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FEDERAL RESERVE’S SECOND MONETARY POLICY 

REPORT FOR 2007 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TENTH CONGRESS 

FIRST SESSION 

ON 

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

1978 

JULY 19, 2007 

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

( 

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

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

ROBERT P. CASEY, Pennsylvania 

JON TESTER, Montana 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

JOHN E. SUNUNU, New Hampshire 

ELIZABETH DOLE, North Carolina 

MEL MARTINEZ, Florida 

SHAWN MAHER, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director and Counsel 

PEGGY R. KUHN, Senior Financial Economist 

MARTIN J. GRUENBERG, Democratic Senior Counsel 

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator 

GEORGE E. WHITTLE, Editor 

(II)

C O N T E N T S 

THURSDAY, JULY 19, 2007 

Page 

Opening statement of Chairman Dodd .................................................................. 1 

Opening statements, comments, or prepared statements of: 

Senator Shelby .................................................................................................. 3 

Prepared statement ................................................................................... 51 

Senator Brown .................................................................................................. 5 

Senator Hagel ................................................................................................... 6 

Senator Reed ..................................................................................................... 6 

Senator Menendez ............................................................................................ 7 

Senator Schumer .............................................................................................. 8 

Senator Bunning ............................................................................................... 25 

Prepared statement ................................................................................... 51 

Senator Allard ................................................................................................... 30 

Senator Bennett ................................................................................................ 36 

Senator Bayh .................................................................................................... 39 

Senator Carper ................................................................................................. 42 

Senator Akaka .................................................................................................. 45 

Senator Dole ...................................................................................................... 52 

WITNESS 

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

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

Prepared statement .......................................................................................... 53 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Monetary Policy Report to the Congress, July 18, 2007 ....................................... 57 

(III)

(1) 

FEDERAL RESERVE’S SECOND MONETARY 

POLICY REPORT FOR 2007 

THURSDAY, JULY 19, 2007 

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

The Committee met at 9:32 a.m., in room SD–538, Dirksen Senate Office Building, Senator Christopher J. Dodd (Chairman of the 

Committee) presiding. 

OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD 

Chairman DODD. The hearing will come to order. 

The Committee is very pleased this morning to welcome the 

Chairman of the Federal Reserve, Ben Bernanke. We thank you for 

being with us to present your outlook for the Nation’s economy, the 

Fed’s conduct of monetary policy, and the status of important consumer protection regulations that are under the Federal Reserve’s 

jurisdiction. 

Mr. Chairman, we once again welcome you to the Senate Banking Committee. 

Before I begin my opening statement, I wanted to recognize several special guests we have with us here this morning, Dick, the 

members of the European Parliament’s Committee on Economic 

and Monetary Affairs led by Chairwoman Pervenche Beres, and we 

thank you very much, Madam Chairwoman, for being here, and 

your colleagues as well. We are honored to have you here at the 

Senate Banking Committee and to have you participate. 

The Chairwoman mentioned to me that the last time you came 

here and visited us was at the last testimony of Chairman Greenspan. So this is kind of a beginning again, so we start with the first 

testimony here of Mr. Bernanke. So welcome and thank you for 

joining us here. 

This hearing is being conducted pursuant to the statute and according to practice. It is an occasion to consider not just monetary 

policy in a narrow or limit sense but also the overall health of our 

economy and what the Fed, as an agency, and we, as policymakers, 

should do to increase prosperity and opportunity in our country. 

The role of the Fed is critical not just to setting monetary policy 

but it also serves as a regulator for the safety and soundness of the 

largest lending institutions, and very significantly, as a regulator 

and enforcer of the laws passed by the Congress to protect consumers and ensure that they have an opportunity to participate 

and succeed in the American economy. 

2 

Mr. Chairman, I know I do not need to tell you that the Fed 

stands at the center of some of the most critical economic and public policy matters of our time. In the 17 months as Fed Chairman, 

your steadiness at the helm of our Nation’s monetary policy seems 

to have earned you the confidence of the markets, which is the initial step toward a successful tenure as Fed Chairman. And I congratulate you on that. 

The confidence has been reflected, in part, by some of the positive economic news that we have experienced, including an official 

unemployment rate that is low by historical standards, by gains in 

the stock market, and the economy’s overall stability in the face of 

serious problems in both the housing and automotive sectors of our 

economy. 

Those positive factors aside, and notwithstanding the positive 

impact of your leadership, there are some facts that are cause for 

deep concern for many of us here about our Nation’s economic future, in particular the future of tens of millions of hard-working 

Americans. Despite some increases in income, working families are 

facing some unprecedented economic burdens. Gas prices reached 

another record high of an average of almost $3.25 a gallon across 

the country this past Memorial Day weekend. Health care costs 

have increased by 25 percent over the last 5 years. And the cost 

of sending a young person to college has risen at more than double 

the rate of inflation over the past 20 years. And default and foreclosure rates, as you well know, for homeowners are an all-time 

high. 

Mr. Chairman, there is a persistent if not growing sense among 

many of our fellow countrymen that their future is less secure and 

less hopeful today than it has been and should be. It is in that respect that the Fed’s role comes into play not just as a monetary 

policymaker but also as a safety and soundness regulator and as 

an agency charged with protecting consumers. The Fed can and, in 

my view, should take additional steps that can make a real difference in improving our overall economic growth as well as an opportunity for all Americans to contribute and to participate in the 

success and prosperity of the economy. 

In that regard, let me say that I am pleased that you, as chairman, have accepted the Fed’s duty to act under the Home Ownership Equity Protection Act. I consider this a significant statement 

by you and I trust and expect that it will result in significant action by the Fed to ensure that every American who seeks to buy 

a home will receive a fair, reasonable, and responsible treatment 

by his or her lender. 

Similarly, with respect to credit cards, I commend the Fed for 

undertaking the effort to update Regulation Z which in my view is 

long overdue. It is vital that consumers have the clearest and most 

complete information possible about credit cards so they can make 

the most informed decision about how to use them. 

However, improved disclosure is not, in and of itself, sufficient to 

address abusive practices. I believe the Fed can and should play a 

more active role not just in improving disclosure for consumers but 

also in prohibiting policies and practices that are harmful to consumers. In my view, credit cards can and should be a tool for ecoVerDate Aug 31 2005 10:51 Jan 29, 2009 Jkt 046629 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 S:\DOCS\46629.TXT JIMC
3 

nomic achievement and advancement rather than an instrument of 

perpetual indebtedness. 

Last, Mr. Chairman, let me raise the issue of Basel II, of the 

bank capital standards, with you. History has taught us that wellcapitalized banks are in the best interest of our Nation when they 

are better positioned to weather unexpected economic shocks, 

thereby protecting American taxpayers from costly bank bailouts. 

And they enhance the competitiveness of U.S. banks by instilling 

confidence in the strength of these vital institutions. 

As Senator Shelby and I have written to you and your fellow 

banking regulators, the stakes are very high for our economy in 

this debate. We believe that it is imperative that the four regulatory agencies together agree upon the standards that will strike 

the vital balance between the remarkable safety and soundness of 

our federally insured lending institutions and their competitiveness 

in the global economy. 

Mr. Chairman, the challenges you face, of course, are daunting. 

I think I speak for all of our Committee Members here in saying 

that we are committed to seeing the Fed succeed at each of these 

three vital missions: As a center of monetary policy, a consumer 

protector, and a bank regulator. 

What is at stake here is not just the success of your agency, obviously, and your tenure as Fed Chairman, as important as those 

are, but rather the success of our entire economy and in particular 

for the tens of millions of Americans whose hard work is the foundation of our economy’s success and who deserve every opportunity 

to maximize the fruits of their labor. 

With that, let me turn to my colleague from Alabama, the Ranking Member of the Committee, Senator Shelby. 

STATEMENT OF SENATOR RICHARD C. SHELBY 

Senator SHELBY. Thank you, Chairman Dodd. 

Chairman Bernanke, we are pleased again to have you before 

this Committee. 

This hearing, as Senator Dodd has pointed out, provides the Congress a very important opportunity to have an open and detailed 

discussion about the Fed’s monetary policy goals and their implementation. I also expect that Members of the Committee here, including myself, will take advantage of your appearance, Mr. Chairman, to raise some other issues that fall under the jurisdiction of 

the Federal Reserve. 

I would also like to join Senator Dodd in welcoming our colleagues from the European Union Parliament that are here today. 

I had a nice meeting with them yesterday and we look forward to 

these transatlantic visits. I think they are healthy. I trust that 

your visit here today will be enlightening and provide you with 

much to discuss with the European Central Bank. 

Chairman Bernanke, your testimony and report this morning 

note the continued healthy performance of the economy in the first 

half of 2000. Although real gross domestic product, GDP, increased 

0.7 percent in the first quarter the consensus view among economists is that growth for the second quarter will show a rebound in 

the neighborhood of 2.5 percent. 

4 

Along with continued GDP growth, we have seen positive news 

on the job front. Gains in the payroll employment average 140,000 

jobs per month in the first half of 2007. We continue to enjoy low 

unemployment rate in this country, both historically and relative 

to other industrialized nations in the world. 

The global economy also continues to be strong with Canada, Europe, Japan, and the United Kingdom experiencing above trend 

growth rates in the first quarter. This is good news, I believe, for 

American businesses seeking to expand their exports around the 

world. 

In its statement following the June 28, 2007, meeting the FOMC 

suggested that while core inflation readings had moderated ‘‘sustained moderation in inflation pressures has yet to be convincingly 

demonstrated.’’ There is a lot in those words. 

Inflation risks, not slow growth, remains the predominant concern as we continue to see a rise in energy and food prices. 

I also share, Mr. Chairman, your view on the importance of low 

inflation in promoting growth, efficiency, and stability which in 

turn equal maximum sustainable employment. 

Chairman Bernanke, your statement also includes an extensive 

discussion of the Federal Reserve’s recent activities relating to 

subprime mortgage lending, which is a concern to all of us. The recent sharp increases in subprime mortgage loan delinquencies are 

troubling. The rating agency’s recent moves are also very interesting too. The initiatives that you highlight in your testimony are 

welcome. 

However, I am concerned that the weaknesses, Mr. Chairman, in 

the subprime market may have broader systemic consequences 

than we are seeing yet. We have been told that the problem is 

largely isolated and contained but I am concerned that that may 

not be the case. 

I will be particularly interested in hearing your views on the 

scope and depth of the problem and how the Federal Reserve will 

monitor and manage the situation hopefully going forward. We are 

pleased to have you with us this morning, as I said, and we look 

forward to the rest of the hearing and my colleagues testimony. 

Chairman DODD. Thank you very much, Senator. 

Let me inform my colleagues that as soon as a quorum appears 

here, I am going to interrupt the hearing. I say that to you, Mr. 

Chairman, as well, respectfully. We have several nominees that are 

prepared to be confirmed by this body and I would like to be able 

to move on that the moment a quorum arrives here. So just to give 

you advance notice when that happens here, realizing people have 

other obligations and may be moving in and out here. So we will 

try to get that done. 

If for whatever reason we do not, then I will be asking all of you 

to join me after the first vote or during the first vote sometime 

around noon off the floor of the Senate to try to get these matters 

moved along so they can be considered by the full Senate before 

our August adjournment. 

With that, let me turn to Senator Brown. 

5 

STATEMENT OF SENATOR SHERROD BROWN 

Senator BROWN. Thank you, Mr. Chairman. And Chairman 

Bernanke, thank you very much for joining us this morning. I am 

particularly pleased that your testimony describes Congress as prescient in the trend toward transparency. It is not often you see the 

words Congress and prescient in the same sentence. Thank you for 

that. 

Of course, you are referring to an action 30 years ago, but we 

will take what we can get. 

As you know, we need to encourage transparency in both central 

banking and in financial services and particularly in the mortgage 

business. I appreciate your devoting much of your testimony in the 

work of the Federal Reserve in promoting better disclosure for 

mortgage borrowers and hope you and your colleagues will approach this task with great urgency. 

As you know, the loans of close to 2 million subprime borrowers 

will reset in the next 2 years. Every day of inaction means another 

2,000 to 3,000 mortgages will reset without sufficient protections. 

If they are lucky, many of these families will be able to take out 

another lousy mortgage. If they are unlucky, they may lose their 

life savings. 

The Federal Reserve must act and must act quickly both to mitigate the damage that has already been done and to prevent a continuation of the abusive practices and products that have characterized too much of the mortgage industry over the past few years. 

I understand why a lender needs to price for risk but I do not 

understand why the structure of mortgage products is so different 

in the prime and subprime markets. Most of the people in this 

room do not have a prepayment penalty on their mortgage. Most 

of us have our property taxes and our hazardous insurance 

escrowed. 

By contrast, the loans in the subprime sector, like the 228s, seem 

almost designed to deceive. They are sold to borrowers with teaser 

rates and with dangerous features and with the smooth pitch that 

there is no need to worry about the reset because good things 

might happen in your life, a better job, a better loan, even winning 

the lottery. But betting on the outcome is not a sound banking 

practice. 

It is possible that I will play like Grady Sizemore in next year’s 

Congressional baseball game but the Indians would be well advised 

not to put him on waivers. Sadly, it is not very likely I will climb 

the fence to rob somebody of a home run next summer because Republicans just do not have that kind of power. 

You obviously need to take a broad view in your position. But the 

very dispersion of risk that makes the subprime problem less of a 

worry from an economic standpoint makes it a greater problem for 

homeowners trying to work out an unaffordable loan. We all know 

it makes economic sense for a lender to mitigate losses but just try 

getting the right person on the phone in a timely fashion, especially if the owner of the loan sits in Shanghai. 

One man’s junk is another man’s treasure. What may look like 

BBB debt to an investor on Wall Street is really the hopes and 

dreams of thousands of families in Slavic Village in Cleveland and 

6 

across the country. Those hopes and dreams diminish with every 

day that we delay. 

So, I would urge you to take action quickly and comprehensively. 

You need to bring an end to the deceptive practices in the subprime 

sector, not just for banks and their affiliates but for all mortgage 

brokers and all types of lenders. 

Thank you. I look forward to your testimony. 

Chairman DODD. Thank you, Senator. 

Senator Hagel. 

COMMENTS OF SENATOR CHUCK HAGEL 

Senator HAGEL. Mr. Chairman, welcome. I will withhold my comments until the question and answer period. I just want to say that 

we are glad you are here with us today. Thank you. 

Chairman DODD. Thank you, Senator. 

Senator Reed. 

STATEMENT OF SENATOR JACK REED 

Senator REED. I will not exercise such statesmanlike restraint. 

Thank you, Mr. Chairman. And thank you, Chairman Bernanke, 

for joining us today to discuss the state of monetary policy and its 

reflection on our economy. 

At the past eight meetings of the FOMC, the Fed has held the 

Federal Fund rates steady at 5.25 percent. However, significant 

turmoil in the housing market particularly related to subprime 

mortgages, a growing trade deficit, and a negative household savings rate continue to pose tremendous challenges to setting monetary policy. 

I know, Mr. Chairman, you have personally expressed concern 

about core inflation being higher than is desirable in the long run. 

But the risk of raising interest rates too high is that a weakening 

housing sector and rising oil prices may be taking their toll on consumers and businesses alike and slowing down the economy too 

much already. 

I look forward to your insights about the kind of policies that are 

likely to be effective in addressing the challenges we face in this 

economy and offering real opportunities for growth that provide 

widespread benefits to the American people. 

On a systemic level, the weakening housing sector and turmoil 

in the subprime mortgage market have placed pressure on both investors and borrowers. Bear Stearns has recently announced that 

two of its hedge funds are now worth nearly nothing after some of 

its investments in subprime mortgages went bad. 

Last week both Moody’s and Standard & Poor’s significantly 

downgraded ratings on hundreds of subprime related bonds. The 

ABX Index, which tracks the performance of various classes of 

subprime related bonds hit new lows yesterday. In the past few 

months portions of the index that tracked especially risky mortgage 

bonds with junk grade ratings have been falling. And this is now 

spread into the portion of the index that track bonds with ratings 

of AAA or AA. 

According to Merrill Lynch’s latest fund manager survey which 

polled 186 fund managers controlling $618 billion in assets, 72 perVerDate Aug 31 2005 10:51 Jan 29, 2009 Jkt 046629 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 S:\DOCS\46629.TXT JIMC
7 

cent of managers said that credit or default risk was the biggest 

threat to financial market stability. 

I would appreciate hearing your thoughts on some of these 

events, particularly as they may pertain to the financial accelerator 

effect you spoke of in Georgia last month and the efforts of the Federal Reserve to monitor some of these risks. 

Finally, the Federal Reserve has the authority and responsibility 

to prohibit unfair and deception lending practices. As such, Mr. 

Chairman, I was pleased to hear that the Fed will likely propose 

additional rules under the Home Ownership and Equity Protection 

Act, HOEPA, to provide consumers with better protections through 

bans on some mortgage purchases. 

Additionally, I understand that the Fed will join other regulators 

in a pilot project to monitor the practices of nondepository 

subprime mortgage firms. I am interested in your perspective on 

what additional actions the Federal Reserve will be taking to meet 

the regulatory portion of its mandate. 

I look forward to your testimony, Mr. Chairman. Thank you. 

Chairman DODD. Thank you very much, Senator Reed. 

Senator Menendez. 

STATEMENT OF SENATOR ROBERT MENENDEZ 

Senator MENENDEZ. Thank you, Mr. Chairman. 

Chairman Bernanke, it is always good to welcome a fellow New 

Jerseyan back to the Committee. I am glad to have the chance to 

have you before the Committee again this year. I think your presence here is especially important, not just because it gives Congress an opportunity to look critically at the economy to see what 

is working and what is not, but because it brings a discussion of 

the economy onto the front pages and into the homes of Americans 

across the country. 

