U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001

26–643 PDF 2006

S. HRG. 109–325

FEDERAL RESERVE’S FIRST MONETARY POLICY

REPORT FOR 2006

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

SECOND SESSION

ON

OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978

FEBRUARY 16, 2006

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

MEL MARTINEZ, Florida

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

ROBERT MENENDEZ, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

MARK OESTERLE, Counsel

PEGGY R. KUHN, Senior Financial Economist

DEAN V. SHAHINIAN, Democratic Counsel

AARON D. KLEIN, Democratic Economist

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

THURSDAY, FEBRUARY 16, 2006

Page

Opening statement of Chairman Shelby ................................................................ 1

Opening statements, comments, or prepared statements of:

Senator Reed ..................................................................................................... 2

Senator Bunning ............................................................................................... 3

Senator Menendez ............................................................................................ 4

Senator Sununu ................................................................................................ 4

Senator Stabenow ............................................................................................. 4

Senator Dole ...................................................................................................... 5

Senator Carper ................................................................................................. 6

Senator Crapo ................................................................................................... 7

Senator Sarbanes .............................................................................................. 8

Senator Bayh .................................................................................................... 8

WITNESS

Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve

System, Washington, DC ..................................................................................... 9

Prepared statement .......................................................................................... 35

Response to written questions of:

Senator Menendez ..................................................................................... 39

Senator Crapo ............................................................................................ 43

Senator Enzi .............................................................................................. 43

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Monetary Policy Report to the Congress, February 15, 2006 .............................. 46

Letter to Senator John E. Sununu from Alan Greenspan, Chairman, Board

of Governors of the Federal Reserve System dated January 3, 2006 .............. 74

(III)

(1)

FEDERAL RESERVE’S FIRST MONETARY

POLICY REPORT FOR 2006

THURSDAY, FEBRUARY 16, 2006

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Committee met at 10:02 a.m., in room SD–538, Dirksen Senate Office Building, Senator Richard C. Shelby (Chairman of the

Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order. We are very

pleased this morning to welcome Chairman Bernanke before the

Committee on Banking, Housing, and Urban Affairs to provide his

first testimony on the Federal Reserve Semiannual Monetary Policy Report to the Congress. On behalf of this Committee, I want to

congratulate Dr. Bernanke on becoming only the 14th Chairman of

the Federal Reserve Board. This Committee has had the opportunity to work with you in your previous tenure as Board Governor

and as Chairman of the Council on Economic Advisors. We look forward to continuing that good and productive relationship as you

guide the Federal Reserve System over the next years.

Our hearing this morning serves as an important part of the

Committee’s oversight function over the Federal Reserve System. It

is also an important mechanism for assuring that Congress maintains accountability over the Fed’s policies and operations. Within

broad statutory parameters, the Fed sets and implements U.S.

monetary policy independent from the Congress and the President.

This hearing, which is also required by statute, provides the Congress an opportunity to have an open and detailed discussion and

debate about the Fed’s monetary policy goals and their implementation.

Chairman Bernanke, your testimony and report this morning

note the economy’s impressive performance in 2005. GDP growth

continues to be strong and core inflation remain moderate. We also

saw continued improvement in the labor markets with the number

of jobs created and a low unemployment rate.

At its meeting on January 31, the Federal Open Market Committee raised its target for the Federal funds rate by 25 basis

points to 4.5 percent. This is the 14th increase since June 2004

when the FOMC began raising the target rate from a low of 1 percent. The Federal Open Market Committee will meet next at the

end of March, its first session under your leadership. Clearly, new

economic data will be reported and other events will transpire beVerDate 11-MAY-2000 17:43 Mar 27, 2006 Jkt 025856 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 26643.TXT SBANK4 PsN: SBANK4
2

tween now and then so you cannot tell us exactly what will happen

at that meeting and you should not. However, our discussion this

morning gives us the opportunity to discuss which factors will be

significant in your deliberations leading up to that meeting. In that

sense, we hope our hearing and discussion this morning can add

to the transparency of the FOMC process.

Mr. Chairman, this Committee is eager to hear your views on the

future direction of our Nation’s economy and how you plan to guide

the Federal Reserve System in the months and years ahead. I look

forward to raising a number of issues during our discussion this

morning.

Senator Reed, do you have an opening statement?

STATEMENT OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman, and thank

you, Chairman Bernanke. Welcome and congratulations. You come

to this job, Mr. Chairman, with considerable bipartisan goodwill,

with very strong academic credentials, and a reputation for independent thinking, and you will need to draw on all these resources

as you confront an economy that seems to be humming along on

the surface, but in fact there is a number of lurking problems,

problems such as large budget deficits, a record trade deficit, negative household saving rate, high energy prices, and a disappointing

labor market recovery. All of these pose tremendous challenges in

setting monetary policy.

We welcome your championship of greater openness and

demystification of the Fed. You really assured us during the confirmation process that you are sensitive to the multiple goals of

monetary policy so I hope that you will continue the Greenspan

model of responding to changing economic circumstances with flexibility rather than a rigid adherence to a predetermined policy.

Now, critical tests will be balancing the goals of fighting inflation

with allowing sufficient employment growth. These are difficult

economic times for many Americans who are facing stagnant incomes, rising costs for health care, rising costs of home heating, rising costs for education, and so I hope, Chairman Bernanke, that

you will look hard at the economic data at the FOMC meetings

rather than allowing some type of rigid plan to take hold.

GDP is growing, but the typical American worker has been left

out of the economic gains of this recovery. Strong proprietary gains

have shown up in the bottom lines of shareholders but not in the

paychecks of many workers. Clearly, there is room for real wages

to catch up with productivity before the Fed needs to worry about

inflationary pressure from the labor market.

Finally, I hope you keep your promise to not comment on the

public policy matters beyond the realm of monetary policy and to

remain politically independent. I think that will be a major service

to the Nation. I look forward to your discussion about the issues

that are important to all of us today and thank you, again, for not

only attending but also your service.

Chairman SHELBY. Senator Bunning.

3

STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. Thank you, Mr. Chairman. Welcome, Chairman Bernanke, to your first appearance before this Committee as

Chairman of the Federal Reserve.

I would like to point out that at the beginning of your hearing

yesterday, the stock market indexes jumped and then fell throughout the hearing. Fortunately, after it was over they recovered and

ended up back in positive territory.

On the way out the door last month, Chairman Greenspan left

us with another hike in interest rates to 4.5 percent. His recent

comments, which came at a much higher price to his fellow diners

than the taxpayers, seem to have tied your hands at the beginning

of your term.

You will not chair your first FOMC meeting until next month,

but it is already taken for granted that another rate hike is coming

and probably more after that. As I told Mr. Greenspan at his last

appearance before this Committee, I do not think that increases

are needed, especially with your projections of reasonable inflation

for the coming year.

I hope they do not continue until it is too late and damage is

done. Our economy is strong and inflation is low, despite high energy prices. Several other factors pose dangers to sustained economic growth in the short and long terms.

We all know that inverted yield curves have been a reliable indicator of trouble ahead. Increased Federal budget deficits cause uncertainty and long-term obligations will begin to soak up more and

more capital that could be put to other productive uses. And our

trade deficit means that we are more dependent on other countries

to sustain our lifestyle and could lead to job loss if we do not begin

to close the gap. Even with those negative factors hanging out

there, the Fed paints a strong picture of the economy.

During your confirmation process, I urged you to be independent

of the other Fed Members, as well as Congress and the executive

branch. I also stressed the importance of further openness at the

Fed and the tolerance of other viewpoints. In other words, I would

like to see less group-think.

I criticized your predecessor for speaking out of place when it

comes to policy matters that do not belong to the Fed. I encourage

you to stay away from those discussions and I am glad that to

some extent you did so yesterday.

Something about this town makes people want to be liked. The

longer someone stays here, the more they seem to want to be liked.

Maybe it has something to do with one day getting paid more than

your previous salary for attending a few dinners and not even having to pay for your own food.

Do not fall into that trap and do not be afraid to tell people ‘‘no.’’

It is an uncommon thing to say around here, but do not try to follow in the footsteps of your predecessor. In other words, be yourself, do not be ‘‘Greenspan-lite.’’ I hope when your time at the Fed

is over people will look back and see a record of doing no harm.

I think the decisions you and the other Board Members make in

the next few months will have a lot to do with the success of your

leadership at the Fed.

4

Thank you, Mr. Chairman, and I look forward to asking some

questions.

Chairman SHELBY. Senator Menendez.

STATEMENT OF SENATOR ROBERT MENENDEZ

Senator MENENDEZ. Thank you, Mr. Chairman. Mr. Chairman,

welcome, congratulations. We are pleased to welcome you, as a fellow New Jersian, and we know that you will do an exceptional job

in this regard. I certainly look forward to your testimony today and

to some of the challenges I think we face: The cooling off of the

housing market and what that may mean, rising energy prices,

consequences of deficit and debt, a variety of global influences, and

a dynamic, modern economy that we have.

Those are all the challenges that you face before you and so we

look forward to your stewardship in meeting, having a steady hand

in the midst of all of the dynamic realities that we face, so we look

forward to hearing your testimony, and once again congratulations

on your appointment, Mr. Chairman.

Chairman SHELBY. Thank you. Senator Sununu.

STATEMENT OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. Thank you, Mr. Chairman, and welcome,

Chairman Bernanke. Yesterday, you touched briefly on issues related to the GSE’s, better regulation of Fannie Mae and Freddie

Mac. This is something that has been of interest to the Committee.

We enacted legislation that you spoke to at the hearing yesterday, and I note that you emphasized two specific concerns with the

portfolios held by the GSE’s, one, the systemic risk that they create

inevitably because of the nature of the portfolios carrying interest

rate risk and prepayment risk, and two, the fact that they really

do not contribute directly to the GSE’s fulfilling their mission.

I appreciate you making these points, some points that are very

consistent with testimony and presentation by other representatives from the Fed in the past, and I think it is important because

we have an opportunity to take up legislation this year, probably

the best opportunity to improve the regulation of these large institutions that we will have in a long time.

Mr. Chairman, I have a letter that I received from the outgoing

Fed Chairman speaking to these issues at the beginning of January. I would ask that that be included in the record so that I do

not have to belabor these points in any greater detail.

Chairman SHELBY. It will be part of the record without objection.

Senator SUNUNU. I appreciate the comments that you made yesterday. Perhaps we will have an opportunity to get into them in

more detail, but not surprisingly you were very direct and plainspoken and I appreciate having you on the record.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Stabenow.

STATEMENT OF SENATOR DEBBIE STABENOW

Senator STABENOW. Thank you, Mr. Chairman, and welcome,

Chairman Bernanke. This is an important time and we wish you

all of the best as we all work together on so many issues that reVerDate 11-MAY-2000 17:43 Mar 27, 2006 Jkt 025856 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 26643.TXT SBANK4 PsN: SBANK4
5

late to our economy and what is happening in terms of monetary

policy.

The Annual Monetary Policy Report comes at a very important

time for many middle class Americans, and I know in my home

State right now, the headlines everyday relate to manufacturing

loss in Michigan and families are feeling squeezed on all sides from

concerns about losing their job, losing their pension, their health

care costs rising, businesses, manufacturers seeing their health

care costs go through the roof basically, and it relates to their ability to compete internationally.

We also know that issues of unfair trade practices are not just

words for us in manufacturing. In Michigan, things like currency

manipulation are real with Japan or with China when we look at

the differences in costs coming in. Counterfeiting, counterfeit auto

parts, which is a $12 billion business costs us 200,000 jobs.

So when we look at all of the issues, the fact that we have lost

2.4 million jobs, 2.4 million people plus their families. Since 2000,

we have lost over 200,000 jobs, families experiencing layoffs in the

last 5 years in my State alone. Just last year, 21,000 manufacturing jobs were lost. I say this because the trade deficit is a critical issue for us, a trade deficit now that is about twice as much

as the budget deficit, the budget deficit being the highest in our

Nation’s history, but the trade deficit now hitting $726 billion.

This is real for us and so I know your basket of economic metrics,

the international component, is just a piece of the analysis, but I

want to stress with you that this is extremely important piece to

us in manufacturing and in Michigan.

And I hope your analysis now and in the future will consider the

global issues that are devastating middle class families and devastating American businesses. We need to be focused on that. We

need your leadership, your thoughts, and your recommendations as

it relates to this global economy now and the international pressures, the unfair trade practices, the currency manipulation, other

kinds of issues in the economy, the way we fund health care which

is different than any other country in the world, and the impact on

our businesses.

All of these issues come down on the people that I represent, my

own family in Michigan and the others that I represent, and so I

hope this international component of your analysis is something

that you will place an emphasis on and work with us on as we address monetary issues and the economy in America.

Thank you.

Chairman SHELBY. Thank you, Senator. Senator Dole.

STATEMENT OF SENATOR ELIZABETH DOLE

Senator DOLE. Thank you, Mr. Chairman. Chairman Bernanke,

a very warm welcome to you. I certainly look forward to working

with you very closely in the months and years to come, and I have

every confidence in you. I want to underscore what Senator

Sununu said about the GSE’s, and one of the issues that I raised

when we met in November was the economic transition that we are

going through in North Carolina.

We continue to experience job loss, especially in textiles and furniture manufacturing. The national economy is indeed trending

6

positively, but I think we must continue to focus special attention

on the areas where people have lost their jobs, where companies

struggle to compete with foreign firms, and their dramatically

lower cost structures.

We have to work toward trade agreements that benefit American

workers and consumers and support jobs and growth in our domestic industries.

One issue I was focused on during my days as Secretary of Labor

was addressing the growing gap between skilled and unskilled

workers. Today in our changing economic environment, this gap

has unfortunately widened, and as our economy moves forward, the

opportunities for lower skilled workers are diminishing. We have to

do everything in our power to ensure that these people realize new

opportunities, educate our less skilled workers so they can take advantage of the new jobs that are being created.

To this end, I believe that we should take steps to improve trade

adjustment assistance and continue to make strengthening our

community colleges a top priority, and I might add that the Labor

Department has estimated that 80 percent of new jobs that are

going to be created over the next decade will require postsecondary

education.

Now, in my conversations with many North Carolinians, I hear

concerns about job creation, high energy and health care costs, and

our growing trade imbalance. I continue to have confidence that

the very forces that stimulate economic growth—tax relief to spur

investment, free but fair trade, ever-improving global communications, higher education and training for our workforce, and of

course hard work—these forces indeed will put us on a course toward greater opportunity for North Carolina and this Nation.

