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MONETARY POLICY AND THE
STATE OF THE ECONOMY
HEARING
BEFORE THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
JULY 16, 2008
Printed for the use of the Committee on Financial Services
Serial No. 110-128
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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania
MAXINE WATERS, California
CAROLYN B. MALONEY, New York
LUIS V. GUTIERREZ, Illinois
NYDIA M. VELAZQUEZ, New York
MELVIN L. WATT, North Carolina
GARY L. ACKERMAN, New York
BRAD SHERMAN, California
GREGORY W. MEEKS, New York
DENNIS MOORE, Kansas
MICHAEL E. CAPUANO, Massachusetts
RUBEN HINOJOSA, Texas
WM. LACY CLAY, Missouri
CAROLYN MCCARTHY, New York
JOE BACA, California
STEPHEN F. LYNCH, Massachusetts
BRAD MILLER, North Carolina
DAVID SCOTT, Georgia
AL GREEN, Texas
EMANUEL CLEAVER, Missouri
MELISSA L. BEAN, Illinois
GWEN MOORE, Wisconsin,
LINCOLN DAVIS, Tennessee
PAUL W. HODES, New Hampshire
KEITH ELLISON, Minnesota
RON KLEIN, Florida
TIM MAHONEY, Florida
CHARLES WILSON, Ohio
ED PERLMUTTER, Colorado
CHRISTOPHER S. MURPHY, Connecticut
JOE DONNELLY, Indiana
BILL FOSTER, Illinois
ANDRE CARSON, Indiana
JACKIE SPEIER, California
DON CAZAYOUX, Louisiana
TRAVIS CHILDERS, Mississippi
SPENCER BACHUS, Alabama
DEBORAH PRYCE, Ohio
MICHAEL N. CASTLE, Delaware
PETER T. KING, New York
EDWARD R. ROYCE, California
FRANK D. LUCAS, Oklahoma
RON PAUL, Texas
STEVEN C. LATOURETTE, Ohio
DONALD A. MANZULLO, Illinois
WALTER B. JONES, JR., North Carolina
JUDY BIGGERT, Illinois
CHRISTOPHER SHAYS, Connecticut
GARY G. MILLER, California
SHELLEY MOORE CAPITO, West Virginia
TOM FEENEY, Florida
JEB HENSARLING, Texas
SCOTT GARRETT, New Jersey
GINNY BROWN-WAITE, Florida
J. GRESHAM BARRETT, South Carolina
JIM GERLACH, Pennsylvania
STEVAN PEARCE, New Mexico
RANDY NEUGEBAUER, Texas
TOM PRICE, Georgia
GEOFF DAVIS, Kentucky
PATRICK T. McHENRY, North Carolina
JOHN CAMPBELL, California
ADAM PUTNAM, Florida
MICHELE BACHMANN, Minnesota
PETER J. ROSKAM, Illinois
KENNY MARCHANT, Texas
THADDEUS G. McCOTTER, Michigan
KEVIN MCCARTHY, California
DEAN HELLER, Nevada
JEANNE M. ROSLANOWICK, Staff Director and Chief
(II)
Counsel
CONTENTS
Page
Hearing held on:
July 16, 2008
Appendix:
July 16, 2008
1
51
WITNESSES
WEDNESDAY, JULY 16, 2008
Bernanke, Hon. Ben S., Chairman, Board of Governors of the Federal Reserve
System
6
APPENDIX
Prepared statements:
Paul, Hon. Ron
Bernanke, Hon. Ben S
52
53
ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD
Bernanke, Hon. Ben S.:
"Monetary Policy Report to the
Written responses to questions
Written responses to questions
Written responses to questions
Congress, July 15, 2008"
from Hon. J. Gresham Barrett
from Hon. John Campbell
from Hon. Adam Putnam
(HI)
63
Ill
116
120
MONETARY POLICY AND THE
STATE OF THE ECONOMY
Wednesday, July 16, 2008
U.S. HOUSE OF REPRESENTATIVES,
COMMITTEE ON FINANCIAL SERVICES,
Washington, D.C.
The committee met, pursuant to notice, at 10:03 a.m., in room
2128, Rayburn House Office Building, Hon. Barney Frank [chairman of the committee] presiding.
Members present: Representatives Frank, Waters, Maloney,
Gutierrez, Velazquez, Watt, Sherman, Capuano, McCarthy of New
York, Baca, Miller of North Carolina, Scott, Cleaver, Moore of Wisconsin, Davis of Tennessee, Hodes, Ellison, Klein, Wilson,
Perlmutter, Donnelly, Foster, Carson, Speier, Childers; Bachus,
Pryce, Castle, Royce, Paul, Manzullo, Biggert, Shays, Miller of California, Capito, Hensarling, Garrett, Brown-Waite, Barrett,
Neugebauer, Davis of Kentucky, McHenry, Campbell, Putnam,
Bachmann, Roskam, Marchant, McCarthy of California, and Heller.
The CHAIRMAN. The hearing will come to order. This is a hearing
pursuant to law on monetary policy and the state of the economy.
It is one of two hearings we have every year according to statute
on the state of the economy under the Humphrey-Hawkins Act.
Let me say preliminarily before we get into the opening statements that there was a good deal of interest in the recent proposal
from the Bush Administration involving some standby financial authority for dealing with the situation in Fannie Mae and Freddie
Mac. Obviously, Members are free to ask whatever they wish. I intend to focus here on the macroeconomy. We did, of course, have
the Chairman before us last week on the Board of Regulatory Authorities. Members are free to ask, obviously, whatever they wish.
I would note that the official subject is the macroeconomy, and that
is what I intend to discuss. Members will use their time as they
wish.
We will have four opening statements; two 5-minute statements
by myself and the ranking member, and two 3-minute statements
from the chairman and the ranking member of the subcommittee.
I will begin my statement now, so we can start the clock.
I am sorry; kill the clock for a minute.
Let me also explain that on the Democratic side—I take from the
ranking member the order in which questions are asked on their
side—we have been following the procedure of going first in this
hearing to members who did not get reached when we did the questioning in the first hearing this year. So we will begin with those
(l)
members who did not get a chance to ask questions during the first
round.
With that, we will start the clock, and I will begin my statement.
I want to focus on the very difficult situation facing a great majority of Americans, people who work for other people for a living.
Unemployment this year has become a serious problem. If you look
at the numbers for the unemployment figures, if the second half of
this year is not better economically than the first half, and I don't
see any reasons to believe that it will be, although we obviously
hope it will be, but if the numbers on unemployment in the second
half are no better than the first half, we are on track to lose nearly
1 million jobs this year, which means 1 million fewer people on the
official employment rolls than at the beginning of the year.
It is not only a case of jobs being lost. There is also a continued
erosion in the real earnings per hour of working people. We had a
debate in this country, in this committee, for several years about
whether that was true or not. It is now conceded that even in those
periods when we were generating wealth, and this continues to be
a wealthy country with a great capacity to generate wealth through
our free markets, the distribution was badly skewed. No one expects equality. Equality is not a good thing, and you can't have an
economy that works if everything is equal. But too much inequality
also has negative consequences.
Former Commerce Secretary Don Evans, a close friend of the
President, commissioned a study which showed how the overwhelming majority of the wealth generated in the good times went
to a handful of people.
Here is the report of the Federal Reserve, the Monetary Policy
Report to the Congress, dated yesterday, when Chairman Bernanke
testified first before the Senate. On page 20, the section begins:
"Productivity and Labor Compensation. Gains in labor productivity
have moved up significantly."
Let me go to page 21. People who wonder about the state of people's feelings are those who think that the American people are just
whiners and that the troubles are all in their mind. For those who
wonder why we have resistance to further globalization without
changes in the basic policies of this country, this sentence should
help them understand it. This is a direct quote from the Monetary
Report on page 21: "Broad measures of hourly labor compensation
have not kept pace with the rapid increases in both overall consumer prices and labor productivity, despite a labor market that,
until recently, had been generally tight."
I want to emphasize, hourly labor compensation has not kept
pace either with consumer prices or with productivity.
People who worry about inflation should understand from this
that no part of the blame for inflation, if it comes, can be put on
workers, because, as the Chairman has acknowledged previously,
and as economists understand, wages which rise along with productivity at the same level are not inflationary.
We have increased productivity and compensation lagging productivity. Working Americans are producing more wealth for this
country than they are being allowed to share, and that has been
exacerbated by the fact that prices are going up. So the situation,
according to the report of the Federal Reserve, is one in which
workers have increased their productivity, in cooperation with the
employers, and have failed to be compensated either to keep up
with the productivity or to keep up with prices.
The point to the business community is very clear. How can you
understand this, how can you look at our being on track to lose
nearly a million jobs this year, how can you note that workers are
getting less compensation than they are earning for the economy
and less than is needed to come up with prices, and wonder why
you can't get trade bills through, wonder why there is resistance
to outsourcing?
I believe that full participation in the global economy is a good
thing, but if it continues to go forward on terms which give a disproportionate share of the benefits to a relatively small number,
and the great majority are not simply even—even here, they are
falling behind, despite increased productivity, then we have to stop
and get our own house in order before we go further.
I now recognize the gentleman from Alabama.
Mr. BACHUS. I thank the chairman.
Chairman Frank, I am going to follow your lead and restrict my
remarks to the real economy, which is the purpose of this hearing,
and not some of the recent developments in the past week or two.
Chairman Bernanke, looking at the economy, we had an overextension of credit. We had too easy of credit, it wasn't properly underwritten, and the risks were not taken into account. As a result
of that, we have had, I think, massive debt accumulation in this
country, and we are going through what is inevitable when people
borrow more than they can repay.
I think a second factor, and it may be in your remarks or questions, you can address this, but a tremendous amount of leverage
and risk-taking and other risky and speculative investment practices and a lot of fortunes were made on the way up, but there is
pain on the way down. As I see it, it is not an easy thing to go
through, but it is a part of a market cycle.
The third factor, and this is a factor that I think is the most important, is the high commodity prices, and particularly energy
prices that have been a particular hardship on importing nations,
and we are obviously an importing Nation. It has been a financial
windfall to exporting countries.
I have been to Abu Dhabi and Dubai, and the fabulous wealth
that has been created out of really a desert society there in the
past 40 years is just almost beyond belief. I think T. Boone Pickens, he is running a commercial right now, and he calls this, I
think rightly so, the largest transfer of wealth in the history of the
world.
That, to me, and the effect it is having on Americans day-to-day,
is our biggest problem. I believe it is the largest source of instability in our financial markets. I think that the consumers are
stressed, they are paying high gas prices, high diesel prices, and
they can't pay their other bills. They are even having trouble putting food on their tables.
Finally, while we require the American people to live within
their budget, we had deficit spending here, and have for some time,
and there is a tremendous lack, I think, in Washington of financial
discipline. The Federal Government has more obligations than it
can fund today, but it continues to obligate itself, it continues to
expand and create new programs, and it continues to assume responsibility for funding services that were traditionally in the province of local or State governments or families themselves.
Obviously, all of these problems, the problem of tremendous
mushrooming of extension of credit and debt accumulation, of
overleveraging and risk-taking, of high energy costs, high food
costs, high gas prices, and then a Federal Government that spent
beyond its means, obviously there is no single approach we can
take to getting ourselves out of this.
I think the banks have repriced for risk. There has been a lot
of—they have raised capital. I will state right here that I know
there is a debate in this country on the overall financial stability
of our financial system, but I, for one, think that we are well on
our way to recovery in the financial system.
I think the present stock prices of our banks don't accurately reflect the value of those banks. I think the stock prices are too low.
The banks are sound, they are solid. I think the stock prices, right
now you may have—I think there is a real—it is just a confidence
factor.
Anyway, we have had a retrenching and a correction, and I do
worry about some attempts that we are doing to short-circuit the
correction and the period of adjustment. I think long term they can
deepen the damage.
But, in contrast, there is something that I think we should do,
and we can do now, and that is to address high energy prices. High
energy prices mean higher production and transportation costs.
Those increases are passed on to the consumers, and we saw that
this morning, causing inflationary pressures. Particularly hard hit
are those Americans, a million-and-a-half Americans, whose adjustable-rate mortgages are adjusting. Those families are facing a double whammy.
To sum up, what I believe is needed now is a concerted bipartisan effort by Congress and the Administration to develop and implement a comprehensive energy and conservation initiative. It
needs to be done now. It should have been last year or the year
before that. I believe until we get a handle on our dependency on
foreign oil, we are going to continue to have real severe problems.
Thank you.
The CHAIRMAN. The gentleman from Illinois.
Mr. GUTIERREZ. Thank you, Mr. Chairman.
Welcome back, Chairman Bernanke.
There is a lot of debate about whether or not we are in the midst
of a recession, but to most people out there, it is really a moot
question as they look at their bank accounts. And we all know
IndyMac went under, and everybody else is really worried. There
are a lot of calls at the office, should I check my savings account,
my bank account, is it insured, do they have enough money? Then
there is word that there might be another 90 banks. Some people
say they are small. We don't know. Nobody is ever going to really
tell us.
So, recession? When gasoline pops up to $4.50 in Chicago, and
your real earnings haven't increased, it seems like a recession to
them.
Most folks say, well, I wasn't in the stock market. Most folks, because we have done so much good work at purchasing homes, have
lost a lot of their net value. Their house isn't worth what it was
worth last year. It seems like a recession to them.
GM is on the verge of bankruptcy. Let's hope it doesn't go under.
I don't want to be a pessimist, but things are not good. Tens of
thousands of retirees heard from GM yesterday that it is so bad
that their health care insurance is being canceled after 35 or 40
years of working at GM.
It is bad. I don't know if we are in a recession, but if you came
out to my district and saw the foreclosure signs, literally the foreclosure signs everywhere. They say it is really worse on the east
or the west coast. I think it is worse in those neighborhoods where
people were finally getting a leg under and finally moving forward.
So I hope today, as we look at gas prices and food prices and
what they really mean, and I know a lot of this is very familiar
to you, I would like to know your thoughts on inflation in the current environment. With stagnant wages, we are not entering into
a wage spiral, and inflation is running high when measured by personal consumption expenditures, and with gasoline and consumer
energies even higher, inflation seems to be a real threat in the near
term.
I understand the markets need to grow, and that means lower
interest rates, but at the same time, specifically with the sharp increases in commodity prices, inflation has had to play a larger role
in Federal Reserve decisionmaking.
So, Mr. Bernanke, in the past you have discussed inflation targets, and I would like to know if you think such targets might be
appropriate in this environment.
I am also concerned about the weak dollar. We went to the Middle East on a congressional delegation to look into sovereign wealth
funds, and it was suggested by some of these sovereign wealth
managers, and I guess they would know since they have so much
oil and the petrodollars, they say about 25 percent of it is due to
the weakening of the dollar.
So I look forward—and I do want to close by saying thank you
for allowing the GSEs access to the discount window. I was really
happy to read and hear about the decisions you made in terms of
stopping predatory lending. I specifically ask you for that as we
move forward.
Thank you so much, Chairman Bernanke.
The CHAIRMAN. The gentleman from Texas.
Dr. PAUL. I ask unanimous consent to submit a written statement at this time.
The CHAIRMAN. Without objection, it is so ordered.
Dr. PAUL. Thank you, Mr. Chairman.
The CHAIRMAN. The Federal Reserve doesn't get to object.
Dr. PAUL. I think everybody recognizes today that our financial
markets are in a big mess, and I have complained for many years
about the Federal Reserve System. But I would have to say that
Chairman Bernanke himself is not responsible for this mess. Not
that I think he has the answers in this deeply flawed monetary
system, but obviously the seeds of this mess have been planted
6
over a long period of time. It is more a reflection of the system
rather than that of one individual.
It is amazing how panicky people have been getting, and how everybody is wringing their hands, and yet our government tells us,
well, there is no recession, so things must be all right. A lot of people are very angry. Yet we know there is something seriously
wrong, with all the mess that we have in the financial markets.
And now we see this morning that inflation is roaring back, yet it
is still way below what the private economists are saying about
what inflation is really doing. But the consumer knows all about
it.
It seems like around here, whether it is from Treasury or the
Federal Reserve or even in the Congress, all we need now is to
have a world-class regulator that is going to solve all our problems,
and I think that is so simplistic. From my viewpoint, what we need
is a world-class dollar, a dollar that is sound, not a dollar that continues to depreciate, and not a system where we perpetually just
resort to inflation and deficit financing to bail out everybody. This
is what we have been doing. It hasn't been just with this crisis, but
an ongoing crisis. We have been able to pull ourselves out of these
nosedives quite frequently. One of the worst with the dollar was in
1979. We patched it together.
I think the handwriting on the wall is there is a limit to how
many times we can bail the dollar out, because conditions are so
much worse today than they have ever been.
We talk a lot about predatory lending, but I see the predatory
lending coming from the Federal Reserve. Interest at 1 percent,
overnight rates, loaning to banks, encouraging the banks and investors to do the wrong things causes all the malinvestment. These
conditions were predictable. They were predicted by the Austrian
free market economists. It should surprise nobody, yet nobody resorts to looking to those individuals who are absolutely right about
what was coming and what we should have done.