I think Americans from all walks of life are clearly affected when 

the market has a dip, by external pressure on prices, by poor investment. For many, these factors are invisible. I welcome these 

discussions with you because you help make them much more tangible for average people across the country. 

And I assume you often ask yourself a question that I certainly 

do, and I believe all of us should be asking, and that is who is this 

economy working for? Who is this economy working for? 

Most middle-class Americans face rising food and energy prices 

as well as health care costs while median incomes for the last 5 

years have remained stagnant. I think that there is a good part of 

the American middle class who does not think that this economy 

is working for them. 

Unfortunately, most are aware of changes in the economy when 

it affects them negatively. I would like to focus on a specific group 

of Americans who have been keenly aware of how the economy has 

not worked for them, those who dreamed of being homeowners but 

in the wake of the subprime tsunami have seen those dreams wash 

away in foreclosure and bankruptcy. More than one million Americans lost their homes last year and few have yet to recover. In fact, 

I would dare to argue that another storm is on its way as adjustable rate mortgages explode in coming months and force more 

homeowners into foreclosure. 

8 

And so in my mind this is not just simply a time for suggestions, 

it is a time for solutions. The Federal Reserve has, and has always 

had, the tools to protect Americans from this storm. But as the 

warning signs were posted and as the foreclosures began we saw 

little to no action. 

Now I want to commend you for addressing this issue, especially 

on low document loans and underwriting to the full indexed rate. 

But I am still hoping for more substantive solutions that will protect the borrower. We are talking also about predatory lenders and 

we must take swift action. I do not believe this is one that the market is going to handle simply on its own. Congress and the Federal 

Reserve need to act and I look forward to discussing this more with 

you today. 

I welcome the focus you have recently had on discussing certain 

inequalities in our economy and I will look forward to your 

thoughts on these and other issues important to the economic prosperity of our Nation. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you, Senator. 

Senator Schumer. 

STATEMENT OF SENATOR CHARLES E. SCHUMER 

Senator SCHUMER. Thank you, Mr. Chairman. 

I want to thank you for holding this hearing and I want to thank 

Chairman Bernanke. As Chairman of the Joint Economic Committee, I am always interested in hearing your thoughts on the current state of economy and appreciate your availability on so many 

issues when we reach out to you. 

As I have said in the past, we live in interesting economic times. 

And you face a number of important challenges in setting a course 

for monetary policy that will achieve the multiple goals of high employment, balanced economic growth, and low inflation. Right now, 

there are certain reasons to be concerned about where we find ourselves. 

In the short-term, even with the likely improvements in the second quarter, overall economic growth in the first half of the year 

has been disappointing to say the least. Most forecasters have revised downward their expectations for economic growth through 

the rest of the year. The Administration continues to run high 

budget deficit that threaten our future stability to compete with 

the rest of the world. And our trade gap, particularly with China, 

remains immense and growing at a rapid rate. 

Energy prices are hovering at record highs, feeding our trade gap 

and fueling anxiety among middle-class families. The collapse of 

parts of the housing market which you call a correction has become 

a serious drag on our economic growth and a threat to economic security of too many American families. 

And while I welcome the Fed’s new pilot program to monitor 

independent subprime brokers, I do not think consumers will truly 

be safe from irresponsible and deceptive lending practices until we 

enact tougher Federal laws to protect the subprime mess from happening again. As indication of the weakness in the housing market 

continue to mount, there is an urgent need for better protections 

for existing and aspiring homeowners, although I do want to 

9 

thank—the Appropriations Committee did a $100 million in for the 

workouts. So nonprofits can do workouts that Senators Casey, 

Brown, and I had asked them to do. 

Most importantly, a view is recognized. We have an economy 

whose rewards seems to be more and more going to fewer and 

fewer privileged Americans. We are facing the greatest concentration of income since 1928 right before the crash and the beginning 

of the Depression when 24 percent of all income went to the richest 

1 percent. It is now close to 22 percent and will pass the 24 percent, if present trends continue, all too soon. 

At a time when the wealthiest in this country have been doing 

extremely well, the American middle class, the engine of our economy, has not been as fortunate. Most Americans have not seen the 

benefits of working harder in their paychecks. 

Between 2000 and 2006 the typical worker’s earnings grew less 

than 1 percent after accounting for inflation while productivity increased a whopping 18 percent. And now that economic growth 

seems to be slowing, its fair to ask whether most middle-class 

Americans will slip even further behind. The dramatic increase in 

productivity and its failure to raise wage rates is a great conundrum for our economy that needs all of our attention. 

I do not pretend that there are easy solutions to the troubling 

challenges facing our economy but we need to remember that our 

collective focus must be on achieving strong sustainable long-term 

economic growth that can be shared by all families in this country, 

not just those in the top 1 or 5 percent. 

Unless economic fortunes in this country grew together rather 

than apart, we cannot be confident about our children’s economic 

futures. 

I look forward to your testimony, and thank you, Mr. Chairman, 

for the time. 

Chairman DODD. Thank you, Senator, very much. 

Mr. Chairman, we welcome you here to the Committee once 

again and we are prepared to receive your statement. 

STATEMENT OF BEN S. BERNANKE, CHAIRMAN, 

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 

Chairman BERNANKE. Thank you. Chairman Dodd, Ranking 

Member Shelby, and Members of the Committee, I am pleased to 

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

As you know, this occasion marks the 30th year of semiannual 

testimony on the economy and monetary policy by the Federal Reserve. And in establishing these hearings, the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in the making of monetary policy. 

Over the years, these testimonies and the associated reports 

have proved an invaluable vehicle for the Federal Reserve’s communication with the public about monetary policy even as they 

have served to enhance the Federal Reserve’s accountability for 

achieving that dual objectives of maximum employment and price 

stability set forth by the Congress. 

10 

I take this opportunity to reiterate the Federal Reserve’s strong 

support of the dual mandate. In pursuing maximum employment 

and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. 

Let me now review the current economic situation and the outlook beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy. I will 

conclude with comments on issues related to lending to households 

and to consumer protection, topics not normally addressed in monetary policy testimony but, in light of recent developments, deserving of our attention today. 

After having run at an above trend rate earlier in the current 

economic recovery, U.S. economic growth has proceeded during the 

past year at a pace more consistent with sustainable expansion. 

Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to 

payrolls thus far in 2007 and the unemployment rate having remained at 4.5 percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of 

the past decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors but 

the underlying pace of productivity gains may also have slowed 

somewhat. 

To a considerable degree, the slower pace of economic growth in 

recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed 

substantially and house prices have decelerated. Although a leveling off of home sales in the second half of 2006 suggested some 

tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders’ inventories to rise further relative to the pace of new home 

sales. 

Accordingly, construction of new homes has sunk further, with 

starts of new single-family houses thus far this year running 10 

percent below the pace of the second half of last year. 

The pace of home sales seems likely to remain sluggish for a 

time partly as a result of some tightening in lending standards and 

the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment as well 

as by mortgage rates that—despite the recent increase—remain 

fairly low relative to historical norms. However, even if demand 

stabilizes as we expect, the pace of construction will probably fall 

somewhat further as builders work down stocks of unsold new 

homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although 

the magnitude of the drag on growth should diminish over time. 

Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace aided by a 

strong labor market. Employment should continue to expand, 

though possibly at a somewhat slower pace than in recent years, 

as a result of the recent moderation in the growth of output and 

ongoing demographic shifts that are expected to lead to a gradual 

11 

decline in labor force participation. Real compensation appears to 

have risen over the past year and, barring further sharp increases 

in consumer energy costs, it should rise further as labor demand 

remains strong and productivity increases. 

In the business sector, investment in equipment and software 

showed a modest gain in the first quarter. A similar outcome is 

likely for the second quarter as weakness in the volatile transportation equipment category appears to have been offset by solid 

gains in other categories. Investment in nonresidential structures, 

after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. 

Like consumption spending, business fixed investment overall 

seems poised to rise at a moderate pace bolstered by gains in sales 

and generally favorable financial conditions. Late last year and 

early this year motor vehicle manufacturers and firms in several 

other industries found themselves with elevated inventories, which 

led them to reduce production to better align inventories with 

sales. Excess inventories now appear to have been substantially 

eliminated and should not prove a further restraint on growth. 

The global economy continues to be strong. Supported by solid 

economic growth abroad U.S. exports should expand further in 

coming quarters. Nonetheless our trade deficit, which was about 

5.25 percent of nominal gross domestic product in the first quarter 

is likely to remain high. 

For the most part, financial markets have remained supportive 

of economic growth. However, conditions in the subprime mortgage 

sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans. In recent weeks, we have 

also seen increased concerns among investors about credit risk on 

some other types of financial instruments. Credit spreads on lower 

quality corporate debt have widened somewhat, and terms for some 

leveraged business loans have tightened. Even after their recent 

rise, however, credit spreads remain near the low end of their historical ranges and financing activity in the bond and business loan 

markets has remained fairly brisk. 

Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying 

trend. Such an assessment was made around the time of the June 

meeting of the Federal Open Market Committee by the members 

of the Board of Governors and the Presidents of the Reserve Banks, 

all of whom participate in deliberations on monetary policy. 

The central tendency of the growth forecasts, which are conditioned on the assumption of appropriate monetary policy, is for real 

GDP to expand roughly 2.25 to 2.5 percent this year and 2.5 to 2.75 

percent in 2008. 

The forecasted performance for this year is about one-quarter 

percentage point below that projected in February, the difference 

being largely the result of weaker than expected residential construction activity this year. The unemployment rate is anticipated 

to edge up to between 4.5 and 4.75 percent over the balance of this 

year and about 4.75 percent in 2008, a trajectory about the same 

as the one expected in February. 

12 

I turn now to the inflation situation. Sizable increases in food 

and energy prices have boosted overall inflation and eroded real incomes in recent months, both unwelcome developments. As measured by changes in the price index for personal consumption expenditures, PCE inflation, inflation ran at an annual rate of 4.4 

percent over the first 5 months of this year, a rate that if maintained would clearly be inconsistent with the objective of price stability. 

Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices 

tend be quite volatile so that, looking forward, core inflation, which 

excludes food and energy prices, may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months with core PCE inflation 

coming in at an annual rate of about 2 percent so far this year. 

Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise and some of the recent improvement could also be 

the result of transitory influences. However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and 

pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower on net over the remainder of this year and next year. 

The central tendency of FOMC participants forecast for core PCE 

inflation—2 to 2.25 percent for all of 2007 and 1.75 to 2 percent 

in 2008—is unchanged from February. If energy prices level off as 

currently anticipated, overall inflation should slow to a pace close 

to that of core inflation in coming quarters. 

At each of its four meeting so far this year, the FOMC maintained its target for the Federal funds rate at 5.25 percent, judging 

that the existing stance of policy was likely to be consistent with 

growth running near trend and inflation staying on a moderating 

path. As always, in determining the appropriate stance of policy, 

we will be alert to the possibility that the economy is not evolving 

in the way we currently judge to be the most likely. 

One risk to the outlook is that the ongoing housing correction 

might prove larger than anticipated, with possible spillovers onto 

consumer spending. 

Alternatively consumer spending, which has advanced relatively 

vigorously on balance in recent quarters, might expand more quickly than expected. In that case, economic growth could rebound to 

a pace above its trend. With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time. 

Yet another risk is that energy and commodity prices could continue to rise sharply, leading to further increases in headline inflation and, if those costs pass through to the prices of nonenergy 

goods and services, to higher core inflation as well. 

Moreover, if inflation were to move higher for an extended period 

and increase became embedded in longer-term inflation expectations, the reestablishment of price stability would become more difficult and costly to achieve. With the level of resource utilization 

relatively high and with a sustained moderation in inflation presVerDate Aug 31 2005 10:51 Jan 29, 2009 Jkt 046629 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 S:\DOCS\46629.TXT JIMC
13 

sures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. 

In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve has been active 

in implementing, interpreting, and enforcing consumer protection 

laws. I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime 

mortgage lending. 

Promoting access to credit and to homeownership are important 

objectives and responsible subprime mortgage can help to advance 

both goals. In designing regulations, policymakers should seek to 

preserve those benefits. 

That said, the recent rapid expansion of the subprime market 

was clearly accompanied by deterioration in underwriting standards, and in some cases by abusive lending practices and outright 

fraud. In addition, some households took on mortgage obligations 

they could not meet, perhaps in some cases because they did not 

fully understand the terms. 

Financial losses have subsequently induced lenders to tighten 

their underwriting standards. Nevertheless, rising delinquencies 

and foreclosures are creating personal, economic, and social distress for many homeowners and communities, problems that will 

likely get worse before they get better. 

The Federal Reserve is responding to these difficulties at both 

the national and the local levels. In coordination with the other 

Federal supervisory agencies we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve Banks 

around the country are cooperating with community and industry 

groups that work directly with borrowers having trouble meeting 

their mortgage obligations. We continue to work with organizations 

that provide counseling about mortgage product to current and potential homeowners. We are also meeting with market participants—including lenders, investors, servicers, and community 

groups—to discuss their concerns and to gain information about 

market development. 

We are conducting a top to bottom review of possible actions we 

might take to help prevent recurrence of these problems. First, we 

are committed to providing more effective disclosures to help consumers defend against improper lending. Three years ago, the 

Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act, or TILA. The initial focus of our 

review was on disclosures related to credit cards and other revolving credit accounts. 

After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide 

clearer and easier to understand disclosures to consumers. In particular, the new disclosures would highlight applicable rates and 

fees, particularly penalties that might be imposed. The proposed 

rules would also require card issuers to provide 45 days advance 

notice of a rate increase or any other change in account terms so 

14 

that consumers will not be surprised by unexpected charges and 

will have time to explore alternatives. 

We are now engaged in a similar review of the TILA rules for 

mortgage loans. We began this review last year by holding four 

public hearings across the country, during which we gathered information on the adequacy of disclosures for mortgages, particularly 

for nontraditional, traditional, and adjustable rate products. 

As we did with credit card lending, we will conduct extensive 

consumer testing of proposed disclosures. Because the process of 

designing and testing disclosures involves many trial runs, especially given today’s diverse and sometimes complex credit products, 

it may take some time to complete our review and propose new disclosures. 

However, some other actions can be implemented more quickly. 

By the end of the year, we will propose changes to TILA rules to 

address concerns about mortgage loan advertisements and solicitations they may be incomplete or misleading and to require lenders 

to provide mortgage disclosures more quickly so that consumers 

can get the information they need when it is most useful to them. 

We already have improved a disclosure that creditors must provide 

to every applicant for an adjustable rate mortgage product to explain that better the features and risks of these products such as 

‘‘payment shock’’ and rising loan balances. 

We are certainly aware, however, that disclosure alone may not 

be sufficient to protect consumers. Accordingly, we plan to exercise 

our authority under the Home Ownership and Equity Protection 

Act, HOEPA, to address specific practices that are unfair or deceptive. We held a public hearing on June 14 to discuss industry practices including those pertaining to prepayment penalties, the use of 

escrow accounts for taxes and insurance, stated income and low 

documentation lending, and the evaluation of a borrower’s ability 

to repay. The discussion and ideas we heard were extremely useful 

and we look forward to receiving additional public comments in 

coming weeks. Based on the information we are gathering, I expect 

the Board will propose additional rules under HOEPA later this 

year. 

In coordination with the other Federal supervisory agencies, last 

year we issued principles-based guidance for nontraditional mortgages, and in June of this year we issued supervisory guidance on 

subprime lending. These statements emphasized the fundamental 

consumer protection principles of sound underwriting and effective 

disclosures. In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding 

companies for compliance with consumer protection laws and guidance. 

As a result of that review and following discussions of the Office 

of Thrift Supervision, the Federal Trade Commission, and State 

regulators as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot aimed at expanding 

consumer protection compliance reviews at selected nondepository 

lenders with significant subprime mortgage operations. 

The reviews will begin in the fourth quarter of this year and will 

include independent state-licensed mortgage lenders, nondepository 

15 

mortgage lending subsidies of bank and thrift holding companies, 

and mortgage brokers doing business with or serving as agents of 

these entities. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring 

effective and consistent examination of and improved enforcement 

for nondepository mortgage lenders. Working together to address 

jurisdictional issues and to improve information sharing among 

agencies, we will seek to prevent abusive and fraudulent lending 

while ensuring that consumers retain access to beneficial credit. 

I believe that the actions I have described today will help address the current problems. The Federal Reserve looks forward to 

working with Congress on these important issues. 

Thank you. 

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

I am sure my colleagues will have some additional questions for 

you on dealing with HOEPA, but I want to express my appreciation 

for the Fed in deciding to aggressively pursue these issues beyond 

just the guidance and looking at regulations. 

I will try to keep this about 7 minutes a round here so can get 

through to everybody, at least one around anyway. And then the 

record will stay open, as well, for those who are not here to submit 

some questions. And we will try to move along. 

Let me, if I can, begin with the Basel II issue here. 

As you know, Mr. Chairman, Senator Shelby and I earlier this 

week sent a letter to the four banking regulators, calling on each 

one of them to make sure a consensus on the final regulation on 

Basel II, the bank capital accords, could be reached. And while I 

believe that no one regulator should have a veto power certainly 

over these important regulations, it is critically important that the 

final rule be in agreement among all the regulators. Proper capital 

accounting is obviously critically important to competitiveness and 

to the safety and soundness of our financial institutions. Capital 

should be based on risk not who the regulator is, in my view. 

