Ben S Bernanke: Current economic and financial conditions and the
federal budget
Testimony by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, before the Committee on the Budget, US Senate, Washington DC, 3 March
2009.
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Chairman Conrad, Senator Gregg, and members of the Committee, I am pleased to be here
today to offer my views on current economic and financial conditions, the federal budget, and
related issues.
Recent financial and economic developments and the policy responses
Over the past 18 months, the global economy has experienced a period of extraordinary
turbulence. The collapse of a global credit boom, triggered by the end of housing booms in
the United States and other countries and the associated problems in mortgage markets, has
led to a deterioration of asset values and credit conditions and taken a heavy toll on business
and consumer confidence.
The financial crisis intensified considerably in the fall. In the United States, the
governmentsponsored enterprises, Fannie Mae and Freddie Mac, were placed into conservatorship, and
Lehman Brothers Holdings and several other large financial institutions either failed, nearly
failed, or were acquired by competitors under distressed circumstances. Losses at money
market mutual funds led to large withdrawals by their investors, and those outflows
undermined both the stability of short-term funding markets, particularly the commercial
paper market, and confidence in wholesale bank funding markets.
In early October, the loss of investor confidence in financial institutions around the world
raised the prospect of an international financial collapse, an event that would have been
devastating for global economic prospects. Using authorities granted by the Emergency
Economic Stabilization Act, on October 14, the Treasury announced a plan to inject $250
billion in capital into U.S. financial institutions. The Treasury's actions were complemented by
the Federal Deposit Insurance Corporation's expansion of bank liability guarantees and by
the expansive provision of liquidity by the Federal Reserve. Together with similar measures
in other countries, these steps averted a collapse and restored a degree of stability to the
financial system. Nevertheless, the cumulative effect of the financial stress was to precipitate
a sharp downturn in economic activity around the world.
The Federal Reserve responded forcefully to the significant deterioration in financial market
conditions and the substantial worsening of the economic outlook by continuing to ease
monetary policy aggressively late last year. By December, the Federal Open Market
Committee (FOMC) had brought its target for the federal funds rate to a historically low range
of 0 to 1/4 percent, where it remains today. The FOMC anticipates that economic conditions
are likely to warrant exceptionally low levels of the federal funds rate for some time.
With the federal funds rate close to zero, the Federal Reserve has focused on alternative
tools to ease conditions in credit markets. We have established new lending facilities and
expanded existing facilities that aim to enhance the flow of credit to businesses and
households: We increased the size of the Term Auction Facility to help ensure that banks
could obtain the funds they need to provide credit to their customers; we expanded our
network of swap lines with foreign central banks to help ease conditions in global dollar
markets that were spilling over into our own funding markets; we established facilities to
promote the functioning of money market mutual funds and the commercial paper market;
and we introduced the Term Asset-Backed Securities Loan Facility, or TALF, which is
designed to facilitate the renewed issuance of consumer and small business asset-backed
securities. In addition, to improve the functioning of the mortgage market and to support
housing markets and economic activity more broadly, the Federal Reserve has begun to
purchase large amounts of agency debt and agency mortgage-backed securities.
The measures taken since September by the Federal Reserve, other U.S. government
entities, and foreign governments have helped improve conditions in some financial markets.
In particular, strains in short-term funding markets have eased notably since last fall, and
London interbank offered rates, or Libor - which influence the interest rates faced by many
U.S. households and businesses - have decreased sharply. Conditions in the commercial
paper market also have improved, even for lower-rated borrowers, and the sharp outflows
from money market mutual funds in September have been replaced by modest inflows. In the
market for conforming mortgages, interest rates have fallen nearly 1 percentage point since
the announcement of our intention to purchase agency debt and agency mortgage-backed
securities. Corporate risk spreads have also declined somewhat from extraordinarily high
levels, although bond spreads remain elevated by historical standards. Likely spurred by the
improvements in pricing and liquidity, issuance of investment-grade corporate bonds has
been strong, and speculative-grade issuance, which was near zero in the fourth quarter, has
picked up somewhat more recently. Nevertheless, significant stresses persist in many
markets. For example, most securitization markets remain closed, and some financial
institutions remain under pressure.
