U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

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

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

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

29–738 PDF 2006

S. HRG. 109–596

THE ECONOMIC OUTLOOK

HEARING

BEFORE THE

JOINT ECONOMIC COMMITTEE

CONGRESS OF THE UNITED STATES

ONE HUNDRED NINTH CONGRESS

SECOND SESSION

APRIL 27, 2006

Printed for the use of the Joint Economic Committee

(

(II)

JOINT ECONOMIC COMMITTEE

[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]

HOUSE OF REPRESENTATIVES

JIM SAXTON, New Jersey, Chairman

PAUL RYAN, Wisconsin

PHIL ENGLISH, Pennsylvania

RON PAUL, Texas

KEVIN BRADY, Texas

THADDEUS G. MCCOTTER, Michigan

CAROLYN B. MALONEY, New York

MAURICE D. HINCHEY, New York

LORETTA SANCHEZ, California

ELIJAH E. CUMMINGS, Maryland

SENATE

ROBERT F. BENNETT, Utah, Vice Chairman

SAM BROWNBACK, Kansas

JOHN SUNUNU, New Hampshire

JIM DEMINT, South Carolina

JEFF SESSIONS, Alabama

JOHN CORNYN, Texas

JACK REED, Rhode Island

EDWARD M. KENNEDY, Massachusetts

PAUL S. SARBANES, Maryland

JEFF BINGAMAN, New Mexico

CHRISTOPHER J. FRENZE, Executive Director

CHAD STONE, Minority Staff Director

(III)

C O N T E N T S

OPENING STATEMENT OF MEMBERS

Hon. Jim Saxton, Chairman, a U.S. Representative from New Jersey ............... 1

Hon. Jack Reed, Ranking Minority, a U.S. Senator from Rhode Island ............. 6

WITNESSES

Statement of Hon. Ben Bernanke, Chairman, Board of Governors of the

Federal Reserve System ...................................................................................... 2

SUBMISSIONS FOR THE RECORD

Prepared Statement of Representative Jim Saxton, Chairman ........................... 35

Prepared Statement of Senator Robert Bennett, Vice Chairman ........................ 35

Prepared Statement Senator Jack Reed, Ranking Minority ................................ 36

Prepared Statement of Hon. Ben Bernanke, Chairman, Board of Governors

of the Federal Reserve System ............................................................................ 37

Chart entitled ‘‘Inflation,’’ submitted by Chairman Jim Saxton ......................... 41

Letter from Chairman Jim Saxton to Chairman Ben Bernanke with written

questions for the record ....................................................................................... 42

Response from Chairman Ben Bernanke to written questions submitted by

Chairman Jim Saxton .......................................................................................... 44

Letter submitted by Senator John Sununu from Chairman Alan Greenspan

to Senator John Sununu, January 3, 2006 ........................................................ 47

(1)

THE ECONOMIC OUTLOOK

APRIL 27, 2006

CONGRESS OF THE UNITED STATES, JOINT ECONOMIC COMMITTEE, Washington, DC.

The Committee met at 10:02 a.m., in room 216 of the Hart Senate Office Building, the Honorable Jim Saxton (Chairman of the

Committee) presiding.

Representatives present: Saxton, Ryan, English, Paul, Brady,

Maloney, Hinchey, and Cummings.

Senators present: Bennett, Sununu, Sessions, Reed, and Sarbanes.

Staff present: Chris Frenze, Robert Keleher, Brian Higginbotham, Colleen Healy, Katie Jones, Jeff Schlagenhauf, Jeff Wrase,

Chad Stone, Matt Salomon, and Pamela Wilson.

OPENING STATEMENT OF HON. JIM SAXTON, CHAIRMAN,

A U.S. REPRESENTATIVE FROM NEW JERSEY

Representative Saxton. Good morning. Chairman Bernanke,

it’s a pleasure to welcome you here this morning. We appreciate

your appearance today and we look forward to hearing your views

on the economic outlook.

According to the official data, a healthy economic expansion has

been underway for several years. The U.S. economy advanced 4.2

percent in 2004, and 3.5 percent in 2005.

As I have noted many times, the pickup in economic growth since

the middle of 2003 is mostly due to a rebound in investment activity, which had been weak prior to that. This rebound was fostered

by a mix of Federal monetary policy and the 2003 tax legislation

and its incentives for investment.

The continued economic expansion has created 5.2 million payroll

jobs since 2003. The unemployment rate, at 4.7 percent, is below

the averages of the 1970s, the 1980s, and the 1990s.

The Federal Reserve and private economists forecast that business investment and the overall economy will continue to grow this

year.

As the Fed noted in a policy report last February, ‘‘The U.S. delivered a solid performance in 2005.’’ The Fed also stated that ‘‘the

U.S. economy should continue to perform well in 2006 and 2007.’’

Recent data indicate that the economic growth rate for the first

quarter of this year will be quite robust when it is released tomorrow.

According to a broad array of economic data, the outlook remains

positive. Consumer spending is expected to be solid in 2006; home

2

ownership has reached record highs; household net worth is also at

record levels; the trend in productivity growth remains strong.

Although oil prices have raised business costs and imposed hardships on many consumers, these prices have not derailed the expansion.

Meanwhile, long-term inflation pressures are contained. As a result, long-term interest rates such as mortgage rates, are still relatively low, although these rates have edged up in recent weeks.

According to the Fed’s preferred price index, inflation is well

under control.

One point that I would like to mention, however, is that it’s important to examine the price of energy, the causes for increased

prices, the relationship between supply and demand, the relationship between the pump price of gasoline and oil companies’ profits,

and the effect of these items on the economy as we go forward.

In sum, current economic conditions are strong. While economic

growth is expected to exceed 3 percent this year, the economic outlook remains positive.

Mr. Chairman, at this point, we would normally hear from the

Ranking Member, Senator Reed, however, he’s tied up on the floor,

and so we’re going to turn to you now for your testimony, and then

we’ll get into questions.

[The prepared statement of Representative Jim Saxton appears

in the Submissions for the Record on page 35.]

STATEMENT OF HON. BEN 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 appear before the Joint Economic Committee to offer my views on the outlook for the U.S.

economy, and on some of the major economic challenges that the

Nation faces.

Partly because of last year’s devastating hurricanes and partly

because of some temporary or special factors, economic activity decelerated noticeably late last year. The growth of the real gross domestic product, or GDP, slowed from an annual average rate of

nearly 4 percent over the first three quarters of 2005, to less than

2 percent in the fourth quarter.

Since then, however, with some rebound in activity underway in

the Gulf Coast region and continuing expansion in most other parts

of the country, the national economy appears to have grown briskly. Among the key economic indicators, growth in non-farm payroll

employment picked up in November and December, and job gains

averaged about 200,000 per month between January and March.

Consumer spending and business investment, as inferred from data

on motor vehicle sales, retail sales, and shipments of capital goods,

are also on track to post sizable first-quarter increases.

In light of these signs of strength, most private sector forecasters

such as those included in the latest Blue Chip survey, estimate

that real GDP grew between 4 and 5 percent at an annual rate in

the first quarter.

If we smooth through the recent quarter-to-quarter variations,

we see that the pace of economic growth has been strong for the

3

past 3 years, averaging nearly 4 percent at an annual rate since

the middle of 2003.

Much of this growth can be attributed to a substantial expansion

in the productive capacity of the U.S. economy, which, in turn, is

largely the result of impressive gains in productivity, that is, in

output-per-hour-worked.

However, a portion of the recent growth reflects the taking up of

economic slack that had developed during the period of economic

weakness earlier in the decade. Over the past year, for example,

the unemployment rate has fallen nearly one-half percentage point,

the number of people working part-time for economic reasons, has

declined to its lowest level since August of 2001, and the rate of

capacity utilization in the industrial sector has moved up 1.5 percentage points.

As the utilization rates of labor and capital approach their maximum sustainable levels, continued growth in output, if it is to be

sustainable and non-inflationary, should be at a rate consistent

with the growth in the productive capacity of the economy.

Admittedly, determining the rates of capital and labor utilization

consistent with stable long-term growth is fraught with difficulty,

not least because they tend to vary with economic circumstances.

Nevertheless, to allow the expansion to continue in a healthy

fashion and to avoid the risk of higher inflation, policymakers must

do their best to help to ensure that the aggregate demand for goods

and services does not persistently exceed the economy’s underlying

productive capacity.

Based on the information in hand, it seems reasonable to expect

that economic growth will moderate toward a more sustainable

pace as the year progresses. In particular, one sector that is showing signs of softening is the residential housing market. Both new

and existing home sales have dropped back, on net, from their

peaks of last Summer and early Fall, and while unusually mild

weather gave a lift to new housing starts earlier this year, the

reading for March points to a slowing in the pace of homebuilding

as well.

House prices, which have increased rapidly during the past several years, appear to be in the process of decelerating, which will

imply slower additions to household wealth, and, thereby, less impetus to consumer spending.

At this point, the available data on the housing market, together

with ongoing support for housing demand from factors such as

strong job creation and still-low mortgage rates, suggests that this

sector will most likely experience a gradual cooling, rather than a

sharp slowdown. However, significant uncertainty attends the outlook for housing, and the risk exists that a slowdown more pronounced than we currently expect could prove a drag on growth

this year and next. The Federal Reserve will continue monitoring

housing markets closely.

More broadly, the prospects for maintaining economic growth at

solid pace in the period ahead, appear good, although growth rates

may well vary, quarter-to-quarter, as the economy downshifts from

the first-quarter spurt.

4

Productivity growth, job creation, and capital spending are all

strong, and continued expansion on the economies of our trading

partners, seems likely to boost our export sector.

That said, energy prices remain a concern. The nominal price of

crude oil has risen recently to new highs, and gasoline prices are

also up sharply. Rising energy prices pose a risk to both economic

activity and inflation. If energy prices stabilize this year, even at

a high level, their adverse effects on both growth and inflation

should diminish somewhat over time. However, as the world has

little spare oil production capacity, periodic spikes in oil prices remain a possibility.

The outlook for inflation is reasonably favorable, but carries

some risks. Increases in energy prices have pushed up overall consumer price inflation over the past year or so. However, inflation

in core price indexes, which, in the past has been a better indicator

of long-term inflation trends, has remained roughly stable over the

past year.

Among the factors restraining core inflation, are ongoing gains in

productivity, which have helped to hold unit labor costs in check,

and strong domestic and international competition in product markets, which have restrained the ability of firms to pass cost increases on to consumers.

The stability of core inflation is also enhanced by the fact that

long-term inflation expectations, as measured by surveys and by

comparing yields on nominal and indexed Treasury securities, appear to remain well anchored.

Inflation expectations will remain low only so long as the Federal

Reserve demonstrates its commitment to price stability. As to inflation risks, I have already noted that continuing growth in aggregate demand in excess of increases in the economy’s underlying

productive capacity would likely lead to increased inflationary pressures. In addition, although pass-through from energy and commodity price increases to core inflation has thus far been limited,

the risk exists that strengthening demand for final products could

allow firms to pass on a greater portion of their cost increases in

the future.

With regard to monetary policy, the Federal Open Market Committee, or FOMC, has raised the Federal Funds rate in increments

of 25 basis points at each of its past 15 meetings, bringing it to its

current level to 4.75 percent.

This sequence of rate increases was necessary to remove the unusual monetary accommodation put in place in response to the soft

economic conditions earlier in this decade. Future policy actions

will be increasingly dependent on the evolution of the economic

outlook, as reflected in the incoming data. Specifically, policy will

respond to arriving information that affects the Committee’s assessment of the medium-term risk to its objectives of price stability

and maximum sustainable employment. Focusing on the mediumterm forecast horizon is necessary because of the lags with which

monetary policy affects the economy.

In the statement issued after its March meeting, the FOMC

noted that economic growth had rebounded strongly in the first

quarter, but appeared likely to moderate to a more sustainable

5

pace. It further noted that a number of factors have contributed to

the stability in core inflation.

However, the Committee also viewed the possibility that core inflation might rise as a risk to the achievement of its mandated objectives, and it judged that some further policy firming may be

needed to keep the risk of attainment of both sustainable economic

growth and price stability, roughly in balance.

In my view, data arriving since the meeting, have not materially

changed that assessment of the risks. To support continued healthy

growth of the economy, vigilance in regards to inflation, is essential. The FOMC will continue to monitor the incoming data closely,

to assess the prospects for both growth and inflation. In particular,

even if, in the Committee’s judgment, the risks to its objectives are

not entirely balanced, at some point in the future, the Committee

may decide to take no action at one or more meetings, in the interest of allowing more time to receive information relevant to the

outlook. Of course, a decision to take no action at a particular

meeting does not preclude actions at subsequent meetings, and the

Committee will not hesitate to act when it determines that doing

so is needed to foster the achievement of the Federal Reserve’s

mandated objectives.

Mr. Chairman, the remainder of my testimony, which I submit

for the record, discusses two longer-term challenges to the U.S.

economy: The first is the long-run sustainability of the Federal

budget deficit. Given the aging of our population, we’re going to see

increasing stress on transfer programs as a share of GDP, and I

argue that Congress needs to make difficult choices about what

share of the GDP is to be devoted to Federal programs, and to set

taxes accordingly to match that share of GDP.

The second issue that I discuss—and I’m simply summarizing—

is the U.S. current account deficit, which is now at about 6.5 percent of GDP, and which cannot be sustained indefinitely at that

level.

Recent discussions with the G7 have made the important point

that the U.S. current account deficit is not a U.S. problem alone,

but is a global problem, and one which requires action and response, not only by the United States, but by our trading partners,

as well. There are a number of steps that both we and our trading

partners can take to improve the current account situation over a

period of time. On our side, again, improved fiscal balance would

be helpful, but, in addition, other countries need to take action, as

well.

