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S. HRG. 112–230 THE SEMIANNUAL MONETARY POLICY REPORT TO CONGRESS HEARING BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED TWELFTH CONGRESS FIRST SESSION ON THE FEDERAL RESERVE’S SEMIANNUAL MONETARY POLICY REPORT TO CONGRESS JULY 14, 2011 Printed for the use of the Committee on Banking, Housing, and Urban Affairs ( Available at: http: //www.fdsys.gov / U.S. GOVERNMENT PRINTING OFFICE 72–339 PDF WASHINGTON : 2012 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800 Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS TIM JOHNSON, South Dakota, Chairman JACK REED, Rhode Island RICHARD C. SHELBY, Alabama CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee DANIEL K. AKAKA, Hawaii JIM DEMINT, South Carolina DAVID VITTER, Louisiana SHERROD BROWN, Ohio MIKE JOHANNS, Nebraska JON TESTER, Montana PATRICK J. TOOMEY, Pennsylvania HERB KOHL, Wisconsin MARK KIRK, Illinois MARK R. WARNER, Virginia JERRY MORAN, Kansas JEFF MERKLEY, Oregon ROGER F. WICKER, Mississippi MICHAEL F. BENNET, Colorado KAY HAGAN, North Carolina DWIGHT FETTIG, Staff Director WILLIAM D. DUHNKE, Republican Staff Director CHARLES YI, Chief Counsel MARC JARSULIC, Chief Economist LAURA SWANSON, Policy Director ANDREW OLMEM, Republican Chief Counsel MIKE PIWOWAR, Republican Senior Economist DANA WADE, Professional Staff Member DAWN RATLIFF, Chief Clerk BRETT HEWITT, Hearing Clerk SHELVIN SIMMONS, IT Director JIM CROWELL, Editor (II) C O N T E N T S THURSDAY, JULY 14, 2011 Page Opening statement of Chairman Johnson ............................................................. Opening statements, comments, or prepared statements of: Senator Shelby .................................................................................................. Senator Moran: Prepared statement ................................................................................... 1 2 41 WITNESS Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System ................................................................................................................... Prepared statement .......................................................................................... Response to written questions of: Senator Shelby ........................................................................................... Senator Reed .............................................................................................. (III) 3 41 105 107 THE SEMIANNUAL MONETARY POLICY REPORT TO CONGRESS THURSDAY, JULY 14, 2011 U.S. SENATE, URBAN AFFAIRS, Washington, DC. The Committee met at 10:03 a.m. in room SD–538, Dirksen Senate Office Building, Hon. Tim Johnson, Chairman of the Committee, presiding. COMMITTEE ON BANKING, HOUSING, AND OPENING STATEMENT OF CHAIRMAN TIM JOHNSON Chairman JOHNSON. I call this hearing to order. We are pleased to welcome Chairman Bernanke, who today will deliver the Federal Reserve’s semiannual Monetary Policy Report to the Congress. His testimony comes at an important moment. While our economy is recovering from the disaster created by the financial crisis, the recovery is far from complete. Employment is unacceptably low. The civilian unemployment rate remains at 9.2 percent. The high levels of unemployment are matched by output that is significantly lower than it ought to be. CBO estimates of potential GDP show that the economy is 5.6 percent below what it could be producing. And, of course, the housing market, which is an important source of wealth for many families and our economy, has yet to recover from the collapse of the house price bubble. Although prices are down significantly from the 2006 peak level, inventories of vacant houses remain high, and residential investment is below pre-bubble levels. In addition to these domestic economic problems, there are concerns about how the European sovereign debt crisis will develop and what affect it may have on our financial markets and institutions. Determining the best policy responses to such a complicated set of economic circumstances is no easy matter, but one thing is certain. We need to put the financial market safeguards of the DoddFrank Act into place as soon as reasonably possible. We must prevent a repetition of the events of 2007 and 2008. Chairman Bernanke, I look forward to your insights on these issues and to discussing the policy course the Federal Reserve has taken. To preserve time for questions, opening statements will be limited to the Chair and Ranking Member. I now turn to Ranking Member Shelby. (1) 2 STATEMENT OF SENATOR RICHARD C. SHELBY Senator SHELBY. Thank you, Mr. Chairman. Welcome again, Chairman Bernanke. Last month the Federal Open Market Committee announced the end of its second round of so-called quantitative easing, commonly referred to as QE2. Chairman Bernanke had claimed that because of QE2 we no longer have the deflation risk. The data seems to support his claim here. For example, the 12-month change in the Consumer Price Index, which was 1.1 percent as recently as November, reached 3.6 percent in May. The rise in inflation, however, reveals that the Fed’s most challenging task still lies ahead, I believe. The Federal Reserve’s balance sheet presently stands at about $2.9 trillion while the Federal funds rate has been effectively zero for more than 2 1⁄2 years. As a result, I believe the stage is set for a resurgence of inflation if the Fed is not real careful. The task confronting the Fed is how to unwind its massive balance sheet without sparking more inflation or damaging the economy—a real task in itself. Unfortunately, the dismal performance of our economy and our record Federal deficit will make this exceedingly difficult in the years ahead. Chairman Bernanke I believe must also contend with the consequences of the Administration’s economic policies. The failure to adopt a pro-growth economic plan or to restrain Federal spending has effectively boxed the Fed into a corner. If the Fed is to curb inflation, it ultimately has to raise interest rates, but the absence of economic growth will likely make such a move more painful for the economy. If the Fed does not raise interest rates, higher inflation is almost assured. Federal borrowing costs could soar, worsening the already severe Federal budget crisis that we have. The last thing our weak economy needs right now is an inflation scare. The economic history of the 1970s should have taught us that it is more painful to get inflation under control than it is to keep inflation in check in the first place. History also demonstrates that the Fed’s monetary policy usually remains too loose for too long. Accordingly, our markets are watching to see if Chairman Bernanke has not only a credible plan but also the will to take the difficult actions necessary to prevent inflation. Today’s hearing gives Chairman Bernanke an opportunity to reassure our markets by explaining to the American people how the Fed intends to navigate through this difficult period. During Chairman Bernanke’s last Humphrey-Hawkins testimony, I was pleased that he explicitly stated the Fed’s price stability target is about 2 percent. Today I would like to know more about how the Fed plans to achieve this target. For example, what is the acceptable range around a 2-percent inflation target? Does the Fed think that the recent inflation data, which shows inflation above 3 percent, violates this target? If inflation is above target, how does the Fed plan to reduce it? In addition, I would like to know how the ongoing turmoil in the European Union could impact monetary policy here. In particular, will the euro crisis further constrain the Fed’s ability to maintain 3 price stability? More transparency we all believe is needed with regard to how the Fed plans to unwind its record balance sheet. And although the Federal Open Market Committee has terminated QE2, it has said that it will maintain the policy of reinvesting principal payments from its existing securities holdings. Chairman Bernanke’s testimony here further indicates that the Federal Open Market Committee may consider another round of quantitative easing if the weak economy continues, and as a result, the Fed’s balance sheet could easily balloon way beyond $3 trillion. It appears that the Fed may be going in the wrong direction. Recent Federal Open Market Committee minutes, however, indicate that the Fed is developing plans for addressing its balance sheet. I hope that Chairman Bernanke can shed here this morning more light on the options that the Fed is considering and when the Fed will begin its difficult task. Finally, I would like to commend Chairman Bernanke on his recent decision to hold press conferences after Federal Open Market Committee meetings. This is an important step that recognizes that the Fed can no longer make policy behind closed doors. This is a positive development because the Fed’s policies will be more effective if they are understood and supported by the public. This step also recognizes that the Fed’s secretive history is an antiquated practice that simply is incompatible with a free society. The Fed is a public institution, and the public has the right to expect both transparency and accountability. The Fed still has far to go in opening up, but I hope Chairman Bernanke will continue his efforts to modernize the Fed’s transparency. I believe the American people deserve nothing less. Thank you, Mr. Chairman. Chairman JOHNSON. Chairman Bernanke, before you begin your testimony, I wanted to let you know that I may have to excuse myself during today’s hearing. In another role as Chairman of the Military Construction VA’s Appropriations Subcommittee, I may need to be on the floor this morning as we begin debate on that bill. Senator Reed will be taking over the gavel. Senator Reed, thank you. Chairman Bernanke, please begin. STATEMENT OF BEN S. BERNANKE, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Mr. BERNANKE. Thank you, Mr. Chairman, Ranking Member Shelby, and other Members of the Committee. I am pleased to present the Federal Reserve’s semiannual Monetary Policy Report to the Congress. I will start with a discussion of current economic conditions and the outlook and then turn to monetary policy. The U.S. economy has continued to recover, but the pace of the expansion so far this year has been modest. After increasing at an annual rate of 2 3⁄4 percent in the second half of 2010, real GDP rose at about a 2-percent rate in the first quarter of this year, and incoming data suggest that the pace of recovery remained soft in the spring. At the same time, the unemployment rate, which had appeared to be on a downward trajectory at the turn of the year, has moved back above 9 percent. 4 In part, the recent weaker-than-expected economic performance appears to have been the result of several factors that are likely to be temporary. Notably, the run-up in prices of energy, especially gasoline, and food has reduced consumer purchasing power. In addition, the supply chain disruptions that occurred following the earthquake in Japan caused U.S. motor vehicle producers to sharply curtail assemblies and limited the availability of some models. Looking forward, however, the apparent stabilization in the prices of oil and other commodities should ease the pressure on household budgets, and vehicle manufacturers report that they are making significant progress in overcoming the parts shortages and expect to increase production substantially this summer. In light of these developments, the most recent projections by members of the Federal Reserve Board and presidents of the Federal Reserve Banks, prepared in conjunction with the FOMC meeting in late June, reflected their assessment that the pace of the economic recovery will pick up in coming quarters. Specifically, participants’ projections for the increase in real GDP have a central tendency of 2.7 to 2.9 percent in 2011, inclusive of the weak first half, and 3.3 to 3.7 percent in 2012—projections that, if realized, would constitute a notably better performance than we have seen so far this year. FOMC participants continued to see the economic recovery strengthening over the medium term, with the central tendency of their projections for the increase in real GDP picking up to 3.5 to 4.2 percent in 2013. At the same time, the central tendencies of the projections of real GDP growth in 2011 and 2012 were marked down nearly one-half percentage point compared with those reported in April, suggesting that FOMC participants saw at least some part of the first-half slowdown as persisting for a while. Among the headwinds facing the economy are the slow growth in consumer spending, even after accounting for the effects of higher food and energy prices; the continuing depressed condition of the housing sector; still-limited access to credit for some households and small businesses; and fiscal tightening at all levels of Government. Consistent with projected growth in real output modestly above its trend rate, FOMC participants expected that, over time, the jobless rate will decline—albeit only slowly—toward its longerterm normal level. The central tendencies of participants’ forecasts for the unemployment rate were 8.6 to 8.9 percent for the fourth quarter of this year, 7.8 to 8.2 percent at the end of 2012, and 7 to 7.5 percent at the end of 2013. The most recent data attest to the continuing weakness of the labor market: The unemployment rate increased to 9.2 percent in June, and gains in non-farm payroll employment were below expectations for a second month. To date, of the more than 8.5 million jobs lost in the recession, 1.75 million have been regained. Of those employed, about 6 percent—8.6 million workers—report that they would like to be working full time but can only obtain part-time work. Importantly, nearly half of those currently unemployed have been out of work for more than 6 months, by far the highest ratio in the post-World War II period. Long-term unemployment imposes severe economic hardships on the unemployed and their families, and by leading to an erosion of skills of those without work, it both 5 impairs their lifetime employment prospects and reduces the productive potential of our economy as a whole. Much of the slowdown in aggregate demand this year has been centered in the household sector, and the ability and willingness of consumers to spend will be an important determinant of the pace of the recovery in coming quarters. Real disposable personal income over the first 5 months of 2011 was boosted by the reduction in payroll taxes, but those gains were largely offset by higher prices for gasoline and other commodities. Households report that they have little confidence in the durability of the recovery and about their own income prospects. Moreover, the ongoing weakness in home values is holding down household wealth and weighing on consumer sentiment. On the positive side, household debt burdens are declining, delinquency rates on credit cards and auto loans are down significantly, and the number of homeowners missing a mortgage payment for the first time is decreasing. The anticipated pickups in economic activity and job creation, together with the expected easing of price pressures, should bolster real household income, confidence, and spending in the medium run. Residential construction activity remains at an extremely low level. The demand for homes has been depressed by many of the same factors that have held down consumer spending more generally, including the slowness of the recovery in jobs and income as well as poor consumer sentiment. Mortgage interest rates are near record lows, but access to mortgage credit continues to be constrained. Also, many potential homebuyers remain concerned about buying into a falling market, as weak demand for homes, the substantial backlog of vacant properties for sale, and the high proportion of distressed sales are keeping downward pressure on house prices. Two bright spots in the recovery have been exports and business investment in equipment and software. Demand for U.S.-made capital goods from both domestic and foreign firms has supported manufacturing production throughout the recovery thus far. Both equipment and software outlays and exports increased solidly in the first quarter, and the data on new orders received by U.S. producers suggest that the trend continued in recent months. Corporate profits have been strong, and larger nonfinancial corporations with access to capital markets have been able to refinance existing debt and lock in funding at lower yields. Borrowing conditions for businesses generally have continued to ease, although, as mentioned, the availability of credit appears to remain relatively limited for some small firms. Inflation has picked up so far this year. The price index for personal consumption expenditures rose at an annual rate of more than 4 percent over the first 5 months of 2011 and 2.5 percent on a 12-month basis. Much of the acceleration was the result of higher prices for oil and other commodities and for imported goods. In addition, prices of motor vehicles increased sharply when supplies of new models were curtailed by parts shortages associated with the earthquake in Japan. Most of the recent rise in inflation appears likely to be transitory, and FOMC participants expected inflation to subside in coming quarters to rates at or below the level of 2 percent or a bit less that participants view as consistent with our 6 dual mandate of maximum employment and price stability. The central tendency of participants’ forecasts for the rate of increase in the PCE price index was 2.3 to 2.5 percent for 2011 as a whole, which implies a significant slowing of inflation in the second half of the year. In 2012 and 2013, the central tendency of the inflation forecasts was 1.5 to 2.0 percent. Reasons to expect inflation to moderate include the apparent stabilization in the prices of oil and other commodities, which is already showing through to retail gasoline and food prices; the still-substantial slack in U.S. labor and product markets, which has made it difficult for workers to obtain wage gains and for firms to pass through their higher costs; and the stability of longer-term inflation expectations, as measured by surveys of households, the forecasts of professional private sector economists, and financial market indicators. Turning to monetary policy, FOMC members’ judgments that the pace of the economic recovery over coming quarters will likely remain moderate, that the unemployment rate will consequently decline only gradually, and that inflation will subside are the basis for the Committee’s decision to maintain a highly accommodative monetary policy. As you know, that policy currently consists of two parts. First, the target range for the Federal funds rate remains at 0 to one-fourth percent and, as indicated in the statement released after the June meeting, the Committee expects that economic conditions are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. The second component of monetary policy has been to increase the Federal Reserve’s holdings of longer-term securities, an approach undertaken because the target for the Federal funds rate could not be lowered meaningfully further. The Federal Reserve’s acquisition of longer-term Treasury securities boosted the prices of such securities and caused longer-term Treasury yields to be lower than they would have been otherwise. In addition, by removing substantial quantities of longer-term Treasury securities from the market, the Fed’s purchases induced private investors to acquire other assets that serve as substitutes for Treasury securities in the financial marketplace, such as corporate bonds and mortgagebacked securities. By this means, the Fed’s asset purchase program—like more conventional monetary policy—has served to reduce the yields and increase the prices of those other assets as well. The net result of these actions is lower borrowing costs and easier financial conditions throughout the economy. We know from many decades of experience with monetary policy that, when the economy is operating below its potential, easier financial conditions tend to promote more rapid economic growth. Estimates based on a number of recent studies as well as Federal Reserve analyses suggest that, all else being equal, the second round of asset purchases probably lowered longer-term interest rates approximately 10 to 30 basis points. Our analysis further indicates that a reduction in longer-term interest rates of this magnitude would be roughly equivalent in terms of its effects on the economy to a 40- to 120-basis-point reduction in the Federal funds rate. 7 In June, we completed the planned purchases of $600 billion in longer-term Treasury securities that the Committee initiated in November, while continuing to reinvest the proceeds of maturing or redeemed longer-term securities in Treasuries. Although we are no longer expanding our securities holdings, the evidence suggests that the degree of accommodation delivered by the Federal Reserve’s securities purchase program is determined primarily by the quantity and mix of securities that the Federal Reserve holds rather than by the current pace of new purchases. Thus, even with the end of net new purchases, maintaining our holdings of these securities should continue to put downward pressure on market interest rates and foster more accommodative financial conditions than would otherwise be the case. It is worth emphasizing that our program involved purchases of securities, not Government spending, and as I will discuss later, when the macroeconomic circumstances call for it, we will unwind those purchases. In the meantime, interest on those securities is being remitted to the U.S. Treasury. When we began this program, we certainly did not expect it to be a panacea for the country’s economic problems. However, as the expansion weakened last summer, developments with respect to both components of our dual mandate implied that additional monetary policy accommodation was needed. In that context, we believed that the program would both help reduce the risk of deflation that had emerged and provide a needed boost to faltering economic activity and job creation. The experience to date with the round of securities purchases that just ended suggests that the program had the intended effects of reducing the risk of deflation and shoring up economic activity. In the months following the August announcement of our policy of reinvesting maturing and redeemed securities and our signal that we were considering more purchases, inflation compensation as measured in the market for inflation-indexed securities rose from low to more normal levels, suggesting that the perceived risks of deflation had receded markedly. This was a significant achievement, as we know from the Japanese experience that protracted deflation can be quite costly in terms of weaker economic growth. With respect to employment, our expectations were relatively modest; estimates made in the autumn suggested that the additional purchases could boost employment by about 700,000 jobs over 2 years, or about 30,000 extra jobs per month. Even including the disappointing readings for May and June, which reflected in part the temporary factors I discussed earlier, private payroll gains have averaged 160,000 per month in the first half of 2011, compared with average increases of only about 80,000 private jobs per month from May to August 2010. Not all of the step-up in hiring was necessarily the result of the asset purchase program, but the comparison is consistent with our expectations for employment gains. Of course, we will be monitoring developments in the labor market closely. Once the temporary shocks that have been holding down economic activity pass, we expect to again see the effects of policy accommodation reflected in stronger economic activity and job creation. However, given the range of uncertainties about the strength of the recovery and prospects for inflation over the medium term, 8 the Federal Reserve remains prepared to respond should economic developments indicate that an adjustment in the stance of monetary policy would be appropriate. On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might re-emerge, implying a need for additional policy support. Even with the Federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the Federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25-basis-point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant. On the other hand, the economy could evolve in a way that would warrant a move toward less accommodative policy. Accordingly, the Committee has been giving careful consideration to the elements of its exit strategy, and as reported in the minutes of the June FOMC meeting, it has reached a broad consensus about the sequence of steps that it expects to follow when the normalization of policy becomes appropriate. In brief, when economic conditions warrant, the Committee would begin the normalization process by ceasing the reinvestment of principal payments on its securities, thereby allowing the Federal Reserve’s balance sheet to begin shrinking. At the same time or sometime thereafter, the Committee would modify the forward guidance in its statement. Subsequent steps would include the initiation of temporary reserve-draining operations and, when conditions warrant, increases in the Federal funds rate target. From that point on, changing the level or range of the Federal funds rate target would be our primary means of adjusting the stance of monetary policy in response to economic developments. Sometime after the first increase in the Federal funds rate target, the Committee expects to initiate sales of agency securities from its portfolio, with the timing and pace of sales clearly communicated to the public in advance. Once sales begin, the pace of sales is anticipated to be relatively gradual and steady, but it could be adjusted up or down in response to material changes in the economic outlook or financial conditions. Over time, the securities portfolio and the associated quantity of bank reserves are expected to be reduced to the minimum levels consistent with the efficient implementation of monetary policy. Of course, conditions can change, and in choosing the time to begin policy normalization as well as the pace of that process, should that be the next direction for policy, we would carefully consider both parts of our dual mandate. Thank you, and I would be pleased to take your questions. 