Mr. Chairman, thank you for being here today. I look forward to

your testimony and again to working closely with you. Thank you.

Chairman SHELBY. Senator Carper.

STATEMENT OF SENATOR THOMAS R. CARPER

Senator CARPER. Thanks, Mr. Chairman. Welcome. It is good to

have you back. Thank you for joining us today and again for your

service to our country.

I think others have indicated that they have an interest in questioning you on some of these same subjects. I will mention them

again. I will be asking you about our savings rate or really our lack

of savings or negative savings rate and what you think we are

doing right to turn that around and maybe what more we could do

or should do.

I want to also visit the issue, the interplay between the trade

deficit and the budget deficit, and the potential effect of doing the

wrong thing or not doing the right thing with respect to interest

rates going forward.

Playing into the trade deficit, our growing reliance on foreign oil.

I think I read the other day that our trade deficit for last year

topped out at a little bit more than $700 billion and roughly a third

of that is now our reliance on foreign oil.

And others have suggested—I think Senator Dole and I believe

Senator Sununu have mentioned the regulatory structure for Government Sponsored Enterprises, Fannie Mae, Freddie Mac, and

7

some of our Federal Home Loan Banks—and I understand, I read

in a news account that you addressed that in your testimony before

the House of Representatives, but I want us to have a chance

maybe to talk with you a bit further about that today.

And finally, just some general thoughts. Maybe put on your old

hat from one of your last jobs about economic policy, and just to

talk about some steps we need to take if our country is going to

continue to be an economic superpower in this century, what we

are doing right and what we are doing wrong, and what we need

to do differently, more of or less of.

Welcome. Thanks for coming.

Chairman SHELBY. Senator Crapo.

STATEMENT OF SENATOR MIKE CRAPO

Senator CRAPO. Thank you very much, Mr. Chairman, and

Chairman Bernanke, I welcome you to your first appearance before

this Committee. I look forward to many more and appreciate the

opportunity we have already had to work together on important

issues, and I am certain that the forecast and information that you

will give us today will be very helpful to us.

I share a lot of the other feelings that have already been expressed to you so I will not repeat them now. There are two issues

that I wanted to raise in addition to those, and if I am here when

it is time for questions, I will go through this a little more in questions, but I have three hearings going on today, one with a member

of the cabinet, one with the U.S. Trade Ambassador, and one with

yourself. And they are all going on right now.

So if I slip out to try to catch a little bit of one of those other

hearings and miss the chance to ask you questions, I wanted to

just toss these two things out right now.

We are getting very close to a markup on the regulatory reform

legislation that we have been working on for several years now,

and we are talking, I think, in terms of weeks, not months, before

we are going to move forward, and I would like to have some kind

of an indication from you as to when the Federal Reserve will be

able to give us its comments on the proposals that are out there.

So, I just toss that one out to you.

And then the second issue is one which you will probably hear

me talk to you a lot about as we have opportunities, and that is

the question of derivatives. I am very concerned about the potential

efforts in this Congress to change the manner in which we regulate

derivatives or to impact the manner in which derivatives operate

in the economy, and I would like to have your comments on the importance of having a strong, stable, and dynamic derivatives market in this country and what it means to our economy.

So, again, in addition to the other issues that we have talked

about, those are just a couple specific ones that I would like you

to think about. If I am not here to ask questions, maybe we can

talk later at a different time.

Thank you.

Chairman SHELBY. Senator Sarbanes.

8

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman. I join

my colleagues in welcoming Chairman Bernanke before the Committee. I think we had him last year at his nomination hearing in

November, and given the schedule, he went to the House first, not

by his choice. That was the process, I hasten to add, so that the

Members of the Committee do not feel slighted in any way, but actually I want to say just a word about that.

We think the Semiannual Report by the Fed is a very important

step forward in the transparency and oversight with respect to

monetary policy. It was a change that Chairman Greenspan welcomed at the time, and I think I recall we had talked about that,

and you indicated very strong support for that process as well.

And I think it does give the public a chance on a regular basis

for the Fed to come before the Congress and spell out its views

with respect to monetary policy and the health of the economy.

And Mr. Chairman, I want to thank you for your oversight and

focus in that regard. It is clearly important.

Chairman SHELBY. I had a good trainer.

Senator SARBANES. The Federal Reserve has a double mandate,

as we all know: Stable prices and maximum employment. And we

have seen in recent years that the goals are not inherently in conflict, as some had argued in the past, and we got unemployment

down to below 4 percent actually, inflation below 3 percent, and at

his hearing, Dr. Bernanke told the Committee, and I quote him,

that he ‘‘subscribes entirely to the Humphrey-Hawkins mandate

which puts employment growth and output growth on a fully equal

footing with inflation in terms of the Federal Reserve’s objectives.’’

And we look forward to working with him in that regard. I am

a little concerned about how sanguine we are about the economy.

Paul Volcker not long ago in an editorial in the Washington Post

said this about our economy:

Under the placid surface, there are disturbing trends, huge imbalances,

disequilibria, risks, call them what you will, although the circumstances seem to me

as dangerous and intractable as any I can remember, and I can remember quite a

lot.

Of course, the Commerce Department recently reported that our

Nation ran a record trade deficit of over $725 billion last year.

Warren Buffett summarized the situation: ‘‘Right now the rest of

the world owns [$] three trillion more of us than we own of them.

In my view, it will create political turmoil at some point. Pretty

soon, I think there will be a big adjustment.’’

And I hope to go into that with Chairman Bernanke when we

reach the question period or in subsequent meetings, but we welcome you back before the Committee as Chairman of the Fed, and

we wish you well in this new responsibility.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bayh.

STATEMENT OF SENATOR EVAN BAYH

Senator BAYH. Thank you, Mr. Chairman. Welcome, Chairman

Bernanke. Just two quick things. First, congratulations on apparently being able to speak in plain English and still not moving the

markets. That is quite an accomplishment.

9

Second, I want to follow up on something that Senator Sarbanes

mentioned. I am increasingly concerned with some of the global imbalances that are accumulating and their effect not only on our potential economic performance but also on our Nation’s security. I

am going to save my time for questions, but I would like to delve

into that with you later today and perhaps at a later point.

Having said that, I have learned from hard experience that we

are all here to hear from you, not from me, and so I would just congratulate you and welcome you again.

Chairman SHELBY. If you will put up with us for a few minutes,

Mr. Chairman, we have established a quorum, and at this time I

would like to move——

Senator SARBANES. Does he have an alternative to putting up

with us?

[Laughter.]

Chairman SHELBY. I am not going to say. If you will stay put just

a few minutes, Mr. Chairman.

[Recess.]

Chairman SHELBY. Chairman Bernanke, your written testimony

will be made part of the record. You may proceed. Welcome again

to the Committee.

Chairman BERNANKE. Thank you.

STATEMENT OF BEN S. BERNANKE, CHAIRMAN

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Chairman BERNANKE. Thank you. Mr. Chairman and Members of

the Committee, I am pleased to be here today to present the Federal Reserve’s Monetary Policy Report to the Congress. I look forward to working closely with the Members of this Committee on

issues of monetary policy as well as on matters regarding the other

responsibilities with which the Congress has charged the Federal

Reserve System.

The U.S. economy performed impressively in 2005. Real gross domestic product increased a bit more than 3 percent, building on the

sustained expansion that gained traction in the middle of 2003.

Payroll employment rose two million in 2005 and the unemployment rate fell below 5 percent. Productivity continued to advance

briskly.

The economy achieved these gains despite some significant obstacles. Energy prices rose substantially yet again in response to the

increasing global demand, hurricane-related disruptions to production, and concerns about the adequacy and reliability of supply.

The Gulf Coast region suffered through severe hurricanes that inflicted a terrible loss of life, destroyed homes, personal property,

businesses and infrastructure on a massive scale, and displaced

more than a million people. The storms also damaged facilities and

disrupted production in many industries with substantial effects on

the energy and petrochemical sectors and on the region’s ports.

Full recovery in the affected areas is likely to be slow. The hurricanes left an imprint on aggregate economic activity as well, seen

in part in the marked deceleration of real GDP in the fourth quarter. However, the most recent evidence, including indicators of production, the flow of new orders to businesses, weekly data on initial

10

claims for unemployment insurance, and the payroll employment

and retail sales figures for January, suggest that the economic expansion remains on track.

Inflation pressures increased in 2005. Steeply rising energy

prices pushed up overall inflation, raised business costs, and

squeezed household budgets. Nevertheless, the increase in prices

for personal consumption expenditures excluding food and energy,

at just below 2 percent, remained moderate, and longer-term inflation expectations appear to have been contained.

With the economy expanding at a solid pace, resource utilization

rising, cost pressures increasing, and short-term interest rates still

relatively low, the Federal Open Market Committee over the course

of 2005 continued the process of removing monetary policy accommodation, raising the Federal funds rate 2 percentage points in

eight increments of 25 basis points each. At its meeting on January

31 of this year, the FOMC raised the Federal funds rate another

one-quarter percentage point, bringing its level to 41⁄2 percent.

At that meeting, monetary policymakers also discussed the economic outlook for the next 2 years. The central tendency of the

forecast of Members of the Board of Governors and the Presidents

of the Federal Reserve Banks is for real GDP to increase about 31⁄2

percent in 2006 and 3 percent to 31⁄2 percent in 2007. The civilian

unemployment rate is expected to finish both 2006 and 2007 at a

level between 43⁄4 percent and 5 percent. Inflation, as measured by

the price index for personal consumption expenditures excluding

food and energy, is predicted to be about 2 percent this year and

13⁄4 percent to 2 percent next year. While considerable uncertainty

surrounds any economic forecast extending nearly 2 years, I am

comfortable with these projections.

In the announcement following the January 31 meeting, the Federal Reserve pointed to risks that could add to inflation pressures.

Among those risks is the possibility that to a greater extent than

we now anticipate, higher energy prices may pass through into the

prices of nonenergy goods and services or have a persistent effect

on inflation expectations. Another factor bearing on the inflation

outlook is that the economy appears now to be operating at a relatively high level of resource utilization. Gauging the economy’s

sustainable potential is difficult and the Federal Reserve will keep

a close eye on all the relevant evidence and be flexible in making

those judgments. Nevertheless, the risk exists that with aggregate

demand exhibiting considerable momentum, output could overshoot

its sustainable path, leading ultimately—in the absence of countervailing monetary policy action—to further upward pressure on

inflation. In these circumstances, the FOMC judged that some further firming of monetary policy may be necessary, an assessment

with which I concur.

Not all of the risks to the economy concern inflation. For example, a number of indicators point to a slowing in the housing market. Some cooling of the housing market is to be expected and

would not be inconsistent with continued solid growth of overall

economic activity. However, given the substantial gains in house

prices, and the high levels of home construction activity over the

past several years, prices and construction could decelerate more

rapidly than currently seems likely. Slower growth in home equity,

11

in turn, might lead households to boost their saving and trim their

spending relative to current income by more than is now anticipated. The possibility of significant further increases in energy

prices represents an additional risk to the economy. Besides affecting inflation, such increases might also hurt consumer confidence

and thereby reduce spending on nonenergy goods and services.

Although the outlook contains significant uncertainties, it is clear

substantial progress has been made in removing monetary policy

accommodation. As a consequence, in coming quarters, the FOMC

will have to make ongoing, provisional judgments about the risks

to both inflation and growth, and monetary actions will be increasingly dependent on incoming data.

As I noted, core inflation has been moderate despite sharp increases in energy prices. A key factor in this regard has been confidence on the part of public and investors in the prospects for price

stability. Maintaining expectations of low and stable inflation is an

essential element in the Federal Reserve’s effort to promote price

stability, and thus far the news has been good. Measures of longerterm inflation expectations have responded only a little to larger

fluctuations in energy prices that we have experienced, and for the

most part they were low and stable last year.

Inflation prospects are important, not just because price stability

is in itself desirable and part of the Federal Reserve’s mandate

from the Congress, but also because price stability is essential for

strong and stable growth of output and employment. Stable prices

promote long-term economic growth by allowing households and

firms to make economic decisions and undertake productive activities with fewer concerns about large or unanticipated changes in

the price level and their attendant financial consequences. Experience shows that low and stable inflation and inflation expectations

are also associated with greater short-term stability and output

and employment, perhaps in part because they give the central

bank greater latitude to counter transitory disturbances to the

economy. Similarly, the attainment of the statutory goal of moderate long-term interest rates requires price stability, because only

then are the inflation premiums that investors demand for holding

long-term instruments kept to a minimum. In sum, achieving price

stability is not only important in itself; but it is also central to attaining the Federal Reserve’s other mandated objectives of maximum sustainable employment and moderate long-term interest

rates.

As always, however, translating the Federal Reserve’s general

economic objectives into operational decisions about the stance of

monetary policy poses many challenges. Over the past few decades,

policymakers have learned that no single economic or financial indicator or even a small set of such indicators can provide reliable

guidance for the setting of monetary policy.

Rather, the Federal Reserve, together with all modern central

banks, has found that the successful conduct of monetary policy requires painstaking examination of a broad range of economic and

financial data, careful consideration of the implications of those

data for the likely path of the economy and inflation, and prudent

judgment regarding the effects of alternative courses of policy action on the prospects for achieving our macroeconomic objectives.

12

In that process, economic models can provide valuable guidance to

policymakers and over the years substantial progress has been

made in developing formal models and forecasting techniques. But

any model is by necessity a simplification of the real world and sufficient data are seldom available to measure even the basic relationships with precision. Monetary policymakers must therefore

strike a difficult balance, conducting rigorous analysis informed by

sound economic theory and empirical methods while keeping an

open mind about the many factors including myriad global influences at play in a dynamic modern economy like that of the United

States. Amid significant uncertainty, we must formulate a view of

the most likely course of the economy under a given policy approach while giving due weight the potential risks and associated

costs to the economy should those judgments turn out to be wrong.

During the 3 years that I previously spent as a Member of the

Board of Governors of the Federal Open Market Committee, the

approach to policy that I have just outlined was standard operating

procedure under the highly successful leadership of Chairman

Greenspan. As I indicated to the Congress during my confirmation

hearing, my intention is to maintain continuity with this and the

other practices of the Federal Reserve in the Greenspan era. I believe that with this approach, the Federal Reserve will continue to

contribute to the sound performance of the U.S. economy in the

years to come.

Thank you, Mr. Chairman.

Chairman SHELBY. Mr. Chairman, we are in our last few minutes of a vote on the floor. We are going to recess and we will probably be back in 15 or 20 minutes, soon as we can get here.