In conclusion, Mr. Chairman, the economy is performing well,

and the near-term prospects look good, although, as always, there

are risk to the outlook. Monetary policy will continue to pursue its

objectives of helping the economy to grow at a strong, sustainable

pace, while keeping inflation firmly under control.

And while many of the fundamental factors that determine longterm economic growth appear favorable, actions to move the Federal budget toward a more sustainable position will do a great deal

to help ensure the future prosperity of our economy.

Thank you, and I’d be happy to take any questions you might

have.

6

[The prepared statement of Hon. Ben Bernanke appears in the

Submissions for the Record on page 37.]

Representative Saxton. Mr. Chairman, normally we would

begin our questions at this point, but let me just ask Senator Reed,

who was tied up on the floor previously, if he has an opening statement.

OPENING STATEMENT OF HON. JACK REED, RANKING

MINORITY, A U.S. SENATOR FROM RHODE ISLAND

Senator Reed. Well, thank you very much, Chairman Saxton,

and welcome, Chairman Bernanke, and thank you for your testimony today and for your service.

All eyes are on you as you embark on a very delicate balance in

terms of allowing the economy to grow and employment to reach

its full potential, while you remain mindful of the risks of inflation.

For some time, the Fed’s job has been easier. It had room to raise

interest rates from very low levels, with little risk of derailing the

economic recovery, while inflation and other lurking economic problems were at bay.

Today, soaring energy prices, record budget and trade deficits,

negative household savings rates, and a disappointing labor market

recovery, all pose tremendous challenges to setting monetary policy.

The Fed has raised its target for the Federal Funds rate by 25

basis points at each of the last 15 FOMC meetings, and, according

to the minutes of the March meeting, most members of the FOMC

thought that the end of the tightening process was near. The question on everyone’s mind is, are we there yet?

The phrase we are hearing is that interest rate changes will now

be data-driven, so I hope that means, Chairman Bernanke, that the

Fed will look hard at the full range of data on economic growth,

employment, and inflation, to determine the best course for monetary policy.

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

out of the economic gains of this recovery. Strong productivity

growth has shown up in the bottom lines of shareholders, but not

in the paychecks of workers.

Too many Americans are being squeezed by stagnant incomes

and rising costs for gasoline, healthcare, and education. It seems

to me that there is still room for real wages to catch up with productivity, before the Fed needs to worry about inflationary pressures from the labor market.

However, there are many other downside risks to the economy on

the horizon. You have mentioned some of them.

Energy prices have been pushing up overall inflation for some

time, but last month, we saw an uptick in core inflation, which

might be an early sign that businesses are starting to pass on their

higher energy costs to customers.

Rising oil prices and interest rates, coupled with a weakening

housing sector, could take their toll on consumers and businesses

alike, and slow down the economy.

Your task in setting the right course for monetary policy is complicated by fiscal policy and international imbalances, which you

7

discuss in the bulk of your statement, which you put into the

record.

We no longer have the fiscal discipline that we had in the 1990s,

which allowed for monetary policy that encouraged investment and

long-term growth. The President’s large and persistent budget deficits have led to an ever-widening trade deficit that forces us to borrow vast amounts from abroad, and puts us at risk of a major financial collapse if foreign lenders suddenly stop accepting our

IOUs.

Even assuming we can avoid an international financial crisis,

continued budget and trade deficits will be a drag on the growth

of our standard of living, and leave us ill prepared to deal with the

effects of the retirement of the Baby Boom generation.

Strong investment financed by our own national saving, not foreign borrowing, is the foundation for strong, sustained economic

growth and rising living standards.

There is final issue that I’d like to raise, and that is the growing

inequality of income, earnings, and wealth in the U.S. economy.

Your predecessor, Chairman Greenspan, regularly raised that issue

as one of the concerns for our political economy. It is not good for

a democracy to have widening inequality.

I know you share those concerns. Recently the Federal Reserve

published the results of the 2004 Survey of Consumer Finances.

They show that the growth in median income and wealth have

slowed substantially, and the top 1 percent of families hold more

wealth than the bottom 90 percent of families.

Mr. Chairman, I hope you can concentrate on that issue as you

continue to develop policy, and, I again encourage and welcome

your presentation here today. Thank you, Mr. Chairman.

[The prepared statement of Hon. Jack Reed appears in the Submissions for the Record on page 36.]

Representative Saxton. Thank you very much, Senator Reed.

Mr. Chairman, let me begin with a question that I think is central to the subject that we’re discussing here, and that is the Fed’s

role in managing our Nation’s monetary policy.

In both your statement and in Senator Reed’s statement, the

subject of inflation was mentioned prominently. As a matter of fact,

the Fed’s monetary policy for many years has focused on price stability and trying to control inflation.

Under such policy, inflation and interest rates are kept low. As

this low inflation persists, the central bank’s policy becomes increasingly credible in the eyes of investors, as well as in the eyes

of savers.

As a consequence, inflationary expectations recede and interest

rates decline. These movements, in turn, encourage economic

growth and lower unemployment, and just better economic outcomes for everyone.

My question is this: If the United States were to move toward

explicit inflation targeting, would this be largely a movement for

greater transparency, or mostly a significant change in the substance of Fed monetary policy?

Chairman Bernanke. Thank you, Mr. Chairman. Let me first

address the point on inflation. The Federal Reserve has a threeVerDate 11-MAY-2000 08:27 Oct 27, 2006 Jkt 029738 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 C:\DOCS\29738.TXT DianeA PsN: DianeA
8

part mandate: Price stability; moderate long-term interest rates;

and maximum employment.

Clearly, keeping inflation low and stable addresses directly the

first two of those, in particular, since long-term interest rates can

only be low if investors expect inflation to remain low. I would

argue, in addition, that there’s very strong evidence that low and

stable inflation and well-anchored inflation expectations also contribute mightily to the third objective, which is strong and stable

employment growth.

For example, we have seen since the mid-1980s, what economists

refer to as the great moderation, the fact that recessions have been

somewhat less frequent and milder, that quarter-to-quarter variation in output and employment has been lower. Many scholars attribute that to the fact that inflation in that last 20-year period,

has been low and stable.

Therefore, it is very much in the interest of all of the objectives,

including the employment objectives of the Federal Reserve, to

keep inflation low and stable. So, then, the question is, how to do

that?

The Federal Reserve already has established strong credibility

for keeping inflation low and stable, and I anticipate we will retain

that credibility.

I have discussed, and will be discussing with the Federal Open

Market Committee, ways in which we can continue Chairman

Greenspan’s movement toward greater transparency and better

communication, to further anchor inflation expectations and reduce

uncertainty in financial markets.

One of the ideas that’s been discussed in that context, is the idea

of defining, quantitatively, what the optimal long-term inflation

rate might be. In doing so, the hope would be to reduce uncertainty

and to help anchor inflation expectations more tightly.

Clearly—and I’d like to emphasize this point—taking this step

would in no way repudiate the employment part of the dual mandate; to the contrary, it would provide the Fed with a stronger tool

and better ability to meet this very important objective.

So, to answer your question most directly, I don’t see, and I don’t

desire, any change in the basic operating procedures of the Fed,

nor in its objectives; rather, I think that we need to work on our

communication, broadly speaking, to make sure that inflation expectations remain low and stable, as a tool for meeting all three

of the Federal Reserve’s mandated objectives.

Representative Saxton. Mr. Chairman, thank you. Some worry

about Fed policy, which has focused on price stability over the last

couple of decades. Recently, under this policy we have seen a relatively long period of Fed tightening, which resulted in higher overnight interest rates.

Some would worry that this translates into higher interest rates

in the economy, particularly in long-term interest rates, and, most

recently, that has not happened. As a matter of fact, we have seen

stable long-term interest rates, in spite of the fact that short-term

rates have increased rather significantly.

Why is it that long-term rates have remained stable and even

come down during this period of time, on occasions, when Fed polVerDate 11-MAY-2000 08:27 Oct 27, 2006 Jkt 029738 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 C:\DOCS\29738.TXT DianeA PsN: DianeA
9

icy has been to tighten and the net result of that is short-term rate

increases?

Chairman Bernanke. Mr. Chairman, first I’d like to reiterate

the point that increasing short-term rates to control inflation has

the effect actually, in the long run certainly, of keeping long-term

rates lower, rather than higher.

I can only draw the contrast between the 1970s and the early

1980s when people paid 18 percent for mortgages, vis-a`-vis today

where they are paying 6 percent-plus, in an environment where inflation is low and stable and under control, and in that respect,

meeting our objective of low to moderate long-term interest rates

is best achieved by keeping inflation low and stable.

With respect to the recent behavior of long-term interest rates,

it’s useful to think about the long-term interest rate as consisting

of a series of short-term rates, the rates for the next few years and

then the rates that investors expect to be maintained further out

into the future.

Over the last almost 2 years, as the Fed has been tightening, the

short-term component of that has been rising, as the policy rate

has risen, but the further-out short-term rates, at the far end of

the yield curve, have been declining and offsetting that effect and

leaving the overall 10-year rate more or less stable.

The declines in the far-out yields, further out in the term structure, seem to result from both an increase of saving in the global

economy, which has been looking for returns—and some of that has

come to the United States and to other industrial countries, driving

down returns—and also some reduction in term premiums, reflecting the reduced sense of risk that investors feel about the general

economy, about inflation, and about the bond market, specifically.

Now, recently, we have seen a turnaround, in that the far-out

short-term rates, the rates that investors expect to be maintained,

5 or 10 years from now, have risen fairly significantly, leading to

an overall increase in long-term interest rates.

I think there are basically two reasons for that: First, there has

been some return of the term premium back to more normal levels,

after a period of unusually low levels.

But, second, and, I think, importantly for our economy, it appears that the world economy is growing this year at a very

healthy pace. We’re seeing strength in Japan; we’re seeing some incipient strength in Europe; China continues very strong, as well as

Southeast Asia; emerging markets are doing well, so general

strength in the world economy is providing some increased upward

pressure on long-term interest rates, and that, I think, explains

what’s been happening in the last couple of months.

Representative Saxton. Thank you. Let me just change the

subject for just a moment.

The price of oil has reached a price in excess of $70 a barrel. Just

let me ask quickly before we turn to the next Member, how does

the oil price increase affect your outlook on the economy? Are you

worried or extremely worried? What is your general outlook on this

subject?

Chairman Bernanke. Yes, Mr. Chairman, higher oil prices do

create problems for monetary policy. On the one hand, they directly

affect the cost of living, inflation, on the other hand, by taking purVerDate 11-MAY-2000 08:27 Oct 27, 2006 Jkt 029738 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 C:\DOCS\29738.TXT DianeA PsN: DianeA
10

chasing power away from consumers, they tend to slow economic

activity, and so they do produce a difficult problem.

For the Federal Reserve, one issue we will be looking at very

carefully is whether the increases in energy prices that we have already seen and that we may see in the future pass through into

core inflation—that is, whether they go beyond the energy sector

itself and begin to be seen in higher prices for other goods and

services. If that were to happen and if expectations of inflation

were thereby to rise, that would be very deleterious to the longterm growth of the economy.

By contrast, if inflation expectations remain stable and core inflation is not infected, so to speak, by high energy prices, that gives

the Fed considerably more leeway to respond to any changes that

may happen in the real economy related to the higher oil prices.

In particular, we do expect to see a slight slowing in growth, perhaps a couple of tenths, this year and next associated with the

higher oil prices and their effects on consumer spending. And we

are very aware of that and are paying attention to those developments.

Representative Saxton. Thank you, Mr. Chairman.

Senator Reed.

Senator Reed. Thank you, Mr. Chairman. Because Senator Sarbanes has to leave, I would yield him 5 minutes for questions.

Senator Sarbanes. Thank you very much, Senator Reed. I will

be very brief and I apologize to Chairman Bernanke that I cannot

stay. I have been looking forward to this hearing, but I have another commitment.

I am drawn to the sentence at the bottom of page 3 of your statement: ‘‘Of course, inflation expectations will remain low only so

long as the Federal Reserve demonstrates its commitment to price

stability.’’ And the question I want to raise to you is that in order

for the Federal Reserve to demonstrate its commitment to price

stability, is it necessary for the Open Market Committee to raise

interest rates 25 basis points every time they meet?

Chairman Bernanke. No, Senator.

Senator Sarbanes. Well that is fine. All I need is an answer,

just so I——

Chairman Bernanke. If that satisfies——

Senator Sarbanes [continuing]. Just so I know that we are not

on an irreversible treadmill here, since we have seen 15 meetings

in a row in which the Open Market Committee has taken the interest rates up. But it has not built itself in so that you have to do

that at every meeting in order to show that you’re inflation fighters, is that correct?

Chairman Bernanke. Yes, Senator. Our assessment currently

is that the risks to inflation are perhaps the most significant at the

moment and we need to address that. But as I emphasized in my

statement—I make two points: first is that now that we have taken

away most of the extraordinary accommodation that we had in the

system back from 2003, we are much more data-driven, we need to

continually reevaluate our forecasts and think about the prospects

for the economy and make our decisions based on the information

that is coming into our hands.

11

And second, as I noted in my written testimony, there is always

the possibility that if there is sufficient uncertainty that we may

choose to pause simply to gain more information to learn better

what the true risks are and how the economy is actually evolving.

Senator Sarbanes. Well, I see that the minutes of your most recent meeting on March 28th did say, ‘‘Most members thought that

the end of the tightening process was likely to be near and some

expressed concerns about the dangers of tightening too much, given

the lags in the effects of policy.’’ I very much share that concern,

and so I welcome that statement and I hope the Open Market Committee will, in effect, act off of that statement in the upcoming

meetings.

The other point I would like to raise to you is I want to again

urge you, as we did when we held your confirmation hearing, on

the issue of Federal statistics and the importance of having appropriate and accurate Federal statistics. A number of us in the Congress—71 Members, 29 Senators and 42 House Members—have

written to the President about the elimination of the Survey of Income and Program Participation series, and we urge the Administration to try to find money with which to continue that particular

program.