9 Chairman JOHNSON. Thank you for your testimony. We will now begin the questioning of our witness. Will the Clerk please put 5 minutes on the clock for each Member for their questions. The Fed, to its great credit, has pursued policies to stimulate the economy. However, although the Fed continues to hold short-term interest rates near zero, it has ended efforts to reduce longer-term rates through quantitative easing. Given the high rate of unemployment and relatively slow growth in output, why not start a new round of easing, a QE3? Mr. BERNANKE. Well, Mr. Chairman, first, as you point out, our policies are already very highly accommodative. We have almost zero interest rates. And the stock of assets that we have acquired, which Mr. Shelby talked about, continue to put downward pressure on interest rates in the markets, even if we are not buying new assets going forward. I think the important point to make is that the situation today is somewhat different than it was in August of 2010, when we began to initiate discussion of further purchases of securities. At that time, inflation was dropping. Inflation expectations were dropping. It looked like deflation was becoming a potential risk to the economy, and a serious risk. At the same time, over the summer, the recovery looked like it was stalling. We were down to 80,000 jobs a month, private sector jobs a month. Growth was not sufficient to prevent what looked like a potentially significant increase in the unemployment rate, and so we felt that with both unemployment and inflation being missed in the same direction, so to speak, that monetary policy accommodation was surely needed and so we undertook that step. Today, the situation is more complex. Inflation is higher. Inflation expectations are close to our target. We are uncertain about the near-term developments in the economy. We would like to see if the economy does pick up as we are projecting. And so we are not prepared at this point to take further action. Chairman JOHNSON. In your testimony, you note that fiscal tightening at all levels of Government is one of the headwinds facing the economic recovery. Can you explain whether this means that additional short-term fiscal expansion could help us return to full employment and increase overall confidence in the economy. Mr. BERNANKE. Mr. Chairman, I think our fiscal planning and policy needs to be integrated in the sense that we have to be looking at both the short run and the long run at the same time. The Congress and the Administration are currently looking to make major changes in our spending, deficit projections over the next decade or so. I think that is extremely important, that we bring down our deficit so we will have a sustainable fiscal policy going forward, and I want to emphasize that that is very important. At the same time, that process is a long-term process. It is something that needs to take place over a number of years. And I only ask or suggest that as Congress looks at the timing and composition of its changes to the budget that it does take into account that in the very near term that the recovery is still rather fragile and that sharp and excessive cuts in the very short term would be potentially damaging to that recovery. 10 It is up to Congress what further actions to take. I guess I could suggest that there is intermediate steps between fiscal stimulus and cuts, and that would be some focused programs addressing some of the areas in the economy which are particularly stressed, like unemployment or housing. Chairman JOHNSON. As you acknowledge in your testimony, the U.S. housing market is stubbornly depressed. Residential investment is more than a third below its 1997 level. The inventory of homes that are vacant and for sale remains elevated. Do you see policy solutions that would help resolve the problems in the housing market? Mr. BERNANKE. Well, Mr. Chairman, you are absolutely right that the weakness in the housing market is one of the major sources of the slow recovery. Normally, in an expansion, you would see the housing market strengthening and adding jobs and creating new opportunities. We are not seeing that, in part because, as you mentioned, the big overhang of distress sales, open, vacant homes, foreclosed homes which are weighing on prices and creating a vicious circle, where people do not want to buy because prices are falling, and prices are falling because people do not want to buy. There are a number of things that we are doing. The Fed is keeping mortgage rates low. There is work to try to modify mortgages. I think it is worth looking at that area, though. One area where clearly more work needs to be done is in housing finance. You know, we have not yet begun to really clarify for the market and the public how housing finance will be conducted in the future. Another area where I just suggest that you might think about is the overhang of distressed houses. For example, Fannie, Freddie, and the banks own about half-a-million homes right now which are basically sitting there on the market and which are pressing down prices and reducing appraisals and making the housing market just much weaker than it otherwise would be. So that is another area to look at. I mean, there are various things that one could do to approach that, but I agree with you that the housing market is really, in some sense, the epicenter of the problem we have at the moment. Chairman JOHNSON. As yet, there has been no agreement on raising the Federal debt limit. What would be the effects on financial markets and the real economy if the Treasury were forced to default on these obligations? Mr. BERNANKE. Well, Mr. Chairman, as I have said on a number of occasions, I think it would be a calamitous outcome. It would create a very severe financial shock that would have effects not only to the U.S. economy, but on the global economy. Treasury securities are critical to the entire financial system. They are used in many different ways as collateral or as margin. Default on those securities would throw the financial system into chaos, and what would certainly be the case is that we would destroy the trust and confidence that global investors have in U.S. Treasury securities as being the safest and most liquid assets in the world. We are already seeing threats of downgrades from rating agencies. This is a tremendous asset of the United States, the quality and reputation of our Treasury securities, and we benefit from it with low interest rates. So I would urge Congress to take every step pos- 11 sible to avoid defaulting on the debt or creating even any significant probability of defaulting on the debt. Chairman JOHNSON. Senator Shelby. Senator SHELBY. Thank you. Mr. Chairman, tell us here today, and, of course, you are speaking to the American people, why our economy is not moving, our jobs are not growing, unemployment is going in the wrong direction, what, 9.2 official unemployment right now. If you bring in, according to the Labor Department, if you bring in people who have quit looking for a job, it is about 16 percent. That is very, very high. I think it does not bode well for the future for all of us. But why, why is all of this? Is it just the housing bubble, which is severe? Is it the housing bubble and reckless lending that put a lot of our banks in jeopardy? Tell us what it all is and how do we get out of it? Is it reckless spending? All of this. Mr. BERNANKE. Well, Senator, you have almost answered your question. Senator SHELBY. Mm-hmm. Not as well as you could, probably. Mr. BERNANKE. Well, first, let me say that, as I mentioned in my testimony, we do think that the weakness of the first half of this year is, in part, due to temporary factors, and I talked about the disaster in Japan and the developments in the Middle East and so on, and we do think we will see somewhat better growth, although forecasting is very difficult, going forward. But that being said, it has been a very slow recovery and there are a number of reasons for that. One is the aftermath of the housing bubble. With so many houses empty and prices having fallen so much, that has created almost new construction in housing. It means that people have lost wealth because they no longer have any equity in their home. So that has been a major factor. Second is that we know from a lot of research that recoveries after financial crises can be slow because it takes time for the credit system to become operative again. And while I think there has been a lot of improvement in the banking system, there are still some areas, like consumer and small business lending, which are constrained to some extent. The consumer has been very cautious, trying to build back up their wealth, concerned about the durability of the recovery, worried about their own financial prospects. So even though the high price of gasoline and food has taken away some purchasing power, as I mentioned, confidence is pretty low and consumers are not showing the confidence in terms of spending. And then I did mention that there is, in the near term, withdrawal of fiscal stimulus, tightening. For example, the job numbers last Friday, the private numbers were certainly better than the headline numbers because part of this report was the loss of 40,000 State and local jobs as those governments are being forced to contract. Now, of course, over time it is perfectly possible to want to change the composition of public and private employment. That is perfectly understandable. But in the short run, as jobs are lost and they are not replaced elsewhere, it creates pressure on the economy. 12 Senator SHELBY. Are you basically telling us we are not going to have a robust recovery, not in the next 6 months, 8 months, 10 months, are we? Mr. BERNANKE. We are expecting improvement, but we are not expecting—— Senator SHELBY. Nothing—— Mr. BERNANKE.——something like would normally follow a deep recession in previous episodes. Senator SHELBY. Let us talk about the European crisis for a minute. We are all familiar with this to some extent, Greece, Portugal, Ireland, perhaps Italy and others. It seems to me that they are sitting on a financial-related time bomb over there. Do you believe that the European Union, Monetary Union, will stay together? Can it stay together with some smaller countries’ fragile economies that will basically never pay their debt back, cannot pay it back, or what will happen? Mr. BERNANKE. Well—— Senator SHELBY. And how will it impact us, because we will be—— Mr. BERNANKE.——let me just say that the European leadership places a great value on maintaining the Euro area and in maintaining the European political integration which has taken place in the post-war period, and I know they are making extraordinary efforts to address these problems. The problems are not entirely economic because the three countries that you mentioned are really a very small part of the European continent and the European economy. So the questions are at least as much political, and they involve how are you going to address these problems in these countries. One approach is to try to do it completely through austerity, to have the countries just cut and cut and see if they can make it with a little bit of temporary assistance. Another strategy would be to get more direct assistance from other countries, but that is a very unpopular strategy in some of the countries that would be expected to pay—— Senator SHELBY. But that is not a solution to their problem, though—— Mr. BERNANKE. Well, if the better-off countries were to basically help solve the problems of the small countries, it would solve their immediate issue and then there would need to be austerity, fiscal reforms, structural reforms, and so on to make sure the countries stay on a healthier path in the future. So there are different ways to approach it, and again, I think it is really a political issue as much as an economic issue. It is causing a good bit of anxiety in markets, and that has been affecting our economy both last summer and now recently, as well. We are spending a lot of time evaluating the exposures of U.S. financial institutions to these countries, including money market mutual funds and so on. The direct exposures to the three countries you mentioned are quite small and manageable. So we would not expect those direct impacts to be the critical channel if there were problems; a default, for example. But I think that, nevertheless, the U.S. economy is at risk from those developments because were there to be a significant deterio- 13 ration in conditions in Europe, we would see a general increase in risk aversion, declining asset prices, a lot of volatility in markets, and we would suffer from that more general financial situation than we would from the direct exposures to those sovereign countries. Senator SHELBY. Thank you, Mr. Chairman. Chairman JOHNSON. Senator Reed. Senator REED. Thank you very much, Mr. Chairman. Mr. Chairman, following up on Senator Johnson’s question, which was about a default on our outstanding obligations of the Federal Government, some have suggested that if we cannot resolve the debt ceiling limit, we simply prioritize payments. We presumably pay on some Treasuries as long as we can, pay some principal, some interest. That, of course, requires us to not pay on things like military pay and Social Security. But just in the context of the financial sector, would that fix the problem, simply not having the debt limit extended and trying to pay as long as we can on our securities? Mr. BERNANKE. Well, Senator Reed, first of all, it is the Treasury’s area to determine how they are going to manage this. They have been very clear that they do not think it is either appropriate or feasible to prioritize. And as the fiscal agent, the Federal Reserve simply does what they tell us to do, and I think there are some operational issues that arise if you were to try to do it. But again, the Treasury is the determinant of this and they are pretty clear that they do not think that is a workable solution. That being said, whether the default is on securities or it is on payments we owe to Medicare recipients, it is going to constitute a default of some type on obligations incurred by the U.S. Government. It will certainly have an impact on both the economy, but also on confidence. You know, what inference should investors take from the fact that the United States is not paying its bills and that it cannot resolve this issue? So I think that there is not really any solution other than to find a way to solve these problems, to address the fiscal issues, and to—— Senator REED. Pass the debt limit. Mr. BERNANKE.——raise the debt limit at the appropriate time. Senator REED. Let me just explore a little bit. Moody’s today and Standard and Poor’s have suggested that they are putting us on a watch, downgrading, and what clearly is behind them is that if we do not pass the debt limit ceiling raise, then they will downgrade us, not only U.S. Treasuries, but Moody’s has indicated Fannie Mae paper, Freddie Mac paper, Federal Credit Bureau paper. We have also placed for possible downgrade securities either guaranteed by, backed by, collateral securities issued by, or otherwise directly linked to the U.S. Government. So, essentially, they are going to downgrade things we do not even know yet—maybe you know. What does this do in terms of interest rates across the board, likely raise them, even in a, quote, ‘‘technical’’ default? Mr. BERNANKE. Well, the combination of downgrades and loss of investor confidence could potentially raise interest rates quite significantly. And the ironic aspect of that is what we are all interested in doing is reducing the deficit. If you raise interest rates, 14 that means your interest costs go up substantially and you are actually making—you are regressing rather than progressing in terms of—— Senator REED. So a failure to raise the debt ceiling would be probably the most significant and immediate increase in the deficit that we are likely to see, the one act that would dramatically increase the deficit? Mr. BERNANKE. It would be a self-inflicted wound, I would say. Senator REED. Let me ask about something else, too, and that is—because you have talked about the fiscal crisis, but also a jobs crisis. What is your presumption into this scenario about jobs? Are we likely to see people eagerly going out and hiring under this situation of technical or real default? Mr. BERNANKE. Well, we have a recent example. In 2008, when the financial system froze up and we saw an immediate, very sharp contraction of the global economy. Even if things did not get that bad, and one of the key issues here is it is very hard to predict exactly what is going to happen, but if interest rates rise, that is clearly going to reduce investment. Uncertainty will arise. That will reduce the willingness of firms to hire and invest. So if the Government is reducing its payments by 40 percent, that is going to have an impact, as well. Senator REED. Right. Mr. BERNANKE. So I can only conclude that this would be very bad for jobs. Senator REED. Let me ask you another area which we discovered much to our chagrin was a huge and explosive problem. That is the situation of derivatives. I would presume that there area a lot of credit default swaps written on many of these securities, et cetera, and that if they are downgraded, that could be a condition of default. That could require additional collateral. Do you have any idea on the institutions that you regulate the potential exposure they would have as credit ratings fall or as there is a default in the market? Is it in the trillions? Mr. BERNANKE. Well, there are many knock-on effects from a default, ranging throughout the entire system. But CDS directly on Treasuries as opposed to on other securities are actually not that big, and it would take an action of the ISDA to invoke the credit event. So that could be a problem for some institutions, but it would not be the biggest problem among all the things that we have been discussing. Senator REED. But your point, which I want to reiterate, is that this could be a self-inflicted wound doing more damage to the deficit than has been done to date. Mr. BERNANKE. It is really not an option that we want—we should be considering. Senator REED. Thank you. Chairman JOHNSON. Senator Toomey. Senator TOOMEY. Thank you, Mr. Chairman, and I am going to follow up on this for just a moment, but then I want to move on to some other issues, and that is to make the observation that the market proceeds, and, in fact, the consequences are starkly different between, on the one hand, the U.S. Government failing to make an interest payment on a bond, or on the other hand, fur- 15 loughing some Government workers or delaying a reimbursement to a vendor or failing to cut the grass at the monument. These are very, very different events. The month of August has scheduled about $30 billion of interest payments. The Treasury is sitting on a $94 billion portfolio of mortgage-backed securities and we expect a minimum of $125 billion in tax revenue. Now, I do not know of anybody that suggests that we can or should go indefinitely without raising the debt ceiling, and I have argued that we certainly would be much better off reaching an agreement and raising the debt ceiling prior to August 2. But there is a big, big difference between a payment default on our debt and the other kinds of payment disruptions. I think this Administration would be wise to send an unambiguous message to the market that under no circumstances would they tolerate a default on our debt which is entirely under their control to prevent. But I acknowledge that that is the realm of the Treasury and that is not your responsibility. What I would like to address is what is under your realm, and I have said, Mr. Chairman, and I fully acknowledge that the things that you have done under very difficult circumstances have only