Ben S Bernanke: The economic outlook and the federal budget situation
Testimony by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal
Reserve System, before the Committee on the Budget, US House of Representatives,
Washington DC, 2 February 2012.
* * *
Chairman Ryan, Vice Chairman Garrett, Ranking Member Van Hollen, and other members of
the Committee, I appreciate this opportunity to discuss my views on the economic outlook,
monetary policy, and the challenges facing federal fiscal policymakers.
The economic outlook
Over the past two and a half years, the U.S. economy has been gradually recovering from
the recent deep recession. While conditions have certainly improved over this period, the
pace of the recovery has been frustratingly slow, particularly from the perspective of the
millions of workers who remain unemployed or underemployed. Moreover, the sluggish
expansion has left the economy vulnerable to shocks. Indeed, last year, supply chain
disruptions stemming from the earthquake in Japan, a surge in the prices of oil and other
commodities, and spillovers from the European debt crisis risked derailing the recovery.
Fortunately, over the past few months, indicators of spending, production, and job market
activity have shown some signs of improvement; and, in economic projections just released,
Federal Open Market Committee (FOMC) participants indicated that they expect somewhat
stronger growth this year than in 2011. The outlook remains uncertain, however, and close
monitoring of economic developments will remain necessary.
As is often the case, the ability and willingness of households to spend will be an important
determinant of the pace at which the economy expands in coming quarters. Although real
consumer spending rose moderately last quarter, households continue to face significant
headwinds. Notably, real household income and wealth stagnated in 2011, and access to
credit remained tight for many potential borrowers. Consumer sentiment has improved from
the summer's depressed levels but remains at levels that are still quite low by historical
standards.
Household spending will depend heavily on developments in the labor market. Overall, the
jobs situation does appear to have improved modestly over the past year: Private payroll
employment increased by about 160,000 jobs per month in 2011, the unemployment rate fell
by about 1 percentage point, and new claims for unemployment insurance declined
somewhat. Nevertheless, as shown by indicators like the rate of unemployment and the ratio
of employment to population, we still have a long way to go before the labor market can be
said to be operating normally. Particularly troubling is the unusually high level of long-term
unemployment: More than 40 percent of the unemployed have been jobless for more than six
months, roughly double the fraction during the economic expansion of the previous decade.
Uncertain job prospects, along with tight mortgage credit conditions, continue to hold back
the demand for housing. Although low interest rates on conventional mortgages and the drop
in home prices in recent years have greatly improved the affordability of housing, both
residential sales and construction remain depressed. A persistent excess supply of vacant
homes, largely stemming from foreclosures, is keeping downward pressure on prices and
limiting the demand for new construction.
In contrast to the household sector, the business sector has been a relative bright spot in the
current recovery. Manufacturing production has increased 15 percent since its trough, and
capital spending by businesses has expanded briskly over the past two years, driven in part
by the need to replace aging equipment and software. Moreover, many U.S. firms, notably in
manufacturing but also in services, have benefited from strong demand from foreign markets
over the past few years.
More recently, the pace of growth in business investment has slowed, likely reflecting
concerns about both the domestic outlook and developments in Europe. However, there are
signs that these concerns are abating somewhat. If business confidence continues to
improve, U.S. firms should be well positioned to increase both capital spending and hiring:
Larger businesses are still able to obtain credit at historically low interest rates, and
corporate balance sheets are strong. And, though many smaller businesses continue to face
difficulties in obtaining credit, surveys indicate that credit conditions have begun to improve
modestly for those firms as well.
Globally, economic activity appears to be slowing, restrained in part by spillovers from fiscal
and financial developments in Europe. The combination of high debt levels and weak growth
prospects in a number of European countries has raised significant concerns about their
fiscal situations, leading to substantial increases in sovereign borrowing costs, concerns
about the health of European banks, and associated reductions in confidence and the
availability of credit in the euro area. Resolving these problems will require concerted action
on the part of European authorities. They are working hard to address their fiscal and
financial challenges. Nonetheless, risks remain that developments in Europe or elsewhere
may unfold unfavorably and could worsen economic prospects here at home. We are in
frequent contact with European authorities, and we will continue to monitor the situation
closely and take every available step to protect the U.S. financial system and the economy.
Let me now turn to a discussion of inflation. As we had anticipated, overall consumer price
inflation moderated considerably over the course of 2011. In the first half of the year, a surge
in the prices of gasoline and food - along with some pass-through of these higher prices to
other goods and services - had pushed consumer inflation higher. Around the same time,
supply disruptions associated with the disaster in Japan put upward pressure on motor
vehicle prices. As expected, however, the impetus from these influences faded in the second
half of the year, leading inflation to decline from an annual rate of about 3-1/2 percent in the
first half of 2011 to about 1-1/2 percent in the second half - close to its average pace in the
preceding two years. In an environment of well-anchored inflation expectations, more-stable
commodity prices, and substantial slack in labor and product markets, we expect inflation to
remain subdued.