Even as early as 7 years ago, I introduced legislation that would
have removed the line of credit to the Treasury, which was encouraging the moral hazard and the malinvestment. Here, it looks like
now we are going to need $300 billion of new appropriations.
So we need to look at the monetary system and its basic fundamental flaws that exist there, and then we might get to the bottom
of these problems we are facing today.
The CHAIRMAN. NOW, Mr. Chairman, I did want to join the chairman of the subcommittee in thanking you for the action you took
on Monday, a very important set of steps with regard to the
subprime. With that, let me welcome you again to your alternate
office and invite you to proceed.
STATEMENT OF THE HONORABLE BEN S. BERNANKE, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE
SYSTEM
Mr. BERNANKE. Thank you, Chairman Frank, Ranking Member
Bachus, and members of the committee. I am pleased to present
the Federal Reserve's Monetary Report to the Congress.
The U.S. economy and financial system have confronted some
significant challenges thus far in 2008. The contraction in housing
activity that began in 2006 and the associated deterioration in
mortgage markets that became evident last year have led to sizable
losses at financial institutions and a sharp tightening in overall
credit conditions. The effects of the housing contraction and of the
financial headwinds on spending and economic activity have been
compounded by rapid increases in the price of energy and other
commodities, which have zapped household purchasing power even
as they have boosted inflation. Against this backdrop, economic activity has advanced at a sluggish pace during the first half of this
year, while inflation has remained elevated.
Following a significant reduction in its policy rate over the second half of 2007, the Federal Open Market Committee eased policy
considerably further through the spring to counter actual and expected weakness in economic growth and to mitigate downside
risks to economic activity.
In addition, the Federal Reserve expanded some of the special liquidity programs that were established last year and implemented
additional facilities to support the functioning of financial markets
and foster financial stability.
Although these policy actions have had positive effects, the economy continues to face numerous difficulties, including ongoing
strains in financial markets, declining house prices, a softening
labor market, and rising prices of oil, food, and some other commodities.
Let me now turn to a more detailed discussion of some of these
issues. Developments in financial markets and their implications to
the macroeconomic outlook have been a focus of monetary policymakers over the past year. In the second half of 2007, the deteriorating performance of subprime mortgages in the United States
triggered turbulence in domestic and international financial markets as investors became markedly less willing to bear credit risk
of any type.
In the first quarter of 2008, reports of further losses and writedowns in financial institutions intensified investor concerns and resulted in further sharp reductions in market liquidity. By March,
many dealers and other institutions, even those that had relied
heavily on short-term secured financing, were facing much more
stringent borrowing conditions.
In mid-March, a major investment bank, The Bear Stearns Companies, Inc., was pushed to the brink of failure after suddenly losing access to short-term financing markets. The Federal Reserve
judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have
significant adverse implications for the U.S. economy.
After discussions with the Securities and Exchange Commission,
and in consultation with the Treasury, we invoked emergency authorities to provide special financing to facilitate the acquisition of
Bear Stearns by JPMorgan Chase & Company. In addition, the
Federal Reserve used emergency authorities to establish two new
facilities to provide backstop liquidity to primary dealers, with the
goals of stabilizing financial conditions and increasing the availability of credit to the broader economy.
We have also taken additional steps to address liquidity pressures in the banking system, including a further easing of the
terms for bank borrowing at the discount window and increases in
the amount of credit made available to banks through the Term
Auction Facility. The FOMC also authorized expansion of its currency swap arrangements with the European Central Bank and the
Swiss National Bank to facilitate increased dollar lending by those
institutions to banks in their jurisdictions.
These steps to address liquidity pressures, coupled with monetary easing, seem to have been helpful in mitigating some market
strains. During the second quarter, credit spreads generally narrowed, liquidity pressures ebbed, and a number of new financial institutions raised new capital. However, as events in recent weeks
have demonstrated, many financial markets and institutions remain under considerable stress in part because of the outlook for
the economy and thus for credit quality, which remains uncertain.
In recent days, investors became particularly concerned about
the financial condition of the Government-Sponsored Enterprises
(GSEs) Fannie Mae and Freddie Mac. In view of this development,
and given the importance of these firms to the mortgage market,
the Treasury announced a legislative proposal to bolster their capital, access to liquidity, and regulatory oversight. As a supplemental to the Treasury's existing authority to lend to the GSEs,
and as a bridge to the time when Congress decides how to proceed
on these matters, the Board of Governors authorized the Federal
Reserve Bank of New York to lend to Fannie Mae and Freddie
Mac, should that become necessary. Any lending would be
collateralized by U.S. Government and Federal agency securities.
In general, healthy economic growth depends on well-functioning
financial markets. Consequently, helping the financial markets to
return to more normal functioning will continue to be a top priority
of the Federal Reserve.
I turn now to current economic developments and prospects. The
economy has continued to expand, but at a subdued pace. In the
labor market, private payroll employment has declined, falling at
an average pace of 94,000 jobs per month through June. Employment in the construction and manufacturing sectors has been particularly hard hit, although employment declines in a number of
other sectors are evident as well. The unemployment rate has risen
and now stands at 5V2 percent.
In the housing sector, activity continues to weaken. Although
sales of existing homes have been about unchanged this year, sales
of new homes have continued to fall, and inventories of unsold new
homes remain high. In response, homebuilders continue to scale
back the pace of housing starts. Home prices are falling, particularly in regions that experienced the largest price increases earlier
this decade. The declines in home prices have contributed to the
rising tide of foreclosures. By adding to the stock of vacant homes
for sale, these foreclosures have in turn intensified the downward
pressure on home prices in some areas.
Personal consumption expenditures have advanced at a modest
pace so far this year, generally holding up somewhat better than
might have been expected, given the array of forces weighing on
households and attitudes. In particular, with the labor market softening and consumer price inflation elevated, real earnings have
been stagnant so far this year. Declining values in equities have
9
taken their toll on household balance sheets, credit conditions have
tightened, and indicators of consumer sentiment have fallen sharply. More positively, the fiscal stimulus package is providing some
timely support to household incomes. Overall, consumption spending seems to be constrained over coming quarters.
In the business sector, real outlays for equipment and software
were about flat in the first quarter of the year, and construction
of nonresidential structures slowed appreciably. In the second
quarter, the available data suggests that business fixed investment
appears to have expanded moderately. Nevertheless, surveys of
capital spending plans indicate that firms remain concerned about
the economic and financial environment, including sharply rising
cost of inputs and indications of tightening credit, and they are
likely to be cautious with spending in the second half of this year.
However, strong export growth continues to be a significant boon
to many U.S. companies.
In conjunction with the June FOMC meeting, Board Members
and Reserve Bank Presidents prepared economic projections covering the years 2008 through 2010. On balance, most FOMC participants expected that over the remainder of this year, output
would expand at a pace appreciably below its trend rate, primarily
because of continued weakness in housing markets, elevated energy prices, and tight credit conditions. Growth is projected to pick
up gradually over the next 2 years as residential construction bottoms out and begins a slow recovery, and as credit conditions
gradually improve. However, FOMC participants indicated that
considerable uncertainty surrounded their outlook for economic
growth and viewed the risks to their forecasts as skewed to the
downside.
Inflation has remained high, running at nearly a 3Vfc percent annual rate over the first 5 months of this year as measured by the
price index for personal consumption expenditures. And with gasoline and other consumer energy prices rising in recent weeks, inflation seems likely to move temporarily higher in the near term.
The elevated level of overall consumer inflation largely reflects a
continued sharp run-up in the prices of many commodities, especially oil, but also certain crops and metals. The spot price of West
Texas intermediate crude oil soared about 60 percent in 2007, and
thus far this year has climbed an additional 50 percent or so. The
price of oil currently stands at about 5 times its level toward the
beginning of this decade. Our best judgment is that the surge has
been driven predominantly by strong growth in underlying demand
and tight supply conditions in global oil markets.
Over the past several years, the world economy has expanded its
fastest pace in decades, leading to substantial increases in the demand for oil. Moreover, growth has been concentrated in developing and emerging market economies, where energy consumption
has been further stimulated by rapid industrialization and by government subsidies that hold down the price of energy faced by ultimate users.
On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of
the subdued supply response reflects inadequate investment and
10
production shortfalls in politically volatile regions where large portions of the oil reserves are located.
Additionally, many governments have been tightening their control over oil resources, impeding foreign investment and hindering
efforts to boost capacity and production.
Finally, sustainable rates of production in some of the more accessible oil fields, such as those in the North Sea, have been declining.
In view of these factors, estimates of long-term oil supplies have
been marked down in recent months. Long-dated oil futures prices
have risen, along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to
come.
The decline in the foreign exchange value of the dollar has also
contributed somewhat to the increase in oil prices. The precise size
of this effect is difficult to ascertain, as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of
all major currencies, suggesting that factors other than the dollar,
notably shifts in the underlying global demand for and the supply
of oil, have been the principal drivers of the increase in prices.
Another concern that has been raised is that financial speculation has added markedly to upward pressures on oil prices. Certainly, investor interest in oil and other commodities has increased
substantially of late. However, if financial speculation were pushing above the levels consistent with the fundamentals of supply
and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But, in
fact, available data on oil inventories show notable declines over
the past year.
This is not to say that useful steps could not be taken to improve
the transparency and functioning of futures markets, only that
such steps are unlikely to substantially affect the prices of oil or
other commodities in the longer term.
Although the inflationary effect of rising oil and agricultural
commodity prices is evident in the retail prices of energy and food,
the extent to which the high prices of oil and other raw materials
have been passed through to the prices of nonenergy, nonfood finished goods and services seems thus far to have been limited. But
with businesses facing persistently higher input prices, they may
attempt to pass through such costs into final goods and services
more aggressively than they have so far.
Moreover, as the foreign exchange value of the dollar has declined, rises in import prices have been greater upward pressure on
business costs and consumer prices. In their economic projections
for the June FOMC meeting, monetary policymakers marked-up
their forecast for inflation during 2008 as a whole. FOMC participants continue to expect inflation to moderate in 2009 and 2010,
as slower global growth leads to a cooling of commodity markets,
as pressures on resource utilization decline, and as longer-term inflation expectations remain reasonably well-anchored.
However, in light of the persistent escalation of commodity prices
in recent quarters, FOMC participants viewed the inflation outlook
as unusually uncertain and cited the possibility that commodity
11
prices will continue to rise as an important risk to the inflation
forecast.
Moreover, the currently high levels of inflation, if sustained,
might lead the public to revise up its expectations for longer-term
inflation. If that were to occur, and those revised expectations were
to become embedded in the domestic wage and price-setting process, we would see an unwelcome rise in actual inflation over the
longer term.
A critical responsibility of monetary policymakers is to prevent
that process from taking hold. At present, accurately assessing and
appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policymakers. The
possibility of higher energy prices, tighter credit conditions, and a
still deeper contraction in housing markets all represent significant
downside risks to the outlook for growth. At the same time, upside
risks to the inflation outlook have intensified lately as the rising
prices of energy and some other commodities have led to a sharp
pickup in inflation, and some measures of inflation expectations
have moved higher.
Given the high degree of uncertainty, monetary policymakers
will need to carefully assess incoming information bearing on the
outlook for both inflation and growth. In light of the increase in upside inflation risk, we must be particularly alert to any indications,
such as an erosion of longer-term expectations, that the inflationary impulses are becoming embedded in the domestic wage and
price-setting process.
I would like to conclude my remarks by providing a brief update
on some of the Federal Reserve's actions in the area of consumer
protection. At the time of our report last February, I described the
Board's proposal to adopt comprehensive new regulations to prohibit unfair or deceptive practices in the mortgage market, using
our authority under the Home Ownership and Equity Protection
Act of 1994.
After reviewing the more than 4,500 comment letters we received
under the proposed rules, the Board approved the final rules on
Monday. The new rules apply to all types of mortgage lenders and
will establish lending standards aimed at curbing abuses, while
preserving subprime lending and sustainable homeownership.
The final rules prohibit lenders from making higher-priced loans
without due regard for consumers' ability to make the scheduled
payments, and require lenders to verify the income and assets on
which they rely when making the credit decision. Also, for higherpriced loans lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included
in consumers' regularly monthly payments.
The final rules also prohibit prepayment penalty for higherpriced loans in cases in which the consumer's payment can increase
during the first few years and restrict prepayment penalties or
other higher-priced loans. Other measures address coercion of appraisers, servicer practices, and other issues. We believe the new
rules will help to restore confidence in the mortgage market.
In May, working jointly with the Office of Thrift Supervision and
the National Credit Union Administration, the Board issued proposed rules under the Federal Trade Commission Act to address
12
unfair or deceptive practices for credit card accounts and overdraft
protection plans. Credit cards provide a convenient source of credit
for many consumers, but the terms of credit cards loans have become more complex, which has reduced transparency.
Our consumer testing has persuaded us that disclosures alone
cannot solve this problem. Thus, the Board's proposed rules would
require card issuers to alter their practices in ways that will allow
consumers to better understand how their own decisions and actions will affect their costs.
Card issuers will be prohibited from increasing interest rates
retroactively to cover prior purchases except under very limited circumstances. For accounts having multiple interest rates, when consumers seek to pay down their balance by paying more than the
minimum, card issuers will be prohibited from maximizing interest
charges by applying excess payments to the lowest rate balance
first.
The proposed rules dealing with bank overdraft services seek to
give consumers greater control by ensuring that they have ample
opportunity to opt out of automatic payments of overdrafts. The
Board has already received more than 20,000 comment letters in
response to these proposed rules.
Thank you. I have would be very pleased to take your questions.
The CHAIRMAN. Thank you.
[The prepared statement of Chairman Bernanke can be found on
page 53 of the appendix.]
The CHAIRMAN. We will put the clock back on.
I want to repeat again my appreciation of the very thoughtful
steps you are taking with regard to consumer protection. They
haven't done everything we would do, but they go very far in that
direction. I think they are very important. They don't totally obviate the need for legislation, but I did want to acknowledge that. I
have to say if the Federal Reserve Board, before you became the
Chair, had promulgated the rules that you promulgated on Monday, I do not think we would be in this dire situation we are in
now.
Now, on the macroeconomy, on the job situation, and you note
this in the report, the total report of jobs lost for the first 6 months
is well over 400,000; 438,000, but you also note private sector job
loss is 564,000. In other words, the public sector has mitigated job
loss this year, and that is very relevant because one of the things
that we will be considering, and I think conditions clearly call for,
is a second stimulus. In fact, I think the argument for a stimulus
is somewhat reinforced by your presentation because we have depended a great deal on monetary easing to help the economy, but
whatever people think, it does seem to be clear we have reached
a limit on monetary easing, at least according to what the Federal
Reserve Board is willing to do. I believe further attention to a very
lagging economy is necessary, and it is going to have to come on
the fiscal side.
One of the arguments that I think is supported by these numbers
is that we should be giving aid to State and local governments. Aid
to State and local governments has a twofold benefit. It improves
the quality of life. They provide police services and fire services,
13
education, sanitation, and quality-of-life improvements. They also
are, as the numbers show, a significant source of employment.
Now, the problem is that the subprime crisis has eroded the ability of State and local government to carry out that function. Property taxes in many parts of this country have been impinged by the
foreclosure process and by the drop in house prices.
So there are several arguments that combine to say that aid to
municipalities and States is very important. We believe aid to help
them buy up foreclosed property is an important part of that. But
I think the numbers clearly show that.
I want to get to the whole question of the constraints on monetary policy. You say here that you have this dilemma, and you do,
where there are both inflationary fears and still some downside
risks to the economy. Without reference to the current situation, I
think an important point comes out of this conversation. There is
an argument for monetary policy increasing restraint, both to deal
with inflation and to deal with the drop in the dollar, which contributes directly to energy prices.
I should note that at the request of the ranking members of the
full committee and the subcommittee, we are scheduling a hearing
to talk about the relationship of the low currency to oil prices and
energy prices. That hearing is going to go forward in the last week
that we are here.
But here is the problem: Your European counterparts have been
able to be much more rigorous in raising interest rates. They, in
fact, have a different statute. You have a dual mandate, which is
very important, to worry about unemployment and inflation. They
are mandated to do inflation. Western Europe is not necessarily
less socially conscious than we are. I don't expect extensive comments from you, but I think here is the problem.
As you contemplate the possible need for raising interest rates to
slow down the whole economy, you face a situation which the social
consequences of that will be more negative than they would be in
Europe; that is, the existence of better social safety nets in Europe,
I think, gives monetary policy more political and social freedom
than it has in the United States.
If you raise rates and slow down the economy, we have people
who are going to lose health care. That doesn't happen in most European countries. There is a better provision of alternative income
supports.
So one of the things I think we should understand is the relative
insufficiency of our social safety net vis-a-vis what you have in
Western Europe constrains monetary policy unduly. No one wants
to see people thrown out of work. There are times when an increase in interest rates is necessary from the standpoint of the currency, and the gap between the European interest rates and our
rates have contributed to a deterioration of the currency, which
contributes to the energy problem.