I think if the Chairman of the Fed would take a keen interest

in Federal statistics, it would be very helpful in assuring ourselves

that we have accurate and reliable data upon which to make some

of these decisions. Major decisions are being made that have vast

economic implications, and yet the amount of money going into the

methodologies is very, very limited. We were never able to get

Chairman Greenspan to agree to any spending program except

Federal statistics. He did on one occasion say that he thought we

ought to do more. So I would just leave that idea with you. Thank

you very much.

And thank you, Senator Reed.

Representative Saxton. Thank you very much, Senator Sarbanes.

Senator Bennett.

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

I would note your comment with respect to rate hikes. Everybody

wants to read into what you are saying to get an advance understanding of what is going to happen tomorrow. My own sense is

that the economic information tomorrow is going to be very strong

with respect to GDP growth in the first quarter; you indicated your

assumption that that will be the case. My market watchers say

that could be really bad for the market, because when the GDP

numbers come out very strong, that means the Fed is going to raise

interest rates and they are all going to sell off in anticipation of

that.

I recognize that there is no way you or I can anticipate what you

are going to do at the next FOMC meeting but, following up on

Senator Sarbanes, I would just reassure the people who were concerned about this, Chairman Bernanke has said that even if in the

Committee’s judgment the risk to its objectives are not entirely balanced, at some point in the future the Committee may decide to

take no action at one or more meetings in the interest of allowing

more time to receive information relevant to the outlook.

12

That is a very Greenspan-type statement, sufficiently tipped in

both directions, but I take it as a signal that what you have said

to Senator Sarbanes here is correct, that we are getting to the

point where this almost automatic increase is not going to occur.

And Chairman Greenspan made it very clear in his statements

that there was going to be an automatic increase every single time

they met when the rate was 1 percent. And he tried to be as clear

as he ever could be that that was going to happen, and I welcome

this statement and I think in this conversation we have had, we

ought to highlight it one more time, as I have done.

Now, let’s talk about the global savings glut. You have made

mention of that, suggesting that one of the explanations for the

persistence of relatively low long-term interest rates has come from

a global savings glut. And as long as we are looking into crystal

balls and trying to predict what is going to happen, let’s get out

of the FOMC crystal ball and look around the world. Do you think

there is still a global savings glut and what is your sense as to how

long it is going to continue? Because that has a great deal to do

with the current account deficit and people investing in the United

States and so on.

Chairman Bernanke. Thank you, Senator. Just to provide a little bit of background, I have argued in the past that there is an

excess of saving over investment in our trading partners around

the world and that extra saving has come to the United States, has

driven down world real interest rates, and has been part of the reason for our current account deficit. And I do believe that is part of

the explanation for why the current account deficit of the United

States has risen and part of the reason why, as I argued earlier,

it is really a global issue and not just a United States issue to deal

with this deficit.

In terms of whether the savings glut still exists, there is a shortterm and a long-term answer to that question. Relevant to my earlier comment, I think we are seeing a bit of a decline in that glut

in that interest rates—global interest rates, not just those in the

United States—long-term rates have risen in the last couple of

months, suggesting some reduction in the excess of savings over investment outside of the United States, and I think that is perhaps

a small step in the direction toward the moderation of the savings

glut.

Longer-term, though, I think there is still a long way to go. And,

in particular, what is needed is for our trading partners, including

those in southeast Asia, and also oil producers, emerging markets

generally, to rely more heavily on their own domestic demand as

a source of growth rather than on exports to the United States.

To take one example, I do see some encouragement that the Chinese are at least talking about these issues, that they have recognized that it is not in their interest to run their economy as an export-led economy indefinitely, and that they are at least discussing

some approaches to increase domestic consumption in order to reduce the amount of saving that they put into the world capital

markets.

So these are steps that are promising. It is still very early; there

is not much to be seen from it yet. But that is the kind of development that, over a number of years, will help rebalance the world

13

economy so that the U.S. is not importing goods and capital at such

a high rate and other countries are growing more from their domestic demand and less from exports.

Senator Bennett. So if I can summarize without putting words

into your mouth, the solution to the current account deficit given

the scenario you have outlined, could very well come in slowly over

time rather than dropping off a cliff, and we could see this thing

resolve itself in the next, say, within the next decade or so.

Chairman Bernanke. I would not expect it to resolve in a short

period. It is going to take quite a few years for these balances to

readjust internationally.

Senator Bennett. But you do not see it dropping off a cliff.

Chairman Bernanke. I do not expect any such change.

Senator Bennett. Good. Thank you.

Representative Saxton. Thank you very much, Senator.

We are going to go now to Mrs. Maloney, the gentle lady from

New York.

Representative Maloney. Thank you.

Welcome, Mr. Bernanke, and thank you for your testimony.

Democrats are concerned not only about price stability and maintaining and controlling inflation, but also jobs, wages, and continuing to grow our economy. We are very concerned that in the recovery the economic positive impact has not shown up in the wages

of the average worker and there has been a decline in the past 2

years, and we hope you will take that into consideration as you develop monetary policy.

My constituents are very concerned, I would say even nervous

about this continued clip or pace in the increase in interest rates—

it has been raised 15 times since June of 2004, and there is a feeling that maybe we should step back a few steps and just assess

where we are. And there is a deep concern about it and I wanted

to relay that to you. My question is can we continue to increase interest rates without having a negative impact on our economic

growth?

Chairman Bernanke. Thank you for the question. Let me just

address a few parts of it, if I might.

On wages, real wages have not grown at the pace we would like

to see. There are a number of reasons: energy prices have clearly

sapped consumer buying power. There has been a spread between

real wages and compensation reflecting increased health costs,

health insurance costs, for example, and, most puzzling, real wages

have not apparently caught up with the productivity boom that we

have seen going on in the economy.

My suspicion is that as the economy continues to strengthen and

labor markets continue to strengthen, we will see further increases

in real wages and that will be very desirable. I would also add that

I do not believe that higher real wages are inflationary. Higher real

wages can be offset by higher productivity and they can be offset

by lower margins between costs and selling prices. And so I do

hope to see higher real wages going forward.

With respect to the Fed’s mission, as I argued before, it is like

the seventies when inflation was out of control and those were not

good times for workers either. I think we all benefit from price stability. The Fed has a very important objective in maintaining price

14

stability and credibility that is going to keep prices at a stable

point. And I believe that doing so supports strong and stable employment growth, and that is the other part of our mandate, to

which we are going to pay very serious attention.

Representative Maloney. Do you believe we can continue to

raise interest rates without having a negative impact on our economy?

Chairman Bernanke. I think we will try to raise rates, if we

do, in a way that maximizes the attainment of our objectives,

which are price stability and maximum sustainable employment

growth. Employment growth that is not sustainable and which

leads to——

Representative Maloney. Mr. Chairman, are we not near full

employment now, so——

Chairman Bernanke. But the underlying growth of the economy, which is being determined by a very robust productivity increases, is still going to be quite healthy, and so my anticipation

is that for example, in 2006 we are still going to see growth in the

range between 3 and 4 percent, a very healthy pace of growth, and

I believe that would be consistent with our attempts to keep inflation well anchored.

Representative Maloney. In your testimony you said our accounts deficit, our trade deficit, was 6–61⁄2 percent of GDP and that

this was unsustainable and that our world partners, our global

partners, are saying the same thing. Right now we have very low

national savings and also this large trade deficit. What role does

fiscal discipline have in addressing these problems and, second,

what will happen if we do not get control of the Federal budget?

What will happen?

Chairman Bernanke. Well first of all, it is very important that

we get control of the fiscal situation, particularly over the longer

term. As my testimony elaborates, in particular as our society ages,

the share of GDP going to the three major transfer programs is

going to go from about 8 percent of GDP today to about 16 percent

in 2040. And if that were to transpire as forecast, we would be

faced either with essentially cutting all other types of spending or

raising taxes quite substantially. So there are some very hard

choices to be made if our Federal budget is going to be sustainable

into the next few decades. That is very important, and we need to

be thinking about that soon. The sooner we make these hard

choices, the better the economy will be able to adjust whatever

changes we make.

With respect to the current account, there is a link, a somewhat

weak link, between fiscal and current account deficits. To the extent that fiscal deficits reduce national saving, that in turn contributes to the need to borrow abroad, which a part of what the current

account deficit is about. Unfortunately, most of the research suggests that fiscal consolidation by the United States on its own will

only have modest impacts on the current account deficit. Every dollar or so by which the fiscal deficit is reduced by most estimates

would only reduce the current account deficit by 20 or 30 cents for

various reasons that I could get into.

But the implication is that the United States really cannot solve

the current account deficit problem by itself. It is a global issue.

15

We need the cooperation of our trading partners. And all together,

by taking actions which are in our own individual interest, we can

also help create a better balance in terms of trade flows as well.

Representative Maloney. My time is up. I did want to ask

what we could do about this growing inequality, but maybe the

next round.

Chairman Bernanke. Sure.

Representative Saxton. We are going to go to Mr. Ryan next,

but I cannot help but talk a little bit here just for a minute about

a real-life experience that I had relative to interest rates and inflation expectations. In 1965, I graduated from college and in 1966,

I became a real estate salesman. And I remember for quite a few

years whether I went to Bank A, B, or C, the interest rate on home

mortgages was 6 percent. And as we got to the late 1970s all of

a sudden inflation became an issue. And by the end of the seventies, 1978, 1979, inflation had reached double digits. And when we

went to the bank with the person who wanted to buy the house,

they were told the interest rate was 18, 19 or 20 percent. And

when I asked the bankers why that was, they said because we

don’t know what inflation is going to be next year. Our expectation

is that we don’t know, and therefore we have to hedge against even

higher inflation than 10 or 11 percent.

Today’s interest rates are back where they were essentially in

1966, when I was a young guy and a real estate salesman. And

today home mortgage interest rates are at 6 percent because the

expectations of inflation going forward are that inflation is under

control. And I credit the policy of the Fed over the past couple of

decades for bringing us back to 1966 levels of mortgage interest

rates.

I wanted to note that because everyone in the public should have

the opportunity to understand what it is that the Fed has been successful in doing over these years. And I don’t know whether you

would like to comment further on that, but this is an extremely important element going forward with respect to economic growth.

Chairman Bernanke. I would just add that it’s often neglected

that the third part of our legal mandate is to maintain low to moderate long-term interest rates and that is, of course, best achieved

by keeping inflation not only low, but keeping a high degree of confidence among bond traders and the like that it will stay low.

Representative Saxton. We have a chart over here that shows

the path of inflation during the decades of the 1980s and 1990s and

into 2000. It very clearly shows that during the early 1990s inflation peaked out at a very moderate 4.5 to 5 percent and today we

are down to a rate that appears to be under 2 percent. And so

these are what creates the environment in which long-term rates

are set. And so to the extent that we thank you and your predecessor for helping us to understand this, it has been a very, very

healthy process.

[The chart entitled ‘‘Inflation’’ appears in the Submissions for the

Record on page 41.]

Mr. Ryan.

Representative Ryan. Thank you, Chairman. We have

belabored monetary policy so I am going to switch to fiscal policy,

but I want to just make one point. Chairman Bernanke, I am very

16

pleased and encouraged with what you had to say about inflation

targeting. To the extent that the Fed can institutionalize expectations and smooth out the investment horizons and remove further

uncertainty by being more transparent with inflation targeting, I

think that is a fantastic contribution you can bring to the Federal

Reserve, so I am very encouraged with your statements on that.

On fiscal policy, we are in the midst of considering tax legislation

right now as to whether or not to extend the tax cuts that passed

in 2003. Many of us are concerned that large tax increases at this

time, during our economic recovery, would be a bad idea. I just

want to go through a few statistics, because we have seen people

make points to the contrary which don’t necessarily add up.

Since the 2003 tax cuts—first of all, our unemployment rate was

6.3 percent at that time. Now it is at 4.7 percent. Since the 2003

tax cuts, we have gained net in the employment survey 5.2 million

new jobs. Our economic growth rate, the 10 quarters preceding the

tax cuts was 1.3 percent, the 9 quarters since then it has been 3.9

percent; so we have seen a remarkable turnaround I would say due

in large part to the fiscal policy of our country. But now is the time

to talk about whether or not to extend these things. And people

have been talking about revenues.

When we passed it—I serve on the Ways and Means Committee,

and we looked at these revenue projections quite a bit. And we

thought, according to our estimates, that we would increase the

deficit or that we would actually see a reduction in revenues. And

what actually ended up turning out was that our revenue projections by the Joint Committee on Taxation didn’t materialize; actually revenues increased at these lower tax rates. Economic revenues from the individual side in 2004 were up 1.9 percent at the

lower tax rates and the corporate income tax receipts were up 43.7

percent in 1904. In 1905, revenues were up 14.6 percent on the individual side and 47 percent on the corporate side.

At this moment, we are debating tax legislation as to whether or

not to extend the 2008 deadline on capital gains and dividends.

And that is where some people are saying the dividends—the capital gains tax cuts cost us money.

The Joint Committee on Taxation at the time, in 2003, told us

that we would lose $27 billion in revenue in lower receipts over the

years 2004–2005. What actually materialized, the actual revenues

were, realization surged and receipts went up. The receipts increased by $26 billion. So we went from a projection of a $27 billion

loss over 2004 and 2005 to actually increasing tax receipts from

capital gains at the lower tax rate by $26 billion over that, so an

enormous difference.

The question I basically have is do you agree that the tax cuts

have been helpful to economic growth, and do you see a benefit in

providing predictability to investors on tax rates? I clearly can tell

that you believe there is a benefit to providing certainty with respect to monetary policy, thus the discussion on inflation targeting.

Do you believe that there is a benefit to the economy and to investors by providing certainty on tax rates given the fact that virtually

every corner of the Tax Code is up for grabs in either 2008 or 2010?

