarter of S*K IUI: Ikpjrliiviil of] JKH, Hiixciui at IJIRH SLUUKH. ZOOS after having increased 414 perccnl over the pre- ceding year. On average, Ihe rise in unil labor costs over the past two years is about on PAR with the increas to use information technology lo Improve the efficiency rrrcmlrci in llu1 prccitliii^ iwtt yearv of (heir operations. Increases in Ehe amount of capital, Prices produclivily giowih. Broad measures of hourly labor compensntion have Headline inflation remained elevated in ihe llrst half no) kept pace with the rapEd increases in bath overall of 2008. as price** Tor hciiti FIICHI SIHI energy uinlimu'd 4 MIIMIIIHT pi ill's IIIILI IHMOI pmilui ii1, itv, [lespile A I. I I •: :• i to surge. The chaiii-lvpr prkv index for personal ron- uiarkrl lli;it, until rrcrnlly, IIIHI IHHMI generally ligtil- The sumption expenditures increased at an annual rale of riii]f)ij'sjin'nl m\l imlr\ lit I! 1111 |tti\.i[i- i[nlii\li\ work 3 4 perccnl between December 2007 and May ZOOS, en, which rnrasuriFS both wages and the cost to employ- about ihe same as the brisk pace registered over the 12 months nf 20D7. Exti tiding food and energy ilenis. the lJ(!i" prite index raw M AW -SFIIIUMI rjiicnf c in urtii litKirCLiMx L'WM 2 19 pertrnt over ihe first S months of the year, down front the 2.2 percent increase over the 12 months of 2007. Energy prices, which jumped 20 percent over 2007r 1.11 iL 11111 LL-i.I lei M>iir in the lirsl (ive nioiiEhs (it this vear. Spurred by risingcrude nil costs, motor fuel prices(mi tinned to move up through May, and increases in prices of healing fuel and natural gas also jumped appreciably. 1-iiMlimiiiiie. [fn1 [wvi llitMii^h n( MIL- in- Mid fiigh le^eK of crude oil prices into retail gasoline prices was only pariiai, and wholesale and retail margins were unusu- a lly compressed in May. As these margins reiurn m 2 more typical levels, retail prices are likely to rise fur- I 1 1 | 1 | | 1 i i | 1 I 1 ther. Indeed, survey evidence suggests that prices at the 14-;< THHI :IHI» pump jumped again in June and early July, The recent NtMifii. Nbrfij^nik tiutinc-Y^ \&skM. Ilk.' L1J!.I Arc qLuflcrlj pickup in natural gas prices apparently rejected substi- SumF 1 Wrori nu.Mn of Labor. Runnv of 1. nhor Slotnl tution by utilities and other users away from relatively 72 TL Monetary Polity Report 10 ilit Congress July ZMJ8 Change in core consumer prices, 2002 AElemalive u s of price change, 2Q07-D& PJkf mr Z0Q7 zon I t"hair-l U >7 l > C e O p H n H r M c F iM ipt J lO c f T lt f f l o p r c Ch 1 a in > i ty II p K e II I l I t ^ ,> I l ' K if H f I • . ? U -9 u u ?.s Z.3 ::<5:^• M.1 I 1 A k i . - li i n r l u ll s l• i- f i ( l H V U . 1 iI • h JL ln I H h T M R iin V g IHKHI mil ran '." g .. y '. M U 2 in .D idJ f-.iu (udiitiJ. fiitid tttd rnrtRt N['n f kinnrv flpr Iwwd m qurtcrly ^TTip^ oT wwiullv Mljn4rd diti AJHIIMHI UyfB^(J»ttfawf hIr wimd^iiln uF 2DH7 jml h SOLKE: For chain-r>pc mmum. FJepar bconom^r Aml^k Fw ii icrd-u CJKN iiii'.tturrv nrHrmrnr oT t JIKT. Bumti is fnwn [Jwcmfrrr lo M , (or «.-luin-[>|K pnH ifltijx. Uepanintni Hk- Analysis. energy and other Industrial commodities continue to add lo [he cost of producing a wide variety of goads, and increases in the prices of non -oil i mpn rts have expensive crude oil as well AS I he unexpec ted shutdown picked up appreciably. McireoviT. iiiiliiiii.ni i\\[in uinui-- of soma produclion in the Gulfor Mexico during Ihc especially for the near term, have moved up since the spring. mm ofthe year. Probably reflecting the elevated level Food prices have also picked up fur tier 11)is year. of actual headline inflation, the median expectation Afler climbing 4* percent in 2007, the PCE price index for year-ahead inflation in the Reuters/University OF Tor Tood and beverages increased at an annual rale of Michigan Surveys of Consumers moved up lo about more Inan 6 percent between December 2007 and May "<',- percent at the end of 2007 and Ilien continued to rise 2008. High grain prices and sirong export demand have in 200R; it reached 5.,'t percent in the preliminary July In-iii |n iriiii i\\ liAjniNNiljIi1 Im sizable increases in die ibslinialEb- 1 l<mn I-I. ilu- upward infivrinunl in Longer run retail prices of poultry, tish. eggs, cereal and bakery inII31ion expectations has been much less pronounced. items. Tats and oils, and a variety orother prepared According to the preliminary July result in the Reuters/ Toads. In addition, the index Tor fruits and vegetables University of Michigan survey, median 5- lo 10-year ife at an annual rale of T Vt percent over the FIRST five inilaiinn expectations were 2A percent for a third nioiirfis [>F flic yi-ar, likt-ly rifli-rlin^, in [.mil. (tiffin ruusftutivc- iiicjTilli, cuniuared with the- n^ulin^s in the input Costs. Aliliuii^li wcirld y,t;i\\\ |)iml»n I ton improved range of 3 percent lo 3H percent thai had prevaiNl For •his spring, excessively wet weather and Hooding In the the preceding few years. Similarly, estimates of 10-year Midwest boosted spot prices for corn and soybeans in inflation compensation, as measured by the spreads of June. yields on nominal Treasury securities over those on ISe small decline in core PCE price Inflation ihts Iheir i il fial ion protected cniinterpans. have moved up year m.i^i'i] yum1 MjIftUcriiLiI bn[ Lir^elv urFsellin^ .;ni UT 2 0 i basis points, on balance, since t he turn of the crosscurrents. Shelter costs have continued to decelerate year. However, most ofthat increase reflected higher as housing markets have softened further. In addition, a inflation compensation over the next 5 years; estimates moderation in the pace of medical care price Increases of inflation compensation 5 to 10 years ahead were up only 10 hasis [Joints by early July. According to Hie ti-is .i KLU In-IM i In'.-, n <fii< |• i in i- in1t,i1iiin tliis Vcn Im.-mi [rii^t, |iritrs uf run1 wrvitE's besides mrcLk JI ;ind shrlter Survey of Professional l-'orecaslers conducted by 'he i ns[s !mv{' iutri'ased mori1 ntpidly. Sii^iiliirEy. prices of Federal Reserve Bank of Philadelphia, expectations of core goods, which declined some in 2007, were about inflation over the next 10 years licked up in the first Itrii. on rn'i. Qyer (lie iiN (i\ii ninntlis of this year. halfof 2008. though they remain essentially unchanged since 1998. More frindamentally, increased slack In labor and product markets is likely damping price increases Mils Broader .NIPA -hascd measures of inflation, which year. Unwrver, ii inintlHT {iF oilier lUcitirs are pulling an1 avjilable only through the llrst qLiiiriLT tiFthis \ih;it. upward pressure on core inflation. Higher prices for slowed relalive to the pace of the past couple of years. 73 Bonn] of Gnwmtir* erf the Federal RPSPJIV Syitrm 23 The latest dala show a rise in Iho price index for CDP kels in the second half of 2007, Substantial losses on less Food and energy of about 2 percent over Ihe year even the highesl -raled structured products based on culling in the liiM quarter, down JIIHUJI 1 percentage subprlme mortgages caused market participants to reas- pcjinl from t he figure for ihf year ending in ihe firsl \r\\ r I -ir • risks JiwHLiCed wilh uthcr slRJilumi tiiMTirial quarter of 2007, In addition lo a lower reading forcore iriMniiiifiiis LLIKI raised ccinremsahout Ihe exposures of PCE inflation over the past lour quarters, prices for major financial institutions lo these asseis. As liquidity some other components of final demand4 especially in markels for structured products evaporated, banks rural rui liun. deceleniicd. V.MIL hut i.-i.l. nil !I-,IM rn-ni]nii.i[iK [n \at]\] i\um .ISM-IS on their balance sheets than they anticipated. In addi- li»n. banks' Iciws nn nUirlgjge rt-l.m-i] sriurtlies JIH.I other aueis prompted oedil concerns anion^ cnunter- Financial Markets parlies. Both nE these ferinrs ronirihuli'd lo sirains in bank funding markels. The rcsulling deleveraging in The rlrt.Urd risk spreads, liijjh Yoljtilitv, ami ini|uiirfk<]< the financial sector reduced the availability of credit to functioning lhat characteriird donteslk and interna- the overall economy. By late 2007, U.S. house prices Mortal financial markets in ihc second half of 2007 con- had tieguu lei tail, rcsLiJrulkil imeMiiM'iit WAS ctMiCrarl linued through the first half of 2008. Spillovers from ihe ing sharply, ami indicators of nverail economic activity slumping U.S. bousing market were die largest direct i had softened noticeably. These developments induced VJII:U- nj iln.-vi- |jii. -Min^ liui a •-^•iiij.iliyi.tl ilnju from investors lo pull back from a broader range of financial riskier ayseis p;iriit ul.srh siruclureU credit |mxlm h assets, leading to impaired liquidity conditions In and worries about a global economic slowdown also many markets, with widened risk spreads and elevated contributed to financial strains.1' The Federal Reserve vol ati lities. lowered the target federal funds rate an additional This market turbulence Cm)tinned inlo early ZOOS. 225 b asis points over the first four months of 2008 in as liquidity in many financial markets continued to be rt'spotiv loa lirirriuniLiiigciuilcKik feir economic impaired and risk spreads remained wide. After declin- activity. ing sharply late lasl yearh Issuance of non-agency- Financial strains increased significantly during the spurisort>il inorl^L^r b;n. kttl sei 11 c i 1 I-I • v ?SM-iili.Lll\ first quarter, leading to a liquidity crisis in March at The UJIIIC to a halt by the iH^mniiigcif 2008. and w lYinhn, Bear Stearns Companies, Inc.. a major investment bank, markei Irades of these assets were rare. Price indexes and to its subsequent acquisition by JPMorgan Chase of non- agency -sponsored subprime MBS basetl on A Co. AiMiiioiia] ariicms Lnikcji by ihr E-4HII-J.II l^.-st-j\c derivatives markets decIined furlher. However, the [n improve markel functioning and liquidity, includ- unusuai pressures that had bren apparent in short-term ing ihe introduceinn of liquidiiy fariliiies for primary dealers, appeared lo have an ameliorative effect, and tensions eased somewhat in the second quarter. (See the Gross i nuance of security's hacked by JII-A and box entitled The Federal Reserves Liquidity Opera- tions'' on pjgr 26J Ni'if'rtlu'k1^. tuudiiion!