The hearing will stand in recess.

[Recess.]

Chairman SHELBY. The hearing will come back to order. Mr.

Chairman, some Fed watchers speculate that the Federal Open

Market Committee may—may—continue to increase its Federal

funds rate target to 5 percent while others seem to believe that 5.5

percent may be likely.

Do you regard either of these speculations regarding the level as

more likely than the other giving the FOMC forecast that you have

outlined today?

Chairman BERNANKE. Mr. Chairman, as I mentioned, in the

statement following the January 31 meeting, the Committee pointed to some potential pressures on inflation and suggested that

some additional firming may be necessary.

However, as you know, it is still about 6 weeks until the next

FOMC meeting.

Chairman SHELBY. You will have to examine the data at

that——

Chairman BERNANKE. We will be examining the data as it comes

in and, of course, my colleagues and I will have an extensive discussion and we will be thinking about both our inflation mandate

and our full employment mandate as we make our decision.

Chairman SHELBY. To what extent, Mr. Chairman, does the Federal Open Market Committee consider the long-term interest rate

in pursuing changes to the Federal funds rate? For example, would

the FOMC continue raising the Federal funds rate even if the yield

13

curve remains inverted in the months ahead and will that be a factor or is that bothersome to you, the inverted yield?

Chairman BERNANKE. Mr. Chairman, the inversion of the yield

curve is due to a number of different factors which have different

implications for policy.

Chairman SHELBY. But historically they meant something? Senator Bunning alluded to that earlier.

Chairman BERNANKE. That is true that historically an inverted

yield curve has often predicted slowing economic activity. That relationship seems to have weakened in the past 15 years or so.

Chairman SHELBY. Why?

Chairman BERNANKE. Well, one of the reasons, as we looked into

it, is that the inverted yield curve is more likely to be indicative

of coming slowing when interest rates in general are high, when

real rates in general are high, because when real rates in general

are high, that tends to restrain activity.

We have an inverted yield curve at this point. It is due to a number of factors which I can go into, if you are interested, but the

short-term, real interest rate is in a fairly normal range and the

long-term real interest rate is actually relatively low historically

speaking. So we are not overly concerned about the implications of

the inverted yield curve for future economic activity.

Chairman SHELBY. Mr. Chairman, your testimony also notes the

possibility of some risk which could add to inflationary pressures

such as high energy prices feeding into the prices of nonenergy

goods and services.

Your testimony further notes the risk to our economy due to a

slowing housing market you reference. What would be the impact

on the economy if both of these effects materialize to a greater degree than is currently anticipated? How would the Federal Reserve

be likely to respond to such a scenario if you found the pressure

there from a double hit?

Chairman BERNANKE. That would be a difficult situation because, on the one hand, higher energy prices would put pressure

on inflation, but higher energy prices would also hurt consumer

budgets and would probably or could possibly lead consumers to

spend less. Together with weakening of the housing market, which

might also lead to a higher savings rate and slower consumption

spending, we would be in a situation with pressures in both directions, and I cannot really offer much more guidance other than to

say that we would have to weigh the relative severity of the two

risks.

Chairman SHELBY. If they were to come about?

Chairman BERNANKE. If they both were to come about, and then

try to manage those risks in a way that would give us the best outcome.

Chairman SHELBY. You reference further in your testimony your

thoughts on global savings glut, with this glut being part of the

reason that the real interest rate in global markets is low. In other

words, there is a lot of money out there.

How does this factor into the Federal Reserve’s growth projections and how would you envision economic events unfolding to

bring returns back to more historical normal levels?

14

Chairman BERNANKE. Well, we were just discussing the relatively low level of long-term real interest rates. I think one of the

factors relevant to the long-term, low, real interest rates is that

there is a lot of savings coming into the global capital market, from

emerging market economies and from oil producers, which is looking for returns.

I think that over time, as the global economy continues to grow

and as those economies find more investment opportunities in their

domestic economies, that some of this global savings glut may

begin to dissipate, but I think that is likely to be a relatively gradual process.

Chairman SHELBY. Yesterday, did the market behavior reflect an

accurate interpretation of the Federal Reserve’s report and your

comments? Do you think it is a good outcome when markets receive

enough signals to know what to expect about monetary policy? Is

that a prediction?

Chairman BERNANKE. We are trying, and we have been for some

time trying, to be transparent and as clear as we can about our

strategy, our objectives, and our approach, and one of the implications of that has been that interest rate moves have been highly

predicted by the markets, and I think, as a general matter, that

is good. It reduces volatility in financial markets and makes policy

actually more effective.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman. I would like to go

back to the inverted yield curve for a minute. You were a professor

at this time. Maybe you remember this at Princeton. In 1989, if I

am wrong, I think you were a professor at Princeton.

Chairman BERNANKE. Yes, sir.

Senator BUNNING. In 1989, even as the economy slowed, the Fed

continued to raise interest rates, and we had a recession. The signs

of the economic problems were ignored. Yesterday, you stated that

the inverted yield curve was ‘‘not signaling’’ a slowdown. Those

were your words—‘‘not signaling.’’ But in recent economic history,

the inverted yield curve has predicted a recession, not just sometimes, but almost every time.

Now, the Fed has pushed interest rates to the highest level in

41⁄2 years. The January rate hike was the 14th consecutive 25 basis

point move since the Fed began raising interest rates in June 2004.

You said you think we are not facing a downturn because interest

rates are lower now than in past inversions.

Do you have any other reason to think that this inverted yield

curve is not a warning, any other reason, other than we started

lower?

Chairman BERNANKE. Yes, Senator. As I was indicating in my

testimony, we look at a wide variety of indicators. We do look at

the structure of interest rates and other financial asset market

prices, but we also look at a wide variety of indicators in the real

economy, and we are seeing very low unemployment insurance

claims, for example, and we are seeing strong retail sales. We are

seeing increased industrial production.

My comments notwithstanding about slowing of the housing market, the level of activity in housing construction remains strong,

and so the economic expansion appears still to be on a solid track.

15

When we make policy, we have to think not only about all these

indicators, but we also have to think in terms of a forecast. We look

ahead and try to think where the economy is likely to be at a period 6 months, a year, 18 months in the future, and based on that

forecast and the risk to that forecast, we try to pick the best policy.

Senator BUNNING. You know as well as I do that normal everyday citizens do not borrow at the Fed funds rate, but about a 300

basis point markup from that. So if Fed funds get to 51⁄2 percent,

the prime rate for borrowing would be about 81⁄2 percent. I do not

know too many Americans that can borrow at 81⁄2 percent on prime

rate. Most Americans pay prime plus. So we are getting to the

point, if the Fed moves two more times, and Fed funds increase 25

basis points and 25 basis points, we are to that point, eight plus

on prime.

Do you find that disturbing to the economy or would that be just

normal for our economic outlook?

Chairman BERNANKE. Well, Senator, again, the choices we make

will be conditioned on our views of where the economy is going and

what interest rates are needed to give us the best combination of

growth and low inflation. The interest rates we currently see are

in some cases historically low. Take mortgage rates, for example;

they are about 61⁄4 percent right now which is relatively low historically.

It is not really a question of comparing it to rates at another period of time, but rather asking, given those rates, what will be the

level of activity in the economy? Will we be on a path that is strong

and sustainable going forward? So we will try to do our very best

to get the best outcome we can for the American people.

Senator BUNNING. Do you not think with the past history of the

Fed and looking at interest rates, when we get them too high, the

economy kind of does a little swan song and turns over for awhile

and we have some kind of a recession? I am talking on Fed funds.

Do you see that happening in the future or do you see that you

would anticipate that before it happened?

Chairman BERNANKE. Senator, there are two possible mistakes.

One is to go on too long and one is not to go on long enough, and

it is a very difficult balancing act, and as I said earlier, we do not

have any kind of mechanical rule. We do not have built in any kind

of set of future moves. As we go along, we are going to be looking

carefully at all the data, trying to make our best assessment where

the economy is, where it is going, and respond to that.

Senator BUNNING. Last question. Is there a lot of discussion at

the FOMC meeting on this very topic when you meet? In other

words, it is not that the Chairman leads and everybody follows?

Chairman BERNANKE. There is extensive discussion and I look

forward to getting a lot of input from my colleagues on the FOMC.

Senator BUNNING. Thank you.

Chairman SHELBY. Senator Bayh.

Senator BAYH. Mr. Chairman, I would like to follow up on my

brief comment in the introductory component here about our increasing global interdependence, some advantages, benefits that

come from that, also some potential threats to both our economy

and our national security, potentially even our sovereignty, and

that is what I would like to ask you about.

16

And increasingly, these are not hypothetical risks. Let me start

by remembering, it was a year or so ago, maybe a year and a half,

there was a rumor going through Seoul, Korea that they were

going to begin to diversify out of dollar denominated assets, and for

a brief period of time, that sent the U.S. dollar into a free fall.

Sometime after that, a matter of months, the Prime Minister of

Japan misspoke, and similar phenomenon followed. He said we perhaps will start diversifying out of dollar denominated assets; the

dollar headed straight down. Someone from the ministry comes out

and says, no, no, the Prime Minister misspoke.

My question to you is twofold. Number one, does it trouble you

that a mere statement by a foreign leader could have such a profound effect on our Nation’s currency? And number two, what if the

Chinese were to misspeak? Or even more, what if they were to announce a similar policy? What kind of impact would that have on

our currency and should we be concerned about that? Is there not

a loss of sovereignty involved in such a situation? So does this

bother you that a mere misstatement can impact in our currency

in a tangible way? And what about the Chinese and their possible

course of action in the future?

Chairman BERNANKE. Senator, as you know, the Chinese central

bank and other Asian central banks do hold large quantities of U.S.

dollar assets in the form of foreign exchange reserves. They hold

those assets because they are very attractive assets to hold. They

are highly liquid, they are very safe, and they are very good assets

to hold in that form as reserves. I am not aware of any significant

changes in the plans to hold U.S. dollar assets by foreign central

banks and my belief is that moderate changes in the holding of dollar assets would not have significant impact on U.S. asset values.

You have to remember that whereas Chinese holdings of U.S. dollar reserves of about $800 billion is an enormous number——

Senator BAYH. Could I interject just for a moment, Mr. Chairman, with my apologies? Boy, when the rumor was going through

Seoul and the Japanese Prime Minister misspoke, the markets

seemed to disagree with your evaluation and we are more reliant

on the Chinese than we are either of them. So I want to—look, I

do not expect you in an open forum here to give me—let me just

fall back on my first question, and we will kind of save the others

for a little bit later.

Does it trouble you that a mere statement could have that kind

of impact at least in the marketplace?

Chairman BERNANKE. Well, I cannot speak to the marketplace,

but I think that over a longer period of time, always there is information that comes in that can affect markets. Perceptions can affect markets. Psychology can affect markets. But over a longer period of time, the holdings of U.S. dollar assets by foreigners are

only a portion of the very deep, very large markets in U.S. dollar

assets, not only in treasuries but also in other high quality assets,

such as corporates and the like, and I believe that those markets

are sufficiently deep and liquid that they can withstand moderate

changes in the holdings of any group, whether it be domestic or foreign.

Senator BAYH. I have time for one more question so I will move

on. And I hope you are right. But with the kind of imbalances that

17

we are building up, we may be testing the definition of moderate

adjustments and that is my concern going forward, that the longer

these things accumulate, the greater risk we run that there will be

a disorderly rather than an orderly adjustment of some kind and

that does put us—last comment I would make is I always hear the

argument, well, they have to consider their own financial interests

and that is true.

But nation states sometimes have interests other than their own

pecuniary gain, and I am concerned that we rely upon their financial interests perhaps at our peril because there are other interests

that might motivate their actions moving forward. That is my concern as these balances pile up.

My final thing is somewhat related. It is the energy front. This

is no longer a hypothetical concern. Russia used their gas exports

to leverage Ukraine and possibly Western Europe. Iran has now

said, well, if you pressure us unduly on our nuclear program, we

will just shut off the oil spigot. Does that concern you, and if so,

what would the impact be on our economy if the Iranians were to

make good on their threat?

Chairman BERNANKE. Once again, of course, it cuts two ways. It

would hurt the Iranians quite a bit to stop exporting their oil. It

hurt the Russians quite a bit to stop exporting their natural gas.

But I agree in the following general sense, that whereas there are

substantial reserves of oil and natural gas in the world, a large

share of them are in areas where there is geopolitical uncertainty

or geopolitical risk, and that means that is a risk factor for the

economy.

We do not have a wide range of spare capacity in these energy

areas so that a major change in the supply of energy available

could make prices move a lot and that could have a major impact

on the economy. That is a concern that we are going to have, I

think, for a number of years. My view, in the long-run, is that with

energy prices at current levels, over a longer period of time, there

are going to be substantial new substitutes, alternative sources of

energy, as well as new ways of conserving and reducing the use of

energy.

But over the next few years, our room for error is modest and

we do face the risk that energy prices may fluctuate with changes

in supply.

Senator BAYH. Thank you. My closing comment, Chairman

Bernanke, would be, you know, interdependence is one thing, increasing dependency is another, and it raises potential risks that

we best think about in advance so that we do not face a potentially

difficult situation at some point down the road. That is the underlying theme of my remarks. Thank you very much.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you, Mr. Chairman. Actually, I want

to pursue a line of questioning that just follows along with what

Senator Bayh has been examining in the course of his questioning,

which I thought was right on target and, of course, this is an

issue—he chairs our Subcommittee in the international arena—and

this is an issue on which he has focused and made some very substantial and positive contributions.

18

Chairman Bernanke, you said to Senator Bayh, they like to hold

our dollar assets. They are attractive to hold. I am interested

whether there is not something more than that here. Now, these

dollar assets, at least according to Marty Feldstein, are being purchased by foreign governments primarily, not by foreign individuals. Feldstein writing in the Financial Times on January 10 said:

My own belief, based on widespread conversations with officials and with private

bankers, is that the inflow of capital that now finances the U.S. current account deficit is coming primarily, perhaps overwhelmingly, from governments and from institutions acting on behalf of those governments.

Do you agree with that statement? Is that your perception as

well?

Chairman BERNANKE. We do not have complete information on

these numbers, as you know, Senator, but I do not agree with the

thrust of the statement. I think that there are substantial private

sector inflows that play a big role in the financing of the U.S. current account deficit.

