Ben S Bernanke: Semiannual Monetary Policy Report to the Congress
Testimony of Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, before the Committee on Financial Services, US House of
Representatives, Washington DC, 18 July 2007.
* * *
Chairman Frank, Ranking Member Bachus, and members of the Committee, I am pleased to
present the Federal Reserve's Monetary Policy Report to the Congress. Monetary Policy
Report to the Congress. As you know, this occasion marks the thirtieth year of semiannual
testimony on the economy and monetary policy by the Federal Reserve. In establishing
these hearings, the Congress proved prescient in anticipating the worldwide trend toward
greater transparency and accountability of central banks in the making of monetary policy.
Over the years, these testimonies and the associated reports have proved an invaluable
vehicle for the Federal Reserve's communication with the public about monetary policy, even
as they have served to enhance the Federal Reserve's accountability for achieving the dual
objectives of maximum employment and price stability set for it by the Congress. I take this
opportunity to reiterate the Federal Reserve's strong support of the dual mandate; in
pursuing maximum employment and price stability, monetary policy makes its greatest
possible contribution to the general economic welfare.
Let me now review the current economic situation and the outlook, beginning with
developments in the real economy and the situation regarding inflation before turning to
monetary policy. I will conclude with comments on issues related to lending to households
and consumer protection-topics not normally addressed in monetary policy testimony but, in
light of recent developments, deserving of our attention today.
After having run at an above-trend rate earlier in the current economic recovery, U.S.
economic growth has proceeded during the past year at a pace more consistent with
sustainable expansion. Despite the downshift in growth, the demand for labor has remained
solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the
unemployment rate having remained at 4-1/2 percent. The combination of moderate gains in
output and solid advances in employment implies that recent increases in labor productivity
have been modest by the standards of the past decade. The cooling of productivity growth in
recent quarters is likely the result of cyclical or other temporary factors, but the underlying
pace of productivity gains may also have slowed somewhat.
To a considerable degree, the slower pace of economic growth in recent quarters reflects the
ongoing adjustment in the housing sector. Over the past year, home sales and construction
have slowed substantially and house prices have decelerated. Although a leveling-off of
home sales in the second half of 2006 suggested some tentative stabilization of housing
demand, sales have softened further this year, leading the number of unsold new homes in
builders' inventories to rise further relative to the pace of new home sales. Accordingly,
construction of new homes has sunk further, with starts of new single-family houses thus far
this year running 10 percent below the pace in the second half of last year.
The pace of home sales seems likely to remain sluggish for a time, partly as a result of some
tightening in lending standards and the recent increase in mortgage interest rates. Sales
should ultimately be supported by growth in income and employment as well as by mortgage
rates that - despite the recent increase - remain fairly low relative to historical norms.
However, even if demand stabilizes as we expect, the pace of construction will probably fall
somewhat further as builders work down stocks of unsold new homes. Thus, declines in
residential construction will likely continue to weigh on economic growth over coming
quarters, although the magnitude of the drag on growth should diminish over time.
Real consumption expenditures appear to have slowed last quarter, following two quarters of
rapid expansion. Consumption outlays are likely to continue growing at a moderate pace,
aided by a strong labor market. Employment should continue to expand, though possibly at a
somewhat slower pace than in recent years as a result of the recent moderation in the
growth of output and ongoing demographic shifts that are expected to lead to a gradual
decline in labor force participation. Real compensation appears to have risen over the past
year, and barring further sharp increases in consumer energy costs, it should rise further as
labor demand remains strong and productivity increases.
In the business sector, investment in equipment and software showed a modest gain in the
first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile
transportation equipment category appears to have been offset by solid gains in other
categories. Investment in nonresidential structures, after slowing sharply late last year,
seems to have grown fairly vigorously in the first half of 2007. Like consumption spending,
business fixed investment overall seems poised to rise at a moderate pace, bolstered by
gains in sales and generally favorable financial conditions. Late last year and early this year,
motor vehicle manufacturers and firms in several other industries found themselves with
elevated inventories, which led them to reduce production to better align inventories with
sales. Excess inventories now appear to have been substantially eliminated and should not
prove a further restraint on growth.
The global economy continues to be strong. Supported by solid economic growth abroad,
U.S. exports should expand further in coming quarters. Nonetheless, our trade deficit - which
was about 5-1/4 percent of nominal gross domestic product (GDP) in the first quarter - is
likely to remain high.