* in a brtwil « nf itilm Mi^tf] nfc range ol domestic and mlE'rciational nnaEidal markeis remained strained relative to previous years,. This week, ihe BoaFd of Governors announced a temporary arrangement that allows the Federal Reserve to extend credit lo Fannie Mae and Freddie Mac, if necessary. Market Functioning and Financial Stability The deteriorating per form ance ofsubprime mortgages in ihe Unilei) Slates prompted widespread Mriiins and turbulence in domestic and international financial mar- V.i i \l,*tgif<n. t JII.A fm.4% 3iif a mix of prink.', i^jkr-ptt™. jnd unr 9 tw . l I v n n a r l v c i m v t w it f t p m ro c d n u tf d ll . I m Ihf o n ir r i d ix U h f r \ K o i f o t f a •u n t o ih fr im k f o e A E i H fu it l t j l m y . p ir t t n i/ l j l t y H H m i ile ri nK M T u h m i^ Jkr o r-L r | Lu e . t ] h iiH er and rhV f 74 24 Monetary Policy Report to the Congress July 2008 Price iriikxtf of subprirtte rt^wiBa Spreads of corporate bond yields over comparable mi credit default maps, 2WJ UK oiT-!liL--niii Treasury yields, by securiitcs raiinj;. t99S-2(10S I . 1 J L J L 2002 2006 IW5 n TIK dm a rf IT ilu w .L d vi i o L l i *W ir r n il o k I i. O il> - > j i r : t if J b H iw tf k « l j M [ i h i m dH u| fH H ) J - u « l « j M Tn . f ^ j* I u H r I > ^ y | w hf U vprf n tcTrt lu pairiii IKruol fmr\ un«4h«l ti-irpi^.iti1 yield BHWI u^k1^g Ma ata inveslmem grade funding markets in December eased rnarkiti preFrrerici- Ftir Treasury i <ill. mi.il ,nnl pushed considerably in January, diving to a t omhlnation »l i,iLi• \ L)31 I [L ,jMij i, ;:rni• i,i] 1.11EI,Mi-r<iI ri •]n iv 111 ]ir^N 11 Ii <iI ihe passing of ycdr nid luljucr slut't rtumrns ,ntrl Mn' lows thai were well below the target federal funds rale. provision ol additional liquidity by Ihe Federal Reserve As liquidity for MBS not sponsored by the GSEs and and foreign central banks. for other private-label asset-backed securities dried up. In February and March, short- and long-term fund- the heightened uncertainly re-ganling values or these ing markets came under renewed ptrssurc after reports Instruments led to an unprecedented increase In the of further losses and wile -downs at major banks, ni.ir^jn. it\ Ei.iii• ill. tr^nircd (in T\-\\f,\ bi.is.i-i| i»\ sue li broker-dealers, and the government-sponsored enter rnlliiri'iiil: IIJC iiiii'trsi r.»ir sfm'iid >m F|H-M- [TJUJS ;I£MI prises. Fears of a weakening economy exacerbated a T[}\C. Sjiir.nh {]|'inr[M)ri![e iirnl tJSK htJiitl yieEd% civrr .".i-iiiT.ili/ni fli^lu Ironi JII liul \\iv safesl assets. Repur- yields on comparable-maturity Treasury securities chase agreement (repo) market mvp Jumped lo mulliyear highs. Ratios of yields on munici- pal bonds la yields on Treasury securities spiked, and LCDX indexes. 2007-OB failures were widespread in the auction rale securities markets for munic ipal securities, sludenl loans, ami nib er a>wC> Prices fell in the secondary niarkel for lever aged loans, and implied spreads on indexes of loan-only credit default swaps, or LCDX, reached record levels In February. Liquidity was strained In many markets: for example, in Ihe market fttr Treasury fuupun seriiri tii'%, l}iil-jskecl spreaiK JIIII S.|JICLLCK bt'lwrni yields im off-the-nin and on-thc-run securities reached mulliyear highs. Bid-asked spreads In the leveraged loan market also widened noticeably. The orderly resolution ofthe Bear Slearus situation along with the implementation uf the Primary Dealer Credit Facility and Ihe Term Secu- rities Lending Faciiily in March appeared to reduce strains in short-term funding markets and to relieve liquidity pressures more broadly across fixed-Income Sim. Tltt Jali OK ibily JHMJ CM em I tlw^vh July 9, JOOfl. EKII LCDX markets (see the box entitled "The Federal Reserve's indH cmsiib uf 100 singl^Hnw cmht Arfiull N»BJW refrreiKing cnli(K» Liquidity Operations" on page 26). uilh 1in,[.lK-ri \vndhralcd Uapn. chiL Iralf in I bo ic^Htdirir uurLcl Imr kvcnpd louu. StLrk> N K^twi [raJimt an May 22,2007, s«ie 4 «(k-mh-T liven [ficuigli {urnliLLtMi'v in MACMI markets iinprnvEsI i. IWT. mi wFKS Hum A [xil U. :00S. somewhat afler mid-March, pressures in some shorl- 75 Brtiinf af Govfrnors ufilir i-'t'dt'nit Krsrrvr System lower. a[ least for lerrns of Ihree nionlhs and less. The expansion in May of the Federal Reserve's Term Auc- tion Facilily and of (lie associated swap lines widt llie European Central Bank and the Swiss National Bank appears to have tnnirihulrd tn tiis easing of pressures. Himi'icr, hir inci-ib.itik ininJiih!. .L1 II r I IL^ J^I I-.IEHT III.MI three mnnllis. transaction volumes are reportedly low, and spreads remain high. In Eonger-terni financial markels. pressures gener- ally eased in April and May. Spreads of conforming ninrt^agr Mirs ,IINI {orjMiraK1 Iniiiit yields uver yields on enm pa rablr-niaturily Treasury1 seen r I Mrs nanrowrd. and prices and liquidity in Ihe secondary market for — 1.000 leveraged loans increased. However, yield spreads for corporale bonds and mortgages moved higher in June. KtjLitlv piitrvs nt tiujniicil iiiLrnihuliarii'N, an-c lutiiny tht- — Tog housing-rftstl^l tiSEs. Fannie Mac ami Fr«kliii Mar. — 600 dropped sharply in June and early July as concerns mounted both aboul ihcir losses and longer-term proiil- ability and about the prospects For earnings dilution jTi: Tht liaiiirt wftrLk iiid «inuJ Lhfiiigli Juk *. 500S. r )'KU rpivida art hx • IW-Jiy malunly ud IR cupKHcd i given the considerable new capital that may need to be raised. OVITJII, im Inn Mrs of lirujic diil nurktt slt.iiiis y Tiuu md Clnr MID remain rlevhlnl romp^red wilh llieir Wvrls in prcvirius years. linHJ m^rkE-is ccmiinupd m itn• -ww'.; inici April. Vi^Lii spreads rtisr in April on unMr;ir«l i.i .-in M assel-harked, anri lower-rated nnnrinannal commer- cial paper Interbank term funding pressures, as mea- Bpbt and Financial Intcnnediation sured by spreads of term London interba nk offered rdlfi aver LoiiiparjJilE' jiiiiinrity iivrrni^lit \ud(-\ swap The total dcbl of the domestic nonrinancial sector jfc|«. peaitH in April I mi have sino' mcivcti ^rl^Hkwh^l expanded at an annual rale tiffin percent in ihe first c|u;irtiT uf^UUK. a UJIIU'WIILLI sluwer pjir ili-i in 2007. One-month Libor minus overnight irukw swap rain, 2O07-O8 EDKNildomesticronfinjnuLiL Jebt. ihJ;M-20OK \J 1 1 . 1 . 1 1.... Apr JuLh I HI Inn Aff. JlLlj .. In I v ua I p h f ( O i1 l ; S H h u u jn ; u d t u i ty n K ar i i ^ d i" "' v ti m ll I >I_LB -• • l l -i J ii ll', III J'HI> 11 hI ..J ch; (ta-us. nt Ihe J|{rcnE r I IK- Jiiri.Tcm.c tvi-rt Lsrlh inKIHI JI (Ik- fixtd Me Jlhl inurrd jt h>' jH.«ng.in|jt 11K lloolinjr. ot ratf I ihir \* the t.tHhiofl irl II'IL-ILLI IIIL- Si* KL y fur LiKif. bruitli l A^MWiiiiun; li1* ibe 1 t\S me, l c MMBoard. How of funds J 76 26 Monetary Poli t ti the Congress July ZWJ8 The Federal Reserve's Liquidity Operations In response TO serious financial strains, the Fed- of banks—ranging at various poinls in lime from eral Reserve has laken a number of steps since around 50 lo more lhan 90—have participated August 2007 to enhance liquidity and losier ihe in each of the Ib auctions held thus far. The size Improved FUN c tioning of financial markets and of individual TAF auctions was raised in several thereby promote its dual objectives of maximum steps from an initial level of $20 trillion ai Emep- employment and pru r ".Libuitv. tion last December to S75 billion mwl recently; The Federal Reserve eased the terms of access the amount of TAF credil currently ouisMnding is Inr borrowing by depository institutions UNDER S1 50 bill km. the regular primary credit program, or discourn In conjunction with ihe introduction of the window. The spread of (he primary credit rale TAF, Ihe Federal Reserve atso established swap over the target federal funds rate was narrowed lines wjlh the European Central H.mk and the from 1 00 tasit points lo 50 \IAM points in Swiss National Bank to provide dollar iwnh to August 2007 and lo 35 basis points in March. facilitate dollar lending by ihose central hanks The maximum loan lenm was extended lo 10 IO banks in their jurisdictions. These swap lines days in August 2007 and to 90 days in March; have been enlarged over lime and currently institutions have ihe option lo renew lerm loons stand at 550 billion with the European Central so Ions as Ihey remain in sound financial condi- Bank and $1 2 billion wilh theSwiss National tion. Over time, more institutions have used the [(.ink. discount window, and Ihe more accommodative In response to the unprecedented pressures in lemrs for borrowing al the window have report- short-term repurchase agreement (repo) markets edly improved confidence by assuring deposit earlier this year, Ihe Federal Reserve initiated lory instilutinns that backstop lEquidily will be a special program of 28-day term repurchase available should t hey need it. agreements; $B0 biilion of such agreements are in December 2007. the* Federal Reserve currently outstanding. These agreements were introduced the Term Auction Facility (TAFhF designed to enhance the ability of primary deal- through whic h predetermined amounts of" dis- ers lo obtain term funding for any assets that count window crediI- are auctioned every two sre eligible as collateral in conventional open ntt'kh ro H•!L— iinI.- M^rr.^^^.