Chairman Bernanke. Mr. Ryan, I highly value the nonpartisan

nature of the Federal Reserve, and for that reason I have decided

17

that I will not be advising on specific individual tax and spending

programs. I will make a couple of comments, though, which I hope

will be useful.

One is that I do agree that fiscal policy, along with monetary policy, was an important factor in helping to restart the economic engine in this latest episode, and some of the statistics you quoted

suggest that we did go from a very weak situation early in 2003

to a much stronger growth path after that.

The other comment I would make on your issues with respect to

revenues I have addressed in a recent letter, and that concerns the

issue of dynamic versus static scoring. To the extent that tax cuts,

for example, promote economic activity, the loss in revenues arising

from the tax cut will be less than implied by purely static analysis

which holds economic activity constant.

There is currently an important and interesting debate going on

to the extent to which so-called dynamic scoring should be used in

the Congress. I don’t want to come down with a definite recommendation. One issue is that any dynamic scoring model requires some assumptions about what theory, what model, you are

going to use to make the assessment, and, therefore, you are going

to have to look at different alternatives in coming up with an outcome. But I do think it is worth considering an alternative range

of scoring mechanisms to give Congress a sense of what the possible outcomes would be on the revenue side from different tax

changes.

Representative Saxton. And as to promoting certainty in the

investment markets and in households and businesses to the tax

climate in the future?

Chairman Bernanke. Well again, I don’t want to make a definite recommendation. The specifics of the dividend tax extension,

for example, would involve not only considerations of efficiency, but

also considerations of equity and revenues. But looking strictly at

the efficiency side, clearly more certainty about the tax code—and

I think this applies to any tax regulation—when people know the

tax rules are going to be stable, they are going to have stronger effects and more positive effects than if they are worried that they

are going to be changing from year to year.

Representative Saxton. Thank you.

Senator Bennett. Senator Reed.

Senator Reed. Thank you, Mr. Chairman. Thank you for your

testimony today. And just in line with the question about the effect

of tax cuts, the former chairman of the Council of Economic Advisors, Greg Mankiw, wrote in his macroeconomic textbook that there

is no credible evidence that tax cuts pay for themselves and that

an economists who makes such a claim is—quote—‘‘a snake oil

salesman who is trying to sell a miracle cure.’’ Do you agree with

that?

Chairman Bernanke. I don’t think that as a general rule tax

cuts pay for themselves. What I have argued instead is that to the

extent the tax cuts produce greater efficiency or greater growth,

they will partially offset the losses in revenues. The degree to

which that offset occurs depends on how well-designed the tax cut

is.

18

Senator Reed. If you will let me—this goes out of the realm, I

think, of macroeconomics to simple arithmetic. We are running a

huge deficit, so over time if the tax cut doesn’t pay for itself and

we cut taxes again, we are not likely to help the deficit. Is that a

fair judgment?

Chairman Bernanke. Well, the issue as always is whether the

deficit should be adjusted on the spending side or on the tax side,

and I have to leave that to Congress, those are very difficult value

judgments.

Senator Reed. Well you are very clear in that statement, but

I can assume that those tough choices that must be made include

choices on the revenue side as well as the spending side, is that

your view?

Chairman Bernanke. I would say that if you are one of those

who supports low taxes that you also have to accept the implication

that spending also has to be controlled in a commensurate way,

whereas if you are in favor of a larger government, then you have

to accept the corollary that taxes have to be higher. So, I think the

specific law I am arguing for here is the law of arithmetic, which

says——

Senator Reed. Well so am I, but right now the arithmetic is not

running favorably in terms of those people who want fiscal discipline.

Chairman Bernanke. And I am agreeing that people need to be

consistent in their choices.

Senator Reed. Thank you.

One of the issues that Congresswoman Maloney mentioned and

I am concerned about also is this growing inequality.

Your recent survey of consumer finances has some very disturbing data. According to the statistics, the top 1 percent of families hold more wealth than the bottom 90 percent of families combined. And that is accurate, I presume?

Chairman Bernanke. Yes.

Senator Reed. It suggests that in most families wage is the

main source of income. Is that true also?

Chairman Bernanke. Yes.

Senator Reed. These figures on wages are not encouraging.

After accounting for inflation, the median usual weekly earnings of

full-time wage and salary workers fell by 0.9 percent between the

end of 2000 and the end of 2004, and the earnings at the 10th percentile fell by 2.1 percent. But meanwhile, earnings for the 90th

percentile, the upscale workers, were up 4 percent.

We are seeing a divergence between low-income/moderate-income

Americans, who are losing ground, and very wealthy Americans,

who are gaining ground. And that has not only economic consequences, it has social and moral consequences in many respects.

What do we do about this? What policies can we adopt to, as you

indicated in your statement, not only increase wages, but make

sure that those benefits are more equally distributed?

Chairman Bernanke. Senator, first of all, I agree that the increasing inequality in wages is an important social problem, first,

because we care about our fellow citizens and want to be sure that

they are living in a decent way, but second, from a political point

of view our society is based on opportunity, it is based on flexibility

19

in labor markets and product markets, it is based on open and fair

trade, and all of those things are at risk if a growing portion of the

population feels they are not sharing in the benefits from those

changes.

So, I am very concerned about rising inequality. It is a very difficult problem. I think it should be made clear that the growing inequality in wages which we are seeing is not a new phenomenon.

It has been going on for about 25 years or so. And indeed a good

bit of it occurred in the early 1980s.

There are a number of arguments and analyses about why these

increases are taking place. My own view, and I think that of most

economists, is that the dominant factor is the increase in the return to skills; the fact that as our society becomes more technologically oriented, people who have not necessarily formal education, but other kinds of skills, on-the-job kinds of training, will

get a higher return, get a higher wage.

So, for a given distribution of education, these changes, this skillbiased technical change, is going to cause the wage distribution to

widen.

In addition, it has been pointed out in some recent research that

there is a phenomenon at the very top, the so-called ‘‘super stars

phenomenon,’’ which suggests that, given the size of our markets

and the interconnectedness of our world economy, those people who

have extraordinary skills can command tremendous premiums for

their work.

Consider what a star baseball player receives today versus 20

years ago, the fact that that player can now play before much larger markets and through an international market; that affects their

wages, as well.

So again, my main explanation for this phenomenon is the higher

return to education, the higher return to skills. What can we do

about it?

Well first of all, the Federal Reserve will do what it can, which

is primarily to try to maintain strong and stable employment

growth, and that is going to keep providing opportunities for people

and give them on-the-job experience that will allow them to have

higher wages.

But more broadly, the only really sustainable response to this

problem is to alleviate the skills deficit. Sometimes that is taken

as a counsel of despair because it takes such a long time to improve

our school system and to bring a whole new generation through the

system, but I would like to point out that skills can be acquired

through a whole variety of programs and mechanisms, including

on-the-job occupational training, community colleges, technical

schools, and all kinds of other vehicles which would allow people

to upgrade their skills relatively quickly.

In our current labor market, people with skills like commercial

drivers’ licenses, or practical nursing degrees, are at a premium.

They have sufficient skills that they are in high demand. So, I do

think that it is feasible within a medium-run period of time to upgrade our skill base sufficiently to make a noticeable dent in this

inequality.

20

I agree it is a very difficult problem, and I hope that we will address it because it does pose issues for our political economy, as

well as for our society.

Senator Reed. Just a final point. Do you believe it should be

the conscious policy, for all the reasons you espoused, of this Government to raise wages and distribute them more equally in terms

of our economic performance?

Chairman Bernanke. Well, in the current Administration?

Senator Reed. Well, in any Administration.

Chairman Bernanke. Well, administration after administration

have tackled the educational issues. This Administration has its

own program. Others have had others. There is a significant

amount of money being put into job training programs and there

have been suggestions for reform about how to make that more effective and more efficient.

There has been a lot of support for community colleges. Your colleague, Senator Dole, for example, has often talked about the benefits of community colleges.

I make just one additional comment, which is that one area

where we are quite deficient is in financial literacy. Many people

who earn even a moderate income are not able to save and to build

wealth in part because they may not understand enough about

banking and financial markets to allow them to do that.

So, I am very much in favor of activities through the Congress,

the Federal Reserve, and through the financial sector itself to help

train people to understand better how to save, how to budget, and

how to build wealth for themselves and for their children.

Senator Reed. Thank you.

Thank you, Mr. Chairman.

Senator Bennett. Thank you very much.

Senator Sununu.

Senator Sununu. Thank you.

Chairman Bernanke, a number of economists and regulators, including members of the Fed, have testified to Congress on a number of occasions that the business models of Fannie Mae and

Freddie Mac effectively amount to privatized profits coupled with

socialized risk that stems from the implied guarantee behind their

securities.

Your predecessor spoke clearly of the need for Congress to anchor

the companies more firmly in their housing mission—which we all

agree is very important but from which they have strayed at

times—and he noted the danger and the risks that are presented

to our financial system and the economy by Fannie and Freddie’s

very large, maybe more fairly put, massive investment portfolios.

I have a letter from Chairman Greenspan, Chairman Bennett,

that I would like to be included in the record——

Senator Bennett. Without objection.

Senator Sununu. [continuing]. Which addresses the relationship between these portfolios and the housing mission.

[The letter from Chairman Alan Greenspan to Senator John

Sununu appears in the Submissions for the Record on page 47.]

Senator Sununu. But in short, the research done by Fed economists has shown that their investment portfolios simply act as investment vehicles whereby they can arbitrage their low borrowing

21

rates against higher yields for mortgage-backed securities. As a result, they earn great profits, but they do so in a way that does not

result in better accessibility for 30-year mortgages, and lower interest rates for consumers.

That is a very profitable arbitrage operation and, as a result, we

should not be surprised that Fannie and Freddie do not support

provisions in our GSE legislation that passed the Senate Banking

Committee that would give a regulator power to set limits on those

portfolios consistent with their mission.

Now in the coming months, as they square away the many financial and accounting irregularities that have delayed their issuing of

financial statements, OFAO, their current regulator, will lift its requirement that they put aside additional capital.

For Fannie Mae, for example, that is going to result in a release of $5 to $6 billion. When that capital is leveraged by what is typical for these institutions 30 or 40 times, that means that they

could potentially grow their portfolios dramatically—$250 billion or

more.

This causes me great concern given the very significant systemic

risks that exist, but I think, fortunately for the taxpayers, the

Treasury does have some power to limit the size of the portfolios,

and in particular the statutes governing Fannie and Freddie state

that the corporation is authorized to issue, upon the approval of

the Secretary of the Treasury, and have outstanding, at any one

time, obligations having such maturities and bearing such rate or

rates of interest as may be determined by the corporation—again,

with the approval of the Secretary of the Treasury.

So obviously the Secretary has the power in statute to clearly

limit the issuance of GSE debt.

My question is that, given the nature of the implied guarantee,

is this power that has been given to the Secretary in statute an important power to have, given the structure of these corporations?

And under what circumstances should the power be exercised?

Chairman Bernanke. Thank you, Senator.

I would like first just to comment on the S. 190 legislation on

portfolios. There is a misperception, I believe, that the legislation

calls for hard caps, or for specific numbers, and that is absolutely

not the case, as you well know.

What the legislation tries to do is specifically to anchor the size

of the portfolio in the housing mission so that it serves the mission

and not other purposes.

In particular, the portfolio would be allowed to hold affordable

housing mortgages that are not otherwise securitizable. They

would be allowed to hold as much liquidity as they wished in order

to intervene perhaps in the housing markets during periods of

stress, but it would be limited in securitizable MBS which, beyond

a moderate amount for inventory purposes and the like, is really

not a direct or obvious affordable housing reason for those holdings.

You are correct, as far as I understand, that the Treasury does

have the power to limit the debt issued by the GSEs, and perhaps

some power even over the terms or maturities, as you suggested.

My preference, in terms of making sure that this is done right

would be to ask the Congress to, or hope the Congress could, make

clear to the regulator what the expectations of the Congress were

22

and what the powers of the regulator were. That would be, I think

from a political economy point of view, the right first step.

If we were unable to achieve progress through Congress, I don’t

think Treasury should abandon that power. I think it should consider using it if it believes that the systemic risks being generated

by the portfolios greatly outweigh the benefits that are mandated

by the affordable housing mandate.

Senator Sununu. So in structuring the language in the legislation—and you have spoken about the legislation I think in past

hearings—one, to reiterate, you would not recommend a hard cap,

and we have no such hard cap in the legislation; are certainly comfortable with maintaining portfolios in the kinds of securities that

you describe; and feel that the portfolio should be consistent with

the housing mission, as everything that they do should be consistent with their mission as chartered by Congress.

One, is that a fair representation of the key elements that we

consider in the legislation?

And is there anything else that you think would be important to

maintaining an appropriate level of flexibility?

Chairman Bernanke. No, I think that is a fair characterization

and I agree with that characterization. I would just add that the

S. 190 bill also has some important provisions relating to capital

and receivership which are part of making the GSE regulator more

like a bank regulator with adequate supervisory powers.

Senator Sununu. Thank you.

Thank you, Mr. Chairman.

Senator Bennett. Thank you.

Mr. Hinchey.

Representative Hinchey. Thank you, Senator.

Thank you very much. Mr. Chairman. Thank you for your testimony here today and for your service. I very much appreciated listening to you. It has been very instructive.

We have heard a lot about the positive aspects of the economy,

including things like low interest rates, and it may have been mentioned also that the productivity rate is now I think more than 3

percent. There are a lot of positive aspects to that.

But there are also a conflux of circumstances that need to be addressed, I think, as well. We live in a demand economy. I think

every successful entrepreneur, at least since Henry Ford, has understood that. But we are not doing much to deal with that end of

our economy.

As you pointed out just a few moments ago, for the last 25 years

or so the median household income of American families has been

stagnant or declining during that period of time. But it has dramatically dropped in the last few years.