For the most part, financial markets have remained supportive of economic growth. However,
conditions in the subprime mortgage sector have deteriorated significantly, reflecting
mounting delinquency rates on adjustable-rate loans. In recent weeks, we have also seen
increased concerns among investors about credit risk on some other types of financial
instruments. Credit spreads on lower-quality corporate debt have widened somewhat, and
terms for some leveraged business loans have tightened. Even after their recent rise,
however, credit spreads remain near the low end of their historical ranges, and financing
activity in the bond and business loan markets has remained fairly brisk.
Overall, the U.S. economy appears likely to expand at a moderate pace over the second half
of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's
underlying trend. Such an assessment was made around the time of the June meeting of the
Federal Open Market Committee (FOMC) by the members of the Board of Governors and
the presidents of the Reserve Banks, all of whom participate in deliberations on monetary
policy. The central tendency of the growth forecasts, which are conditioned on the
assumption of appropriate monetary policy, is for real GDP to expand roughly 2-1/4 to 2-1/2
percent this year and 2-1/2 to 2-3/4 percent in 2008. The forecasted performance for this
year is about 1/4 percentage point below that projected in February, the difference being
largely the result of weaker-than-expected residential construction activity this year. The
unemployment rate is anticipated to edge up to between 4-1/2 and 4-3/4 percent over the
balance of this year and about 4-3/4 percent in 2008, a trajectory about the same as the one
expected in February.
I turn now to the inflation situation. Sizable increases in food and energy prices have boosted
overall inflation and eroded real incomes in recent months - both unwelcome developments.
As measured by changes in the price index for personal consumption expenditures (PCE
inflation), inflation ran at an annual rate of 4.4 percent over the first five months of this year, a
rate that, if maintained, would clearly be inconsistent with the objective of price stability.1
Because monetary policy works with a lag, however, policymakers must focus on the
economic outlook. Food and energy prices tend to be quite volatile, so that, looking forward,
core inflation (which excludes food and energy prices) may be a better gauge than overall
inflation of underlying inflation trends. Core inflation has moderated slightly over the past few
months, with core PCE inflation coming in at an annual rate of about 2 percent so far this
year.
Although the most recent readings on core inflation have been favorable, month-to-month
movements in inflation are subject to considerable noise, and some of the recent
improvement could also be the result of transitory influences. However, with long-term
inflation expectations contained, futures prices suggesting that investors expect energy and
other commodity prices to flatten out, and pressures in both labor and product markets likely
to ease modestly, core inflation should edge a bit lower, on net, over the remainder of this
year and next year. The central tendency of FOMC participants' forecasts for core PCE
inflation - 2 to 2-1/4 percent for 2007 and 1-3/4 to 2 percent in 2008 - is unchanged from
February. If energy prices level off as currently anticipated, overall inflation should slow to a
pace close to that of core inflation in coming quarters.
At each of its four meetings so far this year, the FOMC maintained its target for the federal
funds rate at 5-1/4 percent, judging that the existing stance of policy was likely to be
consistent with growth running near trend and inflation staying on a moderating path. As
always, in determining the appropriate stance of policy, we will be alert to the possibility that
the economy is not evolving in the way we currently judge to be the most likely. One risk to
the outlook is that the ongoing housing correction might prove larger than anticipated, with
possible spillovers onto consumer spending. Alternatively, consumer spending, which has
advanced relatively vigorously, on balance, in recent quarters, might expand more quickly
than expected; in that case, economic growth could rebound to a pace above its trend. With
the level of resource utilization already elevated, the resulting pressures in labor and product
markets could lead to increased inflation over time. Yet another risk is that energy and
commodity prices could continue to rise sharply, leading to further increases in headline
inflation and, if those costs passed through to the prices of non-energy goods and services,
to higher core inflation as well. Moreover, if inflation were to move higher for an extended
period and that increase became embedded in longer-term inflation expectations, the
reestablishment of price stability would become more difficult and costly to achieve. With the
level of resource utilization relatively high and with a sustained moderation in inflation
pressures yet to be convincingly demonstrated, the FOMC has consistently stated that
upside risks to inflation are its predominant policy concern.
* * *
In addition to its dual mandate to promote maximum employment and price stability, the
Federal Reserve has an important responsibility to help protect consumers in financial
services transactions. For nearly forty years, the Federal Reserve has been active in
implementing, interpreting, and enforcing consumer protection laws. I would like to discuss
with you this morning some of our recent initiatives and actions, particularly those related to
subprime mortgage lending.
Promoting access to credit and to homeownership are important objectives, and responsible
subprime mortgage lending can help advance both goals. In designing regulations,
policymakers should seek to preserve those benefits. That said, the recent rapid expansion
of the subprime market was clearly accompanied by deterioration in underwriting standards
and, in some cases, by abusive lending practices and outright fraud. In addition, some
households took on mortgage obligations they could not meet, perhaps in some cases
because they did not fully understand the terms. Financial losses have subsequently induced
lenders to tighten their underwriting standards. Nevertheless, rising delinquencies and
foreclosures are creating personal, economic, and social distress for many homeowners and
communities - problems that likely will get worse before they get better.