•lv <ni (urm> HJI .IS>IHII market opera tions. Also, on March 11, ihe Fed- one month. In effect, TAF auctions arc similar eral Reserve announced plans to create the Term lu open market, operationsbut are conducted Securities Lending Facility (TSLF), in which the with depository institutions rather than primary Federal Reserve tends Treasury securi ties held in derilro and .i^.m^r a much hruauVf r.i?ii:i- of col- its portfolio at auction against Ihe colfalerai of bterftl than is accepted in stand ard open market high-grade securities held by dealers. In addi- operations. The TAF appears to have overcome tion to conventional open market operation the reluctance lo borrow associated with stan- collateral—Treasury securities, agency securities, dafd discount window lending because of its and agency-sponsored mortgage- backed securi- competitive auction format, the certainly thai ties [MBS*—the Federat Reserve now accepts a large amount of'credit would be matte avail- AAA-raled residential MBS, commercial MBS, able, and the fact that it is not designed to meet and other asset-backed securities as collateral at uigeni funding needs. Indeed; a large number the TSLF. The Federal Reserve sets a minimum The moderation in borrowing was mainly accounted hi i!007.|Cl Conunercial and industrial loans, deceleraled for by a slowdown in the growth of hou sell old 'EiL, sharply aftergrowingat AN annual rale of more lhan partic ularly mortgage debt. Bcirrciwing by nnnlinanri al 25 percent in the fourth quarter of 2007, The surge in ]JIIMMI-^I-S alsodcccleralifl. but J[ a 9'i ptTtrnt pace, ji C&I loans late last year reportedly reflected, in part, the was still high by historical standards. Preliminary data difficulties thai banks faced in selling syndicated loans suggest that overall debt growth slowed further in the la ronbank investors: as a result, banks had lo Fund a second quarter Commercial bank credit increased al an annual rate of JJ± (XTCI'III in the l"tr\t half of 2008. dciwn si^- irm H c I n r n ih * c -j { f r l < T l i s h n n f lr i h o r f f l o u m nh m tT ia rd n il o f in a 2 L 0 u 0 ^ 7 e h r » D s n t i u m r c n n a ru d ] ; m Lu i n n k i I r u o a IIiMeant!y from ihe 10W percent expansion registered tlifitI imliltilia 77 fkwnf ufGtivrntttrs ufilir ii Reserve System 27 ItuMirturd lU bid rate for each TSLF AUC tion. Bids submitted Treasury, agreed to supply term funding, secured at most TSLF auctions have fallen short of the by $30 hilfioit in Bear Stijnirn> ,mvi\ to f.icilttnite announced auction quantities. Nevertheless the purchase, IPMorgan Chase completed the market participants have indicated tha( Ihe TSLF acquisition of Pear Stearns on lune 26, and the has conlribuled to improved functioning in repo I '•<}•• 1,11 Kr^eiM-1••>i-i=iKir".i -11JJ>rr>•. match hl-'1 -11' in.itki-r-x 11LNn .hi lundiiiH im lii.ir H.ilr Pressures in short-term funding markets In a further effort to prevent A possible down' worsened sharply in mid-March, On March 13, u.inl ^|]irhil n\ financial markets, the* Federal The Bear Stearns Companies, Inc., 3 prominent Reserve also used its emergency authorities \o t i h nv e e F st e m de e r n a t l h R j e n s t e r a v n e d a p n r d i m oth ly e r d e g a o l v e e r r , n a m dv e i n s t e a d gen' c in re m at i e d - t M he a r P c r h im . T a h ry e D P e O a C l F e r a C llo R w E s D p iit r i F m a ac ry i l d it e y a [ l P e D rs CFj i ii->. [iul n-, i ii 11 • •>• J i I -H |io^i;iim li.id IJI-IITKU^II-II hi 11 v, .it riu' dilfotirll wirtfJmi .lu.nriM Ci>l- s fo if r i n b if a ic n a k n ru tf p y t c a y n d th t e h a n t e x it t w da o y u ld u n b l e e s fo a rc h e e d n t u o t f f w ile g la ra te d ra e l s t e h c a u t r i i n ti c e l s u . d I e n s e a ff e b c r t o , a t d h e ra P n D g C e F of p i r n o v v e id st e m s e p n r t i - - sources of funds became available. A bank- mary dealers with A liquidity backstop similar To ruptcy fifing would have forced the secured the discount window that is available to deposi- creditors and counterparties of Bear Steams to ini1. institutions. liquidate the underlying, collateral, and given These liquidity measures appear to have con- the illiquidity of markets, ihose creditors and tributed lo Some improvement in financial mar- counterparties might well have sustained sub- kets sinc E late March, stantial loses. If they had responded to losses or the unexpected illiquidity oi their holdings by Over recent days, the share prices of Fannie pulling hack front providing secured financing Mae and Freddie Mac dropped sharply on inves- toother firms and by dumping large volumes of t c o a r p c it o a n l c p e o rn s s it io a n b . o u T t h e th T e r i e r a fi s n u a r n y c a ia n l n o co un n c d e it d io n a a le n g d - f i i l n ii a i| n ii c n i l a j l ^ c i r - is h i s i N li I k I e r I l : y i - w m o . u ir ld ki t h . a .L v e III I e JJ n s II u l e ii d c - w J. i - t r h islative initiative to Iwlste* the capital, access io c s o u n c s h e c q i u rc e u n m t s h la a n rm ce S to j t t h h e e o F v e e d r e a r ll j l e R co e n se o r m ve y . B I o n ard m liq e u n i l d -s it p y o , n a s n o d r e re d g e u n la te to rp ry ri s o e v s e r [C si S g E h s t k o f A t s h e A g s o u v p e p r l n e - - judged rh,it i| was appropriate to use its emer- ment to the Treasury's existing authority to lend gency lending aulhorities under the Federal t a o te th m e p C o S ra E r s y , a th rr e a n H g o e a m rd e n o t f t G ha o t v a e l r l n o o w r s s t e h s e ta F b e lis d h - ed S ki te M a - r u n . s - . A A f c 1 c o tn r d .i i ' n . 1 g 111 l 1 y 1, . i t h .i e iv F . e jf d l e ir r V a l i R lo e s s u er rr v e > j i -l a E ft S e i- r .ir n Fr , e il d k d i i - e M M TL a i c ' , i n if in ne te c n e d ss a . r r y rc . l I i n l H es i ta F b . l i is ri h in in i- g \ \ t . h » is - .incj «iii< u^himi*, ^^ i1h r11• - 'n-i uritirn .irnJ i M E•.• r• I_LI- C In o - m .iM m i i r s .. s i . o )L n : r a i'i- n iJ d [ in o c p l u o n se i d c r o - n , s |. u o l r t t a -l t i i - o n n n w lu it n h . r ( i h ii; e .: ^ u i n i. d in e ^ r r s 'i e ih c ' t i i i o l. n iF 1 n 3 - ( 1 K u 33 il r o fl f r I fc h i e 'M F I e M d e il r a IK l R .L e u s T e iU r h v n e l v Act. to Bear Stearns through JPMorpan Chase & Co. Credit under this arrangement will be extended at (he primary credit rate and secured by govern- me nt and federal agency securities. < JI.H-1 :1 ;i • 11 :•! 11 iV, i • I;.'. -\\ i i ki • • 111 \t'W< ;.•..Ml (. h.L-1- agreed to purchase Bear Stearns and assume (he company's financial obligations. The Federal Reserve, again in close consultation with (he IHIIII1JH-I t.A [ireviouslv tcjinmitliii larjjE1 syncJicatrd drals weakening of demand for C&[ loans. Commercial real on their balance shells. |n the [Irst quarter uf200H. estate loans grew at an annual rait? of about SH* percent C&I loans grew at A lower but still qu ite fast rate of in the first half of £U0£. only slightly slower than their lfil/i percent, with part of the strength reportedly due Eo pace in 2007. Increased utilization of existing credit lines, the pricing After contracting sharply in thp final quartet of of which reflected previous Lending practices. En the 2007. the outstanding stock of residential mortgages at sri'tiiitj ijiianiT. t'ftl lending itindiTJti-ii ^i^nillc anlly commercial banks rinse Vk percent in the first quarter, furtlnT. a fiiiiit'cii ctjoststrnl with regxirls fmni Ihc April En part because of a sluggish pace of securitizatton. In Senior Loan Officer O pin ion Survey, which indicated the SECOND quarter, however* banks' hol dings of resi- a Further lightening DF credit standards and terms and drniial mortgage loans foil again, a pattern consistent 28 Monetary Poltcy Repon (o the Congress July 2MB Commercial bank probability, 1 The overall delinquency rate on loans held by com- mercial banks rose in die first quarter lo Its highest level since the early 1990s, and the chargeoff rate Increased Ktfitfnu)l*Ll«Cl 1^ lo ihr upper eiKl of its range siim* 2000. The deleriora A — If. t c i o o n n t i i n n u r e r d e d e i r l o q s u io a n li t i y n w Ih a e s p a e c r c fo o r u m nt a e n d c e fo o r f p r r e im si a d r e i n ly t i b al y M mortgages and a considerable worsening in construction i on rquiiV\ ~ i; and land development loans, but performance of most oilier types of loans also weakened. To bolster equity in positions diminislk^l hy asM-l virilfduwiis .unl loair Ql — loss provisions, commercial b anks raised a substantial t volume of capital in the first half of ZOOS: some banks reduced dividends to further shore up their capital. IWJ iwi l«t MM ;m; am; Equity Markets The Ala fMcnd through :W*(J[ Thcdriiw «nud trough V f i^fcn hi JOOK V' 1 « Jnmijf ml*. Reports of CwrfHwn mi In Overall, share prices have dropped about IS percent from the end of 2007. The declines were led by the financial sector, especially depository institutions and \-, irti rhr nii^uin^ v,i.Mkni'ss in iln.! housing iimrVri .mil broker-dealers, which fell 37 percent and 41 percent, on average, respectively. The energy and basic materials 111 • - niliK id i\ .I i 3 ,i 111131 v, (i| nmrlgagr H I • • I u I IPHIU [h ; il sectors avoided the downtrend and have changed little hiiiitc iijiiii\ linn nt (ri'iln pit ki-d up significant I v in the lirsl half of 2008. likely because of the decline in on HIT shorl-temi market rales to which such loans are gener- ALIII.II JIKI implied volatilities cif hniad ec^uitv prite ally (led. However, commercial banks have taken sleps indexes shot up last year with Ihe onset of financial to limit their exposure lo Ihese loans; according to Ihe strains. The partial easing of financ ial strains in the April Senior Loan Officer Opinion Survey, a significant second quarter was associated wilh modesl declines portion of respondents initiated thai they had tightened in the actual and implied volatilities of cquily prices their credit standards fbr approving new applications to levels still above those of the past few years. The far h<mic {Kjiiily linrs nl rrttiil. and a imNsble |>n)|)(tr 12-inonthforward expected earnings-price ratio for tion reported that they had also timicd tending TERMS SAP 500 firms jumped in the first half of 200S. while on existing lines, mainly in response to declines in llu1 long- lerm real Treasury yield rose only slightly. I!