Ben S Bernanke: Semiannual Monetary Policy Report to the Congress
Testimony by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington, DC,
19 July 2006.
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Mr. Chairman and members of the Committee, I am pleased to be here again to present the Federal
Reserve's Monetary Policy Report to the Congress.
Over the period since our February report, the U.S. economy has continued to expand. Real gross
domestic product (GDP) is estimated to have risen at an annual rate of 5.6 percent in the first quarter
of 2006. The available indicators suggest that economic growth has more recently moderated from
that quite strong pace, reflecting a gradual cooling of the housing market and other factors that I will
discuss. With respect to the labor market, more than 850,000 jobs were added, on net, to nonfarm
payrolls over the first six months of the year, though these gains came at a slower pace in the second
quarter than in the first. Last month the unemployment rate stood at 4.6 percent.
Inflation has been higher than we had anticipated in February, partly as a result of further sharp
increases in the prices of energy and other commodities. During the first five months of the year,
overall inflation as measured by the price index for personal consumption expenditures averaged 4.3
percent at an annual rate. Over the same period, core inflation - that is, inflation excluding food and
energy prices - averaged 2.6 percent at an annual rate. To address the risk that inflation pressures
might remain elevated, the Federal Open Market Committee (FOMC) continued to firm the stance of
monetary policy, raising the federal funds rate another 3/4 percentage point, to 5-1/4 percent, in the
period since our last report.
Let me now review the current economic situation and the outlook in a bit more detail, beginning with
developments in the real economy and then turning to the inflation situation. I will conclude with some
comments on monetary policy.
The U.S. economy appears to be in a period of transition. For the past three years or so, economic
growth in the United States has been robust. This growth has reflected both the ongoing
reemployment of underutilized resources, as the economy recovered from the weakness of earlier in the
decade, and the expansion of the economy's underlying productive potential, as determined by such
factors as productivity trends and growth of the labor force. Although the rates of resource utilization
that the economy can sustain cannot be known with any precision, it is clear that, after several years
of above-trend growth, slack in resource utilization has been substantially reduced. As a consequence,
a sustainable, non-inflationary expansion is likely to involve a modest reduction in the growth of
economic activity from the rapid pace of the past three years to a pace more consistent with the rate of
increase in the nation's underlying productive capacity. It bears emphasizing that, because productivity
growth seems likely to remain strong, the productive capacity of our economy should expand over the
next few years at a rate sufficient to support solid growth in real output.
As I have noted, the anticipated moderation in economic growth now seems to be under way, although
the recent erratic growth pattern complicates this assessment. That moderation appears most evident
in the household sector. In particular, consumer spending, which makes up more than two-thirds of
aggregate spending, grew rapidly during the first quarter but decelerated during the spring. One likely
source of this deceleration was higher energy prices, which have adversely affected the purchasing
power of households and weighed on consumer attitudes.
Outlays for residential construction, which have been at very high levels in recent years, rose further in
the first quarter. More recently, however, the market for residential real estate has been cooling, as
can be seen in the slowing of new and existing home sales and housing starts. Some of the recent
softening in housing starts may have resulted from the unusually favorable weather during the first
quarter of the year, which pulled forward construction activity, but the slowing of the housing market
appears to be more broad-based than can be explained by that factor alone. Home prices, which have
climbed at double-digit rates in recent years, still appear to be rising for the nation as a whole, though
significantly less rapidly than before. These developments in the housing market are not particularly
surprising, as the sustained run-up in housing prices, together with some increase in mortgage rates,
has reduced affordability and thus the demand for new homes.
The slowing of the housing market may restrain other forms of household spending as well. With
homeowners no longer experiencing increases in the equity value of their homes at the rapid pace
seen in the past few years, and with the recent declines in stock prices, increases in household net
worth are likely to provide less of a boost to consumer expenditures than they have in the recent past.
That said, favorable fundamentals, including relatively low unemployment and rising disposable
incomes, should provide support for consumer spending. Overall, household expenditures appear
likely to expand at a moderate pace, providing continued impetus to the overall economic expansion.
Although growth in household spending has slowed, other sectors of the economy retain considerable
momentum. Business investment in new capital goods appears to have risen briskly, on net, so far this
year. In particular, investment in nonresidential structures, which had been weak since 2001, seems to
have picked up appreciably, providing some offset to the slower growth in residential construction.
Spending on equipment and software has also been strong. With a few exceptions, business
inventories appear to be well aligned with sales, which reduces the risk that a buildup of unwanted
inventories might act to reduce production in the future. Business investment seems likely to continue
to grow at a solid pace, supported by growth in final sales, rising backlogs of orders for capital goods,
and high rates of profitability. To be sure, businesses in certain sectors have experienced financial
difficulties. In the aggregate, however, firms remain in excellent financial condition, and credit
conditions for businesses are favorable.
Globally, output growth appears strong. Growth of the global economy will help support U.S. economic
activity by continuing to stimulate demand for our exports of goods and services. One downside of the
strength of the global economy, however, is that it has led to significant increases in the demand for
crude oil and other primary commodities over the past few years. Together with heightened
geopolitical uncertainties and the limited ability of suppliers to expand capacity in the short run, these
rising demands have resulted in sharp rises in the prices at which those goods are traded
internationally, which in turn has put upward pressure on costs and prices in the United States.
Overall, the U.S. economy seems poised to grow in coming quarters at a pace roughly in line with the
expansion of its underlying productive capacity. Such an outlook is embodied in the projections of
members of the Board of Governors and the presidents of Federal Reserve Banks that were made
around the time of the FOMC meeting late last month, based on the assumption of appropriate
monetary policy. In particular, the central tendency of those forecasts is for real GDP to increase about
3-1/4 percent to 3-1/2 percent in 2006 and 3 percent to 3-1/4 percent in 2007. With output expanding
at a pace near that of the economy's potential, the civilian unemployment rate is expected to finish
both 2006 and 2007 between 4-3/4 percent and 5 percent, close to its recent level.
