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30–354 PDF 2006

S. HRG. 109–615

FEDERAL RESERVE’S SECOND 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

JULY 19, 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

PEGGY R. KUHN, Senior Financial Economist

MARK OESTERLE, Counsel

MARK A. CALABRIA, Senior Professional Staff Member

LEE PRICE, Democratice Chief Counsel

STEPHEN R. KROLL, Democratic Special Counsel

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

WEDNESDAY, JULY 19, 2006

Page

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

Opening statements, comments, or prepared statements of:

Senator Sarbanes .............................................................................................. 2

Senator Bennett ................................................................................................ 4

Senator Reed ..................................................................................................... 4

Senator Bunning ............................................................................................... 5

Senator Menendez ............................................................................................ 6

Senator Dole ...................................................................................................... 7

Senator Stabenow ............................................................................................. 8

Senator Allard ................................................................................................... 9

Senator Carper ................................................................................................. 10

Senator Sununu ................................................................................................ 12

Senator Martinez .............................................................................................. 12

Senator Hagel ................................................................................................... 12

Senator Dodd .................................................................................................... 13

WITNESS

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

System, Washington, DC ..................................................................................... 13

Prepared statement .......................................................................................... 46

Response to written questions of:

Senator Shelby ........................................................................................... 49

Senator Reed .............................................................................................. 51

Senator Stabenow ...................................................................................... 51

Senator Crapo ............................................................................................ 54

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Monetary Policy Report to the Congress, July 19, 2006 ....................................... 56

(III)

(1)

FEDERAL RESERVE’S SECOND MONETARY

POLICY REPORT FOR 2006

WEDNESDAY, JULY 19, 2006

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

The Committee met at 10:06 a.m., in room SD–106, 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 Ben Bernanke before

the Committee on Banking, Housing, and Urban Affairs, to deliver

the Federal Reserve’s Semi-Annual Monetary Policy Report to the

Congress.

Chairman Bernanke, your testimony and report this morning

note the economy’s strong performance in the first half of 2006.

Real gross domestic product, GDP, increased at an annual rate of

5.6 percent in the first quarter of 2006. Federal Reserve data released earlier this week showed U.S. industrial production rising

0.8 percent in June with capacity utilization now at 82.4 percent,

the highest rate since June 2000. We continue to enjoy a low unemployment rate, both historically and relative to other industrialized

nations.

Some of the most recent economic data make it clear the balancing act that the Federal Reserve now faces. Energy prices, including oil, have increased over the past year and the turmoil in

the Middle East adds to concerns in this area. Housing markets

seem to be catching their breath, with the pace of rapid price appreciation slowing and in some markets showing small declines.

Both factors lead to questions about the ability of consumers to

continue consumption growth in our economy.

At its most recent meeting on June 29, the Federal Open Market

Committee raised its target for the Federal funds rate by 25 basis

points to 5.25 percent, the seventeenth one-quarter point increase

since June 2004 when the FOMC began raising the target rate

from a then low of 1 percent.

Fed watchers noted that the latest FOMC statement seemed to

leave open the question of whether the FOMC will increase the

Federal funds target at its next meeting, referencing ‘‘the extent

and timing of any additional’’ rate increases. Although the minutes

of that meeting will not be released until July 20, our hearing this

morning gives us the opportunity to discuss which factors were sigVerDate 11-MAY-2000 17:03 Nov 06, 2006 Jkt 025856 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 30354.TXT SBANK4 PsN: SBANK4
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nificant in your deliberations and what factors you may be looking

at as the FOMC prepares for its next monetary policy hearing on

August 8. Our hearing this morning can thus add to the transparency of the FOMC process.

Mr. Chairman, we are pleased to have you with us this morning.

We look forward to discussing in greater detail the Federal Reserve’s performance in carrying out monetary policy and its views

on the future direction of our Nation’s economy. We all look forward to raising a number of questions with you then.

Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Chairman Shelby. I

welcome Chairman Bernanke before the Committee.

I think it is fair to say this hearing comes at a particularly pivotal time for monetary policy. The economy is slowing down and

the run-up in oil prices is contributing to that slowdown. An oil

price spike has preceded a number of recessions since 1973, but

some spikes have occurred without a subsequent recession. We look

to the Federal Reserve to help avoid a recession this time around.

There are a number of signs of economic weakness. Job growth

has been anemic for the last 3 months, averaging just over 100,000

jobs per month. The pace is less than 1 percent a year. Over the

last half century we have tended to have such slow job growth

when we are going into or coming out of a recession. It is less than

half the pace of job growth for the 10 years of expansion from

March 1991 to March 2001.

Not only are jobs growing slowly, but also all the measures of

wages and compensation show gains below inflation over the last

year. Total compensation, including wages and benefit costs, have

risen 2.8 percent in the last year. Such pay gains are not putting

upward pressure on inflation because they are almost entirely offset by productivity gains, which are up 2.5 percent. Unit labor

costs, which adjust hourly labor costs for productivity gains, are up

by a negligible 0.3 percent in the last year.

That is shown rather dramatically in this chart, which shows

compensation, productivity, and unit labor costs.

Unfortunately, the only people with pay gains that are keeping

ahead of inflation are those at the top of the ladder. By this stage

in previous business cycle expansions, people at the middle and

bottom of the wage ladder have typically been enjoying healthy pay

gains. This was certainly the case from 1995 to 2000. We need to

keep the expansion going so that those at the middle and the bottom of the pay scale can finally share in the exceptional productivity gains that they have helped to create.

With the higher cost of fuel and little room to cut back on fuel

use, consumers have been forced to cut back on other types of

spending and they go into debt. Consumer spending has risen at

less than a 2 percent rate over the last 4 months. To manage even

that modest increase, households have had to reduce savings and

increase borrowing. The household savings rate has plunged to an

unprecedented minus 1.7 percent.

Where is the rise in inflation coming from? Although higher

prices for oil and other commodities have contributed, much more

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important is the surge in profit margins. At this hearing 2 years

ago, Chairman Greenspan drew attention to this, stating ‘‘from an

accounting perspective, between the first quarter of 2003 and the

first quarter of 2004 all of the 1.1 percent increase in the prices of

final goods and services produced in the nonfinancial corporate sector can be attributed to a rise in profit margins rather than cost

pressures.’’

He predicted at the time that competition to create new capacity

and hire more workers would bring down the profit share to more

normal levels, but that has not happened. In fact, the profit share

of GDP hit 12.7 percent in the first quarter, the highest profit margin since 1950. With inflation racing ahead of wages and rising interest rates, we see a serious downturn in the housing industry.

The housing affordability index has plunged to the lowest level

since 1989 when declining housing led to a recession in 1990.

New home sales so far this year are running 11 percent below

the rate for the same period last year. With sales down, builders

have cut back on new home construction. They are obtaining permits at a rate of more than 1.7 million a year for 5 months last

year, but that rate fell below 1.5 million in the latest months. We

are now down below 1.4 million. This is new single family home

permits, and it shows a rather marked decline over the last year.

Last week’s report on the consensus of blue chip economic forecasters should also give Federal Reserve policymakers pause. The

consensus expects growth below the trend line starting with the

just-completed second quarter through the end of 2007. In addition,

the blue chip economic forecasters expect inflation to slow down to

about 2.5 percent next year.

I am hopeful that this morning Chairman Bernanke can put to

rest some troubling concerns about monetary policy. The Fed’s

statements that future changes in interest rates will depend on

new data, not an all together unreasonable statement I might say,

but it has been interpreted by some commentators to mean that

the Federal Reserve will raise interest rates at every meeting until

inflation comes down.

The headlines of the last two weekly reports from Goldman

Sachs are ‘‘The Stance of Monetary Policy, Enough is Enough.’’ And

the other one ‘‘Bernanke Preview, Monetary Policy Begins to Bite.’’

Two recent headlines from Merrill Lynch state that its ‘‘getting

tougher for the Fed to justify what it is doing’’ and ‘‘nearly every

indicator showing signs of a slowdown.’’

Merrill Lynch Economist David Rosenberg, in a report last Friday entitled, ‘‘To Pause Or Not To Pause: That Is The Conundrum,’’ expressed this concern: ‘‘The Fed has managed to elevate a

pause to something that is a pretty major event. What was normal

in prior cycles, up or down, is now something that grabs headlines.

The Fed paused twice in the 1999–2000 cycle and three times in

the 1994 cycle, and it elicited a yawn from the markets. This time

around a ‘pause’ is being treated as an ‘ease,’ which has basically

put the Fed in a pickle.’’

The 17 Fed rate hikes over the last 2 years are having an effect.

You can see that in the housing sector, job growth, the blue chip

forecast. Both for subdued growth and for falling inflation over the

next year.

4

I look forward to the opportunity to pursue these concerns with

the Chairman in the question period. I also, just to send a warning,

hope to be able to ask you about the Basel II situation which I

think is a matter that calls for very close attention, which I do not

think it has been receiving.

Thank you very much, Mr. Chairman.

Chairman SHELBY. We have established a quorum and at this

time, if you will bear with us, Mr. Chairman, I would like to move

the Committee to executive session to consider a number of nominations that we have had hearings on.

[Recess.]

Chairman SHELBY. We will now resume the hearing.

Senator Bennett.

STATEMENT OF SENATOR ROBERT F. BENNETT

Senator BENNETT. Thank you, Mr. Chairman.

Chairman Bernanke, welcome to the Committee. I look forward

to hearing what you have to say today. I will not recite a bunch

of statistics as my colleagues have because I think we will get into

those.

I will look for to your comments with respect to how the economy

is changing. We are in the midst of the Information Revolution,

and just as the Industrial Revolution changed things rapidly, so I

believe the Information Revolution is changing things, and we need

to recognize that sometimes past benchmarks in the new, changed

environment in which we find ourselves may not be the best benchmarks to look at. We should look around for new ones and the

signs of the changes.

I am particularly focused on the impact of productivity gains.

Productivity has gone up much more rapidly in the information age

than it did in the industrial age and it is affecting a number other

economic indicators.

So, I welcome you here and look forward to a dialogue with you

on these and other related issues.

Chairman SHELBY. Senator Reed.

STATEMENT OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman. I would

make three points.

Gross domestic product has spiked up in the first quarter but

there is evidence that the economy is slowing even before most

Americans have benefited from the growth we have seen thus far

in the recovery. As my colleagues have pointed out, strong productivity growth has shown up in the bottom lines of shareholders but

not in the paychecks of workers. We are also facing soaring energy

prices, record budget and trade deficits, and a negative household

saving rate. All of these pose tremendous challenges to setting

monetary policy which the Chairman and his colleagues are

charged to do.

We also have a situation where we no longer maintain the fiscal

discipline that we had in the 1990’s which allowed for monetary

policy that encouraged investment and long-term growth. We have,

I think, squandered that fiscal discipline and that complicates your

job also, Mr. Chairman.

5

I would also associate myself with the comments that Senator

Sarbanes made with respect to the growing inequality of income,

earnings, and wealth in this economy. It is particularly troublesome because as we pursue some of these tax policies which further

increase the deficit and further erode the ability to provide basic

support to middle-income Americans, like Pell grants and other

programs, the difficulty of workers in this country to support their

families is infinitely complicated and I think that is something that

the Fed has to be concerned about, even if it does not have direct

policy leverage to use.

So, Mr. Chairman, I look forward to Chairman Bernanke’s testimony. I thank him for his service.

Chairman SHELBY. Senator Bunning.

STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. Thank you, Mr. Chairman.

This is a very important hearing that we do twice a year and I

cannot remember when it came at a more critical time for our markets and our economy. It has been a long time since I have seen

a stock market that is as sensitive and unstable as this one.

Chairman Bernanke, you have only been on the job for 51⁄2

months but it has been a wild ride. I am disappointed in your leadership of the Fed so far but I am not surprised. During your confirmation process, I warned my colleagues that you were going to

be much the same as former Chairman Greenspan, and so far you

have been. The string of interest rate increases started by Chairman Greenspan has continued, and just as he did in 2000, I think

you are going to overshoot.

Also, you have not ended the group think at the Fed. In fact, it

seems you have gone so far as to hand-pick new Fed Members that

think just as you do.

Some commentators point to the situation in the Middle East

and North Korea as driving the market down, but those tensions

have been around a lot longer than the current market downturn.

Others say high energy prices are hanging over the economy. Yes,

oil is expensive, but it is still below all-time highs when adjusted

for inflation, and our energy expenses are a smaller percentage of

our total expenses than in the past. Those are not the market’s

problems.

What is dragging the market down is interest rates and uncertainty about Fed action. The Fed can do three things with its interest rate actions. It can overshoot, it can undershoot, or it can get

it just right. It is much easier to mess up than to get it just right.

The Fed has raised rates at 17 straight meetings. The Fed funds

rate stands at 5.25 percent today and could go higher. There has

been no pause to see how the economy reacts to those rate hikes.

It has been one increase after another. At the current pace the Fed

is going to overshoot and not even know it. By the time the full

impact of interest rate increases is evident it will be too late. The

U.S. economy will be damaged, and for that matter, the world economy could follow.

The decisions of our central banks are often followed by foreign

central banks and many have raised rates to keep pace with the

United States. So many foreign economies rely on a strong U.S.

6

economy for their growth and stability. The Fed is marching into

dangerous territory and not looking back. There is a lot of speculation that the Fed may pause at the next meeting, but that is another way of saying that the Fed is still considering another increase. The markets do not know what the Fed is going to do and

they will be on edge until there is certainty.

Public statements by Fed Members over the last few months

have not helped either. Many Governors have raised concerns that

inflation is growing and said that interest rate hikes should continue. Others have said that it may be time to pause but have not

dissented in Fed actions.

The most recent official Fed statement has even caused more uncertainty. It was softer than the tough talk of the Chairman and

others leading up to the meeting yet it does not rule out further

rate increases. I still do not understand what all this talk and uncertainty is for. Inflation is not out of control. And I say it definitely, one more time. Inflation is not out of control. And if you

think it is, we will further pursue it in the question and answer

period.

All indicators of inflation show that while it may be higher than

in the past few years, it is still far below what we saw in the past

few decades. Key indicators like gold are off their highs from earlier in the year and productivity has kept unit labor costs in check.

The Fed is chasing an inflation monster that is just not there. I

hope the Fed realizes that before it is too late.

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

Chairman SHELBY. Thank you.

Senator Menendez.

STATEMENT OF SENATOR ROBERT MENENDEZ

Senator MENENDEZ. Thank you, Mr. Chairman.

Welcome, Chairman Bernanke. Let me say, recently we learned

that the anticipated deficit for the fiscal year 2006 is down from

what had been projected and for that we should all be happy. However, we are still talking about a deficit of $296 billion. And though

that is better than the original estimated deficit of $423 billion,

which some considered was an inflated estimate in the first instance, it is a far cry from the $600 billion budget surplus for 2006

that was predicted by the White House back in 2001.

Now that discussion certainly belies the $10 trillion to $12 trillion debt that the Congressional Budget Office tells us we are

headed to by 2011. So while some in this country believe that are

our economy is chugging along quite well because our gross domestic product continues to grow, there seems to be an increasing gap

between the average citizen and those at the top of our economic

ladder. The disparity between the haves and have-nots seems to be

widening at an alarming rate.

When I am back in New Jersey, I hear more and more from New

Jerseyians that they are working harder and longer just to try to

keep their heads above water, whether it is because of higher costs

for college, soaring health care costs, increasing energy prices, gas

prices, stagnant and flat wages, or pensions being underfunded and

in some cases totally abandoned, there is a huge disconnect beVerDate 11-MAY-2000 17:03 Nov 06, 2006 Jkt 025856 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 30354.TXT SBANK4 PsN: SBANK4
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tween growth in our GDP and the situation that the average American finds themselves and their families in.

So the question is, who is this economy working for? I look forward to your testimony today and to hearing your thoughts on

some of those items I have just mentioned and other challenges we

face as a Nation, such as the cooling off of the housing market and

what that may mean, rising energy prices, consequences of deficit

and debt, record trade deficits, real wages remaining flat, negative

household and national savings, a variety of global influences and

how these factors affect the dynamic of the modern global economy

that we have. Those are the challenges I hear from average New

Jerseyians and Americans that they are currently facing and that

you have before you.

So as we wish you well in the stewardship of the economy, we

look forward to hearing your testimony and hopefully reflecting

upon some of those items. If not, I will pursue it in my questions.

Thank you, Mr. Chairman.

Chairman SHELBY. Thank you.

Senator Dole.

STATEMENT OF SENATOR ELIZABETH DOLE

Senator DOLE. Thank you, Chairman Shelby.