So one of the things I recommend, and I have deliberately not
asked you to comment because it goes beyond your mandate, I just
want to note that to the extent that we improve the social safety
net in this country, which is important on its own, I think we also
give more flexibility to monetary policy, because the Federal Reserve would then be freer in times when it felt it was necessary for
14
other reasons to slow down the economy in the knowledge that this
would not have, as it has today, a disproportionately negative effect
on a lot of the people who are more vulnerable economically.
The gentleman from Alabama.
Mr. BACHUS. Thank you.
Chairman Bernanke, you talked about the significant increase in
the CPI this morning, and the challenge that high energy prices
present to the Fed and to our economy. Would you agree that the
failure of this country to develop a comprehensive and sustainable
energy initiative to reduce our dependency on foreign sources of oil
represents a major threat to our economy?
Mr. BERNANKE. I do think it is very important for us—and I
agree with you, Congressman, that it would have been better to
have addressed this some time ago. I think it is very important for
us to have an energy strategy, and that would have multiple dimensions: government support for research and development; clarification of regulatory policy; and, of course, letting the market respond to these prices. The only silver lining to these high prices is
that they do induce lots of incentives to conserve, incentives to provide alternatives, and incentives to find and develop other oil
sources.
So I agree with you absolutely that a more aggressive energy policy could be useful, and maybe even in the shorter term than one
might guess, because these future markets are very forward-looking, and to the extent that there is a sense that the United States
and other industrial countries are aggressively tackling their energy problems, it could sort of lessen concern about the long-term
supply and demand balance in oil.
Mr. BACHUS. Representative Paul mentioned the weak dollar.
Obviously, it is helping us with our exports, and it is moving some
consumption inward. Obviously, our constituents are being terribly
stressed by the high energy costs. I believe one factor may be the
weak dollar. What is your policy regarding exchange rate intervention?
Mr. BERNANKE. Well, our principal policy toward the dollar is to
have a strong economy. The Federal Reserve is mandated to provide strong growth and price stability. My belief is that if we work
effectively to achieve that objective, the dollar strength in the medium term will reflect that healthy underlying economy.
Market intervention is a policy that has been undertaken a few
times. I think it is something that should be done only rarely, but
there may be conditions where markets are disorderly where some
temporary action might be justified.
I think the dollar in the long term depends really on the fundamentals, and it is up to us to get the fundamentals right.
Mr. BACHUS. We talk about Bear Stearns and about the GSEs,
about systemic risk because of large financial institutions. Is there
a downside to the belief that I think is taking hold in the marketplace that the Federal Reserve and the Treasury will be lenders of
last resort for the entire financial system? Don't we run the risk
of a moral hazard? And when we do that, what do we do about
where private investors participate in the profits? It seems that we
are socializing the losses, or the public is assuming those losses.
Could you comment on those two things?
15
Mr. BERNANKE. Certainly.
The recent financial crisis, which has been quite severe, as you
know, has revealed a number of weak points in our economy, in our
financial system, and they have required attention because we
need to have a stable, well-working financial system in order for
the economy to recover. In the longer term, I agree that market
discipline is the best source of strength in the financial system. We
need to take action to make sure that moral hazard doesn't induce
excessive risk-taking.
I spoke on this subject last week in a speech, and I indicated
three directions forward that we could take to make sure that
moral hazard is constrained in the future. The first is, now that the
investment banks have received some support, in particular they
have received access to, at least temporarily, to the discount window, I believe that we need to have legislated consolidated supervisory oversight over those firms that would ensure that they have
adequate capital, adequate liquidity, and adequate risk management so they would not be taking advantage of any presumed backstop that they might otherwise see.
Secondly, I talked about the need to strengthen our financial infrastructure. Part of the reason that it was a big concern to us
when Bear Stearns came to the brink of failure was that we were
concerned that there were various markets where the failure of a
major counterparty would have created enormous strains on the financial system.
One way to address the problem, and I discussed that at some
length in my speech and I would be happy to talk more about it,
is to make sure that the financial infrastructure, the systems
through which lending and borrowing takes place, as well as the
risk management of the lenders is strengthened to the point that
the system could better withstand a failure, and therefore there
would be less expectation of support in that situation.
Finally, I think the issues we have approached like the investment banks, these circumstances were not contemplated in other
areas like deposit-insured banks. There is a procedure, a set of
rules, prompt corrective action, systemic risk, those sorts of things
which tell the regulators how Congress wants them to proceed and
create clarity in the market about under what circumstances assistance would be forthcoming.
As Secretary Paulson has also indicated, I think we ought to be
looking at clarifying the congressional expectations for how we
would resolve—were the situation to arrive again, how to resolve
such a problem.
The CHAIRMAN. The gentleman from Massachusetts.
Mr. CAPUANO. Chairman Bernanke, I have been listening to the
GSE issue, and some people think this is nothing more than a crisis of confidence; maybe we should not do anything and let it wait.
It amazes to me to hear this when I have an oil crisis, a food crisis,
a Consumer Price Index going up through the roof, job losses all
over the place, a trade deficit, a budget deficit going through the
roof, corporate losses all across-the-board, and the stock market
shaky every single day.
I would argue very clearly that this is a little more than a crisis
of confidence; I think we have a crisis of leadership. When I say
16
that, I want to except you from that position. I say that because
of the actions you have taken. They have been dramatic, bold, and
courageous. That doesn't mean I agree with every little detail; I
don't want to pretend that. But as far as I am concerned, you have
been the leader in this Congress in proving that taking bold action,
sometimes action that is a little bit on the edge, helps the economy.
It is something that is necessary.
I think you are following in the footsteps of some people who
really saved this country from disaster in the 1930's. People tend
to forget this. In the 1930's, there was no one action, no one silver
bullet that pulled us out of the Depression. It was a series of actions, over a decade. Many of those actions were to correct prior actions that maybe they made a mistake on, maybe they acted too
quickly and had to adjust it.
I don't see that there is anything we can do, unless anyone has
a single action that this Congress and this country should take. I
think we need more action, and that includes Congress as well. I
think we are going to try to do something in the next week or so.
We need it from the regulators. I personally think we need more
action from the SEC. I think we need faster action by everybody.
I think we need more dramatic action by everybody. And I think
we need more coordinated action by everybody. Right now, I think
we have too many people running around on their own.
All that being said, again, I want to thank you for what you have
done thus far and to thank you for your bold and courageous
moves, as I see it, most recently in the predatory lending area. I
would just like to hear your opinion in general, not about the specific proposals we have. I guess I can't escape them right now when
the GSE proposal is floating around in all its different iterations.
In general, in the crisis that we are in, do you believe that government—that includes Congress, regulators, and everybody
across-the-board—but that government should be acting relatively
quickly, or do you think that we should simply sit back and say it
is a confidence problem and people just need to get over it? Because, honestly, especially in the last day or so, I have been
shocked at the number of people who have pretty much said that.
I understand people differ as to what we should do. That is fair.
That is what this is all about. But to imply or to state that no action is necessary, to me, is completely wrong, and I would just like
to hear your opinion on that issue.
Mr. BERNANKE. Well, you want to take the right actions.
Let me say a word about GSEs. The GSEs are adequately capitalized. They are in no danger of failing. However, the weakness
in market confidence is having real effects as their stock prices fall.
It is difficult for them to raise capital. If their debt spreads widen,
it will increase the borrowing costs.
As I said yesterday, I think the housing market is really the central element of this crisis, and anything we can do to strengthen
the housing market or to strengthen mortgage finance would be
beneficial. Therefore, I do think this is one area where Congress
needs to think hard about how to restore confidence in the GSEs
to make sure that they can carry out the function of supporting the
mortgage market, which, right now, except for the FHA-Ginny Mae
combination, they are the entire securitization market for mort-
17
gages. I think that is an area particularly where action is needed
and justified.
Mr. CAPUANO. With that, I yield back the rest of my time because that was the answer I wanted.
The CHAIRMAN. The gentleman from Texas, who may not be
quite so lucky in getting the answer that he wants.
Dr. PAUL. Thank you, Mr. Chairman.
I want to address the subject of the inflation being actually a tax.
Today, most of us who go home and talk to our constituents hear
a major complaint, and that is the rising cost of living, especially
the cost of gasoline, medical care, food, and education. Most economists from all fields, whether they are monetarists or Keynesians,
they generally recognize that inflation is a monetary phenomenon.
But it is interesting that once we get rising prices, very few people
talk about the real source and the cause of the inflation, and they
go to saying, well, it's the oil companies. They charge too much.
That is inflation. Labor makes too much money, and it is a labor
problem. Others just say, well, it's just pure speculation, if we
didn't have the speculators, we wouldn't have the inflation.
Yet, most people conclude not that we have too much money, but
that we don't have enough. If we only had more money, we could
pay all these bills, which I think is absolutely the wrong conclusion. What we need is more value in the money. In terms of gold
and other commodities, prices aren't really going up. Sometimes
they actually even go down. In terms of paper money worldwide,
whether the euro or the dollar, the prices are going up.
But I maintain really that inflation is a tax. If the Federal Reserve and you as Chairman have this authority to increase the
money supply arbitrarily, you are probably the biggest taxer in the
country. You are a bigger taxer than the Congress, because they
are talking now about a bailout package of $300 billion, and we
will have to raise the national debt to accommodate to take care
of the housing crisis. But you as the Federal Reserve Chairman
and the Federal Reserve Board and the system create hundreds of
billions of dollars without even the appropriations process. Then
this money gets circulated, and some people benefit—the people
who get to use it first benefit, and the people who get to use it last
suffer the consequence of the higher prices.
So every time people go and complain about these higher prices,
they should say to themselves, I am paying a tax. Because whether
you are monetizing debt or whatever or catching up for buying up
securities, we have had a free ride for all these years. We have
been able to export our inflation. We have the Chinese buying up
our securities. We haven't had to monetize it. But now it is coming
home, and you have to buy these things to prop them up.
So I maintain that inflation, as the increase in the supply of
money for various reasons is a tax, it is an unfair tax, it is a regressive tax, it hurts the poor, it hurts the retired people more because labor never goes up and keeps up with inflation. We never
keep up with the need for retired individuals to keep up with the
cost of living.
So I would like you to comment on this. Is this completely off
base, or is there something really to this? Every time we see the
cost of living going up, we indirectly are paying a tax.
18
Mr. BERNANKE. Congressman, I couldn't agree with you more
that inflation is a tax and that inflation is currently too high, and
it is a top priority of the Federal Reserve to run a policy that is
going to bring inflation to an acceptable level consistent with price
stability as we go forward.
I would make one distinction, which is that what the Federal Reserve can control is the increase in prices on the average, over the
overall basket of consumer goods and services. The enormous
jumps in oil prices and other commodity prices are to some extent
at least due to real factors out of the control of the Federal Reserve. The Federal Reserve cannot create another barrel of oil. It
is the global supply and demand conditions which are affecting
those particulars things to the most significant extent, but to the
extent that the Fed does have influence on the overall inflation
rate, you are absolutely right that it is very important to maintain
price stability, and I take that very seriously.
Dr. PAUL. But if the oil prices were going up for another reason
other than monetary reasons, other prices would have to come
down because there would be a limit in the money supply. I
think—and the prices are going up today, like I indicated in my
opening statement, not necessarily because of the monetary policy
of the last year but maybe for the last 15 or 20 years and the fact
that we were able to export, so to speak, our inflation. Now it is
coming home. Those people who have been holding these dollars
are not wanting to buy them as readily. Fortunately, foreign central banks are still not dumping them but even the other central
banks might not be as cooperative.
So I still see tremendous pressure. I don't see any signs that you
are able to do very much because all we hear about is more inflation. You know, it is not so much that they are too big to fail. It
just means that everybody needs to be propped up. Congress participates in it. And all the pressure is put on the dollar. It is a dollar bubble. And I think what we are seeing is the unraveling of a
dollar bubble that had been building for more than 35 years.
The CHAIRMAN. The gentlewoman from New York.
Mrs. MCCARTHY. Thank you. And again, I thank you for the
work that you have been doing in the last couple of weeks. I imagine it has been very stressful. I want to just ask a couple of questions and see how prepared we are.
When I think about the small community banks, the regional
small banks, they are going under the same crunches as our, you
know, what we are concerned about as far as the larger banks,
Wall Street. And even my retirees or those of us who are thinking
of retiring in the next 5 to 10 years who have put money away into
our IRA, I don't think a lot of people realize that it is only back
to $250,000. Is that going to put a lack of confidence in those who
are putting money into the IRA? Because this is a country that
does not save, and we have been trying to encourage people to save
for their retirement. So those who put money into the IRA are now
all of a sudden finding a lot of that money is gone again. Is there
anything that Congress should be doing for the future? And what
tools do you have to help the small regional banks that don't have
the ability to go to the Fed for money to help make loans for those
who can actually buy homes to get the housing market to go?
19
Mr. BERNANKE. Well, to the extent that your constituents have
part of their IRA in the form of deposits, you know, they should
understand what the limits are of the FDIC protection. Of course,
one strategy if they have any concerns whatsoever would be to
break up their money across banks or in different accounts and so
on. There are obviously ways to get that protection, if that is what
you are concerned about. And you know, I have complete confidence in the FDIC, as we all should, in that the deposits that are
insured by the FDIC are completely safe and there is not even any
break in time between if there were a problem, when you would be
able to access your money.
So I think we all need to reassure the public that the FDIC is
protecting deposits and that there is no need to be concerned about
those deposits.
With respect to borrowing, all banks can borrow from the discount window, including small banks. Normally they don't as
much. They tend to be well-capitalized and strong and they sometimes come to the window. But if they want to, they certainly are
free to do so.
Mrs. MCCARTHY. SO the school of banks do have the opportunity
to go to the discount window?
Mr. BERNANKE. Yes, they do.
Mrs. MCCARTHY. Okay. I didn't actually know that. So I thank
you for that information. Thank you very much. I yield back.
The CHAIRMAN. The gentleman from Illinois.
Mr. MANZULLO. Thank you, Mr. Chairman. Chairman Bernanke,
earlier this week you took an action to crack down on a range of
shady lending practices that have hurt the Nation's riskiest
subprime borrowers and also have caused a tremendous amount of
economic distress in this country. Among other things, the Fed
issued regulations that would prohibit lenders from lending without considering the borrower's ability to repay and also would require creditors to verify their income and assets at the time of the
borrowing. These are pretty basic.
Although hindsight is a 20/20 issue, and it is easy to sit here and
say the Fed should have done this a long time ago, the evidence
of this housing bubble has been going on for some time. And my
question is, what took the Fed so long to act? And then the regulation you are coming out with is not going to be effective until October 1st of next year. Those are the issues just involving in the
subprime borrowers. As to the regular borrowers, you came up with
another landmark regulation that says, whenever a borrower gives
a check to the bank that the bank has to credit it that day to the
borrower's account. I mean, this shows knowledge of some very
basic problems that have been wrong in the housing industry. But
what took the Fed so long to act? And why wait 15 months before
the regulations go into effect?
Mr. BERNANKE. Well, the regulatory process itself imposes certain time constraints. We obviously have to make sure the rules
are consistent with existing law, including State as well as Federal
law, that they take make sense economically, and so on. It does
take some time to develop these proposals. They are quite elaborate.
20
Mr. MANZULLO. Sir, these are not elaborate proposals. These are
very basic statements that say that nobody can take out a loan on
a house unless he can afford to pay it. What is so elaborate about
that statement?
Mr. BERNANKE. It raises issues according to what kinds of liabilities might be associated with that. Are there circumstances in
which—say we have a long-time relationship between a bank and
a customer where you don't go through the paperwork, those kinds
of questions are still there.
And I was just going to add that under any kind of circumstance,
we have to have a comment period to get input from the public. We
have to revise our regulations.
Mr. MANZULLO. But you didn't start until December.
Mr. BERNANKE. SO there are two questions. What is the length
of the regulatory process, which is basically what we have to do to
follow congressional—
Mr. MANZULLO. The question is, why did you take so long? You
didn't do anything until December of last year.
Mr. BERNANKE. I described in my testimony here in July that we
were going to do a top-to-bottom review of all these issues and we
were going to act as quickly and as effectively as possible. We
began that process and we have supplemented it, as you know,
with considerable work on the credit card side. We have worked
also in—
Mr. MANZULLO. Chairman Bernanke, a lot of people in this country are losing their homes. The Fed has the responsibility and the
authority. You could have moved a long time ago and stopped a lot
of this. I mean why does it take months, if not years, to have a
very simple statement that you can't buy this house unless you can
afford to make the mortgage? These regulations are not that revealing. You talk about—you need a top-to-bottom review for something this simple? This is inexcusable on the part of the Fed. Notice that I said on the part of the Fed, not you.
Mr. BERNANKE. Well, at the current moment, as we all know, the
subprime market is pretty moribund, and so these rules are important but they are not having much impact on the market. What we
hope to do is have rules in place so that when the market comes
back, as it some day will, that the lending will be done in a way
that is prudent and also supportive of homeownership among people with a more modest means. That is our intention, and we have
followed the regulatory principles in order to do that.