I turn now to the inflation situation. As I noted, inflation has been higher than we expected at the time
of our last report. Much of the upward pressure on overall inflation this year has been due to increases
in the prices of energy and other commodities and, in particular, to the higher prices of products
derived from crude oil. Gasoline prices have increased notably as a result of the rise in petroleum
prices as well as factors specific to the market for ethanol. The pickup in inflation so far this year has
also been reflected in the prices of a range of non-energy goods and services, as strengthening
demand may have given firms more ability to pass energy and other costs through to consumers. In
addition, increases in residential rents, as well as in the imputed rent on owner-occupied homes, have
recently contributed to higher core inflation.
The recent rise in inflation is of concern to the FOMC. The achievement of price stability is one of the
objectives that make up the Congress's mandate to the Federal Reserve. Moreover, in the long run,
price stability is critical to achieving maximum employment and moderate long-term interest rates, the
other parts of the congressional mandate.
The outlook for inflation is shaped by a number of factors, not the least of which is the course of
energy prices. The spot price of oil has moved up significantly further in recent weeks. Futures quotes
imply that market participants expect petroleum prices to roughly stabilize in coming quarters; such an
outcome would, over time, reduce one source of upward pressure on inflation. However, expectations
of a leveling out of oil prices have been consistently disappointed in recent years, and as the
experience of the past week suggests, possible increases in these and other commodity prices remain
a risk to the inflation outlook.
Although the costs of energy and other raw materials are important, labor costs are by far the largest
component of business costs. Anecdotal reports suggest that the labor market is tight in some
industries and occupations and that employers are having difficulty attracting certain types of skilled
workers. To date, however, moderate growth in most broad measures of nominal labor compensation
and the ongoing increases in labor productivity have held down the rise in unit labor costs, reducing
pressure on inflation from the cost side. Employee compensation per hour is likely to rise more quickly
over the next couple of years in response to the strength of the labor market. Whether faster increases
in nominal compensation create additional cost pressures for firms depends in part on the extent to
which they are offset by continuing productivity gains. Profit margins are currently relatively wide, and
the effect of a possible acceleration in compensation on price inflation would thus also depend on the
extent to which competitive pressures force firms to reduce margins rather than pass on higher costs.
The public's inflation expectations are another important determinant of inflation. The Federal Reserve
must guard against the emergence of an inflationary psychology that could impart greater persistence
to what would otherwise be a transitory increase in inflation. After rising earlier this year, measures of
longer-term inflation expectations, based on surveys and on a comparison of yields on nominal and
inflation-indexed government debt, have edged down and remain contained. These developments
bear watching, however.
Finally, the extent to which aggregate demand is aligned with the economy's underlying productive
potential also influences inflation. As I noted earlier, FOMC participants project that the growth in
economic activity should moderate to a pace close to that of the growth of potential both this year and
next. Should that moderation occur as anticipated, it should help to limit inflation pressures over time.
The projections of the members of the Board of Governors and the presidents of the Federal Reserve
Banks, which are based on information available at the time of the last FOMC meeting, are for a
gradual decline in inflation in coming quarters. As measured by the price index for personal
consumption expenditures excluding food and energy, inflation is projected to be 2-1/4 percent to
21/2 percent this year and then to edge lower, to 2 percent to 2-1/4 percent next year.
The FOMC projections, which now anticipate slightly lower growth in real output and higher core
inflation than expected in our February report, mirror the somewhat more adverse circumstances
facing our economy, which have resulted from the recent steep run-up in energy costs and
higherthan-expected inflation more generally. But they also reflect our assessment that, with appropriate
monetary policy and in the absence of significant unforeseen developments, the economy should
continue to expand at a solid and sustainable pace and core inflation should decline from its recent
level over the medium term.
Although our baseline forecast is for moderating inflation, the Committee judges that some inflation
risks remain. In particular, the high prices of energy and other commodities, in conjunction with high
levels of resource utilization that may increase the pricing power of suppliers of goods and services,
have the potential to sustain inflation pressures. More generally, if the pattern of elevated readings on
inflation is more protracted or more intense than is currently expected, this higher level of inflation
could become embedded in the public's inflation expectations and in price-setting behavior.
Persistently higher inflation would erode the performance of the real economy and would be costly to
reverse. The Federal Reserve must take account of these risks in making its policy decisions.
In our pursuit of maximum employment and price stability, monetary policy makers operate in an
environment of uncertainty. In particular, we have imperfect knowledge about the effects of our own
policy actions as well as of the many other factors that will shape economic developments during the
forecast period. These uncertainties bear importantly on our policy decisions because the full influence
of policy actions on the economy is felt only after a considerable period of time. The lags between
policy actions and their effects imply that we must be forward-looking, basing our policy choices on the
longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take
account of the possible future effects of previous policy actions - that is, of policy effects still "in the
pipeline." Finally, as I have noted, we must consider not only what appears to be the most likely
outcome but also the risks to that outlook and the costs that would be incurred should any of those
risks be realized.
At the same time, because economic forecasting is far from a precise science, we have no choice but
to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy
must be flexible and ready to adjust to changes in economic projections. In particular, as the
Committee noted in the statement issued after its June meeting, the extent and timing of any
additional firming that may be needed to address inflation risks will depend on the evolution of the
outlook for both inflation and economic growth, as implied by our analysis of the incoming information.
Thank you. I would be happy to take questions.