One, I would ask if you would agree that there would be tremendous value to have a rule that all four regulators agree to? And 

conversely, obviously would it be a failure if there was a failure to 

reach consensus? I know you are working at this, but I want to 

raise that issue with you. I know how important you think it is but 

it is extremely important there be this consensus. I realize that you 

are working toward that but why don’t you share with us how that 

is moving? 

Chairman BERNANKE. Thank you, Mr. Chairman. 

I think we agree that the existing Basel I capital system is no 

longer adequate for the largest international banks and that we 

need to move expeditiously forward to provide a new capital standard that will appropriately link capital to risk taking. I think that 

the Basel II approach, with perhaps some modifications but in essence what was agreed upon with the international banking authorities, is the right approach for providing that kind of capital 

base protection. 

We are already rather late in this process. We have delayed the 

process for a year. Therefore, it is very essential that we do move 

expeditiously. I can assure you that the four agencies are currently 

16 

working very hard on a range of issues. Again, we all appreciate 

the importance of making progress. 

With respect to your question, I too would strongly prefer that 

all four agencies would come together and agree on a single proposal. And I am relatively optimistic that we will be able to achieve 

that in the near future. 

Chairman DODD. Thank you for that. I suspect Senator Shelby 

may raise a question about that as well, since we both have a 

strong interest in that conclusion. And we urge you to do everything you can in these coming days to reach that consensus, because of the importance of it, as you have stated here. 

Let me move, if I can, to the currency manipulation issue. I know 

because of your previous testimony before the Committee, the issue 

was raised here about a speech that you gave during that trip to 

China along with Secretary Paulson and others in which you said 

that China’s exchange rate practices amounted to an effective subsidy. I know there was longer remarks than that alone, but nonetheless that comment was one that certainly attracted some attention. 

As you are aware, there is great concern to me and to many of 

our colleagues here on this issue. Senator Shelby and I have introduced some legislation that has the support of many of our colleagues here, Senator Bayh, Senator Carper, Senator Brown, Senator Casey, Senator Bunning, Senator Dole, on this Committee. 

I should point out that Senator Baucus in the Finance Committee has also introduced some legislation. He and I have talked 

about this. The issue of currency is appropriately a matter of jurisdiction of this Committee but nonetheless there is a strong interest 

reflected by Senator Baucus, and Senator Schumer as well has a 

strong interest in this subject matter. 

And so there is, without a doubt here, as you gather, among 

Democrats and Republicans, while there may be disagreements on 

a lot of other issues on this one there seems to be a growing consensus here of our concern about the currency manipulation. In 

fact, it is our attention here to try before the August recess to possibly markup some legislation which we have introduced and I discussed with you here. 

I wonder if you could still share with us your opinion about this 

matter here, what it means, and some reflection on where you 

think this is heading. Because it is a deep, deep concern regarding 

our manufacturing base in this country that struggles every day to 

stay open and competitive in global markets. Share with us, if you 

will, your thoughts on this matter today. 

Chairman BERNANKE. Thank you, Mr. Chairman. 

I share your concern, I share your frustration about the slow 

pace of the appreciation of Chinese currency. 

I have argued, as I did in that speech you referred to in China, 

that further appreciation of the currency would, in fact, be in China’s interest for a number of reasons. First, it would give them an 

independent monetary policy. And they are, at this point, dealing 

with some issues of inflation and asset price increases that would 

be better dealt with if they had an independent monetary policy. 

And second, again in reference to my comments about distortions, their economy is too oriented toward exports, not enough toVerDate Aug 31 2005 10:51 Jan 29, 2009 Jkt 046629 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 S:\DOCS\46629.TXT JIMC
17 

ward the home market. And I believe that appreciation would better help orient the economy toward serving domestic needs and domestic consumers rather than relying entirely on the global market. 

So, I agree with your premise that it is important that the Chinese begin to appreciate further. 

Let me just raise a couple of issues which I guess I would call 

tactical issues without addressing any specific legislative proposal. 

The first is that the currency, while an important issue, is probably 

in itself not going to solve the trade imbalance problem. There are 

fundamental saving investment imbalances, both in the United 

States and abroad, which need to be changed in order to make real 

progress on the trade balance. In particular, we have emphasized 

with the Chinese the importance of structural changes in their 

economy such as increased safety net and improved financial system that would increase the share of their output going to consumers and being consumed at home. The combination of currency 

appreciation and this other set of measures is really what is needed 

to begin to move things in the right direction. 

So, I would urge you to broaden focus just a bit beyond the currency to talk about the savings and investment balances that need 

to be adjusted in both the United States and in China. 

The other point I would just make from I guess essentially a tactical point of view is that, again as I understand the frustration 

and concern about this particular issue and I advocate and I urge 

the Chinese to move their currency up more quickly, the United 

States and China have a wide range of issues on which we need 

to collaborate, coordinate, and cooperate including energy and the 

environment and financial services and trade and many other 

issues. I hope that as we look toward these sorts of measures that 

we try to keep in mind the importance of engaging China on a wide 

range of questions and not simply restricting our attention to this 

one important issue. But it is only one of many issues. 

Thank you. 

Chairman DODD. I appreciate that and I do not disagree that 

there are these other critical questions. 

In fact, Title II of our legislation deals with some of the trade 

issues here that you have raised, and I think—I will let Senator 

Shelby speak for himself here obviously—but we understand the 

importance of that as well. 

I cannot begin to tell you however, Mr. Chairman, of the difficulty there is for those of us who go back to our constituencies 

and talk about these issues here with, day after day, Chinese firms 

that export to the United States enjoying what you called an effective export subsidy, as a result of their undervaluation. 

So it makes it very difficult for those of us to try to make the 

case that there are a variety of issues that we need to be working 

with the Chinese on. I think all of us would agree with you on that. 

But this issue lurks as this huge obstacle to those issues, particularly when American jobs are being so adversely affected by this. 

Is it still your opinion that this is an effective subsidy on that 

issue? 

Chairman BERNANKE. It is not a subsidy in the legal sense, that 

a subsidy is a payment by the government directly to producers to 

18 

support their production. Nothing like that is going on. That is not 

what I was referring to. 

I was talking about the economic implication which is that the 

undervalued exchange rate creates a distortion in the economy 

which artificially sends resources into the export sector as opposed 

to in the domestic sector. So it is a distortion in the economy. From 

a legal perspective it is not the same thing as a subsidy. 

Chairman DODD. No, I know. I notice you said effective subsidy. 

Chairman BERNANKE. Or implicit. 

Chairman DODD. Implicit subsidy. 

Thank you very much. Let me turn to my colleague, Senator 

Shelby. 

Senator SHELBY. Thank you, Chairman Dodd. 

I want to pick up on what Senator Dodd was talking about, the 

Chinese. We have been dealing with this a long time. And whether 

it is a direct subsidy, Mr. Chairman, or a backyard subsidy they 

have an advantage there obviously because of the currency situation, to their advantage and to our detriment. A lot of us represent 

States that have substantial manufacturing industries there and 

we have seen ourselves the erosion of a lot of these jobs, not just 

in Alabama but Ohio, Connecticut, New Jersey, you name it. We 

have to answer to our constituents. And the American people, they 

know something is wrong. They know something is wrong and they 

look to us to do something about it and I know it is very complicated myself. 

But on the other hand, do we just continue to sit back and say 

well, everything is fine, when we know it is not fine. We know 

there is an advantage there. They are manipulating it to their advantage, in my judgment. 

The other thing I wanted to pick up on, what Senator Dodd has 

already raised, and that is Basel. I do hope, Mr. Chairman, I know 

you are one of the regulators, too, here. But we have talked to the 

FDIC Chairperson and others. 

Senator Dodd and I have been on this Committee quite a while. 

We were here during the savings and loan debacle when the Government, the taxpayers, spent billions and billions of dollars. And 

that is not fun. And we want to avoid that. 

I agree with Senator Dodd that I do not know of any bank, financial institution, that has gone bankrupt or has become insolvent 

that is well-capitalized and well-managed, you know, in combination. And if we are going through this international accord to lower 

our capital standards, that is probably to us. Everybody on this 

Committee—I cannot speak for everybody but just about, Democrats and Republicans, because we have that oversight responsibility here. And ultimately we do not want this to land in our lap. 

Is that right, Senator Dodd? 

Chairman DODD. That is right. 

Senator SHELBY. So, I will move on to some other things. 

Subprime problems. The subprime problems are real, not just in 

New Jersey and Ohio but in Alabama and everywhere else. There 

has been a huge expansion, Mr. Chairman, as you know, of structured financial products. We call what, collateralized debt obligations backed by subprime debt. In concept these projects involve 

19 

converting highly risky loans, as I understand it, into a collection 

of securities that have a range of risk from AAA to junk. 

The rating agencies provide the AAA ratings based on the idea 

that the structure of the products satisfactorily dissipates or 

spreads the risks associated with the underlying prime loan. That 

is the basis of that. But it appears that is not always working. 

It appears that many of the assumptions here regarding these 

structured products, collateralized, have significantly underestimated the true risk. We have seen what the rating agencies, it has 

been talked about, at least Senator Menendez and also Senator 

Brown brought it up. We have seen S&P—and I believe Senator 

Reed. We have seen S&P and Moody’s already downgrading the 

debt that they invited as AAA. How did they get to the point to 

rate a lot of these collateralized obligations AAA grade with so 

much underlying junk you might say? You cannot make gold out 

of lead. We know that. That has been tried. 

Does all of this deeply concern you, how this came about to begin 

with? Because I think the subprime not only has deep repercussions when a lot of people, our constituents that have been victimized I think to some extent by this. But a lot of it has been brought 

about by very ingenious financial people. And then looks like the 

rating agencies fell right in line with them, knowing that this is 

not really AAA stuff. This is questionable stuff. Now it is coming 

home to roost. And, as someone else said earlier here, a lot of those 

loans are going to be reset not downward but upward. 

Senator Dodd is very much out front on this, and should be as 

the Chairman of this Committee. And we are deeply concerned that 

the subprime problem is not going to just be contained so easily but 

could deeply spread and have some repercussions out there. What 

do you think? 

Chairman BERNANKE. Senator, let me address the financial side. 

We have talked about this effect on homeowners. On the financial 

side, I am not sure there is anything essentially wrong with structured credit products, per se. But what we have learned since early 

this year is that a lot of the subprime mortgage paper is not as 

good as was thought originally. And there clearly are going to be 

significant financial losses associated with defaults and delinquencies on these mortgages. 

As a result, the credit quality of many of the structured projects 

that include in them substantial amounts of subprime mortgage 

paper is being downgraded. The one issue is that the structured 

credit products are quite complex. They include many different 

kinds of assets. Then the risks are divided up in different so-called 

‘‘tranches.’’ So it takes quite a complex model or analysis to determine what the real value of these things is. 

Senator SHELBY. But the value seems to be going down instead 

of up. 

Chairman BERNANKE. Well, it is going down because the credit 

losses associated with subprime have come to light and they are 

fairly significant. Some estimates are on the order of between $50 

billion and $100 billion of losses associated with subprime credit 

products. 

20 

The credit rating agencies have begun to try to make sure they 

account for those losses and they have downgraded some of these 

products. 

I should say that the investors, many of them, recognize even before the downgrades occurred that there were risks associated with 

these products including not only credit risks but also liquidity and 

interest rate and other types of risks. And so the spreads they were 

charging on these products were not necessarily the same as would 

be implied by the credit rating agency. 

Senator, if I could just say one word about Basel, I would be very 

grateful. It is simply not the case that Basel II is about lowering 

credit standards. It is about making the banking system safer, not 

less safe. 

Senator SHELBY. I did not say credit standards. We are about 

capital. 

Chairman BERNANKE. Capital standards, I am sorry. Capital 

standards, thank you. 

The system we have now, Basel I, was designed 20 years ago for 

a very different kind of banking world. Banks are far more obligated. They use much more off balance sheets types of operations. 

The existing Basel I Accord, as the GAO study that just came 

agrees, and as the international banking community strongly 

agrees, is not safe for the largest and most sophisticated international banking organizations. 

And so it is not a question of going to lower capital standards. 

It is a question of finding a new system that will provide capital 

on a risk-adjusted basis that will match the capital against the 

risk, and therefore make these banks safer not less safe. 

So we take a backseat to nobody in the importance of making 

sure that these banks are safe and sound. That is our primary objective. And we believe that making this change to Basel II will increase, not decrease, the safety of these banks. 

In addition, of course, in any change from one system to another 

there is going to be a period of uncertainty as we work through the 

new methods and so on. And so we have been very careful to include a wide variety of protections including, as you know, the leverage ratio, prompt corrective action, the transition floors, Pillar 

II, a wide variety of things that will make sure that we have the 

control that we need to begin to see any unsafe drops in capital, 

we can make the changes to ensure that the banks are operating 

safely and soundly. 

So, I would just very strongly urge you to consider that Basel II 

is not about lowering capital, it is about making banks safer. 

Senator SHELBY. But some banks believe it is about lowering 

capital. There has been a lot of stuff written about it. At the end 

of the day they said it would free up their capital, in other words 

lower the capital. That is some of our concerns. 

Chairman BERNANKE. What they are referring to is situations, 

there are situations where banks under the old system are forced 

to hold a lot of capital against which is essentially very safe assets. 

That part of the capital is excess capital. One of the problems they 

face is that foreign banks that do not have as much capital against 

these very safe assets will be able to just come and take that business away because they do not cost as much. 

21 

So against a safe asset and one whose risk is appropriately calibrated, it seems to me appropriate to reduce capital. But against 

risky assets, we need to have enough capital to ensure safety. 

Senator SHELBY. We want to make sure our banking system is 

strong. We have a great banking system. And we do not need to 

weaken the pillars in any way. 

Mr. Chairman, thank you. 

Chairman DODD. Thank you, Senator Shelby. Senator Brown. 

Senator BROWN. Thank you, Mr. Chairman. 

Chairman Bernanke, your response to Chairman Dodd about 

China, I appreciate your talking in terms of broadening the discussion beyond currency, Chinese savings, their domestic economy. 

You have talked in the past about intellectual property as you 

should. I would also implore you in the future, if you would, to also 

bring in labor issues in terms of slave labor, in terms of child labor, 

in terms of fair labor practices. We discussed that back several 

months ago when you were here, on international labor organization standards. 

I hope that your broadening the discussion of the issues with 

China trade and our trade in our bilateral trade deficit which, in 

my first year in Congress in 1992 when I ran, was in the low double digits with China. And today is way in excess of $200 billion. 

As you know that, without prodding, would include labor issues in 

this discussion. 

I would like to switch with a couple questions on the whole issue 

of the subprime loans. I appreciate your willingness to act under 

the HOEPA authority this year. I think the progress you have 

made is generally good. We would obviously like, if possible, for you 

to move a little more quickly but understanding how things go 

sometimes. 

But a couple of questions. With the closing fees that people pay, 

it seems that the prepayment penalties, it seems to me do not seem 

that necessary from the investors standpoint. They seem more designed to lock people into bad loans. Wouldn’t the better protection 

for lenders be to offer a fair loan in the first place rather than the 

prepayment penalties? 

Chairman BERNANKE. Senator, we are looking at that very carefully. Our subprime mortgage guidance, which has already been 

issued with the other banking agencies, takes the position that prepayment penalties should not extend into the period where the interest rates reset. So they should not prevent people from refinancing when their industries are about to go up. We are looking 

at that specifically as part of our HOEPA rules, as well. 

I agree with you, there are situations where prepayment penalties are not in the interest of the borrowers and we are looking 

at those. 

Senator BROWN. Are those just guidelines or are those actually 

requirements? 

Chairman BERNANKE. They are requirements. That is, they are 

enforced by examination and supervision of the banks. But the 

subprime guidance, which is a collaboration of the four banking 

agencies, applies only to banks and thrifts and not to lenders outside of the banking system, which is what the HOEPA was about, 

would apply to everything. 

22 

Senator BROWN. If this is about investors protecting their interests, as it should be in part, doesn’t failure to escrow create the 

very risk that prepayment penalties allegedly guard against? 

Chairman BERNANKE. That is another issue that we heard a lot 

about in our hearings in June. It also is covered in the subprime 

guidance and is also one of the things we are looking at very carefully for our rulemaking. 

Senator BROWN. How are you approaching the determining of 

borrowers ability to repay a loan? You emphasize the importance. 

Are we setting standards on that level, also? 

Chairman BERNANKE. Once again, there is some reference to that 

in the subprime guidance, the idea being there that the loan should 

be underwritten at the fully indexed rate, that is that the rate once 

the adjustable resets have taken place. 

I should say though, particularly from the perspective of writing 

a rule, we are going to do our very best. But it is hard to put into 

a rule exactly what criteria one would use in order to decide whether a loan is affordable or not. But we are going to do our best. 

In particular, we are going to look at the question of underwriting to the fully indexed rate. And also, ask ourselves whether 

or not there can be guidelines in terms of demonstrated payment 

ability or demonstrated income that we related to the payments 

under the mortgage. 

Senator BROWN. But there are some things, understanding the 

difficulty of writing a rule to conclude everything, but there are 

certainly some things, no doc loans, better disclosures, so people 

understand in readable large print, if you will, on the first page 

what this loan is going to cost, what their adjustable rate could be 

in worse case scenario. All of those absolutely could be included; 

right? 

Chairman BERNANKE. These are all on our agenda. The top page 

of the mortgage documents that you are alluding to is part of our 

Regulation Z review which will cover all home mortgage advertising solicitation and disclosures. 

One concern we have about that is just that in the past these 

disclosures have been written by lawyers sitting in an agency. And 

when we put them out, the public does not understand what it 

really means. And so if you are going to have effective disclosures, 

they have to be done in a way that ordinary people can understand 

what the implications are. 