In the last few years, that median household income has gone

down by almost 4 percent.

So we are facing a number of circumstances that we are not really addressing. Rising income inequality has been mentioned on a

number of occasions here. We also have very low and declining personal savings rates. We have a huge and growing debt. And the

current account deficit, which you talked about a moment ago, is

also placing a heavy burden on our economy.

23

These rising imbalances are seemingly at the moment peculiar to

America. You have no other industrial country that has this conflux of circumstances in the way that we do. And it seems to me

that they are essentially impracticable and unsustainable.

So I just would like to hear your opinion on what we ought to

be doing to deal with these circumstances on the demand side. We

have this huge tax cut, the benefits of which have flown to people

who are already very secure, and these benefits have made them

even more so.

The primary beneficiaries of that tax cut are the richest 1 percent and those just a few percentage points below that group. But

it has little or no effect, obviously, based upon these statistics, on

the average working family.

What should we be doing to deal with those economic circumstances?

Chairman Bernanke. Thank you, Congressman. The United

States is unique in some respects and not in others. We do have

an unusually large current account deficit. There are some smaller

countries with large deficits, Japan and Germany have surpluses,

and I have discussed some of the ways in which we can address

that particular problem.

On the long-term issues of the fiscal deficit, one of the main drivers there is the aging of the population. In that regard, we are perhaps no worse off than some of the other major industrial countries

which are aging quickly. Even China, surprisingly, because of their

one-child policy, will become as old as the United States by the

middle of this century.

So the aging and the demographic transition and the implications that that has for fiscal policy is a broader issue, a difficult

one, but one that we share with others.

I have already addressed to some extent the inequality issue. We

are not the most unequal country in the world by any means, but

this trend is a disturbing one and it has I think unfortunate consequences for our political economy.

I am not quite sure what you mean by ‘‘demand policies.’’ I think

that if you mean fiscal and monetary policies to bring the economy

to full employment, I think we have worked hard on that and the

economy is approaching a sustainable growth path consistent with

maximum sustainable employment.

But I do think that if we are going to address wages, and in particular inequality in wages, we have to to do that I would say on

the supply side. That is, by addressing the skills gaps that exist

among different groups of people in our society.

Senator Reed. Well if that is the case, then we are going in the

opposite direction because we are cutting back on education and

training, and we are cutting back on various ways in which we can

enhance the skill sets of our personnel. We are doing that in the

context of the Federal budget.

We are also seeing a decline in pensions as we move away from

defined benefit to defined contribution benefit pension programs.

These are going to reduce the economic circumstances of people

who are working today and those who are about to retire.

So I think the point is that while the emphasis of this particular

Government, this Congress and this Administration, has been on

24

tax cuts and enormous amounts of spending, it is not in ways that

are going to enhance the economy.

We are not doing anything, for example, to increase the amount

of goods that we produce that are marketable both here in America

and around the world. In fact, the amount of goods that we produce

that fall into both of those categories is declining, and that of

course is a major contributor to the current account deficit that we

are experiencing.

So are there not other things that we could be doing, and should

be doing, to deal with those aspects of this economy?

And although you mentioned that there are other countries that

have similar circumstances discretely in one or two of those categories, I do not think there is any other country in the industrial

world—no other advanced country—that is confronting this confluence of circumstances. And I do not know how this economy is

going to continue to prosper unless we begin to deal with those circumstances which are unique in the industrial world.

Chairman Bernanke. A point on which I am very much in

agreement is that in thinking about the budget, it is not enough

just to say what is the total amount that we are spending; it is

really how well are we spending it?

The programs we are spending it on, are they effective? Are they

delivering results? So I would urge Congress to look very hard at

the mix of programs that you authorize to make sure that they are

producing returns for the dollar.

So in particular looking at education, are there ways to increase

accountability? To increase flexibility? To allow schools to do a better job?

With regard to job training programs: We spend on the order of $15 to $20 billion a year on job training programs. Is that money

being well used? I think it is enormously important for us to review

those programs on a regular basis to make sure that the benefits

are flowing to the people who need them and not just being lost

in the bureaucracy.

Senator Reed. Thank you.

Senator Bennett. Mr. English.

Representative English. Thank you, Mr. Chairman.

Mr. Chairman, your testimony here has been actually a source

of not only interest to me today but also a source of great encouragement. But I would like to pursue a couple of the specific issues

that you have brought up in your testimony.

I first of all found it refreshing that you focused as heavily in

your printed remarks as you did on the challenge of the U.S. current account deficit.

On that point, you specifically mentioned that you think it is appropriate for some of our trading partners to pursue exchange rate

flexibility.

In your view, given that China now has massive currency reserves, is China in a position to move seamlessly toward a position

of exchange rate flexibility to benefit themselves, as well as presumably to stop dictating for their goods an artificial price advantage?

Chairman Bernanke. China certainly could and should do

more toward increasing the flexibility of its foreign exchange reVerDate 11-MAY-2000 08:27 Oct 27, 2006 Jkt 029738 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 C:\DOCS\29738.TXT DianeA PsN: DianeA
25

gime. A point I think that is worth emphasizing and that we have

tried in our bilateral discussions to make with the Chinese, and

Treasury of course takes the lead on this, is that increased currency flexibility is in China’s interest.

It is a very large country. They need to have an independent

monetary policy. They cannot really run an independent monetary

policy without a flexible exchange rate.

Moreover, their current policies are distorting prices domestically

as well as internationally. And in particular that means that their

economy is becoming devoted toward export production and not toward the production of domestic goods and services.

Finally, as an emerging power in the world trading system,

China has an interest in global stability, as do we, and by reducing

its overall trade surplus, by increasing its focus on domestic demand, and by increasing the flexibility of its currency, it can help

improve global stability.

So for all those reasons, I think they should move further. There

are technical issues that they are trying to address, but they are

quite conservative, let’s say, in terms of their willingness to move

further on this issue.

Representative English. And a remark that you made that I

found particularly intriguing had to do with your comment about

the fact that simply reducing the fiscal deficit will have a limited

impact on the reduction of the current account deficit.

You know, I know there has been a great deal of political rhetoric

linking the two deficits together. Could you explore for us why

there is a limited interaction where a reduction in the budget deficit has only a limited impact on the trade deficit?

Chairman Bernanke. Yes, I would be glad to.

I would first point out that, just looking around the world, there

is no obvious correlation between trade deficits and budget deficits.

Japan and Germany have budget deficits which are equal to or

larger than ours and they have large trade surpluses. The U.S.

trade deficit began to expand in the 1990s at a time when we had

a budget surplus. And so there is not an obvious 1 to 1 correlation.

The issue in this case is: If the United States were to reduce its

own deficit, if no other action is taken by any other country, that

would tend to slow down economic activity by reducing aggregate

demand. The Fed, following its mandate for full employment,

would lower interest rates, stimulating investment spending in the

United States.

And so the investment/savings imbalance would not be much

changed if that were the only action being taken. And the estimates that have been made by not only the Federal Reserve, but

by the OECD and others, are that a dollar reduction in the U.S.

budget deficit only would by itself lead to about a 20 to 30 cent reduction in the current account deficit.

By contrast, if the U.S. budget deficit reduction were accompanied by increased demand abroad so that the Fed would not have

to respond—that is, exports would take the place so to speak of

Government spending—then you could get a much bigger passthrough from deficit reduction into current account deficit reduction.

Representative English. That is an excellent analysis.

26

Mr. Chairman, I had not planned to bring up this final point, but

in response to some of the strawmen that have been brought up

earlier in previous questions, I wanted to explore the issue of

whether tax cuts can actually promote enough economic growth to

pay for themselves.

I note that in 2003, before the reduced rates of tax on capital

gains were passed, the CBO estimated the total capital gains liabilities in 2004 and 2005 would be $125 billion.

Following the passage of the new tax rates, CBO revised its estimates and at that point their estimate for capital gains tax liabilities in ’04 and ’05 had fallen to $98 billion, a drop of $27 billion.

Earlier this year, however, CBO reported on actual capital gains

liabilities in ’04 and ’05. Rather than falling by the projected $27

billion, they actually rose by $26 billion to a total of $151 billion.

Mr. Chairman, I recognize that many factors influence capital

gains realizations, including the strength of the economy, but as

many experts have speculated the lower rates clearly are partially

responsible for improving the economic outlook and rising stock

prices.

You know, accordingly, can we look at these actual revenue numbers and not conclude that, at least at some level, these tax rate

reductions have actually produced added revenue for the Treasury?

And, accordingly, slapping on a tax increase because it is a tax

increase, that some on the other side have suggested in this area,

might actually generate—might actually not generate the revenue

that we need in order to deal with the deficit?

Chairman Bernanke. As you point out, Congressman, this is a

complex issue. There are a lot of factors affecting both the increase

in the stock market and realizations. And one of the issues here is

the question whether or not some realization is taking place today

which otherwise might have taken place in the future.

And so in that sense the increase in tax revenue is reflecting a

one-time gain as opposed to a permanent gain. So that is one of the

issues that you would have to address in analyzing the revenue effect.

But I go back to what I said before, which is that well-designed

tax cuts which stimulate economic activity will at least partially

offset the revenue losses by stimulating the tax base.

Representative English. Thank you, Mr. Chairman.

And thank you, Mr. Chairman.

Senator Bennett. Thank you.

Mr. Paul.

Representative Paul. Thank you, Mr. Chairman. I would ask

for unanimous consent to submit some written questions, if I don’t

get through this.

Senator Bennett. Without objection.

Representative Paul. Thank you, and welcome. Mr. Chairman.

I have a question dealing with inflation targeting, but I wanted to

make a few assumptions first and have you comment on these assumptions, as well.

You state that inflation is under reasonable control at the moment. I have a lot of constituents that would disagree with you,

and would disagree with the chart because if you look at energy

27

and medicine and education and taxes, there’s a lot of price inflation out there that they are concerned about.

I think there is a discrepancy in who suffers the most from higher prices. Sometimes the wealthy suffer less than the poor and the

middle class because of the way they spend their money. So, one

index is not a perfect answer to how people respond to inflation.

One assumption I would have, I think it was Milton Friedman

who said that inflation is first and foremost a monetary phenomenon, and I sort of ascribe to that. And many other economists,

you know—there’s a consensus among many economists that would

go along with that.

Another assumption that I would make is that the role of the

Fed in dealing with the money supply has to do with increasing or

decreasing the money supply, and yet we mostly talk about interest

rates, we’re raising interest rates or we’re lowering interest rates.

But my assumption is that we’re manipulating increases or decreases in the money supply in order to secondarily affect interest

rates.

Assuming that we did not have an Open Market Committee and

they ceased purchasing securities, my assumption would be that interest rates would go a lot higher, but we don’t know exactly how

high. So the Fed’s job, generally speaking, is to keep interest rates

lower than the market and that the point is there’s only one way

they can do that and that is increasing the money supply so, therefore, the money supply is the most direct measurement that we

need to look at to find out what to anticipate with price increases,

also recognizing that productivity obviously influences that.

Traditionally we’ve always measured our dollar in terms of gold. The dollar was worth $20—gold was worth $20 an ounce when the

Fed came into existence. Today that dollar, pre-Fed dollar is worth

4 cents. We’ve had tremendous depreciation and devaluation and

a lot higher prices since then.

We had major events throughout history that were monetary events. During the Roosevelt era, gold going from $20 to $35, and

this was considered a devaluation. And then twice under Nixon, an

8 percent devaluation and then a 10 percent devaluation. And then

of course when gold was put into the marketplace we had again a

lot of devaluation. Gold settled down after that, around $250 an

ounce, and that’s what the price of gold was in the early—in 2001.

Since that time, gold has gone from $250 up to $630, plus or

minus. That represents more than a 60 percent devaluation of the

currency.

Now in your job in looking at inflation and targeting inflation

and looking at prices, how important is this? We do know that central banks around the world—and our central bank is still very

much aware of the fact that gold is an important monetary element, it is not like we’ve thrown it away or sold it. We hold more

gold than anybody else. So it is a monetary issue.

But how do you look at this price? Does this concern you? Is it

meaningless? What if gold would go to a thousand dollars an ounce,

how would that affect your thinking about what to do with interest

rates and the money supply?

Chairman Bernanke. Thank you, Congressman. You raise a lot

of interesting questions there. I can address a few of them.

28

It’s true that we look at core inflation, which leaves out, for example, energy and food and the question, as you know, is whether

that really is representative of the consumer basket that the average person is facing. The answer is no. And we are interested in

maintaining stability of overall inflation.

Our focus on core inflation is mostly a technical thing, because

generally speaking energy and food prices are more volatile and

tend to stabilize more quickly than other parts of the inflation basket. That hasn’t been true lately, as you know, and we really need

to pay attention I think to the overall inflation rate as well as the

core inflation rate.

You’re also quite correct that our interest rate policy is closely

linked to our control of the money supply, and during periods like

the recent one where interest rates have been rising, you also expect to see slower money growth and that in fact has been generally the case, and those two things do go together.

I don’t think it’s really the case that we keep the interest rate

lower than the market. If we were doing that, then financial conditions would be excessively easy and we would probably see more

inflation. In fact, although we’re obviously not perfect at controlling

inflation, not only the Fed, but other central banks around the

world have done a much better job in the last few decades at targeting and managing inflation and that at least is positive.

You raise the question of gold, and if your question is do I look

at the gold price, it’s on my screen, I look at it every day. I think

there is information in gold prices, as there is in other commodity

prices. But there are also other indicators of inflation. For example,

there is the spread between indexed and nominal bonds—the socalled break even inflation compensation, which suggests that inflation expectations are relatively well controlled.

So the puzzle is why are gold prices rising so fast? There is probably some fear of inflation; there certainly is some speculation

about commodity price increases in general, which is being driven

by world economic growth. But clearly a factor in the gold price has

got to be global geopolitical uncertainty and the view of some investors that, given what’s going on in the world today, that gold is a

safe haven investment and for that reason they purchase it.