Mr. MANZULLO. And then with regard to regular loans, you have
proof, do you not, that homeowners are making payments to lending institutions and the lending institutions are holding on to the
checks while the interest grows on the loan and waiting days before applying that money to the principal balance of the mortgage,
isn't that correct?
Mr. BERNANKE. We have addressed in our regulations some
issues about servicers and how quickly they have to apply the
money to make sure that it is fair and transparent.
Mr. MANZULLO. It simply says—
The CHAIRMAN. The gentleman can't ask questions after the 5minute rule. We have a full, full rostrum.
21
The gentlewoman from New York, I ask you to give me 15 seconds. Chairman Bernanke, quickly, when did you become Chairman of the Federal Reserve?
Mr. BERNANKE. In the beginning of 2006.
The CHAIRMAN. And when did you start working on these regulations that were just being discussed?
Mr. BERNANKE. In 2007.
The CHAIRMAN. And when did Congress give the Fed the authority to do it?
Mr. BERNANKE.
1994.
The CHAIRMAN. 1994. I don't think the delay is fairly laid at your
doorstep given those numbers. The gentlewoman from New York.
Ms. VELAZQUEZ. Chairman Bernanke, thank you for being here.
Since June of 2006, the Federal Reserve has acted consistently
with a series of aggressive cuts to the Federal funds rate. However,
with the rate now at 2 percent and with rising indicators of inflationary risk, what can the Fed do to support the U.S. economy and
force the further decline in the markets?
Mr. BERNANKE. Congresswoman, as I indicated in my testimony,
we at this point are balancing various risks to the economy. And
as we go forward, my colleagues and I are going to have to, you
know, see how the data come in and how the outlook is changing
and try to find the policy that best balances those risks and best
achieves our mandate of sustainable growth and price stability. So
I don't know how to answer beyond that, other than to say that we
are going to be responsive to conditions as they evolve. I noted
today the importance of not letting inflation from commodities
enter into a broader and more persistent and more pernicious inflation. That is certainly an important priority. But in general, we are
going to have to just keep evaluating the new information and see
how it affects the outlook.
Monetary policy works with a lag. We can't look out the window
and do something that will affect the economy today. So the best
we can do is try to make forecasts and try to adjust our policy in
a way that brings the forecast towards the desired outcome.
Ms. VELAZQUEZ. Well, Mr. Chairman, I understand all the steps
and actions taken by the Fed. But it seems to me that the lending
tools are proving to be ineffective at this point. Doesn't this prove
that the current economic conditions have moved beyond a liquidity
crisis that can be mitigated through Federal lending and is now
proven to be a capital crunch?
Mr. BERNANKE. Well, as the earlier questioner mentioned, dealing with these kinds of problems is multi-dimensional. Monetary
policy is one element. Lending is one element. Regulatory policy,
both initiated by the regulators and by Congress, is another element. I think we need to address the Fannie Mae/Freddie Mac situation to try to strengthen the mortgage markets. There are many
other steps. We have done the fiscal stimulus package.
So I absolutely agree that there is no single solution. If there
were, of course we would have used it by now. What we need to
do is have a sensible, coordinated, and proactive approach that is
going to allow us to get through this difficult period and return to
the strong underlying growth of this economy, in which I have
great confidence.
22
Ms. VELAZQUEZ. Okay. Many believe that the losses from the
housing market could spill over into consumer and business credit,
indicating that the worst may be yet to come. What is your take
on that?
Mr. BERNANKE. Well, there has been a problem in that many
banks that have suffered losses from mortgage credit and therefore
have had their capital reduced, they either have to raise more capital or if they don't do that, they have to shrink their balance
sheets or at least be reluctant to make new loans. So there is some
risk of that, that it would spill over to other kinds of credit. In fact
we have seen credit tightening in a number of dimensions. Of
course there is another factor as well, which is as the economy
slows it is natural for banks to be more cautious in their lending
because with a slower economy, credit risks tend to rise.
So that is a very important issue. We want to be sure that banks
are sound and that they have enough capital so that they cannot
just be safe and sound, which of course is critical, but beyond that
so that they can expand credit in a safe and sound way to promote
the recovery and strength of the economy.
Ms. VELAZQUEZ. Mr. Chairman, every day we hear stories about
small businesses being impacted by the credit crunch. And the Fed
used to provide the Survey of Small Business Finances. And you
have been critical to many policy decisions both at the Federal Reserve and here in Congress. If the survey is discontinued, what alternative sources of information will your agency use to make its
report to Congress on the availability of credit to small businesses?
Mr. BERNANKE. Yes, we did cancel that survey for budgetary reasons. But we did so also in the understanding that we could get
almost all the necessary information through other means. And we
in fact discussed this with Congress. We discussed this with various groups of interest in this area. The most important alternative
is the Survey of Consumer Finances, which is a Fed-managed product which surveys families periodically on all aspects of their balance sheets and income. That is an excellent survey instrument for
asking small business owners what their situation is, do they have
access to credit, what is their net worth, and so on.
So what we have tried to do—and I believe this will be successful—is to integrate the key elements of that small business survey
into the Survey of Consumer Finances that will allow us to recover
most of the information. And then we have a variety of other
sources of information that I think will make it possible for us to
get a good picture of small business.
Ms. VELAZQUEZ. Thank you. Thank you, Mr. Chairman.
The CHAIRMAN. The gentleman from Nevada.
Mr. HELLER. Thank you, Mr. Chairman. I appreciate the opportunity to spend some time here with Chairman Bernanke. I will try
to stay on some of the macro issues as you led us earlier in the
hearing. I don't think there is a newspaper out there today that is
not talking about the bad economic news that is out there—the
Washington Post, the New York Times, the Wall Street Journal.
You read them and it is talking about yesterday's hearings. I have
a copy of USA Today in front of me that talks about the signs of
growing crisis, the Dow being down, inflation being up, the U.S.
dollar down, foreclosures being up. All of this, I think, was re-
23
fleeted in your testimony as you spoke with us earlier in this hearing. The only good news I am hearing out there is that by December 31st, the year should be over.
I guess what I want to do is touch on a concept or a statement
that I hear too often, and that is too big to fail and the systemic
economic impact of these financial institutions and their ability to
survive or not. And we have obviously recent examples—Bear
Stearns, the Fed steps in; IndyMac, the Fed steps in; GSEs, the
Fed steps in. I receive a lot of calls from constituents who are concerned about their deposits in other banks including Wachovia,
Bank of America, and Wells Fargo. I guess the question I have—
and I have heard you say in the past, correct me if I am wrong,
that some of these financial institutions should be allowed to fail.
I guess my question is, what is the threshold between a financial
institution that the Fed should step in versus one that should be
allowed to fail?
Mr. BERNANKE. Well, first of all, IndyMac did fail, and the Fed
did not do anything about that. I would add to your constituents,
as I mentioned earlier, that all insured deposits were available immediately and no insured depositor is going to take any loss from
that.
We have in this episode just been confronted with weaknesses
and problems in the financial system that we didn't fully—we collectively, the regulators, the Congress, the economists did not fully
anticipate. And in the interest of the broader financial system and
particularly as always, always the ultimate objective is the
strength of the economy and the conditions for—economic conditions for all Americans. We found weaknesses and we had to respond in crisis situations. I think that—while I certainly would defend the actions we have taken, I would much prefer in the future
not to have to take such ad hoc actions and, as I described, I think
to Ranking Member Bachus, the best solution is to have a set of
rules that govern when a bank can be or other institution can be,
you know, put through a special process. In particular, we already
have such a process for depository institutions, which is a fiduciary
process where the requirement is that the government resolve that
bank at the least cost to the taxpayer unless a determination by
a broad range of financial officials that a systemic risk exists, in
which case other measures could be taken.
So I think it wouldn't be appropriate for me to try to give you
any guidelines right now. I think what we are doing right now is
trying to do the best we can to make sure the financial markets
continue to improve, and that they begin to function at a level
which would be supportive of the economy. I think what is critical
is as we go forward, we take stock from the lessons we have
learned from this experience and try to set up a system that will
be less prone to these kinds of difficult decisions that we have had
to make.
Mr. HELLER. I appreciate your feedback. When we are talking
about 1.5 million foreclosures last year, we are talking about 2.5
million foreclosures in this calendar year. And one of the concerns
that I get back—keep in mind that I am from Nevada and the impact that foreclosures are having on all of Nevada, especially southern Nevada, and their concern is that as the Fed is stepping in in
24
the Bear Stearns issues, the IndyMacs, the GSEs and they don't
feel like the Fed is stepping in enough for the 2.5 million people
who are finding themselves without homes. Any comments or reflections on that?
Mr. BERNANKE. Well, on two dimensions, one is that, as I said,
the actions we have taken—obviously it is not always crystal clear
to the public. But we have always taken our actions with an eye
to helping all Americans. And in particular, if—when we do take
actions to try to promote stability in the financial system, we are
thinking about the availability of credit, the safety of investments,
mortgage credit, all those things which do affect people's lives. So
for example, in these discussions of Fannie Mae and Freddie Mac,
I have no particular concern about the companies per se but they
are very critical right now to the U.S. mortgage markets and there
are people out there who would want to get a mortgage, people out
there who would hope the housing market can come back, and that
can only happen if there is renewed interest and availability to buy
homes. So these actions are intended to make our system work for
the benefit of all Americans.
Now with respect to foreclosures specifically, within our powers
we have done what we can to try to address that. We have, for example, given guidance to banks that we encourage them to do
workouts. I have talked about the need for loan modifications.
When other more temporary measures do not succeed in avoiding
foreclosure, the Federal Reserve has also been extraordinarily active at the local level. All of our 12 reserve banks and collectively
the entire system have been working closely with NeighborWorks
and other institutions to try to assist locally in terms of training,
in terms of helping communities deal with foreclosure clusters and
the like. So wherever we can, given our national footprint, we have
been involved in trying to help.
So you know, I would argue that we are addressing this on two
fronts. I am first of all trying to help the economy get stronger but
also addressing this issue directly.
Mr. HELLER. Thank you very much.
The CHAIRMAN. The gentleman from California, Mr. Baca. Then
we will go to Mr. Sherman and Mr. Scott on our side. Mr. Baca.
Mr. BACA. Thank you very much, Mr. Chairman. Mr. Chairman,
a combination of declining wealth, a weak job market probably because of all of the outsourcing and its impact that it has had on
working families, rising gas, food prices, and foreclosures have created a downward turn on the economy. To put it into perspective:
94,000 jobs have been lost each month this year; 8,500 families are
in foreclosure each day; 2.5 million foreclosures are expected in the
year 2008; home prices have fallen, stripping away household
wealth and equity; the value of the dollar has dropped between 20
to 30 percent; inflation is raising quickly; unemployment has risen
to 5.5 percent; and the real wages have fallen to the level of 2001
value.
More importantly is the real impact these numbers have on families. I go back home and my constituents are asking me, what are
you doing to bring down the gas prices and what are you doing to
help stop the foreclosures? Families are struggling to make ends
meet. They are forced to pick and choose between basic necessities
25
that they can afford each month, food, house payments, child care
or gas. You stated that the growth in the second half of this year
would be well below the trend due to continued weakening in the
house markets, elevated energy prices, and tight credit conditions.
But you stopped short at predicting a recession.
Question number one: Is the worst yet to come? And how would
you explain to the average American and to the working families
who are feeling the impact every day that we are not in a recession?
Mr. BERNANKE. Well, Congressman, first I would like to respond
quickly to something about your initial statement. You talked
about outsourcing and the like. Probably the key source of the job
loss we have had is the decline in the housing market, which has
laid off construction workers and has had spillover effects through
the financial system and so on. At this moment, our trade sector
is actually one of the bright spots in our economy that is creating
new opportunities for exports and job growth.
With respect to whether this is a recession or not, that is a technical determination that a group of economists will make at some
point in the future. It has to do with the various criteria. I think
I agree with the premise of your question, which whether it is a
technical recession or not is not all that relevant. It is clearly the
case that for a variety of reasons, families are facing hardships in
terms of higher energy costs, declining wealth, and all of the things
that you mentioned. So this is clearly a rough time. Whether it is
a recession or not, as you point out, is not—
Mr. BACA. DO you believe that we are in a recession?
Mr. BERNANKE. I don't know. And I don't know if the—in fact,
I am quite confident that the people who officially will determine
that don't know either. In the past—
Mr. BACA. DO you feel like the people who are impacted feel like
we are in a recession?
Mr. BERNANKE. Again, I think I would not put much weight on
this technical terminology. I mean, I think it is clear that growth
has been slow, and that the labor market is weak. And so conditions are tough on families. I have no doubt whether it is technically a recession or not, and I don't see how that makes a great
deal of difference.
As far as the projection is concerned, we see continued growth,
positive growth but weak for the rest of the year. Looking at the
housing market, it is beginning to stabilize, at some point around
the end of the year, early next year. And with the hope that we
can continue to strengthen the financial system, we would hope to
see recovery back to more normal levels of growth in 2009. But like
all economic forecasting, there are uncertainties in both directions.
But with respect to the current situation, again, whether it is a recession or not doesn't really play in our policy decisions.
Mr. BACA. Well, let me ask you the other question before my
time runs out. You mentioned the housing sector together with the
oil is the heart of the current economic uncertainty. How would we
eliminate the uncertainty and cause people to have a greater degree of confidence? And should we do something to address the
market speculation in oil to help drive down the gas prices?
26
Mr. BERNANKE. Well, let me address the oil price situation. I discussed this a bit in my testimony. There are multiple causes, no
doubt, for energy price increases. But the most important cause is
the global supply and demand balance. The fact that oil, for whatever reason and there are a number of reasons, has not kept up
with—oil production has not kept up with the growth in demand
for oil particularly in emerging countries which are growing quickly
and industrializing. So that suggests that probably the best thing
we as a country can do about this is to—perhaps working with
other countries, is to promote conservation, alternatives, new energy exploration, all the measures that will help bring us to a more
sustainable situation as far as energy is concerned.
On speculation, I also discussed this in my testimony. The Federal Reserve is working as part of a task force with the CFTC to
look at these issues empirically. But my sense, based on the information I have at this point, is that speculation or, more properly
defined, manipulation is not a major cause of oil price increases at
this juncture.
Mr. BACA. Thank you very much, Mr. Chairman.
The CHAIRMAN. The gentlewoman from Ohio.
Ms. PRYCE. Thank you, Mr. Chairman. And I want to thank you,
Chairman Bernanke, for being with us today. Thank you for your
activity over the last several months. It has certainly been a tumultuous few months. My concern is that we as a Nation, you as the
Fed, the Administration, and the Congress seems to be working in
a reactionary mode, in crisis mode, that everything that has happened as a result of events. Now I know that you have no crystal
ball any more than we have a crystal ball. But we as a committee
have responsibility for oversight of the safety and soundness of our
financial system. And I just want to ask a very simple question because I just haven't found an answer for it yet. And that is, why
did such sophisticated market participants misjudge so badly the
risk in the U.S. housing market? Is there an answer that you can
impart to the committee to help us understand why we blinked and
missed this one?
Mr. BERNANKE. Well, as we look back on it, we see that there
were just some serious failures in the management of risks. There
were many firms that had exposure to the housing market in a variety of ways across the firm, including holding mortgages and
other ways. And they didn't fully appreciate that in the contingency
that the housing boom would turn around, that house prices would
begin to drop; they didn't fully appreciate their exposure to that situation.
The regulators bear some responsibility on that. It is our job to
make sure that they measure and manage their risks appropriately. We have been working on that for a number of years related to bank supervision initiatives like the Basel Initiative, for
example, and so on. But it is clear that we need to redouble our
efforts to make sure that the risk management is sound, that the
underwriting is sound, and that we don't get ourselves into this
kind of situation again.
Ms. PRYCE. Well, you mentioned Basel. Are there further risks
ahead to our system and therefore the overall economy that might
arise, and the new capital adequacy standards in Basel? You know,
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if we are trying to have this happen simultaneously, could that create new risk to the system? Effects of a crisis in any overseas market, could that affect our system in a negative way? Further decline
in the dollar. There is a list of many things that could potentially
happen.
One of the things I would like your comment on is the commercial real estate market. You know, many banks astutely avoided
the subprime lending, and they instead expanded their commercial
real estate lending. So everywhere we turn we see increased vacancy signs and downward pressure on rents. And do we expect another wave of pressure from that market? And are we planning
ahead as a country to address these things as opposed to, you
know, being reactionary as it seems that we have had to be of late?
Mr. BERNANKE. Well, on commercial real estate, this was an area
where the Federal Reserve and other Federal bank regulators
issued guidance several years ago requiring banks that held very
high concentrations of commercial real estate to make sure that
they were underwriting properly, that they had good risk management. And I believe that guidance, which some people complained
about at the time, I think that is going to help us in the near term
as we face the situation.
Certainly as the economy weakens there is going to be a somewhat weaker performance of commercial real estate. But to this
point, we are not seeing anything remotely like, you know, what we
have seen in the mortgage market. But it is obviously something
we are going to have to keep our eye on.
Ms. PRYCE. Can you comment on anything that is happening at
the Fed in terms of future planning out for other contingencies?