Mr. Chairman, I join my colleagues in extending a very warm

welcome to you this morning. We have seen very strong growth in

our economy over the last few years even as our Nation as has

faced some extremely challenging times. I expect the positive economic trends will continue in the coming months and years. Still,

we have hard work ahead indeed to ensure that all levels and sectors of the economy benefit from this prosperity.

In just the past year, the economy has created nearly 2 million

new jobs and the national unemployment rate remains lower, as we

have said so often, than the average of the 1970’s, the 1980’s and

1990’s. While we are seeing a cooling of the housing sector, the

other pistons of our economic engine are firing.

There have been recent reports that wages are going up, which

I hope signals that wages are beginning to catch up with the very

dramatic increases in productivity. Also, consumer confidence has

continued to rise. The first-quarter GDP results of this year were

revised upward to an impressive 5.6 percent, as we have heard already this morning. This has resulted in higher than expected tax

revenues and a decline in the deficit. In fact in the first 9 months

of fiscal year 2006, we have seen one of the highest growth in tax

revenues in 25 years, second only to last year. These are indeed indicators of a robust and expanding economy.

Still, I share the concerns of the American people that energy

prices continue to increase. There is no question these costs are

putting a real strain on families and businesses. Folks also are concerned about the availability and affordability of health care.

In order to address this broader problem, I believe we must empower families to make health care decisions based on their specific

needs and allow them greater choice over how their health care

dollars are spent. We must also work to improve transparency,

portability, and efficiency to better meet consumers’ needs.

8

In addition, as our overall economy is thriving, we must be mindful that there are areas in some of our States like North Carolina

where the economic picture is not quite as bright, where factories

and businesses have closed and people are out of jobs. In North

Carolina, we have experienced a transition from our tradition tobacco and manufacturing industries of textiles and furniture to

new high-growth industries like biotechnology and pharmaceuticals. These new jobs, as we all know, require a well-educated

and highly trained workforce. To this end, we must make education

and job training a priority and focus our efforts on closing the gap

between skilled and unskilled workers.

Unfortunately, this gap has only widened since my days as Secretary of Labor. As our economy moves forward, the opportunities

for lower-skilled workers are simply diminishing. It is imperative

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

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 workforce, and of course, hard work, these will ensure that

we stay on course toward greater opportunity for North Carolina

and for the Nation.

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

hearing from you and working closely with you on these and other

important issues. Thank you.

Chairman SHELBY. Senator Stabenow.

STATEMENT OF SENATOR DEBBIE STABENOW

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

Chairman Bernanke. It is good to have you with us again. I look

forward to your testimony. I have read your statements recently

and have become increasingly concerned about the slowdown you

are referring to, as my other colleagues have as well. I recognize

that while this may be good for inflationary purposes to hold down

interest rates certainly, and slows down growth to make sure the

economy is not moving too fast, in my home State of Michigan this

just means more bad news because we are already experiencing a

slowdown.

As Senator Menendez spoke, he was really speaking about the

squeeze that middle-class families are feeling on all sides right

now, being hit by slowdown in terms of their wages, maybe losing

a job, health care costs going up, if they get health care at all,

maybe faced with losing a pension, and the cost of college, and the

cost of gas, and so on.

So we are feeling that, certainly, in Michigan as we look at not

just one or two plants or one or two jobs but entire communities

that are struggling as we, as a country, try to figure how we are

going to compete in a global economy in a way that does not lose

our way of life.

There are certainly two different views. One says, compete down

to the lowest wage, lowest health care, lose a pension. And the

other says, which I espouse, which is race up, which means you

level the playing field on trade and you address the costs you can,

9

health care, energy, protect pensions, and then you race like crazy

on education and innovation. That is the American way.

My concern right now is that in a State like mine, because we

make things, grow things, and have been the leaders in doing that,

we now find ourselves struggling in a global economy because we

do not have those elements in place. We have lost another 19,000

manufacturing jobs just in the first half of this year. What I cannot

seem to grasp in the graphs and numbers that you have is really

the impact of this as it relates to middle-class jobs, good-paying

jobs in manufacturing in America. I do not believe we can have a

strong economy unless we make things in this country. That is

what we do, make things and invent things, in Michigan. So, I am

interested in knowing about how you view us in terms of the industries that have created the middle class of America.

What I do see in your analysis is a growing trade deficit which

is on track to make history again. And we are in a path in another

year of a record trade deficit for the entire country which means

more lost American jobs.

More concerning is the fact that one-third of that deficit is with

one country, China. On Monday, I had an opportunity to go to a

hearing that I was pleased to testify at in Michigan, in Dearborn,

the United States-China Commission came into Michigan to hear

about the concerns from business and labor in the community

about what is happening with China, and our relationship and how

it affects the auto industry and other industries. And I want you

to know there is tremendous concern. I was very impressed with

the Commission. Tremendous concern across the board, both on the

Commission and those who testified, about what is happening and

why we are not enforcing our trade laws.

We can compete with anybody if it is a level playing field. China

cheats. Other countries cheat. They steal our ideas. They steal our

patents. They manipulate their currency. They dump counterfeit

products. I recognize, Mr. Chairman, this is not in your jurisdiction

but I do want to know what role you believe our increasing trade

deficit has on our ability to enforce our trade laws.

Furthermore, in your recent testimony at the International Monetary Conference on June 5 you stated, sustaining global expansion

will require a greater reliance by our trading partners on their own

domestic spending as a source of growth. This tells me we are

going to be increasingly beholden to other countries in order to reverse the trade deficit. So, I am hoping to hear more about that in

your testimony.

But as I interpret your statement, we are allowing countries to

ignore our trade laws and hurt good-paying, middle-class jobs while

we simultaneously become more reliant, to use your description, on

their spending habits. This is of great concern to me and I certainly

welcome your thoughts and would appreciate your leadership.

Thank you.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Allard.

STATEMENT OF SENATOR WAYNE ALLARD

Senator ALLARD. Mr. Chairman, thank you for holding this hearing. This is one of the hearings I always look forward to hearing

10

participation and hearing from the Chairman of the Federal Reserve. You have been on the job about 51⁄2 months now, Chairman

Bernanke, and you are settling into the job and I look forward to

hearing what your comments will be.

I am not as down on the economy as some of my colleagues

would express here today. I do think that our pro-growth tax policies we put in place that were implemented in 2003 have had a

positive impact. And I am interested in hearing from you and your

comments on how we are comparing worldwide. If you look at our

growth in the last 21⁄2 to 3 years, 20 percent growth, somewhere around $2.2 trillion in growth, that is almost the size of the entire

Chinese economy. And if you look at the share of product that we

have throughout the world, gross domestic product might be a way

of expressing that, we have grown 2 percent during that time period.

So it looks to me like we remain competitive in a world environment and our economy is doing better than other countries. And I

would like to hear some comments that you have in that regard.

It does not mean that we do not have some problems with our

economy, and things that we need to watch. Areas that I feel particularly distressing is our runaway spending that we are having

here with the Federal budget, particularly in the area of mandatory spending. Interest rates are part of that. We must also, I

think, find ways to deal with the rising energy costs. But historically, it does not seem like energy has had as adverse an impact

on the economy as perhaps other times in our Nation’s history

when we have had high energy costs. And also I am concerned

about low personal savings rates.

Now while the Federal Reserve is an independent agency, Congress must maintain a careful oversight role, particularly given the

importance of the Fed’s responsibility. And Chairman Bernanke,

we are eager to hear your assessment of our economy and we look

forward to your economic insights which will be helpful as we consider various policy issues.

Thank you for taking the time to appear before the Committee.

Chairman SHELBY. Thank you.

Senator Carper.

STATEMENT OF SENATOR THOMAS R. CARPER

Senator CARPER. Thanks, Mr. Chairman.

Welcome, it is good to see you and you are good to join us. I like

to sometimes telegraph my questions and use an opening statement for that purpose. I say this partly with tongue-in-cheek but

some of my colleagues will recall a recently departed Cabinet Secretary who used to come and appear before us and as we would

give our opening statements he would sit there with papers spread

all around him and read this and that and would kid him and say,

he came and he would read the newspaper and he would work his

Blackberry. And you sit here; you are very attentive and listen to

everyone, writing notes.

So one of the questions I am going to ask you is, what do you

actually think about when we give our opening statements, because

you give every impression of paying great attention, which we hope

is true.

11

I am going to ask you about your assessment. You have been in

the job for about 6 months. You had big shoes to fill. And I think

most fair-minded, objective people say that you seem to have settled in pretty well, but just your own assessment. How is the job

similar to what you expected, maybe different than what you anticipated?

Some of my colleagues have touched on the budget deficit which

is for me still troubling. I think we can all celebrate strong GDP

growth. We should be happy about that. We are. We should celebrate strong revenue growth and we are. But as we look ahead I

am troubled by the fact that, you know, it is great that the deficit

is down to only $300 billion. That is a heck of a lot of money in

my view.

As we look down the road I do not know that we are really—assuming any kind of expenditures in Iraq, any kind of expenditures

in Afghanistan, I do not think we assume at all that we are going

to ever fix the AMT problem. I do not think we are assuming that

we are going to do anything about these tax extenders that are

about to expire. And if we do all of those things, continue to fund

Iraq, continue to fund Afghanistan, fix the AMT, continue these tax

extenders, we are back in the soup again. And that does not even

assume that the boomers ever retire which we are about to, as you

know.

I was reading the paper coming down today and it said that

trade numbers are out for June and they reported that the trade

deficit was about $63 billion for the month of June. They said we

are on track for the biggest trade deficit in the history of our country. And they mentioned one country, I think Senator Stabenow

might have mentioned that country, China. And I believe the deficit with China for 1 month might have been $17 billion. I think

that is what it was.

In any event, I thought to myself, that is a bigger trade deficit

with one country in 1 month than we used to have in a whole year.

When does the rest of the world start to look at our trade deficit

and our inability to balance our budget and say that if they are

going to continue to invest money here they want a higher interest

rate? I just want to talk a little bit about that when we have a

chance.

Maybe the last thing is, in addition to saying grace over monetary policy and a whole bunch of other duties, you have a major

responsibility as a regulator. We are familiar with those responsibilities. We have had before this, and hopefully we will have before the full Senate later this year, legislation dealing with the regulation of Government Sponsored Enterprises, Fannie Mae,

Freddie Mac, and the Federal Home Loan Banks.

There are two issues that seem to divide us on that. One is affordable housing fund, and the second deals with the portfolio.

What should be in the portfolio? Who should be in the position to

say whether portfolios can grow, what kind of items can be included in those portfolios? In the interest of telegraphing another

pitch I just want you to know that I would welcome your comments

as we get into that.

I think my time has expired. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Sununu.

12

STATEMENT OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. Chairman Shelby, I have no comment at this

time. I would just like to welcome the Chairman.

Chairman SHELBY. Senator Martinez.

STATEMENT OF SENATOR MEL MARTINEZ

Senator MARTINEZ. Thank you, Mr. Chairman. I will not be nearly that disciplined in my approach.

Mr. Chairman, thank you for being here and thank you for coming to share with us. I will be very brief actually. I was noting with

particular interest the area of labor in your report. I noted, in spite

of what some would profess to be gloom and doom that there are

a lot of good news in the economic report and the forecast terms

of the labor statistics.

For instance, it seems like this past quarter we were able to

reach a low unemployment level that had not been seen in 5 years,

and 4.7 in the second quarter of the year, below 5 percent. That

is consistent, and even not quite as good as what we are experiencing in Florida where I think our unemployment rate is probably

around 2.7 percent. Which gives rise to an issue that I do not know

if you will address but hopefully in the questioning I will have an

opportunity to discuss with you, which is whether in fact we may

not have, in some aspects of our economy, a labor shortage.

Recently, in the agricultural sector in Florida it was reported

that there will be probably 3 million to 6 million boxes of citrus

that will not be harvested this year because there simply was not

the labor there to pick the fruit. I have heard of similar reports

coming from California. I know in the housing industry, which

seems to have slowed down a bit in Florida, but still housing construction is strong, that there is great competition for labor to be

able to get the work done.

So as some of us have been struggling to try to put some sense

into our immigration laws one of the issues that we have repeatedly discussed is some type of a guest worker program and whether

there is the need for such. In fact some Americans, I think mistakenly believe that if only wages rose a bit that there would be plenty

of people to do many of the tasks that today we rely on foreign

workers to do. The fact is that I think a healthy combination of a

guest worker program as well as encouraging job training and so

forth are part of what needs to be for our future economic needs.

But I do hope that I get an opportunity to discuss with you some

of these labor issues that I think are also an important component

part of our economic picture.

Thank you very much for being here.

Chairman SHELBY. Senator Hagel.

STATEMENT OF SENATOR CHUCK HAGEL

Senator HAGEL. Mr. Chairman, thank you.

Chairman Bernanke, welcome. Just a comment regarding your

testimony and the questions that will follow.

As you have heard and as you know because you live with this

every day and have for many years, the strength of our economy

has essentially revolved around, over the last few years, high proVerDate 11-MAY-2000 17:03 Nov 06, 2006 Jkt 025856 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 30354.TXT SBANK4 PsN: SBANK4
13

ductivity, strong housing market, strong consumer spending, and

in my opinion over the last few years since 2001, tax cuts.

Now the reality is, as has been noted here this morning, we are

facing significantly rising and unstable energy costs. There is some

question about continuation of a strong housing market. As has

been noted this morning, record high personal debt, record low savings, continued deficit spending by Government, and I would add

to all of this, a rather dangerous and unstable world environment

today. And I do not think it is isolated just in the Middle East. I

happen to believe the Middle East represents the most combustible

time since 1948, where we are today.

Now I would hope in your testimony that you would give this

Committee some sense of proportion and balance in how all of this

is mixing, and some of these realities are going to affect, in your

opinion, our economy and our growth over the next year or two, realizing that you cannot predict. That is not your job. We do want

you to do that.

But I do think we need to integrate all these dynamics that are

in play, as well as you can, into a comprehensive economic fabric

as to how you are approaching this at the Fed, as how you are intending to deal with these things on a comprehensive monetary

policy basis.

I know you understand these things and I would hope that you

could integrate these issues and will in your testimony. I know we

will get to some of these things during the question-and-answer period.

Thank you very much, Mr. Chairman. Thank you.

Chairman SHELBY. Senator Dodd.

STATEMENT OF SENATOR CHRISTOPHER J. DODD

Senator DODD. Thank you, Mr. Chairman. I have no statement.

Chairman SHELBY. I believe that is everybody.

Mr. Chairman, you may proceed as you wish. Your written statement will be made part of record.

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 again to present the Federal Reserve’s Monetary Policy Report to the Congress.

Over the period since our February report, the U.S. economy has

continued to expand. Real gross domestic product is estimated to

have risen at an annual rate of 5.6 percent in the first quarter of

2006. The available indicators suggest that economic growth has

more recently moderated from that quite strong pace, reflecting a

gradual cooling of the housing market and other factors that I will

discuss. With respect to the labor market, more than 850,000 jobs

were added, on net, to nonfarm payrolls over the first 6 months of

the year, though these gains came at a slower pace in the second

quarter than in the first. Last month, the unemployment rate stood

at 4.6 percent.

Inflation has been higher than we has anticipated in February,

partly as a result of further sharp increases in the prices of energy

and other commodities. During the first 5 months of the year, overVerDate 11-MAY-2000 17:03 Nov 06, 2006 Jkt 025856 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 30354.TXT SBANK4 PsN: SBANK4
14

all inflation, as measured by the price index for personal consumption expenditures, averaged 4.3 percent at an annual rate. Over the

same period, core inflation—that is, inflation excluding food and

energy prices—averaged 2.6 percent at an annual rate. To address

the risk that inflation pressures might remain elevated, the Federal Open Market Committee continued to firm the stance of monetary policy, raising the Federal funds rate another three-quarters

of a percentage point to 5.25 percent in the period since our last

report.

Let me now review the current economic situation and the outlook in a bit more detail, beginning with developments in the real

economy and then turning to the inflation situation. I will conclude

with some comments on monetary policy.

The U.S. economy appears to be in a period of transition. For the

past 3 years or so, economic growth in the United States has been

robust. This growth has reflected both the ongoing reemployment

of underutilized resources as the economy recovers from the weakness of earlier in the decade, and the expansion of the economy’s

underlying productive potential, as determined by such factors as

productivity trends and the growth of the labor force. Although the

rates of resource utilization that the economy can sustain cannot

be known with any precision, it is clear that, after several years

of above-trend growth, slack in resource utilization has been substantially reduced. As a consequence, a sustainable, noninflationary expansion is likely to involve a modest reduction in the

growth of economic activity from the rapid pace of the past 3 years

to a pace more consistent with the rate of increase in the Nation’s

underlying productive capacity. It bears emphasizing that, because

productivity growth seems likely to remain strong, the productive

capacity of our economy should expand over the next few years at

a rate sufficient to support solid growth in real output.