had the best motivation, but I am concerned about the expansion in power of the central bank that we have, the unusual steps that we have taken, the enormous discretion that the Fed now has and exercises. My concern is that this distorts markets, intentionally, actually. It also introduces enormous uncertainty as to how the Fed will behave. The Fed becomes the biggest player in driving the bond market, the equity markets, and that this is a dangerous place that we have come to, and I hope that we revert as soon as possible to the more normal role that the Fed has played. One of the unintended, I suspect, if not unforseen consequences of this unusual policy, it seems to me, if we take the very, very low interest rates, the zero, or roughly zero percent Fed funds rate, the negative real interest rates the Fed has maintained for an extended period now, it seems to me that this contributes to enabling Congress to run excessive deficits. You know, our debt is cheap to finance, especially when compounded by the fact that the Treasury has chosen to shorten up the maturity—I think unwisely. The net effect is we are not yet paying the price, the real market price that we will certainly eventually have to pay for these massive deficits and this huge debt. I do not think for a minute that that is your intention, to facilitate this fiscal irresponsibility, but I think it is the unintended consequence of these extremely low interest rates, as just one example. But to your testimony, you have raised the possibility now that if economic circumstances warranted, you would consider—you have opened the door to an additional round of securities purchases, so what will no doubt be dubbed QE3. And I guess my concern is that what is wrong with this economy is not fundamentally monetary policy. It is other things. And so I would just ask you to comment on what you see that is wrong with our economy that QE3 would fix. What is the theory that another round of security purchases will somehow generate the economic growth that we lack? 16 Mr. BERNANKE. Well, first, to go back to the facilitation issue, our goal is to try to meet our mandate of maximum employment and price stability, which is why we run monetary policy as we do. I do not think that our policy would prevent a loss of confidence if creditors lost confidence in the Treasury, which would drive up interest rates. It has not happened yet, and I do not think it is because of us. I think it is because people still think that they have confidence in our Government’s ability to make its payments. These asset purchases, in terms of their effects on the economy, they work more or less in the same way that ordinary monetary policy works, by easing financial conditions, lowering interest rates, and providing stimulus through that mechanism. Now, you may be entirely correct, A, that it might not be needed, and B, that it might not be particularly effective given the configuration of problems that we have, if credit is not being extended, or if the problems really arise from other sectors that are not responsive to interest rates. So those are certainly things we will take into account, Senator. We are not proposing anything today. The main message I want to leave is that this is a serious situation. It involves a significant loss of human and economic potential. The Federal Reserve has a mandate and we want to meet that mandate, and to do that, we just want to make sure that we have the options when they become necessary. But at this point, we are not proposing to undertake that option. Senator TOOMEY. Thank you, Mr. Chairman. Chairman JOHNSON. Senator Akaka. Senator AKAKA. Thank you very much, Mr. Chairman. Good morning, Chairman Bernanke. Mr. BERNANKE. Good morning, Senator. Senator AKAKA. I appreciate your joining us today again. Before I begin, I want to thank you very much for your strong leadership. You continue to do an excellent job under very difficult circumstances. Chairman Bernanke, we all understand the importance of preventing a Government default. Many Americans, however, seem not to share this urgency. A Gallup poll in May found that only 19 percent of Americans would want their Member of Congress to vote for a debt ceiling increase, and 34 percent did not even know enough about the issue to answer the question. Another poll in July by Pew and Washington Post showed that Americans are more concerned about controlling spending than they are about a Government default. Chairman Bernanke, will you please explain specifically how a Government default would affect the everyday lives of workingclass Americans. Mr. BERNANKE. Yes, Senator, I would be glad to. First, an analogy I made yesterday, some people make the analogy that this is all about sitting down at the kitchen table, making sure that your income and your spending are equal. That is true for the long run, but the debt ceiling is really about paying for bills that we have already incurred. So it is more like saying we are going to solve our problems by defaulting on our credit card, which is not something that most people would consider would be the right way to behave. 17 But putting that aside, not increasing the debt ceiling and certainly allowing default on the debt would have very real consequences for average Americans. First, interest rates would jump. Treasury rates are the benchmark interest rates, so mortgage rates and all other interest rates that consumers pay would rise. Of course, that would also increase the Federal deficit because we have to pay the interest on the debt as part of our spending. If the Treasury cut back as it would be required to do because it could not borrow, it would mean that there would be a significant reduction in both the payments, the benefits, payments for services paid to the Armed Forces and so on, so people would see that in terms of their Medicare check or whatever other benefits they are getting. And then without much delay, I think this would also slow the economy, and so the job situation would get worse. So in almost every area where people have pocketbook concerns—jobs, interest rates, credit, availability of Government payments, benefits, all those things would be affected in relatively short order. Senator AKAKA. Well, thank you for briefly explaining all of that. Chairman Bernanke, even though home prices, and it has been mentioned, have only slightly declined, high-cost housing areas like Hawaii are still feeling the full effects of a weak housing market. Mortgage credit is still limited. Concern for the future is that bank retained mortgages are performing worse than those sold to or backed by the Government and yet the loan limits are scheduled to step down later this year. Do you think it is a good idea to allow the loan limits to decrease? How might loan limits affect the housing market and homeownership opportunities? Mr. BERNANKE. Well, there is a tradeoff, as always, Senator. The increase in the loan limits was made on an emergency basis, obviously, to try to address the housing crisis. The GSEs are making the determination that it is time to begin to wean a little bit the mortgage market from those higher conforming limits. I think the question in terms of the effect on the housing market is to what extent are non-conforming jumbo mortgages available and how are they priced in Hawaii, and I do not know specific facts for Hawaii. But, nationally, there has been some improvement in the willingness of banks to make jumbo loans, and the differential, which at one point was more than 100 basis points, I think is much closer to 25 to 35 basis points at this point. So that will impose some extra costs on borrowers in very large mortgages, but I do not think in most cases that they will be squeezed out of the market. So they are some of the tradeoffs that the GSEs and the Congress are looking at. Senator AKAKA. Thank you, Mr. Chairman. Chairman JOHNSON. Senator Kirk. Senator KIRK. Thank you, Mr. Chairman. Mr. Chairman, I have three quick issues I want to raise with you, and I will put them all on the table. First, my understanding is that, according to Terry Zivney and Richard Marcus in Federal Review, August 1989, we had a technical default of the United States April 26, May 3, and May 10, 1979, when the United States could not pay individual bond hold- 18 ers holding Treasuries on time, and my understanding is it was about a 60-basis-point rise in borrowing costs to the Federal Government. If you could talk about when we defaulted last time, 1979. Second, I understand that Italy just tried to borrow money twice today. Their 5-year benchmark had a 21-percent increase in the cost of borrowing over last year, just went out at 4.9 percent, up from 3.9 percent a year ago. And they set a record on their 15-year borrowing. They paid the highest interest rate ever at 5.9 percent. And we are seeing a real M1 decline in Italy, and my question is: Should we have a kind of Greek-style bailout for Spain and Italy? The Congressional Research Service estimates that the IMF is $50 billion short. And, last, I am worried about the long-term finances of especially my home State of Illinois and California, and given their pension liabilities, Illinois being the lowest-paid pensions in the United States, do you see a systemic risk posed by these two States to the municipal finance and bond sector for the United States? I lay all three of those issues out for your comment. Mr. BERNANKE. Sure. Thank you. It is true that in 1979, mostly because of mechanical problems, operational problems, there were a few Treasury bills that did not receive interest payments on time. Interest rates did go up there, but it is not entirely clear whether it was entirely due to the default or whether it was due to some other factors, like changes in expectations of monetary policy, for example. I do not think it is really comparable to the current situation because this was just a couple of isolated issues, and, in fact, the Wall Street Journal did not even report that this had happened. People did not generally know that this had happened. So it was not viewed as something that was a broad-based risk to the financial markets. On Italy, it is true there has been a bit of market jitters there, and the kind of concern you worry about is exactly this kind of vicious circle that we are worried about in the case of the United States, where loss of confidence raises interest rates, that makes the deficit worse, and it makes it just even more difficult to get fiscal stability. My sense of Italy is that certainly the first line of defense is for Italy to take the necessary steps. It is true that Italy has a very high debt-to-GDP ratio, but it has some strengths. Notably, it currently has a primary surplus, that is, excluding interest, it actually has a small surplus, so its fiscal position in terms of the current deficit is much better than Greece, for example. Its banks are in decent shape. They have taken some extra capital in recently. It has got a well-diversified, manufacturing-based economy. So there are a lot of strengths that it has, so I think the first line of defense, perhaps with some assistance or commitments from the Europeans, would be for Italy to try to address the concerns that the markets have. In terms of explicit debt, States do not generally have the same kinds of levels of debt that our U.S. Federal Government or European governments have, and they rely on Federal money for Social Security, for medical care, and other things. So there are some 19 States—Illinois, California, as you mentioned—that are having more difficulty. We watch those very carefully. We also look at the exposures of banks and other institutions to those States. We do not see any immediate risk there, but it is true that a number of States do need to be thinking about their longer-term sustainability given the unfunded liabilities they may have for State pensions and for in some cases the health care programs as well. But we are monitoring that situation, but we do not think it is really analogous to the European situation. Senator KIRK. I have got 13 seconds to go. What about the adequacy of the IMF should we face a Spanish and Italian contingency? Are you concerned that at Greek bailout levels we would run about $50 billion short? Mr. BERNANKE. Spain and Italy are much bigger economies than the three that have already been addressed, and if it came to that point, I want to be very clear that I do not anticipate that happening. But if it came to that point, I think the Europeans would have to make a very substantial contribution to stabilize those countries. Senator KIRK. Thank you, Mr. Chairman. Chairman JOHNSON. Senator Kohl. Senator KOHL. Thank you very much, Mr. Chairman. Nice to have you with us this morning, Mr. Bernanke. I would like to ask you about our job situation and our recovery and their interrelationship. We have a jobless recovery by many people’s estimate. Even as the economy seems to be getting better and profits in corporations are stronger, hiring has not been what we want it to be, and, of course, wages are not what we want them to be. The wage picture in particular is disturbing because average wages in this country, family income has not moved in many years. And as companies continue to progress and not hire, what we are finding is that they are able to do business at a higher level with the same number of employees, in some cases even fewer employees. So I am asking myself, How do we turn this around? And when is this going to get turned around? Back in other times, there was a much more direct correlation between economic activity, rising profits and growth, and hiring and wages. We do not seem to have that connection today. I would like you to comment on that and what that portends for us even as business gets better. Mr. BERNANKE. Well, I can only agree with your diagnosis. We have high unemployment. It is improving very, very slowly in terms of jobs regained. We have the potential for very long run consequences because of the long-term unemployed. Those folks are going to find it much harder to find new work or find work that was comparable to the work they had before. Wages are very stagnant, and that is affecting consumer spending and consumer confidence. So I agree absolutely this is a major problem. There has been a tendency in the last 20 years or so for recoveries to be more jobless in the early post-war period. We saw the same thing in the 1990s and the beginning of the last decade. There is a little bit of an irony here, which is that, generally speaking, productivity gains are a really good thing and that helps make the country rich over time. But over very short periods in this cri- 20 sis, a lot of firms got very scared. They reduced their labor forces, and they tried to find ways to produce the same output without as many workers, and in doing so they increased productivity remarkably. But given the low level of demand, that means that their demand for workers is not as strong as we would like. There is also ongoing uncertainty about the durability of the recovery and about the economic environment, including fiscal issues, as we have been talking about. So if I had the answer, I would give it to you. The Federal Reserve has been providing as much accommodative support as we can to meet our dual mandate. I do think it would be worth Congress looking at some specific issues related to the unemployed. I am concerned about the long-run implications of the long-term unemployment. Are there things that the Congress could do to help people improve their skills or to find new opportunities? I think those are questions that should be asked. Senator KOHL. And it is also very troubling, isn’t it, that family wages have just stagnated, not just for the last year or two but for the last decade or longer. And unless we can find a way to turn that around, we are looking at a troubling future, to say the least. After all, the economy is driven by consumer demand, and if wages are not increasing in spite of a stronger economy, let alone employment, if wages are not increasing, we are facing a very troubling future. Wouldn’t you say that? Mr. BERNANKE. Yes, and it is a long-run trend. It is a 30-year trend. Senator KOHL. Right. Mr. BERNANKE. And one part of it is skills and preparation. We have a globalized, highly technological society, and those people who are prepared for it can do very well, but it used to be if you had a high school education, you were prepared to get a decent job, but now that is not nearly the case. Senator KOHL. Right. Mr. BERNANKE. So we are going to have to address those education deficits and help people get the skills. Senator KOHL. Can I ask just one more question? Mr. BERNANKE. Sure. Senator KOHL. Consolidation of the banking industry is not new, but it is certainly something that I am thinking about at this time because last week, after 164 years in Wisconsin, the M&I Bank was bought out by Harris Bank, a subsidiary of the Bank of Montreal. M&I was Wisconsin’s largest and oldest banks, and now it has been purchased, as I said, by a national bank. One concern I have with larger national banks moving into Wisconsin is what impact that will have on local customers, small businesses, and farmers. We have seen evidence that mergers of smaller banks can be good for small business, but when a large national bank buys smaller banks, small business loans tend to decrease. That is the statistic. As more national banks acquire regional and community banks, what can we do to see to it that they keep lending to small businesses? Is the Federal Reserve looking at the impacts of consolidation on lending to small business and farmers? Mr. BERNANKE. Yes, Senator, we are. We and the Department of Justice are typically involved in approving mergers and acquisi- 21 tions, and when we do that, one of the key exercises we do is we look at the resulting concentration of banking services within the local area, within a city, within a county. And we want to be sure, when taking into account all the banking services, thrifts, and others that are in that area, that any merger or acquisition does not create a situation where one firm dominates that market. And so we do pay a lot of attention to making sure that there is competition, that consumers and businesses have alternatives to go to within their local market when we approve those mergers. It is true that larger banks, particularly recently, have been not as forthcoming with small business as some local banks, community banks have been. And we see a lot of advantage in community banks, and we are very supportive of community banks. We have a subcommittee in our supervisory function which looks entirely at the implications of new rules and regulations for smaller banks and tries to do whatever we can to minimize the burden on those banks. We would like to see a healthy community banking system, and we are going to do our best to support that goal. Senator KOHL. Thank you very much. Chairman JOHNSON. Senator Johanns. Senator JOHANNS. Mr. Chairman, good to see you again. Mr. Chairman, as we have been working through the challenges of the debt ceiling and August 2nd—and maybe August 2nd is actually August 3rd or August 4th—I have been trying to do as deep a dive as I can to understand the cash-flow and the financial requirements of the U.S. Government. And so I am hoping I can use my 5 minutes to offer hopefully some insight on that, but I would like your reaction to a couple of things that I think I have identified here that are enormously important. The first thing, I looked at the indebtedness of the United States, the Treasuries, the Treasuries we issue, and on August 4th, we need to roll over $90.8 billion; August 11th, $93.3 billion; August 15th, $26.6 billion; August 18th, $87 billion; August 25th, $112 billion; and August 31st, $60.8 billion. Let us say that, for whatever reason, there is no solution to this raising the debt ceiling issue through August and we are constantly in the market, as you know, trying to deal with the Treasury situation. We have got these that we have to roll over. What is the market reaction going to be just in terms of this? It just seems to me that if I were a big trader in Treasuries, I would want a better deal. I would want more interest. I would want something from the U.S. Government, because all of a sudden there is an element of political risk that has been injected that maybe there will not be enough consensus to deal with this. What is your reaction to that? Mr. BERNANKE. Senator, you are absolutely right. We know what our interest payments are going to be, but we have to roll over large amounts of Treasuries, and it could be that if investors demand higher interest rates, that means basically that we will be short, that the price that will be paid will be less than we need to borrow, so that is another source of uncertainty in terms of what we are going to owe from the coffers of the Treasury. So, yes, I think that it is very uncertain, and we are seeing already the downgrade threats and so on. But it is entirely possible 22 that a loss of confidence or political risk could raise interest rates and would effectively make it more difficult or at least more expensive to roll over the debt going forward. Senator JOHANNS. Now, in terms of that rollover, my understanding is we cannot avoid that without really severe consequences. In other words, as these dates come up, we have got to deal with it. Is that a correct assumption, or are there alternatives I do not know about? Mr. BERNANKE. When the principal comes up, we have to roll it over or sell other bonds to meet that amount. Senator JOHANNS. OK. Now, the next piece of this—and, gosh, there was so much discussion out there about whether Treasury could do this and Social Security recipients will, in fact, get paid or whatever the latest point is. But I was looking at an analysis that was done, again, for August, and it anticipates revenues of $172.4 billion. I admit there could be some give and take on that. Outflows—in other words, requirements for money—of $306,713,000,000. So obviously we know we are borrowing 40 cents on every dollar. Less is coming in than we have got obligations for August. But I looked at the requirements in August: interest on Treasuries, $29 billion; Social Security, $49 billion; Medicare, $50 billion; defense vendor payments, $31 billion; unemployment benefits, $12 billion. So if you just paid those items, you would spend $172 billion; in other words, you have spent the money that came in. And since we have not raised the debt ceiling, that is it. Now, there is a whole list of items under that that are not getting paid, and you might move some of those up. But it is pretty awful: Veterans Affairs programs; we have not made payroll for the Federal Government; that does not include military pay, although many would argue it should be above the line. How will the market regard us—let us say we can deal with this Treasury issue. How will the market regard us not paying this long list of other financial obligations? They are not securities, but they are truly financial obligations. Mr. BERNANKE. Well, Senator, nobody knows with certainty, which is part of the reason why we