Senator SARBANES. If Feldstein were right, that the holders or

that this inflow is primarily from foreign governments, would that

raise your concern, or do you have any concern about the current

account deficit? Let me start there first. I mean it is now at, well,

the trade deficit is at $725 billion last year. That is the largest figure we have ever had for a trade deficit. Is that a matter of concern

for you?

Chairman BERNANKE. Yes, Senator, it is.

Senator SARBANES. Okay. All right. Now, if Feldstein is right,

that it is foreign governments that are putting in the capital, would

that cause you added concern?

Chairman BERNANKE. I do not think he is correct, Senator. There

is something on the order——

Senator SARBANES. No, I understand that, and that would require presumably some factual examination, but if he were right,

would that heighten your concern?

Chairman BERNANKE. It depends really on which type of investor

is more sensitive to changes in yields. Central banks have actually

been less sensitive to changes in yields than private sector investors.

So, I cannot say a priori which situation would be one of more

concern. I think it is really not so much the portfolio situation; it

is the fact that we are accumulating foreign debt over time, year

by year. We can do that because foreigners are willing to finance

that debt, but I do not think that we can continue to finance the

current account deficit at 6 or 7 percent of GDP indefinitely, and

it is desirable for us to bring down that ratio over a period of time.

Senator SARBANES. Now it is your view, I take it, that they are

doing this because these are attractive investments; is that right?

Chairman BERNANKE. Attractive in not only the return sense but

also in the sense that they are safe, liquid, and easily negotiated.

Senator SARBANES. Well, now if the governments are doing it,

would it not have an added significance in terms of trying to gain

a trade advantage? Now this is the change in foreign currencies

versus the dollar, the appreciation.

[Chart.]

19

Senator SARBANES. This line is the euro, which generally is seen

as free floating, responding in a market forces and so forth, the

euro-dollar relationship. And this line down here is the Chinese

currency, the yuan, right down here.

Now that is a pretty dramatic contrast. And China, which of

course is holding more and more of our Government debt, actually

our trade deficit with China last year was a record in terms of the

trade deficit ever recorded with a single country; is that correct?

Chairman BERNANKE. I believe so.

Senator SARBANES. Over $200 billion. Does this not enable them

to gain an unfair trade advantage?

Chairman BERNANKE. Senator, if you are asking me whether I

would support or advocate that the Chinese go to greater flexibility

in their exchange rate, I certainly would.

Senator SARBANES. Yes.

Chairman BERNANKE. I think it is, in fact, in their own long-term

interest to do so for a number of reasons. It will give them more

monetary policy independence. It will reduce the overdependence of

their economy on exports and I think it will be commensurate with

their increasing global role for them to take an interest in the overall stability of global financial markets and trade.

Senator SARBANES. But if they can do this on the currency relationship, does it not give them a step up in the trade relationship?

Chairman BERNANKE. To the extent that their currency is undervalued, it does, yes.

Senator SARBANES. Yes. In fact, we are becoming more and more

dependent. Tennessee Williams has that wonderful line in ‘‘A

Streetcar Named Desire’’ where Blanche DeBois says dependent

upon the kindness of strangers, and there are some who look at the

American economy and are increasingly concerned that that is

what is happening.

I quoted Warren Buffett earlier in my opening statement saying right now the rest of the world owns $3 trillion more of us than

we own of them. In my view, it will create political turmoil at some

point. Pretty soon, I think there will be a big adjustment.

Aren’t the Chinese accumulating a leverage over our decisionmaking as a consequence of increasing so substantially these holdings of our Government debt?

Chairman BERNANKE. First, Senator, I think the $3 trillion

should be put in some context. If I recollect, there is something like

$15 trillion gross holdings of U.S. assets from foreigners and U.S.

holders own about $12 trillion foreign assets, so that is a net number, part of a much bigger flow of in and out of capital.

Senator SARBANES. But that is a big change from what it used

to be——

Chairman BERNANKE. We have much more open capital markets.

Senator SARBANES. —not so long ago; is it not?

Chairman BERNANKE. Yes, we have much more open capital markets, much greater capital flows, and it is worth noting that U.S.

national wealth as of the third quarter was $51 trillion to compare

that to the $3 trillion.

Now, as I said, I think that we should work to reduce the current

account deficit over time. I think that would reduce the possibility

of an uncomfortable adjustment process. But, again, as I said earVerDate 11-MAY-2000 17:43 Mar 27, 2006 Jkt 025856 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 26643.TXT SBANK4 PsN: SBANK4
20

lier in response to Senator Bayh, I do not think that the Chinese

ownership of U.S. assets is so large as to put our country at risk

economically.

Senator SARBANES. You do not think they could use it for political purposes?

Chairman BERNANKE. It would be very much against their own

interest to do so.

Senator SARBANES. Well, it would be against their economic interest. It might not be against their political interests in the particular context of what the issue might be. I mean we are struck

by the fact—Senator Bayh, I think, made reference to it—a South

Korean Government official, and of course their holdings are much

less, but still substantial, made a comment about South Korea continuing to hold the dollar, maybe that they would not do it and so

forth, and it sent the stock market down over 150 points. Of course,

then everyone scrambled and he pulled the statement back and so

forth.

But if it can have that kind of impact, is it not suggestive of the

leverage that the Chinese may have in this situation, or others as

well for that matter, but I mean since the deficit with China was

at a record last year, I am focusing on them?

Chairman BERNANKE. Again, information, psychology, and news

can always affect markets in the short-term, but I think that over

a longer period of time that the depth and liquidity of U.S. financial markets would be sufficient to sustain changes in holdings by

foreign central banks.

Senator SARBANES. Mr. Chairman, I see my time is up. I just

want to, in closing——

Chairman SHELBY. Take another minute.

Senator SARBANES. —when we talk about the deterioration and

the net international investment position, when you talk about so

much, this is the chart which illustrates what has happened.

[Chart.]

Senator SARBANES. The first line back there is 1980. We had a

positive net position. We then went into a negative position, but

look at what has happened to it in recent years. I mean if you regard a minus or a negative position as something to worry about,

it seems to me we have very good reason to be worried about what

has happened to our net international investment position.

It is no wonder Buffett is saying this or Volcker says, ‘‘Under the

placid surface there are disturbing trends, huge imbalances,

disequilibria, risk, call them what you will. All together the circumstances seem to me as dangerous and intractable as any I can

remember, and I can remember quite a lot.’’

Thank you, Mr. Chairman.

Chairman SHELBY. Thank you, Senator Sarbanes. I want to shift

to Basel II capital requirements, Mr. Chairman. The Federal Reserve is presently in the process of implementing the Basel II Capital Accord, which will establish new capital requirements for our

largest banks.

Capital requirements play a vital role in protecting the safety

and soundness of the U.S. banking system. I think it is very important that there be no surprises to this Committee and others in the

21

implementation of Basel II, especially unanticipated reductions in

capital requirements.

Last year, Chairman Bernanke, this Committee held a hearing

at which several witnesses here expressed concerns that the adoption of Basel II would result in the lowering of capital requirements. In addition, last year, the Fourth Quantitative Impact

Study, unexpectedly, Mr. Chairman, showed that Basel II would result in substantially lower capital requirements which gives then

this Committee concern.

What steps, Mr. Chairman, need to be taken to make sure that

Federal banking regulators, and you are one of these regulators,

Congress and the public at large are confident that the implementation of Basel II will not, will not adversely impact the safety and

the soundness of the banking system that we know today?

Chairman BERNANKE. Mr. Chairman, let me just assure you that

the Federal Reserve does not want to see a significant reduction in

capital in the U.S. banking system. We are prudential supervisors.

We have a very strong interest in maintaining a safe and sound

banking system and a stable financial system.

We are planning a very slow phase-in process, one that will involve considerable consultation, will involve a variety of safeguards

such as floors that will be phased out over a period of time. Moreover, there are a number of other safeguards such as the leverage

ratio and Pillar II which allows the supervisors to evaluate the

overall safety and soundness of the bank and look at such things

as compliance risk or interest rate or liquidity risk.

We are very much on the same page as you are, Mr. Chairman.

We think Basel II is very important because it will allow banks’

capital holdings to be sensitive to the risks that they take, and it

will be consistent with modern risk management techniques, so we

think it is important to move forward with Basel II. But we do not

see this, we certainly do not want this, to be a source of a significant reduction in aggregate capital in the U.S. banking system.

Chairman SHELBY. Senator Sarbanes wants to be recognized

now. Go ahead.

Senator SARBANES. Mr. Chairman, I just want to observe that is

kind of calming the waters in terms of assurance. Vice Chairman

Ferguson did that when this Basel II was under his jurisdiction.

Mrs. Bies has it now, I think, in her portfolio. And he told us that

they were not going to lower capital and so forth and so on.

But you ran the formula in the QIS–4 and it resulted in very

substantial capital reductions. Everyone said, the regulators all

rushed to say, well, we do not want that; that is not where we

want to go. We do not intend to do that if the Congress raises questions about it. But you are moving ahead with a proposed regulation, as I understand it, that is still utilizing the same formula that

produced the QIS–4 result, and you are saying, well, if it produces

these bad results, we will take all kinds of band-aid measures in

order to contain it.

But why would you not pull the regulation back, develop a revised formula as part of the proposed regulation, which upon testing did not produce these kind of results about which everyone

says, oh, we are very concerned about it, and yet they move ahead

22

with the proposed regulation, still encompassing the formula that

everyone admitted created a terrific problem?

Chairman BERNANKE. Senator, the QIS–4 results were on a best

efforts basis. The banks did the best they could with the information they had. They had not yet developed the models. They do not

have all the data they need. It was just a very experimental kind

of study. In order for this to be really put to the test, the banks

need to have the guidance from the regulators about what our expectations are so that they can actually go ahead and develop the

models, get the data, and take this to the next level.

They really cannot proceed with the process and allow us to do

further analysis without some guidance from us. This is very much

a dialectical process. We are going to provide guidance, we are

going to see the results, we are going to get commentary, and we

are going to work together with the banks to make sure that the

bank capital is adequate.

Senator SARBANES. I understand all that, but why are you moving ahead with a formula that has been shown to be faulty? Why

do you not pull back and develop a different formula?

Chairman BERNANKE. We are adjusting the formulas based on

what we have learned and we will continue to do so.

Senator SARBANES. What is going to happen, and I just sound a

warning, is you are going to continue down this path, you are going

to become more committed, as it were, to your international partners. You are already very heavily committed, I think overcommitted, because you have moved way ahead there, created a

problem, and then one day the Congress is going to say to you wait

a minute, this is not the path we want to go on; this path is going

to lead to a significant reduction in capital. And somehow or other

we are going to put a stop to it.

Now that is the potential that I see developing by what I think

is a faulty process. I think once you had these bad results from the

QIS, you should have pulled back, revised the formula, and gone

back into a—so when you moved ahead on the process, you had

some confidence it was meeting all of these concerns. You are moving ahead on a process now that still has within it the very seeds

from which all this concern flows.

Chairman BERNANKE. Senator, first, we cannot really evaluate

the formulas unless we see the results from the banks’ own models

and their own analyses. There needs to be a dialogue process going

on so that we can continue to learn, and second, it is, after all, a

very flexible framework that allows for capital under Pillar II. It

allows for multipliers and other changes.

I hear you very clearly and I assure you once again that it is not

in the Federal Reserve’s interest to allow inadequate capital in the

banking system because financial stability is one of our primary objectives.

Senator SARBANES. Let me just add. Is it a conflict for the banks,

to look to the banks to develop the model since the banks stand to

benefit in significant ways if they can lower the capital requirement? It will enhance their competitive position vis-a ́-vis other

banks in the U.S. and it will keep them, or they would argue presumably, in a competitive position vis-a ́-vis banks in other countries that are moving to Basel II.

23

So you keep telling me, well, we are looking for the banks to give

us the models, but don’t the banks have a particular vested interest in what they want the models to produce?

Chairman BERNANKE. Well, actually we are looking for them to

give us statistical indicators of their own loss experience in their

past credits. And part of the process will be validation. That is,

they have to show us that their numbers were derived from their

actual experience over a period that encompasses both strong and

weak credit conditions and that they are using those models for

their own internal analysis of capital. So there will be a lot of

checks and we will continue to work with the banks and with the

Congress on this issue.

Chairman SHELBY. Mr. Chairman, before I recognize Senator

Carper for his first found of questions, I just want to emphasize

that Senator Sarbanes and I have talked at length to our counterparts in the House, Democrats and Republicans. They have the

same concerns we do. We have all been on this Committee—Senator Sarbanes and I have been on this Committee during the thrift

bailout and everything. We believe that capital is very, very important for the safety and soundness of our banking system, period.

Senator Carper.

Senator CARPER. Mr. Chairman, I think I would like to ask you

a human question before we get into some of the other things I

mentioned earlier. I told you I wanted to talk about our savings

rate, our poor savings habits in this country, and I wanted to talk

about the interplay between the trade deficit and the budget deficit

and potential impact on interest rates.

But just really a human question at first. You have been in your

new job for how long?

Chairman BERNANKE. Oh, about 14 days now.

Senator CARPER. And we were talking in the anteroom before we

came in, and I was asking you how you are doing as a human

being. And you mentioned jumping right into these hearings 2

weeks into the job was a challenge, and I can understand that. But

where does so far 2 weeks into this job, where does it meet your

expectations; maybe where is it a little bit different from the expectations you had for it?

I say that recognizing that you are probably uncommonly well

prepared for this position.

Chairman BERNANKE. Well, it has been very challenging and

very interesting, and I do have the benefit of having spent almost

3 years at the Board as a Governor, and that experience has been

invaluable in trying to address the wide range of issues the Federal

Reserve deals with.

Senator CARPER. You will be scheduled to come back before us

when? About 6 months or so from now?

Chairman BERNANKE. That is correct.

Senator CARPER. And one of the questions—this is telegraphing

my pitch—but one of the questions I will ask you then is with 6

months of experience under your belt, how do you see the world or

this job, your responsibilities, differently, if at all, then than you

do as you assume these responsibilities?

Let us talk about savings rates. Just share with us, if you will,

your view of the kind of job we are doing as savers in this country,

24

where we might do better, and some things that not just the Federal Reserve but those of us in the Congress should be thinking

about to encourage a better savings rate? And why should this or

should this not be a concern to us?

Chairman BERNANKE. Senator, this actually ties back to the

questions raised about the current account, for example. The reason we have a current account deficit is that we invest more, including housing, than we save, and we have to make up the difference by borrowing abroad, so our national saving is not sufficient to fund our domestic investment opportunities.