As I have noted, the anticipated moderation in economic growth

now seems to be underway, although the recent erratic growth pattern complicates this assessment. That moderation appears most

evident in the household sector. In particular, consumer spending,

which makes up more than two-thirds of aggregate spending, grew

rapidly during the first quarter but decelerated during the spring.

One likely source of this deceleration was higher energy prices,

which have adversely affected the purchasing power of households

and weighed on consumer attitudes.

Outlays for residential construction, which have been at very

high levels in recent years, rose further in the first quarter. More

recently, however, the market for residential real estate has been

cooling, as can be seen in the slowing of new and existing home

sales and housing starts. Some of the recent softening in housing

starts may have resulted from the unusually favorable weather

during the first quarter of the year, which pulled forward construction activity, but the slowing of the housing market appears to be

more broad-based than can be explained by that factor alone. Home

prices, which have climbed at double-digit rates in recent years,

still appear to be rising for the Nation as a whole, though significantly less rapidly than before. These developments in the housing

market are not particularly surprising, as the sustained run-up in

15

housing prices, together with some increase in mortgage rates, has

reduced affordability and thus the demand for new homes.

The slowing of the housing market may restrain other forms of

household spending as well. With homeowners no longer experiencing increases in the equity value of their homes at the rapid

pace seen in the past few years, and with the recent declines in

stock prices, increases in household net worth are likely to provide

less of a boost to consumer expenditures than they have in the recent past. That said, favorable fundamentals, including relatively

low unemployment and rising disposable incomes, should provide

support for consumer spending. Overall, household expenditures

appear likely to expand at a moderate pace, providing continued

impetus to the overall economic expansion.

Although growth in household spending has slowed, other sectors

of the economy retain considerable momentum. Business investment in new capital goods appears to have risen briskly, on net,

so far this year. In particular, investment in nonresidential structures, which had been weak since 2001, seems to have picked up

appreciably, providing some offset to the slower growth in residential construction. Spending on equipment and software has also

been strong. With a few exceptions, business inventories appear to

be well aligned with sales, which reduces the risk that a buildup

of unwanted inventories might act to reduce production in the future. Business investment seems likely to continue to grow at a

solid pace, supported by growth in final sales, rising backlogs of orders for capital goods, and high rates of profitability. To be sure,

businesses in certain sectors have experienced financial difficulties.

In the aggregate, however, firms remain in excellent financial condition and credit conditions for businesses are favorable.

Globally, output growth appears strong. Growth of the global

economy will help support U.S. economic activity by continuing to

stimulate demand for our exports of goods and services. One downside of the strength of the global economy, however, is that it has

led to significant increases in the demand for crude oil and other

primary commodities over the past few years. Together with

heightened geopolitical uncertainties and the limited ability of suppliers to expand capacity in the short-run, these rising demands

have resulted in sharp rises in the prices at which these goods are

traded internationally, which in turn has put upward pressure on

costs and prices in the United States.

Overall, the U.S. economy seems poised to grow in coming quarters at a pace roughly in line with the expansion of its underlying

productive capacity. Such an outlook is embodied in the projections

of Members of the Board of Governors and the Presidents of Federal Reserve Banks that were made at around the time of the

FOMC meeting late last month, based on the assumption of appropriate monetary policy. In particular, the central tendency of those

forecasts is for real GDP to increase about 3.75 percent to 3.5 percent in 2006 and 3 percent to 3.25 percent in 2007. With output

expanding at a pace near that of the economy’s potential, the civilian unemployment rate is expected to finish both 2006 and 2007

between 4.75 percent and 5 percent, close to its recent level.

I turn out to the inflation situation. As I noted, inflation has

been higher than we expected at the time of our last report. Much

16

of the upward pressure on overall inflation this year has been due

to increases in the prices of energy and other commodities and, in

particular, to the higher prices of products derived from crude oil.

Gasoline prices have increased notably as a result of the rise in petroleum prices as well as factors specific to the market for ethanol.

The pickup in inflation so far this year has also been reflected in

the prices of a range of nonenergy goods and services, as strengthening demand may have given firms more ability to pass energy

and other costs through to consumers. In addition, increases in residential rents, as well as the imputed rent on owner-occupied

homes, have recently contributed to higher core inflation.

The recent rise in inflation is of concern to the FOMC. The

achievement of price stability is one of the objectives that makes

up the Congress’s mandate to the Federal Reserve. Moreover, in

the long-run, price stability is critical to achieving maximum employment and moderate long-term interest rates, the other parts of

the Congressional mandate.

The outlook for inflation is shaped by a number of factors, not

the least of which is the course of energy prices. The spot price of

oil has moved up significantly further in recent weeks. Futures

quotes imply that market participants expect petroleum prices to

roughly stabilize in coming quarters; such an outcome would, over

time, reduce one source of upward pressure on inflation. However,

expectations of a leveling out of oil prices have been consistently

disappointed in recent years, and as the experience of the past

week suggests, possible increases in these and other commodity

prices remain a risk to the inflation outlook.

Although the cost of energy and other raw materials are important, labor costs are by far the largest component of business costs.

Anecdotal reports suggest that the labor market is tight in some

industries and occupations and that employers are having difficulty

attracting certain types of skilled workers. To date, however, moderate growth in most broad measures of nominal labor compensation and the ongoing increases in labor productivity have held

down the rise in unit labor costs, reducing pressure on inflation

from the cost side. Employee compensation per hour is likely to rise

more quickly over the next couple of years in response to the

strength of the labor market. Whether faster increases in nominal

compensation create additional cost pressures for firms depends in

part on the extent to which they are offset by continuing productivity gains. Profit margins are currently relatively wide, and the

effect of a possible acceleration in compensation on price inflation

would thus also depend on the extent to which competitive pressures force firms to reduce margins rather than pass on higher

costs.

The public’s inflation expectations are another important determinant of inflation. The Federal Reserve must guard against the

emergence of an inflationary psychology that could impart greater

persistence to what otherwise would be a transitory increase in inflation. After rising earlier this year, measures of longer-term inflation expectations, based on surveys and on a comparison of yields

on nominal and inflation-index Government debt, have edged down

and remained contained. These developments bear watching, however.

17

Finally, the extent to which aggregate demand is aligned with

the economy’s underlying productive potential also influences inflation. As I noted earlier, FOMC participants project that the growth

in economic activity should moderate to a pace close to that of the

growth of potential both this year and next. Should that moderation occur as anticipated, it should also help to limit inflation pressures over time.

The projections of the Members of the Board of Governors and

the Presidents of the Federal Reserve Banks, which are based on

information available at the time of the last FOMC meeting, are

for a gradual decline in inflation in coming quarters. As measured

by the price index for personal consumption expenditures excluding

food and energy, inflation is projected to be 2.25 percent to 2.5 percent this year, and then to edge lower, to 2 percent to 2.25 percent,

next year.

The FOMC projections, which now anticipate slightly lower

growth in real output and higher core inflation than expected in

our February report, mirror the somewhat more adverse circumstances facing our economy, which have resulted from the

recent steep run-up in energy costs and higher-than-expected inflation more generally. But they also reflect our assessment that with

appropriate monetary policy and in the absence of significant unforeseen developments, the economy should continue to expand at

a solid and sustainable pace and core inflation should decline from

its recent level over the medium-term.

Although our baseline forecast is for moderating inflation, the

Committee judges that some inflation risks remain. In particular,

the high prices of energy and other commodities, in conjunction

with high levels of resource utilization that may increase the pricing power of suppliers of goods and services, have the potential to

sustain inflation pressures. More generally, if the pattern of elevated readings on inflation is more protracted or more intense than

is currently expected, this higher level of inflation could become

embedded in the public’s inflation expectations and in price-setting

behavior. Persistently higher inflation would erode the performance

of the real economy and would be costly to reverse. The Federal Reserve must take account of these risks in making its policy decisions.

In our pursuit of maximum employment and price stability, monetary policymakers operate in an environment of uncertainty. In

particular, we have imperfect knowledge about the effects of our

own policy actions as well as of the many other factors that will

shape economic developments during the forecast period. These uncertainties bear importantly on our policy decisions because the full

influence of policy actions on the economy is felt only after a considerable period of time. The lags between policy actions and their

effects imply that we must be forward-looking, basing our policy

choice on the longer-term outlook for both inflation and economic

growth. In formulating that outlook, we must take account of the

possible future effects of previous policy actions—that is, of policy

effects still ‘‘in the pipeline.’’ Finally, as I have already noted, we

must consider not only what appears to be the most likely outcome

but also the risks to that outlook and the costs that would be incurred should any of those risks be realized.

18

At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as

provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections. In particular, as the Committee noted in the statement

issued after its June meeting, the extent and timing of any additional firming that may be needed to address inflation risks will

depend on the evolution of the outlook for both inflation and economic growth, as implied by our analysis of the incoming information.

Thank you. I would be happy to take questions.

Chairman SHELBY. Thank you Mr. Chairman.

Mr. Chairman, your testimony notes the possibility of some risk

which could add to inflationary pressures, in particular the possibility of higher energy prices feeding into the prices of nonenergy

goods and services. Your testimony, Mr. Chairman, also notes the

risk to our economy due to a slowing housing market.

The question is this: What would be the impact, Chairman

Bernanke, on the economy if both of these effects materialized to

a greater degree than is currently anticipated? How would the Federal Reserve be likely to respond to such a scenario? These are not

out of the question, either.

Chairman BERNANKE. No, Senator. As I mentioned, we are following the data very closely and we revise our forecasts as needed.

Right now we see, of course, the housing market slowing. We see

some offsetting strength in some other sectors of the economy and

our expectation is that the economy is going to be growing at or

about the pace of its underlying potential.

We also think that inflation is going to moderate. We see some

risks to the upside, and that is an issue that we have to think

about. But of course, if we see changes in the data, we will certainly adjust our balance of risk and thinks about it accordingly.

Chairman SHELBY. Among that same lines, both your testimony,

Mr. Chairman, and your written report this morning discuss the

lag between Fed policy actions and their effects. Some analysts

have remarked on the trade-offs which may exist between spurring

economic growth by way of low interest rate regime and combating

inflation. That is always a challenge.

How do Members of the Federal Reserve know when your

changes to monetary policy have been fully incorporated throughout the economy?

For example, how does the FOMC go about assessing whether

the 17 quarter point rises in the Federal funds rate are fully incorporated in the market 3 months from now, 6 months from now, or

some other time? Is that a judgement on your part?

Chairman BERNANKE. Senator, it is judgment based on a great

deal of quantitative analysis. We look at extensive models. We look

at statistical models. We look at financial market data. We use our

own judgment. We listen to anecdotes. We try to make our best

judgment about where the economy is heading, including the effects of the policy actions that we have already taken.

Our goal is to achieve a sustainable, noninflationary expansion

and we are adjusting our policy in a way to try to meet that goal.

19

Chairman SHELBY. In other words, you do not want the medicine

to destroy the patient; right, in a sense?

Chairman BERNANKE. Senator, that is absolutely right. Again,

our goal is to achieve a sustainable expansion.

There are risks in both directions, if I may say so. Clearly, we

do not want to tighten too much to cause the economy to grow more

slowly than its potential, and we are very aware of that concern,

and we think about it and we look at it and try to evaluate it.

The risk in the other direction is that, if we were to stop tightening too soon and inflation were to get higher and more persistent, then we would be faced with the situation of having to

address that later on with perhaps even more interest rate increases.

So our goal is to achieve a sustainable expansion. We have to

balance those risks and those two directions. And we do that by

looking forward to our forecasting process and thinking about how

actions we have already taken are likely to affect the economy in

the long-run.

Chairman SHELBY. So whatever you do, you have to keep in

mind price line stability at every move, do you not?

Chairman BERNANKE. Senator, price stability is part of the mandate, of course. And I do believe it is important for achieving stability, and also moderate interest rates. For example, we talk about

mortgage rates and we understand that our actions affect mortgage

rates. But if you look back historically, the periods where mortgage

rates were by far the highest, were high inflation periods like the

1970’s and early 1980’s, when mortgage rates reached 18 percent.

So if we want to keep mortgage rates low, we need to keep inflation

low.

Chairman SHELBY. Mr. Chairman, as the cost of energy, as you

have noted, is often volatile, in part because of its seasonal use and

in part because of factors beyond our control. Historically, energy

prices have been excluded from the measure of what you call core

prices in the consumer price index. If there is a sustained increase

in energy prices, would it be more appropriate for policymakers to

rely upon an inflation measure which includes the energy cost?

In other words, does the exclusion of energy prices from the definition of core prices pose any problems for economists trying to understand the health of our economy at the present time?

Chairman BERNANKE. Mr. Chairman, that is a difficult question.

As you point out, we have excluded it from one of our basic measures, the core measure, because in the past it has been a very volatile price. Of course, more recently, instead of going up and down,

it has just gone up.

So the question is what is the purpose of our measure? If we are

trying to forecast inflation over the next couple of years, we can

still look at the futures markets for energy. And although they

have not been very reliable, I have to admit, they do say that energy prices are likely to be relatively flat over that period. If that

is true, then the core inflation measure is a better forecast of what

total inflation will be a year or two from now.

On the other hand, the inflation rate that people see is the overall inflation rate. They see the gasoline price at the pump. That affects their behavior. That affects their expectations. If those high

20

inflation rates, including energy, cause people to develop an inflationary psychology, that would be a concern that would effect, perhaps, the future course of inflation.

So depending on the purpose, we do have to look at different

combinations of measures.

Chairman SHELBY. We all like 99 cent gasoline, as you well

know, all of us.

Chairman BERNANKE. Yes, sir.

Chairman SHELBY. Mr. Chairman, last question here for now,

dealing with the housing market GSE’s.

In your testimony this morning, you note the cooling down in the

housing market and its associated effect perhaps on consumer

spending.

What effect, Mr. Chairman, if any, would a more significant slow

down in the housing market and asset-based securities industry

have on the financial condition of Freddie Mac and Fannie Mae?

And do you have any concerns regarding effects on the banking

system in this regard?

Chairman BERNANKE. Senator, so far the credit quality looks to

be good. We see that mortgages are, for the most part, fixed-rate

despite the fact that we have seen more nontraditional mortgages

and ARM’s issued recently. We only see about 10 percent of all

mortgages being repriced during 2006. Because of these rapid increases in house prices, a lot of homeowners do have a lot of equity.

And, therefore, they are able to make the payments on their

homes. So we do not see any near-term significant increase in

mortgage delinquencies or credit risk.

The one area that we are watching very carefully is low and

moderate-income subprime mortgage lending. That area, more than

the broader market, has seen adjustable-rate mortgage lending.

And therefore, there is more susceptibility, I think, there to increases in interest rates affecting the monthly cost of mortgages.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you very much Mr. Chairman.

Chairman Bernanke, do you agree that the rate hikes over the

last 2 years, 17 successive rate hikes, are beginning to bite and

they have reduce long-term inflation risks?

Chairman BERNANKE. Senator, as you know, we started from an

extraordinarily low level of about 1 percent, and we had to move

many times to remove that extraordinary degree of monetary accommodation from the system. I would agree we have essentially

removed that extraordinary degree of monetary policy accommodation and we are much more in a more normal range of interest

rates at this point.

I do think it is beginning to have some effect. We are trying to

judge the effect on both real output and inflation, and trying to

make our best judgment.

Senator SARBANES. If there were no further rate hikes, how long

do you think the negative effects of past rate hikes on growth and

output in jobs would continue?

Chairman BERNANKE. Senator, the forecasts that I gave you earlier are based on our analysis of the future of the economy, taking

into account the policy actions that we have already taken. So

based on those actions, or actually based on appropriate monetary

21

policy more specifically, the Members of the FOMC see the economy cooling slightly relative to the last 3 years to a sustainable

pace consistent with underlying productive capacity. And they also

see inflation moderating to a level more consistent with price stability over the next 2 years.

Senator BENNETT. Is there a further lag between the slowing of

the economy and changes in core inflation? If so, how long is that

lag?

Chairman BERNANKE. Again, our forecasts have tried to incorporate those legs. If you were asking about even beyond the 2007

forecast horizon, my guess would be that we would see some further decline in inflation in 2008.

Senator SARBANES. I am concerned about this perception I

quoted in my outset, ‘‘To Pause or Not to Pause, That is the Conundrum,’’ and that ‘‘The Fed has managed to elevate a pause to something that is a pretty major event. What was normal in prior cycles, up or down, is now something that grabs headlines.’’