should not be taking this risk in the first place. But it seems to me very reasonable to expect that a government that shows it is unwilling to pay its bills, pay its obligations, would engender some distrust in the markets and that we would still see response of interest rates and increased financial volatility. I should say once again that this is a hypothetical discussion because Treasury takes the view that it is not appropriate or feasible to prioritize in that strict way that you described. Senator JOHANNS. I will just wrap up with one last comment because my time has expired. For me, this is mathematics. So much money comes in, so much money goes out. It is mathematics. It is not magic. My hope is that between now and whatever date Treasury, you, others will descend upon the Hill to do what I have done, to avoid some of the discussion that, quite honestly, maybe is not just fully accurate—and I do not want to accuse anybody of anything, but I think this would be very helpful to understand the math. 23 Thank you, Mr. Chairman. Chairman JOHNSON. Senator Bennet. Senator BENNET. Thank you, Mr. Chairman. Just to follow up on Senator Johanns’ line of questioning, first, Mr. Chairman, and I do not mean this in a technical sense, but isn’t there a huge risk if we announce to the world that we cannot raise the debt ceiling, that we are so politically dysfunctional that there is no plan, that the market would treat our lack of payment on any of these obligations as a cross-default, in effect, with the debt, and then we would see interest rate rates rise very quickly as a result of that. Mr. BERNANKE. Again, nobody knows for sure, but that is a possibility. And I would just add that nobody thinks the United States cannot pay its debts. It is really a political risk, not a—— Senator BENNET. It is a political risk. Mr. BERNANKE. It is not an economic risk. Senator BENNET. Exactly. It is a political risk. No mayor in my State of Colorado would ever threaten to jeopardize the credit rating of his city. He would be run out on a rail for doing it. And we find ourselves in this position. I wanted to ask a question that—and, by the way, we are not focused on the things that Senator Kohl was talking about, which is what the people in my State want to know: how we are going to create an economy where median family income is actually rising instead of falling and what we are doing to create jobs. I appreciate that line of questioning. Moody’s said yesterday: An actual default, regardless of duration, would fundamentally alter Moody’s assessment of the timeliness of future payments, and a AAA rating would likely no longer be appropriate. Can you remember the last time a credit rating agency threatened a downgrade of U.S. debt? Mr. BERNANKE. It has happened recently. Senator BENNET. Before this. Mr. BERNANKE. But before this? Senator BENNET. It happened recently in the same context that we are in today. Mr. BERNANKE. The current context, yes. Senator BENNET. Right. When was the last time before this debate about raising the debt ceiling arose? Mr. BERNANKE. I do not think that has happened in the 20th century, but I am not certain. Senator BENNET. We are now in the 21st century, so it has not happened in the 21st century, it has not happened in the 20th century. Mr. BERNANKE. I do not believe so. Senator BENNET. This Congress has put ourselves in this position where credit ratings are actually threatening our credit rating. Mr. BERNANKE. That is right. Senator BENNET. Can you think of an asset that is more important to us than our credit rating? When you think about the—— Mr. BERNANKE. Well, there are many assets, but clearly the—— Senator BENNET. That gives us more competitive advantage than our credit rating? 24 Mr. BERNANKE. It is tremendously important that we have the confidence of the world in terms of willingness to hold Treasuries, to trade in Treasuries, to maintain a liquid market in Treasuries for the stability of the dollar. It is a very important asset, and losing that credit rating is a self-inflicted wound. Senator BENNET. Mr. Chairman, am I over time? I am confused about the clock? Did we reset it? Chairman JOHNSON. Yes, it has been reset. Senator BENNET. Thank you. I still have time left. I want to come back to the question of what the effect of losing that credit rating would be—not on our interests cost in the Government because we know they would—the effect would obviously be devastating, but the effect on people living in the State of Colorado. You generally talked about how interest rates—but if you could specifically say to people in my State, what does it mean to me when I go to buy a car or to get a bank loan or to buy my house or to go to the grocery store? What is the effect on me if people wake up in August of 2011 and our debt has been downgraded by these rating agencies and we do not have a political path forward to address the problem? Mr. BERNANKE. Well, Treasuries are the benchmark security. Most other interest rates are priced off of Treasuries. So if 5-, 10year Treasury yields were to go up by 2 percentage points, then you would expect to see mortgage rates go up immediately by 2 percentage points, and likewise with other borrowing costs that firms and households face. There would also very likely be an impact on the economy, which would then affect jobs and consumer income as well. Senator BENNET. What do you mean by ‘‘affect jobs’’? Mr. BERNANKE. Higher interest rates, uncertainty, fiscal contraction—all those—— Senator BENNET. Higher unemployment. Mr. BERNANKE. It would lead to higher unemployment. Senator BENNET. It would lead to higher unemployment. The unemployment rate today is 9 percent. Mr. BERNANKE. Correct. Senator BENNET. Can you think of a greater self-inflicted wound that we could manage to accomplish through our dysfunctionality than drive our unemployment rate higher when it is at 9 percent? Mr. BERNANKE. We certainly do not want to take an action to threaten our credit rating or to drive up our interest rates, which is counterproductive to the goal of reducing the deficit. Senator BENNET. Well, that was where I was going next. Mr. BERNANKE. Right, right. Senator BENNET. Which is, if all you cared about, if the only thing—the sun rose in the morning and it set at night and the only thing you were thinking about was our deficit—which is of huge concern to me. I have spent a lot of time on the floor talking about it. I have got kids that I am worried about, and we have got to get a hold of it—we really do—in a bipartisan way. Can you think of anything that would be more destructive to my desire to pay down our deficit than to fail to raise the debt ceiling—raise the interest rate? Mr. BERNANKE. You tax my imagination. 25 Senator BENNET. I tax your imagination. Mr. BERNANKE. Yes. Senator BENNET. Even economists have imaginations. Mr. BERNANKE. Even some. [Laughter.] Senator BENNET. But, you know, in all seriousness—in all seriousness—we are sitting across the table from you saying: I am deeply concerned about the fiscal condition of this country, I am deeply concerned about the size of the deficit. Can you think of anything I could do that would be more problematic than jeopardize our credit rating? Mr. BERNANKE. That would certainly be a very negative thing, and this is happening at the same time that Europe is dealing with fiscal issues, so there is just a lot of uncertainty piling on each other globally. Senator BENNET. Right. Exactly. So here is the last thing. We are just emerging from the worst recession since the Great Depression, and we went into this recession—we sort of went straight off the cliff. A lot of people did not predict it. A lot of people could not see that it was coming. How do you assess the risk that if we end up driving this car over the cliff with our eyes wide open, which they are, we could see a downturn in our economy at a point when our deficit is already at $1.5 trillion, which it was not before the last recession, when your balance sheet is now $3 trillion, which it was not before the last downturn, that this economic crisis could be at least as bad as the one that we just came out of, and that the policy responses that are available to you and to the Treasury and to the Congress are actually more limited at this point because we are still recovering from the last crisis we went through? Could you talk that through a little bit? What would it look like on the other side if we actually do get to a place where we find ourselves in this utterly predictable—— Mr. BERNANKE. Well, it certainly could slow the economy through higher interest rates and through financial volatility, but you actually make an additional point which I think is worth emphasizing. The higher interest rates would add to the deficit, but also a slowdown in economic activity by reducing revenues would also further add to the deficit. So it really is going in the wrong direction in terms of fiscal stability. Senator BENNET. Thank you, Mr. Chairman. I apologize for going over. Chairman JOHNSON. Senator Corker. Senator CORKER. Mr. Chairman, thank you for being here, and I will continue, as has been the tradition this morning, to use you as a prop to make our own points. [Laughter.] Senator CORKER. But thank you for your willingness to participate in that manner. The fact is that all this talk about the debt ceiling is farcical at this moment. I think we all know that our leadership has concocted a scheme where folks on the other side of the aisle can allow the debt ceiling to increase and continue to appeal to their constituencies for the 2012 election, and on our side, we can continue to cause spending to be an issue for us in the election, and basically by virtue of concocting this scheme, we are not going to make any 26 tough decisions. We all know that. And maybe the debt ceiling was the wrong place for us to be making that argument. But let me move to the other side of this. It is evident the debt ceiling is going to be increased. It is probable that not much is going to occur as it relates to spending. And I would say that the flip side of this is people have to be waking up at some point when we go through this whole short-term hurdle and say, you know, on the other hand, if the U.S. Government does not do something as it relates to spending, then the credit rating agencies—as a matter of fact, some of them have already referred to that, not this debt ceiling issue, as being a major problem. Would you agree? Mr. BERNANKE. Yes, Senator. I want to be clear. Whenever I have talked about this, I have had a two-handed economist approach, which is the debt ceiling needs to be addressed, but we also do need to address the stability and sustainability of our fiscal position. Senator CORKER. Yes. So let me, since you are a prop and you are answering the way we all want you to answer, I guess the debt ceiling is probably not the best place for us to deal with this issue. What is the best place for Congress to actually deal with the issues of spending? Mr. BERNANKE. Well, through the legislative and consultative process that the Founders—— Senator CORKER. Is it called a budget? Mr. BERNANKE. Well, except for one thing—— Senator CORKER. The answer is supposed to be yes—— Mr. BERNANKE. Sorry. [Laughter.] Senator CORKER.——if you are an appropriate prop for us. Mr. BERNANKE. I will. My only point was just to say, the answer is yes, but we need to think about this both in the current year and also on a longer-term basis. Senator CORKER. Future years, I agree. Mr. BERNANKE. Yes. Senator CORKER. So let me just—you know, we basically—I do not know what the most common joke is around the Fed about most of us around here. I would love to hear it maybe sometime if you will not do it with a microphone today, but we basically have been sort of feckless Members. The U.S. Senate has basically caused this great Nation to be in decline because we are not willing to deal with the tough issues we need to deal with. So some people resorted to the debt ceiling, and that is obviously—we figured out a political solution to that that works well for both sides to be able to campaign through 2012. But the fact is, we have not dealt with a budget now for some time. The majority party could actually be mostly criticized for that, but I do not want to do that. I think both sides are critical, because now we are moving to a spending bill today without a budget. And so all these—this has been a lot of fun, for everybody to use you as their prop about the debt ceiling, but the fact is that we are all sort of two-bit pawns in all of this by allowing our country to continue to spend money. What has happened is our leadership has wanted to protect us. You see, we have to make tough decisions when we budget and 27 prioritize. And so in order to protect majorities, we do not go through that process. How do you think—being the good prop that you are—how do you think the financial analysts view our inability to make those tough decisions? Mr. BERNANKE. Well, as I indicated, I think they view this whole situation, both the debt ceiling situation and the long-term fiscal stability situation, as being a political issue and not an economic issue. The question is whether or not we can come together and find real solutions. I think some of the discussions that have been had suggest that some very large-scale fixes could be undertaken. I am not prescribing one or the other. But we need to do something very significant just to keep our debt-to-GDP ratio from rising over the next decade, and then after that, we have entitlement issues, as well. So we need to do something big, strong—— Senator CORKER. I had dinner Monday night with a number of my colleagues on both sides of the aisle, and I will not mention who they were to impugn them, but all complaining about how dysfunctional this place is, and yet today, I am going to use this opportunity to point out that we are moving to a spending bill without a budget. So any of us who complain about how dysfunctional—and my friend used the word ‘‘dysfunctional;’’ I use it often, unfortunately—any of us who complain about how dysfunctional the U.S. Government is today and the fact that the Senate is moving our country into decline who would then vote for a spending bill without a budget are basically accomplices in allowing us to move toward that place that you are talking about where the credit rating agencies are going to be downgrading us because we do not make tough decisions. My time is up and I appreciate you—basically, when you are the second day of Humphrey-Hawkins, there is really not much to talk about other than what we want to put forth. I do want to close with this. I thank you for your service and I respect you and I appreciate the way the Fed has been with me very open, very transparent. You shared confidences with me that I have keep confidential and I have appreciated that. I will tell you that I find the activism at the Fed right now a major turn-off and I am very concerned. As one person who I think we have had a good relationship, I want to tell you that I am quickly moving to a camp that wants to clip the wings of the Fed, because I do believe that the activism there is distortive of the market, and I believe that the dual mandate that we have set up is causing you—something is causing you to do a lot of things that I think are going to create some long-term damage. So just know that while I respect you and I respect certainly the people who work with you and I appreciate the kindness, I am extremely turned off by your activism. Chairman JOHNSON. Senator Menendez. Senator MENENDEZ. Thank you, Mr. Chairman. Chairman Bernanke, thank you again for your service to our country. You know, you and I at different times here have spoken about the 2008 crisis and the reality that, but for the Congress acting, we would have maybe not been in the deep recession we are in but on the verge of a near depression. And as that as a back- 28 drop, I look at past recoveries which were first led by a surge in the home market, home building, and then by the easing of credit, and with the high number of distressed homes on the market creating a crippled housing construction sector and with financial firms still cautious as they rebuild their capital base, is this the best recovery we could have expected? And, second, given those persisting problems, do you really think, or are there policies that can create a stronger recovery with many more jobs? Mr. BERNANKE. I do not see any easy solutions, obviously. I certainly would have recommended them if I saw them. Senator Corker alluded to activism. I think what we are trying to do is to fulfill our mandate, which is to provide as much support as we can for the recovery. On the fiscal side, I recognize there are some real tensions because there would be scope for targeted programs to help some of the issues that we have in housing and otherwise. But I understand the concerns on both sides of the aisle about the long-term fiscal stability of the country and the need to address those issues. So it is a difficult situation. We do not have any substantial unused capacity to increase the speed of the recovery. Senator MENENDEZ. And so it is a difficult situation stemming from where we started, because there is always a starting point here. Mr. BERNANKE. That is right. Senator MENENDEZ. And so I look at, you know, a combination of tax cuts that went unpaid for and deprive the Treasury of enormous amounts of money at a time that we had two wars raging abroad in Iraq and Afghanistan, also unpaid for, a new entitlement program passed in the past Congress that is unpaid for, and a Wall Street that instead of being a free market was a free-for-all market. And you put that all together and that is what we are coming out of. So I am wondering—your answer to me suggests that there is not any more monetary policy that is going to come forward that could, in essence, seek a more faster, more robust recovery with a greater job growth. Mr. BERNANKE. Well, as I said in my testimony, given that there is a lot of uncertainty about how the economy will evolve, we have to keep all options, both for tightening and for easing, on the table, and we are doing that. But again, we are already providing an exceptional amount of accommodation. As you know, recovery is still pretty slow. Senator MENENDEZ. Now, I want to turn to the question of the debt ceiling. I know you have discussed that quite a bit. You know, I find it interesting. Under President Bush’s years, he raised the debt ceiling to the tune of about $5.4 trillion during his period of time. I did not hear the same comments then that raising the debt ceiling was something that was not necessary to do, that, in essence, having the Nation be a deadbeat is OK. And I find it alarming that there are people running for high office in this country and others already in significant positions who suggest that there is no great concern to allowing the Nation to be a deadbeat, to default, and no real consequences. 29 And so in pursuit of a solution, we have had these efforts to have severe cuts, to consider entitlement changes, as well. But I wonder whether entitlement changes should not also be the question of entitlements. Somehow, it seems that revenues are now an entitlement, as well. It seems that those who are the wealthiest in the country, that major entities like the oil and gas industry that is getting $21 billion in tax breaks when they are going to make $144 billion in profits this year alone, no, we cannot touch them. So it seems to me we have a new class of entitlements. Is not, in order to solve this problem, it really going to require real shared sacrifice, because I look at GDP in this country and about 70 percent of it is driven by domestic consumer demand. Well, there are no jobs, there is no demand. And if we are going to put this on the backs of middle-class working families who spend more of their disposable income, then I do not know how we are going to drive this economy based upon your previous answer that there is not too much more monetary policy we can have. Do you not think that it is fair to consider a shared sacrifice that is spread across the board to try to solve this debt ceiling question and the debt questions that confront the Nation? Mr. BERNANKE. Well, Senator, I think you can appreciate I do not inject myself into these negotiations, which are very difficult and delicate, but I do hope that everything will be on the table and that there will be frank and open discussion about the tradeoffs and—— Senator MENENDEZ. Well, as fiscal policy, do you believe that only one section of the American society should bear the burden? For example, is it overwhelmingly going to be the middle class in cuts that affect their lives and may have to reach into their pockets more at the end of the day that is the way in which we achieve the right fiscal policy for the country? Mr. BERNANKE. Well, I think that we want to have shared sacrifice. We also want to make sure we maintain a strong economy. There are a whole bunch of issues there. These are not issues that a pure economic analysis can answer. These are values issues and this is what elected officials are supposed to be determining. I really cannot make those decisions for you. Senator MENENDEZ. No, I am not looking for you to do that, Mr. Chairman. I just think that we have come to a point in which it seems that the tax code for those who benefit by it, whether it be large corporations like the oil and gas companies, whether it be the wealthiest millionaires and billionaires in the country, they are entitled to keep those tax breaks, but middle-class working families seem to be called upon for the burden of the resolution of this problem, and to me, that is both a moral issue, but it also is a fiscal issue. It is the wrong process by which we achieve the balance we need. Thank you, Mr. Chairman. Chairman JOHNSON. Senator Vitter. Senator VITTER. Thank you, Mr. Chairman, and thank you, Mr. Chairman, for being here. Moody’s, in their recent outlooks, said that a credible agreement on substantial deficit reduction would support a continued stable outlook. Lack of such an agreement could prompt Moody’s to 30 change its outlook to negative on the AAA rating. Do you think that sort of statement about a plan for deficit reduction is indicative of the entire market? Mr. BERNANKE. Yes, I do. As I have said, there are two prongs here. One is to navigate this debt ceiling issue without any kind of disruption, but the other, which would not be successful, that we just kick the can down the road in terms of our fiscal, long-term fiscal situation. So I very much support a strong fiscal deal. Senator VITTER. Right, and I have asked you previously how quickly this lack of a sustainable fiscal path could bite us and could have serious consequence, and I believe—I do not want to put words in your mouth—I believe you said you do not know, but it certainly could be sooner rather than later and it is not necessarily years off. Could you make a comment on that now? Mr. BERNANKE. No, that is correct. Markets are forward looking. They are trying to assess the likelihood that they will get paid years down the road. And we are seeing it in other countries around the world, that there is a loss of confidence by investors in a country’s fiscal stability and its political resolve to address those fiscal issues, that interest rates can start to rise and then you get a vicious circle. Senator VITTER. Right. So if the resolution of this present showdown and negotiation is increasing the debt ceiling with no significant change in terms of our fiscal path, how do you think the markets will digest that? Mr. BERNANKE. Well, I am sorry the two things got linked together the way they did, but I would very much like to see both parts of this work, both addressing the debt ceiling and addressing longer-term fiscal issues. I do not know how quickly or in what degree the markets would respond, but I think they are looking to Washington to show that they can manage their spending and control deficits over a long period of time. Senator VITTER. What you said a minute ago is part of my point. We have been talking about this event for months and it has been built up, smartly or dumbly, rightly or wrongly, as an opportunity to do something. So particularly with that buildup and that context, I guess my gut is that if we extend the debt limit and essentially do nothing for fiscal sustainability, the markets will have some sort of meaningful negative reaction as reflected in the Moody’s statement. Would you agree with that or not? Mr. BERNANKE. It is possible. Senator VITTER. Turning to other policy and talk of, essentially, a QE3, I certainly agree with Senator Corker’s comments. I am sure that does not surprise you. What would you point to in terms of success with QE1 or QE2 in terms of suggesting and convincing us that a third round is advisable? Mr. BERNANKE. Well, QE1 came in, basically in March of 2009, which was at a very, very weak point in the recovery. It was the absolute trough of the economy. The stock market was about half where it is now. The first round seemed to restore confidence and seemed to strengthen financial markets. It helped the economy grow quickly in the latter part of that year. And it was not the only contributor to the recovery and improvement in financial conditions, but I think it was a significant contributor. 