«• properly values. Despite the reported lightening of difference between Ihese Iwo values—a rough measure crrdit conditions in Ilk1 huuu-hnld switw. runsuini-r of Ihe premium that investors require for holding equity leu us yjvw iiL J IIICHIITJTI1 |i<iri' in [lie llr\E lulfof ZOOS. Siock pTKP imlcxfr. \99$-2OQX Profitability of the commercial banking sector improved somewhat in the first quarter of 2008 but remaii^ed well bchm- llir leveh seen l>eforr ilic Mimnwr uf 2007. MJIIV liirj;*.1 biiiilfi mrivrd J si^nihijut IHXJM ID I heir 1ip>t-(|U3rier jinci(ils a&a result uf their Makes in JA — Visa—(he initial public offering of which occurred in March. However, continued writedowns of mortgage- relaled assets and leveraged loans, along with increas- ing lt>an Iciss prDVisicim, hrld proliK duwn in ilk- fiftl qn^ner. C'nnrpms ^Ijcigl recent and potential lOBBBI ll^l^^' weighed heavily on bank slock prices this year. The median spread on credit default swaps on the senior debt of major banks climbed from 50 basis points al ihe end of ZM7 to more than 100 basis poinls in mid- MtfTfli. After dri'lining noticeably in April duel \\a\, il relumed close to the March peak in late June. 79 BoanfofGoirmons of the Frdeml (hnr System 29 Imptied SAP $00 VDlaiility, 1995 2 »ym -Sh I I I I I I I I I I I I I ton MM iwn M» :UOT :aa* •A4 oknil Ibtnu^i luty flL 20HI 2tfM. Tk Tntt otn*f% jjk* 11 HI mtnulf hiwd MI du Jvough July 4, itt ibvL poet Lr^Vv fa kjkubki! inwti j w inj;bkJ a*.vfij[T of ofHMH (*JV*Y. SCH.IH.-I: Chicago BoardO ptmaEx die markpEs |nr nominal and indexed Treasury securi- ties at times affected the spreads between nominal and shares— has r EA c he d i he high end of its range over the indexed yields, also known as inHalion compensation. p.lM 20 UMis On net, 10-year inflation compensation has risen aboul 20 basis points since the end of 2007. suggesting som e inrreasf* in invesinrs' {twrmis aboui thp inHntjon out Policy Expectations and Interest Rates look. Inflation compensation rose o^er both (he near lerrn and Ihe longer lermh hut the increase was larger The current targcl for the federal Funds rales at 2 prr- over t he near term, as compensation over the next cent, is substantially below THY level that investors 5 yean Jose about 30 basis points whereas compensa- expected as of late December 2007, According to tion over ihe period from 5 years ahead to 10 years futures quotes at that lime, market participants expected ahead rose only 10 iwsis points. In pan because of a tag iiiLii Mil1 fiuliTJil IUIHK rjiLc wnuld IH1 around 'A'-; [KTM-JH in ihe iudi'xaimn of inflalion -prolected securities, near hy July- LrtHiking tnrwanl. howner. insrMuri now term inflation compensation can bestrongly affected by expect thai Ihe next policy move will be up. and a small degree of Eighlcntng has been priced in by Ihe end of 2008. Measures of uncertainty abou tme path of policy TIPS-ha*L-d inIIJlMil ciiii iovh viii)i the Diksci of tinimt IJI lurbuli'iic r ],\\i year LIIUI AT? ujiTPniJy near Mir high rml tt( ihi-ir rrt]i«Ei nver thp pasi 10 years. Treasury yields fell sharpK1 from ihernd of 2007 ihrongh March amid concerns about the health of finan- cial firms, severe strains in financial markets, a weaken- ing economic oullook, and lower expectations for future [Kjlicy rales. Siine laic Miiuli, ^ t< • Lc 1^ \IA\V risen 'At ross '•I - (he curve as fearsof a deep economic contraction have receded and concerns about me inflation outlook have • increased. On net, 2-year yields are down 65 basis poinls, and 10-year yields are down 20 basis points since me start of the year, I I [ I I I i |_J Yields nn TreHMiry iiMldiimu pi i iit-< i• -•.I serurilie^ ,i»i unt xn$ 2004 xxn mm largely moved in line with nominal yields—that tef they Vii. [he liHd J/L- •iiiS jnd n\*&i OAHth IJK 4. 3«1« HIKJ .HI A fell illrough mid-March and then rose—but ihc rise ^HUfmihM of .ht jttld itmt hM TKUIM) .ifliiHwv-pro4KtAl mumm since March has been somewhal less than (hat of nomi- 11 S 1 TB P S R j L w I tih I c i » h t : T i r J h x K iH fs H c l ^ o c T I T t - u tl r v J -f u ^ i i i L T -u t t r ^ a H w M y h j h n m U J n n no * c ilil* fiun >fcd tn Ih: nal yields. En addition, shifting liquidity conditions in hnknt IMU UmL ,.f s™ Vort. nt Harbyv 80 30 Monetary Policy Report to the Congress July 200E regarding ihe appropriate quantity of reserves to be sup- plied each day through open market operations have been i nni|ilic.ili!il. iirnl Mihcilicy in Uie fedrnil fmlds rate has been elevated. The authority to pay interest «n reserves could be helpful to the Federal Reserve in lim- iling Ihe volatility in the federal funds rale. The ability to pay interest on reserves would also allow (he Federal Reserve to manage its balance sheet more efficiently in circumstances in which promoting linancial stabil- ity required the provision of substantial amounts of III\HJIMI[ windem rrctlil to llu1 ILJI.UIL ial \ecdir. In light of these considerations, the Federal Reserve has asked Ihe Congress lo accelerate Ihe effect ive date of statutory authority to pay interest on reserve balances, which is currently October 2011. HOIK Ttvtbafnd Pm# ZUWQI vdn cMinuicd Tor ^MKS.Cj: ThfA^h 2007, ifat diu ft* Wul <M a limit h. qua Her M Lmrt Ih.*|ujr1tr I r M tc S H. M A 2 c C fiu O l H H a U h e o n f j i c n w n K r i e t f c e y rs . a to a J v 0 r W ic . r < '* J ? c h K e IH ck II * C , d 1k n > n ~U w U d 7 :( d > q J m jf i i l n ^ J n rw th n c u r .il Inh tn.ilimi.il Ui'vi'luji dbW dtpUuli, UHHIp JcpOuli Kfeluditig nto*C} nuikrl Lkpn\H JIdeiHininjiiHi Imw drpoubv md bal-inoe^ MI Jdiil nhimiy International Financial Markets . JrtVrtal I Ikwl, SmjMK.il RLJCJM: lib, 'MDBCV Slml CMcihal financial markets uTiuirn <\ iliMresvfl n\vr the tint hall «f 2[H)Hr prinurilv liccauw nf enncrrns ,IIK>LI1 the latest movements in energy and Food prices: Ehcse weakness in real estate and slowing global economic prices have risen sharply in recenl monlhs. growth. Amid heightened market turbulence In March, Ihe European Central Bank (ECB)> Bank of England, Bank of Canada, and Swiss National Bank (SNB) Money and Reserves amiuunivd ,i further set tif joint arlitinswitli the t'edt'rai Rc^erV'i1 Lo hrlp improve ttie li][3{li[>riLiig n\ short term MZ is estimated to have expanded al an annual race of luiiiliitii, nurkets. The Federal {J[K'n M.trkcl C ommillee 7^i pfn enl over ihc hrM halfofi!008. notably faster increased Us temporary' swap line tothe ECB in March ilian (hth Iiki4y |;ru\vl)i ral^ nfiiuniinat CiDP. Drnmikl from S20 billion to $30 billion and ils line to the SNB for ITIOIH'V lulanL"fb% was Mi|ifKJrdi] hy ilrrlicirs in 111• - from S1 billion lo S6 billion. In May, these amounts opportunitycost ofholding money relative loother were increased further to S5D bitlion and $12 billion, financial assets and by strongdemand for safe and respectively, and the lines were extended through Janu liquid assets amid volatility and strains in linan cial ary Z009, Meanwhile, the Bank of England and ihe nuiki-iN. Mnnry ni.itkii iriDin.i] fund hliar^s I-JI-1.1. pan K.mk MM .IM.ILI.I I-:H h Liiri,nli]i rd iL.-•.•_ ii-rui funding liiuliirly nipully in lilt- tirM IJIJIUII-F. Ilimi'Vff. jinmih arrangenients in their domestic currencies, and the Bank lit iiiiiiHY [iiarkel iiiiLiu.ii Ininh tirtt|iprii n>HMdprah|y in of England also established a facility to swap govern- the second quarter, and small time deputies rontractedi ment bonds for banks' mortgage-backed securities for a M2 slowed accordingly. Demand for currency conlin- term of one to three yearv the EC B has also continued ued to be lackluster for the most of t he first half-year, looffer longer- term funding in euros, auc tioning three- bul it picked up noticeably lale in the second quarter as month funds killing 2€7G billion in the JirM purler domestic demand grew and foreign demand was esti- and 2€ 50 billion in the second quarter and adding a ni.Ht'c] HJ IH1 \v\\ weak. new long-term refinancing operation with a six-month I'lii' MM ins in h.uik liuitiiiti; itiiirkriMj'.i-t tCOBfll maturity. niunlhs have posed challenges for the implementalkin Market volatility has persisted in recent mouths, of monetary policy. Banks generally have seemed more \MIII ongoing [ iniuiir-. a^Kint the habnte sheets ol caulious in their activity in Ihe federal funds market financial institutions. Sincethe middle of last year, and less willing to lake advantage of potential arbitrage Hurnpean Iwuks have announcetl akmt 5200 hiEhmi in opport unities in thai market over ihe course of a day WTite-downs—largely as a result of indirect exposure and across the days of a reserve itiainsetianc EPERIOD. to U.S. credil markets through both sponsorship of and In (his environment, the Open Markel Desk's decisi investments in structured credit products—and further 81 Bosmi of Governors of the Feffcrnl Reserve System Equity indexes in selected advanced foreign economics. Equity indexes in selected emerging market «ononiicsH 2007OS 3007 OS v\ i: Apr. Jul) Ort. Apr. iuh Oel. 2W1 itofK Tkdtfj K duly The tul obcn*« far tub me* H July *. Sim: 11K<1U m «lut> 11K tai obwnatm for «ch wm n Jury ». MOS. H^urltr T[A>tr tAcbMpr ll Dt 31 3UTV JOOH, bctwr Ike SJUi£hii Mttk Kuhtf«r Ttfc <k**d « lltttrtfct ll. Jjpw q*dn PI *«W w Ifc* (V ML 100 IV LHIA tiomotrbt* ate Ai^auu. Bn/il, Chile, SanCE l(« <VP MM. n™ Jut* | STOXX |n*V Aw e ^JittiUL^ AIUB CV^VHTBO ^K C'HIOJ. T«HM Stock kutunfe WO C'onpMHr irti foe Jifwi. T<* II. ihf PhNp^K^ Sowh Kor». TAIVM. I uhup LTIHiVp, *kl hir tV I nil(J L Sfc l |FTSfc IWi. B Kporkd b> Ukvmtvfy ftmrpng Atu. ^V^HI Sunb> t'iprt * intv CiV C'htru, Slurgtui C'tidAptniV Lr*t.t. rcpo*tal by Btemhrf. s may br rccogni?xd tn second-quartrr finiinfial SttteOKafe In ^tliijticHi. ni»n^^ Irntlcrs in thp Lj ii il-ccl K i ni^ch m ti hiivr IHI'II alTn'lrd by ivriiknc*\& in CJu nc1!. IIKIM tiujor n^nilv inilrxi^ in ihc tt(l\iin nJ propeny pricts ilii-n- jmJ l>v ntluifd aetou to ijpiul fori'i^n itcmfnitii-i slartd IZ percent i» i!s perctnt lo^rr market Funding. In general, ihe instilulionsthat have in local currency terms compared with me end of 2007, recngnized slgniliranl losses have laken [irtirnpi European slnck indexes were led lower by the slock step* lo replenish rapiial from a variety of «jurces; prices ni lui.iiK i,il li;m*. whkh clerlined 24 pcrrfjil mare tlun SI40 lnlln.ui hjd IH.