And then the commentator noted ‘‘The Fed paused twice in the

1999–2000 cycle, three times in the 1994 cycle. It elicited a yawn

from the markets. This time it is attracting enormous attention.’’

There is an article in this morning’s Wall Street Journal in which

they quote Alan Greenspan, who made this observation after a series of rate increases: ‘‘There may come a time when we hold our

policy stance unchanged or even ease despite adverse price data

should we see signs that underlying forces are acting ultimately to

reduce inflation pressures.’’

He made that statement to the Senate days after the Labor Department had reported the biggest monthly increase in the core

CPI since 1992. What is your reaction to that?

Chairman BERNANKE. I absolutely agree with your point, Senator. In fact, in my testimony before the Joint Economic Committee, I argued that at some point, a point which I did not specify,

the Fed would have to get off this 25 basis point per meeting escalator and adopt a more flexible approach, possibly varying its pace

of tightening, possibly taking a pause.

That has been the practice in the past. That is the practice of the

European Central Bank and the Bank of Japan today. They do not

move at every meeting. They move based on the state of the economy and based on the pace at which they wish to tighten.

So I did make that point. I think it is still relevant. But of

course, we always look at this meeting by meeting, and we will be

evaluating all options when we come to meet in August.

Senator SARBANES. This development in the housing market that

I showed earlier, and the drop in the new housing starts, that is

a 22 percent drop in a matter of months.

Now the National Association of Home Builders, which obviously

would be quite concerned about something of this sort, has written

to Members of the Committee about this. And I understand that

some forecasters say that this could result in a 1.5 percent drop in

GDP.

Now we have relied on the strong housing market to keep the

economy up in recent times, and now this seems to indicate a deterioration in that position.

22

Furthermore, in your statement when you talk about higher core

inflation, you reference increase in residential rents, as well as the

imputed rent on owner-occupied homes. Now the Association of

Home Builders makes, it seems to me, a rather valid point in communicating with us about this measure, saying that the weakness

in new housing increases the demand for rental housing. Therefore,

the price of rental housing goes up and the imputed value of the

owner’s equivalent rent—which they are not actually paying, it is

a statistical measure—that goes up. And therefore, the core inflation goes up. Then the reaction to the core inflation going up is to

raise the interest rates in order to check what is perceived as an

inflation problem.

The raise in the interest rates intensifies this trend in the decline in new housing, available housing, greater demand for rental

housing, a greater imputed value into the core inflation measure.

And you have this vicious circle contributed to by the raised interest rates.

That seems to me to have some validity, that observation. What

is your reaction to that?

Chairman BERNANKE. Senator, on your first point about housing,

we are watching housing market very carefully. I would point out

that there have been some offsets in nonresidential construction, in

exports, and in investment. So other parts of the economy are picking up to offset some of the weakness we see in the housing market. But we are watching that very carefully.

Your point on owner-occupied equivalent rent is a good point and

we are quite aware of it.

Senator SARBANES. Seventy percent of the housing in this country is owner occupied; correct?

Chairman BERNANKE. Senator, what I was going to say is, and

I think that is a good reason, that for example we focus more on

the personal consumption expenditure deflator, which puts a much

lower weight on that than does the CPI, for example.

In addition, as I mentioned in my testimony, the increase in inflation we have seen is a much broader phenomenon than that single component. If that single component was the only issue, I would

think twice. But I do see movements in inflation in a broad range

of goods and services.

Senator SARBANES. Is it worth thinking one-and-a-half 5 times

when you see that component doing that thing?

Chairman BERNANKE. No, I will think twice, Senator.

Senator SARBANES. Mr. Chairman, I want to make one final

point, if I could, with the Chairman. I want to use two charts to

show it.

One is a chart showing that rising profits more than account for

inflation in the nonfinancial corporations. What this shows is the

red line represents the increase accounted for by higher profits.

The blue line is the increase in prices. And it goes back to the chart

I showed about the labor costs.

It seems to me it is fair to say, at least up to this point, that a

rise in labor costs, which had 0.3 percent I guess, most of it is we

have increased productivity, is not a factor in looking at a current

inflationary situation. Would you agree with that?

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In fact, the whole thing is skewed so that the benefits of whatever economic activity is taking place are going very much to profits, which then translate out to this growing inequality in incomes

and wealth in the country.

Chairman BERNANKE. Senator, I agree that there is more of a

problem in the product markets than in the labor markets. In the

product markets they are sufficiently tight that firms are developing pricing power and they are passing on their energy and materials costs.

It still is an inflation problem because if inflation rises, it is still

going to have the same adverse affects. It is going to get into expectations. I am not saying that is going to happen. Our forecast is

for inflation to decline over time. But it is a risk. And nevertheless,

if it is coming from product markets more than labor markets, it

is still a risk to inflation.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bennett.

Senator BENNETT. Thank you.

Chairman Bernanke, we have had a lot of conversations about

wage growth compared to inflation. I find it hard to get a single

statistic on this. If you look at the narrow measure of labor compensation that is labeled average hourly earnings, which does not

include any benefits, then you get one answer. If you look at the

more comprehensive measures of labor compensation, such as those

that come from the Bureau of Labor Statistics, productivity statistics, and the employment cost index from the International Compensation Survey, you get another answer.

If you take those BLS measures that include benefits as well as

that which shows up in the W–2, suggesting that benefits sometimes very often comprise 30 percent of compensation. So leaving

them out of the figure would be kind of misleading. If you take the

information from the BLS statistics, you find that workers have

made gains, in some cases very healthy gains, after adjusting for

inflation.

Now, what statistics do you use when you look at this? And can

you give me some help as to where I should go?

Chairman BERNANKE. Senator, we look at them all. I am sorry

that I cannot point to one in particular.

But you do make a valid point, which is that if you look at nonfarm business compensation per hour, you have real increases

about 2.5 percent over the past few years. If you look at real average hourly earnings, it is much closer to zero.

The difference, as you point out, is really two things. One is the

fact that the former, the nonfarm business compensation, includes

benefits. But it also includes the full universe of workers, not just

production workers. So depending on what sector you are looking

at, you might use one or the other.

For purposes of looking at household income, that is how much

income consumers have to spend, you would probably look at the

nonfarm business compensation. If you are looking at costs affecting manufacturing, for example, you would look at some of the average hourly earnings numbers.

Senator BENNETT. When I was an employer, I learned very

quickly you cannot look at your labor costs in terms of what shows

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up on the W–2. Your labor costs are based on the entire compensation package, which includes all of the benefits. And you learned

very quickly that if you did not recover enough value added from

the employee’s work to cover everything, what is in the W–2 plus

the Social Security plus the health care, plus the unemployment

compensation, plus, plus, plus all of the other things that got added

on. If you did not get sufficient value added from the work of the

employee to cover all of that, you could not afford the employee.

And all of that was always significantly higher than the earnings

that was reported in the W–2.

So, I have to continue to look at that when we have these arguments about compensation and where it really goes.

Let me shift completely from that argument to another one that

we have had maybe in some of the opening statements. You have

suggested that persistently low, long-term interest rates, even as

short-term rates have risen significantly, comes as a result of a

global savings glut with respect to global investment opportunities.

And it is that global savings glut that has allowed large amounts

of savings to flow into the U.S. investments.

I was at the Aspen Ideas Festival and one economists there said

people send their money here because, number one, it is the safest

place to do it. And number two, they get a higher rate of return

in the United States than they get elsewhere.

Do you still believe there is a global savings glut and that we can

expect people to continue to want to put their money here?

Chairman BERNANKE. I think there still is a global savings glut.

It may have moderated somewhat because of increased growth in

some of our trading partners. But on the other hand, there has also

been, of course, these large revenues that the oil producers are accumulating because of the high price of oil. They are not able to

absorb, or use those revenues at home, very quickly. So they are

taking that money and putting it back into the global financial system. So that is contributing to this overall global savings glut.

I would say that real interest rates at the long end have recent

risen a bit recently. And I think that some moderation in the global

savings glut, together with some return toward normalcy in term

premiums, may account for that. So, I think there has been some

change. But the broad idea that the global savings glut is out

there, I think, is still valid.

Senator BENNETT. So you are suggesting that foreign investment

in the United States is not about to dry up at any point soon?

Chairman BERNANKE. I do not think it is going to dry up. I do

think that over a period of time we should become more reliant on

our own saving and reduce the current account deficit.

Senator BENNETT. Surely.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Reed.

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

Thank you, Mr. Chairman, for your testimony today. You have

indicated that you expect inflation to moderate going forward. Is

that a consequence of the slowing economy or moderating economy?

Chairman BERNANKE. That is one part. But in addition, we are

seeing, we are hoping at least that these energy price increases will

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not continue at the same pace as they have been going on in the

past. And that would remove a source of inflation pressure, as well.

Senator REED. If the economy moderates, what will that do to already, from my perspective, inadequate job growth? Would you anticipate job growth to also moderate?

Chairman BERNANKE. I think that job growth will continue to be

close to what the labor force growth demands, in some sense. There

has been a change in the last few decades in terms of the rate of

growth of the labor force, in part because, for demographic and

other reasons, the share of the population that participates in the

labor force has flatted out and now looks to be declining.

It therefore appears that the number of jobs we need to create

each month to keep the unemployment rate roughly constant is

lower today than it would have been, say, in the early 1990’s. And

so I think job growth will be lower than it has been over the last

15 years. But I think it will be close to where it needs to be to keep

the unemployment rate at a healthy, low level.

Senator REED. But that is a function of the participation rates.

And for some reasons, demographic rates, an older population you

would have a lower participation rate. But you still have a significant number of Americans that are looking for both work or looking

to move up. And with a job rate that simply replaces the new entrants in the job market, that is not going to provide the type of

robust job growth that most people associate with a vibrant economy.

Chairman BERNANKE. What we see in the labor market, and it

is a very difficult problem, is a bifurcated market. What we see is

people who are skilled, who are machinists, registered nurses,

truck drivers with a commercial driver’s license, and so on, are

finding a lot of opportunities. People with less skills are finding it

more difficult.

That is, of course, a serious problem for our economy. But it is

one probably that needs to be addressed more by education and

skill training and other approaches rather than monetary policy.

Senator REED. I think that is a conclusion we have all reached.

But in the short to intermediate run, it is hard to reeducate a

workforce. And people have to be able to live and work. And that

is a dilemma that we both face.

Is it accurate to say that some of the productivity gains have

been increased not by upgrading the skills of Americans or the

equipment they have, but by simply shipping jobs overseas? That

as you lower the unit cost of labor, for example, and your output

is constant that would seem to me to increase productivity. Are

some of these productivity gains a direct result of outsourcing

American jobs?

Chairman BERNANKE. I do not think we have clear knowledge of

which direction that effect is working. It depends on the composition of jobs that have been outsourced. It depends on how it affects

the productivity of firms that remain in the United States. For example, if they are able to improve their global supply chains and

the like.

I think the primary source of the productivity gains are two.

First is the improvements in information communication technology we have seen over the last 20 years or so.

26

But second, the United States has done a lot better at using

those technologies than a lot of other industrialized countries. I

think that relates to the fact that we do have very flexible product

and labor markets. We have deep capital markets that provide

funding for new ventures. And we have an economy that has an entrepreneurial spirit.

So we have made better use of those technological changes than

some other countries. I think that is the primary source of our productivity gains.

Senator REED. But is it worth, in terms of just an analytical approach, to look at the effect on productivity of outsourcing jobs? We

take great pride in increased productivity. But I think if part of the

story is it represents the loss of American jobs, it is not as compelling or as desirable a notion.

Chairman BERNANKE. We could look at that. As I said, I do not

think we have clear evidence on that point. I think a broader issue

is competition.

There is some very interesting research done by the McKinsey

Corporation that has looked at firms around the world and looks

at their productivity gains. What it finds is that firms that are exposed to competition, as unpleasant as that might feel, increase

their productivity gains much more rapidly.

And so one of the benefits, I think, of a more open trading system, a more open economy where we compete with, and trade with,

countries around the world, despite the fact that it does create

stress and sometimes changes and dislocations, is that competition

forces productivity gains and has been, I think, a source of growth

for us as well as for our trading partners.

Senator REED. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman.

Chairman Bernanke, as I said in my opening statement, the

stock market has been on a wild ride since you took over in February. I have a chart here that I would like to share with you.

Since you were sworn in, the Dow is down 65 points, 0.61 percent. Standard & Poor’s is down 43.22 points, 3.49 percent. The

Nasdaq has suffered what we call a severe drop. It is down 262

points or 12.85 percent.

Since your lapse in judgment, in your words, took place, the Dow

is down 567 points, a total of 5.26 percent. Standard & Poor’s is

down 73.75, almost 6 percent. The Nasdaq is down 279 points,

13.67 percent.

But even more importantly, since the May 10 Fed rate increase,

the Dow is down 840 points, 7.78 percent. Standard & Poor’s is

down 88.28, 7.14 percent. And the Nasdaq is off 295.02, or 14.4

percent.

My question, to follow that up, why do you think the markets

have reacted so drastically to the Fed’s actions?

Chairman BERNANKE. Senator, I do not think it follows necessarily that they are reacting to the Fed’s actions. There are a lot

of factors in the world that could explain why the markets are

down. We have geopolitical uncertainty and oil prices going on. We

have, around the world, many other central banks raising interest

rates. And that has led to a clear reduction in the amount of risk

27

that people willing to take on. We have seen that in lots of markets, in other stock markets in other countries, as well. There is

greater uncertainty now about inflation and growth in the U.S.

economy. I think all of those things can help explain why the markets are down.

I would add that the literature suggests that stock markets do

not do well in periods of inflation. I think the best thing the FOMC

can do, to strengthen, to get the stock market up, although that is

not one of our mandated goals but I think it would be a good thing,

but to help get the market up, would be to go toward our mandated

goals and create stable growth and to keep inflation low. And that

is what we intend to do.

Senator BUNNING. Do you know how this translates for the average American? Into the higher interest rates, which the FOMC has

done, into lower values on their pension plans? This is average

America. Lower 401(k) values by billions of dollars.

It seems like a straw horse to use higher energy costs when higher energy costs have been occurring off and on since 1974, we have

had an unstable energy market, sometimes to the extreme of $12

or $8 per barrel to $78 plus per barrel, which it hit this past week.

So that is not a real factor. That is one that is coming and going.

That is why it is not in the core inflation rate.

These are real problems that everyday Americans are facing.

And your action on the FOMC, and your 11 other people that are

with you, deciding interest rates on a given day, trying to project

9 months down the road how it will affect the U.S. economy is just

breathtaking.

Last week, a writer for one of our wonderful business publications, Business Week, said if you, as a Chairman of the Federal Reserve, expect growth to moderate and inflation to ease, why do you

even consider another rate hike?

Chairman BERNANKE. Senator, again, I do not think you have

made the case that this is not a fundamental set of factors affecting

the stock market. If we had stopped raising rates at 4.25 or 4.50,

I think there would be a lot of concern in the market and in the

economy about inflation at this point. We have tried to balance

those inflation concerns against growth concerns. We are looking at

both very carefully.

As far as the future policy, as I said, we have not made any future decisions. We are going to be looking at the situation at each

meeting. We do have to take into account, though, the possible

risks, as well as the expected path that we are looking forward to,

because if there is a chance that a very bad outcome might occur,

there is a risk management approach, which Chairman Greenspan

and other central bankers apply, which suggests that you need to

lean a bit against that possible outcome.

But again, we will be looking at all the data and thinking hard

about it when the time comes for us to meet again.

Senator BUNNING. Thank you, Mr. Chairman. My time has expired. I will wait for the next round.

Chairman SHELBY. Senator Menendez.

Senator MENENDEZ. Thank you, Mr. Chairman.

Mr. Chairman, I want to return to some of the issues I raised

in my opening statement. It appears to me that we have an econVerDate 11-MAY-2000 17:03 Nov 06, 2006 Jkt 025856 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 30354.TXT SBANK4 PsN: SBANK4
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omy in which increasing productivity and large tax revenues are

driving up our gross domestic product. But that, in turn, has benefited a very small number of people who own capital.

As I said to you in my opening statement, in New Jersey when

I talk to people, they tell me that they are constantly feeling

squeezed by higher tuition rates as they try to send their kids to

college, facing the challenges of the costs of taking care of a loved

one, facing higher energy prices to heat or cool their homes, facing

higher gas prices, facing higher insurance premiums and copays,

and yet finding their median incomes are flat over the last 5 years.

And so, with all of those challenges and negative personal savings, who is this the economy working for?