You know what I mean. So that we have less of, you know, a reactionary mode in the future?
Mr. BERNANKE. Well, we are working with our international
counterparts in trying to strengthen the regulatory system. You
mentioned my mention of Basel. Clearly we learned some of these
in this last year and the Basel Committee is looking at places
where they should strengthen capital requirements, strengthen liquidity management requirements, and so on. So as that becomes
rolled in over time, it will reflect what we have learned from the
past year. So even as we are trying to manage the current difficulties, we are also working with other regulators and with Congress
to try to make sure that our system would be stronger and that we
will emerge from this with a system that is a lot more resilient
than we saw in the last year.
The CHAIRMAN. The gentleman from California.
Mr. SHERMAN. Thank you. First, a few comments. I would like
to join the chairman with regard to his comments on your consumer protection efforts. Your statements say that the new rules
will apply to all types of mortgage lenders. So for the record I will
ask you to refine that a little bit. I can't imagine that those rules
will apply to individuals who make loans in order to sell their
homes or whatever.
I would also note that in your statement you say that despite a
sharp increase in prices, production of oil has risen only slightly.
And then you go on a couple pages to go on to explain why oil production has only risen slightly. I would add to that—and I am sur-
28
prised that you didn't mention the fact that OPEC exists for the
exact purpose of preventing increases in supply and that the
Saudis have oil fields ready to go. They could turn on the spigot
and they have refused to do so. Talking about oil prices, there is
a lot of talk here in Congress about, well, what can we do to decrease demand by 10,000 barrels a day? Or how can we go drill and
get 500,000 barrels a day?
There is a worldwide price for oil. And what level of production,
or in the case of the SPRO not acquiring for reserves, how many
barrels a day would the United States have to deal with in order
to really affect the world price of oil? And in contrast, there is a
North American price for natural gas. What percentage increase or
decrease in supply or demand of natural gas would it take to have
a perceptible effect on the prices consumers pay?
Mr. BERNANKE. Well, first on the lending rules, the Federal Reserve normally issues guidance and rules for the banks that it supervises. But of course as the mortgage market has evolved, more
and more mortgage lending took place in nonbank companies, various kinds of mortgage companies, brokers and the like. And our
rules will apply to all of those types of companies. In some cases,
when they are outside of our enforcement authority, we have to
rely on State and other regulators to enforce the rules. And therefore, as part of this effort, we are working closely with them, doing
some joint examination exercises, and so on, to try to help them ensure that they will enforce these rules.
You made a good point, that the global oil market, about 84 million barrels a day, is large. And so it takes—you know, that very
small change in oil supply and demand would not necessarily have
a big effect. But I would make a couple of comments on that. One
is that the fact that we have to import most of our oil hurts our
trade balance, forces us to send money overseas, so to speak. It
would be better for the dollar and better for our economic prosperity here at home if we had more sources of energy domestically.
So that is one consideration. The other consideration is that—
and we can see this in the tremendous movements in oil prices up
and down, over a short-term period even though there is a large
market, the elasticity of supply and demand, the ability of suppliers or demanders to change their behavior in the short run is
quite limited. So sometimes relatively small events like a strike or
political unrest in a given country can have a big effect on the price
because there is so little spare capacity. So to the extent that that
spare capacity could be enlarged and have more flexibility, that
could have—
Mr. SHERMAN. IS there any way to give a numerical answer?
Would half a million barrels a day affect the price, a quarter million?
Mr. BERNANKE. Well, any—
Mr. SHERMAN. Can you give me figures on natural gas?
Mr. BERNANKE. But the short-term elasticity is sort of that a 1
percent increase in supply could lower prices as much as 10 percent.
Mr. SHERMAN. IS that your natural gas answer or does that answer apply to oil as well?
29
Mr. BERNANKE. I assume natural gas is similar. Natural gas has
more flexibility to use it in electricity generation and so on. So I
am not sure it is quite the same.
Mr. SHERMAN. Okay. Now a question for the record relating to
Bear Stearns. The rules of capitalism which are applied with a
vengeance on Main Street would have said that in a situation like
that, the shareholders and the subordinated debt holders should
take the losses long before anybody else. But in the deal that was
worked out, not only did the shareholders get $10 a share, which
I realize is far less than they had hoped for, but the subordinated
debt holders are going to get every penny with interest. And I wonder whether giving you the right to demand the conservatorship
immediately would put us in a position where we could impose the
risks and costs not on the taxpayer but on those who are supposed
to bear them.
Mr. BERNANKE. I agree. We need some kind of resolution regime
that will help us do this in a more orderly and predictable way.
The CHAIRMAN. The gentleman from Delaware.
Mr. CASTLE. Thank you, Mr. Chairman. And Chairman
Bernanke, I am going to talk about something else that you mentioned that concerns me in terms of our economic future. At the
very end of your testimony, you mentioned that the Board worked
with the Office of Thrift Supervision and the National Credit Union
Administration to issue proposed rules under the Federal Trade
Commission Act to address unfair deceptive practices for credit
card accounts and overdraft protection plans. You suggested credit
card issuers should alter their current practices. You also note that
the Fed has received over 20,000 comments on the proposed UDAP
rules.
I hope the Fed will be deliberate and take time to closely scrutinize these comments. I presume you share my concern that while
we want to protect consumers, we likewise want to maintain a
competitive credit card market, and not further damage the standing of the financial services industry.
Any comments you have beyond that I would appreciate.
Mr. BERNANKE. Only to agree with you that both in our mortgage
rules and in the credit card rules we want to strike an appropriate
balance between increasing clarity and eliminating bad practices
on the one hand versus making sure the credit is still available on
the other. And that has always been our balance and has always
been our concern.
With respect to credit cards, we have been using consumer testing quite a bit to see what people could understand, what they do
understand about their statements and about the provisions of
their contract. And we find that there are some elements that it
is just very difficult to explain, like double cycle billing for example.
And you know markets work best when people understand what
they are buying. And so there may be some circumstances where
the market will actually work better and produce more credit in
situations where there is not so much distrust and confusion about
what it is exactly that is in the contract. And that is the kind of
thing we have been trying to tackle.
Mr. CASTLE. Thank you. On another subject, Mr. Ackerman and
I have introduced legislation which was numbered H.R. 6482 to de-
30
termine what kind of structured finance investments are eligible to
receive ratings from National Recognized Statistical Rating Organizations. We feel measures like these would contribute to restoring
confidence in financial markets.
Would you agree that small steps like this one could contribute
to the overall stability of our market or any other comments you
may have concerning the credit rating agencies and their role, particularly in the housing circumstance?
Mr. BERNANKE. Well, the SEC has been quite active in this area
with support from us and the President's working group and international regulatory agencies. There is a wide variety of steps that
they have taken, including looking out for potential conflicts of interest, providing guidelines for increasing transparency to investors
so they can better know how to use the credit ratings; discussing
the idea of making credit ratings for different types of instruments,
corporate bonds versus structured credit versus municipals; having
different rating schemes and so on.
So we recognize, as I said earlier, this episode has shown a lot
of areas where our financial system wasn't as effective and strong
as we thought it was. And this is one of those areas. And you know
I think there is a lot of activity underway to strengthen the credit
rating agencies.
At the same time I think we have learned—and this is true both
in a regulatory context as well as in an investor context—that
there really is no substitute for direct due diligence. The investor
has to do their own work, and that includes more than just looking
at the credit rating.
Mr. CASTLE. Well, not to argue with you or to beg the question,
I would agree with you except it is very hard and complex for many
investors to do that. And I am thinking of the pension funds and
others who are making relatively big decisions as well as individuals. So it concerns me a little bit. There is a dependency on the
credit rating agencies' reports, I believe.
Mr. BERNANKE. Then you can have a fiduciary or an investment
manager that can provide advice.
Mr. CASTLE. One final area, and I just read this in the papers
today, but the whole question of the GSEs and their future. I have
read what your recommendations are and obviously we need to consider that with respect to loans or capitalization or whatever. But
a further question is, are they sound at this point? I mean, are
they well-capitalized? Should we consider a privatization or nationalization of these entities? Are we going in the right direction with
respect to Fannie Mae/Freddie Mac in particular?
Mr. BERNANKE. Well, they are adequately capitalized at this
point. And you know the OHFEO says that they are fine and they
can continue to operate and there is nothing about to happen. But
we want these firms not just to be, you know, solvent, which is of
course is critical, but beyond that we want them to play an active
role in strengthening and stabilizing our mortgage market because
they really are a big part of what is going on in mortgage markets
right now. And to the extent that—even if regulatory criteria are
met, to the extent that markets have lost confidence and shares
have come down and spreads widen, we need to restore that confidence so they can have the financial strength they need to not
31
only be solvent, which they are, but to go ahead and be more
proactive in strengthening our mortgage markets.
On the broad issue, you know based on the discussions I have
had and my own thinking, it looks like the best solution at this
point is to maintain their current form but to increase the supervisory oversight, make it much stronger, which is part of the bill
that has been looked at in both the House and the Senate, and to
take whatever steps are needed to try to restore confidence in the
markets, that these are in fact strong institutions going forward.
Mr. CASTLE. Thank you.
The CHAIRMAN. The gentleman from Georgia, I would just ask
him for 10 seconds to say that yes, that is exactly right. The bill
this House passed in April of last year gives all of those new powers to the regular Fannie Mae and Freddie Mac, including the right
to put them in a conservatorship. All the powers of the gentleman,
that the Chairman has asked for with regard to being able to resolve other issues, they are in the bill that we hope to pass soon
and send to the President regarding the GSEs.
The gentleman from Georgia.
Mr. SCOTT. Thank you, Mr. Chairman. Chairman Bernanke, let
me first start by complimenting you as well. I think you have done
a remarkable job in responding. Your views, your tools very wisely
of the rate cuts and your action to protect our Fannie and Freddie
are very, very important to send a signal to the world that we are
going to keep our markets as stable as we can.
Let me just assure you that this economy is deeply in a recession
certainly, and in many parts of our country they are hovering
around the elements of a depression. Many American families are
just basically hanging on by their fingernails. And you touched on
two major areas of concern to that, which of course are housing and
energy.
Let me start with a series of questions. First of all, I believe
strongly—you have touched very excellently on the oil and the energy concerns that we have, especially our overwhelming dependency on oil, which I was very delighted to hear you say we need
to wean ourselves off of. But we are not doing that quickly enough,
Chairman Bernanke. And one area in which we are failing miserably is in the area of quickly, the most effective way I believe we
can bring down immediately the cost of gasoline, and that is what
the American people want. They want immediate answers now.
Drilling is not that answer. None of that is our answer. What is
our answer is getting some alternatives on the market quickly that
will cut our demand on foreign oil. And nowhere is that more precise than in ethanol.
And with that, I would like to ask you why, for example, it would
take a tremendous downward pressure and immediately lower the
price of gasoline at the pump today if we would remove the 54
cents per gallon tariff that we have on ethanol coming in from
Brazil made from sugarcane, the most potent, the most effective
form of ethanol. That would help immediately increase the available supply. If they are running the automobiles in Brazil, 90 percent of them off of ethanol made from sugarcane, and they have
plenty of that, that would make a lot of sense for us to immediately
lower that 54 cents and bring in as much of that ethanol as we can
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so it would offset this great need and gluttony that we have for this
imported oil and would send a loud message over to OPEC.
First of all, would you recommend that? Is that not a smart thing
to do, to take that 54 cents a gallon tariff off of the imports of ethanol made from sugarcane from Brazil?
Mr. BERNANKE. Congressman, I do support free trade, and I
think that would be a good step to take. I think it would be helpful.
I wouldn't want to overstate it because of course Brazil is using a
lot of its ethanol for its own country. And indeed they have been
remarkably successful. They are essentially energy self-sufficient
based on ethanol and their own oil sources and so on, which is a
very different situation from where they were in the 1970's.
Mr. SCOTT. Absolutely. Let me get to my other point. I am glad
to hear you say that. And I think we should move to do that.
In other areas, in biodiesel fuel, for example, I have not heard
any incentives, any cries from the Administration or anybody to increase the output of biodiesel fuel. We have advances being made,
for example, in my own district in Georgia, in Clayton County. In
Ellenwood, we have a biodiesel plant that is making biodiesel not
from petroleum, not from oil, not from fossil material, but from the
fatty parts of chicken and pork. And Chairman Bernanke, they are
producing 18 million gallons of it a year, going directly to the market, not on a world market, but going directly to the points of distribution in that area.
Where are the incentives for biodiesel fuel when we have the
mechanisms for that? If we have that one plant that is producing
18 million gallons going directly to the market, wouldn't it make
sense to get behind this movement? It would create more jobs and
help stimulate the economy.
Before my time is out, I wanted to ask you another question—
The CHAIRMAN. Excuse me, gentleman. There won't be time to
get an answer. I apologize. We have 5 minutes. If you can make
it quick.
Mr. SCOTT. I have two points. Your answer on the economic stimulus package, how good was it, is it good, and given the weakness
of the economic forecast, wouldn't it make sense perhaps to extend
another round of that economic stimulus package to get some
checks more directly into the hands of the American people?
The CHAIRMAN. The Chairman can answer that.
Mr. BERNANKE. First of all, what is the incentive for biofuels?
The high price of oil is a pretty strong incentive. As long as there
is regulatory clarity about what is involved, I think there will be
plenty of market-driven movement in that direction.
On the fiscal stimulus, I believe the one that was done is having
some effects. But it is somewhat early to make that judgment. And
so you know I certainly think that we should consider all options.
At the moment I think it is a bit premature. With all due respect,
what I suggest at this point is that the most pressing need is in
the housing sector and the Fannie issue and in the housing measures, and that is where I would urge you to look now.
The CHAIRMAN. The gentleman from California.
Mr. ROYCE. Thank you, Mr. Chairman. Chairman Bernanke, for
a better part of a decade there has been a push to improve what
is a very weak regulator in OHFEO over Fannie and Freddie. And
33
I remember the week after you took your position we talked about
this issue. We were in agreement. Here on this committee I have
raised this issue countless times. In 2003, I introduced the first legislation which sought to bring Fannie and Freddie and the Federal
Home Loan Bank System under one strong regulator within the
Federal Government.
Back in 2005, I introduced an amendment on the House Floor to
give the new regulator the authority to review and adjust the
GSEs' retained portfolios in order to mitigate against systemic
risks. This is the same thing we are trying to do now with an independent regulator. And we are now witnessing what the current
weak regulator, without the ability to mitigate against systemic
risk, means for these two institutions and our broader capital markets.
I will just mention that the majority of my colleagues voted
against that amendment on the Floor of the House. But as we go
forward with an episode here that could have been prevented long
ago had your counsel or the counsel of those of us pushing this had
been taken, we move closer now to passing legislation to strengthen the regulator for Fannie and Freddie.
And I must again express my sincerest opposition and frankly
my amazement to the inclusion of a roughly $600 million affordable
housing fund and a $300 billion bailout for lenders and speculators
that has been put in the bill. And I said this since its inception,
this affordable housing fund is straight out of Central Planning
101. It should not be accepted by my colleagues. It should not be
accepted by this Administration. And much of this money, pushed
for by certain NGOs, will most likely end up in the pockets of a
group of radical activist organizations with history of both voter
fraud and anti-free market advocacy nationwide.
So even if the money is used to promote affordable housing, because it is fungible, the American taxpayers will be indirectly subsidizing the most egregious actions taken by certain radical groups.
So unfortunately, the safeguards in the bill meant to prevent
abuses are far from sufficient. As a recent Wall Street Journal editorial noted, if later investigations prove the taxpayer funds were
misused, the bill provides that recipients can simply return the
amount of the grant with no further financial penalty.
And Chairman Bernanke, I know you are not an advocate for
this fund. So I will spare you a line of questioning to address that
part of the issue, but I would like to get your thoughts on an additional issue, and that has to be on stability in the economy. As we
watch our capital markets, as we watch this economy struggle, I
believe there is plenty Congress could do to help in the recovery.
And I think if we are able, I believe we should provide certainty
to the environment in which our companies operate. And part of
that certainty, if we go back to a speech that you gave as Chairman
of the Council of Economic Advisors, you mentioned the 2001 tax
cuts. And you said, additional tax legislation passed in 2002 and
2003 provided incentives for businesses to expand their capital investments and reduce the cost of capital by lowering tax rates on
dividends and capital gains.
Well, with those cuts looking to expire in 2010, it would seem
critical to give the markets the certainty necessary to recover fully
34
in the coming months. So I would ask, Chairman Bernanke, do you
still agree with your previous assessment of the impact of the 2002
and 2003 cuts on the economy? And what would be the effects of
an increase in the capital gains and dividends rate of 20 percent
or higher as being discussed, what would that effect be on our already weak capital markets, especially considering the much lower
rates that exist around the world?
That would be my question to you now.
Mr. BERNANKE. Thank you. First, let me just agree with you on
the regulator. He fought a good fight. The Federal Reserve, my
predecessor for many years raised these issues. And you know, it
would have been helpful if we had been able to do that. I don't generally in my current capacity comment on tax policy, but I do think
and I expect that the Congress as they think about all these things,
all these packages, you know, will be looking—I am sure you will
be looking at the cyclical situation and trying to see what impact
that has along with any other fiscal steps you might be taking.
