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 House of Representatives,
Washington DC, 3 June 2009.
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Chairman Spratt, Ranking Member Ryan, and other members of the Committee, I am
pleased to have this opportunity to offer my views on current economic and financial
conditions and on issues pertaining to the federal budget.
Economic developments and outlook
The U.S. economy has contracted sharply since last fall, with real gross domestic product
(GDP) having dropped at an average annual rate of about 6 percent during the fourth quarter
of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the
loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the
labor market - the number of new and continuing claims for unemployment insurance
through late May - suggests that sizable job losses and further increases in unemployment
are likely over the next few months.
However, the recent data also suggest that the pace of economic contraction may be
slowing. Notably, consumer spending, which dropped sharply in the second half of last year,
has been roughly flat since the turn of the year, and consumer sentiment has improved. In
coming months, households' spending power will be boosted by the fiscal stimulus program.
Nonetheless, a number of factors are likely to continue to weigh on consumer spending,
among them the weak labor market, the declines in equity and housing wealth that
households have experienced over the past two years, and still-tight credit conditions.
Activity in the housing market, after a long period of decline, has also shown some signs of
bottoming. Sales of existing homes have been fairly stable since late last year, and sales of
new homes seem to have flattened out in the past couple of monthly readings, though both
remain at depressed levels. Meanwhile, construction of new homes has been sufficiently
restrained to allow the backlog of unsold new homes to decline - a precondition for any
recovery in homebuilding.
Businesses remain very cautious and continue to reduce their workforces and capital
investments. On a more positive note, firms are making progress in shedding the unwanted
inventories that they accumulated following last fall's sharp downturn in sales. The
Commerce Department estimates that the pace of inventory liquidation quickened in the first
quarter, accounting for a sizable portion of the reported decline in real GDP in that period. As
inventory stocks move into better alignment with sales, firms should become more willing to
increase production.
We continue to expect overall economic activity to bottom out, and then to turn up later this
year. Our assessments that consumer spending and housing demand will stabilize and that
the pace of inventory liquidation will slow are key building blocks of that forecast. Final
demand should also be supported by fiscal and monetary stimulus, and U.S. exports may
benefit if recent signs of stabilization in foreign economic activity prove accurate. An
important caveat is that our forecast also assumes continuing gradual repair of the financial
system and an associated improvement in credit conditions; a relapse in the financial sector
would be a significant drag on economic activity and could cause the incipient recovery to
stall. I will provide a brief update on financial markets in a moment.
Even after a recovery gets under way, the rate of growth of real economic activity is likely to
remain below its longer-run potential for a while, implying that the current slack in resource
utilization will increase further. We expect that the recovery will only gradually gain
momentum and that economic slack will diminish slowly. In particular, businesses are likely
to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after
economic growth resumes.
In this environment, we anticipate that inflation will remain low. The slack in resource
utilization remains sizable, and, notwithstanding recent increases in the prices of oil and
other commodities, cost pressures generally remain subdued. As a consequence, inflation is
likely to move down some over the next year relative to its pace in 2008. That said, improving
economic conditions and stable inflation expectations should limit further declines in inflation.
Conditions in financial markets
Conditions in a number of financial markets have improved since earlier this year, likely
reflecting both policy actions taken by the Federal Reserve and other agencies as well as the
somewhat better economic outlook. Nevertheless, financial markets and financial institutions
remain under stress, and low asset prices and tight credit conditions continue to restrain
economic activity.
Among the markets where functioning has improved recently are those for short-term
funding, including the interbank lending markets and the commercial paper market. Risk
spreads in those markets appear to have moderated, and more lending is taking place at
longer maturities. The better performance of short-term funding markets in part reflects the
support afforded by Federal Reserve lending programs. It is encouraging that the private
sector's reliance on the Fed's programs has declined as market stresses have eased, an
outcome that was one of our key objectives when we designed our interventions. The
issuance of asset-backed securities (ABS) backed by credit card, auto, and student loans
has also picked up this spring, and ABS funding rates have declined, developments
supported by the availability of the Federal Reserve's Term Asset-Backed Securities Loan
Facility as a market backstop.
In markets for longer-term credit, bond issuance by nonfinancial firms has been relatively
strong recently, and spreads between Treasury yields and rates paid by corporate borrowers
have narrowed some, though they remain wide. Mortgage rates and spreads have also been
reduced by the Federal Reserve's program of purchasing agency debt and agency
mortgage-backed securities. However, in recent weeks, yields on longer-term Treasury
securities and fixed-rate mortgages have risen. These increases appear to reflect concerns
about large federal deficits but also other causes, including greater optimism about the
economic outlook, a reversal of flight-to-quality flows, and technical factors related to the
hedging of mortgage holdings.