Chairman BERNANKE. Senator, I think what you are addressing

is the issue of inequality. I agree that inequality is potentially a

concern for the U.S. economy. We want everybody in the society to

have a chance to participate in the American Dream. We want everybody to have a chance to get ahead. And to the extent that incomes and wealth are spreading apart, I think that is not a good

trend.

That however is a development, a trend, that has been going on

for about 25 years now, according to most of the studies. It is therefore, a big challenge to think about what to do about it. I could go

into some of the literature, if you would like, about some of the research on why this is happening. But I do think that fundamentally the increased importance of skilled jobs and of technology in

our society puts a higher premium on people with more education,

more experience, and more skills.

I think really the only long-term solution to this problem is to

try to upgrade the skill levels of our workers. And I think that is

not necessarily a 10, 15, or 20 year process because people can

learn, as Senator Dole often says, in community colleges or technical schools. They can learn on the job. There are all kinds of

adult training and various things that can be done. I think we need

to take that seriously because I think that is really the only way

we can address this issue on a long-term basis.

Senator MENENDEZ. Often when we talk about inequality, we

think about the people at the lowest level. I am talking about middle-class families who are facing those squeezes of all of these higher costs. Many of them are pretty well-educated. And yet their incomes remain relatively stagnant.

Our global challenge is it used to be that the casualties of global

trade were those at the lowest skill levels. But I have software engineers telling me that they are losing their jobs, and they make

some pretty significant incomes. And that the certainty of their job

employment has moved. One guy told me he is in his third different company in the last 18 months, not because he is not a good

employee, but because the global challenges are either consolidation or offshoring of the services that he provides.

So it seems to me that we have to look at the underpinnings of

this in terms of middle-class families increasingly being squeezed.

And we talk about inflation. If all of these prices are going up

and yet your incomes remaining relatively flat is not inflationary

to the average family, it seems to me they are pretty inflationary.

29

The other question I would like to ask you is what do you see

currently as the most significant threat to economic expansion, in

your view?

Chairman BERNANKE. Economic expansion in the short term?

Senator MENENDEZ. Yes.

Chairman BERNANKE. I think it is the risk that we are considering, and again it is just a risk, that inflation might move up and

might force us to be more aggressive, which we do not want to do,

because we hope that inflation will stay under control or come

down as we expect it to. I think that is a risk.

We also have the geopolitical issues. We have seen the latest in

the Middle East, for example. Oil prices are a risk and a concern,

and we are paying very close attention to that situation as well.

Senator MENENDEZ. And last, I had asked you in a written question which you answered about paying down publicly held debt and

the importance of that. Now we see where CBO tells us we are

headed to $12 trillion worth of debt by 2011. How much importance

do you place on paying down that publicly held debt in the context

of long-term economic health?

Chairman BERNANKE. Senator, I think it is really important to

think about the long-run. And what we are facing going forward is

an aging population, increasing costs of medical care, and the costs

for our entitlement programs that are going to be rising very seriously.

So, I think the strongest case for trying to pay down some debt

sooner is to try and provide some buffer or some savings that will

help us meet those challenges as we go forward. I think that the

most serious long-term issue for our budget, is these growing transfer programs.

Senator MENENDEZ. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Dole.

Senator DOLE. Mr. Chairman, are there signs that wages are beginning to catch up to past productivity growth? And if not, when

do we expect this to happen? And would it be a concern to the Fed?

Can you have a period in which wages catch up to productivity

without an increase in inflation?

Chairman BERNANKE. Senator, we see some evidence of this, but

it is not very overwhelming. For example, the average hourly earnings number is up about a percentage point this last year versus

the previous year. We are seeing anecdotally that firms are finding

it harder to hire skilled workers and are either giving or contemplating wage increases. So our forecast is for increase in wage

growth going forward.

But again, it has been slow coming. I want to be clear about that.

As far as inflation is concerned, I want to also be very clear that

increases in the real buying power of workers are not inflationary.

For example, if it happens because the inflation rate is going

down and a given wage buys more, there you have an increase in

real wages without any inflation.

Similarly, if wages go up but they are offset by productivity

gains, which has been the case for the last few years, you have

higher real wages but no inflation.

And third, another possibility is that markups go down, the margins go down.

30

So, I do think the wages will rise. I am a little surprised they

have not risen more already. I believe that real wage increases,

though, are not at all inconsistent with our prediction that inflation

is going to moderate over the next couple of years.

Senator DOLE. Congress has been engaged in a debate over increasing the minimum wage. As a former Labor Secretary who has

testified on this issue, I know that increasing the minimum wage

is not an effective mechanism for lifting people out of poverty. I

have long advocated for increasing the earned income tax credit

and jobs and skills training, which I think are far more effective

at relieving poverty.

Would you share with this Committee your thoughts on the most

effective ways that Congress can act to reduce poverty?

Chairman BERNANKE. Senator, the minimum wage is controversial because economics suggests that, when you raise the minimum

wage, you would pay a higher wage to some workers, but then

some workers would not get work because of the higher wage. The

research on this is controversial. Some people have argued that the

effect is very small. Others think it is larger.

My inclination is to say that you would like to find ways of increasing the return to work, which do not have the effect of potentially shutting some people out of the workforce. So, I think I would

agree, and I have said this in previous testimony, that the earned

income tax credit, which provides extra income to people who are

working, and increased training for increased skills and productivity, are in my opinion probably more effective ways to approach

this question.

Senator DOLE. Thank you.

Another question. Do you believe that Fannie Mae and Freddie

Mac’s regulator should have the authority to allow the GSE’s to increase their portfolios when there is a downturn in the housing

market?

Chairman BERNANKE. This is another controversial issue. The

point is sometimes made that the GSE’s can enter into a situation

where there is a downturn and provide extra liquidity in the market through their portfolios to support the mortgage-backed security market, for example.

In our research at the Federal Reserve, we have not found that

to be a very important effect. We have really found very little effect

in that direction. We would also point out that if you are going to

do that, what you want to have in your portfolio is liquid assets

like treasuries, not MBS, because you cannot increase liquidity if

you buy MBS with other MBS. So we have been some concerns

about that.

Now having said that, I think it is worth, for the purposes of trying to come to some kind of agreement on GSE’s legislation, we

could perhaps discuss or consider the possibility that the director

might provide some emergency ability to GSE’s to make extra purchases during times in which the director judged the housing market to be in distress for some reason, but then to get rid of that

extra portfolio, get rid of the extra MBS, over a period of time

when the emergency was eliminated.

31

Again, we do not really see much evidence that this is necessary.

But if that were part of an overall agreement that brought a strong

and effective regulator to the GSE’s, it might be worth considering.

Senator DOLE. Thank you. I believe my time has expired, Mr.

Chairman.

Chairman SHELBY. Thank you. Senator Carper.

Senator CARPER. Thank you very much.

I had indicated several questions I was going to ask you. One is

what do you think about when we give our opening statements. I

will ask you that in private on another day.

I want to go back to this issue of GSE regulations, of Fannie Mae

and Freddie Mac and the Federal Home Loan banks. I know our

Chairman has raised this issue and Senator Dole has just raised

it and I suspect others have as well.

As Chairman of the Federal Reserve, you regulate some of our

biggest entities and holding companies in the country. I want to

just come back and ask you for some advice as we try to find—we

have really differences in two principal areas. One of those is with

respect to an affordable housing fund and how to structure that.

The House has passed legislation, by a pretty wide margin, where

they establish one.

I think they ask for setting aside I want to say 5 percent of net

income from Fannie Mae and Freddie Mac to go into an affordable

housing fund, that monies would be apportioned from there into affordable housing in our different States.

The other issue, of course, is the portfolio, what could be in it?

How much can it grow? What powers do we give the regulator with

respect to regulating what is in the portfolio?

If you are giving us advice, and you have given us a little bit but

I am going to ask you just, sitting back, looking at it as a regulator

yourself, what would you want to have as a strong regulator and

legislation that would enable you to do a good job? If you were regulating the GSE’s.

Chairman BERNANKE. Senator, I do not have much to offer on

the affordable housing. I know that is an item for negotiation. I

would just point out that an alternative would be to put it directly

on budget rather than to do it indirectly through the GSE’s.

With respect to the portfolios, as you know, the Federal Reserve

has argued for a substantial time that the portfolios are larger

than is needed to serve the fundamental housing mission of the

GSE’s. My advice would be not to set a hard cap or a number and

restrict the portfolio in that way, but to give strong guidance to the

regulator about how to relate the portfolio to the mission of the

GSE’s.

For example, it would make perfectly good sense for the GSE’s

to hold affordable housing mortgages that are difficult to securitize

in their portfolio, for example, or maybe to hold liquidity for some

of the issues that Senator Dole is raising.

But I think by grounding the size of the portfolio in the mission

of the GSE’s, you would bring down, over time, the portfolio to a

safer level and not hurt the underlying mission of the GSE.

Senator CARPER. How important do you think it is that we find

common ground and actually regulate in this area this year before

we call it a day?

32

Chairman BERNANKE. I do think it is very important. The Federal Reserve was drawn to this issue initially because we felt that

while the securitization function of the GSE’s is extremely valuable

and constructive, we felt that the large portfolios exceeded what

was needed for the housing purpose, and indeed posed a threat to

the stability of the financial system.

The reports we have seen recently on GSE accounting by

OFHEO and so on, which cast into doubt the underlying accounting

and internal controls of these agencies, I think just heightens my

concern that those large portfolios at some point might create serious problems for financial markets.

Senator CARPER. Thank you.

I suspect others have already talked to you about, as you have

raised short-term interest rates, and we have actually seen the

emergence of an inverted yield curve. Why is that happening? Do

you think it is going to persist? Is it something we should be concerned about?

Chairman BERNANKE. Senator, there appears to be a structural

tendency for the yield curve to be flatter than it was in the past.

Part of it, as I answered to Senator Bennett, is the global savings

glut which is keeping long-term real interest rates lower than they

otherwise would be.

The second is, for a variety of reasons that I went into in a

speech earlier this year and talked about in some detail, for a variety of reasons the term premium, the risk premium on long-term

debt, seems to have been lower recently than historically.

And for those reasons, the term structure seems to be flatter

structurally than has been the case historically, although there has

been a bit of an increase, I think, in the long rates in both the term

premium and the portion attributable to the savings glut, I think,

since the beginning of the year.

Senator CARPER. A question on energy independence, if I could.

I mentioned in my earlier comments that over a third of the trade

deficit this year now is imported oil. When we look at inflation, a

significant part of what is pushing up prices is the cost of energy.

Our neighbors down to the south in Brazil, about 15 years or so

ago they had said they wanted to become energy independent. And

they have done a fair amount of work. We hear a lot about what

they have done with flexible fuel vehicles and greater reliance on

ethanol.

We, meanwhile, have gone in the other direction over the last 15

years. We have become more and more dependent on foreign oil

and it takes an ever larger bite out, in terms of with respect to the

trade deficit.

Your advice for our country with respect to moving toward energy independence and whether or not it is something we should

be taking seriously? And if so, what counsel would you have for us

there?

Chairman BERNANKE. I think as a practical matter being literally energy independent is not something that is feasible in the

near-term.

Senator CARPER. It will not happen in my term and probably not

yours either.

33

Chairman BERNANKE. I think what we should do broadly is to diversify our portfolio, to have a wider range of energy sources including ethanol, coal, nuclear, and other possibilities.

And I think there are a number of ways Government can help,

but in two ways in particular. The Government has, in the past,

been effective in helping in basic research. That is research that individual companies do not find it profitable to undertake because

they cannot appropriate the returns.

I think we also need to try to increase the amount of regulatory

certainty. It is certainly appropriate to have regulations that offset

environmental and other concerns. That is totally appropriate. But

there is so much uncertainty about what the regulations will be

when the time comes to apply them that many projects simply do

not get undertaken.

So if we can provide clearer mechanisms by which those who

wish to build new energy sources can understand what is expected

of them, I think we will see, given the very high prices we are seeing for oil, we will see, over the next few years, a lot of alternative

energy sources coming forward.

Senator CARPER. Thank you.

I would just share with you and our friends, I think it was 106

years ago this year that the very first diesel engine was introduced.

I believe it was at an exhibition in Paris, France. It was powered

by peanut oil.

We now just opened up last month, in the central part of my

State, not too far from where Senator Sarbanes is from, Dover, a

biodiesel refinery which is run entirely on soybean oil, which we

have a lot of on the Delmarva Peninsula, as Senator Sarbanes

knows.

The other thing, we just got a new air conditioner at our house,

and we also got a new air-conditioning standard, a new SEAR

standard for air-conditioning efficiencies this year. The new standard is SEAR–13, as opposed to SEAR–8. And we had a battle over

whether we were going to go to SEAR–10 or SEAR–13. We ended

up at SEAR–13.

What that means, just the difference between a SEAR–10 and a

SEAR–13 with respect to energy consumption, it means roughly 50

or so power plants we will not have to build over the next 15 or

20 years, simply by having SEAR–13 standards for new air conditioners, as opposed to SEAR–10.

Thank you.

Chairman SHELBY. Senator Sununu.

Senator SUNUNU. Thank you, Mr. Chairman.

Chairman Bernanke, in your testimony you used what seems to

me to be an interesting phrase in a couple of places. That is the

phrase ‘‘appropriate monetary policy,’’ ‘‘reflect our assessment that,

with appropriate monetary policy—the economy should continue to

expand at a sustainable pace and core inflation—from its recent

level over the medium term.’’ You use it in another place.

Could you elaborate a little bit on what appropriate monetary

policy is? Is that not too hot, not too cold?

Chairman BERNANKE. I wish I could, Senator. The forecasts are

made under that assumption, and each person who is submitting

34

their forecast makes their own assumption about what that would

be.

So what I take this to be is really a summary view of what we

can achieve, where we should be heading with policy.

Senator SUNUNU. If everything goes perfectly?

Chairman BERNANKE. No, not perfectly, but if things go as generally expected.

I think there is a lot we could do to make those forecasts more

informative and that might be one direction to go in the future. But

I understand that is an ambiguous phrase.

Senator SUNUNU. You also say in your testimony that ‘‘It bears

emphasizing that, because productivity growth seems likely to remain strong.’’ So you were assuming that productivity growth will

remain strong.

On what are you basing that assumption?

Chairman BERNANKE. I am basing it on looking at the pattern

of recent years. First, we saw the productivity gains mostly in the

industries producing high-tech equipment, as companies learned

how to build ships faster, for example.

Then we saw it moving into the users. That is firms that were

not high-tech producers but were using and consuming those goods

to increase their own productivity. And what we see as we talk to

people in the industries and the like is we see first that there is

continuing innovation and improvement at the level of high-tech

producers.

And moreover, what we hear from CEO’s and the like is that

they feel there is a lot more diffusion to take place before they have

fully exhausted the benefits of new technologies in terms of increased productivity.

As a historical matter, when productivity changes from a high

level to a low level, it does tend to last for a while. And that is another piece of encouraging evidence.

Senator SUNUNU. So you have what you feel to be some pretty

good anecdotal evidence.

Chairman BERNANKE. It is mostly anecdotal, a little statistical.

The fact is that as our society relies more and more on productivity

gains as a source of growth, the forecasting is going to get tougher

because it is more difficult to forecast in say the size of the workforce.

Senator SUNUNU. Which are you more worried about with regard

to the medium term prospects for inflation: Inflationary expectations or the absolute level of inflation based on changes in energy

prices or labor prices?

Chairman BERNANKE. Senator, the two interact because if there

was just a one-time pass-through and the public were completely

convinced that the Fed would keep inflation low and expectations

were low and the Fed were perfectly credible, then that inflation

would be just a temporary thing and would come back down.

So the risk is the interaction of the two. The risk is that inflation

will go up because of energy prices, because of greater passthrough, and that will feed into inflation expectations, which then

will feed into a round of additional price increases and the like.

35

You really cannot get a permanent increase in inflation unless

people increase their inflation expectations. That is why the Fed’s

credibility is, I think, such a major asset of the United States.

Senator SUNUNU. It seems to me to the extent that you are in

the midst of a little bit of a dilemma it is as follows. Right now,

inflation is above what has been stated in different ways your target range. We have still got high energy prices. So that would suggest that the absolute level of inflation remains a concern.

On the other hand, you have a forecast for moderating growth.

You have a slowdown in the housing industry. So while the inflation numbers may push you toward a rate increase, the moderating

growth that has been forecast might encourage you to pause or to

forgo further rate increases. That is a dilemma. I think we all understand that.

To what extent is the fact that you now find yourself in this dilemma the result of a slowness or a delay to action in beginning

this cycle of rate increases?