As I noted, the ongoing stresses in the financial markets have been accompanied by a sharp
contraction in economic activity. After edging down during the summer, real gross domestic
product (GDP) is reported by the Commerce Department to have declined at an annual rate
of 6.2 percent in the fourth quarter of last year, with nearly every major category of final sales
contributing to the drop.
The recent near-term indicators show little sign of improvement. Businesses shed 600,000
jobs in January, about the same pace of job loss as in November and December, and the
unemployment rate jumped to 7.6 percent. Moreover, the number of claims for
unemployment insurance has moved higher since mid-January, suggesting that labor market
conditions may have worsened further in recent weeks. In reaction to the deteriorating job
market, the sizable losses of equity and housing wealth, and the tightening of credit
conditions, households have continued to rein in their spending. Home sales and new
construction have continued to decline despite lower mortgage rates, reflecting the uncertain
economic environment and the expectation of many potential buyers that home prices have
further to fall.
The manufacturing sector has also deteriorated further so far this year. Manufacturing output
fell sharply again in January, bringing the rate of capacity utilization to its lowest level in the
post-World War II period. Orders and shipments of durable goods, which dropped in the
fourth quarter, fell markedly further in January, and most survey-based measures of business
conditions are at or near record low levels. Given the weak economic environment, many
businesses have apparently cut back their plans for capital expenditures significantly.
Moreover, exports, which had provided a welcome offset to the weakness in domestic
demand through the middle of 2008, fell sharply in the final months of last year, and the
incoming news suggests a widespread contraction in activity abroad.
Despite the considerable decline in final demand in the United States, businesses have
managed to trim inventories in recent quarters. Still, with sales anticipated to remain poor for
a while longer, many businesses are carrying more inventories than they desire and,
consequently, are likely to cut production further in the months ahead.
Meanwhile, overall consumer price inflation has slowed considerably, primarily because of
the steep drop in energy prices in the second half of last year. The PCE price index was up
just 0.7 percent in January from its year-earlier level, after having risen 3-1/2 percent over
the preceding 12-month period. Core PCE price inflation, which excludes the direct effects of
food and energy prices, has also slowed, decreasing to 1-1/2 percent for the 12 months
ending in January from 2-1/4 percent in the year-earlier period. Wide margins of economic
slack and reduced cost pressures suggest that inflation is likely to remain quite low over the
next couple of years.
Although the near-term outlook for the economy is weak, over time, a number of factors
should promote the return of solid gains in economic activity in the context of low and stable
inflation. The effectiveness of the policy actions taken by the Federal Reserve, the Treasury,
and other government entities in restoring a reasonable degree of financial stability will be
critical determinants of the timing and strength of the recovery. If financial conditions
improve, the economy will be increasingly supported by fiscal and monetary stimulus, the
beneficial effects of the steep decline in energy prices since last summer, and the better
alignment of business inventories and final sales, as well as the increased availability of
credit.
Fiscal policy in the current economic and financial environment
As you are well aware, the Congress recently passed a major fiscal package, which is aimed
at strengthening near-term economic activity. The package includes personal tax cuts and
increases in transfer payments intended to stimulate household spending, incentives for
business investment, federal grants for state and local governments to reduce their need to
cut services or cancel building projects, and increases in federal purchases. By supporting
public and private spending, the fiscal package should provide a boost to demand and
production over the next two years as well as mitigate the overall loss of employment and
income that would otherwise occur.
That said, the timing and the magnitude of the macroeconomic effects of the fiscal program
are subject to considerable uncertainty, reflecting both the state of economic knowledge and
the unusual economic circumstances that we face. For example, households confronted with
declining incomes and limited access to credit might be expected to spend most of their tax
cuts; then again, heightened economic uncertainties and the desire to increase precautionary
saving or pay down debt might reduce households' propensity to spend. Likewise, it is
difficult to judge how quickly funds dedicated to infrastructure needs and other longer-term
projects will be spent and how large any follow-on effects will be. The Congressional Budget
Office (CBO) has constructed a range of estimates of the effects of the stimulus package on
real GDP and employment that appropriately reflects these uncertainties. According to the
CBO's estimates, the effect of the stimulus package on the level of real GDP at the end of
2010 could range from about 1 percent to a little more than 3 percent, relative to a baseline
forecast that does not include the stimulus. They estimate that these effects on output would
leave the corresponding unemployment rate between 1/2 percentage point and 2 percentage
points lower at the end of next year than in the baseline forecast.