As you know, last month, the federal bank regulatory agencies released the results of the
Supervisory Capital Assessment Program (SCAP). The purpose of the exercise was to
determine, for each of the 19 U.S.-owned bank holding companies with assets exceeding
$100 billion, a capital buffer sufficient for them to remain strongly capitalized and able to lend
to creditworthy borrowers even if economic conditions over the next two years turn out to be
worse than we currently expect. According to the findings of the SCAP exercise, under the
more adverse economic outlook, losses at the 19 bank holding companies would total an
estimated $600 billion during 2009 and 2010. After taking account of potential resources to
absorb those losses, including expected revenues, reserves, and existing capital cushions,
we determined that 10 of the 19 institutions should raise, collectively, additional common
equity of $75 billion.
Each of the 10 bank holding companies requiring an additional buffer has committed to raise
this capital by November 9. We are in discussions with these firms on their capital plans,
which are due by June 8. Even in advance of those plans being approved, the 10 firms have
among them already raised more than $36 billion of new common equity, with a number of
their offerings of common shares being over-subscribed. In addition, these firms have
announced actions that would generate up to an additional $12 billon of common equity. We
expect further announcements shortly as their capital plans are finalized and submitted to
supervisors. The substantial progress these firms have made in meeting their required
capital buffers, and their success in raising private capital, suggests that investors are
gaining greater confidence in the banking system.
Fiscal policy in the current economic and financial environment
Let me now turn to fiscal matters. As you are well aware, in February of this year, the
Congress passed the American Recovery and Reinvestment Act, or ARRA, a major fiscal
package aimed at strengthening near-term economic activity. The package included personal
tax cuts and increases in transfer payments intended to stimulate household spending,
incentives for business investment, increases in federal purchases, and federal grants for
state and local governments.
Predicting the effects of these fiscal actions on economic activity is difficult, especially in light
of 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, by the end of 2010, the stimulus package
could boost the level of real GDP between about 1 percent and a little more than 3 percent
and the level of employment by between roughly 1 million and 3-1/2 million jobs.
The increases in spending and reductions in taxes associated with the fiscal package and
the financial stabilization program, along with the losses in revenues and increases in
income-support payments associated with the weak economy, will widen the federal budget
deficit substantially this year. The Administration recently submitted a proposed budget that
projects the federal deficit to reach about $1.8 trillion this fiscal year before declining to $1.3
trillion in 2010 and roughly $900 billion in 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 about 70 percent in 2011.
These developments would leave the debt-to-GDP ratio at its highest level since the early
1950s, the years following the massive debt buildup during World War II.
Certainly, our economy and financial markets face extraordinary near-term challenges, and
strong and timely actions to respond to those challenges are necessary and appropriate.
Nevertheless, even as we take steps to address the recession and threats to financial
stability, maintaining the confidence of the financial markets requires that we, as a nation,
begin planning now for the restoration of fiscal balance. Prompt attention to questions of
fiscal sustainability is particularly critical because of the coming budgetary and economic
challenges associated with the retirement of the baby-boom generation and continued
increases in medical costs. The recent projections from the Social Security and Medicare
trustees show that, in the absence of programmatic changes, Social Security and Medicare
outlays will together increase from about 8-1/2 percent of GDP today to 10 percent by 2020
and 12-1/2 percent by 2030. With the ratio of debt to GDP already elevated, we will not be
able to continue borrowing indefinitely to meet these demands.
Addressing the country's fiscal problems will require a willingness to make difficult choices. In
the end, the fundamental decision that the Congress, the Administration, and the American
people must confront is how large a share of the nation's economic resources to devote to
federal government programs, including entitlement programs. Crucially, whatever size of
government is chosen, tax rates must ultimately be set at a level sufficient to achieve an
appropriate balance of spending and revenues in the long run. In particular, over the longer
term, achieving fiscal sustainability - defined, for example, as a situation in which the ratios
of government debt and interest payments to GDP are stable or declining, and tax rates are
not so high as to impede economic growth - requires that spending and budget deficits be
well controlled.
Clearly, the Congress and the Administration face formidable near-term challenges that must
be addressed. But those near-term challenges must not be allowed to hinder timely
consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a
strong commitment to fiscal sustainability in the longer term, we will have neither financial
stability nor healthy economic growth.
Federal Reserve transparency
Let me close today with an update on the Federal Reserve's initiatives to enhance the
transparency of our credit and liquidity programs. As I noted last month in my testimony
before the Joint Economic Committee, I asked Vice Chairman Kohn to lead a review of our
disclosure policies, with the goal of increasing the range of information that we make
available to the public.1 That group has made significant progress, and we expect to begin
publishing soon a monthly report on the Fed's balance sheet and lending programs that will
summarize and discuss recent developments and provide considerable new information
concerning the number of borrowers at our various facilities, the concentration of borrowing,
and the collateral pledged. In addition, the reports will provide quarterly updates of key
elements of the Federal Reserve's annual financial statements, including information
regarding the System Open Market Account portfolio, our loan programs, and the special
purpose vehicles that are consolidated on the balance sheet of the Federal Reserve Bank of
New York. We hope that this information will be helpful to the Congress and others with an
interest in the Federal Reserve's actions to address the financial crisis and the economic
downturn. We will continue to look for opportunities to broaden the scope of the information
and supporting analysis that we provide to the public.