-ITI ruivii by [lie CIHI of liiic.iMin. i.i in I'uros}; Japaneu1 Mum L.tl MtHrks an1 duwn June. 9 percent on the year. The linancial turbulence has had ]ess impact on Latin American stock prices. Equity indexes in Mexico acid Brazil wm? virtually unchanged, t nit hcrKnniirie gtrt cmmtfi L hands in s XC<I tiireign cvimomin. 20(li7-Olt on balance OVerihe first half of 2008. However Chi- new stijclt prices have ;lumbled A4 percenl since the end of 2007. virtually erasing last year'sgains, and oltier major emerging Asian equity indexes are also down, bul to a lesser extent, L.iijLiicIily in Ruropejin ^nernnient btmtt markets was impaired in MJFI'II liul sifins in \IAW imprcned in 111 --I: i monchs. 1 ^ HI-.- ill iii bond vields in the advanced foreign economies fell in the firs! quarter but have more lhan reversed Ihese declines as investors no longer expect the F-CB anil ilie Bank nf t'ughnil let rase their policy Mirv Siim- ihe CJIL! of 2007. Icin^ Eenn rat« \ut\y risen, on net, 1 1 basis points in Germany, 38 basis points in the United Kingdom, and 12 basis poinls in japan, and nominal yield curves have flattened. Mean- while, implied Inug'term m:!.i[iuu rnrnpensviiion has 10-jrM hnh, MV dul>. Tb bu Increased in hasis points in Japan and nearly 30 basis points in G erma ny and Canada, 82 '.M MOHttn Fiiliry Report toIlie Congress July 200& U.S. dollar noni ina I cxctungt: rate, broad IIKJC^. 2WI (it! Change in consumer prices far major Curtign 2004-08 3001 3XU MOJ 2004 ZOO* 2006 2W? \«ri: IV AMX, WTIKII w tn faKipi eun«k:> unila per Joiltp. ut J TV UM otMc^umif orI br tain ts Jul> <>. :«tf Tbr Ivrud index Ihc tbti art nwmhly, jnd cfainp n fm th-cithicxl A^ crave H^F ElW Fnvrhi^i s:ii/tun£c uhm nF EFK L- S L1II| IJT ajb eli May 200R. khe cofKKKi- rf J lnf piwp of ita mm impofunf L'.S. (ratting pan ih tmtim TV miss ni;i;hiv wliivh i-hjnpf ii^vi time, JF? Jfn^cd Fmm L'.S. cn vharo mA ftntn tU JmJ U^njiii imfun ^haro. I ft l Hty The dollar has declined 6 percent agalnsl the Chinese The Federal Reserve's broadest measure of [he nom- MTiniinhi since ihe end Q[ 2W11, inal iradc -wcighlcd foreign exchange value of Che dollar has declined about 3 percent, on net, since Ihe end of last year. Over the tame period, llir ajtsr L-nrrencips Advanced Foreign Economies index of Ihe dollar has aku ditlini'd alxiui 3 percenl. MLitl sJi^rfaK ,i;;iiin\t I hi1 {hLir[} ;iin1 [fir Economic grawlh in the major advanced foreign y and March but has recovered some economies appears to have slowed somewhat thisyear HI ni( [-in nionrli-, (in iii-1 rluK f.n tliis w,\\ ilir ilnh.it Although bctili the euni area And Japan poSKtl slruug is down about 4 percent against the yen and 7 percent (ir^t-quartiT GDfgrciulh rdtL-%, rrcrnl nituillily indi against theeuro. The dollar Is 2 percent higher against i^nars luvr heen more1 MIIMIIIC^]. In mlifi (ninifrirv ihe Canadian dollar ami silghtlv higher a^ain&t M i• 11: i- -•. ^rciwih ni(E*s cleclinnl in ihe lii\( {|Li,ir[rr, LIIHI first- quarter real GDP even contracted slightly in Canada, where trade and financial lies to ihe Unlled Stales are V. S. dol \if t\c tun^o rat strong. Surveys of banks in Europe show a further cies. 2007-Q8 Ii^rilfiling (ij [Ti'dil strtiwhj-tJs in ilu> i\r\[ half uf 20(IS I Ml' IJIHIJ liouvillirlih . I • i • 1 hllSLIH^U'S t.rlL(lill!^ 1(1 hlisi nesses appriirs to have rrniiditird solid, BUT household hoiTowing has slewed. Housing markets in a number of counlrles—including Ireland. Spain, and the United Kingdom—have continued to soflen. Since the beginning of the year, headline rates of flirtation have continued to move up, on halancer In tiH]si ttt]FKmiii's. IIIRIIIEV lnk("«iiisp iif inrrrasmg prjres Tw RMKI nnd energy, The IZmunlh change in consumer prices in bolh Ihc euro area and the United Kingdom increased Further Trorn Januar>r to mid-2008, while core inflation rates [which exclude the changes in the prices of energy and unprocessed food) have increased much Apr- July less. In Canada, where food price Increases have been muted, inhibition i% link11 han^ecl, un r•=• I-.:i:•. • since ML..- Th S f e f t t U i L T b K I i : I o T b F K x i J v J i U u . i n * f ts ^ J i u i h i ir 4 m ,2F v ) > tW u . nilM [HT thhllii. ire JJIIJ. o i -: f -•- m •=i o ^ 1 n 1 t h •• s i; • J o a i p [h a i1 n y e e s a e r c hi o ;! n 1 s 1. u ; - m . ri e s r e n p i r n i c I e he s | a in r s e t i r o E u iup g le hly 83 Board of Governors of the Federal Reserve System 33 Oflickil or tirjecoJ iniervM me* in Kfoc exuorl ^fowlli slowed, domestic ilrmLiml ,ip|h,ir> Iti foreign economies, 2004-OS have accelerated. ! \w\: Ih'tc in i-nlM^ilt^ \vin. m.CJH [H'Mtn irl.int i1 llJS varied but, on balance, indicators suggest that activity has remained solid in the region. In the first quarter real GDPgrowth moderated in Korea, Malaysia, and Thailand but was strong in Hong Kong and Singapore. Exports of the region have generally slowed along with the deceleration in globaE economic activity: however, domestic demand strengdiencd in a number of countries. E-icTjnciiiiii dc[Lvil> JIMS \W< clrr-in-il in I al in America. In Mexico, output {yowlh slowed to about 2 percent in Ihe first quarter, in Une wilh the step-down En the pace of activlly in ine United Stales thai began toward ihe •H end of last year In other Latin American countries, ) ^h 1.MAn T V LIJU J^n notably Brazil and Venezuela, growth also moderated. w n n u . ii t o K t ( f w ku d K a n , g th e c v pr r m c w m i ^ H r . a t f e i , x f o Jj r fU *c fL * . m th v r n c n a ll Ih n c a i t m ty n n w t n r r h l i a J d m . f a « r n (far Higher prices For food and energy have continued I. nrtfJ ktrr^om. Lhf 4.11 IK U( t\uiL rale pj*J fw t^nMnfiVnl (VKTtn. toexert upward pressures on inflation <uttr*\ emerg- S"nv Thf cranl book *fc*:b no w ccunuy iknn ing market economies. In China, headline Inflation has risen, reaching roughly S percenl in recent months. unchanged on a 12-month basis when both Food and In response to the inflationary pressures, the Chinese energy prices art 1p authorities have atiowed the renminbt to appreciate ( her ihr lirsl halFuflhis M'.u llur fctrus u5 1111• in:i|iii ata more rapid pace, and the People's Bank of China furpi^n ifiilr.il lunks ;i|>|Hj.us lei have* shifted MMiirutLil has further tightened monetary polity. The Bank has I [ > • I i I ihc1 llll[i..L( ( u\ NlkblK Inil iriiil ki"1 MrilJllS Dll •; 111 \h. L h COraised the required reserve ratio five times this year hy ihc CITIHI {>f hij;lHT tuinmodiiy prices on inflaiiun. Afitr a total of 300 basis points, lo l7l--> percent. Elsewhere initially lowering oflicial interest rales, the Bank of in emerging nittrkei eccinumicv. 12-monlh hraiiline Canada and Ihe Bank of England have held Iheir target iiiElijcioci in a number of cnunlries COIUJUUIKI [o rise in rales steady since April, and ihe Bank of japan has kept its policy rale unchanged at 0,5 percent all year. Reecnl r id e c L e i n gh t t n e i n u i m ili o iv n e d ta ie r r y e t p iy o l p ic n y i . m In p l s in o g m e m c a a n s y e c s e , n g l o rL v i e l r i n ia m Tt e k n s ts in fla tion rates and statements from all of these central also instituted export restrictions or reduced import banks have led market participant lo expect potiry duties Forsome food products. The rising cost ofenergy Mif\ (n increase slightly ar lafrmaiii <m bolii. On July 3. llie Ft-B rai%e<J iis pci]icy rjie 25 IJKK pfiini%, subsidies has led governments fn China4 India. Malay- sia. Indonesia, and Taiwan to raise administered gaso- In I !J |;I h I m IHJI il IMJII'.I.I llial furthrr rale htkra were line prices roughly 10 percent to 40 percent in recent nol in t he offing, months. Emerging Market Economics Recent data suggest (hat real CDP growth in China remained strong in the tim half of this year. Alt hough 84 Part 3 Monetary Policy over the First Half of 2008 Alin easing iIn- sumc of monetary policy 100 basis generally of the view that substantial additional policy poinls over the second half uf 2007, Ihe Federal Open easing might well be necessary to support economic Market Committee (FOMO lowered the toga federa] activity and reduce [he downside risks to growth, and funds rale 225 basis poinls further in the first half of iluLv rliviissi't] lhe |M)ssil)N' timing thl stkh iinictnv 2008." The Federal Reserve also took a number of addi- C)o January 21. the Committee held another con tional actions to increase liquidity and to improve the Terence call. St rains in some financial markets had functioning of financial markets. intensified, and Incoming evidence had reinforced the In a conference call on January 9. the Committee view that the outlook for economic activity was weak. reviewed n-i mi economic if.ti.i and lir^inu.il nur P^riififianls ulrtrmti IKLLI kntSlOU ap|>dmilly HOB Ki"l developments. The in format ion, whic h included bpenming iricrpisingly concemrd alxmi the rrniHiTiiit weaker -lhan- expccled data on home sales and employ- outlook and downside risks to activity and that these ment for December as well as a sharp decline in equity developments could lead to an excessive pull back in prices since the beginning of the year, suggested that credit availability. In light of these developments, all Nir downside risks [o growth had increased signific antly members judged that a substantial easing in policy was sini'i' thr time of the Disri'mbtT K)M( milling. I'.'i appmpnale (n fuster mcHirratr economic pimlli diu] ticipants cited concerns that thes lowing of economic reduce Ihe downside risks to economic activity. The growth could lead to a further lightening of financial Committee decided to lower the target for the federal conditions, which In turn could reinforce the economic funds rate 75 basis poinls. to 3'a percent, and judged Slowdown However, core inflation had edged up in dial appreciable downside risks IO growth remained. recent months, and considerable uncertainly surrounded Although inHalion was expec ted to edge lower over the inflation outlook. On balance, participants were Ihe course of ZOOK, participants underscored their view that this assessment was conditioned upon inflation especialions remain ing well anchored and stressed that 11. Afrm*rr*oflhrF<lMt tit 2008 rtrtfaiu uf tttnilbrn o 1 • i• • inil.unjn MMi.itHJii stmuM {HJiHirnic \tt W- mci-nifii-rccl Eluiril or tkn,niHjf s u\ [hr Knkril Rnn\ c S> Mnn plus i p careful I v u\ llr Pnlrrjl Hrwrvr llaik% nf C Inrbrxl, MM, Minm J^ILV Xru Vtwii. jnd PEiiljtHphij t'.irtiiifitnKil t-OMC nteriinjfs romia of The data reviewed at Ihe regularly scheduled FOMC m«nbfrj gf ihe tVurd of Cwcnwrc and M Hn meeting an January 29 and 30 confirmed a slurp decel- — i j The dill arc duly «nd »tcml hmgb My *t. WK. The 10-jle» Tnc«) me » OK nxntHC-mtirit)' )wU baed c* I be mmt Kind)' Indtd vruntici. lk hn*uimLil a%r* aftrihtn* <•( rr^-uLwt], vh^Juknl I C*T»] Open Mattel C UHMIUJVC mr^inp Ucpanmcn efihe THAIU> tad ik-1'tilted KCSCTHt. 