Chairman BERNANKE. To comment on your first part of your

question, we cannot do anything about this month’s inflation number because our policy works with a lag. And so we have to be looking at a forecast or a future to make those judgments and to assess

the risks.

I do not know the answer to your second question.

Senator SUNUNU. First of all, the second question was the good

one. I did not have a first question.

I think we are working under the assumption that the forecast

for inflation is in the, I think you said 2.25 percent, 2.5 percent,

that is still above the 1 to 2 percent target.

Chairman BERNANKE. We do not have a target, Senator.

Senator SUNUNU. I stand corrected.

But the answer to the second question, is this the result of slowness to act or delay to act initially in the tightening cycle?

Chairman BERNANKE. I think certainly an important part of

what has happened has been the increases in energy and commodity prices. That has directly added to total inflation, and now

we are seeing it passing through, to some extent, to core inflation.

I think if energy prices were $40, I think things would be much

better. I would say that.

Whether policy has been optimal or not, I really cannot judge.

Certainly, along with fiscal stimulus and other measures we did

succeed in getting the economy back on a strong growth track in

the middle of 2003. And we have seen 3 years of strong growth. It

took a while for jobs to come back but eventually the labor market

also began to improve.

Senator SUNUNU. When you say I cannot judge, is that because

you are not technically suited to do that evaluation? Or because

you do not think it would be productive in your current occupation?

Chairman BERNANKE. We could try to do an evaluation with our

models and the like. I am not sure how accurate it would be. In

addition, the interesting thing about the energy price increases is

that if you go back for 3 or 4 years and you look at each month

at what the futures market was expecting, it was always expecting

these things. We have had these increases, the energy prices are

36

going to finally stabilize. And every single month it has been

wrong.

And so this increase in energy prices and commodity prices certainly has been a significant contributor. And I think that we

would not really be talking about this now if energy prices were

still $30 or $40 a barrel.

Senator SUNUNU. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Dodd.

Senator DODD. Thank you, Mr. Chairman. And thank you, Mr.

Chairman, for your presence here today.

I want to raise three quick issues if I can with you. I think all

three of them could normally consume significant more time than

will be allotted to me here to talk about him. And I realize we are

here today to talk about monetary policy, but obviously fiscal policy

has a direct bearing on monetary policy.

I am concerned, along with I presume many of my colleagues,

about the rising level of our debt. I recall only a few years ago having a hearing in this Committee with your predecessor on which we

actually had a hearing about what the effects would be about eliminating the national debt. Here we find yourselves today, 5 years later, with $8.4 trillion in debt, $2.6 trillion of it occurred in the last 4 or 5 years. In fact,

more debt accumulated, I gather, in this period of time than all of

our previous administrations combined, and the implications of

that.

It has been reported that our Vice President allegedly commented that deficits just do not matter. I am quoting him here,

that is what I am told he said. I disagree with that. I would like

to know how you feel about this.

I want to raise with you, in the conjunction of this rising level

of debt, and the accumulation of it, the implications about how

much of it is being held offshore. I noted when you consider some

of the problems we are wrestling with today, whether it is the presence of a—the possibility of a presence of a growing weapons of

mass distraction on the Korean Peninsula and obviously the problems we are facing as we speak here in the Middle East, the issue

of immigration and the policy on our southern border.

I note that of the 10 top holders of our national debt are China

at some $326 billion, oil exporters of $103 billion, Korea at $69 billion, Hong Kong at $51 billion. And coming in at number 10 is

Mexico at $43 billion.

My experience has been that when you are trying to lecture your

banker, it can be dangerous in a sense. And I wonder if you are

as worried, as many of us are, about this trend and whether or not

we should be more concerned about this growing problem, a trillion

dollars of it now or more of our debt being held offshore, and what

the implications could be here, and what these implications mean

in terms of the monetary policy for the country.

Chairman BERNANKE. That was a lot of questions, Senator.

Senator DODD. I realize that, and I apologize.

Chairman BERNANKE. First, I think I will comment that, in retrospect, the idea that the national debt would disappear was never

all that realistic. The share of GDP that was collected in taxes in

the late 1990’s was over 21 percent, compared to a historical averVerDate 11-MAY-2000 17:03 Nov 06, 2006 Jkt 025856 PO 00000 Frm 00040 Fmt 6633 Sfmt 6633 30354.TXT SBANK4 PsN: SBANK4
37

age of about 18 percent. A lot of that came basically from the stock

market, which we know now was not sustainable at the pace it was

rising.

Nevertheless, I do think that deficits matter. I think the size of

Government also matters. But deficits matter because they represent additions to debt that our children and grandchildren will

either have to pay through higher taxes or reduced services. And

so I think they do matter.

I would add, though, that one must also think about the size of

the Government and what share of the GDP we want to devote to

Government services.

With respect to the offshore holdings, you can look at it two different ways. From one perspective, it is a good thing that countries

that are holding reserves want to hold them in the form of U.S.

Treasuries because we have a deep and liquid capital market which

is very attractive and very safe and very low cost to people as a

way of holding wealth. And we do not want to do anything that

would disturb that. We want people to want to hold our assets. It

is good for our country.

On the other hand, from a different perspective, I think that part

of what you are getting at is the fact that with a large current account deficit, the external debt that the United States owes, whether it be held in the form of treasury debts or MBS or whatever, is

growing over time.

And as I agreed, I think it would be very desirable for us over

a period of time to reduce that current account deficit and reduce,

therefore, the growth in the holdings of U.S. assets abroad.

Senator DODD. Just a related quick question here. You mentioned earlier our trading partners and the economic circumstances

in those countries where, in fact, some of the very nations that are

purchasing a lot of this debt may find more attractive markets elsewhere than the United States. Does that pose a problem, in your

mind, for the United States in the shorter term?

Chairman BERNANKE. That is what I was saying, that it is in our

interest to keep our debt attractive both because the capital markets are deep and liquid and because our economy is strong. I do

not really see a good alternative right now. I think that the great

majority of the international reserves are held in U.S. dollars and

I think that will continue to be the case.

However, from a current account perspective, if we look forward

5 or 10 years at the rate we are going, there will be increasing reluctance of foreigners to hold U.S. assets. And that will have effects

on our economy and we need to address that.

Senator DODD. Mr. Chairman, I will come back to the savings

rate and the consumer debt issue, which is a concern of mine as

well. And I want to just quickly raise this issue about the job creation issue, because it seems to me based on indications—this did

not happen, by the way, in the last 4 or 5 years. There has been

a trend, as you pointed out, over the last 20 or 30 years where we

are seeing job growth occurring at the very low level of the lowerincome levels and at the upper-income levels. It is in that middle

range, that middle-income earner that Senator Menendez talked

about, and Senator Reed addressed, where we see not just a skill

gap. But it seems to be hollowing out of job opportunities in that

38

area. And that troubles me very deeply, with that sense of being

a low-income earner and the sense of upper mobility, moving into

those middle-income jobs. And they just seem to be disappearing at

an incredible rate.

I heard you say you had not really examined the outsourcing

issue of jobs. I wish you would. It would be interesting to come

back and give us some report on how you look at that issue of that.

If I am correct, is there a hollowing out occurring here? And if so,

how troubling is that to the Federal Reserve?

Chairman BERNANKE. Let me give you an example, which would

be manufacturing, that certainly Senator Stabenow, for example,

would be interested in.

Whether you think U.S. manufacturing is strong or not depends

on how you look at it. In terms of output and production, U.S. manufacturing output is up 50 percent in the last 10 years. It is growing faster than in any other major industrialized country.

And moreover, we have moved toward higher tech, higher valueadded, types of manufacturing. So from that perspective, manufacturing in the United States is alive and well.

On the other side, you look at the labor inputs, you look at the

number of workers. Because manufacturing has also been extraordinarily productive, we have about a 6 percent a year increase in

manufacturing productivity over the last 10 years, we can produce

that extra output with many fewer workers. And so the number of

manufacturing jobs, and I think these are the kind of jobs that you

are possibly referring to, has been declining.

One thing to say about that, which is actually I think very interesting, is that even though the overall number of manufacturing

jobs has declined quite significantly, the number of high skilled

manufacturing jobs has actually been rising.

And so again, and I know this sounds repetitive, but again there

is a solution, which is to help workers get the skills that will give

them those opportunities.

But I agree that manufacturing is an example where the overall

number of jobs has declined as the productivity of that sector has

increased.

Senator DODD. Could you just add, by the way, you said to Senator Reed that the number of jobs that needed to be created on a

monthly basis is dropping. I know the number today is roughly

about 150,000 jobs per month. At least that is the number I have

always used. What is the number you have in mind that we will

be looking at?

Chairman BERNANKE. I think it is dropping. I would say now it

is more like 130,000. And within the next few years we might be

down to 100,000. This is all based on research at the Federal Reserve on labor force participation rates, which suggests that we will

be seeing, over the next 10 years, some significant decline from the

current rate. About 66 percent of the adult population is in the

labor force. We expect to see that coming down, and therefore the

number of jobs a month we need to keep the unemployment rate

constant is likely to fall, as well.

Senator DODD. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Allard.

Senator ALLARD. Thank you, Mr. Chairman.

39

Obviously, we are going through a period of time where there has

been a huge relative change in the price of energy. And the most

recent period of time when we experienced this great a change

would be in the late 1970’s.

At that particular point in time in our Nation’s history, we had

double-digit inflation, we had double-digit unemployment, we had

double-digit interest rates. In fact, all of this was put together and

frequently referred to as the misery index.

We have a similar situation today. But when you look at these

same figures that we looked at today, our unemployment is 4.6 percent. Our inflation rate is 4.3 percent. Our interest rate is 5 to 6

percent.

What is the difference between the late 1970’s, when we had this

huge increase in energy costs, yet the economy did not respond,

and today when we have a huge increase—the economy is still

staying very strong.

I wondered if you could shed some light on your view on that?

Chairman BERNANKE. Thank you, Senator.

There are a lot of reasons including, for example, the fact that

we are less energy intensive as an economy now than we were 30

years ago.

But the one I would like to somewhat self-servingly emphasize,

and it relates to my answer to Senator Sununu, is the fact that the

Fed has a lot more credibility for keeping inflation low and stable.

In the 1970’s, when the energy crisis arose, it generated expectations of further increases in wages and prices, and you got into a

wage price spiral. The Fed was caught between a rock and a hard

place, having to raise rates very significantly in order to try to arrest that inflation, at the same time leading to deep recessions.

Over the last 20 years or so, the U.S. economy has become much

more stable. And one of the very important reasons for that is the

fact that the Fed has gained strong credibility for keeping inflation

low.

The Michigan Survey just came out, and the front page was describing inflation expectations of the American public. And they

have a lot of confidence that the Fed will keep inflation low, despite

the fact that gas prices are up at the pump.

To the extent that the Fed’s credibility is strong and people think

that inflation will be low in the long-term, when energy price increases hit, it causes a temporary burst of inflation. But if nobody

expects it to continue, then it will just moderate away. And we do

not get into this pattern of having to raise rates a lot and getting

into a stagnant, inflationary situation.

So, I think monetary policy is not the only factor. There are other

factors. But I think it does have a lot to do with the better performance we have seen the last 4 or 5 years.

Senator ALLARD. Has the tax stimulus package had an impact on

this?

Chairman BERNANKE. I think the tax stimulus package did help

the economy recover from the 2003 period. And monetary policy

helped, as well.

Senator ALLARD. Now the United States has been enjoying a period of economic expansion. What do you see as a single biggest

threat to the continuation of that expansion?

40

Chairman BERNANKE. I think I had a similar question earlier

and I mentioned two things. One would be that we would have an

inflationary problem which is greater than we now expect. And the

other would be energy prices coming from geopolitical concerns or

other sources. I think those are two.

Obviously you can think of others. Senator Sarbanes has pointed

to the housing market and other things. But I think those would

be the ones I would point to.

Senator ALLARD. My colleague from Connecticut talked about the

debt. We have the public debt and then we have the total debt,

which includes transfer funds for Social Security into the debt.

If we did not have a deficit today and even, in fact, had a surplus, wouldn’t our total debt figures increase because of the transfer from Social Security surpluses into the general fund? Would

that not reflect on the total debt figure?

And if we are ever really going to accomplish total debt reduction, how are we going to do that without mandatory spending reform?

Chairman BERNANKE. You are correct that because we have a

consolidated budget the money we are essentially borrowing from

Social Security, which shows up as paper in the trust fund, does

not count in the deficit. So in that sense, a broader sense, if you

want to think about the U.S. deficit as being the current flow deficit plus the accrued liabilities to future Medicare and Social Security recipients, it is actually a lot larger than the official deficit.

And all that is just another way of saying that as we look forward to the next 10 or 15 years, we are going to be seeing a lot

more pressure coming from these transfer programs and we do

need to be thinking about how we are going to address those problems.

Senator ALLARD. I see, Mr. Chairman, my time has expired.

Chairman SHELBY. We have concluded our first round.

I have two questions I am going to submit to you, Mr. Chairman,

for the record. One has to do with the Basel II capital standards.

Senator Sarbanes raised Basel II earlier. We have some concern

there. We have talked with you about this privately before.

The other one has to do with the Chinese economy. And I know

you will respond to these.

Chairman BERNANKE. Yes, sir.

Chairman SHELBY. Senator Sarbanes, do you have any other

comments or questions?

Senator SARBANES. A few questions, Mr. Chairman.

Chairman Bernanke, first of all, just to be clear, you make constant reference to the cost of energy going up and you relate that

to a potential inflation problem. But it is my understanding it also

has a relationship to a slowing down the economy problem, as well.

So once again you are caught betwixt and between. It works in

one direction to create more of an inflationary concern, but it also

works in a direction to create more of a concern about the possibility of an economic downturn. Would you agree with that statement?

Chairman BERNANKE. Yes, I would.

Senator SARBANES. Now let me ask you this question. In view of

the energy situation, the fact that household savings rate is now

41

down at minus 1.7 percent, which is I think unprecedented certainly over a very long period of time. This chart I showed about

new single-family housing home permits, which is way down, almost 25 percent since a year ago. And what we are hearing from

the people in the housing field is that there is a real slow down.

The inequality in income which we referred to earlier, which I

think erodes purchasing power on behalf of the people not at just

the lower end but the median portion of the income scale. The people that are getting these benefits, their consumption is not going

to go up significantly because they are getting these benefits. But

the people who are falling behind, it is going to impact consumer

purchasing.

This raise in interest rates, of course, carries with it making

much more expensive servicing the national debt. We have run up

the debt, the interest rates are going up. Now we have to have a

bigger item in the budget to handle the interest charges.

When you put all of this together, how worried are you about the

possibility that we could have a substantial economic downturn?

Chairman BERNANKE. Senator, you raised a lot of issues.

I would just say that I take very seriously the dual mandate,

which is to keep the inflation low and to keep the economy growing

at its potential. And we are setting our policies in a way that we

think will do that. Our forecast is for the economy to grow near potential, and for inflation to moderate, and so that is consistent with

what Congress has charged us to do.

I do not see a recession as being very likely. We can never rule

out anything. My expectation is that the economy will continue to

grow going forward.

Consumption, in particular, can still be strong enough to support

growth even as the savings rate moves northward. I believe the

savings rate will be improving somewhat over the next couple of

years.

Senator SARBANES. I think the Members of the FOMC have some

very tough decisions to make here in this particular—I think you

yourself said we were in a transition period. I think you said that

at the outset of your statement.

And of course, only some of the Federal Reserve regional presidents are on the Open Market Committee. A lot of them seem to

be running around making statements nowadays about the situation. I am not sure where that exactly takes us. I just make that

observation.

I want to just ask one final question, and the Chairman referenced the Basel II. I actually want to get that out here on the

table.

The Fed has taken the lead on this issue amongst our regulatory

agencies. I am concerned that the Fed—and this is really before

your watch—that the Fed has gotten us down a path that is now

very difficult for us.

In fact, I note that four of the largest U.S. banks have recently

written the Federal bank regulatory agencies, saying that they

want the option of adopting alternative methodologies, including

the standardized approach, which are permissible under the Basel

II framework.

42

Other countries are allowing this. We are the only country, apparently, proposing to limit its banks to the advance approach option only.

I do not know how we got so far down the path that when we

ran the quantitative impact analysis, we had these tremendous

drops in the capital the banks would be required, which have set

off alarm bells all over the place. I mean virtually everyone has

looked at that and said well, this is not a good model.

How seized of this issue is the Federal Reserve? We expressed

repeated concern here from the Congress. The Chairman has held

a number of hearings on this issue to try to maintain oversight.

But it seems to have almost a life of its own. It seems to me the

Fed really needs to grab hold of this issue and start thinking it

through because everyone who is looking at this thing thinks this

is not going to work.