Against that backdrop, the Federal Open Market Committee (FOMC) decided last week to
maintain its highly accommodative stance of monetary policy. In particular, the Committee
decided to continue its program to extend the average maturity of its securities holdings, to
maintain its existing policy of reinvesting principal payments on its portfolio of securities, and
to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee now
anticipates that economic conditions are likely to warrant exceptionally low levels of the
federal funds rate at least through late 2014.
As part of our ongoing effort to increase the transparency and predictability of monetary
policy, following its January meeting the FOMC released a statement intended to provide
greater clarity about the Committee's longer-term goals and policy strategy.1 The statement
begins by emphasizing the Federal Reserve's firm commitment to pursue its congressional
mandate to foster stable prices and maximum employment. To clarify how it seeks to achieve
these objectives, the FOMC stated its collective view that inflation at the rate of 2 percent, as
measured by the annual change in the price index for personal consumption expenditures, is
most consistent over the longer run with the Federal Reserve's statutory mandate; and it
indicated that the central tendency of FOMC participants' current estimates of the longer-run
normal rate of unemployment is between 5.2 and 6.0 percent. The statement noted that
these statutory objectives are generally complementary, but when they are not, the
Committee will take a balanced approach in its efforts to return both inflation and
employment to their desired levels.
Fiscal policy challenges
In the remainder of my remarks, I would like to briefly discuss the fiscal challenges facing
your Committee and the country. The federal budget deficit widened appreciably with the
onset of the recent recession, and it has averaged around 9 percent of gross domestic
product (GDP) over the past three fiscal years. This exceptional increase in the deficit has
mostly reflected the automatic cyclical response of revenues and spending to a weak
economy as well as the fiscal actions taken to ease the recession and aid the recovery. As
the economy continues to expand and stimulus policies are phased out, the budget deficit
should narrow over the next few years.
Unfortunately, even after economic conditions have returned to normal, the nation will still
face a sizable structural budget gap if current budget policies continue. Using information
from the recent budget outlook by the Congressional Budget Office, one can construct a
projection for the federal deficit assuming that most expiring tax provisions are extended and
that Medicare's physician payment rates are held at their current level. Under these
assumptions, the budget deficit would be more than 4 percent of GDP in fiscal year 2017,
assuming that the economy is then close to full employment.2 Of even greater concern is that
longer-run projections, based on plausible assumptions about the evolution of the economy
and budget under current policies, show the structural budget gap increasing significantly
further over time and the ratio of outstanding federal debt to GDP rising rapidly. This dynamic
is clearly unsustainable.
These structural fiscal imbalances did not emerge overnight. To a significant extent, they are
the result of an aging population and, especially, fast-rising health-care costs, both of which
have been predicted for decades. Notably, the Congressional Budget Office projects that net
federal outlays for health-care entitlements - which were about 5 percent of GDP in fiscal
2011 - could rise to more than 9 percent of GDP by 2035.3 Although we have been warned
about such developments for many years, the time when projections become reality is
coming closer.
Having a large and increasing level of government debt relative to national income runs the
risk of serious economic consequences. Over the longer term, the current trajectory of
federal debt threatens to crowd out private capital formation and thus reduce productivity
growth. To the extent that increasing debt is financed by borrowing from abroad, a growing
share of our future income would be devoted to interest payments on foreign-held federal
debt. High levels of debt also impair the ability of policymakers to respond effectively to
future economic shocks and other adverse events.
Even the prospect of unsustainable deficits has costs, including an increased possibility of a
sudden fiscal crisis. As we have seen in a number of countries recently, interest rates can
soar quickly if investors lose confidence in the ability of a government to manage its fiscal
policy. Although historical experience and economic theory do not indicate the exact
threshold at which the perceived risks associated with the U.S. public debt would increase
markedly, we can be sure that, without corrective action, our fiscal trajectory will move the
nation ever closer to that point.
To achieve economic and financial stability, U.S. fiscal policy must be placed on a
sustainable path that ensures that debt relative to national income is at least stable or,
preferably, declining over time. Attaining this goal should be a top priority.
Even as fiscal policymakers address the urgent issue of fiscal sustainability, they should take
care not to unnecessarily impede the current economic recovery. Fortunately, the two goals
of achieving long-term fiscal sustainability and avoiding additional fiscal headwinds for the
current recovery are fully compatible - indeed, they are mutually reinforcing. On the one
hand, a more robust recovery will lead to lower deficits and debt in coming years. On the
other hand, a plan that clearly and credibly puts fiscal policy on a path to sustainability could
help keep longer-term interest rates low and improve household and business confidence,
thereby supporting improved economic performance today.
Fiscal policymakers can also promote stronger economic performance in the medium term
through the careful design of tax policies and spending programs. To the fullest extent
possible, our nation's tax and spending policies should increase incentives to work and save,
encourage investments in the skills of our workforce, stimulate private capital formation,
promote research and development, and provide necessary public infrastructure. Although
we cannot expect our economy to grow its way out of our fiscal imbalances, a more
productive economy will ease the tradeoffs that we face and increase the likelihood that we
leave a healthy economy to our children and grandchildren.