And for that reason we have, for the Government at least, been 

very innovative in making sure that all of our disclosures are being 

consumer tested and focus group tested. And we are making sure 

that people really do understand what the disclosure is telling 

them. I think that is critical if this is really going to be effective 

and not just a cosmetic step. 

Senator BROWN. And you can write that prescriptively in your 

rule? 

Chairman BERNANKE. We can prescribe the form, yes. 

Senator BROWN. In several of the answers, and I appreciate your 

answers, you spoke in terms of it is on your agenda. A skeptical 

look would say that implies some inertia. Are you pleased, personally, with the speed at which you are doing this? Chairman Dodd 

has talked about and Senator Shelby has talked about with a numVerDate Aug 31 2005 10:51 Jan 29, 2009 Jkt 046629 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 S:\DOCS\46629.TXT JIMC
23 

ber of resets in the next couple of years and the number of people 

who are going to lose their life savings every week, every day, 

every week, every month. Are you satisfied you are moving as fast 

as you can? 

Chairman BERNANKE. I believe that we are moving as fast as we 

responsibly can. We have to do it right. We have to make sure the 

disclosures, for example, are actually of value. And we have to follow, of course, the rules and regulations associated with how an 

agency makes rules. Congress has told us what steps we have to 

take and we have to follow those steps. 

I would say to you, Senator, if you feel that the regulatory process is too slow the only remedy I can think of is for Congress to 

act directly. 

Senator BROWN. We always move fast enough, too, Mr. Chairman. 

Chairman BERNANKE. I understand. 

Senator BROWN. Thank you. 

Chairman DODD. Let me just say in that regard, Mr. Chairman, 

before I turn to Senator Reed here, my hope would be that you— 

and I am sure you will—keep us posted on the progress of this. I 

had a chance to speak with the Chairman a day or so ago about 

the very matter that Senator Brown has raised here. My hope is 

that you would give us a commitment to come back to the Committee once the regulation comes out to discuss it with the Committee, we would have a strong interest. I see your head nodding 

affirmatively. 

Chairman BERNANKE. Yes. 

Chairman DODD. I appreciate that response, as well. It will give 

us a chance to move on this. 

Senator Reed. 

Senator REED. Thank you, Mr. Chairman. And thank you, Chairman Bernanke. I want to return to the topic that I broached in my 

opening statement and Senator Shelby addressed. And that is the 

issue of the valuation of CDOs. What you have is an illiquid market, basically. There is a thinly traded, very complex instruments, 

asset valuation is difficult to determine. As a result, what we have 

is something described as mark to ratings. Senator Shelby alluded 

to that. 

How comfortable are you with this approach? What are you doing 

specifically to engage the rating agencies to ensure that they are, 

and the originators of these products are, valuing their assets accurately? 

As I pointed out in my opening statement, there seems to be a 

growing wave and realization that these assets are overvalued. 

Some people have suggested billions and billions of dollars. What 

appears to be the motivating factor in the workout of the Bear 

Stearns funds was the extreme reluctance to try to have the market evaluate these assets and that would cause a value of mark to 

market for everything else they held and probably through the 

whole system. This is potentially a very serious problem. 

So specifically what are you doing with the rating agencies and 

the originators of these products to make sure they are valued effectively? 

24 

Chairman BERNANKE. The Federal Reserve does not have any 

specific powers or responsibilities regarding the rating agencies 

themselves. What we are doing is working with our banks that we 

supervise to ensure that they are safe and sound and that they are 

doing due diligence in the types of assets that they purchase or the 

types of assets they themselves securitize and resell. So our perspective is protecting the safety of the banking system. We do not 

have broader authority to dictate how these assets are created. 

Senator REED. Should someone have the broader authority to do 

that? I mean if we assume, as I think you perhaps might, that the 

market will not evaluate these assets accurately because they are 

so thinly traded, difficult to understand, it falls upon a rating agency. And if the rating agency, if there is no supervision, is there a 

gap? 

Chairman BERNANKE. No, I think the market will find solutions. 

They already are finding some. For example, even if the individual 

instruments are not particularly liquid, there are indices that are 

based on the payments from CDOs or CLOs which are traded and 

therefore give some sense of the market valuation of these underlying assets. 

So this is a market innovation. Sometimes there are bumps associated with a market innovation. I think we just have to sit and 

see how it works out. There are very strong incentives in the market to change the structure of these instruments as needed to make 

them attractive to investors. 

Senator REED. Let me change gears just slightly. You alluded to 

it, not the CDOs but the CLOs, the collateralized loan obligations, 

essentially derivatives of corporate debt. There has been a lot of 

discussion that it is very easy now to go out in this market and 

to prop up companies that do not have the ability to borrow directly. And that the underwriting standards have slipped a bit because the banks who typically do the underwriting do not hold the 

product. They move them out very quickly in these complex secondary markets. 

First, can you comment on the underwriting standards for the 

corporate borrowing? Are they loosening to a degree that could— 

Chairman BERNANKE. Recently, I think they perhaps tightened 

a bit, actually, because of some concerns that were initially prompted by the subprime mortgage lending issues. 

Again from the Federal Reserve’s perspectives, our principal concern is the safety and soundness of the banking system. What we 

have done recently is work with other regulators such as the SEC 

and the OCC and, in some cases also with foreign regulators, the 

FSA in the United Kingdom for example and German and Swiss 

regulators, to do what we call horizontal reviews which is that collectively we look at the practices of a large set of institutions, both 

commercial banks and investment banks, to see how they are managing certain types of activities. For example, the financing of leveraged buyouts, abridged equity and the like. And trying to make 

an evaluation of what are best practices, trying to give back information back to the companies and trying to use those reviews to 

inform our own supervision. 

And so we are very aware of these issues from the perspective 

of the risk-taking by large financial institutions and we are studyVerDate Aug 31 2005 10:51 Jan 29, 2009 Jkt 046629 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 S:\DOCS\46629.TXT JIMC
25 

ing them, trying to provide information to the institutions themselves, and using them in our own supervisory guidance. 

Senator REED. Are you confident that you can identify and monitor these risks posed by CLOs? And in a related point, do you anticipate seeing the same phenomena in the CLO market that we 

have seen in the CDO market, a bump? 

Chairman BERNANKE. It is not our expertise to directly say that 

this deal is a good deal and that deal is a bad deal. What we try 

to do is make sure that the banks and the investment banks themselves have good controls, have good models, have good approaches, 

have good risk management so that they can make what we believe 

to be, in general, appropriate decisions about these instruments. 

Senator REED. Let me shift gears again, Mr. Chairman, to try to 

cover a lot of ground. We have witnessed all a booming housing 

market until very recently. As your predecessor, Chairman Greenspan, opined in many homes their increasing equity valuation was 

an ATM that they could go to without leaving the house. 

Current estimates are that equity withdrawals are down precipitously, 70 percent from 2005. What is your view of the macroeconomic effect as people can no longer essentially use their equity 

as a quick source of cash? 

Chairman BERNANKE. Taking equity out of a home is one very 

convenient and sometimes tax favored way of getting at your assets 

essentially. That explains the tremendous increase in that type of 

cash out refinancing and home equity loans. 

Our sense though, and so far this seems to be borne out by the 

data, is that consumers respond to changes in the value of their 

home essentially because there is a change in their wealth not because there is a change in their access to liquid assets. So there 

is probably something on the order of between four cents and nine 

cents on the dollar of an effect on consumer spending when home 

values decline. So that is one of the things we are looking at. 

It should be pointed out that by, I think, the most reliable indices that house prices nationally speaking have not declined. They 

have only risen more slowly. So we have not yet seen anything, except in a few local areas, akin to a decline in house prices. So 

again, we have not seen a significant effect on consumption. We are 

watching it carefully. Once again, I think the so-called ‘‘wealth effect,’’ the effect that the value of the home has on the consumer’s 

overall wealth is probably the principal relationship between house 

values and consumer spending. 

Senator REED. Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much, Senator Reed. 

As colleagues are coming in here, so my colleagues are aware, 

Senator Bunning has arrived. We will then turn to Senator Menendez, then Senator Allard. Senator Schumer has come back and then 

Senator Carper and Senator Bayh have joined us, as well. I thank 

you for being here. 

Senator Bunning. 

STATEMENT OF SENATOR JIM BUNNING 

Senator BUNNING. Thank you, Mr. Chairman. 

First of all, I would like to enter my opening statement into the 

record. 

26 

Chairman DODD. All statements, by the way, will be included in 

the record and we will leave the record open for a day or so for 

other questions. 

Senator BUNNING. I figured that. 

I do not want to go over old business but I have to because everybody looked at the past Fed Chairman and the past Fed’s oversight 

of the banking industry and what happened in the subprime area. 

The banks all looked very good when you looked at their bank 

statements. But what happened is that those mortgages, ARMs, interest-only loans were sold off. And therefore the bank statements 

all look clean. 

But where we found we had a problem was that they were overextended, a lot of people were overextended. Instead of buying a 

$400,000 home it should have been a $200,000 home. Instead of an 

interest-only loan, it should have been a 30-year mortgage and on 

down on the line. That did not show up on the Fed’s record but I 

do not think the Fed went far enough. 

Do you have the capability of going far enough now to see what 

happens to the loan after the bank sells it off? 

Chairman BERNANKE. Again, our interest in this particular case 

is in bank safety and soundness. And the question: Is there any recourse question? Does the bank have any responsibility for that 

loan? 

Senator BUNNING. All of them had responsibility when they were 

originally taken out. 

Chairman BERNANKE. There are two issues, Senator. One is the 

consumer protection issue and one is the safety and soundness 

issue. On safety and soundness, the question is does the bank have 

financial responsibilities in case the loan goes bad? In which case 

they should have capital against that. This is an example of why 

Basel I does not adequately capture the necessary—— 

Senator BUNNING. That is why we did Basel II. 

Chairman BERNANKE. That is exactly right. 

On the consumer side, the issue is where was the loan made? In 

some cases, the bank simply bought up packaged loans that were 

made somewhere else. And there part of the problem is that it used 

to be that you could only get a loan at the bank or a thrift. Now 

of course, there is a great diversity of lending institutions and it 

is not entirely a level playing field in terms of the oversight of their 

consumer protection. 

Senator BUNNING. Please get to my question. 

Chairman BERNANKE. I am sorry, what is the question? 

Senator BUNNING. The question is does the Fed now have the 

ability to go beyond the original bank and find out what happened 

to that loan when it went sour? In other words, if they sold that 

loan off to a third party and now the people are incapable of making the payments or it was an interest-only loan or there was an 

ARM that popped up after 5 years. 

Chairman BERNANKE. We can follow where the bank initially disposes of the loan. But if it goes through several steps, then we can 

only make general estimates. 

Senator BUNNING. You do not figure that you have a responsibility in that respect? 

Chairman BERNANKE. I do not think we have the authority. 

27 

Senator BUNNING. You do not have the authority but how about 

the responsibility? 

Chairman BERNANKE. Without authority, I cannot be responsible, 

Senator. 

Senator BUNNING. Let me go back to inflation and interest rates. 

In your statement you repeated a line from the June Fed statement 

that says ‘‘A sustained moderation in inflationary pressure has yet 

to be convincingly demonstrated.’’ Those are quotes. What will it 

take for moderation to be convincingly demonstrated? 

Chairman BERNANKE. Our objective is to achieve enduring price 

stability and in particular we want to be sure that inflation remains under good control in the medium run. There are several 

elements of that. One is that I think it is important to recognize 

that the month-to-month inflation numbers are very noisy. And so 

a couple of good numbers does not, by itself, mean that the problem 

is solved and gone away. So part of it is just simply seeing more 

data and getting a greater sense of assurance that the trend is 

really in the direction we would like to see it. 

The other is that as long as there are some very important risks 

out there to inflation, there is the possibility of inflation—even if 

it has come down some—there is the possibility that it will go back 

up in the future. The risks that I talked about in my testimony include high resource utilization, the fact that the economy is working at a very tight use of resources. 

And second, the fact that energy and food prices have raised 

headline inflation. Those prices might feed through into core inflation, they might raise inflation expectations. 

So what we need to see is enough confidence that the risks have 

subsided so that we can feel confident that in the medium term inflation will be well-controlled. 

Senator BUNNING. Last week, you gave a speech and spoke at 

length about inflation expectations. You also said that expectations 

are ‘‘imperfectly anchored.’’ What in the world does ‘‘imperfectly anchored’’ mean? 

Chairman BERNANKE. Senator, it means that expectations as 

measured through various means are not at a fixed number. That 

is, if a piece of news comes in, about, say, employment that longterm inflation expectations move. And what that means is that although the confidence in the Federal Reserve to maintain price stability—— 

Senator BUNNING. Isn’t that in your model when you are looking 

at inflation, all the different things that you put in? 

Chairman BERNANKE. I am thinking now about the very longterm. So if there was complete confidence—let me not overstate. I 

think there is a great confidence in the Federal Reserve that we 

will maintain low inflation in the long-term. But if that confidence 

were complete then people would say oh, this is a temporary movement in the economy but we know that in the long-term inflation 

is going to go back to whatever is the normal level. And there 

would not be much movement in these longer-term inflation expectations when there was a short-term development in the economy. 

Senator BUNNING. But that is exactly what you are trying to do 

every time you meet, is to anticipate—— 

28 

Chairman BERNANKE. We are trying to anticipate it. But in order 

to make sure that inflation in the long-term is very stable. If people 

are saying oil prices have gone up, that not only affects what we 

think inflation is going to do over the next year but it affects what 

we think inflation is going to be 5 years from now. Then that leads 

to the possibility that they do not have complete confidence that 

the Fed to bring inflation back down to a stable level. 

Again, let me not overstate this. I think that we have made tremendous progress over the last 20 years or so in increasing the 

confidence the public has in the Fed’s ability to keep inflation low 

and stable. I am only saying that there is still some imperfect degree in terms of which those expectations are completely tied down. 

Senator BUNNING. Mr. Chairman, we know we are not all perfect 

and we know that the Fed does the best they can. We appreciate 

your service and thank you for being here. 

Chairman BERNANKE. Thank you. 

Chairman DODD. Thank you, Senator. 

Senator Menendez. 

Senator MENENDEZ. Thank you, Mr. Chairman. 

Chairman Bernanke, I appreciate the testimony you have given 

on the subprime issue and the actions. But I am wondering if the 

actions reflect the crisis at hand. I find it hard to believe that 

months of hearings and reviews, a pilot project that will not commence until the end of the year, and guidance after guidance that 

seems to take only small steps, is a swift enough response for a crisis that has led to over one million foreclosures last year and ruined the American Dream of owning a home for too many people 

in this country. 

With all due respect, when, as part of that challenge, we are 

talking about predatory lending, I am not convinced that the proposals the Fed has put forward will be enough to stop predatory 

lenders dead in their tracks. 

I also hope that we have at least prospectively a better monitoring system because it is my personal opinion that, in many respects, the Fed was somewhat asleep at the switch, that we could 

have been more proactive in this process. It seems to me we are 

coming to the table with a plan after a tornado has already ripped 

through a community. 

So, I hope that the one message I think many of our colleagues 

have for you and the Reserve is that you will be as swift and use 

the powers that were given to you under the Home Ownership and 

Equity Protection Act as vigorously as we would like to see you use 

them. I hope that that is both your intent, your mission, and in 

terms of timing within the context of being judicious but not be judicious to the point that we err on the side of being able to protect 

more people in this country. 

I would like to hear your response to that in a moment. Let me 

get my second line of question and give you the balance of the time 

to answer. 

In my mind, I always ask who is this economy working for? Is 

inflation tame or is it still a significant problem? I guess that depends upon where you sit. Consumer prices rose at a moderate rate 

in June with a key factor keeping things under control is collapsing 

clothing costs. They have dropped for the past 4 months. But after 

29 

energy, clothing is probably about the next most volatile component 

in the Consumer Price Index. So, I would not be surprised if sometime soon we see a major increase in prices in that regard. 

In addition, we already know that the pullback in gasoline prices 

in June has been unwound so energy will be adding greatly to consumer woes in July. And then there is food. As you mentioned 

yourself, prices jumped again and since June 2006 food and beverage costs have risen by 4 percent. 

With that, with the ethanol issues that are spiraling through 

food costs, I do not know that we can be looking for relief anytime 

soon, at least if you are looking at it from the context of the consumer. It seems to me that pain for the consumer is still there. 

When I look at household debt in America that has risen to 

record levels over the past 5 years. In the first quarter of 2007, 

household debt relative to disposable income stood at 130.7 percent. That is the third highest ratio on record. That means the average family in America is in debt for over $130 for every $100 it 

has to spend. Compounding this, the average household savings 

rate has actually been negative for the past seven quarters, averaging a negative 1 percent for 2006. 

One last measurement, one measure of this economic insecurity 

that I hear New Jerseyans talk to me about, that I hear other 

Americans talk about, is the percentage of middle-class families 

who have at least 3 months of their salary in savings. That percentage of middle-class families who had three or more months salary in savings rose over 72 percent from 16.7 percent in 1992 to 

28 percent in 2001. But unfortunately, in the span of less than 4 

years that percentage has dropped to 18.3 percent in 2004. 

So, I am looking at this and I am saying to myself so you have 

rising food costs, you have rising energy costs, rising health costs. 

You have stagnant median income for the last 5 years for families 

in this country. You have more debt, the third-highest ratio on 

record, and you have less families in quite some time that have 3 

months and savings or more. Who is this economy working for? 

And is inflation tame or is it still a significant problem? 

Chairman BERNANKE. Senator, you asked a lot of questions. 

Senator MENENDEZ. I have given you a lot of time. I have not 

even used all my time. You can take that and plus the rest of what 

is necessary to answer. 