It is a good thing in a sense that we are able to go to the international capital markets and find funding for good domestic investment opportunities, but we would be better off in some sense if we

ourselves could fund those investment opportunities creating more

wealth for Americans and greater capacity in the future for us to

deal with the long-term challenges associated with demographic

changes and the like.

So, I think it is desirable for us to try to raise our national saving. There are various dimensions to that. One is on the fiscal side.

We are looking in the next 5, 10, 15 years to increasing obligations

and entitlement spending, for example, and increasing challenges

in the Government’s budget.

Congress is going to have to make some very tough decisions

about controlling the deficit, and by doing so, to the extent that the

deficit can be reduced, that is a direct contribution to national saving and would be constructive.

In addition, Americans, in part because of the increased wealth

they have gained through increased home values and through other

asset price increases, have not saved too much out of current income. In fact, the current saving out of disposable income is a negative rate.

Senator CARPER. Say that one more time.

Chairman BERNANKE. The savings rate, the ratio of household

savings to after-tax income, is currently less than zero. That is,

spending is more than income. Our expectation is that that saving

rate will increase over time for a number of natural reasons, including the possibility that house prices will no longer rise as

quickly as they have and so people will be forced to turn to saving

out of current income in order to build their assets.

But in addition, it would be desirable for Americans to save more

to prepare better for the future. The problem is we do not have

really good effective tools to achieve that. There are obviously ways

of providing tax incentives or other kinds of tax-favored vehicles to

help people save.

There is a lot of debate about how effective those actually are

and I really cannot give you a strong answer there. One thing

which I think can be done and would be positive would be on the

financial literacy front. When I was on the school board in New

Jersey many years ago, I argued for more economics in the schools.

I thought that it was very important for young people to understand early on that they need to put something away; they need

to develop a habit of saving, and they need to understand enough

about financial markets and financial instruments that they can

save effectively.

25

So that is one dimension where I think we can be helpful, but

I agree that saving is something that needs to be promoted and

that it is good for our long-term future to have greater wealth accumulation.

Senator CARPER. I would just say, Mr. Chairman, and to my colleagues and to Chairman Bernanke, in our experience in Delaware,

trying to get people to save through the State of Delaware’s deferred compensation program, State employees, people who were

higher income, and there are not very high-income State employees

in Delaware, but people whose incomes are higher tend to save a

lot. They maxed out in the deferred comp program.

But in order to get the people who were at the lower end to save,

we had to be able to provide some incentives for them, and to say

for every dollar that you save, we will like match it with two dollars, and to get to prime the pump, and once we did, they would

participate.

And the other thing I would say, for most of us, the biggest

source of savings is really the equity in our homes, and to the extent that we can include homeownership opportunities not for people like $150,000 or $200,000, but to the people who are making

$25,000, then we do a very good thing for them as they prepare for

their golden years.

Thank you, sir.

Chairman BERNANKE. Thank you.

Chairman SHELBY. Senator Schumer for your first round.

Senator SCHUMER. Thank you, Mr. Chairman, and I thank you,

Chairman Bernanke—that has a nice ring to it. I am glad you are

here. I thought your confirmation process was both a tribute to you

and a model of how we should do other confirmations, particularly

on other Committees on which I might serve or do serve, with a

lot of consultation, bipartisanship, et cetera.

I have a bunch of questions. The first relate to the overall global

situation of the United States and as it relates to China. You said

yesterday that we need to increase national savings as one of the

ways to deal with our big trade deficit with the rest of the world

and China.

Yet, the budget we passed 2 weeks ago increased the debt we

have further and there is a push to put new tax cuts in that. Now,

I am not asking you to opine on tax cuts. I know you do not want

to do that.

I do want to ask you does it make sense, from a global perspective, for us to continue to increase this deficit, whether it is by tax

cuts or increased savings? Does that not weaken the position of the

United States in trying to accomplish many of our other international economic goals?

Chairman BERNANKE. As I indicated to Senator Carper, I think

reducing the fiscal deficit is an important priority. It is important

because looking forward 10, 15, 20 years, we have a demographic

challenge coming, and we need to be prepared for that, and it does

contribute to national savings which enhances our wealth creation

and the strength of our economy in the future.

So, I do think that we should look at that. There really are two

separate questions. I just would note the first one is the size of the

Government itself. I mean what we should agree on how big the

26

Federal Government, that is the Federal budget, should be, and

then we need to make sure that the revenues we collect are commensurate with those expenditures over a period of time.

Senator SCHUMER. You do agree that, again, now looking more

at the type of actions that Senator Graham and I have been active

in, not commenting on our methodology, that it would be better for

the world economy and for the United States if China were after

some point of time to allow its currency to float, which would adjust for trade imbalances that would occur. Do you agree with that?

Chairman BERNANKE. Yes, Senator, I do. I think China should

move toward a more flexible exchange rate.

Senator SCHUMER. And why do you think we are making so little

progress with China right now?

Chairman BERNANKE. That is a good question. They have, I

think, mixed views about the benefits to their own economy of

making that change.

Senator SCHUMER. Right.

Chairman BERNANKE. They see some benefits in what they view

as stability. They see an advantage in exports from keeping their

exchange rate where it is. But as I was suggesting, I think, to Senator Sarbanes, it is very much in their interest to move toward a

more flexible exchange rate to increase their monetary independence, to reduce their reliance on exports, and just to continue to

play an appropriate role in contributing to global financial and

trade stability.

Senator SCHUMER. Right. And I agree with the thrust of your

comments there. The Chinese seem to want a lot of the benefits of

being part of the global system, but are much less quick to take

their responsibilities.

What would you suggest to people like Senator Graham and I?

Now make no mistake about it, our legislation is very popular in

Congress, but lots of economists and people I respect say you are

right on your goals and you are right that China is not moving

quickly enough, but this is the wrong way to go.

The problem is we are ready to tear our hair out. There seems

to be no other way to go. The Administration has tried talking softly and talking loudly. It just seems nothing gets them to move. Do

you have any suggestions on how we can get the Chinese to let the

currency float? No one is saying it has to float freely, completely,

immediately. There have to be adjustments. But what can we do

other than the legislation that Senator Graham and I have introduced?

We do not see any other solution at this point. The Chinese say

to us if you put pressure on us, we will not move, and then when

we do not put pressure on them, they do not move.

Chairman BERNANKE. I appreciate your frustration, Senator

Schumer. As you probably know, I think it is not a good idea to

break down some of the gains we have made in terms of free and

open trade in the world economy. We should be very careful about

that.

But in terms of working with China, there are really two things

we can do. We can continue to try to be persuasive and we can try

to offer technical assistance in helping them. They have taken

some steps in terms of increasing their trading platforms and their

27

capacity to allow the exchange rate to float. I agree they need to

do more and we just need to continue to work with them and be

as persuasive as possible.

Senator SCHUMER. One final question on this, if I might, Mr.

Chairman.

Chairman SHELBY. Go ahead.

Senator SCHUMER. Doesn’t the fact that China and other countries, Japan, have such large amounts of American reserves mean

that they could, if they wanted, actually have a little bit of your

job, have some effect over interest rates in the United States by

what they do?

Chairman BERNANKE. As I indicated already this morning, I

think that the capital markets for U.S. dollar assets are sufficiently

large, deep, and liquid that the impact of such changes would be

mostly transitory and could be managed.

Senator SCHUMER. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman. We are on 5

minute round of questions, are we not?

Chairman SHELBY. Or as much time as you need.

Senator BUNNING. Thank you. Just to follow up on Senator Schumer’s discussion about China. We took six Senators to China to

talk trade with the Chinese. They would not even visit with us. Six

U.S. Senators, five were on the Trade Subcommittee of the Finance

Committee, and we got number six in line in the Chinese bureaucracy and he knew nothing about trade.

So, I just want you to know what a problem there is, and we

worked like the devil to get them into the WTO, and I wish that

they would just follow the rules of WTO. That is an aside.

Yesterday, you talked a lot about our budget deficits and particularly our long-term obligations that are only going to increase. You

also rightly said those decisions are ones that Congress needs to

make. How much of a factor are those long-term entitlements in

your economic forecast? I am speaking about Medicare, Medicaid,

and Social Security.

It looks like by the year 2030 that they will take up about 70

to 75 percent of our budget. So we will be squeezed down to about

25 percent for discretionary spending. So how much do they come

into your forecast?

Chairman BERNANKE. Senator, your basic facts are absolutely

right. The numbers I have are that in the next 40 years the share

of GDP being devoted to Social Security, Medicare, and the Federal

part of Medicaid is going to go from about 8 percent today to about

16 percent 40 years from now.

Since the historical share of GDP collected as tax revenues is

something in the order of 18.2 percent, that suggests there will be

very little room in the budget for anything other than entitlement

spending and suggests it is very important for Congress to begin

thinking about how it wants to reorder or set its priorities.

It is important to get that going soon, first of all, to assure financial markets that Congress will be responsible and, second, and

perhaps even more importantly, to give people the time they need

to plan for retirement and make provision based on any changes

that Congress might decide to make.

28

In terms of our forecast, as I reported today, are usually only a

year or two in the future, uncertainty being what it is. So only the

near-term effects are reflected in our forecasts. We are already beginning to see some effects of entitlement spending on the budget

deficit. We factor that in, but since we are only looking at the nearterm effects, we obviously are not incorporating these very large,

long-term entitlement obligations into the near-term forecasting exercise.

Senator BUNNING. If nothing is done to shore up these programs,

and I am speaking about entitlements, for several more years,

what kind of impact is this going to have on our economic growth

and employment and how will that affect your ability to act?

Chairman BERNANKE. Well, the widening deficits over a period of

years will reduce national savings, will probably exacerbate the

current account deficit, may raise interest rates, and will probably

inhibit the dynamism of the economy.

I do not foresee, in the near-term, that these factors are going

to substantially affect monetary policy or the way monetary policy

functions in the economy, but from a broader perspective, the

health of our economy, in the long-run, requires that we achieve a

better fiscal situation and higher national saving.

Senator BUNNING. In reference to the trade deficit, how long do

we have to reduce trade imbalances before our economy starts to

suffer because of them?

Chairman BERNANKE. Senator, it is very hard to judge. It took

us about 10 years to get where we are today from about 1995 when

the current account deficit began to open up. It might take that

long to reverse. It might take a number of years to reverse, and

I think that it is certainly possible to have a decline in the current

account taking place over a number of years, but it is very hard

to judge exactly how long the process is going to take.

Senator BUNNING. Thank you, Chairman.

Chairman SHELBY. Mr. Chairman, the January survey of senior

loan officers indicated that 40 percent of respondents felt that the

outlook for delinquencies and chargeoffs of nontraditional mortgages was likely to deteriorate somewhat.

Would this type of credit quality deterioration be consistent with

the forecast that you outlined for a soft landing in housing markets? And do you believe that bank regulators including the Fed,

yourself, acted quickly enough in putting out supervisory guidance

regarding these types of nontraditional mortgage products?

Chairman BERNANKE. I cannot really speak to the timing. We

have put out——

Chairman SHELBY. First of all, I realize you have just gone to the

Fed.

Chairman BERNANKE. We have put out guidance for comment on

nontraditional mortgages and I think that it is good guidance. It

addresses what I think are the main issues. First, are banks underwriting nontraditional mortgages in an appropriate way? In particular, are they selling these mortgages to people who are able to

manage them effectively?

Chairman SHELBY. Will you as a regulator at the Federal Reserve require banks to take any additional steps to mitigate the

29

risk and how might these steps affect the economy if you see it is

necessary?

Chairman BERNANKE. Mr. Chairman, as I was saying, the guidance includes several components, including both underwriting and

consumer disclosure to protect consumers, but also safety and

soundness. The banks should manage the risks associated with

nontraditional mortgages in a way that maintains their capital at

a safe and sound level.

Chairman SHELBY. Your report this morning, Chairman

Bernanke, indicates that growth in labor productivity over the past

5 years has averaged over 3 percent per year.

For the fourth quarter of 2005, it declined 0.2 percent in the

business sector and 0.6 percent in the nonfarm business sector. The

productivity declines were unexpected by most market watchers.

What is your assessment of these numbers? Do they represent a

one time aberration or are they indicative of things to come? Do

you believe it is possible for us to sustain the pace that we have

seen over the past 5 years?

Chairman BERNANKE. Mr. Chairman, the fourth quarter appears

to have been a transitory decline in growth related to a number of

special factors, including effects of the hurricanes, the seasonal pattern of sales of automobiles, and some other factors as well.

So with output down more than the underlying trend would indicate, productivity, which of course is output per worker, also declined in the fourth quarter.

Chairman SHELBY. Think that will continue?

Chairman BERNANKE. It appears that the first quarter will see

significant rebound from the fourth quarter and likely productivity

will come back with it. We, in the Federal Reserve, pay most attention to productivity growth over the longer-term, and the ability of

the U.S. economy to generate ongoing productivity gains through

use of technology, through the flexibility of our labor and capital

markets has been most impressive. And we expect good productivity gains to continue for the next few years.

Chairman SHELBY. Thank you. Senator Bennett for your first

round.

Senator BENNETT. Thank you, Mr. Chairman. I apologize for

coming in late. I have been over in the House side chairing the

meeting of the Joint Economic Committee to hear the President’s

Annual Economic Report from the Council of Economic Advisors,

and they miss you, Mr. Chairman, but they acquitted themselves

extremely well, and your former colleagues did a great job.

Let me focus on an area where you had questioning on the House

side where some of your comments were, shall I say, not the ones

that I would have wanted. I want to talk to you about ILC’s. I am

sure that comes as no surprise to you. Being the Senator from

Utah, I represent the State where the ILC’s are a very significant

industry.

I have not had a chance to review the transcript directly. I have

been told by one of the Members of the House who was there that

you were told that some ILC’s have failed, and that is not true.

Chairman BERNANKE. I was not told that.

Senator BENNETT. Okay. I want to get the record straight on

that. The ILC’s are back in the news right now because of WalVerDate 11-MAY-2000 17:43 Mar 27, 2006 Jkt 025856 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 26643.TXT SBANK4 PsN: SBANK4
30

mart’s application, and people are saying, well, we have to prevent

Wal-mart from getting an ILC charter. That is just awful. No one

wanted to prevent Target from getting an ILC charter, and I have

a hard time understanding why it is okay for one large retailer to

have such a charter and not for its competitor to have such a charter.

I have talked with the Wal-mart executives. I believe they are

sincere in their statement that they do not intend to go into the

banking business. Indeed, they are signing long-term leasing contracts with community banks, community banks entering Wal-mart

with their own branches. The Wal-mart people told me we have

looked at this, but we are not bankers, we are retailers, they are

different businesses, and we do not want to go into a business we

do not understand.