And yet I get reports that the Fed continues to press ahead on

this path, I guess in part because the Fed is being pushed by its

international partners to do so. But I, for one, think you need to

really take a hard look at this and reconsider exactly where we are.

You do not have to answer that. I just leave that with you, unless you have some comment.

Chairman BERNANKE. I would like to comment briefly, Senator.

I think you and I or a group need to talk about this in much more

detail. I would just make a few comments.

One is that the notice for proposed rulemaking which is going

out is a joint product of all four Federal banking agencies. So it is

an agreed upon notice. And it is one where, of course, we are going

to invite all kinds of comments from all parties who are interested.

I discussed the QIS–4 in previous testimony. I will not take time

to do that. But we certainly agree that we would not tolerate,

would not want to see capital levels decline anywhere like what

was seen in the QIS–4.

We do think that safety and soundness of the banking system,

given how complex and sophisticated it is becoming, does require

some significant updates of the Basel II approach. And the banking

agencies have essentially agreed that this is the right framework.

But we are very open both to suggestions about details and also

about methods of making sure the capital does not fall unduly.

If I may finally say, on the three methods, I believe it is the case

that other countries will be asking their largest and most sophisticated banks to use the advanced method because that is really the

only one of the three that is appropriate for the kind of international banks that we are talking about.

Senator SARBANES. We understand that the Conference of State

Bank Supervisors has recently written, encouraging consideration

of the standardized approach in the implementation of Basel II.

And this also apparently is the request that these major U.S.

banks have now made to the regulatory agencies. It is an approach

apparently being allowed by other countries.

What is the problem in considering the standardized approach?

Chairman BERNANKE. It is being allowed for other countries for

the appropriate banks, for small banks. The standardized approach

is very similar to what we have now. What we are doing is proposing a Basel I–A, that is a modification of the existing system

43

that would be appropriate for the smaller and medium-sized banks

in our system. And that is analogous to what foreign countries will

be doing when they put smaller banks on the standardized approach.

But I do not think you are going to see any large international,

sophisticated, complex banks with all these different kinds of derivatives and off-balance sheet activities and operational risks, you

are not going to see any of those on the standardized approach because they just do not accommodate the risks that those banks are

taking.

Senator SARBANES. So you would not allow that as an option?

You would not be prepared to even consider it is an option?

Chairman BERNANKE. We are prepared to consider anything, but

I think that my judgment is that the standardized approach is essentially the same as the existing approach and would not be adequate for complex internationally active banks.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. I apologize, but since we only get to see you

twice a year, I am going to ask some more questions.

Does it concern you that so many on the Federal Reserve Board

come from an academic background? Do you think it would be beneficial to have some of the remaining vacancies filled with someone

with experience in the business or finance world?

Chairman BERNANKE. Well Senator, we have an opening right

now. As you know, Mark Olson, who is a banker, former President

of the American Bankers Association, has moved over to the accounting board. I would very much like to see his replacement be

somebody with a similar set of banking and financial business

skills, yes.

Senator BUNNING. That is a yes answer.

Chairman BERNANKE. Yes.

Senator BUNNING. I do not get many of them from you. That is

okay.

The Fed minutes say that there is a discussion of a range of options. But it turns out that the vote is almost always unanimous.

I had to go back, I cannot remember when the last dissenting vote

in the FOMC occurred. Leading up to the June meeting, public

statements by some of the Fed Members indicated there might be

a pause. But once again the vote was unanimous to raise rates.

How much serious debate is there really if the Fed keeps coming

up with unanimous decisions?

Chairman BERNANKE. Senator, different committees have different approaches to decisionmaking. The Monetary Policy Committee in the United Kingdom, for example, like the Senate, is

where everybody votes directly. And on a recent occasion, the Governor of the Bank of England was voted down in his recommendation.

Senator BUNNING. Gee, that would be a very pleasant surprise

at times.

Chairman BERNANKE. In the Federal Reserve, we are more of a

consensus-based organization. We do try to come to an agreement

among ourselves, the same way other organizations like the European Central Bank do. But I assure you that we have lengthy and

44

spirited discussions within the meetings, and outside the meetings

with staff. And each person is contributing a perspective and a

point of view to the policy.

Senator BUNNING. Mr. Chairman, they never show up in the

minutes of the FOMC meetings. All this discussion, all this debate

never shows up in the minutes when we get them.

Chairman BERNANKE. Perhaps the minutes could be more detailed.

Senator BUNNING. Transparent?

Chairman BERNANKE. Possibly. Another possibility, sir, is to look

at some of the transcripts, which are of course only available with

5-year legs. But they give a full verbatim description of the meeting. You will see there, if you look, quite a bit of debate and discussion. That is the tradition we continue today.

Senator BUNNING. It took me years of practice, but before Chairman Greenspan left, I was actually able to understand what he

was talking about. There is still a problem with understanding

what the Fed is thinking though totally. You have thought about

bringing back the balance of risk statements or doing something

else so people can understand what is going through all of your

heads.

Is that a fact? Is that going to happen?

Chairman BERNANKE. In the short-run, Senator, we are trying to

maintain some continuity with previous practice so as not to confuse people who are paying attention to the Fed too much. But

what we are doing, as was revealed in the minutes, we have set

up a small committee which is going to help the entire FOMC

think through our entire range of communications, all aspects, including the minutes, including the statements, and try to develop

a better, more explicit, and more useful form of communication.

And I will certainly keep Congressional leaders apprised of this.

And if anything happens that is a departure from past practice, I

will certainly let you know about it and get your input.

Senator BUNNING. Last but not least, one thing different in your

time as Fed Chairman than when Chairman Greenspan, is the

amount of attention the public is paying to statements from other

Fed Members. There was even a Bloomberg article yesterday about

that.

Do you have any problem with other Fed Members speaking out

with different points of view? Do you think that is good for the

markets and the economy?

Chairman BERNANKE. Senator, you were asking about differences

of opinion and getting around group think, and this is one way in

which Members of the FOMC can express different shades of their

views.

We do not restrict, we do not coordinate, the speeches of FOMC

Members. They are going out on their own in their own districts

and talking about whatever issues are important to them. And

sometimes they make comments on monetary policy.

Senator BUNNING. Most of those people that are speaking out are

members of the four banks that happen to be also Members of the

FOMC, the different banks that are also members, four different

ones.

45

Chairman BERNANKE. Not necessarily, Senator. All 12 bank

presidents do come to the meeting and offer their views. Of course

only four——

Senator BUNNING. Vote.

Chairman BERNANKE. Actually five, including the Bank of New

York, vote.

Senator BUNNING. Thank you very much, Mr. Chairman.

Chairman SHELBY. Thank you.

Chairman Bernanke, we appreciate your appearance here. We

wish you well in your job. We know it is difficult, but we think you

are up for the job.

Chairman BERNANKE. Thank you very much, Senator.

Chairman SHELBY. The hearing is adjourned.

[Whereupon, at 12:39 p.m., the hearing was adjourned.]

[Prepared statements, response to written questions, and additional material supplied for the record follow:]

46

PREPARED STATEMENT OF BEN S. BERNANKE

CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

JULY 19, 2006

Mr. Chairman and Members of the Committee, I am pleased to be here again to

present the Federal Reserve’s Monetary Policy Report to the Congress.

Over the period since our February report, the U.S. economy has continued to expand. Real gross domestic product (GDP) is estimated to have risen at an annual

rate of 5.6 percent in the first quarter of 2006. The available indicators suggest that

economic growth has more recently moderated from that quite strong pace, reflecting a gradual cooling of the housing market and other factors that I will discuss.

With respect to the labor market, more than 850,000 jobs were added, on net, to

nonfarm payrolls over the first 6 months of the year, though these gains came at

a slower pace in the second quarter than in the first. Last month, the unemployment rate stood at 4.6 percent.

Inflation has been higher than we had anticipated in February, partly as a result

of further sharp increases in the prices of energy and other commodities. During the

first 5 months of the year, overall inflation as measured by the price index for personal consumption expenditures averaged 4.3 percent at an annual rate. Over the

same period, core inflation—that is, inflation excluding food and energy prices—

averaged 2.6 percent at an annual rate. To address the risk that inflation pressures

might remain elevated, the Federal Open Market Committee (FOMC) continued to

firm the stance of monetary policy, raising the Federal funds rate another 3⁄4 percentage point, to 51⁄4 percent, in the period since our last report.

Let me now review the current economic situation and the outlook in a bit more

detail, beginning with developments in the real economy and then turning to the

inflation situation. I will conclude with some comments on monetary policy.

The U.S. economy appears to be in a period of transition. For the past 3 years

or so, economic growth in the United States has been robust. This growth has reflected both the ongoing reemployment of underutilized resources, as the economy

recovered from the weakness of earlier in the decade, and the expansion of the

economy’s underlying productive potential, as determined by such factors as productivity trends and growth of the labor force. Although the rates of resource utilization

that the economy can sustain cannot be known with any precision, it is clear that,

after several years of above-trend growth, slack in resource utilization has been substantially reduced. As a consequence, a sustainable, noninflationary expansion is

likely to involve a modest reduction in the growth of economic activity from the

rapid pace of the past 3 years to a pace more consistent with the rate of increase

in the Nation’s underlying productive capacity. It bears emphasizing that, because

productivity growth seems likely to remain strong, the productive capacity of our

economy should expand over the next few years at a rate sufficient to support solid

growth in real output.

As I have noted, the anticipated moderation in economic growth now seems to be

under way, although the recent erratic growth pattern complicates this assessment.

That moderation appears most evident in the household sector. In particular, consumer spending, which makes up more than two-thirds of aggregate spending, grew

rapidly during the first quarter but decelerated during the spring. One likely source

of this deceleration was higher energy prices, which have adversely affected the purchasing power of households and weighed on consumer attitudes.

Outlays for residential construction, which have been at very high levels in recent

years, rose further in the first quarter. More recently, however, the market for residential real estate has been cooling, as can be seen in the slowing of new and existing home sales and housing starts. Some of the recent softening in housing starts

may have resulted from the unusually favorable weather during the first quarter

of the year, which pulled forward construction activity, but the slowing of the housing market appears to be more broad-based than can be explained by that factor

alone. Home prices, which have climbed at double-digit rates in recent years, still

appear to be rising for the Nation as a whole, though significantly less rapidly than

before. These developments in the housing market are not particularly surprising,

as the sustained run-up in housing prices, together with some increase in mortgage

rates, has reduced affordability and thus the demand for new homes.

The slowing of the housing market may restrain other forms of household spending as well. With homeowners no longer experiencing increases in the equity value

of their homes at the rapid pace seen in the past few years, and with the recent

declines in stock prices, increases in household net worth are likely to provide less

of a boost to consumer expenditures than they have in the recent past. That said,

favorable fundamentals, including relatively low unemployment and rising disposVerDate 11-MAY-2000 17:03 Nov 06, 2006 Jkt 025856 PO 00000 Frm 00050 Fmt 6621 Sfmt 6621 30354.TXT SBANK4 PsN: SBANK4
47

able incomes, should provide support for consumer spending. Overall, household expenditures appear likely to expand at a moderate pace, providing continued impetus

to the overall economic expansion.

Although growth in household spending has slowed, other sectors of the economy

retain considerable momentum. Business investment in new capital goods appears

to have risen briskly, on net, so far this year. In particular, investment in nonresidential structures, which had been weak since 2001, seems to have picked up

appreciably, providing some offset to the slower growth in residential construction.

Spending on equipment and software has also been strong. With a few exceptions,

business inventories appear to be well-aligned with sales, which reduces the risk

that a buildup of unwanted inventories might act to reduce production in the future.

Business investment seems likely to continue to grow at a solid pace, supported by

growth in final sales, rising backlogs of orders for capital goods, and high rates of

profitability. To be sure, businesses in certain sectors have experienced financial difficulties. In the aggregate, however, firms remain in excellent financial condition,

and credit conditions for businesses are favorable.

Globally, output growth appears strong. Growth of the global economy will help

support U.S. economic activity by continuing to stimulate demand for our exports

of goods and services. One downside of the strength of the global economy, however,

is that it has led to significant increases in the demand for crude oil and other primary commodities over the past few years. Together with heightened geopolitical

uncertainties and the limited ability of suppliers to expand capacity in the short

run, these rising demands have resulted in sharp rises in the prices at which those

goods are traded internationally, which in turn has put upward pressure on costs

and prices in the United States.

Overall, the U.S. economy seems poised to grow in coming quarters at a pace

roughly in line with the expansion of its underlying productive capacity. Such an

outlook is embodied in the projections of members of the Board of Governors and

the Presidents of Federal Reserve Banks that were made around the time of the

FOMC meeting late last month, based on the assumption of appropriate monetary

policy. In particular, the central tendency of those forecasts is for real GDP to increase about 31⁄4 percent to 31⁄2 percent in 2006 and 3 percent to 31⁄4 percent in

2007. With output expanding at a pace near that of the economy’s potential, the civilian unemployment rate is expected to finish both 2006 and 2007 between 43⁄4 percent and 5 percent, close to its recent level.

I turn now to the inflation situation. As I noted, inflation has been higher than

we expected at the time of our last report. Much of the upward pressure on overall

inflation this year has been due to increases in the prices of energy and other commodities and, in particular, to the higher prices of products derived from crude oil.

Gasoline prices have increased notably as a result of the rise in petroleum prices

as well as factors specific to the market for ethanol. The pickup in inflation so far

this year has also been reflected in the prices of a range of nonenergy goods and

services, as strengthening demand may have given firms more ability to pass energy

and other costs through to consumers. In addition, increases in residential rents, as

well as in the imputed rent on owner-occupied homes, have recently contributed to

higher core inflation.

The recent rise in inflation is of concern to the FOMC. The achievement of price

stability is one of the objectives that make up the Congress’s mandate to the Federal Reserve. Moreover, in the long run, price stability is critical to achieving maximum employment and moderate long-term interest rates, the other parts of the

Congressional mandate.

The outlook for inflation is shaped by a number of factors, not the least of which

is the course of energy prices. The spot price of oil has moved up significantly further in recent weeks. Futures quotes imply that market participants expect petroleum prices to roughly stabilize in coming quarters; such an outcome would, over

time, reduce one source of upward pressure on inflation. However, expectations of

a leveling out of oil prices have been consistently disappointed in recent years, and

as the experience of the past week suggests, possible increases in these and other

commodity prices remain a risk to the inflation outlook.

Although the costs of energy and other raw materials are important, labor costs

are by far the largest component of business costs. Anecdotal reports suggest that

the labor market is tight in some industries and occupations and that employers are

having difficulty attracting certain types of skilled workers. To date, however, moderate growth in most broad measures of nominal labor compensation and the ongoing increases in labor productivity have held down the rise in unit labor costs,

reducing pressure on inflation from the cost side. Employee compensation per hour

is likely to rise more quickly over the next couple of years in response to the

strength of the labor market. Whether faster increases in nominal compensation creVerDate 11-MAY-2000 17:03 Nov 06, 2006 Jkt 025856 PO 00000 Frm 00051 Fmt 6621 Sfmt 6621 30354.TXT SBANK4 PsN: SBANK4
48

ate additional cost pressures for firms depends in part on the extent to which they

are offset by continuing productivity gains. Profit margins are currently relatively

wide, and the effect of a possible acceleration in compensation on price inflation

would thus also depend on the extent to which competitive pressures force firms to

reduce margins rather than pass on higher costs.

The public’s inflation expectations are another important determinant of inflation.

The Federal Reserve must guard against the emergence of an inflationary psychology that could impart greater persistence to what would otherwise be a transitory increase in inflation. After rising earlier this year, measures of longer-term

inflation expectations, based on surveys and on a comparison of yields on nominal

and inflation-indexed government debt, have edged down and remain contained.

These developments bear watching, however.

Finally, the extent to which aggregate demand is aligned with the economy’s underlying productive potential also influences inflation. As I noted earlier, FOMC

participants project that the growth in economic activity should moderate to a pace

close to that of the growth of potential both this year and next. Should that moderation occur as anticipated, it should help to limit inflation pressures over time.

The projections of the Members of the Board of Governors and the Presidents of

the Federal Reserve Banks, which are based on information available at the time

of the last FOMC meeting, are for a gradual decline in inflation in coming quarters.

As measured by the price index for personal consumption expenditures excluding

food and energy, inflation is projected to be 21⁄4 percent to 21⁄2 percent this year and

then to edge lower, to 2 percent to 21⁄4 percent next year.