Chairman BERNANKE. First, on the subprime rules, as I said, I 

asked for a top to bottom review. We looked at every possible 

power that we have. We have examined each one. We have had a 

lot of input, a lot of hearings, and we are moving forward. We will 

move as expeditiously as the process allows, making sure, of 

course, that we do a good job. But we will move forward as expeditiously as possible to try to address these issues. 

With respect to inflation, I agree in the sense that certainly over 

2007 food and energy prices have risen significantly so that the 

overall inflation rate is higher than we would like it to be. Our concern is that high food and energy prices might somehow infect the 

underlying trend of inflation, for example causing people’s expectations—this is Senator Bunning’s question—to rise and become less 

persuaded that inflation will be stable in the long-run. Therefore, 

30 

that is part of the reason why we continue to treat inflation as our 

predominant policy concern. 

With respect to the household financial situation, it is a complicated story. Part of the reason that official saving rates for 

households are negative as that those saving rates do not include 

any capital gains in assets that households may own. So in some 

cases, people have had their homes appreciated, as happened over 

the last 5 years until recently and they took money out, the money 

they took out would count as spending but the appreciation in their 

home would not count the saving. 

So that has been part of the reason that saving has been so low, 

that people have seen increases until recently in their home equity. 

As that situation flattens out—— 

Senator MENENDEZ. But if they took their savings on their appreciation, the only way to do that would be to sell and/or accrue debt? 

Chairman BERNANKE. No, they can make use of some of their 

capital gains by home equity loans or refinancing. 

Senator MENENDEZ. But that would be accruing debt. 

Chairman BERNANKE. I am sorry? 

Senator MENENDEZ. If you take a loan out in order to get to your 

accrued appreciation, now you are going into debt to do that. 

Chairman BERNANKE. But if I have $1,000 appreciation and I take out $500 in debt, I have increased my debt by $500 but I am 

still, on net, $500 better off than when I started. 

Now having said all that, let me just say that I agree with you 

on the issue of consumers needing to build wealth and assets. The 

Federal Reserve manages the Survey of Consumer Finances, which 

is the best available source for family asset building, information 

about family asset holdings. The fact is that the bottom third of our 

population has almost no savings, maybe less than $500. And I 

think that is a very serious problem. We need to find ways to make 

people more cognizant of the need to save, to help them to save, 

so that they can build wealth and that they will have more security 

in case they have, for example, an illness or an unemployment 

spell. 

So your general point that there are many families that do not 

have adequate wealth reserve, I think is entirely correct. 

Senator MENENDEZ. Thank you, Mr. Chairman. 

Chairman DODD. Thank you, Senator. 

Correct me if I am wrong, Mr. Chairman, but the numbers I 

have used, what I am told is that the average household has revolving debt in excess of $9,000, most of that being credit card 

debt. Just to make the point that Senator Menendez is talking 

about, and a negative savings rate. These are very disturbing statistics, if in fact those numbers increase like that. That is just unacceptable, I think. 

Senator Allard. 

STATEMENT OF SENATOR WAYNE ALLARD 

Senator ALLARD. Thank you, Mr. Chairman. 

I have an opening statement I would like to have put in the 

record, if you would, please. 

Chairman DODD. All opening statements will be put in the 

record. 

31 

Senator ALLARD. Thank you very much. 

I want to talk about a little bit about stock market and some of 

the things that are going on there and how you view those. You 

have been getting a lot of articles written about hedge funds and 

private refunds and the like. Are they of much concern as far as 

the Fed is concerned? 

Chairman BERNANKE. Hedge funds and private equity funds and 

other private pools of capital provide some very important beneficial services to the U.S. economy. They represent a way to share 

risks more broadly. Instead of all the risk sitting in the banking 

system, it can be spread through a whole different set of institutions. They provide a lot of liquidity in financial markets. It is easier to buy and sell when the hedge funds are taking part in market 

activity. 

And one other particular area where private equity is valuable, 

it is important for our economy to have an active market for corporate control. That is we need to have some way of putting pressure on poorly managed companies or poor management that will 

create some discipline and improve our economic performance. 

We had LBOs in the 1980s. Private equity is the current manifestation of that. Not all private equity deals are beneficial and not 

all of them work out well, but we do need to have a mechanism 

that strengthens the efficiency of our corporate sector. 

Now are there concerns? There are some concerns. Hedge funds 

in private equity are relatively opaque in terms of seeing what 

their assets are. And they vary considerably in the types of investments that they make. 

Recently, the President’s Working Group issued a set of principles which argue that the best way to control the risk of hedge 

funds and other private pools of capital is through market discipline, by which we mean that the first line of defense should be 

the investors, the counterparties, the creditors, those people in the 

market who have the most to lose if a hedge fund goes bust, for 

example. 

The role of the supervisors is to make sure that banks and other 

counterparties are, in fact, getting the information they need, managing the risk in the way they need to so that should there be any 

problems in a hedge fund that it does not spread more broadly 

probably in the financial system. 

So, I think that is the best way to manage the risks in those 

pools of capital. 

Senator ALLARD. Now has Sarbanes–Oxley contributed to the 

growth of the hedge funds, in your view? 

Chairman BERNANKE. If you are referring to the private equity 

in particular, taking firms private, there is some disagreement 

about that. I think I would point out that private equity is also a 

very big thing in the UK, as well, where Sarbanes–Oxley is obviously not relevant. So, I do not think it is the principal explanation. 

I think that what is happening is that financing is available and 

there are these firms that feel that they can essentially do a better 

job of running certain corporations than the existing management 

is. 

32 

Senator ALLARD. If taxes were applied to these equity funds and 

these hedge funds, would that have an adverse impact on our economy? 

Chairman BERNANKE. I do not want to take a position on particular tax rules. I think I would just point out that hedge funds 

have a lot of international flexibility. They can move around. And 

even if they are based in another place they can still operate with 

U.S. corporations. And so I think there is a lot of international mobility, so to speak, in these institutions. 

Senator ALLARD. This leads me to the next question. We have 

these sovereign wealth funds, apparently. 

Chairman BERNANKE. Yes. 

Senator ALLARD. They are Government Sponsored Entities and 

apparently they are pretty flush with cash right now. How do you 

view them as impacting our economy and our risk in the securities? 

Chairman BERNANKE. I have talked about in the past what I 

called the global saving glut, which is basically the idea that outside the United States there is a huge amount of funds looking for 

returns. That includes reserves of China and other countries that 

have accumulated lots of reserves. But it also includes the profits 

from oil and commodity sales. And that is a lot of where the sovereign wealth funds are based on revenues from, say, oil sales. So 

a lot of that capital is looking for return, is looking for a home, and 

a lot of it is flowing into the United States. 

On net, I think that is beneficial because it provides capital for 

our economy. It does drive real interest rates probably lower than 

they might otherwise be. 

In terms of risk taking, the sovereign wealth funds, for the most 

part, are pretty passive investors. They are not active in switching 

between types of assets. They may sometimes have components 

which are more return-seeking, such as the Chinese, for example, 

have a component of their reserves fund that is more return-seeking. But for the most part they are pretty passive suppliers of capital. 

Senator ALLARD. They are going after security more than anything; is that right? 

Chairman BERNANKE. They are looking for return and, in particular, some of them—the purpose of sovereign wealth funds, in 

many cases, is to take the current windfall and to make sure it is 

available for future generations. So for example, Norway is taking 

its oil profits, putting them into this fund in order to help fund the 

retirement pensions of its citizens. For that purpose, it needs to 

have long-term safe assets. And that is the kind of investment that 

they tend to make. 

Senator ALLARD. Do you feel the free trade agreement between 

the United States and South Korea is having a positive or negative 

impact on our economy? 

Chairman BERNANKE. I am not conversant with any specific elements of that particular agreement, but in general, as most economists do, I think that opening the economy to trade is beneficial. 

It creates new opportunities for trade in both good and services as 

well as opportunities for investment. So as a general matter, I 

think that we should continue to keep our economy open both to 

trade and to investment, keeping in mind that trade and investVerDate Aug 31 2005 10:51 Jan 29, 2009 Jkt 046629 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 S:\DOCS\46629.TXT JIMC
33 

ment—international trade and investment sometimes do create dislocations in the economy and we should be prepared to address 

those, as well. 

But overall, I believe that open economies are more prosperous 

and would therefore support, in general, free trade type agreements. 

Senator ALLARD. Mr. Chairman, I see my time has expired. 

Chairman DODD. Thank you. Senator Schumer. 

Senator SCHUMER. Thank you. Thank you always, Mr. Chairman. 

I would like to return to the issue of carried interest and partnerships, as well. I know you will not take a public position on any 

of these but I have two questions. 

First is the breadth of what we do. In other words, some have 

said we should look at them for hedge funds and for private equity 

funds. But there is carried interest and publicly PTP’s in other 

areas, oil and gas, venture capital, real estate. Does it make any 

economic sense to treat one of these industries differently than the 

other when the broad concept of either carried interest or taxing 

corporate partnerships who go corporate basically extends through 

all of them? Some have talked about singling out financial services 

and obviously I am very concerned about that. 

Chairman BERNANKE. Senator, as you point out, there are two 

different issues. 

Senator SCHUMER. Yes, they are separate issues. 

Chairman BERNANKE. All else equal, I think consistent treatment under the tax code is a good approach. 

The carried interest turns, as you know, on how to divide the returns to hedge fund managers between compensation for services 

and capital gains. And there are a lot of technical issues there. I 

think the Treasury or the IRS might be better at figuring out the 

details of that. 

With respect to partnerships, the issue is whether or not the income can flow through directly to the partners. And the rule is that 

as long as more than 90 percent of the income is ‘‘passive’’ that it 

should. And so I think I see the argument for making the treatment uniform among partnerships. I think the question is defining 

what is passive and making sure we are comfortable with that definition. 

Senator SCHUMER. That would apply to any industry, whether it 

is oil and gas, venture capital, real estate, or financial services. 

Chairman BERNANKE. Yes. 

Senator SCHUMER. So all things being equal, you should treat 

them all the same. 

Chairman BERNANKE. If the underlying economic principles are 

the same and economic sources of income are comparable, then 

that is what is called horizontal equity, treating likes in the same 

way. 

Senator SCHUMER. Exactly. 

The second question I had is the proposals to treat carried interest differently in terms of tax treatment, the same with publicly 

traded partnerships. You know they are out there. And there are 

arguments on both sides. Obviously someone from New York, but 

someone who believes our Government has to raise revenues and 

the highest income people are the appropriate place to raise those 

34 

revenues—those are my beliefs, I know they are not necessarily 

yours. It is the very tough issue. 

One of the things that greatly concerns me is if we were to raise 

taxes in both of these ways, would there be a danger that America 

would decline on a percentage basis, on a general basis, as a financial center? Obviously, that would affect New York dramatically 

and would be of great concern to me. 

Now is that a worry on either of these two issues? 

Chairman BERNANKE. On the case of carried interest, it might 

not affect their activities. But it might affect the location of their 

activities. 

Senator SCHUMER. Yes. That is what I am worried about. If they 

all move to London or the Cayman Islands, I do care about that, 

for some strange reason. 

Chairman BERNANKE. If they are looking for the lowest tax regime, that might be an effect. As I mentioned to Senator Allard, 

if the company moves to London they still could potentially be involved in U.S. investments. 

Senator SCHUMER. No question. But that jobs would be in London. 

Chairman BERNANKE. But the individuals might choose to move 

elsewhere. 

Senator SCHUMER. So it is something to keep an eye on and 

worry about, in your opinion. 

Chairman BERNANKE. It is a consideration. As you pointed out 

initially, I am not taking a position on this. 

Senator SCHUMER. I understand. I am just asking your economic 

views of these things and I appreciate it. 

Next, I would like to go to subprimes. Basically, you mentioned 

today that direct Federal legislation would help speed up the Fed’s 

efforts to fix the problems in the subprime industry. As you know, 

Senators Brown, Casey, and I have introduced proposed legislation 

that would specifically regulate the mortgage broker industry. Our 

bill would establish a fiduciary duty and good faith stands for 

mortgage brokers and other nonbank originators and require originators to underwrite loans at the fully indexed rate, prohibit steering, among other things. 

First, could you give us your thoughts—I am not asking you to 

endorse the specific bill—but on those concepts and whether it 

makes sense? And are these types of proposals some that would 

help the Fed’s efforts to regulate the subprime mortgage broker industry? 

Chairman BERNANKE. There is a whole set of diverse initiatives 

that you are referring to. 

Senator SCHUMER. Can you comment on each of them or any of 

them? 

Chairman BERNANKE. I will try. One issue, as you know, as we 

discussed earlier, is trying to make sure there is an even playing 

field in terms of enforcement and oversight. One suggestion that 

has been made is for more cooperation between Federal and State 

authorities, for example, through to a Federal registry or some Federal licensing. 

The Federal Reserve, as I mentioned, is also trying to increase 

our cooperation with the State authorities. And so there are difVerDate Aug 31 2005 10:51 Jan 29, 2009 Jkt 046629 PO 00000 Frm 00038 Fmt 6633 Sfmt 6633 S:\DOCS\46629.TXT JIMC
35 

ferent ways to approach that issue. That is certainly one thing that 

I think is very important to increase that coordination and cooperation if possible. 

Senator SCHUMER. But if the State resists you, there is not too 

much you can do. 

Chairman BERNANKE. We have backup Federal authority in FTC, 

which is another possible vehicle. 

Senator SCHUMER. They have not been a tiger on—— 

Chairman BERNANKE. As well as the U.S. Attorneys General 

would also have some authority in those—— 

Senator SCHUMER. What do you think of legislation that would 

require this at a Federal level? 

Chairman BERNANKE. Require which? 

Senator SCHUMER. Require, say, regulation of mortgage brokers 

in certain ways so that there is a suitability rule. 

Chairman BERNANKE. In terms of the uniform authority, I think 

one very important question to answer is if you are not going to 

let the States be the primary regulators, what would be the substitute? How would you propose to do that? 

Again, I think at this point my preferred approach would be to 

work with the States because many of the States are, in fact, very 

effective. 

Senator SCHUMER. I am a little confused here. I thought earlier, 

in reference to Senator Brown’s questions, you said that Federal 

legislation would help speed up the Fed’s efforts to fix those problems? 

Chairman BERNANKE. I was referring there to the HOEPA rules 

that we are considering and the other things that we are doing 

under our regulatory authority. We have certain procedures we 

have to follow in terms of putting out proposed rules and taking 

comments and the like. And I was only commenting that while we 

would move as expeditiously as possible, if Congress wanted to 

move more quickly, of course, legislation can override those procedural steps. 

Senator SCHUMER. But much of your authority here is not—you 

cannot force it to happen basically if you have reluctant parties 

that you are trying to exert pressure on; is that correct? 

Chairman BERNANKE. Our HOEPA authority applies to all lenders. We can set rules for all lenders but we do not have the enforcement authority outside of the banks. So finding ways to have better 

cooperation between the Federal and State authorities, I think, is 

a useful direction. 

Another thing you have mentioned I know, and we have discussed this before, is counseling. I think that the Federal Reserve 

itself, the Reserve Banks around the country, are partnering with 

nonprofit agencies that do counseling. I, myself, have visited with 

some nonprofits that do counseling. It is not a panacea, in part because not all counselors are effective and so on. But it can be helpful and it is something to be kept in mind. 

With respect to suitability, this is, I think, a very tough issue. 

It has to be done in a way that will not essentially drive away interest in this market. One way of thinking about suitability—let 

me take a step back. 

36 

If you think of suitability as requiring the lender to pick the very 

best of the dozens of products available for the borrower, that may 

be setting a standard which is not actually viable. Perhaps another 

way of thinking about it is equating suitability with affordability. 

Senator SCHUMER. That is what we do. 

Chairman BERNANKE. And essentially saying that there is some 

presumption that the lender will appropriately take into account 

ability to pay in making the loan. And that itself turns to some of 

the things that we are trying to think about under our HOEPA authority, which is whether or how to require underwriting to the 

fully indexed rate and how or whether to require more documentation than is currently required about ability to pay, for example, 

and what standards one might set in terms of linking ability to pay 

to the monthly payment. So those are some of the issues. 

Senator SCHUMER. So we are somewhat on the same page on 

some of these things. 

Thank you, Chairman Bernanke. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you, Senator Schumer. 

Let me thank Senator Schumer for his comments on the issue of 

these matters affecting the carried interest and other issues. As 

Chairman of the Committee, I share some of his concerns about 

that, in terms of there being an equitable application of these 

issues here, and that we understand the full implications of what 

may be occurring here. You have raised them very, very well. And 

I think it is something the entire Committee would want to express 

an interest in. 

So as we look at these issues here we may, at some point, Mr. 

Chairman, want to ask you to participate and ask you—I realize 

it is a bit—and you point out that the IRS and Treasury may be 

a more appropriate place to look but obviously your expertise and 

thoughts on this could be helpful as well, as we consider the implications of all of this. 

But I thank Senator Schumer for his points. 

Senator Bennett. 

STATEMENT OF SENATOR ROBERT F. BENNETT 

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

Chairman Bernanke, welcome. 

I have two issues I want to pursue with you and get your 

thoughts on, but I want to make just an observation prior. 

I have been on this Committee now for over a dozen years. And 

we see the pressure going one way and then the other. First, the 

requirement on or the desire on the part of Members of this Committee to make capital available to the people that are poor. We 

have to do everything we can to make capital available to them and 

push in the direction. No, you are holding capital just for the rich. 

You have to make it available to the poor. 