31 QE2, as it is called, was first signaled in August of last year, and as I mentioned in my testimony, at that time, we were missing our mandate in the same direction on both parts of the mandate. That is, employment was very weak. It looked like the growth was so weak that unemployment might start to rise again. And inflation, rather than not being inflation, was actually falling down toward a very low level, and we know that we have not experienced it here since the 1930s that deflation can be a very pernicious situation. So our policies, which are admittedly different from the normal ones, they lower interest rates, they strengthen asset prices, and they provide more incentive for people to borrow, spend, invest. I think it obviously has addressed the inflation issue, and we think that by the second half of the year, we are going to be more or less on target in terms of where we want to be in inflation. And although job creation has not been all we would like it to be, it has been consistent with our expectations of about 700,000 jobs over 2 years. So we think it has moved in the right direction and it has not had, if our forecasts are right and inflation stabilizes around 2 percent in the second half of the year, then some of these fears about hyperinflation and so on will have been shown not to have been accurate. So we think it has been constructive. That being said, we are trying to maintain flexibility in both directions, both in terms of easing and tightening. But we recognize that monetary policy is not a panacea and we hope that Congress will be addressing issues related to the economy, as well. Senator VITTER. Mr. Chairman, if I can just have one more question to finish out—— Senator REED. [Presiding.] Very quickly, sir. Senator VITTER. Thank you. In that framework of promoting growth, promoting recovery, what do you think the impact would be if we announced today letting the Bush tax cuts expire at the end of 2012 for the top brackets, so essentially a tax increase for those brackets. What do you think the impact on growth and the economy would be? Mr. BERNANKE. I cannot really assess that. It would have some effects on higher marginal rates. It would have some effects on incentives. Higher rates would also take some consumer spending out of the economy. On the other hand, we have all been talking about the importance of addressing the overall deficit situation, so that would work in the other direction. So it would have multiple, different effects on the economy, and those kinds of specific policy decisions are going to have to be worked out by the folks who were elected to do that. Senator REED. Senator Hagan. Senator HAGAN. Thank you, Mr. Chairman, and Mr. Bernanke, thank you for your testimony and thank you for your hard work and all that you are doing right now. Mr. BERNANKE. Thank you. Senator HAGAN. I served for 10 years in the State Senate in North Carolina, co-chaired our budget, and we did everything possible to keep a AAA credit rating in the State because we knew the consequences if we did not, the increase of our interest rates on our debt, and I just think the American people deserve better than 32 what they are seeing right now from the lack of inaction—of the inability for Democrats and Republicans to come together right now and help solve this issue. So I am extremely concerned about it, as I know the American people are, and I think we agree that failing to raise the debt ceiling could create, obviously, tremendous problems for our financial system and our economy that you have been discussing today and problems that might require accommodative monetary policy from the Fed. I understand that the Federal funds rates, they cannot be lowered in any other meaningful way, and that one of the Fed’s responses to an economic weakness would be to initiate more securities purchases. I was just wondering, can you help me understand what the Fed would do, how you would respond if we went into default, and could the Fed purchase Treasury securities that had defaulted? Mr. BERNANKE. Well, on that last question, that is really an FOMC decision and I would have to leave that to that broader group. We would do what we could to preserve the operationality of the system. We participate in securities transfers and so on. But I want to eliminate any expectation that the Fed through any mechanism could offset the impact of a default on the Government debt. I think that it would be a very destructive event, and while the Fed would do what it could, again, I do not think it is fair to have any expectations that we could offset the impact of that. Senator HAGAN. How would this impact the Fed’s ability to conduct monetary policy? Mr. BERNANKE. Well, it would immediately offset a lot of the benefits from our policy by causing interest rates to rise and that would effect the state of the economy. It would also likely create disorderly conditions in money markets and so on where we do actually move interest rates around. So it would be counterproductive, certainly, to the goal of restoring a healthier economy. Senator HAGAN. What happens to the Fed’s income and its distributions to the Treasury if the Treasury stops making timely payments? Mr. BERNANKE. Well, that part is kind of a wash with respect to the Fed’s payments because we receive interest from the Treasury and then we remit most of it back to the Treasury. So I think our greater concerns would be the impacts on the financial markets. I think it is important to understand that Treasuries are not just a buy-and-hold asset. They are used for margin, for collateral, for liquidity, for hedging, for a whole variety of different functions. They are the fundamental element that keeps the financial system moving. And so there would be a great deal of disruption in the private sector in the financial markets, and that is where I think the main problems would occur. Senator HAGAN. Chairman Bernanke, I cannot tell you how alarmed I was on Friday of this past week when the Bureau of Labor Statistics released the employment report and there are over 430,000 people unemployed in my State now that are looking for work. And the bottom line of the creation of 18,000 new jobs nationwide is obviously very disappointing to everybody. 33 I am very concerned, too, about the persistently high unemployment rate among veterans. We have quite a few veterans in North Carolina, and over 13 percent of these veterans are currently unemployed right now. And it seems that we have got a serious problem in the short run when it comes to unemployment, and we have all been talking about that today, too. I believe it is a problem that we do need to separate from the longer-term fiscal imbalance that we are attempting to address. What can be done in the short term to boost demand, help get our citizens back to work? And I would be interested to hear what you think of different policies that maybe have worked in the past or any policies and thoughts that you might have going forward. Mr. BERNANKE. Well, we were very disappointed, as well, and as I said, we think it is partly temporary. We hope it is going to be a little better going forward. We have to think of fiscal policy as a whole. It is a complicated problem because we are trying to maintain several objectives at the same time, and one is we want to achieve a long-term credible stabilization of our fiscal policy and reduce deficits. We want to do that in a way that is going to promote growth. We want to have a better tax system. We want to have good investments made by the Government and so on. But I also think we need to be a little bit careful about the very short term because the recovery is still fragile and, you know, very sharp cuts in the very short term could pose some risk to that recovery. So I hope that all those different goals can be combined in trying to solve this overall problem. Again, the Fed is doing what it can to support the recovery. Congress might want to look at some targeted programs. For example, one of the issues that we have been talking about is the effects on skills of long-term unemployment. Veterans have perhaps been out of the labor force while coming back. So one thing to look at, and again, there are many different ways to do this, using the private sector and so on, but one thing to look at would be what can we do to help unemployed workers refresh their skills so that they will be available and eligible for employment when job opportunities arise. Senator HAGAN. I actually have a bill on that, and I was not using you as a prop, either. Mr. BERNANKE. As a prop. OK. Thank you. [Laughter.] Senator HAGAN. Thank you, Mr. Chairman. Senator REED. Senator Wicker. Senator WICKER. Thank you, and thank you, Chairman, for your testimony this morning and also yesterday, which I watched part of. I think a number of us on both sides of the table are asking the question that is on the minds of Americans, and that is, where is the recovery and why is the economy not doing any better? In your testimony on page 2, you say that Open Market Committee participants see the first-half slowdown as persisting for a while, and you mention at least four headwinds: number one, slow growth in consumer spending; number two, continued depressed housing sector; number three still-limited access to credit for some 34 households and small businesses; and, number four, fiscal tightening at all levels of Government. Let me ask you, isn’t it a fact that another headwind affecting our economy and helping to cause this slowdown to persist is the daunting slew of regulatory requirements, particularly on financial institutions, in the past few years? We have got the Basel capital requirements, enhanced examinations of institutions, multiple new regulations under Dodd-Frank. Has any attempt been made by the Fed or some other entity, by FSOC, to add up the cumulative cost of these regulatory burdens? Mr. BERNANKE. Well, what the Federal Reserve does is that for each rule that we promulgate, we do a cost/benefit analysis, which is part of our practice and required by law, and we do our very best to make sure that we interpret the statutes in a way that will be effective but will also minimize the costs on the financial system. So we are doing what we can to assess the costs and benefits. It is a very difficult balance, I agree. On the one hand, we certainly want to have credit flowing, and we want to have a strong financial sector, and I think we will have a strong financial sector. But we cannot forget where we were 3 years ago when the financial system almost collapsed. And we are still seeing the damage from that. So we are trying to apply rules in a way that will minimize the risk of another crisis and still permit good loans to be made to creditworthy borrowers. Senator WICKER. But you concede that credit is not flowing as it should be. Mr. BERNANKE. In some areas it is, but in small business and some household areas, not like we would like. Part of it is the financial condition of the borrowers because they have suffered through the recession or the value of their house or collateral has fallen that they are not qualified. But certainly there is still some tightness in some areas, that is correct. Senator WICKER. And small business is where jobs are created. Mr. BERNANKE. Small businesses are an important part of job creation, yes. Senator WICKER. I appreciate that you said you do a cost/benefit analysis on each individual regulation. How about looking at doing a cost/benefit analysis of the cumulative effect of all the regulations taken together? I think it is possible that you might find that at some point these expected benefits of addressing the problems of 2008 become such a burden that actually the cost is too great and credit shuts down. Mr. BERNANKE. Well, to do that, we would have to understand the interactions, and we do try to understand those interactions between different rules. But that is difficult. I understand your point and am sympathetic with your point. But once again, we do know that a financial crisis can be extraordinarily costly, and so we want to take that into account as well. Senator WICKER. And one final question. Do you see any particularly negative effect of a short-term increase in the debt ceiling given the negotiating impasse that has occurred so far? Would it be particularly disadvantageous to our credit rating if we agreed to a ceiling last until early next year, for example? 35 Mr. BERNANKE. Well, it would be certainly advantageous not to put us in a situation where we are threatening to default or not make other payments. That would be—— Senator WICKER. It would be far better than no agreement at all, would it not? Mr. BERNANKE. I think it would, but as Senator Corker pointed out, or Senator Vitter, the other part of this is we also want to make substantial progress on the long-term fiscal situation. And if the rating agencies felt we were just abandoning that effort, that would not be so good either. So we want to make a convincing case that we are continuing to try to find solutions to our fiscal issues. Senator WICKER. And I would share that. I think speaking for this side of the aisle, we would continue that, but clearly rather than have the situation blow up, a short-term is not something you would walk out of the room about, is it? Mr. BERNANKE. Well, my first best is that the debt limit gets increased promptly and that we have a real solution for our longerterm fiscal problems. Senator WICKER. Thank you. Thank you, Mr. Chairman. Senator REED. Senator Tester? Senator TESTER. Well, thank you, Senator Reed, and you for being here, Chairman Bernanke. Real quickly, I think we all understand we have a fiscal problem in this country. We can keep kicking the can down the road forever. The problem is if we want stability, predictability, dependability, if we want the markets to react like they can, we need a long-term plan. Correct? Mr. BERNANKE. Correct. Senator TESTER. Thank you. I want to talk about housing. One of the areas of particular concern to me continues to be the housing market. I know it is of concern to you. It is weighing heavily on our ability to recover. In fact, earlier I think you told Chairman Johnson it is the epicenter of the problem. The loan servicers, some of them are square in the middle of this, and I think they have taken a role in creating it. They did not seem very interested in solving the problem until they were associated with the problem, to a large extent. We learned about robosigning, which you know about, not double-checking the facts; in fact, in some cases even selling mortgages they did not even own. The result has been in my State, and I think probably throughout the country—you would know this better than I—that we have got some folks that are being foreclosed on without good reason. In fact, that kind of attitude is not healthy for our recovery, and it is not going to cut it. We have got a number of reports about different settlements that address the liabilities associated with toxic mortgages. One bank recently announced $20 billion. There is another report as large as $30 billion between State and Federal prosecutors. It is apparent to me—and I would like to get your opinion on this—that some of the same guys that we bailed out in the interest of stabilizing the markets are the ones who have made the housing market far worse than it has to be. The market is tied in a massive knot, and banks have made little progress in untying it. 36 You have performed a second round of stress tests earlier this year—correct—to determine the ability of many of these servicers to withstand tough conditions? Can you give me a sense of the scope and the magnitude of this problem and the challenge it poses for the housing market and if, in fact, this second round of stress tests have indicated whether these servicers really have the ability to get their act together and move forward in a way that can do positive things for the housing industry? Mr. BERNANKE. Well, Senator, the stress tests actually bore on the broader capital levels of these institutions, not specifically on the servicing part. We had an investigation of the servicing concerns jointly with the other banking agencies, and as you know, we found many bad practices. I agree with your characterization. It is just very poor business, very poor practices in terms of making sure that consumers were contacted, that they were appropriately treated, that all the legalities were observed, et cetera. The Federal Reserve together with other agencies has imposed an order on the servicers to fix up their act and to go back and look at every foreclosure going back for some number of years and to compensate anybody who was injured by their practices. And we will be imposing civil money penalties at some point. Senator TESTER. That is good. I will tell you that some of the folks that dealt in my office—and, by the way, there are a lot of folks who did not call my office, and they should not have to call a U.S. Senator’s office to get results. But I can give you an example of a man who was widowed and was about to be kicked out of his house, and within weeks of doing it by one of these servicers. Absolutely ridiculous. So I think you need to help hold the people accountable, and if we can be helpful in that, we will. The housing market, it is in a knot. What can you do to help unwind it? Mr. BERNANKE. Well, from the Fed’s perspective we are trying first obviously to keep mortgage rates low. We are trying to encourage lending, an appropriate balance of lending between making sure that loans are safe and sound but making sure creditworthy borrowers have access to credit. I think one area where I think Congress might want to take a look, one of the basic problems is that we have such a large overhang of empty, distressed-sale, foreclosed-upon houses. That is pulling down prices. That is pulling down appraisals. As I mentioned earlier, there are about half a million of these houses in the REO books of the banks and Fannie and Freddie, plenty more with other types of ownership. And it is hurting neighborhoods, it is hurting cities. I think that is an area that is worth looking at. Can we find a way to try and reduce that overhang or to try to provide incentives for investors to convert them or something like that? I think that is one of the main problems that the Fed cannot directly address, but it could be addressed perhaps by some focused program. Senator TESTER. OK. Do you have any idea of how many—we talked about excess housing for a while, and that is the overhang you are talking about, right? Mr. BERNANKE. Well, that is just the REO. There are a couple million houses that are vacant. 37 Senator TESTER. And typically what do we have normally in a robust housing market? Mr. BERNANKE. Probably a third of that. I do not know the exact number. Senator TESTER. OK. Do you have any idea of what percentage of homes are underwater at this point in time? Mr. BERNANKE. About a quarter or more, 25 to 30 percent. Senator TESTER. A quarter or more? Mr. BERNANKE. Of mortgages. Not homes but of mortgaged homes. Senator TESTER. OK. All right. Well, thank you very much, Mr. Chairman. I appreciate it. Thank you, Senator Reed. Senator REED. Senator Schumer, please. Senator SCHUMER. Thank you, Mr. Chairman—Mr. Chairman and Mr. Chairman, for being here, and my colleague Jon Tester. First, I would like to talk a little bit about deficit reduction, and Senator Wicker touched on this, but I want to clarify. Leader McConnell, as you know, has proposed a plan that would allow for the debt ceiling to be lifted but without accomplishing any debt reduction. Many of us have conflicted feelings about this approach because, on the one hand, it would ensure we do not default, but on the other, it does not make any headway in reducing our debt, which sooner or later will cause problems. I like to say we are blindfolded man heading toward a cliff. If we keep walking in that direction, we will fall off. Some people think the cliff is 5 yards away, and some people think it is 50 or 100 yards away. But we are headed that way. Anyway, we have to make—the McConnell plan says, OK, renew the ceiling, no progress on debt. Which do you think would be more reassuring to investors and the markets: just raising the debt ceiling or raising the debt ceiling and achieving some debt reduction at the same time? Mr. BERNANKE. Well, as I said to Senator Wicker, there are two prongs to this: one is to avoid the problems associated with not raising the debt ceiling, but the other is to make meaningful reductions in the long-term deficit. Senator SCHUMER. It would be better to do both than just one. Mr. BERNANKE. We certainly should. That is certainly the best outcome. Senator SCHUMER. OK, and that is the outcome some of us are working toward right now, so I appreciate that, because to do one without the other does not make much sense. This is about prioritizing interest payments. Many of our Republican colleagues here in the Senate today, Mr. Toomey on the Committee, they seem to feel that we can avoid default by prioritizing interest payments on the debt, pay back just the debt we owe but not all the other obligations, whether it is paying our troops or paying the FAA, the guys in the towers so our airplanes can go, our food inspectors, our Border Patrol, our FBI. But if we do not raise the debt ceiling after August 2nd, that would require us to stop paying almost half of our other bills, even if you paid back the debt. Isn’t that just default by another name? And, in fact, wouldn’t the credit rating agencies likely downgrade 38 our credit rating anyway if we miss payments on our other obligations? Mr. BERNANKE. I think the downgrade is possible. I do not know for sure. I do not think they have stated that precisely. But, yes, I do think this is a direction we do not want to go. I think that not paying our obligations, whether they be financial obligations or payments to Social Security recipients or others, any of those things would involve essentially a default. Senator SCHUMER. So you do not agree with those that—that in a sense is default, right? Mr. BERNANKE. I want to add that the Treasury has been pretty clear that they do not think that is either appropriate and they are concerned about—— Senator SCHUMER. And, by the way, to boot, wouldn’t that hurt the economy? If we stop—— Mr. BERNANKE. Yes, of course. Senator SCHUMER.