The FOMC projections, which now anticipate slightly lower growth in real output

and higher core inflation than expected in our February report, mirror the somewhat more adverse circumstances facing our economy, which have resulted from the

recent steep run-up in energy costs and higher-than-expected inflation more generally. But they also reflect our assessment that, with appropriate monetary policy

and in the absence of significant unforeseen developments, the economy should continue to expand at a solid and sustainable pace and core inflation should decline

from its recent level over the medium term.

Although our baseline forecast is for moderating inflation, the Committee judges

that some inflation risks remain. In particular, the high prices of energy and other

commodities, in conjunction with high levels of resource utilization that may increase the pricing power of suppliers of goods and services, have the potential to

sustain inflation pressures. More generally, if the pattern of elevated readings on

inflation is more protracted or more intense than is currently expected, this higher

level of inflation could become embedded in the public’s inflation expectations and

in price-setting behavior. Persistently higher inflation would erode the performance

of the real economy and would be costly to reverse. The Federal Reserve must take

account of these risks in making its policy decisions.

In our pursuit of maximum employment and price stability, monetary policy makers operate in an environment of uncertainty. In particular, we have imperfect

knowledge about the effects of our own policy actions as well as of the many other

factors that will shape economic developments during the forecast period. These uncertainties bear importantly on our policy decisions because the full influence of policy actions on the economy is felt only after a considerable period of time. The lags

between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic

growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions—that is, of policy effects still ‘‘in the pipeline.’’ Finally, as I have noted, we must consider not only what appears to be the most likely

outcome but also the risks to that outlook and the costs that would be incurred

should any of those risks be realized.

At the same time, because economic forecasting is far from a precise science, we

have no choice but to regard all our forecasts as provisional and subject to revision

as the facts demand. Thus, policy must be flexible and ready to adjust to changes

in economic projections. In particular, as the Committee noted in the statement

issued after its June meeting, the extent and timing of any additional firming that

may be needed to address inflation risks will depend on the evolution of the outlook

for both inflation and economic growth, as implied by our analysis of the incoming

information.

Thank you. I would be happy to take questions.

49

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY

FROM BEN S. BERNANKE

Q.1. China’s foreign exchange reserves stand at $941.1 billion, creating excess liquidity in their banking system. In addition, various

estimates of China’s first and second quarter growth rates suggest

that the Chinese economy has grown by upward of 10 percent this

year.

Do you see any danger that the Chinese economy is overheating?

Are the Chinese now willing to take all necessary steps, like a revaluation of their currency, which could rein in problems before

they pose systemic risk?

A.1. The ratio of investment to GDP was over 40 percent in 2005,

which is likely too high a rate for an economy to absorb efficiently.

This is leading to overcapacity in some industries and is likely to

add to the already large stock of bad loans in the future. However,

there is less evidence of widespread overheating. Inflation is still

quite low, at about 11⁄2 percent for consumer prices on a 12-month

basis, despite the fact that the money supply has been growing at

a rate of almost 19 percent.

Chinese authorities have indicated that they would like investment to slow and that they would also like growth to be better balanced between external and domestic demand. They have taken

some steps to try to encourage consumption. However, they still

have not allowed a substantial appreciation of the reminbi, a step

that many analysts argue would be the most effective way to address the imbalances in the economy.

Q.2. Has the Federal Reserve been asked or offered to provide

guidance to the Chinese Central Bank and are you concerned about

any spillover effects that a Chinese economic crisis could have in

U.S. markets?

A.2. The Federal Reserve has provided technical assistance to the

People’s Bank of China for a number of years on various aspects

of central banking. The Federal Reserve has also been supportive

of the U.S. Treasury’s initiative to provide technical assistance to

China in the economic and financial areas.

We believe that the chance of a Chinese economic crisis is very

low for the foreseeable future. Although the banking sector is burdened with an enormous and probably growing stock of problematic

loans, the government possesses sizable resources and is unlikely

to allow the banking system to fail. The large stock of foreign exchange reserves also makes a potential currency crisis a very low

probability event.

However, we do not entirely discount the possibility of a ‘‘hard

landing,’’ in the form of significantly slower growth, as the authorities attempt to reduce investment growth from its current rapid

pace. We do not think this is the most likely outcome, but it is a

possibility. Such an outcome would have significant repercussions

for other Asian economies, including Japan, and would also be detrimental for some of the other emerging market economies, notably

in Latin America and the Middle East, that have been supplying

the enormous Chinese demand for oil and other commodities. The

impact on the United States would be less direct, given that China

is not a major buyer of our exports, but the overall impact on world

50

GDP would certainly have some negative effect on the United

States.

Q.3. In recent weeks, several banks have suggested that the current Basel II framework should be revised to provide any bank the

option to use either the advanced approach or the standardized approach set forth in the original Basel II framework. Apparently,

there is concern that Basel II as set forth in the draft NPR released last March would not be cost effective for banks to implement. Does the Federal Reserve support allowing banks such an

option? If not, please explain your rationale. Does the Federal Reserve believe that concerns about the cost effectiveness of Basel II

as presently set forth in the draft NPR are valid? Would you please

update the Committee on the Federal Reserve’s timetable for the

implementing Basel II and Basel IA? Please provide specific dates,

if possible, by which the Federal Reserve expects to have completed

each of steps for implementing Basel II and Basel IA.

A.3. The Federal Reserve and the other banking agencies have received several comment letters asking that we provide optionality

in the United States. Basel II framework similar to that provided

in the Basel Mid-Year text. As with other comments we have received on the draft Basel II NPR, and consistent with out duties

under the Administrative Procedure Act, we will seriously consider

the merits of the suggestion.

As I tried to indicate in my response to a similar question posed

by Senator Sarbanes, I am concerned that the Basel II standardized approach would not accommodate the risks that the large,

complex, internationally active banks take, both on and off their

balance sheets. In my judgment, elements of the Basel II standardized approach, particularly those related to the measurement of

credit risk, would be more appropriately applied to smaller, less

complex, and primarily domestic U.S. banking organizations. That

is how it was designed and that is how it appears it will be implemented in other countries. For example, there is no evidence that

any of the largest 50 non-U.S. G–10 banks plans to adopt the

standardized approach, even though they have the option to do so.

Evaluating the cost effectiveness of Basel II NPR requires measurement of both costs and benefits, both of which are difficult. With

respect to the costs of compliance, it should be noted that many of

the risk measurement and risk management policies and practices

required by the draft Basel II NPR are policies and practices that

banking organizations adopted or would have adopted even in the

absence of Basel II in order to (i) improve their own understanding

of their risk profile; (ii) meet supervisory expectations for good risk

measurement and management; or (iii) satisfy Basel II regulatory

capital requirements in other jurisdictions. On the benefits side, we

expect that Basel II will improve the risk sensitivity of our bank

regulatory capital framework, remove opportunities for regulatory

capital arbitrage, improve our supervisory ability to evaluate a

bank’s capital adequacy, improve market discipline of banks, and,

ultimately enhance the safety and soundness of our banking system. Given the inherent complexities in measuring costs and benefits, it is difficult to evaluate the question of cost effectiveness in

any simple terms. We have sought, and will continue to seek, comVerDate 11-MAY-2000 17:03 Nov 06, 2006 Jkt 025856 PO 00000 Frm 00054 Fmt 6602 Sfmt 6602 30354.TXT SBANK4 PsN: SBANK4
51

ment from banks and others to gain a better understanding of the

costs of compliance with our Basel II proposals.

The timetable for implementation of Basel II and Basel IA is set

by the four Federal banking agencies acting in concert. That timetable currently contemplates adoption of final rules for Basel II and

Basel IA by mid-2007 so that the parallel run for Basel II can

begin in January 2008. Transitional capital floors and other safeguards will be in place at least through January 2012 and perhaps

longer for some banks depending on when they complete their parallel run.

RESPONSE TO A WRITTEN QUESTION OF SENATOR REED

FROM BEN S. BERNANKE

Q.1. Chairman Bernanke, in your testimony you state that the

standardized approach is ‘‘essentially the same as the existing approach’’ in Basel I. My understanding is that the standardized approach has some significant differences, including, for example,

greater differentiation of assets by credit quality; an operational

risk charge; more accurate measures of counterparty exposure; recognition of some credit risk mitigation measures; and riskweighting of mortgages. Could you clarify for the record whether

you really believe that the standardized approach is the same as

Basel I?

A.1. I believe that the general broad-brush approach to risk-weight

categories and the expectations for risk management contained in

the credit risk standardized approach in Basel II are not a large

change from our existing Basel I-based capital rules. To be sure,

there are a number of differences between Basel I and the credit

risk standardized approach in Basel II, and your question highlights many of these differences. However, my remarks were made

in the context of whether the Basel II credit risk standardized approach would be appropriate for large, internationally active banking organizations in the United States. In my opinion, the Basel II

credit risk standardized approach is much less risk-sensitive than

the Basel II advanced approach and does not make use of the most

advanced risk management practices. For example, I note that the

Basel II credit risk standardized approach generally provides the

same risk weight for all first-lien mortgage loans (35 percent), nonmortgage retail loans (75 percent), and unrated corporate credits

(100 percent), regardless of the creditworthiness of the borrower.

As you are aware, the agencies intend to update the Basel Ibased capital rules for most banks in the United States. In updating those rules, we expect to utilize some of the improvements in

the Basel II standardized approach.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR STABENOW

FROM BEN S. BERNANKE

Q.1. On Wednesday, July 12, China’s top planning agency forecasted that China would report a more than 10 percent growth for

the first half of the year.

In response, the National Development and Reform Commission

reiterated their calls for stronger action to curb excessive investment. And, the Financial Times reported that credit tightening

policies are imminent—a matter of weeks not months.

52

Given that the United States-China trade deficit continues to

surpass previous records every passing month, we need to be much

more in tune with Chinese economic policies. Therefore, my question for you is—do you think China will begin to tighten their lending policies and if they do, how will it impact our trade deficit and

the global economy at large?

A.1. China has taken a number of steps this year to try to restrain

growth in lending, with limited success. Chinese authorities have

imposed some administrative controls, raised interest rates, and increased banks’ reserve requirements. Most recently, the Chinese

central government has issued a circular requiring a review of all

new investment projects undertaken this year in excess of RMB

100 million, with a cutoff of RMB 30 million in sectors that are

thought to have excess capacity (including steel, aluminum, and

autos). If these measures are still not successful in slowing investment growth, they are likely to do more. In any case, slower growth

is not likely to translate into any improvement in our trade deficit

with China. In fact, if slower growth in China resulted in reduced

growth in China’s imports, the Chinese trade surplus would increase.

Q.2a. The next time we meet will be at the end of 2006. From now

until then, China is gearing up for its first real push into the U.S.

auto market.

In your opinion, how will the entrance of China—who has a history of under pricing their products through currency manipulation—affect the manufacturing industry in the United States?

A.2a. I understand that three Chinese companies are aiming to introduce autos and light trucks into the U.S. market over the next

several years. Overall, they are not likely to have a significant impact on the U.S. auto industry because they are small: The largest,

Chery, sold fewer than 200,000 vehicles globally last year compared

with GM’s sales of more than 8 million vehicles. More important

over the longer-run, our experience with other foreign firms indicates that offering vehicles at a low price will by no means guarantee their success. The quality and reliability of these vehicles

will be an important determinant of their effect on the domestic

market for vehicles. Foreign firms also will need to adapt their designs to meet strict U.S. safety and emissions standards and to establish new dealerships.

Q.2b. I have one broader question about manufacturing in the

United States. Every quarter I review the manufacturing numbers

produced by the Bureau of Labor Statistics. As you can see from

this graph—manufacturing continues to decline, ever since 2000.

When do you see this slowing down? And in Michigan, the graph

looks like this. Again, how do you analyze these trends and what

do you expect in the future?

53

A.2b. Although manufacturing employment fell substantially during the last economic downturn, declines in the sector slowed

markedly beginning in late 2003 and from April through July of

this year, manufacturing jobs and the average factory workweek

were up from the lows reached last fall. Over the longer-run, even

as manufacturing employment has been declining, manufacturing

production has risen solidly. This is because the reduction in labor

input has been more than offset by rapid increases in productivity.

Indeed, we estimate that overall manufacturing capacity in the

United States in 2005 stood about 50 percent higher than in 1995.

Of course, underlying those positive overall trends are structural

changes that affect the composition and location of manufacturing

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1William A. Testa, Thomas H. Klier, and Richard H. Mattoon, ‘‘Challenges and Prospects for

Midwest Manufacturing,’’ Chicago Fed Letter (March 2005).

jobs. For example, many of the expanding manufacturing industries in recent years, such as computers and electronic components,

have located outside of the Midwest. The Federal Reserve Bank of

Chicago, which studies trends in the Midwest, notes that structural

developments in the motor vehicle industry have had an important

effect in the region and in Michigan.1 With the introduction of new

assembly by transplants, the geographic distribution of motor vehicle production has spread to the mid-South. And, the loss of market

share of sales by the Big Three producers to the transplant firms

has exacerbated the loss. Suppliers have followed the shift in assemblies.

RESONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO

FROM BEN S. BERNANKE

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. As

you know, the President’s Working Group on Financial Markets

has explained why proposals we have faced in the last couple of

years for additional regulation of energy derivatives were not warranted, and has urged Congress to be aware of the potential for unintended consequences. Do you share this view? Do you agree with

the view of Alan Greenspan and others that derivatives have

helped create a far more flexible, efficient, and resilient financial

system? Are you aware of any evidence that additional reporting

requirements or other regulatory actions would reduce energy

prices and price volatility or are energy prices and price volatility

determined by the market?

A.1. I share the view that additional regulation of energy derivatives is not warranted. More generally, I agree that derivatives

have created a more flexible, efficient, and resilient financial system. To be sure, as Chairman Greenspan recognized, derivatives

pose a variety of risk management challenges that users must address. In particular, they must effectively manage the counterparty

risks associated with derivatives. Thus far, with a few notable exceptions they have done so and, as a result, derivatives have produced the benefits that you have mentioned.

I am unaware of any evidence that supports a view that additional reporting requirements or other new regulations would reduce energy prices or energy price volatility. Prices and volatility

are indeed determined by the market, and as far as I am aware,

energy prices and volatility recently have moved in ways that seem

sensibly related to fundamentals.

Q.2. Mr. Chairman, in your Sea Island speech in May on the subject of ‘‘Hedge Funds and Systemic Risk,’’ you noted that ‘‘[t]he primary mechanism for regulating excessive leverage and other

aspects of risk-taking in a market economy is the discipline provided by creditors, counterparties, and investors.’’

You further observed that, in light of 1998’s LTCM episode, the

President’s Working Group’s ‘‘central policy recommendation was

that regulators and supervisors should foster an environment in

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which market discipline—in particular, counterparty risk management—constrains excessive leverage and risk-taking.’’

You also noted that the PWG rejected so-called ‘‘direct regulation’’ of hedge funds, observing that ‘‘[d]irect regulation may be

justified when market discipline is ineffective at constraining excessive leverage and risk-taking but, in the case of hedge funds, the

reasonable presumption is that market discipline can work. Investors, creditors, and counterparties have significant incentives to

rein in hedge funds’ risktaking. Moreover, direct regulation would

impose costs in the form of moral hazard, the likely loss of private

market discipline, and possible limits on funds’ ability to provide

market liquidity.’’

Can you tell us a little more about what is involved in fostering

market discipline in the hedge fund context and why you believe

that is a superior approach to ‘‘direct regulation?’’

A.2. The creditors and counterparties of hedge funds are regulated

banks and securities firms. Banking and securities supervisors

have been fostering market discipline by issuing supervisory guidance on counterparty risk management, by encouraging private

sector initiatives to identify and promote best practices for risk

management, and by undertaking supervisory reviews that assess

whether banks and securities firms’ practices are consistent with

supervisory guidance and emerging best practices.

As I indicated in my Sea Island speech, I believe that it is a reasonable presumption that market discipline can effectively constrain hedge funds’ leverage. The banks and securities firms that

provide hedge funds with leverage have strong incentives and capabilities to constrain their leverage so as to avoid counterparty

losses. Supervisors of those banks and securities firms can and

should take action if competition appears to be dulling those incentives in ways that threaten the counterparties and the financial

system. Direct regulation of hedge funds could weaken market discipline if hedge funds’ creditors and counterparties came to view direct regulation as an effective substitute for their own due diligence

and monitoring of risks. Furthermore, development of an effective

regulatory regime for hedge funds would be challenging in light of

the diversity of hedge fund investment strategies and the speed

with which their risk profiles tend to change. A regulatory regime

that was insufficiently risk sensitive could impair hedge funds’

ability to bear risks and provide liquidity to financial markets,

which would make our financial system less efficient and less resilient.

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