However, simply getting an ILC charter will save Wal-mart $30

million a year in processing fees to a bank. If they are technically

a bank, they do not have to pay another bank to process all the

charges, all the credit card charges, all the checks, and money orders, et cetera, that they process. They will process them themselves through their ILC. It is worth $30 million a year to them.

I do not see anything wrong with that, and I hope the FDIC does

not see anything wrong with that. They are the regulator of the

ILC’s. For years, the staff at the Federal Reserve has felt strongly

that the FDIC is not capable of regulating the ILC’s and they either want them destroyed or short of that, they want them transferred to the Fed, so that the Fed oversees them.

I see no market reasons why that is necessary, no circumstances

in the real world that says the Fed could do a better job than the

FDIC. So, I would like your responses to that and your comments

about the ILC’s, your attitude as to how dangerous they may be,

and any data that you might have to back that up, and then your

sense of what would happen to the ILC’s if indeed the Fed were

to succeed in its crusade to get the regulatory responsibility shifted

away from the FDIC?

Chairman BERNANKE. Senator, first of all, as you point out, the

specific case at hand, the Wal-mart case is the FDIC’s decision. I

understand they are going to have a public hearing and will evaluate the merits of that individual case.

The concerns that the Federal Reserve have had about ILC’s

have turned largely on recent proposals that ILC’s would have additional powers including interest on business checking and out-ofState branching which would de facto make ILC’s the functional

equivalent of banks.

And our concern has been that if ILC’s are to be the functional

equivalents of banks, that they receive parallel treatment in terms

of consolidated supervision and other responsibility requirements

that banks face. And it may be that I have only been in the job

2 weeks, but I am not aware that the Fed has lobbied to become

the regulator of the ILC’s.

Senator BENNETT. I think the staff will make you aware of that

fairly soon.

Chairman BERNANKE. Perhaps they will. The main thing is that

Congress should try to be consistent, make sure that rules that

they apply are applied consistently across similar types of organizaVerDate 11-MAY-2000 17:43 Mar 27, 2006 Jkt 025856 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 26643.TXT SBANK4 PsN: SBANK4
31

tions, and that is the concern that we have had, and we have been

concerned about the ownership of ILC’s by nonfinancial institutions

and whether or not that poses risks to the safety net or creates an

unlevel playing field with other kinds of financial institutions.

Senator BENNETT. I think those are legitimate questions, and I

believe the ILC’s qualify for their present circumstance in the face

of all of those questions. In 1997, Chairman Greenspan said, quote:

The case is weak in our judgment for umbrella supervision of a holding company

in which the bank is not the dominant unit and is not large enough to induce systemic risk should it fail.

And that, of course, is the case with the ILC’s. If Wal-mart were

to get its charter, the bank would clearly not be the dominant unit.

And its size would not indicate systemic risk. Taking that statement from your predecessor, do you have any ideas about how it

no longer applies or any reaction or, again, is this issue, and I am

not saying this to put you down in any sense, I think it is very possible that this issue is simply too new for you to feel comfortable

commenting on it, and I would not complain if you said that was

the case. But we do have this comment by Chairman Greenspan,

which he has subsequently recanted, but which we really like. And

I would like your reaction to it.

Chairman BERNANKE. Again, I think that it would probably not

be appropriate for me to comment on the Wal-mart case given its

status of being adjudicated by the FDIC.

Senator BENNETT. Just comment about this whole idea generally

because this statement was made before Wal-mart applied for their

charter.

Chairman BERNANKE. The general concern is that if a commercial firm owns a bank, would there not be a possibility that the

safety net would be inadvertently extended to the commercial firm?

Would we be able to segregate the financial condition of the commercial firm from the bank and would it be possible for not just

the FDIC but for any bank supervisor to adequately supervise not

only the bank but also the owning firm to ensure that the safety

and soundness rules were being met?

Senator BENNETT. Now we are edging into Gramm-Leach-Bliley

and the conversation about banking and commerce. I used Walmart as the example because they put a specific number on it. Simply having an ILC charter is worth $30 million to them a year if

they do absolutely nothing as far as the consumer is concerned and

it does not change the safety and soundness of anything to me.

Many of the largest ILC’s in Utah are owned by automobile companies. GMAC, Volkswagen, Mercedes, they do very large financing

operations, and they find that having an ILC charter is enormously

valuable to them even if they do not issue checkbooks and they do

not open branches, and they do not do the traditional kinds of

things that banks do. This is a device, created by the Congress,

that is helping the marketplace, making things more efficient, saving money all the way around, which presumably means that consumers benefit because there is less money going into it.

We do not have to continue this, but I just want to lay this issue

on the table before you because I think you will see down at the

Fed that there is an effort on the part of some members of the staff

to, if not curtail the ILC’s all together, to bring them under Fed

32

jurisdiction, and that is certainly former Chairman Leach’s desire.

He is not fond of ILC’s and I think would like to see them eliminated, and I am laying down again the marker, I am very fond of

them, and I want to see them continued.

Chairman BERNANKE. Senator, the thrust of the Leach bill would

be essentially to restrict the kind of firm that could own an ILC

and that was the part that I commented on favorably yesterday.

Again, the Federal Reserve is not in itself looking to find new

areas, new domains, but having a financial holding company or a

financial company owning the ILC mitigates some of the concerns

that I have talked about relating to consolidated supervision.

Senator BENNETT. Thank you. I am sure we will be having more

conversations about this.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Sarbanes, you have any other questions?

Senator SARBANES. Senator Bennett having laid the issue on the

table, I think I should continue with it for a bit just to be clear.

As I understand it, the FDIC does not have consolidated supervisory authority and that is the problem with these ILC’s, unlike

the role the Fed has with respect to regular financial institutions

under the Federal Bank Holding Company Act; is that correct?

Chairman BERNANKE. That is correct.

Senator SARBANES. And, of course, Chairman Greenspan was

quite outspoken about this issue. I do not know. You cited him for

something, but it is——

Senator BENNETT. I acknowledge he has changed his mind since

he said that.

Senator SARBANES. He has been quite strong about it. In fact, he

expressed a concern that the ILC’s, which are chartered in just a

handful of States, represented a breach in the traditional separation of banking and commerce in the United States, and unlike the

financial institutions with banking subsidiaries, the owners of the

ILC’s are not currently subject to the supervisory requirements of

the Bank Holding Company Act.

So you have a very significant loophole here. I mean these ILC—

I understand Senator Bennett’s interest in this matter—but, you

know, they have grown at an incredible rate. The aggregate

amount of assets controlled by Utah-chartered ILC’s is 16 times the

total of all the banks, savings associations, and credit unions chartered in Utah.

Senator BENNETT. We are very grateful.

Senator SARBANES. It has become a huge business there. One

ILC has more than $58 billion in assets. I do not think Target

should have a bank. I mean you said no one questions that. I question that.

Senator BENNETT. Okay.

Senator SARBANES. In Gramm-Leach-Bliley, we closed the unitary thrift loophole as a way to further the separation of banking

and commerce, and this one loophole remained and is now being

exploited and expanded to the hilt, and I think it is a very serious

problem.

Now, the Leach legislation, as I understand it, would simply subject the ILC’s to the same prudential constraints including consoliVerDate 11-MAY-2000 17:43 Mar 27, 2006 Jkt 025856 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 26643.TXT SBANK4 PsN: SBANK4
33

dated supervisory requirements, bank level capital, managerial criteria, enforcement mechanisms, as applied to financial holding

companies. And the GAO was asked to do a study and they concluded that the ILC’s were not adequately regulated under current

law.

The problem may come somewhere down the line, just like it did

with the savings and loans. I mean we had the savings and loans

people came in and said, well, we need to accommodate here, it is

an important part of our economy. And 50 percent of the savings

and loans that failed were in the State of Texas. So we had Members of the Committee who were deeply interested in that and so

we went along, went along, and whammo. I think the taxpayers paid $132 billion for the savings and loans.

So, I am concerned about these loopholes and the exploitation of

these loopholes because there is not around them the kind of regulatory examination, the regulatory framework, which helped to assure the safety and soundness of the system. So the matter having

been put on the table, I thought I should contribute to the discussion.

Senator BENNETT. I am always grateful for your contribution.

Senator SARBANES. I want to very quickly, Mr. Chairman, ask

you two or three quick questions, just as kind of an alert of our interest. One is the remittances, an issue that you have taken an interest in. I want to underscore that. Is there a greater role for the

Fed to play in expanding the service of its international automated

clearinghouse? There is some opinion that think that.

I mean you have just reached an understanding with the Mexican central bank and it is felt that that is going to make a difference. What about expanding it?

Chairman BERNANKE. It is correct that we have reached an

agreement with Mexico, and to the best of my knowledge we are

exploring further opportunities and we are open to your comments

or suggestions.

Senator SARBANES. Okay. Everyone thinks of you as primarily a

monetary policy, and that is understandable, but the Fed has a

very significant role, of course, as a bank regulator. Privacy and

data security, something the Chairman has focused a great deal of

attention on. Last year, we had these incredible instances of several financial institutions—actually Government agencies, private

companies as well—reporting these breaches of Social Security

numbers, credit and debit card numbers, security codes, and bank

account information.

What can the Fed do to help tighten up data privacy and security

and enhancing the privacy rights of consumers?

Chairman BERNANKE. The Federal Reserve together with the

other banking regulators already has issued, I believe, its regulations to the banking system concerning management of data. There

are really two parts to it. First, that banks are required to have

good internal controls, to make sure the data are protected. And

second, that banks are required, and other financial institutions

are required, to inform customers if there is a data breach that has

caused, or is likely to cause, or be a source of fraud.

So we have created a structure in the banking system to address

these issues, and to my knowledge, I believe that Congress is lookVerDate 11-MAY-2000 17:43 Mar 27, 2006 Jkt 025856 PO 00000 Frm 00037 Fmt 6633 Sfmt 6633 26643.TXT SBANK4 PsN: SBANK4
34

ing to some extent at our approach as a model for thinking about

extending these rules to other kinds of organizations.

Senator SARBANES. And finally this Committee has held a number of hearings on money laundering and terrorism financing. Actually, you know, the Department of Justice has undertaken criminal

investigations of bank officials in these areas. But that suggests

that the regulatory authorities, the bank regulatory authorities of

whom the Fed is one, somehow fell behind the curve, so to speak.

What can be done to boost that oversight with respect to money

laundering and terrorism financing?

Chairman BERNANKE. We consider it a very important issue, and

we are putting a lot of resources into it. Our approach is again to

assess information management systems that banks have to make

sure that they know their customer or they know the source of a

transaction. That is the best way we have to approach this and

again we will continue to work hard to make sure that the AntiMoney Laundering and Bank Secrecy Act rules are obeyed.

Senator SARBANES. Is there a special unit at the Fed that focuses

on this?

Chairman BERNANKE. I think it is part of the general Bank Supervision Division, but there are certainly quite a number of individuals who are specially involved in it, who have special backgrounds.

Senator SARBANES. Do you think it has a high enough profile

within the Fed organization or the Fed hierarchy?

Chairman BERNANKE. Would you allow me more time to learn

more about the structure of the organization?

Senator SARBANES. Fine. Thank you, Mr. Chairman. I do want

to commend the Fed on the work it is doing in the area of financial

literacy and in particular Chairman Bernanke’s commitment to

that effort. He made reference to when he was on the school board.

It was an elected school board, as I recall; correct?

Chairman BERNANKE. Yes, sir. I received over 1,000 votes.

[Laughter.]

Senator SARBANES. We are always impressed by that.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Chairman Bernanke, we look forward to

working with you in many areas, and we know you will be back

before the Committee. We wish you the best as you undertake your

new opportunities and responsibilities.

The hearing is adjourned.

Chairman BERNANKE. Thank you, Mr. Chairman.

[Whereupon, at 12:23 p.m., the hearing was adjourned.]

[Prepared statements, response to written questions, and additional material supplied for the record follow:]

35

PREPARED STATEMENT OF BEN S. BERNANKE

CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

FEBRUARY 16, 2006

Mr. Chairman and Members of the Committee, I am pleased to be here today to

present the Federal Reserve’s Monetary Policy Report to the Congress. I look forward to working closely with the Members of this Committee on issues of monetary

policy as well as on matters regarding the other responsibilities with which the Congress has charged the Federal Reserve System.

The U.S. economy performed impressively in 2005. Real gross domestic product

(GDP) increased a bit more than 3 percent, building on the sustained expansion that

gained traction in the middle of 2003. Payroll employment rose 2 million in 2005,

and the unemployment rate fell below 5 percent. Productivity continued to advance

briskly.

The economy achieved these gains despite some significant obstacles. Energy

prices rose substantially yet again, in response to increasing global demand, hurricane-related disruptions to production, and concerns about the adequacy and reliability of supply. The Gulf Coast region suffered through severe hurricanes that

inflicted a terrible loss of life; destroyed homes, personal property, businesses, and

infrastructure on a massive scale; and displaced more than a million people. The

storms also damaged facilities and disrupted production in many industries, with

substantial effects on the energy and petrochemical sectors and on the region’s

ports. Full recovery in the affected areas is likely to be slow. The hurricanes left

an imprint on aggregate economic activity as well, seen, in part, in the marked deceleration of real GDP in the fourth quarter. However, the most recent evidence—

including indicators of production, the flow of new orders to businesses, weekly data

on initial claims for unemployment insurance, and the payroll employment and retail sales figures for January—suggests the economic expansion remains on track.

Inflation pressures increased in 2005. Steeply rising energy prices pushed up

overall inflation, raised business costs, and squeezed household budgets. Nevertheless, the increase in prices for personal consumption expenditures excluding food

and energy, at just below 2 percent, remained moderate, and longer-term inflation

expectations appear to have been contained.

With the economy expanding at a solid pace, resource utilization rising, cost pressures increasing, and short-term interest rates still relatively low, the Federal Open

Market Committee (FOMC) over the course of 2005 continued the process of removing monetary policy accommodation, raising the Federal funds rate 2 percentage

points in eight increments of 25 basis points each. At its meeting on January 31

of this year, the FOMC raised the Federal funds rate another 1⁄4 percentage point,

bringing its level to 41⁄2 percent.