Mr. ROYCE. Thank you, Chairman Bernanke.
The CHAIRMAN. The gentleman from Missouri.
Mr. CLEAVER. Thank you, Mr. Chairman. I have some curiosity
about the radical groups my colleague was talking about, but I will
suppress that and move on.
Mr. Chairman, because our economy seems to have so many economic moving parts and with connections to the world economy, is
it possible any more for us to bring forth a clear forecast? I mean,
has forecasting just been tossed out of the window?
Mr. BERNANKE. Forecasting is always very difficult, and it is extremely difficult when you have the kind of financial issues that we
have had recently because it is just hard to know which way that
is going to go.
Unfortunately, for monetary policy purposes, because monetary
policy works with a lag, even if our forecasts aren't very good, we
have to take our best stab because we have to have a sense of
where the economy will be when the monetary policy actions begin
to take effect. So we have at the Federal Reserve just about the
best team of forecasters anywhere, and they have done a very good
job over the years. But they are facing a very, very tough environment both because of the global issues that you mentioned and because of the changes in financial situation.
Mr. CLEAVER. That question actually was a setup for the next
question. And to some degree it may have been asked in various
forms. Each night since this has started I have been taking piles
of stuff home and reading it and essentially dropping a rock down
in a well, and I have been waiting to hear the sound of a splash
and I haven't. I am wondering if you have. I mean, is there a bottom? And if so, how long before we hear a splash? My concern, the
airline industry is now hemorrhaging and crying. It appears as if,
you know, one—we are having a domino effect. And you know I
think as the cries go up, more and more people are becoming
afraid. I used to say that we had a transportation-based economy.
Now I am wondering if we have a confidence-based economy. Help
us, please.
Mr. BERNANKE. Well, Congressman, it is the nature of my testimony. I am supposed to be reporting on the next 6 months and the
35
immediate period ahead, so I tend to have a very short-term focus.
Obviously, we have a lot of challenges in the near term.
I can't predict precisely the contour of economic activity going
forward, but I am personally very confident that we will return to
a strong growth path. I think it is very striking that even during
all that uproar, U.S. labor productivity has continued to grow faster than almost any other industrial country. It just shows how
strong this economy is. We will work our way through these financial storms, we will work our way through this cyclical movement
that we have, and the economy will return to good growth, but we
just have a few things to work through on the way to doing that.
Mr. CLEAVER. This is a rhetorical question, I think. We need action immediately with regard to the housing bill that is in the
hands now of our chairman and leadership.
Mr. BERNANKE. I would advise prompt action on housing issues,
including Fannie and Freddie.
Mr. CLEAVER. Thank you, Mr. Chairman.
The CHAIRMAN. If he would yield, the Chairman again said, and
we should be proud of this, that American worker productivity is
growing faster than anywhere else in the world. Worker compensation is failing to grow comparably, and that is a fundamental social
and economic issue we have to address.
The gentlewoman from Illinois.
Let me say to people that we are going to have to vote soon, so
I am prepared personally to miss the vote on the previous question
on the intelligence bill, which will give us maybe 20 minutes from
the time of the first vote. Anyone who wants to stay and continue
to ask questions is welcome to do that. But there are a series of
votes, so we will have to end it at that point. So about 20 minutes
after the bell rings, we will have that amount of time.
The gentlewoman from Illinois.
Mrs. BlGGERT. Thank you, Mr. Chairman.
Chairman Bernanke, thank you for being here. I would like to
thank you for your work to update the regulations to protect consumers; in particular, thank you for taking action on the credit
card regulations, Reg Z and UDAP, and recently finalizing the
HOEPA regulations that protect consumers and I think restore
confidence in the mortgage market.
I think that you published on July 14th final rules amending
Regulation C. When do you anticipate that the credit card regulations will be finalized?
Mr. BERNANKE. My understanding—and if I am mistaken, we
will follow up—my understanding is that we aim to complete that
this year, later this year. We are trying to coordinate our Reg Z
disclosure package with the UDAP rules so that companies can implement all this at the same time. So those two things ought to be
released at the same time. We are looking to do that, to my knowledge, this year.
Mrs. BIGGERT. One aspect of the proposal would require creditors
to provide transaction-specific mortgage loan disclosures, such as
the APR and payment schedule for all home-secured closed-end
loans no later than 3 days after application. This proposal sounds
very similar to HUD's efforts to reform RE SPA. I just wondered if
you had worked with HUD in preparing this regulation.
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Mr. BERNANKE. We have worked with HUD on these issues, the
mortgage disclosure issues, because we both have responsibilities
in this area, and obviously the more coordinated we can be, the
better off the public will be. So we have worked with HUD for a
number of years as we have looked at their changes in their disclosures. But there is no joint approval process. This is our product.
The CHAIRMAN. If the gentlelady would yield. She has asked two
very important questions. But you are going to make a regulation
so the HOEPA regulations and HUD's RESPA, we hope there can't
be any conflict there.
Mr. BERNANKE. It has been our interest to do that for a number
of years.
The CHAIRMAN. When the gentlewoman asked about credit cards,
and you said you would try to coordinate, is that true of the overdraft? Are they all going to be done at the same time? The credit
cards and the overdraft, are they also on the same timeline?
Mr. BERNANKE. The overdraft is on the same timeline as far as
comment is concerned. Frankly, I don't know whether there is a
possibility of breaking that off and releasing that earlier.
Mrs. BlGGERT. Thank you.
When you were doing the disclosure rules, there was a real focus
on the consumer testing. Was there similar consumer testing done
as you put out the proposal on unfair and deceptive card practices?
Mr. BERNANKE. There was consumer testing, and it was precisely
that consumer testing that led us to conclude that there were certain practices that could not be made adequately transparent
through disclosures that did not have direct beneficial effects to
consumers. That outweighed whatever problems that might arise.
That was the reason that we, in some cases, chose prohibition over
disclosure.
Mrs. BlGGERT. There has always been this worry that this is
going to limit credit, some of the regulations are, whether there
was going to be legislation. Do you think that this will, the regulations will, result in a reduction of the credit that can be offered?
Mr. BERNANKE. We are going to monitor that closely. As I said
before, we always want to try to balance availability of credit
versus having a transparent marketplace. I do think that markets
work better when the information is good. So even if the equilibrium amount of credit is a little different, maybe people will be
getting products that are better for their needs and that they better understand. So it may be in some sense more effective and
more helpful credit than we had before.
Mrs. BIGGERT. So education is a big part.
Mr. BERNANKE. Education is very important, but I have become
persuaded over time now that you need three things: education on
the consumers' part; good, effective consumer-tested disclosures;
and as a last resort, when those two things do not adequately protect the consumer, then you need to use the ability to ban certain
practices.
Mrs. BlGGERT. Thank you.
I yield back.
The CHAIRMAN. The gentlewoman from Wisconsin.
Ms. MOORE OF WISCONSIN. Thank you, Mr. Chairman.
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And thank you, Mr. Chairman, for all the work that you did over
the weekend for sort of cooling out the housing crisis.
I read through your testimony, and I was very interested in your
comments regarding the commodities market. You say that you
doubt that financial speculation is the cause, a causal factor, in the
upward pressures on oil prices, but you find that you are baffled
by what it could be. You say that "this is not to say that useful
steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil and other commodities in the
longer term."
I was curious. I would like for you to expand on that and explain
that to me.
Mr. BERNANKE. About the possible steps?
Ms. MOORE OF WISCONSIN. Yes.
Mr. BERNANKE. Well, with respect
to possible steps, as I indicated, the Federal Reserve is part of a task force being led by the
CFTC, which is trying to get as much clarity as we can on exactly
this question, and that includes right now we and the CFTC in particular has been gathering information from other petroleum futures exchanges like the ones in U.K., has been gathering information on the activities of swaps dealers and index traders who invest
in these economies. We are trying to understand how these investments are made and how they relate to price movements, those
sorts of things. So we are looking at that seriously.
It is possible that the CFTC may decide, and, of course, it is their
province to do so, that changes in the information requirements or
in positions, limits or things of that sort might be justified under
certain circumstances.
There is a lot of evidence, though, on which I base my earlier
statement in the testimony that makes it seem unlikely that speculation or, better termed, manipulation is driving up energy prices.
I mentioned the absence of inventories. There are a number of
other things. For example, there seems to be no empirical relationship between long, open positions by noncommercial traders and
movements in prices. It is striking that there are many or at least
some commodities which are not even traded on future markets
which have had big price run-ups, like coal and iron ore, for example.
So it doesn't seem to us to be the central issue. It does mean that
energy prices in the very short run can respond quite sensitively
to news that comes in because they begin to trade like a stock
price, for example. But that is not necessarily a bad thing; that
means that information is being incorporated into those prices, and
that helps suppliers and demanders know how better to respond.
Ms. MOORE OF WISCONSIN. Mr. Chairman, thank you for that.
Is the SEC a part of this committee that is looking at the commodities irregularities?
Mr. BERNANKE. I believe so. Yes.
Ms. MOORE OF WISCONSIN. All right. I know that the CFTC and
the SEC have been having talks. Do you think—this committee, by
the way, doesn't have jurisdiction over the CFTC, and I think most
of the questions have been related to commodities. Do you think
that we need to modernize our regulatory system by having these
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commodities come under the same jurisdiction as the SEC? I know
the CFTC and SEC have been talking about such a collaboration
or merger, and I am wondering, do you think there would be any
benefit in that?
Mr. BERNANKE. I know that they work very closely, and there are
areas where there is some overlap of responsibility and jurisdiction.
The Treasury Blueprint for reform envisions that we would merge
at some point. I don't really have a recommendation to make on
that. I think it would depend in part on the overall plan for regulatory reform if, in fact, that takes place in the context of that
broader plan.
Ms. MOORE OF WISCONSIN. Well, I just only say that because so
many of these commodities are paper transactions and futures contracts versus bringing your hog to the marketplace to sell. It seems
to me that the modern thing would be to bring these together and
have perhaps a better regulatory framework.
I yield back.
The CHAIRMAN. I will say in the 10 seconds I will borrow from
the gentlelady, my jurisdiction proposal is we leave with the Agriculture Committee jurisdiction over all those futures and things
you can eat, and we get the rest.
The gentleman from California.
Mr. MILLER OF CALIFORNIA. Thank you, Mr. Chairman.
I kind of enjoyed the comments that the Federal Reserve is getting blamed for not dealing with the predatory issue as it applies
to subprime. But I recall 5 years ago, I repeatedly tried to introduce language to effectively define what predatory was versus
subprime and included the issues you have dealt with finally. So
I feel guilty blaming you for something 5 years ago we should have
done and didn't.
The purpose and intent of the GSEs was to inject liquidity into
the marketplace, which we have done. If you look at the amount
of loans that are out there, I think it has proven to be very beneficial to the housing market.
Having been a developer for over 35 years, I have been through
the 1970's recession, 1980's, 1990's. Any time you see a housing
boom, you know eventually there is a going to be a housing recession occurs. It has happened repeatedly. This one is a little different, but every one I have been through has been somewhat different.
In the stimulus package we passed recently, I think the most important part on the economy was increasing conforming loan limits
for FHA and GSEs. Sending people a check, yes, there is a benefit
to that. But the main reason I think for the situation the economy
is in today is because of the housing recession we have gone
through. I think raising conforming loan limits in high-cost areas
has gone a long way to mitigating an impact that could have been
worse than it was. Especially in California and other areas there
are many lenders that will not make a loan today if it is not conforming because they don't have the assets basically to tie their
capital up if they can't make the loan and sell the loan off.
Now, there has been discussion about after December 31st, we
are going to be dropping those limits down to much lower levels.
I believe that is going to have a major detrimental impact on the
39
housing market because it sends—even the discussion and debate
about doing that sends a message that we are not going to be committed in the future to trying to create liquidity in these high-cost
areas.
I would like to have your opinion on that issue.
Mr. BERNANKE. First, you are correct about the centrality of the
housing market. The issue you raise should be predicated on
Fannie and Freddie being strong and effective and having good supervisors. I think that is really the first step.
I recognize that there is disagreement about where the loan limits should be. I think in the near term that there is some benefit
to having a bit more scope, but I recognize there is disagreement
about that. So my main hope is that you will come to a good consensus and get legislation out.
Mr. MILLER OF CALIFORNIA. Let me rephrase my question so
maybe you can answer it then. The reality is that many lenders in
areas will only make loans that are conforming because they lack
liquidity of their own because of the market requirements placed
on them, and that they are making loans today that, and am I not
correct, if GSEs are out of the marketplace, those loans otherwise
could not be made? Is that a fair assumption?
Mr. BERNANKE. Not a universally fair assumption because there
are lenders that make loans and hold them on their balance sheets.
Where you are correct is that the normal securitization function
whereby a lender would make a loan, a jumbo loan, and then sell
it to be securitized, that that securitization function for loans that
don't conform to Fannie and Freddie has broken down, and it is a
reason why there is a fairly unusually high premium or a differential in the mortgage rates on jumbo loans relative to conforming
loans.
Mr. MILLER OF CALIFORNIA. NOW, when GSEs and FHA got into
the marketplace in the stimulus, rates dropped 400 percent basis
points below what they were. The way I see it, in the economy
where a housing market is depressed to begin with, we are going
and making loans in areas that the housing market has actually
declined in value, which are actually safer loans, but the individuals are saving a tremendous amount of money on their payments
because the GSE loan is at a much lesser interest rate than a normal jumbo loan. Do you not see that as a benefit to turning the
housing market as it exists today?
Mr. BERNANKE. The Fannie and Freddie function of securitizing
mortgages and getting them into the secondary market, providing
a new source of capital for mortgage lending, is clearly the most
valuable thing that they do. I am not quite sure I understood all
of your question, but I do want to reiterate my support for making
it possible for them to continue to do that on an expansive scale.
Mr. MILLER OF CALIFORNIA. My goal is to say that the more liquidity we can inject into the marketplace will create a higher percentage of—higher possibility that the marketplace will turn much
more rapidly and create more stability, and should we do things to
create less liquidity in the marketplace that will also have the opposite effect?
Mr. BERNANKE. Providing mortgage credit to all qualified borrowers by itself will not necessarily turn the housing market
40
around, because there are a lot of other fundamental issues. But
to the extent we can make mortgage credit available to those who
want to buy homes and who are credit-qualified, I think that is
something we should try to do.
Mr. MILLER OF CALIFORNIA. Thank you.
The CHAIRMAN. The gentleman from Tennessee.
Mr. DAVIS OF TENNESSEE. Mr. Chairman, thank you very much.
Chairman Bernanke, thank you for being here. This is the second
day, I understand, that you have been on the Hill. It would be my
hope, and I think all of us on this committee and certainly on the
other side, that you could solve our problems overnight with these
2 days of hearings. But thank you for being here and offering and
being willing to make suggestions, and for your leadership with the
Fed.
Our country is readjusting to living in the world with far less
available credit and high energy prices. Either would be a problem,
but both at the same time guarantees a long period, in my opinion,
of uncertainty as business adapts. The evidence is increasingly
clear that the economy fell into a near recession in January, which
set off a significant contraction in lending. Our hopes that the tax
rebates here in Congress would spur a recovery by midyear have
been dashed, in my opinion, at the feet of $150-a-barrel oil.
Now, new signs of problems that lenders, large and small, are beginning to surface despite very wide interest margins. The failure
of inflation to spill over into wages has left consumers stripped of
buying power. By the combination of the credit crunch and oil
prices, businesses are becoming increasingly cost-conscious in the
face of weak volume growth and inability to pass on oil inflation.
The result is weaker jobs in the district I represent, job growth,
more defaults, tighter credit, and a growing spiral of economic
weakness and, in my opinion, not inflation.
As you noted earlier, we have seen payroll employment fall
62,000 jobs in June, with downward revisions for another 52,000
for the 2 previous months. This was the 6th consecutive month
with declining jobs.
While I understand that it is politically more expedient for you
to keep emphasizing inflation concerns, while watching the data as
it develops in coming months, this is a clear signal from the job
market that the U.S. economy is slowing to stalled speed, and that
the risk is not just inflation, but rather of a slide into a full-blown
recession.
The inflation hogs constantly reinforce the argument that maintaining a low and stable inflation rate is the best way to achieve
maximum sustainable growth. Yet, to the man on the street, the
rising unemployment rate, in my opinion, is the key indicator. I
think we need to start adjusting so we are thinking about inflation
as being the major problem that we have today.
The question I want to ask—and I want to make a statement basically about what happened to the Nikkei average in 1989 and
1990. We saw reluctance of lenders and a reluctance of the National Bank of Japan to address, I think, the main issue there was
over-inflated prices of homes, mortgages, high interest rates. When
you look at the value of the land around the Emperor's palace,
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some folks said it actually brought in currency more than the entire appraised value, tax-assessed value, of the State of California.