——paying $160, $170 billion worth of obligations—maybe it is $110 billion, but it is over $100 billion of obligations. Some estimate that it could reduce the GDP by a significant percent. Is that right? Mr. BERNANKE. Sure. Of course. Senator SCHUMER. So it seems to me you are saying—and I am not going to put words in your mouth—that Senator Toomey is just way off base here. For a smart guy, I mean, to say we can pay the obligations and not pay the rest and that is just fine, wow, I am sort of surprised at it. And I do think, by the way, in today’s Wall Street Journal I think, it stated that Standard & Poor’s said it would likely downgrade U.S. debt if we missed payments on other obligations, so they agree with you. OK. Next, short-term extension. Some around here—Leader Cantor has been pushing this—have advocated shorter-term extensions of the debt ceiling so we would have to do this every few months. Now, of course, markets would be relieved that default is off the table—in other words, better than not doing anything. But do you agree that eventually the markets would start to get nervous that we cannot find the political will to get a meaningful deal together and might start to view us a little more like Europe? Wouldn’t it send a troubling signal to the markets if Congress attempted to only extend the debt ceiling a month or two at a time? Mr. BERNANKE. It is important both to raise the debt ceiling to avoid these kinds of problems we discussed; it is also important to show that we can make progress on the long-term deficit. Senator SCHUMER. But I am not talking about the long-term deficit. I am talking about renewal of the debt ceiling by such a little amount that month after month we would have to come back and renew it. Isn’t it preferable to do it in as large an amount as possible just from the debt ceiling point of view? Mr. BERNANKE. Well, there are political and tactical issues here which I do not want to get into, but clearly—— Senator SCHUMER. I am not asking you that. I am asking economically. Mr. BERNANKE.——what we want to do is to get as big a deal as we can to show that we are serious and that we are going to address the long-term stability—— 39 Senator SCHUMER. How would you characterize a 1-month extension of the debt ceiling compared to, say, doing it until 2012? Mr. BERNANKE. Well—— Senator SCHUMER. Two thousand thirteen, early 2013? Mr. BERNANKE. The risk is that you would lose credibility in the markets about your willingness to carry through, and so if you did that, it would be important to send signals somehow that you have a plan and—— Senator SCHUMER. Better to do it through 2013 than do it a month at a time? Mr. BERNANKE. Well, better to do a strong, credible plan, and the sooner the better. Senator SCHUMER. OK. Thank you, Mr. Chairman. Thank you, Mr. Chairman. Mr. BERNANKE. Thank you. Senator REED. Thank you, Senator Schumer. I just have one question. Who is the largest holder of our Treasury debt and our agency debt? Is it the Chinese Government or Chinese institutions? Mr. BERNANKE. Well, the Fed has a lot—— Senator REED. You have a lot of it. Mr. BERNANKE. The Chinese, I think probably right. Senator REED. Right after the Fed would be the Chinese. Mr. BERNANKE. As an individual institution, the central bank that holds the reserves. Senator REED. Of China. Mr. BERNANKE. Of China, yes. Senator REED. So, effectively, if we were to be paying our debt and not paying our Social Security payments, we would be principally paying the Chinese central bank in lieu of paying Americans? Mr. BERNANKE. That is right. But if we did not do that we would suffer financial consequences. Senator REED. I completely concur, and I think the solution is to appropriately raise the debt ceiling, deal with the fiscal issues of the deficit that we face, and we are trying to do that. But just ironically, you know, when you do this sort of prioritization, the irony is the priority is to the Chinese central bank, and lower on the pecking order would practically be seniors and Social Security recipients and maybe even American military personnel. I think that is the reality, isn’t it? Mr. BERNANKE. Well, again, if prioritization were even feasible—— Senator REED. Were even feasible. Your point is you do not believe it is even feasible. Well, Mr. Chairman, thank you again not only for your testimony today but your service to the Nation in very, very difficult and challenging times. The hearing record will remain open for 7 days for additional statements and questions. With that, the hearing is adjourned. Thank you, Mr. Chairman. Mr. BERNANKE. Thank you, Senator. [Whereupon, at 12:15 p.m., the hearing was adjourned.] 40 [Prepared statements and response to written questions supplied for the record follow:] 41 PREPARED STATEMENT OF SENATOR JERRY MORAN Mr. Chairman, I thank you for calling this hearing today and I thank Chairman Bernanke for joining us to have an important discussion about the state of our economy. Mr. Chairman—as you well know, our country is facing a financial crisis. But in my view, the financial collapse around the corner is the most expected economic crisis in our lifetime, yet nothing is being done to stop it. The co-chairs of the President’s own Fiscal Commission agree and have warned that if we fail to take swift and serious action, the United States faces ‘‘the most predictable economic crisis in its history.’’ They predict such an event could occur in 2 years or less. The President’s solution is to raise revenues to balance the budget, but does anyone really believe that increased taxes will be used to pay down the debt or will it just be used for even more spending? History shows that money raised in Washington, DC, results in more spending in Washington, DC. If we increase taxes, we reduce the chance of economic growth and we reduce the chance of more and better paying jobs. In Kansas, for example, the President proposes we increase taxes on those who own a business plane. Airplanes are a pretty important component of our State’s economy, and this proposal would have a devastating impact upon the Wichita economy, which has already suffered the loss of thousands of jobs under declining business in this country. Now is not the time to penalize a U.S. industry that produces the best quality airplanes in the world. The United States and North America ship a significant amount of business jets worldwide, more than any other region in the world. But because of the recession, nearly every aircraft manufacturer has had to cut jobs, some up to 50 percent of their workforce. We see this in Kansas day in and day out, and yet the proposal is to make it more expensive to own an aircraft. This does not punish the owners of aircraft. It punishes the people who work every day to make an airplane. To turn our economy around and put people back to work, Congress and the Obama administration should be implementing policies that encourage job creation, not diminish the chances; rein in burdensome Government regulations; replace our convoluted Tax Code with one that is fair, simple, and certain; open foreign markets for American manufactured goods and agricultural products; and develop a comprehensive energy policy. Yet none of these things are being done. The debate over Government spending is often seen as a philosophical or academic debate that always goes on in Washington, DC. And I am aware of the heated rhetoric that has been exchanged between both political parties the last few weeks, but the reality is this time it is different, and our failure to act will have dramatic consequences on the daily lives of Americans. Officials from the Obama administration warn that the failure of Congress to raise the legal debt limit would risk default. But at least an equal economic threat confronts our country: the consequences of allowing our country’s pattern of spending and borrowing to continue without a serious plan to reduce that debt. We are not immune from the laws of economics that face every country, and if we fail to get our financial house in order, our creditors will decide we are no longer creditworthy, and we will face the same consequences that other countries are suffering that followed this path. Our Government is not on the verge of a financial meltdown because Republicans will not vote to raise the debt ceiling. We are at the point of financial catastrophe because Republicans and Democrats have spent money we do not have for way too long. We must now seize this opportunity to force elected officials to do something they otherwise would not do: curb spending, balance the budget, and put in place policies that allow business, industry, and agriculture to invest in plants and equipment and create jobs. If we fail to act responsibly, if we fail to act as we should, if we let this issue pass one more time for somebody else to solve because it is so difficult, we will reduce the opportunities the next generation of Americans have to pursue the American dream. I look forward to having a conversation with Chairman Bernanke about these topics and thank him for his appearance here today. PREPARED STATEMENT OF BEN S. BERNANKE CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM JULY 14, 2011 Chairman Johnson, Ranking Member Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve’s semiannual Monetary Policy 42 Report to the Congress. I will begin with a discussion of current economic conditions and the outlook and then turn to monetary policy. The Economic Outlook The U.S. economy has continued to recover, but the pace of the expansion so far this year has been modest. After increasing at an annual rate of 2 3⁄4 percent in the second half of 2010, real gross domestic product (GDP) rose at about a 2 percent rate in the first quarter of this year, and incoming data suggest that the pace of recovery remained soft in the spring. At the same time, the unemployment rate, which had appeared to be on a downward trajectory at the turn of the year, has moved back above 9 percent. In part, the recent weaker-than-expected economic performance appears to have been the result of several factors that are likely to be temporary. Notably, the runup in prices of energy, especially gasoline, and food has reduced consumer purchasing power. In addition, the supply chain disruptions that occurred following the earthquake in Japan caused U.S. motor vehicle producers to sharply curtail assemblies and limited the availability of some models. Looking forward, however, the apparent stabilization in the prices of oil and other commodities should ease the pressure on household budgets, and vehicle manufacturers report that they are making significant progress in overcoming the parts shortages and expect to increase production substantially this summer. In light of these developments, the most recent projections by members of the Federal Reserve Board and presidents of the Federal Reserve Banks, prepared in conjunction with the Federal Open Market Committee (FOMC) meeting in late June, reflected their assessment that the pace of the economic recovery will pick up in coming quarters. Specifically, participants’ projections for the increase in real GDP have a central tendency of 2.7 to 2.9 percent for 2011, inclusive of the weak first half, and 3.3 to 3.7 percent in 2012—projections that, if realized, would constitute a notably better performance than we have seen so far this year.1 FOMC participants continued to see the economic recovery strengthening over the medium term, with the central tendency of their projections for the increase in real GDP picking up to 3.5 to 4.2 percent in 2013. At the same time, the central tendencies of the projections of real GDP growth in 2011 and 2012 were marked down nearly 1⁄2 percentage point compared with those reported in April, suggesting that FOMC participants saw at least some part of the first-half slowdown as persisting for a while. Among the headwinds facing the economy are the slow growth in consumer spending, even after accounting for the effects of higher food and energy prices; the continuing depressed condition of the housing sector; still-limited access to credit for some households and small businesses; and fiscal tightening at all levels of Government. Consistent with projected growth in real output modestly above its trend rate, FOMC participants expected that, over time, the jobless rate will decline—albeit only slowly—toward its longer-term normal level. The central tendencies of participants’ forecasts for the unemployment rate were 8.6 to 8.9 percent for the fourth quarter of this year, 7.8 to 8.2 percent at the end of 2012, and 7.0 to 7.5 percent at the end of 2013. The most recent data attest to the continuing weakness of the labor market: The unemployment rate increased to 9.2 percent in June, and gains in nonfarm payroll employment were below expectations for a second month. To date, of the more than 8 1⁄2 million jobs lost in the recession, 1 3⁄4 million have been regained. Of those employed, about 6 percent—8.6 million workers—report that they would like to be working full time but can only obtain part-time work. Importantly, nearly half of those currently unemployed have been out of work for more than 6 months, by far the highest ratio in the post-World War II period. Long-term unemployment imposes severe economic hardships on the unemployed and their families, and, by leading to an erosion of skills of those without work, it both impairs their lifetime employment prospects and reduces the productive potential of our economy as a whole. Much of the slowdown in aggregate demand this year has been centered in the household sector, and the ability and willingness of consumers to spend will be an important determinant of the pace of the recovery in coming quarters. Real disposable personal income over the first 5 months of 2011 was boosted by the reduction in payroll taxes, but those gains were largely offset by higher prices for gasoline and other commodities. Households report that they have little confidence in the durability of the recovery and about their own income prospects. Moreover, the ongoing weakness in home values is holding down household wealth and weighing on consumer sentiment. On the positive side, household debt burdens are declining, delin1 Note that these projections do not incorporate the most recent economic news, including last Friday’s labor market report. 43 quency rates on credit card and auto loans are down significantly, and the number of homeowners missing a mortgage payment for the first time is decreasing. The anticipated pickups in economic activity and job creation, together with the expected easing of price pressures, should bolster real household income, confidence, and spending in the medium run. Residential construction activity remains at an extremely low level. The demand for homes has been depressed by many of the same factors that have held down consumer spending more generally, including the slowness of the recovery in jobs and income as well as poor consumer sentiment. Mortgage interest rates are near record lows, but access to mortgage credit continues to be constrained. Also, many potential homebuyers remain concerned about buying into a falling market, as weak demand for homes, the substantial backlog of vacant properties for sale, and the high proportion of distressed sales are keeping downward pressure on house prices. Two bright spots in the recovery have been exports and business investment in equipment and software. Demand for U.S.-made capital goods from both domestic and foreign firms has supported manufacturing production throughout the recovery thus far. Both equipment and software outlays and exports increased solidly in the first quarter, and the data on new orders received by U.S. producers suggest that the trend continued in recent months. Corporate profits have been strong, and larger nonfinancial corporations with access to capital markets have been able to refinance existing debt and lock in funding at lower yields. Borrowing conditions for businesses generally have continued to ease, although, as mentioned, the availability of credit appears to remain relatively limited for some small firms. Inflation has picked up so far this year. The price index for personal consumption expenditures (PCE) rose at an annual rate of more than 4 percent over the first 5 months of 2011, and 2 1⁄2 percent on a 12-month basis. Much of the acceleration was the result of higher prices for oil and other commodities and for imported goods. In addition, prices of motor vehicles increased sharply when supplies of new models were curtailed by parts shortages associated with the earthquake in Japan. Most of the recent rise in inflation appears likely to be transitory, and FOMC participants expected inflation to subside in coming quarters to rates at or below the level of 2 percent or a bit less that participants view as consistent with our dual mandate of maximum employment and price stability. The central tendency of participants’ forecasts for the rate of increase in the PCE price index was 2.3 to 2.5 percent for 2011 as a whole, which implies a significant slowing of inflation in the second half of the year. In 2012 and 2013, the central tendency of the inflation forecasts was 1.5 to 2.0 percent. Reasons to expect inflation to moderate include the apparent stabilization in the prices of oil and other commodities, which is already showing through to retail gasoline and food prices; the still-substantial slack in U.S. labor and product markets, which has made it difficult for workers to obtain wage gains and for firms to pass through their higher costs; and the stability of longer-term inflation expectations, as measured by surveys of households, the forecasts of professional private-sector economists, and financial market indicators. Monetary Policy FOMC members’ judgments that the pace of the economic recovery over coming quarters will likely remain moderate, that the unemployment rate will consequently decline only gradually, and that inflation will subside are the basis for the Committee’s decision to maintain a highly accommodative monetary policy. As you know, that policy currently consists of two parts. First, the target range for the Federal funds rate remains at 0 to 1⁄4 percent and, as indicated in the statement released after the June meeting, the Committee expects that economic conditions are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. The second component of monetary policy has been to increase the Federal Reserve’s holdings of longer-term securities, an approach undertaken because the target for the Federal funds rate could not be lowered meaningfully further. The Federal Reserve’s acquisition of longer-term Treasury securities boosted the prices of such securities and caused longer-term Treasury yields to be lower than they would have been otherwise. In addition, by removing substantial quantities of longer-term Treasury securities from the market, the Fed’s purchases induced private investors to acquire other assets that serve as substitutes for Treasury securities in the financial marketplace, such as corporate bonds and mortgage-backed securities. By this means, the Fed’s asset purchase program—like more conventional monetary policy— has served to reduce the yields and increase the prices of those other assets as well. The net result of these actions is lower borrowing costs and easier financial condi- 44 tions throughout the economy.2 We know from many decades of experience with monetary policy that, when the economy is operating below its potential, easier financial conditions tend to promote more rapid economic growth. Estimates based on a number of recent studies as well as Federal Reserve analyses suggest that, all else being equal, the second round of asset purchases probably lowered longer-term interest rates approximately 10 to 30 basis points.3 Our analysis further indicates that a reduction in longer-term interest rates of this magnitude would be roughly equivalent in terms of its effect on the economy to a 40 to 120 basis point reduction in the Federal funds rate. In June, we completed the planned purchases of $600 billion in longer-term Treasury securities that the Committee initiated in November, while continuing to reinvest the proceeds of maturing or redeemed longer-term securities in Treasuries. Although we are no longer expanding our securities holdings, the evidence suggests that the degree of accommodation delivered by the Federal Reserve’s securities purchase program is determined primarily by the quantity and mix of securities that the Federal Reserve holds rather than by the current pace of new purchases. Thus, even with the end of net new purchases, maintaining our holdings of these securities should continue to put downward pressure on market interest rates and foster more accommodative financial conditions than would otherwise be the case. It is worth emphasizing that our program involved purchases of securities, not Government spending, and, as I will discuss later, when the macroeconomic circumstances call for it, we will unwind those purchases. In the meantime, interest on those securities is remitted to the U.S. Treasury. When we began this program, we certainly did not expect it to be a panacea for the country’s economic problems. However, as the expansion weakened last summer, developments with respect to both components of our dual mandate implied that additional monetary accommodation was needed. In that context, we believed that the program would both help reduce the risk of deflation that had emerged and provide a needed boost to faltering economic activity and job creation. The experience to date with the round of securities purchases that just ended suggests that the program had the intended effects of reducing the risk of deflation and shoring up economic activity. In the months following the August announcement of our policy of reinvesting maturing and redeemed securities and our signal that we were considering more purchases, inflation compensation as measured in the market for inflation-indexed securities rose from low to more normal levels, suggesting that the perceived risks of deflation had receded markedly. This was a significant achievement, as we know from the Japanese experience that protracted deflation can be quite costly in terms of weaker economic growth. With respect to employment, our expectations were relatively modest; estimates made in the autumn suggested that the additional purchases could boost employment by about 700,000 jobs over 2 years, or about 30,000 extra jobs per month.4 Even including the disappointing readings for May and June, which reflected in part the temporary factors discussed earlier, private payroll gains have averaged 160,000 per month in the first half of 2011, compared with average increases of only about 80,000 private jobs per month from May to August 2010. Not all of the step-up in 2 The Federal Reserve’s recently completed securities purchase program has changed the average maturity of Treasury securities held by the public only modestly, suggesting that such an effect likely did not contribute substantially to the reduction in Treasury yields. Rather, the more important channel of effect was the removal of Treasury securities from the market, which reduced Treasury yields generally while inducing private investors to hold alternative assets (the portfolio reallocation effect). The substitution into alternative assets raised their prices and lowered their yields, easing overall financial conditions. 