Ben S Bernanke: The economy and financial markets
Testimony of 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, 14 February 2008.
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Chairman Dodd, Senator Shelby, and other members of the Committee, I am pleased to be
here to offer my views on financial conditions, the near-term economic outlook, and related
issues.
As you know, financial markets in the United States and in a number of other industrialized
countries have been under considerable strain since late last summer. Heightened investor
concerns about the credit quality of mortgages, especially subprime mortgages with
adjustable interest rates, triggered the financial turmoil. However, other factors, including a
broader retrenchment in the willingness of investors to bear risk, difficulties in valuing
complex or illiquid financial products, uncertainties about the exposures of major financial
institutions to credit losses, and concerns about the weaker outlook for the economy, have
also roiled the financial markets in recent months.
As the concerns of investors increased, money center banks and other large financial
institutions have come under significant pressure to take onto their own balance sheets the
assets of some of the off-balance-sheet investment vehicles that they had sponsored. Bank
balance sheets have swollen further as a consequence of the sharp reduction in investor
willingness to buy securitized credits, which has forced banks to retain a substantially higher
share of previously committed and new loans in their own portfolios. Banks have also
reported large losses, reflecting marked declines in the market prices of mortgages and other
assets that they hold. Recently, deterioration in the financial condition of some bond insurers
has led some commercial and investment banks to take further markdowns and has added to
strains in the financial markets.
The banking system has been highly profitable in recent years and entered this episode with
strong capital positions. Some institutions have responded to their recent losses by raising
additional capital. Notwithstanding these positive factors, the unexpected losses and the
increased pressure on their balance sheets have prompted banks to become protective of
their liquidity and balance sheet capacity and, thus, to become less willing to provide funding
to other market participants, including other banks. Banks have also become more restrictive
in their lending to firms and households. For example, in the latest Senior Loan Officer
Opinion Survey conducted by the Federal Reserve, banks reported having further tightened
their lending standards and terms for a broad range of loan types over the past three months.
More-expensive and less-available credit seems likely to continue to be a source of restraint
on economic growth.
In part as the result of the developments in financial markets, the outlook for the economy
has worsened in recent months, and the downside risks to growth have increased. To date,
the largest economic effects of the financial turmoil appear to have been on the housing
market, which, as you know, has deteriorated significantly over the past two years or so. The
virtual shutdown of the subprime mortgage market and a widening of spreads on jumbo
mortgage loans have further reduced the demand for housing, while foreclosures are adding
to the already-elevated inventory of unsold homes. Further cuts in homebuilding and in
related activities are likely.
Conditions in the labor market have also softened. Payroll employment, after increasing
about 95,000 per month on average in the fourth quarter, declined by an estimated 17,000
jobs in January. Employment in the construction and manufacturing sectors has continued to
fall, while the pace of job gains in the services industries has slowed. The softer labor
market, together with factors including higher energy prices, lower equity prices, and
declining home values, seem likely to weigh on consumer spending in the near term. On the
other hand, growth in U.S. exports should continue to provide some offset to the softening in
domestic demand, and the recently approved fiscal package should help to support
household and business spending during the second half of this year and into the first part of
next year.
On the inflation front, a key development over the past year has been the steep run-up in the
price of oil. Last year, food prices also increased exceptionally rapidly by recent standards,
and the foreign exchange value of the dollar weakened. All told, over the four quarters of
2007, the price index for personal consumption expenditures (PCE) increased 3.4 percent,
up from 1.9 percent during 2006. Excluding the prices of food and energy, PCE price inflation
ran at a 2.1 percent rate in 2007, down a bit from 2006. To date, inflation expectations
appear to have remained reasonably well anchored, but any tendency of inflation
expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded
could greatly complicate the task of sustaining price stability and reduce the central bank's
policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead
we will be closely monitoring inflation expectations and the inflation situation more generally.
To address these developments, the Federal Reserve has moved in two main areas. To help
relieve the pressures in the interbank markets, the Federal Reserve - among other actions -
recently introduced a term auction facility (TAF), through which prespecified amounts of
discount window credit can be auctioned to eligible borrowers, and we have been working
closely and cooperatively with other central banks to address market strains that could
hamper the achievement of our broader economic objectives.
In the area of monetary policy, the Federal Open Market Committee (FOMC) has moved
aggressively, cutting its target for the federal funds rate by a total of 225 basis points since
September, including 125 basis points during January alone. As the FOMC noted in its most
recent post-meeting statement, the intent of these actions is to help promote moderate
growth over time and to mitigate the risks to economic activity.
A critical task for the Federal Reserve over the course of this year will be to assess whether
the stance of monetary policy is properly calibrated to foster our mandated objectives of
maximum employment and price stability and, in particular, whether the policy actions taken
thus far are having their intended effects. Monetary policy works with a lag. Therefore, our
policy stance must be determined in light of the medium-term forecast for real activity and
inflation, as well as the risks to that forecast. At present, my baseline outlook involves a
period of sluggish growth, followed by a somewhat stronger pace of growth starting later this
year as the effects of monetary and fiscal stimulus begin to be felt. At the same time, overall
consumer price inflation should moderate from its recent rates, and the public's longer-term
inflation expectations should remain reasonably well anchored.
Although the baseline outlook envisions an improving picture, it is important to recognize that
downside risks to growth remain, including the possibilities that the housing market or the
labor market may deteriorate to an extent beyond that currently anticipated, or that credit
conditions may tighten substantially further. The FOMC will be carefully evaluating incoming
information bearing on the economic outlook and will act in a timely manner as needed to
support growth and to provide adequate insurance against downside risks.