35 85 36 Monetary Policy Report H i the Congress July 2WH (•ration in economic growlh during the fourth quarter oF Honing In financial markets, including the approval of 2007 and a continued lightening of linancia! conditions. the financing arrangement associated with the aquisi With the contract)™ In the housing sector Intensify- tion of The Bear Steams Companies. Inc.. by JPMorgan ing and a range n! financial markets remaining under ClNusi1 & Ho. and I lie establish riu'iic ol ilu' Primary pn'ssurv, vt unomk ^rmvil] was rxpK'k'd m Slav vtU in Dealer Credit Facility to improve the ability of primary [hr lir>i IIHIEOI ?.\WH Itrftin' |iirkhif; up strength in rhc dealers to provide financing to participants in securili- second half. HBVHVK I he ongoing weaknesses in home zatlon markets. In addition, the primary credit rale was sales and house prices, as well as the lightening of cred- loUE'red 25 basis point*, and the ii,i\uiiiirn term of pri- it conditions fur households and businesses, were seen mary credit loans was extended TO 911[ lays. as posing down side risks tu the near-term outlook for When the Committee met on March 18, financial = i •••_•: M 11 • •in1.-, ill Moreover, iin- ;niM-iif;-il foradvcr\r markets continued to be under great stress, particularly fri'iHwt k betwrrn Ihe linannnl markets ami ilu1 •DODO' the markets for short-term collateralIzcd and um utl.n my was a significant risk. Participants expressed some erali/ed funding. Spreads on Interbank loans and lower- concern about the disappointing inHalion data received rLni.Lii 1 (Hiiiiirnial jhifn-i hail widened over llir inter- over the latter pan of 2007. Although many expected mrrliFlg prrioO. and cidlaiuii^ rrrclil ihruugh rt'purchiist* thai a r<iLiliiiir 111! i nf prkrs fur IIIIT^V -u-'l f\l\:-\ torn agreements backed by agency and private-label MBS miwliliE'v MJE'II as thai cinEn'ilifrd In liilmcs 111:11 ki'Ls. had become more difficult amid reports of increased and a period of below-trend growlh would contribute margin, or "haircuts." being required by lenders. Yields to some moderation tn innation pressures over lime, on Treasury bills and repurchase agreements backed by the Committee believed that It remained necessary to luMMirv securities had uEiiiurnrlHl, rfOnllng IHVOtOn* monitor inHalIan developments carefully. Against ili.it heightened demand for the safest assets. backdrop, the KOMI driidrd to louer the target for Participants at Iho March 18 FOMC meeting noted Ehr lt'£l[hral funds rale M basis [ininls. Ki 3 piTt"(*nt. 1 In1 I lh.it |>MJ^|)I-( i\ dn Inil3i i'[ i.fh 11113111 ,n li^ \t\ .Hill tii'.n letIS Committee believed that this policy aclion. combined inHation liad deteriorated since January, and many with those taken earlier, would help promote moderate thought that some contraction in economic activity in growth over lime and mitigate the risks to economic the first half of ZOOS was likely. Although lite economy activity. However, members judged that downside risks was expected to recover In the second half and togrow to growth remained. further in ZOOS, considerable uncertainly surrounded In a conference call on March 10. the Committee [his ftirrtast. Sunlc parti[rijianls rxprvssrd njimcrn reviewed linandaL tiiarkrl dev^Kipineuis JISII {unsidrEnl that falling HOUSE prices and financial market stress niififn lead \u a tmnc \?\ nc .md JHIIH.IL t<d do\Miiiiin I • 1 • • I •. •- • = I -^ .niinil al -s 1 L 1 "• 1:1115 I 1 i_i •„ ilii- ln|i)iiln\ dcid urtlrrlv functioning of those markets. In light of the sharp than anticipated. Recent readings on inflation had been deterioration of some key money and credit markets, elevated, and some indicators of Inflation expectations the Committee approved the establishment of the Term had risen. However, a Rattening. out of prices for oil and Securities Lending Facility, under which primary deal- other {(intmiHfilirs as Implied by futures prices mid ers would hr able to borrow Treasury securities from the projected casing of pressures on resour ces were tlif S^U'in ( )|)CIL Markri Arnjinn Im ,-i IITIII IIE Jipj»r«»i expected to contribute tosome moderation in inflation mately one month against any collateral eligible for All in all. most members judged that a 75 basis point open market operations and the highest-quality private reduction in the target federal funds rate, to Z'A percent, residential mortgage-backed securities (MBS)." The ••'i .i^ .i]i|iin|M i: 1 n• Eo adilrthss thr fiiniliiitaliun of risks of new facility was designed to alleviate pressures In sluwingf'coriiMiiii" ^»iuw ill. inlliili(niiir\ pressures, Lsml thr - -11.1 r 1: II: _• markrls im sirurllirs. In adthlkin, financial market disruptions. In its statement, the Com- [hi1 ("rinuniurr agn-n^ in c-xpiiml the existing rrclpro- mittee highlighted the further weakening In the outlook cal currency agreements with the European Central for economic activity, but It also emphasized the Impor- Bank and the Swiss National Bank to $30 billion and tance of monitoring inflation developments carefully 56 billion, respectively, and to extend the terms of these ] In1 fl.iu ir\ ii will ,i[ Ihi111 n -1 • 11 c i: •; i m \|ii i[ 29 and agreement sthrough September 2008. Over llit> iwxt few 30 indicated that economic growlh had been weak in tljys, Miuni'ial nurkE'l slniins irilcusillrci lurlhi'r. (hi the first three months of 2008 and that core consumer March 16. the Federal Reserve announced emergency price hi Hal ion had slowed, but that overall inflation had measures to bolster liquidity and promote orderly func- remained elevated. FOMC participants Indicated that these developments had been broadly consistent with i iii -1 r expri'laliiins. t^oiidiiiuns arrn%^ 3 11 • 111 i 1: • 1 • •: liiuu< \Z. By iKHallon vcnc compldnl on Maich 20. AAA ralrd commw cial markets were judged to have improved since the cEat MBS Hfrr aiWfd In Ihr IN uf arr 86 rfit' Fetkr;tl Awn r S\ \tvm M March meeting* buE financial markets remained under was expanded to include all AAA-raled asset-backed considerable Stress. Although the likelihood thai eco- securities, in addition, Chairman Bernanke announced nomic activity would be severely disrupted by a sharp his tnEenlion to expand the Term Auction Facility to deterioration in IULIILC i\A nidrkcls had upparenllv u-tnl 5I5U liillii.ui under Utburiiy ureviuusly dcli-^atnl by ctl must jh.ic 1 iL ipanls IIUHLJJIH that lln1 risks tn i^cinomic 1111• Ekhird (ij (^n\[b^J1C}^^. growth were Mill \kv\\red Mi the downside. All panic] A| lhe lime Of lhe meeling held June 24 and 25P the pants expressed roncem ABOUT upside risks lo inflation availnhle jndicalnrs snggesie<l Ihnl ecnnon)ic acltvjiy posed by rising commodity prices and ihc deprecia- in Ihe iirsl half of ihc year had not been as weak as had lion of C he dollar but sonic partic ipants noted thai ihe been expected in April. Nevertheless, several factors downside risks to economic activity also implied lhat were viewed as likely to restrain activity in the near there were downside risks to price pressures as welL 1ILIIII Lin luiEiiiL] [fir nmErLtiiinii in llu1 lum^in^ wt Participants expressed significant uncertainty concern- tor, sharply higher energy prices, and continued tight iii1! [lir jjiprnpriiiie >i.niui cif in 'I.L]\ JHIIKV !TI I!M -V credit i nnnlili^jr-i. Milum^li MiiiiiuJLiI market cnntlkiotiis dKumStaOCes, Some participants noted chat ihe level ^L'IHT.LII\ .\\I\-M .II rd [» have improved mnc]es|h \ince of the federal funds target, especially when compared Hie April meeting, paiiiripaiTCS noted Ihat the polcnnal with the current rate of inflation, was relatively low by for advene •• •• •• I market developn^encs slilL posed historical standards. Others noted lhat linanclal market sign if i cant downside risks lo economic activity. The stminvancl i-lc\ ;iii-il risk spre^d^ hfld ciffsei nmrh nf |he furltier large incrpase in energy prices ALSO prompted effects of policy easing on therosi of rredi l totiomm ,io upwHird re\ isimi nfpmj^ tiims For nvcrall •• •: l.n i> 3-n ers. On Iwlance, most meml>ers agreed lliai thp isrgE'l in Ihe seroiid half of 2008, Most participants expected for Ihc federal funds rsle should be lowered 25 basis thai a leveling-oul of energy prices and continued slack points, to 2 percenl. The Comniiltee expecled thai the in resource utilization would lead inilation to moderate policy easing would help lo foster moderate growth In 2009 and 2010. bul the persistent tendency in recent over lime without impeding a moderation in initiation. years for commodity prices lo exceed the trajectory Ihe CniiiniiiTrr j^recd ili;ii. in ti^lit of I In1 MII}\[JTHJJI implied tiy Entun's nsjrkei prices en^endi'nul ccinsitler piiliry ezisiiif; ic^cljite jincI the on^iiin^ measures |ci femef nlile uiiciTljinlv unniEid lilt' pnijecti'il [ncHleriilion CJI financial umrkiE |i(|ui{lily. Lhe risks lo growth were mm inHalitin. Members generally agreed that ihp downside iiniri- closely haJartced by the risks lo inlialion. risks lo growth hail eased somewhat since the previ- In view of persisting strains in funding markets, ihc ous FOMC meeting while the upside risks to inflation FOMC also approved proposals toexpand the liquid- had intensified. Against this backdrop, mosl members Liv arrangements lhat had been put in place in previous judged (hat maintaining the current stance of policy al months. The reciprocal currency agreements with the this meeting represented an appropriate balancing of the European Centra* Bank and Swiss National Bank weFe risks lo Lhe economic outlook, Monelhelessr policymak inrrravrd (u $5(1 ti ill ion aiul SI? hillLEiii, respectively, ers refo^ni/i'd that cirtiiinsLiiiLccs cnul-cl {lumge ijiiicklv HIW! bcith were enti'ntletl thremjih Jantijry Z009r The c«l- .nit] noted iliiir they might neeel [n responii prcimptt) 10 lalefal accepted by the Term Seciirilics [ending Facility incoming information ahuui ihc evolution of risks. 