At that meeting, monetary policymakers also discussed the economic outlook for

the next 2 years. The central tendency of the forecasts of Members of the Board of

Governors and the presidents of Federal Reserve Banks is for real GDP to increase

about 31⁄2 percent in 2006 and 3 percent to 31⁄2 percent in 2007. The civilian unemployment rate is expected to finish both 2006 and 2007 at a level between 43⁄4

percent and 5 percent. Inflation, as measured by the price index for personal consumption expenditures excluding food and energy, is predicted to be about 2 percent

this year and 13⁄4 percent to 2 percent next year. While considerable uncertainty

surrounds any economic forecast extending nearly 2 years, I am comfortable with

these projections.

In the announcement following the January 31 meeting, the Federal Reserve

pointed to risks that could add to inflation pressures. Among those risks is the possibility that, to an extent greater than we now anticipate, higher energy prices may

pass through into the prices of nonenergy goods and services or have a persistent

effect on inflation expectations. Another factor bearing on the inflation outlook is

that the economy now appears to be operating at a relatively high level of resource

utilization. Gauging the economy’s sustainable potential is difficult, and the Federal

Reserve will keep a close eye on all the relevant evidence and be flexible in making

those judgments. Nevertheless, the risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading

ultimately—in the absence of countervailing monetary policy action—to further upward pressure on inflation. In these circumstances, the FOMC judged some further

firming of monetary policy may be necessary, an assessment with which I concur.

Not all of the risks to the economy concern inflation. For example, a number of

indicators point to a slowing in the housing market. Some cooling of the housing

market is to be expected and would not be inconsistent with continued solid growth

of overall economic activity. However, given the substantial gains in house prices

36

and the high levels of home construction activity over the past several years, prices

and construction could decelerate more rapidly than currently seems likely. Slower

growth in home equity, in turn, might lead households to boost their saving and

trim their spending relative to current income by more than is now anticipated. The

possibility of significant further increases in energy prices represents an additional

risk to the economy; besides affecting inflation, such increases might also hurt consumer confidence and thereby reduce spending on nonenergy goods and services.

Although the outlook contains significant uncertainties, it is clear that substantial

progress has been made in removing monetary policy accommodation. As a consequence, in coming quarters the FOMC will have to make ongoing, provisional

judgments about the risks to both inflation and growth, and monetary policy actions

will be increasingly dependent on incoming data.

In assessing the prospects for the economy, some appreciation of recent circumstances is essential, so let me now review key developments of 2005 and discuss

their implications for the outlook. The household sector was a mainstay of the economic expansion again last year, and household spending is likely to remain an important source of growth in aggregate demand in 2006. The growth in household

spending last year was supported by rising employment and moderate increases in

wages. Expenditures were buoyed as well by significant gains in household wealth

that reflected further increases in home values and in broad equity prices. However,

sharply rising bills for gasoline and heating reduced the amount of income available

for spending on other consumer goods and services.

Residential investment also expanded considerably in 2005, supported by a strong

real estate market. However, as I have already noted, some signs of slowing in the

housing market have appeared in recent months: Home sales have softened, the inventory of unsold homes has risen, and indicators of homebuilder and homebuyer

sentiment have turned down. Anecdotal information suggests that homes typically

are on the market somewhat longer than they were a year or so ago, and the frequency of contract offers above asking prices reportedly has diminished. Financial

market conditions seem to be consistent with some moderation in housing activity.

Interest rates on 30-year, fixed-rate mortgages, which were around 53⁄4 percent over

much of 2005, rose noticeably in the final months of the year to their current level

of around 61⁄4 percent. Rates on adjustable-rate mortgages have climbed more considerably. Still, despite the recent increases, mortgage rates remain relatively low.

Low mortgage rates, together with expanding payrolls and incomes and the need to

rebuild after the hurricanes, should continue to support the housing market. Thus,

at this point, a leveling out or a modest softening of housing activity seems more

likely than a sharp contraction, although significant uncertainty attends the outlook

for home prices and construction. In any case, the Federal Reserve will continue to

monitor this sector closely.

Overall, the financial health of households appears reasonably good. Largely reflecting the growth in home mortgages, total household debt continued to expand

rapidly in 2005. But the value of household assets also continued to climb strongly,

driven by gains in home prices and equity shares. To some extent, sizable increases

in household wealth, as well as low interest rates, have contributed in recent years

to the low level of personal saving. Saving last year was probably further depressed

by the rise in households’ energy bills. Over the next few years, saving relative to

income is likely to rise somewhat from its recent low level.

In the business sector, profits continued to rise last year at a solid pace, boosted

in part by continuing advances in productivity. Strong corporate balance sheets combined with expanding sales and favorable conditions in financial markets fostered

a solid increase in spending on equipment and software last year. Investment in

high-tech equipment rebounded, its increase spurred by further declines in the

prices of high-tech goods. Expenditures for communications equipment, which had

fallen off earlier this decade, showed particular strength for the year as a whole.

In contrast, nonresidential construction activity remained soft.

Although the financial condition of the business sector is generally quite strong,

several areas of structural weakness are evident, notably in the automobile and airline industries. Despite these problems, however, favorable conditions in the business sector as a whole should encourage continued expansion of capital investment.

For the most part, the financial situation of State and local governments has improved noticeably over the past couple of years. Rising personal and business incomes have buoyed tax revenues, affording some scope for increases in State and

local government expenditures. At the Federal level, the budget deficit narrowed appreciably in fiscal year 2005. Outlays rose rapidly, but receipts climbed even more

sharply as the economy expanded. However, defense expenditures, hurricane relief,

and increasing entitlement costs seem likely to worsen the deficit in fiscal year

2006.

37

Outside the United States, economic activity strengthened last year, and at

present global growth seems to be on a good track. The economies of our North

American neighbors, Canada, and Mexico, appear to be expanding at a solid pace.

Especially significant have been signs that Japan could be emerging from its protracted slump and its battle with deflation. In the euro area, expansion has been

somewhat modest by global standards, but recent indicators suggest that growth

could be strengthening there as well. Economies in emerging Asia generally continue to expand strongly. In particular, growth in China remained vigorous in 2005.

Expanding foreign economic activity helped drive a vigorous advance in U.S. exports in 2005, while the growth of real imports slowed. Nonetheless, the nominal

U.S. trade deficit increased further last year, exacerbated in part by a jump in the

value of imported petroleum products that almost wholly reflected the sharply rising

price of crude oil.

Surging energy prices also were the dominant factor influencing U.S. inflation last

year. For the second year in a row, overall consumer prices, as measured by the

chain-type index for personal consumption expenditures, rose about 3 percent.

Prices of consumer energy products jumped more than 20 percent, with large increases in prices of natural gas, gasoline, and fuel oil. Food prices, however, rose

only modestly. And core consumer prices (that is, excluding food and energy) increased a moderate 1.9 percent.

The relatively benign performance of core inflation despite the steep increases in

energy prices can be attributed to several factors. Over the past few decades, the

U.S. economy has become significantly less energy intensive. Also, rapid advances

in productivity as well as increases in nominal wages and salaries that, on balance,

have been moderate have restrained unit labor costs in recent years.

Another key factor in keeping core inflation low has been confidence on the part

of the public and investors in the prospects for price stability. Maintaining expectations of low and stable inflation is an essential element in the Federal Reserve’s

effort to promote price stability. And, thus far, the news has been good: Survey

measures of longer-term inflation expectations have responded only a little to the

larger fluctuations in energy prices that we have experienced, and for the most part,

they were low and stable last year. Inflation compensation for the period 5 to 10

years ahead, derived from spreads between nominal and inflation-indexed Treasury

securities, has remained well-anchored.

Restrained inflation expectations have also been an important reason that longterm interest rates have remained relatively low. At roughly 41⁄2 percent at yearend, yields on ten-year nominal Treasury issues increased only slightly on balance

over 2005 even as short-term rates rose 2 percentage points. As previous reports

and testimonies from the Federal Reserve indicated, a decomposition of long-term

nominal yields into spot and forward rates suggests that it is primarily the far-forward components that account for the low level of long rates. The premiums that

investors demand as compensation for the risk of unforeseen changes in real interest rates and inflation appear to have declined significantly over the past decade

or so. Given the more stable macroeconomic climate in the United States and in the

global economy since the mid-1980’s, some decline in risk premiums is not surprising. In addition, though, investors seem to expect real interest rates to remain

relatively low. Such a view is consistent with a hypothesis I offered last year—that,

in recent years, an excess of desired global saving over the quantity of global investment opportunities that pay historically normal returns has forced down the real

interest rate prevailing in global capital markets.

Inflation prospects are important, not just because price stability is in itself desirable and part of the Federal Reserve’s mandate from the Congress, but also because

price stability is essential for strong and stable growth of output and employment.

Stable prices promote long-term economic growth by allowing households and firms

to make economic decisions and undertake productive activities with fewer concerns

about large or unanticipated changes in the price level and their attendant financial

consequences. Experience shows that low and stable inflation and inflation expectations are also associated with greater short-term stability in output and employment, perhaps in part because they give the central bank greater latitude to counter

transitory disturbances to the economy. Similarly, the attainment of the statutory

goal of moderate long-term interest rates requires price stability, because only then

are the inflation premiums that investors demand for holding long-term instruments

kept to a minimum. In sum, achieving price stability is not only important in itself;

but it is also central to attaining the Federal Reserve’s other mandated objectives

of maximum sustainable employment and moderate long-term interest rates.

As always, however, translating the Federal Reserve’s general economic objectives

into operational decisions about the stance of monetary policy poses many challenges. Over the past few decades, policymakers have learned that no single ecoVerDate 11-MAY-2000 17:43 Mar 27, 2006 Jkt 025856 PO 00000 Frm 00041 Fmt 6621 Sfmt 6621 26643.TXT SBANK4 PsN: SBANK4
38

nomic or financial indicator, or even a small set of such indicators, can provide reliable guidance for the setting of monetary policy.

Rather, the Federal Reserve, together with all modern central banks, has found

that the successful conduct of monetary policy requires painstaking examination of

a broad range of economic and financial data, careful consideration of the implications of those data for the likely path of the economy and inflation, and prudent

judgment regarding the effects of alternative courses of policy action on prospects

for achieving our macroeconomic objectives. In that process, economic models can

provide valuable guidance to policymakers, and over the years substantial progress

has been made in developing formal models and forecasting techniques. But any

model is by necessity a simplification of the real world, and sufficient data are seldom available to measure even the basic relationships with precision. Monetary

policymakers must therefore strike a difficult balance—conducting rigorous analysis

informed by sound economic theory and empirical methods while keeping an open

mind about the many factors, including myriad global influences, at play in a dynamic modern economy like that of the United States. Amid significant uncertainty,

we must formulate a view of the most likely course of the economy under a given

policy approach while giving due weight to the potential risks and associated costs

to the economy should those judgments turn out to be wrong.

During the nearly 3 years that I previously spent as a Member of the Board of

Governors and of the Federal Open Market Committee, the approach to policy that

I have just outlined was standard operating procedure under the highly successful

leadership of Chairman Greenspan. As I indicated to the Congress during my confirmation hearing, my intention is to maintain continuity with this and the other

practices of the Federal Reserve in the Greenspan era. I believe that, with this approach, the Federal Reserve will continue to contribute to the sound performance

of the U.S. economy in the years to come.

39

RESPONSE TO WRITTEN QUESTIONS OF SENATOR MENENDEZ

FROM BEN S. BERNANKE

Chairman Bernanke, you wrote in your macroeconomic textbook

about the consequences of budget deficits.

The Congressional Budget Office estimates that the deficit for

2006 will be $337 billion—even before including the cost of an anticipated supplemental appropriation for Iraq and Afghanistan expected early this year. The deficits for 2003, 2004, 2005, and 2006

are the four largest deficits in American history.

Because of these deficits, the long-term attractiveness of the

United States as an investment destination could be hurt as investors worry about our Nation’s ability to manage its debts. And the

deficits could also cause consumers problems if foreign investors

stop buying U.S. assets, forcing interest rates to rise sharply. Finally with the ongoing wars in Iraq and Afghanistan, our budget

is going to be under continued pressures in the future.

Over time, large deficits and debt will raise interest rates, crowd

out private sector investment, and slow long-term economic growth.

Q.1. How much importance do you put on paying down the publicly

held debt that our Nation currently holds?

A.1. I am quite concerned about the intermediate to long-term Federal budget outlook. In particular, the budget is expected to come

under severe pressure as impending demographic changes fuel

rapid increases in entitlement spending. By holding down the

growth of national saving and real capital accumulation, the prospective increase in the budget deficit will place at risk future living standards of our country. As a result, I think it would be very

desirable to take concrete steps to lower the prospective path of the

deficit. Such actions would boost national saving and ultimately

the future prosperity of our country, as our children and grandchildren would inherit a larger capital stock that would support

greater productivity and higher income. Moreover, steps should be

taken soon to address the long-term budget pressures so that people have adequate time to prepare for whatever changes might

occur, especially to entitlement programs.

Although the stock of debt held by the public would decline in

absolute magnitude only if budget surpluses are run, fiscal actions

that result in smaller deficits can slow the growth in the stock of

debt held by the public and reduce the Federal debt relative to the

size of the economy. The key is not so much the absolute level of

Federal debt, but rather that we take deficit-reducing steps to increase national saving and, hence, future living standards.

As you know, the pay-as-you-go budget provisions of the 1990’s

required lawmakers to pay for any increases in entitlement spending or decreases in revenues (that is, tax cuts); such changes had

to be offset either by equivalent budget cuts or by revenue increases elsewhere. Since those rules expired in 2002, Congress has

strived and did enact a variation on PAYGO that completely exempts taxes from the equation: No tax cuts would require offsetting, and spending increases could only be offset by entitlement

cuts elsewhere—never by tax increases. This despite the fact our

Federal budgets over the last few years have run recorded deficits.

40

This one-sided PAYGO passed despite the recommendations of

people like Federal Reserve Chairman Alan Greenspan, Congressional Budget Office Director Douglas Holtz-Eakin, and Government Accountability Office Comptroller General David Walker, who

all strongly and repeatedly urged Congress to adopt full PAYGO

rules.

Q.2.a. Chairman Bernanke, do you support full PAYGO rules over

spending-only ones?

A.2.a. As I noted in response to the previous question, I believe reducing the Federal deficit is very important, especially in light of

the need to prepare for the retirement of the baby-boom generation.

I urge the Congress to proceed on that effort in a timely manner

and to pay particular attention to how its decisions on spending

and tax programs will affect the U.S. economy over the long-term.

However, I also believe that in my role as head of the Federal Reserve, I should not be involved in making specific recommendations

about the internal decisionmaking process of the Congress and the

structure of its budget procedures.