So to summarize in trying to forecast inflation, I strongly believe

that you need to look at lots of different things. The commodity and

gold prices and oil prices, energy prices, are all part of the matrix

of things that a good central banker has to pay attention to. But

no single variable I think is going to be adequate for judging the

inflation situation.

Representative Paul. Thank you.

Senator Bennett. Mr. Brady.

Representative Brady. Thank you, Chairman Bennett.

Mr. Chairman, I’m Kevin Brady, a five-term Member from the

Texas area, east Texas and part of the Houston region. International trade is a big job creator for our State and obviously helps

stretch families’ budgets by giving them lower prices and more

choices when they shop. As a Nation we are a fairly open market.

How important is it economically that we continue to pursue more

open markets overseas, more trade agreements that lower those

29

barriers and continue to offer more consumer choices here at home?

How important is it that we continue to follow that policy?

Chairman Bernanke. Congressman, it’s extremely important,

and for more reasons than the textbook will tell you, I think. The

textbook tells us about comparative advantage, the idea that some

countries can produce some things cheaper than others and therefore it pays them to trade to take advantage of that. And that’s certainly going on in the world today, we’re getting specialization

across different countries.

But I think also that an open trading system increases competition, it increases the flow of ideas, increases the flow of capital, and

makes the world overall a more dynamic and effective economic environment. And so I think it’s a terrible mistake to try to shut out

the world, to embrace economic isolationism and, even though it’s

not always popular, economists and I hope Congress will try to

keep trade open.

There is an issue which is an important one, not to be neglected,

that while trade provides broad benefits to our society and to our

economy, there are sometimes people who are made worse off by

trade, workers who lose their jobs because a certain factory goes

overseas or because the competition from imports is reducing their

market. We need to pay attention to that concern.

But rather than attempting to freeze their jobs in place by preventing any change in the economy, we’re much better off allowing

the change to take place, but helping people retrain or otherwise

provide for themselves so that they can join the global economy

rather than be isolated by it. So I certainly agree with your proposition with the proviso that we need to pay attention to those who

are adversely affected by trade as well as those who benefit.

Representative Brady. I agree. People oftentimes look at the

trade deficit and proclaim it a failure of our trade policy, but your

testimony, written testimony, makes the point it’s much more complex than just how much we buy and how much we sell. America

is a key investment target overseas. But, it is also our failure to

save as a Nation is—a factor we can control as a solution on current accounts and the trade deficit. Is it your view that our best

solution or approach is increase our savings and increase our sales

abroad, which also requires other countries to boost their spending

and lower their barriers? Is that the solution to how we approach

this problem? It’s not to stop free trade, it is to increase our savings and our sales.

Chairman Bernanke. Absolutely. And I think one of the reasons to be concerned about the current account deficit is that it

may promote protectionist impulses which would be very counterproductive to our economy.

Representative Brady. Mr. Chairman, let me finish with this

thought. I was not going to ask this question, but in the last week

we’ve seen a spate of ideas on how to deal with current energy

prices, from a windfall profits tax to today where I read about $100

rebates and gas tax holidays. I won’t ask you if these are political

gimmicks, but I will ask you are these substantive? Do these substantively, positively impact the fundamental drivers of our energy

prices?

30

Chairman Bernanke. Congressman, unfortunately the high

prices we’re seeing are due to a multitude of factors, but they’re

driven primarily by supply and demand conditions in the world

today. We have substantial economic growth which generates increased demand, and supply has been very insecure for a variety

of reasons. And unfortunately there’s nothing really that can be

done that’s going to affect energy prices or gasoline prices in the

very short run. This situation has been building up for a long time.

And what we need to do is think about whether there are actions

we can take that, over a number of years, will put us on a more

secure footing and allow for either increased supply or reduced demand that will help keep prices down. Unfortunately, after many

years of not really doing as much as we should on the energy front,

this situation has arisen and I don’t see any way to make a marked

impact on it in the very short run.

Representative Brady. Does a windfall profits tax increase

production or in any way lower our gas prices?

Chairman Bernanke. I don’t think it would. Profits taxes have

the adverse effect of removing one of the major incentives of our

market system. If people think that their profits are going to be

taxed away, that reduces their incentive to engage in certain activities.

So I would like to let the market system work as much as possible to generate new supplies, both of oil but also of alternatives,

and for the prices, as painful as they may be, to help generate more

conservation and alternative uses of energy on the demand side.

Representative Brady. Thank you, Chairman. Thank you,

Chairman Bennett.

Senator Bennett. Thank you, Mr. Chairman. This has been a

most illuminating morning.

Representative Hinchey. Mr. Chairman, are you concluding?

Senator Bennett. Did you want a second round?

Representative Hinchey. If you don’t mind. It’s not quite 20 of.

Senator Bennett. All right. Well, in that case, I’ll use my prerogative to comment and then yield to you.

I’m on my way tonight to Brussels, where I will be addressing,

with some other Members of both the House and the Senate, economic issues with members of the European Union. As your testimony makes clear, the United States would not trade its place economically with any other country in the world. If you look at the

level of unemployment, if you look at the level of deficit computed

as a percentage of GDP—rather than in total dollars—and if you

look at the aging populations and the demographic projections in

other developed countries of the world, and every other country

would like to be where we are, which is not to say we don’t have

serious problems.

But I think we should put it in that perspective, and that’s going

to be, I think, some of the conversations we will have in Brussels.

With your predecessor, Chairman Greenspan and I used to have

a kabuki dance that we went through every time he appeared before this Committee, and I had not planned to do it here, but it

keeps coming up. I would always ask him, stroking my chin in a

thoughtful fashion, as if it has just occurred to me, Mr. Chairman,

what is the ideal capital gains rate?

31

And he would stroke his chin and say, Senator, the ideal capital

gains rate is zero. And I would say, thank you, and, you know, we

would do that every time he came, because capital gains means if

there’s a capital gains tax rate, it locks the capital to the degree

that the rate is high, in its current investment.

And it may well be that the entrepreneur or the venture capitalist who has built, by his investment, Business A, now wants to

sell Business A to the pension fund that’s perfectly happy with the

mature investment, and move that venture capital to Business B,

that creates an opportunity for more entrepreneurial activity, and,

thereby, more wealth.

But there is a barrier to making that movement from a mature

business to an entrepreneurial activity, in the form of a tax. As we

lower that tax barrier from 28 percent to 20 percent, we see more

capital flowing over the wall, if you will.

And when we lowered it again to 15 percent, we saw more capital flowing over the wall, and I would like to see the barrier disappear altogether, because the two things that are essential to create wealth, are accumulated capital and risk-taking.

And if the accumulated capital is held in one place where the

risk-taking—it can’t join with the risk-taking in another place, the

economy, as a whole, doesn’t get the benefit of the growth.

Now, that’s my non-professional economic analysis, and having

done that dance with Chairman Greenspan, I now give you an opportunity to comment on it one way or the other, and disagree with

your predecessor, if you will, but let’s at least discuss that, because

I think that is the major issue with respect to capital gains.

It has to do with the movement of capital to the place where it

can produce within the economy, ultimately the most wealth.

And I would add this comment: When we asked Chairman

Greenspan, during the great expansion of the late 1990s, who is

benefiting the most, even though the statistics were showing the

great growth at the top, he very instantly said, the people who benefited the most from this booming economy, is the bottom quintile,

because they have jobs.

And the difference in lifestyle for Bill Gates, by this growth, is

really nothing, but the difference in lifestyle by people who can’t

get jobs who now can, because there’s a booming economy, is night

and day.

So, regardless of the statistics, the people who benefit the most

from a growing economy and the creation of wealth are the people

at the bottom. And that’s what we all need to be concerned about,

so I’d be interested in your responses.

Chairman Bernanke. Well, Senator, I think most public finance economists would agree that, on an efficiency basis, the zero

tax rate on capital gains is the optimal one. You can see that, for

example, in the President’s Tax Panel, which tried to push our system toward a consumption-based tax; that is, one which exempts

from taxation returns to savings, including dividends and capital

gains, the idea being that by exempting savings from taxation, you

create more rapid capital accumulation and that does generate

broader economic growth.

So, as a theoretical matter, I think that’s correct. Again, I want

to be very careful not to make an unambiguous recommendation,

32

and I would just point out that people may differ about the equity

implications in terms of who benefits the most from a cut in capital

gains taxes, and that to the extent that there are revenue effects—

and we just had some discussion about how big they might be and

whether they are temporary or permanent—issues of the deficit

and funding and government spending, would also arise.

So, the final policy decision is a complex one, but I think that

purely from an efficiency perspective, it’s a fairly broad view among

public finance economists, that capital income should be taxed at

a low rate.

Senator Bennett. Thank you.

Mr. Hinchey.

Representative Hinchey. Thank you very much, Mr. Chairman, and, thank you, Mr. Chairman. I have a number—actually,

I think, a large number of constituents who take the position that

the optimum tax rate on wages should be zero percent. That’s a

slightly different point of view, from a different perspective.

I want to——

Senator Bennett. I’ll be happy to join them——

(Laughter.)

Senator Bennett [continuing]. If we find another way to finance

the government. I don’t think wages is the most efficient way to do

it.

Representative Hinchey. Let’s talk, Mr. Chairman, let’s talk.

I very much appreciate your solid and straight answers to the

questions that were delivered today, including the one about the

payback on tax cuts. Your predecessor said something very similar

in testimony before the House Budget Committee. He said: ‘‘It’s

very rare and few economists believe that you can cut taxes and

you will get an equal amount of revenues. When you cut taxes, you

gain some revenue back. We don’t know exactly what this amount

is, but it’s not small, but it’s also not 70 percent or anything like

that.’’

And we have similar statements from the Congressional Budget

Office and the Congressional Research Service. The one that I liked

the best was the one from the former Chairman of the Council of

Economic Advisors, Greg Mankiw, who wrote in his macroeconomic

textbook, and he says and I quote, ‘‘There is no credible evidence

that tax cuts pay for themselves and an economist who makes such

a claim, is a snake oil salesman who is trying to sell a miracle

cure.’’

So we have some interesting points of view on this particular

issue.

I wanted to just ask you about the dollar. We have a national

debt now which is about $8.33 trillion. Congress just raised the

debt ceiling a couple of weeks ago—3 weeks ago, to just below $9

trillion.

Projections are now that within the next 5 years, that the national debt is going to exceed $11 trillion, based upon the circumstances that are prevailing currently. This year, we’re anticipating a budget deficit of $379 billion.

The circumstances here have got to be putting enormous pressure on the value of the dollar. We’ve seen the value of the dollar

decline recently, and I’m wondering what you would say about the

33

potential for the strength of the dollar, given these economic circumstances of huge growing debt and these huge annual budget

deficits that are fueling that growing debt, and the current accounts deficit, which—I’m not sure what that number is, but I

think it’s something in excess of, what—what is the current accounts deficit?

Chairman Bernanke. Eight hundred billion dollars.

Representative Hinchey. Eight hundred billion, yes, a little

over $800 billion.

What does this mean for the value of the dollar? Is the value of

the dollar going to go down?

We have the situation and an interesting report from the IMF.

They report that the internal purchasing parody of the Chinese

currency is more than five times its external value. Given the outcome of the recent visit of the President of China, there doesn’t

seem to be any indication that those circumstances are likely to

change.

What do we have to anticipate with regard to the pressure on the

value of our dollar?

Chairman Bernanke. Well, Congressman, I just wanted to say

a word about the Federal debt, which you mentioned, first of all.

There are different ways of measuring it, and you get somewhat

different answers.

The debt limit includes a lot of debt with the government, like

the Social Security Trust Fund, for example, and if you look at the

debt held by the public, including the Federal Reserve, you find

that it’s something on the order of 40 percent of GDP, which is

lower than a number of other industrial countries.

From that perspective our current deficit last year was 2.6 percent of GDP, so in a short-term sense, we are in a comparable situation with other industrial countries.

I think we have a much larger problem, if you take an unfunded

liability approach and say, well, what is it that we really owe to

our senior citizens, based on the promises we’ve made in Social Security and Medicare, and there you get a much larger number, so

that that’s an issue.

I don’t think the Federal debt has a great deal to do with the

dollar. The usual arguments have to do with the current account

deficit and the dollar, and here, I’d like to, I guess, make a clarification.

There was some media report that the discussions of the G7 over

the weekend, had discussed some kind of depreciation of the dollar

or managed depreciation of the dollar as part of the strategy for addressing the U.S. current account.

That is not correct. The G7 supports a market-determined dollar,

not a managed dollar.

In terms of making forecasts, as I think Chairman Greenspan

often said in this context, you can forecast the dollar and half the

time, you’re going to be right.

The experience is that forecasting the dollar is very difficult, and

we want to just leave it to market forces to determine where the

dollar is going to be.

Representative Hinchey. Thank you.

34

Senator Bennett. Thank you very much, Mr. Chairman. We appreciate your being here, and look forward to continued meetings

with you, with the JEC.

This Committee was created by the Humphrey-Hawkins Act, as

Senator Humphrey wanted to increase the connection between the

Fed and the Congress, and established these regular reports.

We know you have other things to do, but we’re grateful for your

willingness to come spend the morning with us on the Hill. The

hearing is adjourned.

Chairman Bernanke. Thank you, Senator.

(Whereupon, at 11:55 a.m., the hearing was adjourned.)

(35)

Submissions for the Record

PREPARED STATEMENT OF REPRESENTATIVE JIM SAXTON, CHAIRMAN

Chairman Bernanke, it is my pleasure to welcome you this morning before the

Joint Economic Committee (JEC). We appreciate your testimony on the economic

outlook.

According to the official data, a healthy economic expansion has been underway

for several years. The U.S. economy advanced 4.2 percent in 2004, and 3.5 percent

in 2005. As I have noted many times, the pick-up in economic growth since the middle of 2003 is mostly due to a rebound in investment activity, which had been weak.