87 Part 4 Summary of Economic Projections Tito following material appears as ait addotttttna to tht* TableI. Economic projections or Federal Reserve Governors miftuirs fifthfjttaf 24 25, 2008, ntfviing iif/tir Frdrfiil and Reserve Bank presidents. June anon Open M Fnrrrt am emg | ZOIQ ttril in.tr. i Fn mnjunrlion with the Jane 2008 FOMC meeting, the [ huvr in rrJ C.llf 1 Ota 1 EZDlaZS JStoJO members or t HE Board or Governors and the presidents Aprbt pf>^« iMw .O3blJ Z.OlaZ.I ZAtoJLi orthe Federal Reserve Banks, all of wham participate S.3l>S.ft SO to 16 Apil yn^n ik^. in deliberations of the FOMC. provided projections for Z.DMZ.J lflbZP rtcinnmu- growth, oncmpltAiitt-M, aiul iullaiiim in ZtXJH, 1 :.T. ) ? 21KH). JIiicI £010. J'rujirimns i«*re tuisifl mi intnniLUinri IfhiZ.I 1 7to 19 avai lable through the conclusion of Ihc June meeting, on each participant's assumptions regarding a range UUtoitUl 1 .fig XV :ato3 5 of factors likely to affect economic outcomes, and oti O.Otl S I.SulO Uto3Ll his or her assessment of appropriate monetary poiky. ISMU UKU SflioSS "Appropriate monetary policy" is defined as the future WinM IkKh.it [KJIH s lhal. based {HI currem inFunnalicm. \\ iffemrii April fHijAHfq l.7ia3.Ch 1S»?.O most likely to foster outcomes for economic activity and Inflation that best satisfy the participant's interpretation IT la Z Z 1 3to?.Q a\ ihc Federal Re serve's dual objectives or maximum N<J:I ' hufrt Iwmi DI <ka^(r in irjl ppuw dunw-JK piodurE U--1J1'I ad iJ tnftflloi Jlr fivnt thr fmtih qnriin of ihr prvkn^ >M in itv (HHUI^ ipuirf c J employment and price stability. iVhrjnmlji jlnJ ft> itinjtkKi jnl i ixr rt I in CMH n jrr Ihr prir rnttjfr TJ(*-L LJ If cung^ri n.r ir^finl ih T K. Ihr Hkr indr v ruri pcrmnfti E umunvriiufi cAUMrttnMn FOMC part icipants generally expected that, over the IPC h> iod dif pitct hdft hf KE ntUkiR roodjod «wjp. ?ntfHiiixp. tar tht remainder ofthis year, output would expand at a pace i^ra^ojwd nMt- JIT rw Ihr JH CTJJP1 cii Hun unrmphn mral ratr n to IDHIII njwin nf HIT ir« jpjk^Onl l>h p«ltdpB«"i pnjnrtkHn «r tudrf m te w appreciably L;ELMV its trend rate, owing primarily lo brr rtfl^vmM <rf juinMUIr innrlii^ notici f cinliiiui-d uraknesN in linn^iui1, Niarki-K. ihv Mibstaniidl I [ h<-1 rnllJI Irratnx ^ r\x kiiJn Ibr 1hrir httfrU jnj 1htrr IIFHTM fit^ntlnn RISE in energy prices in recent mcinihs. n\u\ the reduc- rof f« b ^ubk tn t* k \TM tion in the availability of household and business credit fnm totnl to b^hnj (o DM lauUr'ui 4m in resulting from continued strains in iinanclal markets. As Indicated In lahle 1 and rigure U output growth further ahead was projected to pick upsufficiently to begin The Outlook to RWtnc untie of THE increase in (he unemployment rate by 2010. In light of the recent surge in the prices The central tendency of participants' projections for of oil and agricultural commodities, lota! inflation was real GDPgrowth in 2008. at 1.0 percent to 1 .6 percent. expected to rise further in coming months and to lie ele- was noticeably higher than the central tendencyof vated for 2008 as a whole. However, many participants the projections provided in conjunction with the April expected that persistent economic slack and a flattening FOMC meeting, which was 0.3 percenl to 1.2 percent. ciul tt\ i-m-r^Y iirnl OIIKT f ciirimiKliCY prices in linr wilh The upward revmtni tu the 2008 out look stemmed Fuiures uiarkel prices ivciuld rauw* IIYCMII inil;nn:ni to [irimarilv from lMitli'r-[Jianexp(i."Uid tljta fin cnnsiimer decline notia'sbh in 2009 and 2010. Most participants and business spending received between the April and judged that grealer- than-notmal uncertainly surrounded June FOMC meetings. Nonetheless, several participants their projections for both output growth and Inflation. noted thai the recent firmness In consumer spend- A signiflcanl majority of participants v iewed the risks ing could well prove transitory and thait in' ongoing tu i In ii Fim-fasts furnutpul gTiiwth as un^lni-tl lc> ihe housing market correction, tigh t credit conditions, and cln^insicle, ami a similar IIIIIIIIHT saiv I he risks lei [he i=U• •-.!Li• • I ibnerg>' prn ••••• wmilii ilarupflniiH^lic {k'maiul inflation outlook as skewed to the upside. in the second halfof this year. Still, the substantial eas- 88 40 Moneiary Policy Repon to the Congress July 2008 Central Hndtnda and ranges of economic projections. 2008-10 {."funge in FL'JI GDP — t • U'nlral mtaQ j — J — 1 I I 2OD1 20O4 MM M» 2007 200t 2004 2010 PttWM — * — J JOM 2004 IOW 2006 2007 1008 20W 2010 — 4 — 3 — 2 — 1 2'Hl.l 20« MU5 Core PCE inflation — 4 — 3 — 2 — 1 ll IhlinilriHHDrviinihloarcinilK n:*?*Imuhk I. Thedi[ufortlwKliul vulucfttif Ihtf vanjhlcs j 89 Boanf of Governors of (he Federal Reserve System A I i ng cif monetary p»l it"y s IIKT ] A\\ year -i m 11 he roii t i n LU -i I might remain slightly above its longer-run sustainable strength in exports shcnilt] help to support i-ronomic level even in 2010: total inHalion in 2010 was also growlh; in addition, st rains had cased somewhat in judged likely lo continue to run a bit ABOVE levels that some financial markets since April. Real GDP growth IIHKI i•.11 Jii L|>.uii\ vaw avconsistrnl wilh ihe pricr sta was expected lo increase in 2009 as [he adjuslmenE bility objersive of ihe Federal Reserve's dual nunuhiti'. in the housing sector ran its course, financial niarkels Most participants saw further declines in btnti nnE'ni- gradually resumed more-normal functioning, and the plovmcnl and inflation ss likely in the period beyond downward pressure on real incomes ste mming from the. forecast horizon. (Sec table 1 on page 39 and Increases in energy and food prices in t he lirst half of figure 1 on page 40). 2008 began lo fade. In 2010, economic activity was projected Ki expand at or a link1 alxivc participanls estimates of the rate of trend growth, Risks to the Outlook With oulpul growth continuing lo run below trend in the second half of 2003, most participants expected Most participants viewed the risks to their projec- ifi.ii rln- liiirniplnh, inrin i ,i[i- would iimvi1 ii[i ^unteuliHii tions for GDP growth as weighted lo the downside over the remainder of this year The central tendency of and the associated risks lo their projections for the ]KII 11L b|)JllLS |)luf(( UullS fllf till" <)\fMj.»r r Ll IL1 (hi llllt'JIl unemployment rate as lilted lo the upside. The pos- ployment in t he fourthi juarter of 20UH was 5.5 percent sihiliu due Imute priies t mild CJL-I ILJLL*1 nmre sfrrph1 t(t 5.7 penem, unclunited I'mm the ft1rural tendency of than aniicipatMl. rurihtir r«hicinn, htigsehcilds' V.L-.IIIIL projections that were provided in conjunction wilh the stricting their access to credit, and eroding ibr capital April FOMC meeting and consistent with some slack of lending institutions, continued lo \K perceived as a in resource utilization. The central tendency of partici- significant downside risfc to the outlook for economic pants' projections was for the unemployment rate to sta- growth. Although financial markets had shown some bilize in 2009 and toedge down in 2010 as output and further improvement since April, conditions in those employment growth pick up. markets remained strained: a number of participants The surge in the prices of oil and agricultural com- also |xnnk(l lt> die risk dni[ further iruprcuernpiic {ciuid nictdiiii's siiife April led pjirtLc*ipjinis to rt-visc up hi- cjuile slmv and vubjnc Hi rc'ljpv. Ihr piitejilijil fur noticeably Iheir projection* for toul inflation in ihe (iirreui lighi credit ruTidiiiim* t» I'^eri an mirxperiedly near temn. However, the central tendency of partici- large ml mini nn houvholii and business spending was pants' projections for core PCE inOalion in 2D08 was also viewer! as a significant downside risk to economir 2,2 percent to 2,4 percent, unchanged from ihc central activity. An adverse feedback loop, in which weaker tendency in April, as !OW er-lhan -cxpecled rates of core economic activity led to a further worsening of financial inflation over recent months offset the expectations of conditions, which in turn could damp economicgrowth some [iniss thruu^li of die reteni surge in energy prices even further, continued lo be viewed as a worrisome Lntu fnre icitiaiinn irter die w.xt U-\\ numilis Rain of possibility, though less so than in April Indeed, some IHJ11 L DM't.til and ccirr inil.nnjii were L'\|M-( d'd |ci decline parltfi|ijnls p^inn. il N) die ^pjiareul n^iltciir i1 nf ihe iiver MM* n^xt tMQ yearv relleciing n rtaneninj" ciui of U.S. ercinmny in iho farr cifreteiu ticiam ial {liMrcs^ .sud the prices of oil and oiher commodities consistent with suggested that the adverse effects of financial develop- futures market prices, slack in resource ulilizalion. and ments on economic activity outside of the housing sec- longer-term inflation expectations mat were expected to tor could prove tobe more modest than anticipated. remain generally well anchored. Most participants viewed the