Then when we get into the subprime problem, I understand, at 

least on the House side, there is legislation to hold the lender responsible for the fact that they pushed money at people who could 

not afford to pay it. And now that the homes are being foreclosed 

on it is the lender’s fault and we have to punish the lender for 

making the capital available in the first place. 

37 

It is an interesting pendulum to watch it swing back and forth 

in this debate. I hope we do not end up saying to the counselor, 

the counselor is liable if the counselor said you should make this 

deal rather than that deal and then the counselor has to pay the 

damages if, in fact, there is a problem and the people cannot pay 

their mortgage. 

The two issues I want to talk to you about are labor and housing. 

In my home State of Utah, the unemployment rate is two-pointsomething percent and the something does not really matter. When 

you get down that low it is a very, very serious problem. We have 

a labor shortage. 

Nationwide the unemployment rate is at levels approaching historic lows. I would like your reaction to that problem and what it 

might do with respect to inflation. Your predecessor, Chairman 

Greenspan, talked about tight labor markets and the impact of that 

on inflation. 

Productivity is going up so we have to have a different historic 

benchmark on unemployment figures. I was taught in college that 

6 percent was full employment, that you got below 6 percent and 

you were facing serious inflationary pressures. Interestingly 

enough, at the height of the last recession the unemployment was 

in the 6 percent range. And now we are at 4 percent or something. 

So, I would like your comment on that. 

And then on housing, the housing bubble has the potential, in 

my view, of triggering an economic downturn just as the dot-com 

bubble that we were all excited about and thrilled about in the late 

1990s triggered the recession that began in 2000 as that bubble 

started to burst. Everyone was delighted to see his house value go 

up, particularly if he did not have to buy a new one. And you referred to the number of people who took home equity loans and 

went out and went on a spending binge. Now the housing prices 

have flattened, if not fallen, in many areas. There has to be a 

shakeout just as there was a shakeout from the dot-com bubble 

there has to be a shakeout from the housing bubble. 

Look into your crystal ball and see if it is, in fact, going to create 

an economic downturn? If so, any ideas as to how severe or when? 

I know you do not make those specific prophecies and I am not 

asking you to. But just in a general term what you might see as 

the housing shakeout works its way through the economy. If you 

could address those two, I would appreciate it. 

Chairman BERNANKE. Certainly Senator. 

Just one word on your initial comment. I agree with you that legitimate subprime lending is beneficial. It gives people access to 

homeownership and access to credit. 

So the real trick for us is to write rules, to write regulations that 

will screen out the abusive practices and the improper practices 

while preserving this market. I think that is a very challenging 

task. 

Senator BENNETT. If I just might, a witness in a previous hearing 

said not all predatory lending is subprime. 

Chairman BERNANKE. That is correct. 

Senator BENNETT. And not all subprime lending is predatory. 

Chairman BERNANKE. I agree entirely. 

38 

On labor shortages, there is, I think, a very strong demand in 

this country for skilled workers. In particular, we hear from our 

contacts around the country how difficult it is to find people, not 

just Ph.D.’s, but people who are familiar with plumbing and welding and other kinds of what we used to think of and still think of 

as blue-collar type occupations. And so I think there is an enormous opportunity here, if we can help people acquire those skills, 

to help them obviously but also to lower the unemployment rate 

that the economy can sustain because we will change unskilled 

workers into people who can fill these spots. I think that is very 

important. 

With respect to the effect on inflation, the way I think about this 

is that the economy at a given time has a certain amount of normal 

potential output. If the Fed is too easy or other factors lead to increased aggregate demand, and that demand is exceeding the supply essentially, then you can get inflation pressures. And so the 

challenge for the Fed is always to balance supply and demand, to 

think about whether or not the level of demand that we are generating with our interest rate policies and with other policies, Government policies for example, is consistent with the underlying 

supply. 

It is not so much that a given level of employment is per se inflationary. But if the economy is overheating, one might see a temporary dip in unemployment reflecting the extra resource utilization associated with it. 

So we do not have a magic unemployment rate that we look at, 

say, that is too low or too high. What we try to do is look at the 

whole economy, look for sources of price pressure. Are firms finding 

it easy to raise prices? Are there indications that markets are very 

tight, both at the labor level and the product level? And we try to 

make a judgment about the balances of supply and demand and 

that helps to govern our thinking about this. 

The labor market, you mentioned 6 percent. The labor market 

changes a lot over time in terms of demographics, in terms of skills 

and education, in terms of job finding through the Internet and so 

on. And so that number is not a fixed number. We always have to 

think about how it might be changing over time. 

With respect to housing, I talked about that quite a little bit in 

my testimony. There is, at this point, a pretty substantial overhang 

of unsold new homes. So even if demand stabilizes, as we think it 

will soon, there is going to be a period of weakness as builders 

work down those inventories and reduce their construction. 

Housing has been subtracting from GDP growth over the last 

year about a percentage point. If demand stabilizes and builders 

begin to work down those inventories, we think that the drag, 

while still negative, will begin to diminish over time. And so that 

effect will begin to moderate. 

In the testimony we do mention housing as a downside risk. It 

is, of course, possible that declining housing values will cause consumers to spend less. It is possible that it might lead to fewer construction jobs. That might also have effects on the economy. 

But to this point we have not seen significant spillovers from the 

housing sector into other parts of the economy. Most of the rest of 

the economy is functioning at a pretty strong level. But that is obVerDate Aug 31 2005 10:51 Jan 29, 2009 Jkt 046629 PO 00000 Frm 00042 Fmt 6633 Sfmt 6633 S:\DOCS\46629.TXT JIMC
39 

viously something we are very alert to, the possibility that the 

housing slowdown might have implications for other parts of the 

economy. 

Chairman DODD. Thank you very much. 

Senator Bayh. 

STATEMENT OF SENATOR EVAN BAYH 

Senator BAYH. Thank you, Chairman Dodd. And thank you, 

Chairman Bernanke, for your presence here today and for your 

service. 

I, too, have a keen interest in some of the issues that have been 

raised today, particularly the currency valuation issue in China, 

which tends to have an impact on our manufacturing sector, which 

is concentrated in the Midwest. And also in the housing issue, 

which is having a tremendous impact on my home State right now. 

But I think that territory has been pretty thoroughly covered here 

today, so I will perhaps focus on some other things but I did not 

want anyone to think that my lack of questioning in those areas 

evinced any disinterest. 

This is, of course, the beginning or we are well into a political 

season and I do expect you to answer any political questions. But 

they are going to be a number of issues debated over the next year 

that are going have a pretty profound impact on the course of the 

American economic and financial policy. So, in general terms, I 

would like to raise a couple of those and get your take on them if 

that is OK. 

Our economy has done pretty well over the last decade or two, 

in terms of the macro level of growth. But there is a growing belief 

that the benefits of that growth have been disproportionately concentrated in the hands of the top 1 percent or so of the American 

people. There is at least one candidate who points out that about 

50 percent of the wealth generated over the last couple of decades 

has gone to the top 1 percent in our country. 

So my question to you is are there things that can be done to try 

and more equitably distribute the fruits of the growth that our 

economy has been generating into the hands of the middle class in 

this country? 

Chairman BERNANKE. Senator, this is a very hard problem because it touches on almost all the other problems that we address 

as a country. I think you could break down the lack of progress of 

the middle class, if you like, into several different factors. One is 

this very long-term movement toward inequality and wages which 

has arisen partly because of technological change which favors 

higher skilled workers, to a lesser extent because of globalization. 

That is a long-term trend that has been going on for 30 years. That 

is one factor. 

A second factor which I think is probably temporary and I am 

not sure what can be done about it in any case, is that over the 

last few years profits have been very high and so there has been 

somewhat of a shift between capital and labor income. In the past, 

those things have corrected themselves. I am not sure that is a policy issue at this point. 

A third factor is the cost of energy and the cost of health care 

which—— 

40 

Senator BAYH. Can I interrupt you for just a minute, Mr. Chairman. 

Chairman BERNANKE. Sure. 

Senator BAYH. So you say in the past that the rewards to capital 

versus labor has tended to correct itself. If we are living in an era 

of more rapid rates of innovation, might that not lead it to correct 

perhaps not quite as quickly as in the past? 

Chairman BERNANKE. We, of course, had many areas of rapid innovation in the past and it is just one of the long-standing economic irregularities that the share of capital and labor tends to 

stabilize over time. We saw in the 1990s, for example, that capital 

went ahead of labor for a while during the productivity boom and 

then labor began to catch up again. 

So, I do think that we will see a more normal—— 

Senator BAYH. I do not want to use all my time on this question 

and I apologize for interrupting. We are not for redistributing 

wealth overtly. But to judge at least by the first part of your answer, if the economy is rewarding more highly skilled parts of the 

labor force better, then perhaps a focus on education, access to college, and those kind of things might empower the middle class to 

enjoy a larger share of the wealth. 

Chairman BERNANKE. I agree entirely. The way I was trying to 

answer your question was here are some of the major things that 

are explaining and they all tie into these major issues, particularly 

this inequality. I do believe that education, in a very broad sense— 

not just K–12 and college—but on-the-job training, vocational 

schools, technical schools, junior colleges, community college, a 

whole variety of mechanisms can be used to give people higher 

skills to meet the kind of demand for workers that Senator Bennett 

was asking me about. 

I think that is a very important part of trying to reverse this increasing inequality in wages. But there are some things like energy 

policy and health care policy that the cost of those things have subtracted from the gains that families otherwise would have enjoyed. 

Those, themselves, are very important issues. 

The other thing I would mention is that there is a perception of 

greater economic insecurity, not just the level of income but that 

your tenure is not as long in a particular job, for example. There 

is some evidence of that. I would have to say it is not overwhelming evidence but there is some evidence that people spend a 

somewhat shorter period of time at a given job. Some have argued 

there is a little bit more volatility of income year-to-year than there 

was in the past. 

Part of the response of the political system to the public to try 

and reassure them about these huge forces of globalization and 

technology which are taking place is steps to try to increase or reduce the feeling of insecurity. Ways to do that include, for example, 

trying to make health care and pension more portable between jobs 

so people do not feel that if they lose their job they lose everything. 

There might also be more creative ways to structure unemployment 

insurance to help people move from one job to another, to acquire 

necessary training, and so on. 

So there are a lot of creative policies out there that could be considered. But I guess my bottom line is that this issue of income 

41 

stagnation is really a multifaceted thing. It ties into almost all of 

these other big issues. And so a single magic bullet is probably not 

there. You have to address the different components of it. 

Senator BAYH. Let me ask you about another component. As you 

are aware, we continue to face some deficits with the aging of the 

population, particularly on the health care side, that is going to exacerbate it. We will have to deal with that from the spending point 

of view. Perhaps there are revenue issues that come into that, as 

well. 

One of the issues that will be debated over the course of the next 

year and several months is going to be tax policy. So in my remaining 37 seconds, I will try to pose two questions to you and I hope 

you will address them both. 

How would you explain to an audience of middle-class Americans 

that is experiencing the economic anxiety that you just mentioned, 

that we tax income up to a marginal rate of 35 percent but capital 

gains and dividends at a 15 percent rate? How would you explain 

to them that that is an equitable tax policy? That is number one. 

Number two, there are some proposals out there to focus on the 

top 1 percent or so as a way to reduce the deficit, or to fund education initiatives that you just pointed out are important, or health 

care initiatives, that thing. Some people argue that that will have 

a drag effect on the economy. 

I think that argument was made back in 1993, the last time 

rates were raised in the top brackets. In fact, the economy did very 

well. 

So if you could address how do you explain to middle Americans 

the disparity between how we tax income versus capital gains and 

dividends on the one hand? And second, what would the likely effect on the economy be of looking at the top 1 percent, given the 

history in 1993 and the effect or lack thereof that that had at that 

point in time? 

Chairman BERNANKE. Senator Bayh, I hope you can appreciate 

my position as the head of the nonpartisan central bank that I do 

not want to take—— 

Senator BAYH. I am asking in a purely theoretical context, Mr. 

Chairman. 

Chairman BERNANKE. A theoretical question. I will make a couple responses. 

One, the tax code overall, the general progressivity of the tax 

code has not changed radically. On the one hand, you mentioned 

35 percent. At one point, of course, the top marginal rate was 28 

percent 20 years ago. We have also seen a lot of credits for—so 

forth and so on. 

Senator BAYH. Here is what we have going on. Forgive me for interrupting your thoughts. 

That is all true. We now tax capital gains and dividends at 15. 

As you pointed out, given the trend in the economy, it skewed the 

returns toward capital a little more than labor. And yet there is the 

difference in the tax rates, even though on labor it was much higher in the past at the top marginal rate. 

Chairman BERNANKE. To answer your question, what a defender 

would say is that there are both equity and efficiency arguments 

for differential taxation. The equity argument is much capital inVerDate Aug 31 2005 10:51 Jan 29, 2009 Jkt 046629 PO 00000 Frm 00045 Fmt 6633 Sfmt 6633 S:\DOCS\46629.TXT JIMC
42 

come is also taxed, for example, at the level of the corporation. The 

efficiency argument is that in order to promote saving and risk-taking and investment it is better to put a lower tax on capital income. 

And then your concern about the differential between labor income and capital income is an argument that would be made on 

the other side. So it is a very long-standing debate in economics. 

Senator BAYH. And about the likely grow effect of changing the 

marginal rate on the top 1 percent, given the experience after 1993, 

the last time that was done? 

Chairman BERNANKE. After 1993 there was a lot of things happening besides changes in fiscal policy. 

Senator BAYH. There always are. 

Chairman BERNANKE. Let me say something which I think is objective or at least as objective as can be, is that the studies that 

have been done of the revenue benefits of the very top rate suggest 

the revenues are pretty small from doing that. 

So if you want to have a substantial revenue impact, you would 

probably have to go down somewhat further than 1 percent. So 

there really is a question of trading off the revenue versus whatever efficiency benefits might be involved. 

I cannot give you a precise estimate of what—— 

Senator BAYH. On the marginal effect on growth. 

Chairman BERNANKE. —the marginal impact. I do believe as a 

general matter that there is some trade-off. As you raise marginal 

tax rates, you do tend to get a less efficient economy. But the exact 

trade-off, economists have not really pinpointed it precisely. 

Senator BAYH. Thank you, Mr. Chairman. 

Chairman DODD. Thank you, Senator. 

I do not know if I heard you, in response to Senator Bayh’s excellent questions, mention the statistics you cited that have been 

highly quoted now and frequently quoted in your Omaha, Nebraska, speech back earlier this year, something that I have repeated over and over again to people, and that is the declining 

number of union households in the country as also being a major 

factor in what has happened in income disparity. 

I thought it was very interesting statistics, just looking at the 

data at what had happened. And of course, knowing that a lot of 

those gains that the middle-class acquired were not necessarily 

given out freely but negotiated rather extensively and intensively 

to produce the incomes, the working conditions, the hours, and so 

forth that raised those levels so that people moved into that income 

category that allowed them to purchase and to do the other things 

that middle-income people have historically done. 

You may have mentioned that and, if you did, I may have missed 

it. But I thought it was a very worthwhile observation you made, 

among others, as to what had happened over this gap that has 

grown now 82 years. Great questions. 

Senator Carper. 

STATEMENT OF SENATOR THOMAS R. CARPER 

Senator CARPER. Thanks, Mr. Chairman. 

Chairman Bernanke, welcome. It is good to see you again. Thank 

your coming and joining us today, and for your service. 

43 

Others have asked about the subprime mortgage market. I want 

to just touch briefly on that as we start out here. 

Yesterday, we tried to have a hearing in this same room on FHA 

reauthorization. In my opening statement yesterday, I mentioned 

that if you look at the increase in the subprime mortgage market 

it really mirrors the decrease of FHA’s market presence for 

subprime lending. 

The Administration has come to us with the recommendation, a 

series of recommendations, on how to change things in the FHA 

program. I just wanted to ask if you have any thoughts on what 

might be an appropriate course for us? 

Chairman BERNANKE. The FHA’s market share is declining quite 

radically, as I am sure you know, down to about 3 percent. 

Senator CARPER. Actually, I think they reported it about 6, down 

from about 14 to 6 just in the last couple of years or something like 

that. 

Chairman BERNANKE. So there is clearly less reliance on the 

FHA than in the past. My sense is that part of the problem is lack 

of flexibility, costs of dealing with the FHA, lack of diversity of 

products and so on. So, I think that modernizing the FHA and trying to make it more responsive, easier for ultimate lenders to work 

with and so on, might reverse this trend and might give the FHA 

a larger share in the market which could be a positive thing. 

I guess I would point out that the FHA, if I remember correctly, 

still has a fairly high delinquency and default rate and it has not 

solved the problem of delinquencies and so on. 

And so as those changes get made, I would suggest moving with 

some caution to make sure that we do not create yet another 

source of problems in terms of inappropriate loans for specific borrowers. 

So, I do see a case for trying to make the FHA more modern and 

to expand its role. But I would urge some caution and go slow on 

that. 

Senator CARPER. Thank you. 

When you were before us, I believe a year or so ago, I raised the 

issue of concern expressed by domestic auto manufacturers with regards to alleged manipulation of currency by not China but by the 

Japanese. I think you indicated in your response that as far as we 

can tell, at least since the earlier part of this decade, the Japanese 

have not been manipulating their currency. 

Since that time we have had a huge debate here in the U.S. Senate about whether or not we should raise fuel efficiency requirements for cars, trucks, and vans built in this country, to do that 

over the next 13 years or so. The domestic auto industry has come 

back to us and said please do not raise CAFE standards dramatically. If you do, you will push us closer to being out of business. 

They said do something about the Japanese currency manipulation. They said do something about our legacy costs, particularly 

health costs for employees and for pensioners. And they call on us 

to provide some Federal investments in plants, in their plans to enable them to move toward flexible manufacturing where they would 

make more than just one or two products in a plant. 