3 Studies that have provided estimates of the effects of large-scale asset purchases, holding constant other factors, include James D. Hamilton and Jing (Cynthia) Wu (2011), ‘‘The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment,’’ NBER Working Paper Series No. 16956 (Cambridge, Mass: National Bureau of Economic Research, April), and Journal of Money, Credit and Banking (forthcoming); Arvind Krishnamurthy and Annette Vissing-Jorgensen (2011), ‘‘The Effects of Quantitative Easing on Interest Rates,’’ working paper (Evanston, Ill.: Kellogg School of Management, Northwestern University, June); Stefania D’Amico and Thomas B. King (2010), ‘‘Flow and Stock Effects of Large-Scale Treasury Purchases,’’ Finance and Economics Discussion Series 2010–52 (Washington: Board of Governors of the Federal Reserve System, September); Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack (2011), ‘‘Large-Scale Asset Purchases by the Federal Reserve: Did They Work?’’ Federal Reserve Bank of New York, Economic Policy Review, vol 17 (May), pp. 41–59; and Eric T. Swanson (2011), ‘‘Let’s Twist Again: A High-Frequency Event-Study Analysis of Operation Twist and Its Implications for QE2,’’ Working Paper Series 2011–08 (San Francisco: Federal Reserve Bank of San Francisco, February), and Brookings Papers on Economic Activity (forthcoming). 4 See Hess Chung, Jean-Philippe Laforte, David Reifschneider, and John C. Williams (2011), ‘‘Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?’’ Working Paper Series 2011–01 (San Francisco: Federal Reserve Bank of San Francisco, January). 45 hiring was necessarily the result of the asset purchase program, but the comparison is consistent with our expectations for employment gains. Of course, we will be monitoring developments in the labor market closely. Once the temporary shocks that have been holding down economic activity pass, we expect to again see the effects of policy accommodation reflected in stronger economic activity and job creation. However, given the range of uncertainties about the strength of the recovery and prospects for inflation over the medium term, the Federal Reserve remains prepared to respond should economic developments indicate that an adjustment in the stance of monetary policy would be appropriate. On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the Federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the Federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant. On the other hand, the economy could evolve in a way that would warrant a move toward less-accommodative policy. Accordingly, the Committee has been giving careful consideration to the elements of its exit strategy, and, as reported in the minutes of the June FOMC meeting, it has reached a broad consensus about the sequence of steps that it expects to follow when the normalization of policy becomes appropriate. In brief, when economic conditions warrant, the Committee would begin the normalization process by ceasing the reinvestment of principal payments on its securities, thereby allowing the Federal Reserve’s balance sheet to begin shrinking. At the same time or sometime thereafter, the Committee would modify the forward guidance in its statement. Subsequent steps would include the initiation of temporary reserve-draining operations and, when conditions warrant, increases in the Federal funds rate target. From that point on, changing the level or range of the Federal funds rate target would be our primary means of adjusting the stance of monetary policy in response to economic developments. Sometime after the first increase in the Federal funds rate target, the Committee expects to initiate sales of agency securities from its portfolio, with the timing and pace of sales clearly communicated to the public in advance. Once sales begin, the pace of sales is anticipated to be relatively gradual and steady, but it could be adjusted up or down in response to material changes in the economic outlook or financial conditions. Over time, the securities portfolio and the associated quantity of bank reserves are expected to be reduced to the minimum levels consistent with the efficient implementation of monetary policy. Of course, conditions can change, and in choosing the time to begin policy normalization as well as the pace of that process, should that be the next direction for policy, we would carefully consider both parts of our dual mandate. Thank you. I would be pleased to take your questions. 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKE Q.1. Chairman Bernanke, in prior testimony before this Committee, you stated that the Fed chose $600 billion as the appropriate amount for QE2 because that amount would roughly correspond to a 75 basis point cut in the policy rate in terms of its broad impact. • Did QE2 work as intended? Did it have the broad impact of a 75 basis point cut in the policy rate? A.1. As the expansion weakened in 2010, developments with respect to both components of our dual mandate implied that additional monetary accommodation was needed. The Federal Reserve’s second asset purchase program—like more conventional monetary policy—was intended to reduce interest rates and boost the prices of a broad range of financial assets, thereby supporting spending and economic activity. A wide range of market indicators supports the view that the program had the desired effects. For example, between August, 2010—when we announced our policy of reinvesting principal payments on agency debt and agency MBS and indicated that we were considering more securities purchases—and late 2010, equity prices increased significantly, volatility in the equity market declined, corporate bond spreads narrowed, and inflation compensation as measured in the market for inflation-indexed securities rose to historically more normal levels. These market responses were similar to those that occurred in the months following our March 2009 announcement of increased asset purchases. As I noted in my testimony, we did not expect so-called QE2 to be a panacea for the country’s economic problems. But, we believed that the program would both help reduce the risk of deflation that had emerged and provide a needed boost to faltering economic activity and job creation. In the event, the evidence suggests that the program had its intended effect in shoring up economic activity and particularly in reducing the risk of deflation, which as we know from the Japanese experience can be quite costly in terms of weaker economic growth. Q.2. Chairman Bernanke, according to your testimony, the economic outlook remains uncertain. • What specific metrics do you use to determine how the economy is doing at any point in time? A.2. In assessing current and prospective developments in the macroeconomy, the Federal Reserve monitors a wide variety of information. For example, we analyze closely data on production, spending, labor market conditions, prices and financial markets. We also look at survey-based indicators of household and business attitudes and spending intentions. In addition, the Federal Reserve Banks collect anecdotal information from business contacts in their Dis(105) 106 tricts regarding current economic conditions, which we publish in the Beige Book eight times per year. Participants in the meetings of the Federal Open Market Committee incorporate all of this input into the formulation of the economic projections that they prepare four times per year. Q.3.a. Chairman Bernanke, last month, the Obama administration announced that it would release 30 million barrels of oil from the Strategic Petroleum Reserve to ‘‘offset the disruption in the oil supply caused by unrest in the Middle East.’’ When you were an academic economist, you studied the recessionary effects of oil price shocks and the Fed’s responses to those shocks. • Has the recent turmoil in the Middle East and the resulting increase in oil prices already affected our economic recovery? A.3.a. Oil prices jumped significantly as a result of the loss of oil production in a number of North African and Middle Eastern countries earlier this year, with the most substantial supply disruptions happening in Libya. The higher energy prices damped consumer purchasing power and spending during the first half of the year and likely contributed to some of the weakness in economic activity in economy that we have observed. Q.3.b. How will it affect our economy in the coming months? A.3.b. Since their peak in early April, oil prices have retraced some of their recent run up. If the lower prices are maintained, these negative influences on economic activity should prove to be transitory. Q.3.c. Has the Obama administration’s surprise announcement resulted in any meaningful positive effects in the oil markets? Has it had any detrimental effects? A.3.c. On June 23, the International Energy Agency (IEA) announced a release of 60 million barrels of oil from strategic stocks in light of the significant disruption to Libyan crude supplies and the impending seasonal rise in oil demand. Oil from the United States’ Strategic Petroleum Reserve (SPR) accounted for about half of the total release. Although the IEA announcement prompted an immediate decline in oil prices, parsing out the independent influence of the SPR release on oil prices is extremely difficult given the myriad factors that move oil prices. The IEA’s announcement may have provided some certainty regarding near-term oil availability and, therefore, may have been helpful in reducing oil price volatility in the short run. In the longer run, however, only increased production or reduced demand will keep oil prices contained. Q.3.d. What type of Fed response should we expect? A.3.d. The Federal Reserve does not respond directly to movements in oil prices nor to the price of any other individual items. Rather, consistent with its statutory mandate, the Federal Reserve seeks to foster maximum employment and overall price stability. Accordingly, if movements in oil prices were to have sustained adverse effects on the macroeconomy—for example, reducing aggregate production and employment for a prolonged period or causing inflation expectations to become unanchored—those adverse macroeconomic developments would factor in the Federal Reserve’s overall policy 107 analysis. As of now, it does not appear that the increase in oil prices during the latter part of 2010 and the first part of 2011 has had sustained adverse macroeconomic effects. Q.4. In an article earlier this year, Dr. Martin Feldstein, former President of the National Bureau of Economic Research, expressed his concern that QE2 could result in asset-price bubbles that may come to an end before the year is over. In recent speeches, you and Federal Reserve Bank of Kansas City President Thomas Hoenig both have mentioned potential bubbles in agricultural land prices. • What data do you examine to evaluate the risk of asset bubbles from QE2? • In addition to agricultural land prices, do you see any evidence of asset bubbles forming in other markets, such as the stock market or the bond market? A.4. The Federal Reserve, working in concert with the Financial Stability Oversight Council (FSOC), reviews a very wide range of data in assessing financial conditions and evidence of asset price imbalances. The FSOC annual report provides a very useful discussion of the types of data employed in financial stability analysis (see http:// www.treasury.gov/initiatives/fsoc/Pages/annualreport.aspx). As discussed in the FSOC annual report, there are no clear signs at present of the types of financial imbalances observed prior to the financial crisis. The management of credit and liquidity risk in most sectors appears conservative, and market prices do not provide clear indications of a departure of asset prices from fundamentals. Q.5. Federal Reserve Bank of Philadelphia President Charles Plosser has proposed a plan to shrink the Fed balance sheet while raising interest rates, based on a simple exit rule proposed by Professor John Taylor. Under Taylor’s plan, the Fed would reduce reserve balances by $100 billion for each 25 basis point increase in the Fed funds rate. • Do you agree that this would be a good strategy? A.5. As noted in the minutes of the June 2011 FOMC meeting, all but one of the FOMC participants agreed on key elements of an exit strategy that will adjust the level of short-term interest rates and normalize the size and composition of the balance sheet over time. (See the discussion on page 3 of the FOMC minutes at http://www.federalreserve.gov/monetarypolicy/files/fomcminutes 20110622.pdf). This strategy would not involve the type of tight linkage between increases in the Federal funds rate and incremental declines in reserve balances described by President Plosser. However, it is quite likely that reserve balances would gradually decline over the same period in which short-term interest rates are rising. Q.6. Chairman Bernanke, I want to follow up on the FOMC’s discussion, detailed in the minutes for the June meeting, of the principles that will ‘‘guide the strategy’’ of shrinking the Fed’s balance sheet. • Do you believe that the Fed’s exit plan should be transparent to the public? 108 • If so, when can we expect the Fed to announce its formal plan for shrinking its balance sheet? A.6. The Federal Reserve remains committed to transparency as a fundamental principle that supports both the effective implementation of monetary policy and appropriate accountability of the central bank to the Congress and the U.S. taxpayer. The FOMC provided a considerable level of detail regarding its plans for shrinking its balance sheet over time in the minutes of the June 2011 FOMC meeting; more details on the precise timing and operational implementation of these steps will be communicated well in advance of any policy actions. Based on current information, it appears that more detailed information on the exit strategy will not be necessary for some time. In its January 2012, FOMC statement, the FOMC noted that it currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the Federal funds rate at least through late 2014. Q.7. Federal Reserve Bank of Philadelphia President Charles Plosser has said that the excess bank reserves parked at the Fed are ‘‘fuel for inflation.’’ • Are you concerned that excess reserves will flow out too quickly and create inflationary pressures? • What specific metrics are you using to determine whether the Fed should start reining in excess reserves by raising interest rates? A.7. The FOMC has the tools it needs to remove policy accommodation at the appropriate time. As noted in the exit strategy discussion in the June 2011 FOMC minutes, even with an expanded balance sheet and elevated levels of excess reserves, the Federal Reserve can put upward pressure on interest rates by raising the interest rate paid on reserve balances. Moreover, the Federal Reserve has developed new reserve draining tools such as reverse RPs and term deposits that can be used to reduce the quantity of excess reserves. Finally, the Federal Reserve can sell securities to remove policy accommodation and lower the quantity of reserves. The Federal Reserve conducts monetary policy to foster its statutory mandate to promote maximum employment and price stability. The Federal Open Market Committee carefully monitors a very wide array of economic indicators in assessing the outlook for inflation including variables such as various measures of resource slack, cost pressures, and inflation expectations. In addition, the Committee regularly monitors the level of excess reserves, money growth, and bank lending as part of the policy process. In its January, 2012 statement, the Committee noted that it anticipates inflation will run at or below those consistent with the Committee’s dual mandate over coming quarters. Q.8. The Federal Reserve recently lost a case against Bloomberg in which it opposed disclosing to the public the names of banks that had borrowed from the discount window. This case is an important precedent in improving the Fed’s transparency. 109 • Who made the initial decision to not release the information? When Bloomberg decided to litigate, who made the decision to fight the release in court? • How will the Bloomberg case impact the Fed’s disclosure policies going forward with respect to its bank regulation activities? In other words, will you continue to oppose the release of this type of information notwithstanding the ruling in Bloomberg? A.8. It had been the Federal Reserve’s longstanding practice since 1914 not to publicly release the names, loan amounts, dates or collateral pledged for individual discount window loans. This practice, consistent with the practices of major central banks around the world, resulted from concern about the stigma that can result from public knowledge that a financial institution has borrowed from the Federal Reserve, which acts as the lender of last resort to banks that are unable to access ordinary sources of liquidity on a shortterm basis. Although a bank may borrow from the discount window for reasons other than financial difficulties, disclosure of just the fact that a bank has borrowed can lead to runs on the bank or other serious consequences that can harm individual banks or our Nation’s economy. The decision to defend the Board’s position in litigation initiated by Bloomberg was made after consultation between the Board and its Legal Division, and the Board’s litigation position was developed by the Board’s Legal Division. The decision to litigate was based on well-established FOIA precedent holding that privileged or confidential commercial or financial information obtained from a person, the disclosure of which would likely result in competitive injury—such as the discount window lending information at issue— is exempt from disclosure under FOIA Exemption 4. Following the Supreme Court’s denial of the petition for certiorari filed in the Bloomberg case, the Board fully complied with the Second Circuit’s decision in Bloomberg. Section 1103(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, 124 Stat. 1376, provides for the disclosure of the names, loan amounts, and certain other information about individual discount window loans made after the date of enactment. This information must be released 2 years after the loan was made, and is exempt from disclosure before that period. 124 Stat. 2118–19. Section 11 03(b) also provides for disclosure of borrower information for lending under emergency facilities that may be authorized in the future under section 13(3) of the Federal Reserve Act no later than 1 year after the effective date of the termination of the credit facility. Id. Separately, as required under section 1109(c) of Dodd-Frank, on December 1, 2010, the Board disclosed on its public Web site borrower and related information concerning emergency credit decisions made prior to July 21, 2010, under section 13(3). 124 Stat. 2129. This and much more information can be found at the following link: http:// www.federalreserve.gov/monetarypolicy/bstlsupportspecific.htm. The Board believes that the time lag provided for in section 1103(b) between the time a discount window loan is made and the date of publication of borrower-related information about that loan will substantially lessen the stigma and potential for harm to bor- 110 rowing institutions that could result from the earlier publication of this information while at the same time fostering public accountability for the Federal Reserve’s lending practices. The FOIA as written and interpreted prior to the enactment of Dodd-Frank would not have allowed this balancing of interests. Q.9. In a recent editorial in the Wall Street Journal, University of Chicago Professor John Cochrane points out that the average maturity of Treasury debt is less than a year. • Should we be concerned that the need to frequently roll over our debt presents more opportunities for Treasury investors to take flight over concerns about the U.S. fiscal condition? • What impact could that have on our debt service costs? • What impact could that have on the real economy? A.9. As noted in the Treasury’s quarterly refunding documents, the average maturity of marketable Treasury debt outstanding is about 5 years—about in the middle of the range observed over the last 25 years. (See http://www.treasury.gov/resource-center/data-chartcenter/quarterly-refunding/Documents/TBAC%20Discussion%20 Charts%20Feb%202012.pdf.) The U.S. Treasury issues large volumes of debt on regular weekly, monthly and quarterly auction cycles. As was widely noted in the discussions over the debt ceiling, the inability to rollover maturing debt would have very serious consequences for debt servicing costs, the level of interest rates, financial market functioning, and the real economy. At present, investor demand for Treasury securities remains strong and Treasury yields are very low by historical standards. However, as I have noted on previous occasions, the current fiscal situation of the United States is not sustainable. The low level of Treasury yields reflects confidence that Congress and the Administration will implement in a timely manner changes necessary to bolster the long-run fiscal position of the United States. RESPONSE TO WRITTEN QUESTION OF SENATOR REED FROM BEN S. BERNANKE Q.1. Extended unemployment insurance benefits provided during the economic downturn have fostered economic stability by helping to maintain consumer spending and keeping people in their homes. • Nationwide, Federal Government outlays for unemployment assistance were $120 billion in 2009 and $158 billion in 2010— a marked increase from 2008 levels of $43 billion.1 • Rhode Islanders have received a total of more than $850 million in Federally funded UI benefits since the outset of the temporary program.2 These benefits are set to terminate at the end of this year. Considering the Federal Reserve projects the unemployment rate to be as high as 8.7 percent (with a low of 7.5 percent) next year, what do you believe will be the consequences to the economy and 1 Table 11.3 pgs. 247; FY l2 Historical Tables. 