The Federal Reserve is responding to these difficulties at both the national and the local
levels. In coordination with the other federal supervisory agencies, we are encouraging the
financial industry to work with borrowers to arrange prudent loan modifications to avoid
unnecessary foreclosures. Federal Reserve Banks around the country are cooperating with
community and industry groups that work directly with borrowers having trouble meeting their
mortgage obligations. We continue to work with organizations that provide counseling about
mortgage products to current and potential homeowners. We are also meeting with market
participants - including lenders, investors, servicers, and community groups - to discuss
their concerns and to gain information about market developments.
We are conducting a top-to-bottom review of possible actions we might take to help prevent
recurrence of these problems. First, we are committed to providing more-effective
disclosures to help consumers defend against improper lending. Three years ago, the Board
began a comprehensive review of Regulation Z, which implements the Truth in Lending Act
(TILA). The initial focus of our review was on disclosures related to credit cards and other
revolving credit accounts. After conducting extensive consumer testing, we issued a proposal
in May that would require credit card issuers to provide clearer and easier-to-understand
disclosures to customers. In particular, the new disclosures would highlight applicable rates
and fees, particularly penalties that might be imposed. The proposed rules would also require
card issuers to provide forty-five days' advance notice of a rate increase or any other change
in account terms so that consumers will not be surprised by unexpected charges and will
have time to explore alternatives.
We are now engaged in a similar review of the TILA rules for mortgage loans. We began this
review last year by holding four public hearings across the country, during which we gathered
information on the adequacy of disclosures for mortgages, particularly for nontraditional and
adjustable-rate products. As we did with credit card lending, we will conduct extensive
consumer testing of proposed disclosures. Because the process of designing and testing
disclosures involves many trial runs, especially given today's diverse and sometimes
complex credit products, it may take some time to complete our review and propose new
disclosures.
However, some other actions can be implemented more quickly. By the end of the year, we
will propose changes to TILA rules to address concerns about mortgage loan advertisements
and solicitations that may be incomplete or misleading and to require lenders to provide
mortgage disclosures more quickly so that consumers can get the information they need
when it is most useful to them. We already have improved a disclosure that creditors must
provide to every applicant for an adjustable-rate mortgage product to explain better the
features and risks of these products, such as "payment shock" and rising loan balances.
We are certainly aware, however, that disclosure alone may not be sufficient to protect
consumers. Accordingly, we plan to exercise our authority under the Home Ownership and
Equity Protection Act (HOEPA) to address specific practices that are unfair or deceptive. We
held a public hearing on June 14 to discuss industry practices, including those pertaining to
pre-payment penalties, the use of escrow accounts for taxes and insurance, stated-income
and low-documentation lending, and the evaluation of a borrower's ability to repay. The
discussion and ideas we heard were extremely useful, and we look forward to receiving
additional public comments in coming weeks. Based on the information we are gathering, I
expect that the Board will propose additional rules under HOEPA later this year.
In coordination with the other federal supervisory agencies, last year we issued
principlesbased guidance on nontraditional mortgages, and in June of this year we issued supervisory
guidance on subprime lending. These statements emphasize the fundamental consumer
protection principles of sound underwriting and effective disclosures. In addition, we
reviewed our policies related to the examination of nonbank subsidiaries of bank and
financial holding companies for compliance with consumer protection laws and guidance.
As a result of that review and following discussions with the Office of Thrift Supervision, the
Federal Trade Commission, and state regulators, as represented by the Conference of State
Bank Supervisors and the American Association of Residential Mortgage Regulators, we are
launching a cooperative pilot project aimed at expanding consumer protection compliance
reviews at selected nondepository lenders with significant subprime mortgage operations.
The reviews will begin in the fourth quarter of this year and will include independent
statelicensed mortgage lenders, nondepository mortgage lending subsidiaries of bank and thrift
holding companies, and mortgage brokers doing business with or serving as agents of these
entities. The agencies will collaborate in determining the lessons learned and in seeking
ways to better cooperate in ensuring effective and consistent examinations of and improved
enforcement for nondepository mortgage lenders. Working together to address jurisdictional
issues and to improve information-sharing among agencies, we will seek to prevent abusive
and fraudulent lending while ensuring that consumers retain access to beneficial credit.
I believe that the actions I have described today will help address the current problems. The
Federal Reserve looks forward to working with the Congress on these important issues.