This rebound was fostered by a mix of Fed monetary policy and the 2003 tax legislation and its incentives for investment.

The continued economic expansion has created 5.2 million payroll jobs since August of 2003. The unemployment rate, at 4.7 percent, is below its average levels of

the 1970s, 1980s, and 1990s. Federal Reserve and private economists forecast that

business investment and the overall economy will continue to grow this year.

As the Fed noted in a policy report last February, ‘‘the U.S. delivered a solid performance in 2005.’’ The Fed also stated that the ‘‘U.S. economy should continue to

perform well in 2006 and 2007.’’ Recent data indicate that the economic growth rate

for the first quarter of this year will be quite robust when it is released tomorrow.

According to a broad array of economic data, the outlook remains positive. Consumer spending is expected to be solid in 2006. Homeownership has reached record

highs. Household net worth is also at a record level. The trend in productivity

growth remains strong. Although high oil prices have raised business costs and imposed hardship on many consumers, these prices have not derailed the expansion.

Meanwhile, long-term inflation pressures are contained. As a result, long-term interest rates, such as mortgage rates, are still relatively low, although these rates

have edged up in recent weeks. According to the Fed’s preferred price index, inflation is well under control.

In sum, current economic conditions are strong. With economic growth expected

to exceed 3 percent this year, the economic outlook remains positive.

PREPARED STATEMENT OF SENATOR ROBERT BENNETT, VICE CHAIRMAN

It is a pleasure to welcome the Honorable Ben Bernanke, Chairman of the Board

of Governors of Federal Reserve System, before the Committee this morning. We

view your testimony on the economic outlook as a continuation of the longstanding

productive exchange between the Federal Reserve and the Joint Economic Committee.

A wide range of economic data confirms that the U.S. economic expansion remains

on a solid foundation. Growth in the inflation-adjusted, or ‘‘real,’’ gross domestic

product increased 3.5% during 2005, on the heels of over–4% growth in 2004. Real

GDP has now been growing for 17 consecutive quarters. Most private forecasters believe that growth for the first quarter of this year will be a sizeable acceleration

from the temporary lull in the final quarter of 2005 and growth is then expected

to return to more trend-like, yet still healthy, rates through the remainder of the

year.

The unemployment rate has fallen to 4.7 percent, the lowest level in five years

and stands below the averages of the 1960s, 1970s, 1980s, and 1990s. In 31 consecutive months of job creation, payroll employment in the Nation has expanded by over

5.1 million new jobs. Last year alone, 2 million new jobs were added to business

payrolls.

While long-term interest rates, including mortgage rates, have edged up recently,

they remain low by historical standards and financial conditions of households and

36

businesses seem to be in reasonably good shape. Activity in housing markets has

recently been showing signs of cooling, but levels of activity remain strong.

Although headline consumer price inflation has been boosted by another round of

increased energy prices, so-called ‘‘core’’ consumer price inflation remains relatively

steady and measures of inflation expectations remain stable.

Nevertheless, last year was the third consecutive year of rising and volatile energy prices, and we all feel how energy price increases have cut into households’

purchasing power and the profitability of non-energy producing businesses. The

economy has remained resilient in the face of escalating energy prices, but further

increases pose a risk to future growth and inflation.

As I mentioned, the economic expansion remains on a solid foundation. And I believe that one important ingredient that helped generate the robust economic

growth over the past few years is the enactment of pro-growth tax relief in 2003.

We look forward to your review of recent economic developments and your outlook

for the U.S. economy.

Welcome, again, Chairman Bernanke.

PREPARED STATEMENT OF SENATOR JACK REED, RANKING MINORITY

Thank you, Chairman Saxton. I want to welcome Chairman Bernanke and thank

him for testifying here today.

All eyes are on you, Chairman Bernanke, as you embark on a tricky high-wire

act in which you allow the economy to grow and employment to reach its full potential, while you remain mindful of the risks of inflation. For some time, the Fed’s

job had been easier—it had room to raise interest rates from very low levels with

little risk of derailing the economic recovery, while inflation and other lurking economic problems were at bay. Today, soaring energy prices, record budget and trade

deficits, a negative household saving rate, and a disappointing labor market recovery all pose tremendous challenges to setting monetary policy.

The Fed has raised its target for the federal funds rate by 25 basis points at each

of the last 15 FOMC meetings. According to the minutes of the March meeting, most

members of the FOMC thought that the end of the tightening process was near. The

question on everyone’s mind is: are we there yet? The phrase we are hearing is that

interest rate changes will now be ‘‘data driven.’’ So I hope that means, Chairman

Bernanke, that the Fed will look hard at the full range of data on economic growth,

employment, and inflation to determine the best course for monetary policy.

GDP is growing, but the typical American worker has been left out of the economic gains of this recovery. Strong productivity growth has shown up in the bottom

lines of shareholders but not in the paychecks of workers. Too many Americans are

being squeezed by stagnant incomes and rising costs for gasoline, health care, and

education. It seems to me that there is still room for real wages to catch up with

productivity before the Fed needs to worry about inflationary pressures from the

labor market.

However, there are many other downside risks to the economy on the horizon. Energy prices have been pushing up overall inflation for some time. But last month,

we saw an uptick in core inflation, which might be an early sign that businesses

are starting to pass on their higher energy costs to customers. Rising oil prices and

interest rates coupled with a weakening housing sector could take their toll on consumers and businesses alike and slow down the economy too much.

Your task in setting the right course for monetary policy is complicated by fiscal

policy and international imbalances. We no longer have the fiscal discipline that we

had in the 1990s, which allowed for a monetary policy that encouraged investment

and long-term growth. The President’s large and persistent budget deficits have led

to an ever-widening trade deficit that forces us to borrow vast amounts from abroad

and puts us at risk of a major financial collapse if foreign lenders suddenly stop accepting our IOU’s.

Even assuming we can avoid an international financial crisis, continued budget

and trade deficits will be a drag on the growth of our standard of living and leave

us ill-prepared to deal with the effects of the retirement of the baby-boom generation. Strong investment financed by our own national saving—not foreign borrowing—is the foundation for strong and sustained economic growth and rising living standards.

One final issue that I would like to raise is the growing inequality of income,

earnings, and wealth in the U.S. economy. Your predecessor, Chairman Greenspan,

regularly raised that issue as one of concern for our political economy—it is not good

for democracy to have widening inequality. I know you share these concerns. Recently, the Federal Reserve published the results from the 2004 Survey of Consumer

37

Finances. They show that growth in median income and wealth have slowed substantially and the top 1 percent of families hold more wealth than the bottom 90

percent of families.

In this environment, it is hard to understand why the Administration is continuing to pursue policies that add to the budget deficit by providing tax breaks to

those who are already well-off, including the permanent elimination of the estate

tax. Meanwhile, they continue to propose budgets that cut programs for those who

are struggling to make ends meet. Mr. Chairman, I know you don’t want to get into

the specifics of particular policies, but I hope you can offer us some insights about

the kinds of policies that are likely to be effective in addressing the real challenges

we face in this economy and offering real opportunities for growth that provides

widespread benefits to the American people.

I look forward to your testimony on the economic outlook and to a discussion of

these issues.

PREPARED STATEMENT OF HON. BEN BERNANKE, CHAIRMAN, BOARD OF GOVERNORS

OF THE FEDERAL RESERVE SYSTEM

Mr. Chairman and members of the Committee, I am pleased to appear before the

Joint Economic Committee to offer my views on the outlook for the U.S. economy

and on some of the major economic challenges that the Nation faces.

Partly because of last year’s devastating hurricanes, and partly because of some

temporary or special factors, economic activity decelerated noticeably late last year.

The growth of the real gross domestic product (GDP) slowed from an average annual

rate of nearly 4 percent over the first three quarters of 2005 to less than 2 percent

in the fourth quarter. Since then, however, with some rebound in activity under way

in the Gulf Coast region and continuing expansion in most other parts of the country, the national economy appears to have grown briskly. Among the key economic

indicators, growth in nonfarm payroll employment picked up in November and December, and job gains averaged about 200,000 per month between January and

March. Consumer spending and business investment, as inferred from data on

motor vehicle sales, retail sales, and shipments of capital goods, are also on track

to post sizable first-quarter increases. In light of these signs of strength, most private-sector forecasters, such as those included in the latest Blue Chip survey, estimate that real GDP grew between 4 and 5 percent at an annual rate in the first

quarter.

If we smooth through the recent quarter-to-quarter variations, we see that the

pace of economic growth has been strong for the past 3 years, averaging nearly 4

percent at an annual rate since the middle of 2003. Much of this growth can be attributed to a substantial expansion in the productive capacity of the U.S. economy,

which in turn is largely the result of impressive gains in productivity—that is, in

output per hour worked. However, a portion of the recent growth reflects the taking

up of economic slack that had developed during the period of economic weakness

earlier in the decade. Over the past year, for example, the unemployment rate has

fallen nearly 1⁄2 percentage point, the number of people working part time for economic reasons has declined to its lowest level since August 2001, and the rate of

capacity tilization in the industrial sector has moved up 11⁄2 percentage points. As

the utilization rates of labor and capital approach their maximum sustainable levels, continued growth in output—if it is to be sustainable and non-inflationary—

should be at a rate consistent with the growth in the productive capacity of the

economy. Admittedly, determining the rates of capital and labor utilization consistent with stable long-term growth is fraught with difficulty, not least because

they tend to vary with economic circumstances. Nevertheless, to allow the expansion

to continue in a healthy fashion and to avoid the risk of higher inflation, policymakers must do their best to help to ensure that the aggregate demand for goods

and services does not persistently exceed the economy’s underlying productive capacity.

Based on the information in hand, it seems reasonable to expect that economic

growth will moderate toward a more sustainable pace as the year progresses. In

particular, one sector that is showing signs of softening is the residential housing

market. Both new and existing home sales have dropped back, on net, from their

peaks of last summer and early fall. And, while unusually mild weather gave a lift

to new housing starts earlier this year, the reading for March points to a slowing

in the pace of homebuilding as well. House prices, which have increased rapidly during the past several years, appear to be in the process of decelerating, which will

imply slower additions to household wealth and, thereby, less impetus to consumer

spending. At this point, the available data on the housing market, together with onVerDate 11-MAY-2000 08:27 Oct 27, 2006 Jkt 029738 PO 00000 Frm 00041 Fmt 6601 Sfmt 6621 C:\DOCS\29738.TXT DianeA PsN: DianeA
38

going support for housing demand from factors such as strong job creation and stilllow mortgage rates, suggest that this sector will most likely experience a gradual

cooling rather than a sharp slowdown. However, significant uncertainty attends the

outlook for housing, and the risk exists that a slowdown more pronounced than we

currently expect could prove a drag on growth this year and next. The Federal Reserve will continue to monitor housing markets closely.

More broadly, the prospects for maintaining economic growth at a solid pace in

the period ahead appear good, although growth rates may well vary quarter to quarter as the economy downshifts from the first-quarter spurt. Productivity growth, job

creation, and capitalspending are all strong, and continued expansion in the economies of our trading partners seems likely to boost our export sector. That said, energy prices remain a concern: The nominal price of crude oil has risen recently to

new highs, and gasoline prices are also up sharply. Rising energy prices pose risks

to both economic activity and inflation. If energy prices stabilize this year, even at

a high level, their adverse effects on both growth and inflation should diminish

somewhat over time. However, as the world has little spare oil production capacity,

periodic spikes in oil prices remain a possibility.

The outlook for inflation is reasonably favorable but carries some risks. Increases

in energy prices have pushed up overall consumer price inflation over the past year

or so. However, inflation in core price indexes, which in the past has been a better

indicator of longerterm inflation trends, has remained roughly stable over the past

year. Among the factors restraining core inflation are ongoing gains in productivity,

which have helped to hold unit labor costs in check, and strong domestic and international competition in product markets, which have restrained the ability of firms

to pass cost increases on to consumers. The stability of core inflation is also enhanced by the fact that long-term inflation expectations—as measured by surveys

and by comparing yields on nominal and indexed Treasury securities—appear to remain well-anchored. Of course, inflation expectations will remain low only so long

as the Federal Reserve demonstrates its commitment to price stability. As to inflation risks, I have already noted that continuing growth in aggregate demand in excess of increases in the economy’s underlying productive capacity would likely lead

to increased inflationary pressures. In addition, although pass-through from energy

and commodity price increases to core inflation has thus far been limited, the risk

exists that strengthening demand for final products could allow firms to pass on a

greater portion of their cost increases in the future.

With regard to monetary policy, the Federal Open Market Committee (FOMC) has

raised the Federal funds rate, in increments of 25 basis points, at each of its past

fifteen meetings, bringing its current level to 4.75 percent. This sequence of rate increases was necessary to remove the unusual monetary accommodation put in place

in response to the soft economic conditions earlier in this decade. Future policy actions will be increasingly dependent on the evolution of the economic outlook, as reflected in the incoming data. specifically, policy will respond to arriving information

that affects the Committee’s assessment of the medium-term risks to its objectives

of price stability and maximum sustainable employment. Focusing on the mediumterm forecast horizon is necessary because of the lags with which monetary policy

affects the economy.

In the statement issued after its March meeting, the FOMC noted that economic

growth had rebounded strongly in the first quarter but appeared likely to moderate

to a more sustainable pace. It further noted that a number of factors have contributed to the stability in core inflation. However, the Committee also viewed the possibility that core inflation might rise as a risk to the achievement of its mandated

objectives, and it judged that some further policy firming may be needed to keep

the risks to the attainment of both sustainable economic growth and price stability

roughly in balance. In my view, data arriving since the meeting have not materially

changed that assessment of the risks. To support continued healthy growth of the

economy, vigilance in regard to inflation is essential.