2 Rhode Island Dept. of Labor & Training; Labor Market Information; http://www.dlt.ri.gov/ lmi/uiadmin/2011.htm. 111 the impact felt by individual families if unemployment insurance benefits are allowed to lapse? A.1. According to the latest estimates, about 3 3⁄4 million persons received extended or emergency unemployment compensation (EUC) in mid-July, of whom 2,000 were Rhode Islanders. Nationally, EUC benefit payments have averaged about $4 billion per month so far this year, of which about $20 million per month was received by Rhode Islanders. Were those benefits to lapse, some current recipients would likely find jobs. However, given the weak economy and the associated scarcity of job opportunities, many others would have difficulty finding employment and would likely suffer a significant reduction in their incomes. All else equal, I would expect that the expiration of emergency unemployment compensation would lower total household income and consumption in 2012, reducing the rate of economic growth by a small amount. Q.2. On Tuesday, July 12, 2011, Bruce Bartlett, a former senior policy advisor to both Presidents Reagan and H.W. Bush, warned about the possibility of repeating mistakes of the past. Mr. Bartlett compared the contraction in Government spending and investment during 1937–38, which spurred a recession, to our current situation. Then, as now, the economy was slowly recovering from a financial crisis. Mr. Bartlett wanted us to be ‘‘very careful, because it may only take a small misstep on either the monetary or fiscal side to the balance.’’ In 1937, during the Great Depression, the Government made a significant economic policy error. Federal fiscal policy turned sharply contractionary, and the Federal deficit was reduced to about 2.5 percent of GDP. The Fed also tightened monetary policy. The result was a downturn that extended the Depression. Do you think that, under current circumstances, a significant fiscal contraction could recreate the ‘‘Mistake of 1937’’? Why or why not? A.2. The Federal budget swung from a deficit of 4 percent of GDP in 1936 to balance in 1937. To be sure, if Congress and the Administration were to balance the budget as rapidly as occurred in 1937 this would have significant negative consequences for economic growth and employment in the near term. In part, this reflects the fact that monetary policy has less capacity than usual to offset a contractionary fiscal policy of magnitude of 1937 because interest rates are already quite low. In this regard, both fiscal and monetary policy face the challenge of balancing the short run concerns of supporting the recovery with long run concerns of sustainable fiscal policy and low inflation. I have spoken about the challenges facing fiscal policymakers as they try to balance support for the economy in the near-term with the need to address long-run fiscal imbalances. Fiscal policy actions over the past 2 years have bolstered aggregate demand and given some impetus to economic activity. For example, the 2009 stimulus package and last year’s fiscal policy actions have provided support to the economy during this period of weakness without significantly worsening the long-run 112 outlook.3 Recent budget actions and most current proposals to reduce the large Federal deficits appear to be designed to phase-in the budget restraint over time, again trying to balance these two objectives. Q.3. As you know, the Federal Reserve’s Flow of Funds report (first quarter 2011) indicates that nonfinancial businesses are sitting on $1.9 trillion in ‘‘cash’’ defined as total liquid assets [L. 102 Nonfarm Nonfinancial Corporate Business, Line 41, Total liquid assets]. Can you put this figure into historical perspective? What is the Federal Reserve doing—consistent with its statutory mandate to foster maximum employment—to get corporations to use their cash to make more investments that create jobs? Are there other good measures of how much cash on hand is held by corporations? A.3. The share of cash in the total assets for nonfinancial corporations is estimated to have remained at about 11 percent as of 2011 Q1,4 a high level by historical standards. Part of the explanation for these high cash balances may reflect an upward shift in the precautionary demand for cash, following the liquidity and credit market disruptions seen during the past recession. High cash retention may also result from firms that earn significant profits overseas. These firms may choose to hold the resulting cash on balance sheets of their foreign subsidiaries to facilitate future investment overseas or to minimize corporate tax expenses. Q.4. Corporate profits reached an all-time high in the first 3 months of 2011, with companies raking in an annualized $1.727 trillion in pre-tax operating profits.5 6 Can you explain the disjunction between booming profits and the need for more robust job creation? How much of this profit is earned overseas? Why isn’t more of it being invested in job-creating activities? A.4. In the most recently published National Income and Product Accounts (NIPAs), total corporate profits increased in the first quarter of 2011 to $1.876 trillion, an 8.8 percent gain relative to year-earlier levels. A large fraction of those profits, about one-third, were earned from operations outside of the United States.7 In fact, in the first quarter, receipts from foreign operations grew 12 percent from four quarters earlier, while profits generated from U.S. domestic operations grew 8 percent. As overseas operations have become a larger part of the business of U.S. parent companies, a higher fraction of the parent firms’ profits are generated using foreign, as opposed to domestic, labor. Moreover, firms may be reluctant to invest in activities that create jobs in the United States if they are uncertain about the prospects for growth in U.S. demand, especially if they perceive that opportunities for sales and profit growth primarily lie in overseas markets. Q.5. Most States began the new fiscal year on July 1st. Even though revenues are rising, many States are not in a position to 3 These actions included the extension of Medicaid and education grants, the extension of the 2001–3 tax cuts and EUC benefits, and the enactment of the payroll tax cut. 4 Source: Standard and Poors Compustat. 5 http://www.bea.gov/national/xls/technoteltaxlacts.xls. 6 http://www.bea.gov/newreleases/national/gdp/2011/pdf/gdp1q11l3rd/pdf. [Table 11] 7 Receipts from the rest of the world totaled $612 billion in 2011 Q1. 113 close their budget gaps. Consequently, States have been forced to make massive spending cuts, often impacting the most vulnerable populations. How has the lapse of Federal funding flowing from the temporary assistance provided by the Recovery Act affected States? Will cuts in State spending exacerbate the economic situation? If current expectations weaken, would further Federal stimulus in the short term help prevent protracted stagnation? Why or why not? A.5. State and local government budgets have been under considerable stress owing to the combination of a deep recession and their balanced budget requirements. Some of this strain has been alleviated by the extraordinary Federal aid given through the 2009 Recovery Act and the subsequent aid package enacted last year. Nevertheless, the Bureau of Economic Analysis estimates the real State and local purchases have been contracting since early 2008. This decline in State and local government spending reduced real GDP growth by two-tenths percent in 2010 and by four-tenths percent so far in 2011. With the depth of the recession and slowness of the recovery it is likely that State and local governments are spending a large fraction of the extra Federal aid, but it is difficult to determine how much of the recent weakness in State and local spending reflects the decline this year in Federal aid from the Recovery Act and how much reflects their reaction to weak revenues.8 In particular, because the size and timing of the grants has been known from some time, State and local governments may have tried to smooth through the 2010 bulge in grants, saving some of the 2010 grants to support spending in 2011. Moreover, in the aggregate data the pickup in State and local tax revenues over the past year has offset the downshift in Federal grants. State government revenues remain low relative to pre-recession trends, though, and layoffs in the sector have shown no signs of slowing. This suggests that budgets are still strained and that additional Federal aid would likely provide some support for State and local spending. Q.6. Consumer spending accounts for roughly 70 percent of overall economic activity. As a result of the recession and the impact on wealth, personal savings as a percentage of disposable personal income has increased from its recent low of 0.8 percent in April 2005 to 5.0 percent in May (down from recent peak of 8.2 percent in May 2009). How can we spur the type of economic growth we need in order to create jobs in light of consumers appropriately decreasing spending and increasing savings in response to a weak economy? A.6. You are correct to emphasize the importance of consumer spending for the economic outlook. The forces weighing on consumer spending, which include a need by many households to increase savings in a difficult economic environment, are an important part of the reason that the FOMC projects only moderate eco8 Federal aid to State and local governments from the 2009 Recovery Act totaled $79 billion in 2009, $124 billion in 2010, and $63 billion (at an annual rate) so far in 2011. Some of this decline has been offset by last year’s $25 billion extension of Medicaid and education stimulus grants. 114 nomic growth and a relatively slow decline in the unemployment rate during the next couple of years. Nevertheless, increasing personal saving, and the exercise of sound judgment in personal financial affairs more generally, are not inconsistent with a healthy growing economy, and sound household decisionmaking can lay the foundations for sustainable economic growth. Looking forward, I do expect consumer spending to play some role in contributing to an economic recovery that gradually picks up steam as households make further progress in strengthening their balance sheets, as credit availability improves further, and especially as job and income prospects gradually improve. The Federal Reserve is committed to doing its part to meet its statutory mandate to promote maximum employment in the context of price stability. Q.7. On Wednesday, June 29th, the Federal Reserve announced the extension of temporary U.S. dollar liquidity swap lines with several foreign central banks until August 2012. What were the reasons for this action? What are the strengths and weaknesses of this policy? A.7. These lines were extended because we believe they are helpful in relieving persistent strains in dollar funding markets abroad, which, as we saw beginning in 2007, can spill over into U.S. financial markets. Given the level of integration of global finance and the possibility that further turbulence in European financial markets would spill over into the United States, it seemed prudent, as a precautionary measure, to leave the lines in place for a while longer. The main policy benefit of the swap lines is to help contain the spread of pressures in global dollar funding markets into the United States. In addition, the swap lines carry minimal risk to the Federal Reserve. The lines convey no exchange rate risk and negligible counterparty risk because the Federal Reserve’s transactions are only with other foreign central banks, whose credit standing is of the highest quality. The credit risks that result from lending the dollars acquired through the swap lines are borne solely by the foreign central banks. Q.8. In April of this year, the Federal Reserve, the OCC, and the OTS released their Interagency Review of Foreclosure Policies and Practices, which resulted in the OCC’s consent orders requiring banks to hire independent consultants to do a foreclosure review of past practices. As part of this review, these consultants will be reviewing the bank’s loss mitigation activities. That is, whether the banks properly evaluated families for loan modifications in order to avoid foreclosures that could have been prevented. Do you believe that as part of this review, which requires the consultants to ‘‘1) identify borrowers that have been financially harmed by deficiencies identified in the independent review and 2) provide remediation to those borrowers where appropriate,’’ the consultant should review the file of every borrower who was denied a loan modification? A.8. For the four mortgage servicers that have entered into Consent Orders with the Federal Reserve, we are requiring a 100 percent review of all denied loan modifications for loans serviced by the servicer that were pending foreclosure at any time from 1/1/ 115 2009 until 12/31/2010, as well as where a foreclosure sale occurred during that time period. Q.9. Please describe any recent trends in bank’s converting from Federal to State charters, or from State to Federal charters. For example, a number of smaller financial institutions in Massachusetts recently became Federal Reserve members, including Canton Cooperative Bank, Reading Co-operative Bank, Walpole Co-operative Bank, among others. • Please provide a list of the banks converting their charters to the Federal Reserve during the past the last year. • Please describe all factors that contribute to this trend. • Please describe any incentives or encouragement by Federal Reserve staff relating to these conversions. A.9. During the year ended June 30, 2011, 36 banks converted to State member banks supervised by the Federal Reserve. This includes eight national banks that were previously supervised by the Office of the Comptroller of the Currency and 28 State-chartered banks that were previously supervised by the Federal Deposit Insurance Corporation. Over the last 5 calendar years (through December 31, 2010), the average number of banks converting to State member banks was 24 and the number of conversions in each year ranged from 19 to 35. This suggests that the trend has not changed significantly. A number of factors may affect a bank’s decision to change charters. These include the perceived quality of supervision by a given agency, an agency’s perceived level of knowledge about local market conditions, the accessibility and responsiveness of regulators, the amount of examination fees charged by State versus Federal regulatory agencies, or the perceived benefits of a national charter for operating a nationwide banking operation. The Federal Reserve typically accepts only banks rated 1 or 2 under the interagency CAMELS rating system as State member banks. New State members also generally must have satisfactory or better consumer compliance or CRA ratings and present no major unresolved supervisory issues. In some cases, pre-membership examinations may be required as described in the Federal Reserve’s SR Letter 11–2/CA Letter 11–2. In addition, the Federal Reserve complies with the July 1, 2009 interagency Statement on Regulatory Conversions which, among other things, emphasizes that the agencies will not entertain regulatory conversion applications that undermine the supervisory process. Federal Reserve staff members do not provide incentives to converting banks, but the Federal Reserve Banks provide information on the process for applying for membership when asked and on their Web sites. Also, when approached by banks about potential membership they explain their approach to supervising State members, provide information on the support and guidance that they provide to current State members, and answer banks’ inquiries related to membership. Q.10. What is the counterparty exposure in the financial sector on the ‘‘sell side’’ to Government paper (U.S. Treasuries, Fannie Mae, Freddie Mac, etc.) Please include all financial firms for which you 116 have data, including but not limited to bank holding companies, hedge funds, and money markets. In addition, please list the increase to cash collateral that may required if any of this Government paper defaults, as well the cash which may be necessary to pay off the contract. A.10. The first attached table shows Treasury and Agency holdings of the top 50 bank holding companies as of March 31, 2011. It is based on FRY9–C filings. The Federal Reserve does not directly regulate hedge funds or money market funds. The Securities and Exchange Commission (SEC) may be better positioned to respond to that part of the request. The procedures for addressing changes in collateral values, including due to default of the issuer of the debt serving as collateral, vary substantially across types of activities and by counterparties. In a worst case scenario, a USG default would require the party posting U.S. Treasury debt as collateral to replace the full amount with cash or other eligible assets, as specified in the underlying contract(s) governing each bilateral relationship. The second attached table shows the fair value of Treasury and Agency securities posted by OTC derivatives counterparties and held by the top 50 bank holding companies. Separately, under a credit default swap contract where the USG is the reference entity, the party having sold default swap protection will need to pay to the buyer of protection the notional amount less the recovery rate, under cash settlement. In the worst case scenario, where there is zero recovery on a defaulted USG debt obligation, the amount necessary to payoff the contract would be the notional amount of protection sold. Data on CDS, including those contracts referencing the USG, is compiled by the Trade Information Warehouse (TIW) managed by DTCC. See http://www.dtcc.com/ products/derivserv/dataltableli.php. Q.11. What is the size of the market for credit default swaps on United States Government paper? What are the consequences of low rates on these contracts if the Government defaults on its obligations? What other current market forces may affect this market? A.11. According to the Depository Trust and Clearing Corporation (DTCC) $29.4 billion in gross notional CDS on U.S. Treasury debt were outstanding as of July 29, 2011. However, a significant proportion of this gross value reflects offsetting trades between counterparties in which, for example, a party’s long position is effectively unwound by entering into an offsetting short position. Measured on a net notional basis, $5.6 billion in CDS referencing U.S. Government paper were outstanding. Whether measured on a gross or a net basis, the market for CDS on U.S. Government paper is miniscule relative to the $9.9 trillion in Federal Government debt held by the public. CDS on U.S. Government paper represents well under 1 percent of the outstanding CDS on single-name reference entities (both corporates and sovereigns). DTCC reports that overall $15.8 trillion gross notional and $1.2 trillion net notional CDS on single name reference entities were outstanding as of July 29. 117 CDS spreads reflect market participants’ forward-looking expectations about the likelihood and severity of a reference entity default as well as participants’ risk appetite. To the extent that market participants revise expectations about the likelihood or severity of a U.S. sovereign default upward, spreads on CDS referencing U.S. treasuries could be expected to rise. Were a default to actually occur, it is likely that no new contracts referencing U.S. treasuries would be negotiated until existing contracts were settled. Spreads on all CDS (not just those referencing U.S. Government paper) also depend on market participants’ overall willingness to bear risk. Both CDS and bond spreads tend to fall during times when market participants are more willing to take on risk and rise when market participants become more risk averse. Spreads on short-duration CDS referencing U.S. treasuries increased substantially prior to the passage of the Federal debt-limit expansion on August 2. The spread on 1-year maturity CDS on U.S. treasuries reported by Markit Partners hovered around 10 basis points from January through April but grew to about 30 basis points in May and peaked at 57 basis points on July 27. By market close on August 3, the spread had fallen back to a still somewhat elevated level of 26 basis points. Q.12. What analysis has been done to evaluate and quantify the gross credit default exposure of the top 10 banks in the United States to credit defaults swaps written on European sovereign? What source data does the Federal Reserve use in such analysis? A.12. Banking supervisors and analysts at the Board and Reserve Banks have been monitoring the peripheral European sovereign CDS exposures of the largest U.S. bank holding companies (BHCs) for some time. Analyses have tended to focus on the market risk and counterparty profiles for each BHC. Special analyses—e.g., with regards to ‘‘hedge (in)effectiveness’’ and its impacts—are done as events in the region and supervisory assessments warrant. With regards to CDS, a variety of data sources are utilized and cross-checked against each other to ensure that risk assessments are not reliant on any single source: 1. CDS trade data from DTCC’s Trade Information Warehouse provides useful perspectives on trends, in particular with gross and net notional positions referencing different sovereigns and the identities of counterparties. (Note, counterparty credit risk exposures cannot be inferred from DTCC CDS data. See #3 below.) 2. Targeted supervisory data requests provide opportunities to gather additional information (e.g., mark-to-market information, which the DTCC CDS data lacks) from different perspectives (e.g., risk systems). Given that over-the-counter derivatives trading is bilateral, data provided by one firm can be cross-checked against the same data provided by a counterparty firm to gauge data robustness and to flag areas for supervisory followup. 3. Continuous monitoring of firms’ top European bank counterparty credit risk exposures, internal scenario loss estimates, liquidity/funding conditions and ad hoc internal risk management analyses provide insight into BHCs’ evolving 118 risk profiles. Although these are not CDS-specific, the risks from CDS positioning are reflected, and as such can be crosschecked against information gleaned from the sources above. 4. Regulatory reporting data provides another perspective. Attachment for Question 9 119 Attachments for Question 10 120
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