The goal of the fiscal package is not just to provide a one-time boost to the economy, but to
lay the groundwork for a self-sustaining, broad-based recovery. Historical experience
strongly suggests that without a reasonable degree of financial stability, a sustainable
recovery will not occur. Although progress has been made on the financial front since last
fall, more needs to be done. As you know, in response to ongoing concerns about the health
of financial institutions, the Treasury recently announced plans for further steps to ensure the
strength and soundness of the financial system and to promote a more smooth flow of credit
to households and businesses. The plan would use the remaining resources appropriated to
the Treasury under the Emergency Economic Stabilization Act - approximately $350 billion -
and also involve additional spending to support the activities of Fannie Mae and Freddie
Mac. Whether further funds will be needed depends on the results of the current supervisory
assessment of banks, the evolution of the economy, and other factors. The Administration
has included a placeholder in its budget for more funding for financial stabilization, should it
be necessary.
Unfortunately, the spending for financial stabilization, the increases in spending and
reductions in taxes associated with the fiscal package, and the losses in revenues and
increases in income-support payments associated with the weak economy will widen the
federal budget deficit substantially this year. Taking into account these factors, the
Administration recently submitted a proposed budget that projects the federal deficit to
increase to about $1.8 trillion this fiscal year and to remain around $1 trillion in 2010 and
2011. As a consequence of this elevated level of borrowing, the ratio of federal debt held by
the public to nominal GDP is likely to move up from about 40 percent before the onset of the
financial crisis to more than 60 percent over the next several years - its highest level since
the early 1950s, in the years following the massive debt buildup during World War II.
Of course, all else equal, this is a development that all of us would have preferred to avoid.
But our economy and financial markets face extraordinary challenges, and a failure by
policymakers to address these challenges in a timely way would likely be more costly in the
end. We are better off moving aggressively today to solve our economic problems; the
alternative could be a prolonged episode of economic stagnation that would not only
contribute to further deterioration in the fiscal situation, but would also imply lower output,
employment, and incomes for an extended period.
With such large near-term deficits, it may seem too early to be contemplating the necessary
return to fiscal sustainability. To the contrary, maintaining the confidence of the financial
markets requires that we begin planning now for the restoration of fiscal balance. As the
economy recovers and resources become more fully employed, we will need to withdraw the
temporary components of the fiscal stimulus. Spending on financial stabilization also must
wind down; if all goes well, the disposition of assets acquired by the Treasury in the process
of stabilization will be a source of added revenue for the Treasury in the out years.
Determining the pace of fiscal normalization will entail some difficult judgments. In particular,
the Congress will need to weigh the costs of running large budget deficits for a time against
the possibility of a premature removal of fiscal stimulus that could blunt the recovery. We at
the Federal Reserve will face similar difficult judgment calls regarding monetary policy.
As I mentioned earlier, the President has recently submitted a budget, and it proposes an
ambitious agenda, including new initiatives for energy, health care, education, and tax policy.
These are all complex policy issues in which the specific design of each program is as
important as the budgetary amount allocated to it. The Congress will have considerable work
in evaluating how to proceed in each of these areas.
As part of that evaluation, it will be critical to consider the formidable challenges and
tradeoffs needed to simultaneously achieve an economic and financial recovery, fiscal
responsibility, and program reforms that accomplish their desired goals effectively and
efficiently. In particular, policymakers must remain prepared to take the actions necessary in
the near term to restore stability to the financial system and to put the economy on a
sustainable path to recovery. But the near-term imperative of achieving economic recovery
and the longer-run desire to achieve programmatic objectives should not be allowed to
hinder timely consideration of the steps needed to address fiscal imbalances. Without fiscal
sustainability, in the longer term we will have neither financial stability nor healthy economic
growth.