I am not going to ask you to comment on all of those but I would 

be interested in your thoughts again on alleged manipulation by 

44 

the Japanese of their currency. A year ago you suggested that it 

had not been done for several years, and I just wanted to ask your 

views on that today. 

Chairman BERNANKE. There has not been any changes to my 

knowledge. The last time that the Japanese intervened was in—as 

far as we know, was in March 2004 and there has not been a subsequent intervention since then. The yen has been quite weak reflecting in large part the fact that interest rates in Japan are quite 

low, which in turn reflects the policies of the Bank of Japan in the 

face of still very low, near deflation, inflation rates. 

I view the end as being essentially a market determined exchange rate and I think that market determined rates are the way 

to go. And so I would not advocate any particular policy changes 

with respect to Japan. 

Senator CARPER. Thank you. 

Are you alarmed at all by our growing reliance on foreign oil? 

Chairman BERNANKE. It is certainly an issue. We now import 

about two-thirds of our oil. We are very heavily reliant on oil. It 

would be very desirable for us to have a more diversified energy 

portfolio. I think there are ways to do that. 

As a very basic approach, I could suggest three things. One is 

that the Government has a very substantial role and has been very 

effective in the past in promoting or doing basic research, developing alternative technologies either in terms of conservation or 

new energy sources. 

A second issue is what I guess I would call regulatory certainty. 

We do not get new refineries, we do not get nuclear plants, not so 

much because the regulations per se are so onerous but because between the uncertainty of how they will be applied and legal suits 

and so on nobody wants to undertake a new investment. 

So it is fine to have strong regulations to protect the environment and achieve other social goals but it would be productive to 

have a system whereby people who want to make investments in 

alternative energy forms or refineries, et cetera, would know in advance what they have to do in order to meet the regulatory requirements. 

The third thing I would say is that although the high energy 

prices and high oil prices we are seeing right now, of course are 

very painful, and I do not want to downplay that in any way, they 

do have at least the benefit that they make a lot of other alternatives potentially economically viable. With regulatory certainty 

and basic research, among other things, that market I think can 

begin to deliver some alternatives. 

We do have to address issues related to the environment and 

global warming and the like. But I think there are really a large 

number of possible alternatives and we should let the economy explore those. 

Senator CARPER. Thank you. Those are excellent points. 

The last question. In the past you have been vocal in your support for reforming our Government Sponsored Enterprises, at least 

the regulation of those. I think you actually gave a speech back in 

March that dwelled on that. 

I guess my question is we seem to be hung up. The House has 

passed a bill, we are expecting to take up legislation later this year 

45 

that addresses GSE reform and regulation of our Fannie Mae, 

Freddie Mac, and Federal Home Loan Banks. 

The hang up appears to be really in two areas: What kind of support should we provide for low-income housing through some kind 

of creation of a low-income housing fund? And the questions about 

the mortgage portfolio and what kind of constraints should be on 

the mortgage portfolio? 

Any advice that you would have for us as we approach that? 

Chairman BERNANKE. The Federal Reserve’s concern is about financial stability. And so we have not taken a position on the housing fund type things. 

But for financial stability purposes, I think there are three elements: Strong bank-like capital powers. Second, well-defined receivership positions so that if a GSE goes out of business we know 

under what circumstances that would happen and what the resolution of that would be. And third, anchoring the portfolio in a public 

purpose. Right now, it can expand almost at will and it is not tied 

directly to public purpose. 

In my speech that you referred to, I advocated tying the portfolio 

to affordable housing or to housing goals in some explicit way. 

So those are the recommendations that I would suggest in order 

to assure us, in terms of our concern which is about the implications for financial stability if these large portfolios were to come 

under financial stress. 

Senator CARPER. Thank you very much. 

Chairman DODD. Senator Carper, thank you. 

Senator Akaka. 

STATEMENT OF SENATOR DANIEL K. AKAKA 

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

Mr. Bernanke, it is good to see you in person here. And I want 

to tell you my role here on the Banking Committee has come down 

to being very concerned about the consumers of America. Here I 

have looked upon this as trying to improve the quality of life for 

consumers, as well as to help them improve themselves. Consumer 

protection is important, and also equipping them with the skills 

and knowledge that will help them with their understandings and 

also to empower them with economic empowerment. 

So this area has been important to me. Our modern complex 

economy depends on the ability of consumers to make informed financial decisions. Without a sufficient understanding of economics 

and personal finance, individuals will not be able to appropriately 

manage their finances, evaluate credit opportunities, and successfully invest for long-term financial goals in an increasingly complex 

marketplace. 

Mr. Chairman, I really appreciate your personal involvement on 

the important issues of financial literacy. I also wanted to take the 

time to thank all of the Federal Reserve employees, and I want to 

include Sandy Bronstein in that, and all of those who have taken 

such an active role in helping improve the financial knowledge of 

consumers and evaluating the effectiveness of education programs. 

As you know, approximately 10 million households in the United 

States do not have accounts at mainstream financial institutions. 

Unfortunately, too many of these households depend on high cost 

46 

fringe financial services. They miss out on opportunities for saving, 

borrowing, and lower cost remittances found at credit unions and 

banks. And so the unbanked has become one of my concerns. 

My question to you is what must be done to bring these households into mainstream financial institutions? 

Chairman BERNANKE. Senator, first let me say that I agree 

wholeheartedly with your views on financial literacy. As I discussed earlier, the Federal Reserve works very hard on all these 

disclosures for these sometimes complex financial products. But if 

people do not have the basic literacy to understand them and 

evaluate them, it is really of no use. Without financial literacy they 

are not going to be able to participate fully in our economy. 

In terms of bringing more people into the banking system, I 

think it would be a positive development. The main way the Federal Reserve can help that process is what we do, which is to encourage the banks and bank holding companies that we supervise 

to reach out into underserved communities, partly through the 

Community Reinvestment Act but more generally to provide services and to try to attract unbanked people into the banking system. 

I have given not only testimony before the Senate on financial 

literacy, but I have also given some testimony in the past on remittances which is one mechanism. Many of the remittances that immigrants send back home, they lose a significant portion of the 

money they are sending because of the high cost of the types of 

services they use and other problems. One of the ways in which 

credit unions and banks have made inroads into the minority communities, in particular, has been by offering better and cheaper remittance services. I think that is one particular way to get in. 

But we are seeing banks more and more employing Spanish 

speaking, for example, tellers and understanding that there really 

is a good market in these low and moderate income neighborhoods. 

And we encourage banks to provide services in those neighborhoods. 

Senator AKAKA. Mr. Chairman, FDIC has found that their Money 

Smart financial literacy program has resulted in positive behavioral change among consumers. I know that measuring the effectiveness of financial literacy programs is an issue that the Federal 

Reserve has been interested in for several years. 

What has the Federal Reserve learned thus far about the effectiveness of financial education? 

Chairman BERNANKE. First, a lot of what we do is partner with 

various groups. The Chicago Federal Reserve Bank partners with 

the Money Smart group that you just referred to. So a lot of what 

we do is try to develop best practice and to try and spread that to 

schools and to nonprofit organizations and so on. 

In terms of what we learned, we are still, I think—and here I 

am referring to the entire education community—groping with how 

best to teach financial literacy at the school level. There is an organization called JumpStart which does testing of kids in high school. 

Unfortunately, the progress on financial literacy there has not been 

all that we would like. 

One place, however, where we do see more progress, and I referred to this in my discussion with Senator Schumer, is that when 

potential homebuyers receive counseling nearer to the time when 

47 

they are going to be making their decisions that they do learn and 

they do understand and it does affect their decisions, as you might 

expect, because they are very highly motivated at that point to understand the terms of the contract that they are about to enter 

into. 

So it is still a very open issue. We have a website which includes 

lots and lots of materials which have been tested in various contexts. But I cannot say that there is, at this point, a definitive approach. I think you have to take a little bit of this, a little bit of 

that, and mix it all together and recognize that financial literacy 

is not just a school subject. It really has to be used throughout life 

because it is really, as you get older and you have to worry about 

buying a house and sending your kids to college and retirement, 

that you really begin to think hard about these financial issues. 

Kids in the 10th grade may not be as motivated to think about 

them. 

Senator AKAKA. I thank you so much for your responses. My time 

has expired, Mr. Chairman. 

Chairman DODD. Thank you very much, Senator Akaka. These 

are very important questions and I thank you for raising them. 

Your point about the 10 million households without access to mainstream financial institutions is a very legitimate concern and something I have talked a lot about myself. 

The Chairman points out that the cost of this to these people, because they are using financial services, and it will cost an average 

person thousands of dollars more than they would otherwise pay if 

they were dealing with mainstream financial institutions. So the 

cost differentials are huge, not to mention, of course, the ability for 

people in those circumstances to improve their economic lot. So, I 

thank you for raising it. 

I, too, find it remarkable, from the time a young person enters 

a traditional schooling system in this country through the 12th 

grade there is not a single requirement that I know of anywhere 

that there is some period of time in which just basic financial services literacy would be required. We have talked a lot about this and 

schools are inundated with requests and demands on them. They 

do not want to hear about another one. But one of the major problems is people’s inability to understand basic financial obligations. 

So, I thank you for raising and thank you, Mr. Chairman, for your 

comments. 

Chairman BERNANKE. A few States, Senator, have actually made 

these requirements but it is not universal. 

Chairman DODD. Have they done that? That is good to hear. 

Let me turn to Senator Shelby for one question. I have one additional one after his and then we will complete the hearing. 

Senator SHELBY. Thank you. 

Chairman Bernanke, GSE reform. We have talked about this before. This Committee has been interested in strengthening the regulatory system for the housing related Government Sponsored Enterprises for a number of years. The House recently, as you are 

probably aware, considered language giving the new proposed regulator the ability to regulate the size and the growth of the enterprise portfolios and charged the regulator to consider risk of the 

portfolios. However the language, which was amended on the 

48 

House floor, I understand, which passed in the House, limited the 

risk consideration to only risk to the enterprises. 

Would you view this language, as it was passed by the House as 

amended on the floor, with what bank regulators have over financial institutions? That is do you consider, as a regulator, only the 

risk to a particular financial institution? Or do you look at the 

portfolio? Do you look at other things? 

The portfolio your predecessor, Chairman Greenspan, says right 

here in this Committee and I believe you have reiterated that there 

is risk there in that portfolio, possibly to the taxpayer. Would you 

comment on this? 

Chairman BERNANKE. Senator, I am aware of this legislation and 

the amendment. The amendment in the House does concern me 

greatly because I think it eliminates the ability of the regulator to 

take the financial system’s stability overall into account. So in particular, one might imagine a situation where greatly increasing the 

size of the GSE portfolio is in the interest of the company but 

raises the risk to the overall system. 

As I said a moment ago, in my role my principal concern is about 

the stability of the overall system. And I fear that without some 

consideration of the overall financial stability implications, that 

this new regulation would be incomplete. 

Senator SHELBY. I think there are some good things in the 

House-passed bill but that was not one of them, in my judgment. 

I appreciate your comment. 

Thank you, Chairman Dodd. 

Chairman DODD. Thank you, Senator Shelby. And just on that 

point alone, obviously we are going to looking at that and trying 

to get a bill done fairly soon. Again, the realization here, I just 

have to add two cents on this. And that is, of course, the presence 

of the GSEs in this area, I think many would agree, have created 

a possibility. One of the unique opportunities we offer in our economy is that 30-year more fixed rate mortgage which provides great 

stability and great wealth creation for an awful lot of people, in the 

absence of which it would be very difficult to achieve. So striking 

the balance here, the points you have raised here, and seeing to it 

we do not move away from the opportunity that those vehicles provide is something very important to all of us. 

Let me raise a quick question if I can, as well, with you here. 

The hedge fund industry is obviously an important wealth creator 

in the country. It has done an awful lot of worthwhile things in 

terms of a valuable role in capital markets. 

The President’s Working Group, which you are a part of, back in 

February released a set of principles and guidelines. I would just 

quote, it says ‘‘To guide U.S. financial regulators as they address 

public policy issues associated with the rapid growth of the private 

pools of capital, including hedge funds. The agreement concentrates 

on investor protection and systemic risk concerns.’’ The President’s 

Working Group, at that point, determined that additional regulation was not needed. 

Let me raise the issue that has been raised by others. You had 

a piece in the Chicago Tribune recently talking about the Amaranth situation, which many people pointed out, given the size of 

49 

it, it did not create that much of a bubble unless you were in San 

Diego and had a pension fund and then $100 million was lost. 

So from your perspective, from stepping back from a macro 

standpoint, it had seemingly very little effect. And yet if you were 

dealing with the pensions in San Diego, it was a rather significant 

effect. 

There was then a story in, I think it was Business Week, that I 

was not aware of. A lot of smaller colleges are now moving aggressively into hedge funds, according to this article. It identified colleges that had invested between 60 and 82 percent of their endowments in hedge funds. They said they may be putting their endowments in jeopardy. That was the conclusion of this Business Week 

article. 

Again, they are just two newspaper stories here. I just wonder, 

in light of all of this, do you have any additional recommendations 

about this? What did the President’s Working Group want market 

participants to do differently after the release of the principles than 

they were doing before? How were the Working Group agencies 

overseeing the impact of this new guidance that they put out? And 

last, do you feel that additional regulation of hedge funds is needed 

to avoid concerns about systemic risk? 

Chairman BERNANKE. Mr. Chairman, the essence of making the 

market discipline approach work is that the counterparties, investors, and creditors be sophisticated and able to evaluate the investments that they are undertaking. In the case of a pension fund, the 

pension fund manager has a fiduciary duty to make investments 

which are appropriate for the risk/return needs of that fund. 

So if that fiduciary manager has sufficient sophistication to use 

some of these things, that perhaps is OK. But in most cases I think 

that pension funds should probably not go heavily into these types 

of instruments. 

In fact, on average, ERISA funds have relatively small shares of 

their assets in these funds. But again, in those cases and in the 

cases of endowments as well, it is really the responsibility of the 

sophisticated managers to make sure that they are making the 

right risk/return trade-offs. The whole system depends on those 

people knowing what they are doing. 

Chairman DODD. Given the exposures you were talking about, 

and I agree with that totally. I do not disagree with what you said. 

Do we, you, and these other appropriate agencies bear an additional responsibility here to be more mindful of what is going on, 

including possibly some regulatory role here? 

Chairman BERNANKE. With respect to the pension funds, for example, they already are regulated by ERISA and the Department 

of Labor. And they have fiduciary responsibilities and that should 

be enforced, obviously. 

In terms of the broader issue of market discipline for private 

pools of capital, I would like to emphasize that this is not a laissezfaire approach. In particular the supervisors, including the Federal 

Reserve, have the responsibility to make sure that the institutions 

who are the prime brokers, the counterparties, the creditors of 

these private pools of capital, that they have in place adequate risk 

measurement techniques, risk management techniques, they have 

50 

enough information so they can make adequate assessments of the 

risks that they are facing. 

So we, in fact, do put a lot of effort into ensuring that these institutions—and I say we, this is in collaboration with the SEC and 

other regulators—that they are doing sufficient due diligence to 

protect themselves and their own investors and depositors from excessive risk. 

So that is what makes the system work, a combination of selfinterested counterparty market discipline but overseen and overlaid by effective supervisory attention. 

Chairman DODD. I interpret that that you do not see any additional regulation needed at this point? 

Chairman BERNANKE. I do not, at this point, see any need for additional regulation, no. 

Chairman DODD. Mr. Chairman, I thank you and we have a vote 

on here. Obviously, there will be a lot more questions for you but 

you have been very generous with your time. We appreciate that 

very much. 

I am going to leave the record open for a day or two here for additional questions. We had very good participation by the Committee Members here but there may be some additional questions 

that they would like to raise with you. We will submit them to you 

in a timely fashion. 

Once again we thank you immensely for your participation. 

Chairman BERNANKE. Thank you. 

Chairman DODD. This hearing will stand adjourned. 

[Whereupon, at 12:10 p.m. the hearing was adjourned.] 

[Prepared statements, response to written questions, and additional material supplied for the record follow:] 

51 

PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY 

Chairman Bernanke, we are very pleased to have you before the Committee this 

morning to deliver the Federal Reserve’s Semi-Annual Monetary Policy Report. This 

hearing provides the Congress a very important opportunity to have an open and 

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

I also expect that Members of the Committee, including myself, will take advantage 

of your appearance to raise some other issues that fall under the jurisdiction of the 

Federal Reserve. 

I also would like to welcome our colleagues from the European Union Parliament. 

I trust that their visit today will be enlightening and provide them with much 

to discuss with the European Central Bank. 

Chairman Bernanke, your testimony and report this morning note the continued 

healthy performance of the economy in the first half of 2007. Although real gross 

domestic product (GDP) increased 0.7 percent in the first quarter of 2007, the consensus view among economists is that growth for the second quarter will show a 

rebound in the neighborhood of 2.5 percent. Along with continued GDP growth, we 

have seen positive news on the job front. Gains in payroll employment averaged 

145,000 jobs per month in the first half of 2007. We continue to enjoy a low unemployment rate, both historically and relative to other industrialized nations. 

The global economy also continues to be strong, with Canada, Europe, Japan, and 

the United Kingdom experiencing above-trend growth rates in the first quarter. This 

is good news for American businesses seeking to expand their exports around the 

world. 

In its statement following the June 28, 2007, meeting, the FOMC suggested that 

while core inflation readings had moderated, ‘‘sustained moderation in inflation 

pressures has yet to be convincingly demonstrated.’’ Inflation risk, not slow growth, 

remains the predominant concern as we continue to see a rise in energy and food 

prices. I also share your view on the importance of low inflation in promoting 

growth, efficiency, and stability which in turn equal maximum sustainable employment. 