The FOMC will continue to monitor the incoming data closely to assess the prospects for both growth and inflation. In particular, even if in the Committee’s judgment the risks to its objectives are not entirely balanced, at some point in the future

the Committee may decide to take no action at one or more meetings in the interest

of allowing more time to receive information relevant to the outlook. Of course, a

decision to take no action at a particular meeting does not preclude actions at subsequent meetings, and the Committee will not hesitate to act when it determines that

doing so is needed to foster the achievement of the Federal Reserve’s mandated objectives.

Although recent economic developments have been positive, the Nation still faces

some significant longer-term economic challenges. One such challenge is putting the

Federal budget on a trajectory that will be sustainable as our society ages. Under

39

current law, Federal spending for retirement and health programs will grow substantially in coming decades—both as a share of overall Federal spending and relative to the size of the economy—especially if health costs continue to climb rapidly.

Slower growth of the workforce may also reduce growth in economic activity and

thus in tax revenues.

The broad dimensions of the problem are well-known. In fiscal year 2005, Federal

outlays for Social Security, Medicare, and Medicaid totaled about 8 percent of GDP.

According to the projections of the Congressional Budget Office (CBO), by the year

2020 that share will increase by more than 3 percentage points of GDP, an amount

about equal in size to the current Federal deficit. By 2040, according to the CBO,

the share of GDP devoted to those three programs (excluding contributions by the

states) will double from current levels, to about 16 percent of GDP. Were these projections to materialize, the Congress would find itself in the position of having to

eliminate essentially all other non-interest spending, raising Federal taxes to levels

well above their long-term average of about 18 percent of GDP, or choosing some

combination of the two. Absent such actions, we would see widening and eventually

unsustainable budget deficits, which would impede capital accumulation, slow economic growth, threaten financial stability, and put a heavy burden of debt on our

children and grandchildren.

The resolution of the nation’s long-run fiscal challenge will require hard choices.

Fundamentally, the decision confronting the Congress and the American people is

how large a share of the nation’s economic resources should be devoted to Federal

Government programs, including transfer programs like Social Security, Medicare,

and Medicaid. In making that decision, the full range of benefits and costs associated with each program should be taken into account. Crucially, however, whatever

size of government is chosen, tax rates will ultimately have to be set at a level sufficient to achieve a reasonable balance of spending and revenues in the long run.

Members of the Congress who want to extend tax cuts and keep tax rates low must

accept that low rates will be sustainable over time only if outlays can be held down

sufficiently to avoid large deficits. Likewise, members who favor a more expansive

role of the government must balance the benefits of government programs with the

burden imposed by the additional taxes needed to pay for them, a burden that includes not only the resources transferred from the private sector but also the reductions in the efficiency and growth potential of the economy associated with higher

tax rates.

Another important challenge is the large and widening deficit in the U.S. current account. This deficit has increased from a little more than $100 billion in 1995 to

roughly $800 billion last year, or 61⁄2 percent of nominal GDP. The causes of this

deficit are complex and include both domestic and international factors. Fundamentally, the current account deficit reflects the fact that capital investment in the

United States, including residential construction, substantially exceeds U.S. national saving. The opposite situation exists abroad, in that the saving of our trading

partners exceeds their own capital investment. The excess of domestic investment

over domestic saving in the United States, which by definition is the same as the

current account deficit, must be financed by net inflows of funds from investors

abroad. To date, the United States has had little difficulty in financing its current

account deficit, as foreign savers have found U.S. investments attractive and foreign

official institutions have added to their stocks of dollar-denominated international

reserves. However, the cumulative effect of years of current account deficits have

caused the United States to switch from being an international creditor to an international debtor, with a net foreign debt position of more than $3 trillion, roughly

25 percent of a year’s GDP. This trend cannot continue forever, as it would imply

an evergrowing interest burden owed to foreign creditors. Moreover, as foreign holdings of U.S. assets increase, at some point foreigners may become less willing to add

these assets to their portfolios. While it is likely that current account imbalances

will be resolved gradually over time, there is a small risk of a sudden shift in sentiment that could lead to disruptive changes in the value of the dollar and in other

asset prices.

Actions both here and abroad would contribute to a gradual reduction in the U.S.

current account deficit and in its mirror image, the current account surpluses of our

trading partners. To reduce its dependence on foreign capital, the United States

should take action to increase its national saving rate. The most direct way to accomplish this objective would be by putting Federal government finances on a more

sustainable path. Our trading partners can help to mitigate the global imbalance

by relying less on exports as a source of growth, and instead boosting domestic

spending relative to their production. In this regard, some policymakers in developing Asia, including China, appear to have recognized the importance of giving domestic demand a greater role in their development strategies and are seeking to inVerDate 11-MAY-2000 08:27 Oct 27, 2006 Jkt 029738 PO 00000 Frm 00043 Fmt 6601 Sfmt 6621 C:\DOCS\29738.TXT DianeA PsN: DianeA
40

crease domestic spending through fiscal measures, financial reforms, and other initiatives. Such actions should be encouraged. For these countries, allowing greater

flexibility in exchange rates would be an important additional step toward helping

to restore greater balance both in global capital flows and in their own economies.

Structural reforms to enhance growth in our industrial trading partners could also

be helpful. Each of these actions would be in the long-term interests of the countries

involved, regardless of their effects on external imbalances. On the other hand, raising barriers to trade or flows of capital is not a constructive approach for addressing

the current account deficit because such barriers would have significant deleterious

effects on both the U.S. and global economies.

In conclusion, Mr. Chairman, the economy has been performing well and the nearterm prospects look good, although as always there are risks to the outlook. Monetary policy will continue to pursue its objectives of helping the economy to grow at

a strong, sustainable pace while seeking to keep inflation firmly under control. And,

while many of the fundamental factors that determine longer-term economic growth

appear favorable, actions to move the Federal budget toward a more sustainable position would do a great deal to help ensure the future prosperity of our country.

41

42

43

WRITTEN QUESTIONS SUBMITTED BY HON. JIM SAXTON TO HON. BEN BERNANKE

Question 1. Your testimony regarding the stance of monetary policy indicated that

the Fed is not locked into a rigid, predetermined schedule of increases in the federal

funds rate. Rather, future decisions will be data dependent, i.e., made on the basis

of the most recent economic and financial information available. Your statement did

not rule out any future increases in the federal funds rate. Is this a fair summary

of the point you were making?

Question 2. As you know, there are a number of reasons why inflation targeting

allows for a good deal of operational flexibility. Yet critics of inflation targeting often

contend that adopting this procedure removes much of monetary policymaker’s discretionary powers and flexibility.

This criticism appears questionable given the host of adjustments and exceptions

used in inflation targeting. For example, numerical bands rather than point estimates are usually used as policy targets by those countries successfully implementing inflation targeting. Similarly, multi-year targets are often employed. The

inflation indices normally used are adjusted for volatile components as well as for

other factors. In practice, countries adopting inflation targeting have all used a flexible approach in implementing monetary policy. Doesn’t this suggest that inflation

targeting is quite flexible?

Question 3. What is the role of asset prices in a monetary policy focused on price

stability? Should the central bank respond to asset price ‘‘bubbles’’ or disturbances

such as a bubble in the stock market or a bubble in the real estate market? Or

should it ignore such movements in asset prices?

Are there ‘‘moral hazard’’ problems associated with highly predictable central

bank attempts to respond to asset price bubbles?

Question 4. Federal Reserve officials often refer to the PCE (personal consumption

expenditure) deflator in addressing measures of price changes. What are the advantages of the PCE deflator over the CPI? Does the CPI overstate inflation to some

extent?

What does the core PCE deflator currently tell us about the degree to which inflationary forces are being contained at present?

44

45

RESPONSE FROM CHAIRMAN BEN BERNANKE TO WRITTEN QUESTIONS SUBMITTED BY

CHAIRMAN JIM SAXTON

Chairman Bernanke subsequently submitted the following in response to written

questions received from Chairman Saxton in connection with the Joint Economic

Committee hearing on April 27, 2006:

Question 1. Your testimony regarding the stance of monetary policy indicated that

the Fed is not locked into a rigid, predetermined schedule of increases in the Federal funds rate. Rather, future decisions will be data dependent, i.e., made on the

basis of the most recent economic and financial information available. Your statement did not rule out any future increases in the Federal funds rate. Is this a fair

summary of the point you were making?

Answer. Yes. As conveyed in my testimony, monetary policy must be forward looking and depend on the Federal Reserve’s best assessment of the economic outlook

as inferred from economic and financial information. Indeed, the Federal Open Market Committee was quite explicit on this point in the statement issued after its

meeting on May 10. The statement explained that ‘‘the Committee judges that some

further policy firming may yet be needed to address inflation risks but emphasizes

that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.’’

Question 2. As you know, there are a number of reasons why inflation targeting

allows for a good deal of operational flexibility. Yet critics of inflation targeting often

contend that adopting this procedure removes much of monetary policymaker’s discretionary powers and flexibility.

This criticism appears questionable given the host of adjustments and exceptions

used in inflation targeting. For example, numerical bands rather than point estimates are usually used as policy targets by those countries successfully implementing inflation targeting. Similarly, multi-year targets are often employed. The

inflation indices normally used are adjusted for volatile components as well as for

other factors. In practice, countries adopting inflation targeting have all used a flexible approach in implementing monetary policy. Doesn’t this suggest that inflation

targeting is quite flexible?

Answer. By definition, an inflation targeting framework focuses on keeping inflation low and stable, and on clearly communicating to the public both the objectives

of monetary policy and the strategy for achieving those objectives. The key advantage of such a framework is that it can help anchor inflation expectations more firmly and therefore promote greater stability in both inflation outcomes and resource

utilization. As you point out, however, inflation targeting frameworks can be quite

flexible. For example, in practice, all inflation-targeting central banks pay important

attention in their policy decisionmaking not only to inflation but also to output and

employment. Objectives generally are set for some date in the future, in recognition

of the fact that monetary policy affects the economy only with a considerable lag.

Some inflation-targeting central banks set multi-year targets, while others set policy

so as to keep their inflation projection at a certain horizon close to its target; yet

others aim to keep inflation close to its target on average over the business cycle.

Specifying the inflation objective as a band may help convey the reality that inflation cannot be controlled perfectly at every instant, though a band may also increase

the challenges around the communication of objectives and strategies to the public.

These are a few of the key design features that can be used to build flexibility into

the overall policy framework.

Question 3. What is the role of asset prices in a monetary policy focused on price

stability? Should the central bank respond to asset price ‘‘bubbles’’ or disturbances

such as a bubble in the stock market or a bubble in the real estate market? Or

should it ignore such movements in asset prices?

Are there ‘‘moral hazard’’ problems associated with highly predictable central

bank attempts to respond to asset price bubbles?

Answer. In setting monetary policy to achieve price stability, a central bank

should take account of all factors influencing the economic outlook. Accordingly, a

central bank cannot ignore movements in stock prices, home values, and other asset

prices, but should respond to them only to the extent that they have implications

for future output and inflation. Some observers have argued that a central bank

should respond more aggressively to asset-price booms thought to have an important

speculative component. In so doing, so the argument goes, a central bank can limit

the future expansion of the bubble, thereby mitigating the fallout from its eventual

bursting. However, the validity of this argument rests on several conditions for

which there is little or no empirical evidence, including the presumptions that the

central bank is better able than the market to identify speculative bubbles and that

it can successfully ‘‘deflate’’ such bubbles without harming the broader economy.

46

Given our limited knowledge of the forces driving speculative bubbles, the more prudent approach is to respond only as the overall outlook for output and inflation merits. Such a limited approach should also mitigate potential moral hazard problems

that might arise were a central bank to, in effect, take responsibility for the appropriateness of asset prices.

Question 4. Federal Reserve officials often refer to the PCE (personal consumption

expenditures) deflator in addressing measures of price changes. What are the advantages of the PCE deflator over the CPI? Does the CPI overstate inflation to some

extent?

What does the core PCE deflator currently tell us about the degree to which inflationary forces are being contained at present?

Answer. While the PCE price index generally moves roughly in line with the

CPI—and indeed is derived largely from CPI source data—it does have some advantages relative to the CPI as a measure of inflation. The PCE chain-type index is

constructed from a formula that reflects the changing composition of spending and

thereby avoids some of the upward bias associated with the fixed-weight nature of

the CPI. In addition, there is some evidence that the PCE weights are measured

more accurately than the CPI weights. The PCE price measure also has some disadvantages relative to the CPI; most important, its broader scope necessitates the

inclusion of some prices that are not derived from market transactions and so may

add some noise to the overall index as a proxy for the cost of living.

Most analysts believe that changes in the CPI overstate changes in the cost of

living to some extent. In 1996, the Senate Advisory Commission to Study the CPI

(The Boskin Commission) assessed the bias in CPI inflation as centering on 1.1 percentage points per year, with a range of 0.8 to 1.6 percentage points per year. This

result was similar to the findings of other analysts. Since the time of these studies,

the BLS has made several improvements to the CPI that have, on balance, served

to reduce that bias. In part for this reason, more recent estimates of bias in CPI

inflation have generally been a little smaller than estimated by the Boskin Commission. For example, a recent study by Federal Reserve economists judged the bias in

CPI inflation currently to center around 0.9 percentage point per year. The PCE

price index likely is also biased upward, though probably by less than the CPI in

light of the PCE measure’s advantages cited above.

Although increases in energy prices have pushed up overall consumer price inflation over the past couple of years, core inflation has been more stable. The core PCE

price index increased 2 percent over the twelve months to March of this year, about

the same as the increase over the preceding twelve months. Similarly, the core CPI

has increased 21 percent over each of the past 2 years. The stability of core inflation, even as many firms have faced substantial cost increases for energy products,

has been enhanced by the fact that long-term inflation expectations appear to remain well contained. Of course, inflation expectations will remain low only so long

as the Federal Reserve demonstrates its commitment to price stability.

47

48

49

Æ