Q.2.b. The Treasury Department recently issued its first 30-year

bonds in over 4 years. Do you support this decision to bring back

the long bond?

A.2.b. The responsibility for Federal debt management, of course,

rests with the Treasury Department. However, I do support the

Treasury’s decision to resume issuance of 30-year bonds. Given the

large current and prospective Federal financing needs, it is prudent

to distribute the Treasury’s borrowing across the yield curve. Moreover, long-term interest rates are currently quite low, apparently

reflecting in part strong demand among investors for long-term

issues. In these circumstances, it is sensible for the Treasury to accommodate this demand in part by issuing 30-year securities.

Last week, when the Treasury issued its first 30-year bond since

2001, there was $28 billion in bids for $14 billion of bonds being

offered. This in turn made it cheaper for the Treasury to borrow

for 30 years than 6 months.

Q.3. Do you have any concern that this will contribute to the creation of a bond market bubble, which has the potential effect of

lowering inflation-adjusted interest rates to incredibly low levels?

A.3. I do not have any such concerns. I should note that I do not

see particular significance to the level of bids relative to the size

of the recent auction. I attribute the relatively low level of longterm interest rates generally to several factors, including a tendency in recent years for global saving to exceed the amount of

potential capital investments, yielding historically normal rates of

return as well as relatively low-term premiums in interest rates to

compensate investors for interest rate risk. In the unlikely event

that any of these factors tended to push real long-term yields to

levels that appeared to be incompatible with our macroeconomic objectives, the Federal Reserve would respond by adjusting the stance

of monetary policy appropriately.

Q.4. What impacts could this have on our economy?

A.4. No significant adverse effects are likely.

41

Last week, the Commerce Department reported that our trade deficit rose 17.5 percent to $725.8 billion in 2005, a new record for

the fourth consecutive year.

You have stated in the past your belief that what you call a

‘‘global savings glut’’ is the main driver behind America’s record

trade deficit, and that the ability to reduce our trade deficit is

largely beyond our control.

Q.5. Is there nothing we can do to alleviate the pressure building

up in the global financial system?

A.5. The emergence of large U.S. trade deficits and corresponding

surpluses on the part of our trading partners is, to an important

extent, the outcome of market forces. Several factors, including the

lingering effects of financial crises in emerging market economies

and concerns about the outlook for growth in some industrial

economies, have led saving abroad to exceed investment. This excess saving has been attracted to the United States by our favorable investment climate, strong productivity growth, and deep

financial markets. Although the U.S. net external debt has been

growing as a consequence of these inflows, as a fraction of our Nation’s income it remains within international and historical norms.

Given the strength and flexibility of our economy, there is every

reason to believe that, if changes in the foreign outlook or in the

tone of financial markets were to cause a reduction in capital

inflows and the trade deficit, economic activity, and employment

would stay strong.

Q.6. Wouldn’t reducing our budget deficit and getting tough on currency manipulators help?

A.6. All that said, as our net external debt rises, the cost of servicing that debt increasingly will subtract from U.S. income. Accordingly, it would be helpful to raise our domestic saving and reduce

our trade deficit while maintaining an environment conducive to

investment and growth. Reducing the budget deficit would release

resources for private investment and reduce the future burden of

repaying the public debt, although studies indicate a relatively

modest effect of budget-cutting on the trade deficit. Pro-growth

policies among our trading partners would also contribute to some

adjustment of external imbalances. Finally, more flexible exchange

rate regimes in some countries would provide greater scope for

market forces to reduce our trade deficit, and would be in the interests of the countries implementing these regimes as well. Nevertheless, in the absence of a shift in market perceptions of the relative

attractiveness of United States and foreign assets, government

policies would likely have only limited effects on the trade balance.

Chairman Bernanke, under the fiscal year 2006 Congressional

budget resolution and the two related reconciliation bills, Congress

has cut Medicaid by $6.9 billion while spending up to $70 billion

over the next 5 years to repeal some of the sunsets of President

Bush’s 2001 and 2003 tax cut packages. According to the UrbanBrookings Tax Policy Center, more than 70 percent of the benefits

of those tax breaks have gone to the 20 percent of taxpayers with

the highest incomes, and more than 25 percent of the benefits to

the top 1 percent. Medicaid’s benefits, by contrast, go almost entirely to those at the bottom of the income scale.

42

Q.7. Don’t these additional tax breaks (from the fiscal 2006 reconciliation bills), when combined with the Medicaid cuts, amount

to a massive redistribution of income from those at the bottom to

those at the top?

A.7. As I stated in my testimony on the Monetary Policy Report,

the Federal Government has an important role to play in boosting

national saving as a share of national income over time. Of particular concern to me is the mismatch between taxes and spending

in long-term budget projections. This mismatch means that over

time either taxes will have to be raised or the spending increases

embedded in current laws will need to be scaled back, or some combination of the two. Deciding on the mix of policy actions to be

implemented will require the difficult balancing of sometimes conflicting goals regarding the provision of public services, the effects

on economic efficiency of increasing taxes, and the distribution of

fiscal burdens among various groups. The judgments about how to

balance these priorities are ultimately political judgments and not

ones that I believe I should address in my role as Chairman of the

Federal Reserve.

Chairman Bernanke, the 1991 edition of your Macroeconomics

textbook contains a policy debate on the minimum wage. At the

end of the debate, the textbook concludes: ‘‘Therefore, the total

labor income of unskilled workers does increase when the minimum wage rises . . . . Overall, taking these various effects into

account, a recent study finds that raising the minimum wage from

$3.35 per hour to $4.25 per hour [note: those were the amounts

under discussion at that time] could reduce the number of families

in poverty by about 6 percent, on balance a reasonably substantial

effect.’’ The textbook goes on to find: ‘‘Thus, the inflationary effects

of an increase in the minimum wage are relatively small . . . As

a result, an increase in the minimum wage has negligible effects

on aggregate employment and output.’’

Your textbook was written in 1991 when the minimum wage was

$4.25 an hour. Today, in real terms it is below that level ($4.25 in

1991 would be $5.89 today).

Q.8. Do you believe that increasing the minimum wage above its

current level of $5.15 an hour—where it has been stuck for over 8

years—would be good economic policy, along the lines that your

textbook concluded?

A.8. I am reluctant to comment on specific proposals regarding the

minimum wage, but I can offer some general comments. In particular, I would note that the minimum wage is a very controversial issue among economists. Clearly, if the minimum wage were

raised, then those workers who retain their jobs will benefit from

the higher income associated with the higher minimum wage. However, economists have raised two concerns about minimum wages.

The first is whether minimum wages have adverse employment effects; that is, do higher wages lower employment of low-skilled

workers? The second is whether the minimum wage is as well targeted as it could be; that is, to what extent is the increase benefiting workers other than those from low-income families?

My own view is that an increase in the minimum wage probably

does lower employment. However, I would note that while this is

43

the consensus view among economists, there is some research indicating that any such disemployment effects could be negligible. In

any event, it does seem likely that the employment losses from a

modest increase in the minimum wage would be relatively small

from a macroeconomic standpoint and thus, at the levels of the

minimum wage prevailing in the United States, a modest increase

would not have sizable negative effects on aggregate output.

The effect of a higher minimum wage on poverty is also a hotly

debated topic among economists. However, my reading of the research that has become available over the past 10 years or so is

that if there is any reduction in poverty associated with a higher

minimum wage, it is likely to be quite small. In this context, one

might consider alternative ways of helping low-income workers,

such as the Earned Income Tax Credit, which delivers money directly to working families and is thus better targeted toward poverty reduction than is the minimum wage.

RESPONSE TO A WRITTEN QUESTION OF SENATOR CRAPO

FROM BEN S. BERNAKE

Q.1. I am very concerned about the potential efforts in this Congress to change the manner in which we regulate derivatives or to

impact the manner in which derivatives operate in the economy,

and I would like to have your comments on the importance of having a strong, stable, and dynamic derivatives market in this country and what it means to our economy.

A.1. Derivatives markets have had important effects on two dimensions of our economy. First, as is often noted, derivatives enable financial risks to be unbundled and shifted to those willing and able

to bear them. The U.S. economy has proven to be resilient in the

face of shocks over the past several years. Although no single factor

accounts for this favorable performance, derivative instruments undoubtedly have contributed to this resilience because they offer

firms means for managing their risks. Second, derivatives have

contributed to our understanding of the measurement and management of risk. Today’s sophisticated risk management systems developed in tandem with derivatives markets. When individual firms

become less vulnerable to shocks, the financial system as a whole

becomes more resilient. Certainly, derivative instruments pose

challenges to risk managers and to supervisors, but these risks are

manageable and thus far have generally been managed quite well.

Market discipline has provided strong incentives for effective risk

management, the key to ensuring that the benefits of derivatives

continue to be realized.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI

FROM BEN S. BERNAKE

Mr. Chairman, I noted in a press release dated November 10,

2005 that the Federal Reserve would cease publication of the M3

money aggregate, the broadest measure of the U.S. money supply.

I have carefully read your testimony in the House Financial Services Committee on this topic. I have some follow-up questions:

Q.1. You noted in your testimony to the House Financial Services

Committee that money aggregates are among the many indicators

that the Federal Reserve Board uses to determine monetary policy.

44

In your opinion, would discontinuing the M3 aggregate deprive the

Board of information useful in the formation of U.S. monetary policy? Has the M3 aggregate become obsolete?

A.1. Over time, the Federal Reserve continuously assesses the usefulness of the various statistics that it monitors in the conduct of

monetary policy. In cases in which the Federal Reserve compiles

and publishes the data, the Board seeks to revise its statistical program appropriately, taking into account ongoing developments in

the economy and the financial system as well as both the benefits

and the costs of data collection. For example, in the early 1980’s

the Federal Reserve redefined the monetary aggregates to reflect

changes in the financial environment. Similarly, for a time research suggested that a broad measure of nonfinancial sector debt

should receive considerable attention in monetary policymaking,

and the Board began to publish monthly data on such an aggregate. Over subsequent years, policy experience and accumulating

empirical evidence indicated that some of these aggregates—in particular, domestic nonfinancial sector debt at a monthly frequency,

and the broadest monetary aggregate—were not particularly useful

in the conduct of policy. Accordingly, the publication of those aggregates was either scaled back or dropped. Similarly, the Board over

time recognized that M3 was not providing information that was

useful to policymakers. Recently, the Board decided that discontinuing the compilation of that aggregate would not deprive the

Federal Reserve of information useful in the formulation of U.S.

monetary policy and, given the costs involved in compiling the aggregate, it decided to discontinue M3.

Q.2. Reducing regulatory burden for our Nation’s banks is a laudable goal and an effort I support. How many financial institutions

are currently required to provide data to the Fed to calculate the

M3? Do these same institutions report data to calculate the M1 and

M2 aggregates? Is there any quantitative data on the savings

achieved by reporting institutions once publication of the M3 has

ceased?

A.2. A complex system of reports is employed to collect the data

necessary to compile the monetary aggregates, and discontinuing

M3 will allow two reports—the FR 2415 and the FR 2050—to be

dropped. The FR 2415 form (Report of Repurchase Agreements

[RP’s] on U.S. Government and Federal Agency Securities with

Specified Holders) is reported by approximately 450 institutions

(270 reporting annually, 90 quarterly, and 90 weekly). The FR

2050 form (Weekly Report of Eurodollar Liabilities Held by Selected U.S. Addressees at Foreign Offices of U.S. Banks) is reported

by about 35 institutions. The discontinuation of the FR 2415 and

the FR 2050 is estimated to reduce annual reporting burden by a

total of 4,487 hours. These reports are used to obtain data only for

M3, not M1 or M2.

I should note that discontinuing M3 will also allow two of our fellow central banks, the Bank of Canada and the Bank of England,

to stop collecting, editing, compiling, and transmitting additional

data on Eurodollars—a task that no doubt involved the expenditure

of significant resources for which those institutions were not compensated. We do not have estimates of the savings that will accrue

45

to the Bank of Canada and the Bank of England, or of any of the

entities that report to those central banks, as a result of the elimination of M3.

Q.3. Is there any indication of how useful the M3 aggregate is to

the U.S. public? How did the Fed determine the public’s demand

for this data?

A.3. Federal Reserve staff conducted a search to determine the extent to which M3 was used in the professional literature on monetary economics. The staff found that the vast majority of academic

papers published between 1990 and 2000 that referenced ‘‘M3’’ actually referred to foreign versions of M3, which correspond most

closely to the Federal Reserve’s M2 aggregate rather than our M3

aggregate. The remaining papers, which actually did use U.S. M3,

fell into the following categories:

• Papers testing new methods of creating monetary aggregates (for

example, so-called ‘‘Divisia monetary aggregates’’). These papers

did not demonstrate any important indicator properties of M3.

• Papers testing new methods of estimating long-run econometric

relationships. Some of these papers estimated equations based on

the quantity theory of money for a range of monetary aggregates.

Again, these papers suggested that M3 played no particularly

valuable role.

• Papers testing the forecasting properties of various financial or

other variables. M3 would be one of hundreds of variables used

in such tests.

In all cases, M3 was studied only in combination with M2 and

other monetary aggregates. In summary, our review of the academic literature revealed no evidence that M3 was particularly

useful in macroeconomic analysis or forecasting.

The Board believes that it has a responsibility to the taxpayer

to weigh carefully the costs and benefits of all of the various activities of the Federal Reserve, including data collection and publication, to determine whether the Federal Reserve is performing its

responsibilities most efficiently. In the course of such a review, the

Board recently judged that the costs to the Federal Reserve of collecting and processing the data necessary to publish M3 exceeded

the benefits. Moreover, discontinuing two of the reports that need

to be filed in order to construct M3 will permit a small reduction

in the burden on some depository institutions.

As the Nation’s central bank, the Federal Reserve recognizes the

importance of carefully monitoring as well as releasing to the public data on useful concepts of the money supply, and the Board will

continue to publish timely data on the monetary aggregate M2. Of

the various monetary and debt aggregates, in our view M2 has exhibited the most stable, explicable, and useful relationship with

measures of nominal spending and interest rates. In addition, the

Board will continue to publish the monetary aggregate M1, which

is a component of M2, as well as the other components of M2. The

Board will also continue to publish data on shares issued by institution-only money market mutual funds, which are currently included in the non-M2 component of M3.

46

47

48

49

50

51

52

53

54

55

56

57

58

59

60

61

62

63

64

65

66

67

68

69

70

71

72

73

74

75

76