When you study and other economists study the almost near collapse of the Nikkei average from up 40,000, down to roughly 8,000,
an 80 percent drop, as you have looked at that, have you also studied the regulatory authorities demanded by the Government of
Japan to be sure that never happened again? And have we put in
place and are you recommending that some of those regulatory authorities be established here in the United States?
Mr. BERNANKE. That was a very difficult episode for Japan when
the bubbles in both the stock market and in property prices collapsed at the same time. I think the key lesson that we learned
from that experience was that in Japan, banks had very wide holdings in land and equity and other assets whose values came down,
and so the banks were in very, very bad financial condition, but
they were not required to disclose or inform the public about what
their actual condition was.
For many, many years they kind of limped along. The same with
the companies they lent to. They didn't call those loans because
they knew they couldn't be paid. So it was a situation in which
there was a reluctance to act and in which transparency was quite
limited.
I think one benefit of our current system here in the United
States is that as painful as it is to see the losses that financial institutions are suffering, at least they are getting that out, they are
providing that information to the public, and they have been
proactive in raising capital to replace those losses. In order to avoid
a prolonged stagnation, as in Japan, it is important for us to get
through this period of loss and readjustment and get back to a
point where the financial system can again support good, strong,
stable growth for the United States.
The CHAIRMAN. The gentleman from Texas.
Mr. HENSARLING. Thank you.
Chairman Bernanke, last week on Thursday when you were before our committee, I asked you a question about the criteria by
which the Fed chooses to open the discount window to nondepository institutions. As part of your answer you said, "I don't want to
do it again." But clearly, 4 days later you did. So it hadn't happened in 70 years. It has now happened twice, I guess, in the last
3 to 4 months. So I have a couple of questions related to that.
One, I am very concerned on where does the moral hazard end.
And to, I guess, capture a phrase of our ranking member, I think
there is the danger of us adopting nationally a system where if you
are big enough, if you are interconnected enough, if somehow the
interplanetary economic stars align just right, you are in a position
to privatize your profits, but socialize your losses to where the taxpayers end up picking up the tab.
My theory is that we could have even greater S&L debacles,
greater Fannie and Freddie debacles. I know since I have been
here for almost 6 years, people have been raising a hue and cry,
including myself, about how big these institutions are getting, how
they are increasing their risk profile. Your predecessor spoke fervently about the systemic risk, yet we find ourselves here today.
42
So I guess my question is it is still somewhat unclear to me what
is the criteria by which you open this discount window to nondepository institutions. I think I heard in a response to the gentleman from Nevada, it sounded like either one objective criteria
doesn't exist today, and it is done on an ad hoc basis, or perhaps
you are being purposely ambiguous in hopes that the institutions
will not feel that they qualify, in the hopes that we don't have the
moral hazard problem.
So if you could give me further illumination as of today, this moment in time, what is the criteria for which the discount window
is open to nondepository institutions?
Mr. BERNANKE. In the case of Fannie and Freddie, our attention
was very, very limited. The Treasury Secretary had a bunch of proposals to ask Congress to take steps to restore market confidence
in Fannie and Freddie. Our intention was to just provide a bit of
bridge to the point where Congress could make its decision about
how to restructure those firms.
Mr. HENSARLING. Mr. Chairman, let me interrupt. Did representatives of either Fannie or Freddie approach you to have the discount window open?
Mr. BERNANKE. NO.
Mr. HENSARLING. SO
they did not request this, to the best of your
knowledge.
Mr. BERNANKE. Not to my recollection, no.
Mr. HENSARLING. Thank you. Continue on.
Mr. BERNANKE. SO we have used it very sparingly in our history.
We have done so in this current episode in situations where we
thought it was helpful to the broad financial stability of the economy.
I agree with you 100 percent about moral hazard, but I think the
time to think about that is in advance. We need to take steps going
forward to clarify exactly when the Congress wants us to take
these kind of actions and under what circumstances that would
eliminate moral hazard.
I mentioned previously the importance of strong, consolidated supervision of the investment banks, of strengthening the infrastructure, of developing resolution regime. The reason the savings and
loans crisis went the way it did is because there was a forbearance,
regulatory forbearance. There were no guidance or rules or laws
about how the regulators ought to treat companies that were under
water.
Mr. HENSARLING. Mr. Chairman, at this time if we can't say precisely who would qualify for the discount window, I suppose the
converse is true as well, we can't say who doesn't qualify. I mean,
for example, would Anheuser-Busch qualify? Many Americans
might consider them more mission-critical to the Nation than
Fannie and Freddie.
Mr. BERNANKE. We have to make findings of unusual and exigent circumstances. I think our criterion has been—and, again, despite what I said last week, I will say again, I hope we don't ever
have to do this anymore—my criterion would be to provide liquidity
and support in circumstances where we thought there were concerns about the systemic risks associated.
43
Mr. HENSARLING. Speaking of not having to do this again today,
nobody wants to see Fannie and Freddie fail. They are too big to
fail today, but I want to ensure they are not too big to fail tomorrow on the taxpayer dime or perhaps, more precisely, the taxpayers' $5 trillion. In your professional opinion, is there anything
inherent about the secondary mortgage market that would prevent
Congress from considering reconstituting these companies as part
of the quid pro quo for their charters, from perhaps busting them
up into a dozen different companies or over a 3- to 5-year period
totally privatizing them?
Mr. BERNANKE. There are certainly a number of different possibilities ranging from outright nationalization, to privatization, to
breaking them up. In the near term, thinking about the needs of
the housing market, I think the right solution is to keep them in
their current form, but to provide very strong oversight that will
assure adequate capital going forward.
Mr. HENSARLING. Thank you.
The CHAIRMAN. The gentleman from Minnesota.
Mr. ELLISON. Mr. Bernanke, can you tell what you think 30
years of wage stagnation, how that contributes to the current burgeoning debt that consumers are carrying today?
Mr. BERNANKE. Well, I don't think it is accurate there has been
30 years of wage stagnation. There has been a pretty substantial
increase in real wages and in consumption over the last 30 years
or so. Clearly, in the most recent past, energy prices, a slowing
economy, and other factors have caused wages to stagnate, which
is a serious problem.
Mr. ELLISON. Wages didn't stagnate in the late 1990's, but in the
1980's and 1970's.
Mr. BERNANKE. If we compare today to 1978, 30 years ago, you
would see some significant rises, particularly if you look at a particular individual or family as opposed to the fact that you always
have a shift and change.
Mr. ELLISON. What about average hourly wage? What did those
numbers look like over the past, say, 30 years?
Mr. BERNANKE. I wouldn't want to take a wild guess.
Mr. ELLISON. YOU don't have to guess, because I think they have
been pretty stagnant.
Mr. BERNANKE. They are not static. They have risen considerably
over the last 30 years.
Mr. PERLMUTTER. Would the gentleman yield for 1 second?
Mr. ELLISON. GO ahead.
Mr. PERLMUTTER. YOU have a lot of very interesting graphs in
your report, and one of these is on page 9, which shows the personal savings rate. I think that falls right in line with what the
gentleman from Minnesota has been talking about, the fact that
wages have been fairly steady, things have been going up, and people can't save.
Mr. Chairman, my question to you is how are we going to get
people to start saving?
Mr. ELLISON. Reclaiming my time, that is where I am going with
it. The fact is we have had recorded negative savings rates, and I
believe that the stagnancy of wages—will you grant me 2000, will
you agree with that, stagnant wages since then—I think that helps
44
to explain part of the problem that Americans are having right
now. That is why we are doing the refis, the payday loans, the
credit cards, things like that.
I just want to know from you to what degree does stagnant
wages help contribute to the present situation even with regards
to people getting into exotic mortgage products, credit cards, all of
these loan products? Does it play a role, in your view?
Mr. BERNANKE. I think there are a lot of factors.
Mr. ELLISON. What role does stagnant wages play, Mr. Chairman?
Mr. BERNANKE. Obviously it is more difficult to save if your family income is not rising, I agree with that.
Mr. ELLISON. Doesn't the Fed have a mandate to try to promote
full employment and keep inflation down? I mean, is that part of
your mandate?
Mr. BERNANKE. Absolutely.
Mr. ELLISON. What are we going to do to increase real wages for
people so they have enough money to buy the things they need as
opposed to borrowing the money?
Mr. BERNANKE. I think that—and I have expressed this in detail
in another context—the only long-term solution is to help those
people who are not getting appropriate training and skills because
those are the people who are being left out of the globalized economy. People who have high levels of skills have lots of opportunities and potential for high wages. That is beyond the power of monetary policy to do that.
Mr. ELLISON. Are you familiar with the livable wage movement?
Mr. BERNANKE. Yes.
Mr. ELLISON. Does it
have the power to help improve wages for
average working people?
Mr. BERNANKE. Again, this is somewhat out of my department,
but I think I would rely on markets, plus give the workers the
tools, the skills, the education they need, plus, if necessary, some
assistance in getting retrained if they are displaced.
Mr. ELLISON. What do we do to help people save more money?
Mr. BERNANKE. This has been a long-term issue. Part of the reason that people didn't save for awhile, it is not relevant now, but
for awhile people were letting their houses do their saving for them
because they were looking at appreciation. Now they are under
pressure because house prices are no longer rising, and they need
to find savings under their current income.
In terms of policy measures to help people save, there are very
few, if any, magic bullets for that. There have been some suggestions about having people opt out of 401(k) plans. Suppose we allow
for a more widespread access to tax-preferred retirement plans and
ask people to opt out rather than to opt in. There is some evidence
that that helps people save more. It gets them to participate more.
The low saving problem, this is a low-saving country, and it is
part of the reason we are borrowing a lot from abroad, it is a significant one, and I don't have an answer. Again, the Federal Reserve's mandate is to maintain employment, but we can't guarantee
necessarily high-paying jobs. Those jobs have to come because—
high-paying jobs have to come because workers have the skills, and
the training, the education they need to get those kinds of jobs.
45
The CHAIRMAN. The gentleman from New Jersey.
Mr. GARRETT. I thank the chairman.
I thank you, Chairman Bernanke, for being with us today. I
would like to begin by complimenting you for your foresight in
warning this committee and actually all of Congress today, but
your foresight in the past. You have been before this committee on
numerous occasions speaking of the risk posed by the GSEs, by
Fannie and Freddie. During those times, you spoke about their current form and their current regulatory framework, or maybe lack
thereof, and the potential that that could bring somewhere down
the road, potentially putting them at risk and also the taxpayer at
risk as well. So I compliment you on that. And it was you and the
President and the Secretary of Treasury has also emphasized this
point repeatedly, and they have also emphasized the point that we
have to move quickly as possible to address this issue of a comprehensive GSE reform.
Maybe it is because of that knowledge that we need to do something that the chairman and others, when regulatory reform had
been going through in the 110th Congress, had added on as some
of us call extraneous measures to the legislation above and beyond
just the basic regulatory framework; the housing fund, the $4 billion rehabilitation assistance. These add-ons have led to, I believe,
the GSE reform legislation being slowed down not here in the
House so much, but over in the Senate, where such extraneous
matters sort of complicated the process of trying to get it through,
when at the end of the day we simply wanted to have that proverbial world-class regulator in place. Some say if you had that done
earlier on, maybe we wouldn't be having this discussion and other
actions that we have done with this.
The chairman says the GSEs are struggling due to a lack of investor confidence. I believe if that is the case, passing a strong
stand-alone, world-class regulator would be the best thing in Congress to address that. For that reason, later today I will be actually
dropping in a strong stand-alone piece of legislation, without anything else on it, basically taken from the Senate compromise that
mirrors the compromise on the GSE reform language that doesn't
have anything else on it.
So my first question to you is, would that stand-alone bill, if we
pass it through this week, since we have already passed that similar language and the Senate has as well—would that stand-alone,
world-class regulator be important to get moving on this process to
bring some relief to the GSEs and the overall economic market?
Mr. BERNANKE. Congressman, I really can't advise you on legislative tactics, but I would certainly say that getting a strong regulatory bill through in whatever context you can do it has always
been important and now is particularly important, and I hope that
you will act in an expeditious way.
Mr. GARRETT. One of the things that needs to be addressed
through the regulator or however else is the capital requirements
for the GSEs. As I understand it, it would be better had they begun
to raise more capital. Fannie did, Freddie didn't, I guess, to some
extent. But capital increase would be beneficial, correct, for the
survivability of the GSEs? You are shaking your head yes.
Mr. BERNANKE. Yes.
46
Mr. GARRETT. Part of the issue, though, with the bills that we
have that is going through potentially this week is that they
have—some called it a tax, extraneous measures, whatever, that
would potentially draw some of the revenue from the GSEs and use
it for other purposes. My understanding—correct me if I am
wrong—my understand would be that would impact potentially
negatively upon their ability to do what is necessary, and that is
to build their capital. Is that a correct understanding?
Mr. BERNANKE. Well, I have stayed away of this issue of the
housing fund because it is part of the log-rolling process. I don't
how exactly how it will play into the legislation. My main concern
is the regulator be able to have bank-like capital powers.
Mr. GARRETT. I understand that. But if the regulators have all
the powers, but some of the funds are being extracted from it to
use it for other funds, could that have a detrimental effect on their
ability to raise capital?
Mr. BERNANKE. It will affect their retained prospects, from that
respect. Again, these are trade-offs that Congress has to make.
Mr. GARRETT. On the political side, my last question, last week
I sent one question to you that I didn't get the answer to, and that
is with regard to your powers under section 13. Are there any limitations on your powers going forward? You told us last week that
you hoped this wouldn't happen again, but, of course, it didn't.
So would you use those powers in the future? Are there any limitations right now until we say don't do anything or put some restrictions on you to as to your powers under that section?
Mr. BERNANKE. I can tell you what the legislation says. Under
Section 13.3 of the Federal Reserve Act, we can lend to an individual partnership or corporation if conditions are unusual and exigent, and other credit accommodation is not available. So there are
some conditions on that, on 13.3, somewhat less restrictive in that
respect, but the collateral can only be treasuries or agencies.
The CHAIRMAN. The gentleman from Colorado, I ask him to yield
me 1 minute, if I can, because the gentleman from New Jersey's
history is deeply flawed. The Affordable Housing Fund, which people are opposed to for philosophical reasons, for the slowing down
of the GSEs, makes no historical sense. In the previous Congress,
controlled by the Republicans, there was no Affordable Housing
Fund attached to GSE reform, and the Senate didn't act on it. Any
kind of historical experiment, you look for control. In fact, under
the Republican Congress, GSE reform passed the House, it went to
the Senate, and they didn't act on it.
By the way, the Senate bill, which the Senate Republicans put
forward, did have an Affordable Housing Fund. They were prepared to accept it, and the bill didn't go forward. In fact, it is now
under a Democratic Congress we are on the verge of passing legislation that the Republic Congress wouldn't pass. But to blame the
Affordable Housing Fund ignores the history that in a previous
Congress the House passed the bill, sent it to the Senate with an
appropriate set of regulations, and the Senate didn't act on it under
Republican rule, and it was not in any way, shape, or form the
problem of the Affordable Housing Fund.
I thank the gentlemen from California.
47
Mr. GARRETT. Would the gentleman yield since he referenced my
motives?
The CHAIRMAN. It is the gentleman from Colorado's time.
Mr. PERLMUTTER. Ten seconds.
Mr. GARRETT. Thank you. Since the gentleman did indicate with
respect to my motives because I am ideologically driven on this, I
am not ideologically driven on this, I just want to set the record
straight, and the bills did pass in the House previously in the last
Congress. It went to the Senate and was held up there by the Democrat opposition. What we need to do now is move as expeditiously
as possible.
Mr. PERLMUTTER. I will take my time back.
The CHAIRMAN. The Republicans controlled the Senate, they
didn't pass the bill, and it was not because of the Affordable Housing Trust Fund.
As to motives, I am surprised the gentleman takes exception to
my noting that he is philosophically opposed to that.
Mr. PERLMUTTER. First, Mr. Chairman, just thank you for the
time that you have given to us. Thank you for rolling up your
sleeves, working with the Secretary of the Treasury, and working
with our chairman to try to deal with a lot of tough problems you
have out there. There is no minimizing what those problems are.
Like I said, I found a wealth of information in your report, some
of it pretty disturbing. I don't know if you have it in front of you,
but on page 25 of the report, there are several graphs there, and
I just ask you about on the commercial paper it looks like everything is going along hunky-dory, and then boom, there is an earthquake in the summer of 2007. That same thing applies in the
graph below it.
What happened in the summer of 2007 that just has caused this
tremendous upheaval right now?
Mr. BERNANKE. Well, the media trigger was the refusal of a bank
to allow withdrawals from the hedge funds because it said it
couldn't value the assets. Basically, more broadly, it was about that
time that losses related to subprime mortgages and CDOs and
other structured products became apparent, and there was a real
change in risk perception and in risk attitude at that juncture last
August.
There were many off-balance-sheet vehicles, structured investment vehicles and so on that were holding CDOs, for example, that
were financed by short-term money or commercial paper, creating
a maturity mismatch. That was perceived to be fine as long as
there was sufficient credit quality. Once the credit quality appeared
to deteriorate, the overnight funders of those particular types of instruments withdrew, and they had either to be dissolved or taken
off the balance sheet. So that whole class disappeared.