Chairman Bernanke, your statement also includes an extended discussion of the 

Federal Reserve’s recent activities relating to subprime mortgage lending. The recent sharp increases in subprime mortgage loan delinquencies are troubling. The 

initiatives that you highlight in your testimony are welcome. 

However, I am concerned that the weaknesses in the subprime market may have 

broader systemic consequences. We have been told that the problem is largely isolated and contained, but I am concerned that it may not be. I will be particularly 

interested in hearing your views on the scope of the problem and how the Federal 

Reserve will monitor and manage the situation going forward. 

Chairman Bernanke, we are pleased to have you with us this morning. We look 

forward to discussing in greater detail the Federal Reserve’s performance and its 

views on the future direction of our Nation’s economy. 

Thank you, Mr. Chairman. 

PREPARED STATEMENT OF SENATOR JIM BUNNING 

Chairman Bernanke, I watched your testimony yesterday with interest. Apparently the markets did too, but I am not sure if they did or did not like what they 

heard. 

You covered a lot of ground yesterday, but there is some new ground I will cover 

in the questions and some things that are worth repeating. First, it has been interesting to watch market reactions and expectations to Fed policy statements over the 

last few months. For a while, the markets did not believe your clear statements that 

the biggest concern was that inflation would not moderate as expected. Market indicators have moved more in line with your view in the last month or two, and I hope 

both the markets and you have learned about communication and the way each 

other think. 

While this is a monetary policy hearing, I think it is worth repeating that many 

of us believe the Fed and other regulators share some responsibility for the current 

state of the housing market. Low interest rates fueled the housing boom, and loose 

supervision of mortgage writing allowed it to proceed. The market is certainly punishing bad behavior by lenders, but some of the damage could have been prevented 

by more careful scrutiny of some of the most undisciplined lending. The Fed should 

have been especially careful because of the credit bubble it created with cheap 

money. 

I am glad you and your fellow regulators have taken action, and that you did not 

overreact and cause further damage. It is important for you to remain vigilant, but 

52 

not to give in to pressure to over regulate. I would also say to Chairman Dodd that 

I hope we can quickly confirm the new nominees so that the Fed board will have 

more industry experience when tackling these issues. 

I continue to be impressed by the current economy, which seems to have passed 

through the worst of the slowdown caused largely by Fed tightening. My biggest 

concerns are rising food and energy prices, and the negative effects on the economy 

of the massive tax increases the new majority in Congress seems determined to 

allow. The current economic expansion is driven by the 2001 and 2003 tax cuts, and 

allowing a tax increase in 2010 will reverse years of gains in the economy and the 

stock markets. 

I look forward to hearing your responses. 

PREARED STATEMENT OF SENATOR ELIZABETH DOLE 

Thank you, Chairman Dodd. Chairman Bernanke, I join my colleagues in extending you a very warm welcome. Thank you for your strong leadership as Chairman 

of the Federal Reserve and for joining us here today. 

As you know, we have seen very strong growth in our economy over the last few 

years—even as our Nation has faced some extremely challenging times. Over the 

past year, the Dow Jones Industrial Average has risen by approximately 26 percent, 

and in 2006 GDP expanded by approximately 3 percent. The market continues to 

shatter records with both the Dow and the S&P 500 reaching all-time highs. 

No question, we have hard work ahead to ensure that all levels and sectors of 

the economy continue to prosper. For example, the housing sector has been showing 

some signs of weakness . . . and high gas prices continue to be a burden, as Americans must allocate more and more of their income to fund this necessity of everyday 

life. According to AAA, the current average price of gas in my home State North 

Carolina is $2.93. The price of a barrel of oil has hovered around the $70 mark and 

has recently hit $75. If high gas prices and housing sector weaknesses persist, and 

if we face other challenges, future economic growth could be hindered. 

With regard to job creation, over the past 10 months, the national unemployment 

rate has hovered around 4.5 percent, and the economy has continued to add jobs, 

bringing us to an impressive total of 8.2 million new jobs created since August 2003. 

While the overall national economy trends positively, too many areas of North Carolina continue to face obstacles. The forces of the global marketplace have triggered 

an economic transformation in our State, and many thousands of our manufacturing 

jobs have been lost. 

New opportunities and jobs for North Carolinians, however, are being created in 

this transition. As our economy moves forward, in North Carolina and across America, we must educate our workforce so that all individuals can take advantage of 

the new jobs being created. To this end, as I have discussed with you in the past, 

I believe our community colleges are a tremendous resource. This certainly is the 

case in North Carolina—where our university system and 58-member-strong community college network have been a beacon of hope—providing retraining and remedial education to those who have lost their jobs, and developing curriculum to suit 

the evolving needs of employers. 

Before I conclude, let me mention what I believe to be a vital resource that North 

Carolina workers have been able to utilize to update and improve their skill set— 

Trade Adjustment Assistance (TAA). The TAA program is critical to ensuring that 

displaced workers can train for new careers and that they do not slip through the 

cracks. I recently introduced legislation with my colleague Senator Cantwell to 

strengthen this program. Our bill would help workers whose jobs relocate to countries without preferential trade agreements with the United States to receive TAA 

benefits. Eligible workers can receive training, job search and relocation allowances, 

income support, and other reemployment services. 

Mr. Chairman, we must continue backing programs such as TAA, and supporting 

an agenda that will create jobs and grow our economy—by reducing regulatory burdens, educating and training a highly skilled workforce, building and updating infrastructure, and ensuring affordable, accessible energy and health care. 

Chairman Bernanke, thank you again for being here today. I look forward to hearing from you—and working with you—on these and other important issues. 

53 

PREPARED STATEMENT OF BEN S. BERNANKE 

CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

JULY 19, 2007 

Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am 

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

As you know, this occasion marks the 30th year of semiannual testimony on the 

economy and monetary policy by the Federal Reserve. In establishing these hearings, the Congress proved prescient in anticipating the worldwide trend toward 

greater transparency and accountability of central banks in the making of monetary 

policy. Over the years, these testimonies and the associated reports have proved an 

invaluable vehicle for the Federal Reserve’s communication with the public about 

monetary policy, even as they have served to enhance the Federal Reserve’s accountability for achieving the dual objectives of maximum employment and price 

stability set for it by the Congress. I take this opportunity to reiterate the Federal 

Reserve’s strong support of the dual mandate; in pursuing maximum employment 

and price stability, monetary policy makes its greatest possible contribution to the 

general economic welfare. 

Let me now review the current economic situation and the outlook, beginning 

with developments in the real economy and the situation regarding inflation before 

turning to monetary policy. I will conclude with comments on issues related to lending to households and consumer protection—topics not normally addressed in monetary policy testimony but, in light of recent developments, deserving of our attention 

today. 

After having run at an above-trend rate earlier in the current economic recovery, 

U.S. economic growth has proceeded during the past year at a pace more consistent 

with sustainable expansion. Despite the downshift in growth, the demand for labor 

has remained solid, with more than 850,000 jobs having been added to payrolls thus 

far in 2007 and the unemployment rate having remained at 41⁄2 percent. The combination of moderate gains in output and solid advances in employment implies that 

recent increases in labor productivity have been modest by the standards of the past 

decade. The cooling of productivity growth in recent quarters is likely the result of 

cyclical or other temporary factors, but the underlying pace of productivity gains 

may also have slowed somewhat. 

To a considerable degree, the slower pace of economic growth in recent quarters 

reflects the ongoing adjustment in the housing sector. Over the past year, home 

sales and construction have slowed substantially and house prices have decelerated. 

Although a leveling-off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading 

the number of unsold new homes in builders’ inventories to rise further relative to 

the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent 

below the pace in the second half of last year. 

The pace of home sales seems likely to remain sluggish for a time, partly as a 

result of some tightening in lending standards and the recent increase in mortgage 

interest rates. Sales should ultimately be supported by growth in income and employment as well as by mortgage rates that—despite the recent increase—remain 

fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work 

down stocks of unsold new homes. Thus, declines in residential construction will 

likely continue to weigh on economic growth over coming quarters, although the 

magnitude of the drag on growth should diminish over time. 

Real consumption expenditures appear to have slowed last quarter, following two 

quarters of rapid expansion. Consumption outlays are likely to continue growing at 

a moderate pace, aided by a strong labor market. Employment should continue to 

expand, though possibly at a somewhat slower pace than in recent years as a result 

of the recent moderation in the growth of output and ongoing demographic shifts 

that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains 

strong and productivity increases. 

In the business sector, investment in equipment and software showed a modest 

gain in the first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset 

by solid gains in other categories. Investment in nonresidential structures, after 

slowing sharply late last year, seems to have grown fairly vigorously in the first half 

of 2007. Like consumption spending, business fixed investment overall seems poised 

54 

1Despite the recent surge, total PCE inflation is 2.3 percent over the past 12 months. 

to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year, motor vehicle manufacturers and 

firms in several other industries found themselves with elevated inventories, which 

led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth. 

The global economy continues to be strong. Supported by solid economic growth 

abroad, U.S. exports should expand further in coming quarters. Nonetheless, our 

trade deficit—which was about 51⁄4 percent of nominal gross domestic product (GDP) 

in the first quarter—is likely to remain high. 

For the most part, financial markets have remained supportive of economic 

growth. However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans. In recent 

weeks, we have also seen increased concerns among investors about credit risk on 

some other types of financial instruments. Credit spreads on lower-quality corporate 

debt have widened somewhat, and terms for some leveraged business loans have 

tightened. Even after their recent rise, however, credit spreads remain near the low 

end of their historical ranges, and financing activity in the bond and business loan 

markets has remained fairly brisk. 

Overall, the U.S. economy appears likely to expand at a moderate pace over the 

second half of 2007, with growth then strengthening a bit in 2008 to a rate close 

to the economy’s underlying trend. Such an assessment was made around the time 

of the June meeting of the Federal Open Market Committee (FOMC) by the members of the Board of Governors and the presidents of the Reserve Banks, all of whom 

participate in deliberations on monetary policy. The central tendency of the growth 

forecasts, which are conditioned on the assumption of appropriate monetary policy, 

is for real GDP to expand roughly 21⁄4 to 21⁄2 percent this year and 21⁄2 to 23⁄4 percent in 2008. The forecasted performance for this year is about 1⁄4 percentage point 

below that projected in February, the difference being largely the result of weakerthan-expected residential construction activity this year. The unemployment rate is 

anticipated to edge up to between 41⁄2 and 43⁄4 percent over the balance of this year 

and about 43⁄4 percent in 2008, a trajectory about the same as the one expected in 

February. 

I turn now to the inflation situation. Sizable increases in food and energy prices 

have boosted overall inflation and eroded real incomes in recent months—both unwelcome developments. As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first 5 months of this year, a rate that, if maintained, would clearly 

be inconsistent with the objective of price stability.1 Because monetary policy works 

with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which 

excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few 

months, with core PCE inflation coming in at an annual rate of about 2 percent so 

far this year. 

Although the most recent readings on core inflation have been favorable, monthto-month movements in inflation are subject to considerable noise, and some of the 

recent improvement could also be the result of transitory influences. However, with 

long-term inflation expectations contained, futures prices suggesting that investors 

expect energy and other commodity prices to flatten out, and pressures in both labor 

and product markets likely to ease modestly, core inflation should edge a bit lower, 

on net, over the remainder of this year and next year. The central tendency of 

FOMC participants’ forecasts for core PCE inflation—2 to 21⁄4 percent for 2007 and 

13⁄4 to 2 percent in 2008—is unchanged from February. If energy prices level off as 

currently anticipated, overall inflation should slow to a pace close to that of core 

inflation in coming quarters. 

At each of its four meetings so far this year, the FOMC maintained its target for 

the Federal funds rate at 51⁄4 percent, judging that the existing stance of policy was 

likely to be consistent with growth running near trend and inflation staying on a 

moderating path. As always, in determining the appropriate stance of policy, we will 

be alert to the possibility that the economy is not evolving in the way we currently 

judge to be the most likely. One risk to the outlook is that the ongoing housing correction might prove larger than anticipated, with possible spillovers onto consumer 

spending. Alternatively, consumer spending, which has advanced relatively vigorously, on balance, in recent quarters, might expand more quickly than expected; in 

that case, economic growth could rebound to a pace above its trend. With the level 

55 

of resource utilization already elevated, the resulting pressures in labor and product 

markets could lead to increased inflation over time. Yet another risk is that energy 

and commodity prices could continue to rise sharply, leading to further increases in 

headline inflation and, if those costs passed through to the prices of nonenergy 

goods and services, to higher core inflation as well. Moreover, if inflation were to 

move higher for an extended period and that increase became embedded in longerterm inflation expectations, the reestablishment of price stability would become 

more difficult and costly to achieve. With the level of resource utilization relatively 

high and with a sustained moderation in inflation pressures yet to be convincingly 

demonstrated, the FOMC has consistently stated that upside risks to inflation are 

its predominant policy concern. 

In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve 

has been active in implementing, interpreting, and enforcing consumer protection 

laws. I would like to discuss with you this morning some of our recent initiatives 

and actions, particularly those related to subprime mortgage lending. 

Promoting access to credit and to homeownership are important objectives, and 

responsible subprime mortgage lending can help advance both goals. In designing 

regulations, policymakers should seek to preserve those benefits. That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and 

outright fraud. In addition, some households took on mortgage obligations they 

could not meet, perhaps in some cases because they did not fully understand the 

terms. Financial losses have subsequently induced lenders to tighten their underwriting standards. Nevertheless, rising delinquencies and foreclosures are creating 

personal, economic, and social distress for many homeowners and communities— 

problems that likely will get worse before they get better. 

The Federal Reserve is responding to these difficulties at both the national and 

the local levels. In coordination with the other Federal supervisory agencies, we are 

encouraging the financial industry to work with borrowers to arrange prudent loan 

modifications to avoid unnecessary foreclosures. Federal Reserve Banks around the 

country are cooperating with community and industry groups that work directly 

with borrowers having trouble meeting their mortgage obligations. We continue to 

work with organizations that provide counseling about mortgage products to current 

and potential homeowners. We are also meeting with market participants—including lenders, investors, servicers, and community groups—to discuss their concerns 

and to gain information about market developments. 

We are conducting a top-to-bottom review of possible actions we might take to 

help prevent recurrence of these problems. First, we are committed to providing 

more-effective disclosures to help consumers defend against improper lending. Three 

years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act (TILA). The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts. After conducting 

extensive consumer testing, we issued a proposal in May that would require credit 

card issuers to provide clearer and easier-to-understand disclosures to customers. In 

particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed. The proposed rules would also require card 

issuers to provide 45 days’ advance notice of a rate increase or any other change 

in account terms so that consumers will not be surprised by unexpected charges and 

will have time to explore alternatives. 

We are now engaged in a similar review of the TILA rules for mortgage loans. 

We began this review last year by holding four public hearings across the country, 

during which we gathered information on the adequacy of disclosures for mortgages, 

particularly for nontraditional and adjustable-rate products. As we did with credit 

card lending, we will conduct extensive consumer testing of proposed disclosures. 

Because the process of designing and testing disclosures involves many trial runs, 

especially given today’s diverse and sometimes complex credit products, it may take 

some time to complete our review and propose new disclosures. 

However, some other actions can be implemented more quickly. By the end of the 

year, we will propose changes to TILA rules to address concerns about mortgage 

loan advertisements and solicitations that may be incomplete or misleading and to 

require lenders to provide mortgage disclosures more quickly so that consumers can 

get the information they need when it is most useful to them. We already have improved a disclosure that creditors must provide to every applicant for an adjustablerate mortgage product to explain better the features and risks of these products, 

such as ‘‘payment shock’’ and rising loan balances. 

56 

We are certainly aware, however, that disclosure alone may not be sufficient to 

protect consumers. Accordingly, we plan to exercise our authority under the Home 

Ownership and Equity Protection Act (HOEPA) to address specific practices that are 

unfair or deceptive. We held a public hearing on June 14 to discuss industry practices, including those pertaining to prepayment penalties, the use of escrow accounts 

for taxes and insurance, stated-income and low-documentation lending, and the 

evaluation of a borrower’s ability to repay. The discussion and ideas we heard were 

extremely useful, and we look forward to receiving additional public comments in 

coming weeks. Based on the information we are gathering, I expect that the Board 

will propose additional rules under HOEPA later this year. 

In coordination with the other Federal supervisory agencies, last year we issued 

principles-based guidance on nontraditional mortgages, and in June of this year we 

issued supervisory guidance on subprime lending. These statements emphasize the 

fundamental consumer protection principles of sound underwriting and effective disclosures. In addition, we reviewed our policies related to the examination of 

nonbank subsidiaries of bank and financial holding companies for compliance with 

consumer protection laws and guidance. 

As a result of that review and following discussions with the Office of Thrift Supervision, the Federal Trade Commission, and State regulators, as represented by 

the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders 

with significant subprime mortgage operations. The reviews will begin in the fourth 

quarter of this year and will include independent State-licensed mortgage lenders, 

nondepository mortgage lending subsidiaries of bank and thrift holding companies, 

and mortgage brokers doing business with or serving as agents of these entities. The 

agencies will collaborate in determining the lessons learned and in seeking ways to 

better cooperate in ensuring effective and consistent examinations of and improved 

enforcement for nondepository mortgage lenders. Working together to address jurisdictional issues and to improve information-sharing among agencies, we will seek 

to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. 

I believe that the actions I have described today will help address the current 

problems. The Federal Reserve looks forward to working with the Congress on these 

important issues. 

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