risks to their inflation The contour of participants' projections for output projections as weighted lo ihe upside. Recent sharp gTuwth, miemptoyinenj, aiul inliaiioit iv^s importantly increases in energy and food prices and the pass - sha|]rd \i\ their jutJ^niE'iiTs aljciui die measurcfl rales through of dollar depreciation into import prices could (hi imljfimi rcinsisteni wilh die Fedrnd Resen'c'i ilu.il THKISI inflation in die uejir lenit by umre IILIII cunrnEly mamlale tt> |jroinoie ni^ximuni emplciymenl and price anlicipale<l AllJinugti parciripjnis grnemJIy assunie^l stability and about the time horizon over which policy that commodity prices will flatten out. roughly in line should aim to attain those rates given current economic with the trajectory implied by futures prices, the fart conditions. Most participantsjudged that it might take that futures markets had persistently undcrpredicted a substantial period of lime for output and in flation to commodity prices in recent experience was viewed as recover from the recent shocks, whEch had elevated ,ni LipsiUi- tisk IL> 1311- •:11]111 II ik trir iiii:,niiin. F:ariii ij.uni1-. infl ATioni and damped economic activity. A number of also saw a risk that inflation expectations could become ji.n in. L|:uiiL\ ]»t)|L={ Li (I ili.it liter rate of unemployment less llnnly anchored, particularly if the current elevated 42 Monetary Policy Report lo the Congress July 2008 rates of headline Inflation did not moderate as quickly Table 2. Average historical projectione rror r as they expected Participants continued to view uncertainty about the ZOOS 2MB outlook for economic activity as higher lhau normal, 9±U ll.l with a number pointing to uncertainly about the dura- tion and effects of the ongoing Hnancial strainson real activity- In addition, participants expressed noticeably \< in: h(nn nantMhawi awitiH pkn M nitam thf- toot mrw M|iiJ( nn ir i- mnriE.iHt;-'. atkiut thrii inflation pruJLtliuns than they had In January anil April, a shift in perception thai Ifi ibf bo\ "Fwcui LiKcrulm, uoiW • nUin tp they attributed importantly to increased uncertainly flbnC 170 prrrrnt pipbjhilJ^ itut «iui] auimnHT Iv ITJI t'Uf. wn mfil m>mnH. aboul Ibe future course of ENERGY and food prices and jfd tmuinn p*wr% will br 1B rm&\ in^Jlrd Ih llv iirrap- ILFTJ pm)n4ian nnnnyrtaik pw. Fdihrf UTuiuiian ksii Hi^ hi Rtfu hvkW ad Prtn (o greater uncertainly about the extent of pass through Tvlipl2(»7L'tJi«ii*lbtliKrTtilA rfUtr Erqwmk UulwA from Nnlorittl of changes in [hose prices Into core inflation, ft able 2 o lo rG nx n i r l n l^ M I \ h o n r< rn b , r " F f A ln kf i a n l r R J n «d n v h r m S^ x w n n H L i D N n m ri ^ n t ^ i u r n tl Snin ^OOJ M {EfciMtl provides estimates of forecast uncertainty for real (.DP 1. Fu nrJdrillUH. lrf« In ftntrMl AUr la LtMr I growth, umTii|jtuv[iHhi][, mill inflaiion since 1987.") 2. Mf«MTh kfctmmll imunh pNkr tsdn. lb< pfkr IHWT ikM hn bcra RHHt it-Mtty mrd la jpjifTumrft «ioJ pivitr nwHtntr rwrr-Jdtv ftnfrc- itan h pnrnd ik^ fmulh QBirtrr of Ibr prrtop jmr m (br fwrth quMln f f a f t rf Diversity of Participants' Views Figures 2.A and 2.B provide more detail on the diver- which {Hil|Mil nml i'mplcivmejil n{iii!{l recover in ^OdS), sity of participants' views regarding likely economic wilh wmp p^rtit i[wni\ rxpm%ingu cynrrm Mini grciuih outcomes over the projection period. The dispersion of illi'.llil In- ( onsCr.iilH i\ h\ thr fM-lSJ^N-IH i- <M 1:11,1114 i.ll participants' projections for real CDP growth in ZOOS strains over a considerable period. Thedispersion of was noticeably narrower than In the forecasts provided part icipants' longer-term projections was atso affceied In April , reflecting primarily the accumulation of data to some degree bydifferences in their judgments aboul aboul the actual performance of Ibe economy in the the economys trend growth rate and the unemployment first half of the year; their views aboul output growth rate that would be consistent over time with maximum In coming quarters and In M09 continued lo exhibit employment. The dispersion of the projections for PCE appreciable dispersion. The dispersion of participants' mHalion in the near term reflected in large part differ- projections for real activity next year seemed largely to ing views on the extent to which recent increases in retire! differing assessments of tile effects of adverse energy and food prices would pass through inlo higher financial market conditions on economic growlh. the consumer prices. In addition, participants held differ speed with which credit conditions might improve, and tng views on the degree to which inHalion expectations Ihe depth and dunilion of thecorrection in the housing were anchored and the role that expectations might play market. Indeed, views differed notably on the paceat In the inflation process over the short and medium term. Participants' Inflation projections furt her ahead were shaped by the views of the rale of in Hal ion consistent ll. TV box "l-omriM UnrrftaLnEy' Jl llr rod of ihii vimnun with the Federal Reserve's dual objectives and Ibe lime dLvrascrt the wurm 3ml 1-iErrprrtai wtn of urn trlainly in rronomk" it would lake to achieve these goats given current eco- f<xrra.\l\ and rxplalu^ ihr appnuch inei\ la lura ihr unrctiainfi And Tisk-i JllmtLn^ pjii kipjni *" prnjrrliofn. nomic conditions and appropriate policy. 91 Board ofGovernors of 'tiw Federal Reserve System 43 Figure 2,A. Dislributfon of participants" projections for the change in real <JDP and for Ihc unemployment rule. 2QQB-1P (h..;f iartiH.DP L ntmnloi mmi raCi — 14 — 11 — 10 — • — I 4.3 S.Q 5.2 $.i 5ft 5.S 4.9 5.1 J.J 5.J 5.7 5.9 Ifi — H — 12 — 10 — • — A J 5.0 J.S 0.0 6.2 4. 5 I.I S.J 5.7 V9 b.1 6i — 16 — N — IZ — 10 — > — 6 — 4 M ^D 5.1 $4 3.0 S.S 4^ 3 1 5J J.5 5.7 5Q intkjen^fJI IV.XC IUul AA Monrtaiy Policy Rep-url L» Ihe Congress July 2UH8 Figure IK. l>Lh.[rihuiELi]-i 1 projections for PCE inflation and ihreorePOiinflanflation. -OdK HJ <.I. PC1- inflation — 16 B Jlunc proJL-clion « l|-i i ;•:•.• ii-iJiii- — H " Aprilp — 15 — 10 — 1 — ft .nil.. I.I JJ 14 -20M If, — -IJ - i: - ID — * i . — 6 1.4 Id L.h U U — 16 |J L J — 6 — A — 2 |J I.T FA 11 II 1-i J-I 1* J.L iJ I.S 1.T vi j i .114- iH. IK i\y i i IA U U U *.3 Lt U UUU <+ -". Pncminiip li HI; PcfimliLin* nl' vjnnhlcs. jf^ I \t Lfcf EflVniJ rwHc lii tqbk 1. 93 Boaid of Covernors ofihe Federal Reserve System 45 Forecasi Uncertainty The Konomic projections provided hy the projections i-s similar to that experienced m ihe member of the Board of Governors and the \wA and the rista around the projections are presidents of the Federal Reserve Banks inform broadly balanced, the numbers reported in table discussions of monetary policy ^.monp policy- 2 would imply a probability of about 70 percent makera and can aid public understanding of the that ad HA l GDP would expand 2A percent lo haiis for policy act ions. Considerable uncer- i.O percent in the current year, 1.7 percent lo toiii-Ey attends threw projection^ hovwwr. The 4,3 percent [n ihe second year, and 1 .h percent economic and statistical models and relation- to 4.4 percent in Ihe third year. The correspond- ships used to help produce economic forecasts ing 70 percent confidence interval for overall are necessarily Imperfect descriptions of ibe real Inflation would be1A percent to 2,fr percent in world. And the future path of ihe economy can the current year and 1.0 percent lo 3.0 percent be affected by myriad unforeseen development in the second and iliird years, )nd evenK. Thuh, in M.'l1rnn ihe iiliirKt? cif riiurt- Bee Ltust-1 c LJITI'I.-JII condiiicins may differ from etary policy. participa nts consider not only wftal those t hat prevailed on average over history, appears to be Ihe most Eikely economic outcome participants provide judgments as to whether ihe as embodied in iheir projections, hut also ihe uncertainly attached to their projections of each i.ii ,,.• i..: .ii1iTii.i1ivf istts'.ihililii".. ill'1 MtcliFinorl .IIi.ilih' is greater than, smaller than, or broadly of their occurring, and the polenltsl m>^ to the similar to lypicaI levels of forecast uncerlainly economy shoutd they occur. in the past as shown in table 2. Participants Table 2 (see pafie 42} summarizes the aver- also provide judgments as lo whether ihe risks a in g c e l u h d is in to g r i t c h a o l s a e c r c tC u | r i[ a » c rt y r- d o f i n a p r i a i n st g M e o o n f o fo -M re r c y a P st o s l , icy t d o o w Ih n e s ir i d p e ro , o je r c a ti r o e n s b r a o r a e d w ly e b ig a h la te n d c e to d . I h T e h a u i p i s s i , d p e a j r- Reports and those prepared by Federal Reserve tic ipants judge whether each variable is more Board staff in advance of meetings of [he federal likely to be above or below their protections of Open Mcirkt-l Commitlec. The projection error the most likely outcome. These judgments about ranges shown bi ihe table illustrate the consid- Ifir inn r'M.iiriU ,in. I llit' rrk- .Mr hnu. K-.H FI erabJe uncertainty associated with economic participant's projections are distinct from ihe forecasts. For example, suppose a participant diversity of partic ipants' views about ihe most projects that real uross domestic product (GDP) likely outcomes. Forecast uncertainty is con- and total consumer prices will rise steadily at cerned wilh the risks associated with a particular annual rates ofr respectively, 3 percent and projection, raiher ihan wilh divergences across a 2 percent. If the uncertainly atlendiinji those number of different projections,.

Ben S. Bernanke (2008, July 14). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_20080715_chair_federal_reserves_second_monetary_policy

@misc{wtfs_testimony_20080715_chair_federal_reserves_second_monetary_policy,
  author = {Ben S. Bernanke},
  title = {Congressional Testimony},
  year = {2008},
  month = {Jul},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_20080715_chair_federal_reserves_second_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}