You will notice that conventional commercial paper, unsecured or
commercial paper, issued by corporations was much more stable because that wasn't the new part. The part that was proven to have
some real flaws is once we began to see credit losses from subprime
and other types of structured—
Mr. PERLMUTTER. That was the time the market realized that
housing prices weren't always going to go up. That is the way I
48
would describe it. A lot of it was just based on increased housing
prices over time.
Mr. BERNANKE. Partly also the recognition that those losses were
going to be greater than expected, and that these complicated
structured credit products did not have as much cushion, as much
coverage as the investors thought they did.
Mr. PERLMUTTER. DO you think we need more regulation within
that market of creating these very complicated things?
Mr. BERNANKE. Certainly the kind of regulation we do have is at
least two types. One is the bank regulators have been and already
have considered increasing capital requirements and toughening up
standards to allow these kind of vehicles. And then the accountants
themselves also are looking at under what circumstances should
you bring those things on the balance sheet, under what circumstances should they be kept separate.
The CHAIRMAN. Will the gentleman yield?
Mr. PERLMUTTER. I will yield.
The CHAIRMAN. I am going to recognize the gentleman from Connecticut and, in an act of unprecedented bipartisanship, leave him
in charge while I go vote.
Mr. SHAYS, [presiding] You are safe, Mr. Chairman.
First, I want to thank you, Mr. Chairman, and Senator Dodd,
and our ranking members. The House and Senate and the White
House, both you, Mr. Bernanke, and Mr. Paulson, you are all trying to work together because I think we know this is a very serious
time. I have some pride in seeing how Republicans and Democrats,
both Chambers, and the White House and Congress are trying to
work together.
I wrestle with, and I would like a fairly short answer, we keep
talking about how we need to consume more. I just get the feeling
like that is something we do too much of, and that we need to be
investing and saving more. Just a quick comment about that.
Mr. BERNANKE. Certainly. There is a difference between the
short run and the long run. In the short run, if consumption spending drops sharply, and there is no other type of demand to pick it
up, then most of the saving will be dissipated because you will just
have a slowing economy. What we need is an economy that is better balanced, less consumption, more investment, more exports.
That should take place over time, but in a very short period of
time, unless you get the other compensating sources of demand,
you will just get a slowdown in the economy, which is part of what
is happening.
Mr. SHAYS. SO in the short run, we need consumption up?
Mr. BERNANKE. We are, in fact, getting a lot of benefit now from
trade and exports. As we shift from producing for domestic consumers and towards producing for exports, that is the kind of direction that will in the longer term get us where we want to go.
Mr. SHAYS. When we dealt with Enron, it was clear what we
were doing to countries that were under the 1933 and 1934 acts,
but the GSEs weren't. Then there was an effort by me and others
to put them under it. They voluntarily decided they would be under
the 1934 act. Should they be under the 1933 act as well?
Mr. BERNANKE. I don't have a view on that as well. I leave that
to the SEC.
49
Mr. SHAYS. Let me ask you in regards to energy, I think you
have voiced an opinion, but I would like to clarify it a little bit.
There are many of us who have said that we need to conserve
more, we need alternative fuels, but that when we did that, that
we should also be looking to increase supply.
You said that, I think, you favored a comprehensive approach. It
is my sense then you want to see conservation, you want to see alternative fuels, and you want to see increased production, whether
it is nuclear, whether it is some drilling offshore, maybe on land,
but that you need to see the United States pick up its production
and mining of oil. Would that be a fair statement?
Mr. BERNANKE. Congressman, there are always trade-offs Congress makes between environmental and other concerns and energy
exploration. That is the prerogative of Congress to do that. But I
think to the extent possible there is a multidimensional approach
to this problem that high prices will, in fact, encourage those actions.
Mr. SHAYS. If the market sees a comprehensive approach, do you
think it would have an immediate impact on the speculators and
what they think will happen in the future and what they will price
oil today?
Mr. BERNANKE. It is hard to judge how much and how fast, but
it is the case that there is a forward-looking element to the futures
markets, obviously. And to the extent that traders become more optimistic about the long-term supply and demand balance, it should
be helpful even in the near term.
Mr. SHAYS. I am told that if we know when the bottom is to the
housing market, there are plenty of resources that will come into
it, but they need to know the bottom. There are some articles that
I am starting to read that say we are getting very close to the bottom.
Have you voiced an opinion when I was out of the committee
about that issue; and if so, what would it be?
Mr. BERNANKE. It is difficult to judge with any certainty. It looks
as though the construction activity will begin to stop falling, will
begin to bottom out probably later this year or early next year. The
more difficult judgment is how much further house prices might decline. There still are significant overhangs of inventories of unsold
new homes.
I agree absolutely, once there is some confidence that the market
has found its level, that there will be considerable improvement in
financial conditions and probably a stronger economy as well.
Mr. SHAYS. One last point, and that is on the whole issue of
loans to students. If students aren't able to get loans this fall, Congress is going to hear it big time. What do you think is the most
important thing we can do to provide liquidity to that market?
Mr. BERNANKE. Well, my understanding is that Congress has addressed that to some extent by allowing direct lending or backup
lending.
Mr. SHAYS. I guess the question will be: Do you think it will
work?
Mr. BERNANKE. That is a bit outside of my expertise, but I believe it is going to go a significant part of the way, and also some
private-sector lenders will still participate in that market.
50
Mr. SHAYS. Thank you for your graciousness and for being here.
I thank the chairman for allowing me to ask these questions.
With that, we will adjourn this hearing. Thank you very much,
Mr. Bernanke.
[Whereupon, at 12:52 p.m., the hearing was adjourned.]
APPENDIX
July 16, 2008
(51)
52
Congressman Ron Paul
Statement before the Financial Services Committee
U.S. House of Representatives
Humphrey Hawkins Hearing on Monetary Policy
July 16, 2008
Mr. Chairman,
Today we find ourselves on the verge of an economic crisis the likes of which the United States has not
seen in decades. Our economy is very clearly in a recession, and every time someone tells us that the
worst has passed, another serious event takes place, as we saw once again last week and early this
week. Everyone now realizes that the situation is dire, yet cither no one understands the cause behind
the credit crisis, or no one is willing to take the necessary steps to ensure as orderly an end to the crisis
as possible. Instead, we hear talk of further bailouts. The Fed-brokered takeover of Bear Stearns, a
supposed one-off incident, has now been joined by a potential bailout of the Government-Sponsored
Enterprises, Fannie Mae and Freddie Mae.
The two GSli's have been disasters waiting to happen, as 1 and many others have warned over the
years. It was bad enough that Fannie and Freddie were able to operate with significant advantages,
such as lower borrowing costs and designation of their debt as government debt. Now, the implicit
government backstop has turned out to be an explicit backstop, just as we feared. The Greenspan
reflation of the economy after the dot-com bust pumped additional liquidity into an already-skewed
housing market, leading to an unsustainable boom that from many accounts has only begun to unravel.
With a current federal funds rate of two percent, and inflation at over four percent, the Fed is currently
sowing the seeds for another economic bubble.
At the heart of this economic malaise is the Fed's poor stewardship of the dollar. The cause of the
dollar's demise is not the result of a purely psychological response to public statements on US dollar
policy, but is rather a reaction to a massive increase in the money supply brought about by the Federal
Reserve's loose monetary policy. The policies that led to hemorrhaging of gold during the 1960's and
the eventual closing of the gold standard are the same policies that are leading to the dollar's decline in
international currency markets today. Foreign governments no longer wish to hold depreciating
dollars, and would prefer to hold stronger currencies such as the euro. Foreign investors no longer
wish to hold underperforming dollars, and seek to hold better-performing assets such as ports and beer
companies.
Hvery government bailout or promise thereof leads to moral hazard, the likelihood that market actors
will lake ever riskier actions with the belief that the federal government will bail them out. Bear
Steams was bailed out, Fannie and Freddie will be bailed out, but where will the line be drawn? The
precedent has been established and the taxpayers will end up footing the bill in these cases, but the
federal government and the Federal Reserve lack the resources to bail out every firm that is deemed
"too big to fail." Decades of loose monetary policy will lead to a financial day of reckoning, and
bailouts, liquidity injections, and lowering of the federal funds rate will only delay the inevitable and
ensure that the final correction will be longer and more severe than it otherwise would. For the sake of
the economy, 1 urge my colleagues to resist the temptation to give in to political expediency, and to
oppose loose monetary policy and any further bailouts.
53
For release on delivery
10:00 a.m. EDT
July 16, 2008
Statement of
Ben S. Bernanke
Chairman
Board of Governors of the Federal Reserve System
before the
Committee on Financial Services
U.S. House of Representatives
July 16, 2008
54
Chairman Frank, Ranking Member Bachus, and members of the Committee, I am pleased
to present the Federal Reserve's Monetary Policy Report to the Congress.
The U.S. economy and financial system have confronted some significant challenges thus
far in 2008. The contraction in housing activity that began in 2006 and the associated
deterioration in mortgage markets that became evident last year have led to sizable losses at
financial institutions and a sharp tightening in overall credit conditions. The effects of the
housing contraction and of the financial headwinds on spending and economic activity have been
compounded by rapid increases in the prices of energy and other commodities, which have
sapped household purchasing power even as they have boosted inflation. Against this backdrop,
economic activity has advanced at a sluggish pace during the first half of this year, while
inflation has remained elevated.
Following a significant reduction in its policy rate over the second half of 2007, the
Federal Open Market Committee (FOMC) eased policy considerably further through the spring
to counter actual and expected weakness in economic growth and to mitigate downside risks to
economic activity. In addition, the Federal Reserve expanded some of the special liquidity
programs that were established last year and implemented additional facilities to support the
functioning of financial markets and foster financial stability. Although these policy actions
have had positive effects, the economy continues to face numerous difficulties, including
ongoing strains in financial markets, declining house prices, a softening labor market, and rising
prices of oil, food, and some other commodities. Let me now turn to a more detailed discussion
of some of these key issues.
Developments in financial markets and their implications for the macroeconomic outlook
have been a focus of monetary policy makers over the past year. In the second half of 2007, the
deteriorating performance of subprime mortgages in the United States triggered turbulence in
55
-2-
domestic and international financial markets as investors became markedly less willing to bear
credit risks of any type. In the first quarter of 2008, reports of further losses and write-downs at
financial institutions intensified investor concerns and resulted in further sharp reductions in
market liquidity. By March, many dealers and other institutions, even those that had relied
heavily on short-term secured financing, were facing much more stringent borrowing conditions.
In mid-March, a major investment bank, The Bear Stearns Companies, Inc., was pushed
to the brink of failure after suddenly losing access to short-term financing markets. The Federal
Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall
financial stability and would most likely have significant adverse implications for the U.S.
economy. After discussions with the Securities and Exchange Commission and in consultation
with the Treasury, we invoked emergency authorities to provide special financing to facilitate the
acquisition of Bear Stearns by JPMorgan Chase & Co. In addition, the Federal Reserve used
emergency authorities to establish two new facilities to provide backstop liquidity to primary
dealers, with the goals of stabilizing financial conditions and increasing the availability of credit
to the broader economy.' We have also taken additional steps to address liquidity pressures in
the banking system, including a further easing of the terms for bank borrowing at the discount
window and increases in the amount of credit made available to banks through the Term Auction
Facility. The FOMC also authorized expansions of its currency swap arrangements with the
European Central Bank and the Swiss National Bank to facilitate increased dollar lending by
those institutions to banks in their jurisdictions.
These steps to address liquidity pressures coupled with monetary easing seem to have
been helpful in mitigating some market strains. During the second quarter, credit spreads
1
Primary dealers are financial institutions that trade in U.S. government securities wilh the Federal Reserve Bank of
New York. On behalf of the Federal Reserve System, the New York Fed's Open Market Desk engages in the trades
to implement monetary policy.
56
-3-
generally narrowed, liquidity pressures ebbed, and a number of financial institutions raised new
capital. However, as events in recent weeks have demonstrated, many financial markets and
institutions remain under considerable stress, in part because the outlook for the economy, and
thus for credit quality, remains uncertain. In recent days, investors became particularly
concerned about the financial condition of the government-sponsored enterprises (GSEs), Fannie
Mae and Freddie Mac. In view of this development, and given the importance of these firms to
the mortgage market, the Treasury announced a legislative proposal to bolster their capital,
access to liquidity, and regulatory oversight. As a supplement to the Treasury's existing
authority to lend to the GSEs and as a bridge to the time when the Congress decides how to
proceed on these matters, the Board of Governors authorized the Federal Reserve Bank of
New York to lend to Fannie Mae and Freddie Mac, should that become necessary. Any lending
would be collateralized by U.S. government and federal agency securities. In general, healthy
economic growth depends on well-functioning financial markets. Consequently, helping the
financial markets to return to more normal functioning will continue to be a top priority of the
Federal Reserve,
I turn now to current economic developments and prospects. The economy has continued
to expand, but at a subdued pace. In the labor market, private payroll employment has declined
this year, falling at an average pace of 94,000 jobs per month through June. Employment in the
construction and manufacturing sectors has been particularly hard hit, although employment
declines in a number of other sectors are evident as well. The unemployment rate has risen and
now stands at 5-1/2 percent.
In the housing sector, activity continues to weaken. Although sales of existing homes
have been about unchanged this year, sales of new homes have continued to fall, and inventories
of unsold new homes remain high. In response, homebuilders continue to scale back the pace of
57
-4-
housing starts. Home prices are falling, particularly in regions that experienced the largest price
increases earlier this decade. The declines in home prices have contributed to the rising tide of
foreclosures; by adding to the stock of vacant homes for sale, these foreclosures have, in turn,
intensified the downward pressure on home prices in some areas.
Personal consumption expenditures have advanced at a modest pace so far this year,
generally holding up somewhat better than might have been expected given the array of forces
weighing on household finances and attitudes. In particular, with the labor market softening and
consumer price inflation elevated, real earnings have been stagnant so far this year; declining
values of equities and houses have taken their toll on household balance sheets; credit conditions
have tightened; and indicators of consumer sentiment have fallen sharply. More positively, the
fiscal stimulus package is providing some timely support to household incomes. Overall,
consumption spending seems likely to be restrained over coming quarters.
In the business sector, real outlays for equipment and software were about flat in the first
quarter of the year, and construction of nonresidential structures slowed appreciably. In the
second quarter, the available data suggest that business fixed investment appears to have
expanded moderately. Nevertheless, surveys of capital spending plans indicate that firms remain
concerned about the economic and financial environment, including sharply rising costs of inputs
and indications of tightening credit, and they are likely to be cautious with spending in the
second half of the year. However, strong export growth continues to be a significant boon to
many U.S. companies.
In conjunction with the June FOMC meeting, Board members and Reserve Bank
presidents prepared economic projections covering the years 2008 through 2010. On balance,
most FOMC participants expected that, over the remainder of this year, output would expand at a
pace appreciably below its trend rate, primarily because of continued weakness in housing
58
-5
markets, elevated energy prices, and tight credit conditions. Growth is projected to pick up
gradually over the next two years as residential construction bottoms out and begins a slow
recovery and as credit conditions gradually improve. However, FOMC participants indicated
that considerable uncertainty surrounded their outlook for economic growth and viewed the risks
to their forecasts as skewed to the downside.
Inflation has remained high, running at nearly a 3-1/2 percent annual rate over the first
five months of this year as measured by the price index for personal consumption expenditures.
And, with gasoline and other consumer energy prices rising in recent weeks, inflation seems
likely to move temporarily higher in the near term.
The elevated level of overall consumer inflation largely reflects a continued sharp run-up
in the prices of many commodities, especially oil but also certain crops and metals.2 The spot
price of West Texas intermediate crude oil soared about 60 percent in 2007 and, thus far this
year, has climbed an additional 50 percent or so. The price of oil currently stands at about five
times its level toward the beginning of this decade. Our best judgment is that this surge in prices
has been driven predominantly by strong growth in underlying demand and tight supply
conditions in global oil markets. Over the past several years, the world economy has expanded
at its fastest pace in decades, leading to substantial increases in the demand for oil. Moreover,
growth has been concentrated in developing and emerging market economies, where energy
consumption has been further stimulated by rapid industrialization and by government subsidies
that hold down the price of energy faced by ultimate users.
On the supply side, despite sharp increases in prices, the production of oil has risen only
slightly in the past few years. Much of the subdued supply response reflects inadequate
2
The dominant role of commodity prices in driving the recent increase in inflation can be seen by contrasting the
overall inflation rate with the so-called core measure of inflation, which excludes food and energy prices. Core
inflation has been fairly steady this year at an annual rate of about 2 percent.
59
-6investment and production shortfalls in politically volatile regions where large portions of the
world's oil reserves are located. Additionally, many governments have been tightening their
control over oil resources, impeding foreign investment and hindering efforts to boost capacity
and production. Finally, sustainable rates of production in some of the more secure and
accessible oil fields, such as those in the North Sea, have been declining. In view of these
factors, estimates of long-term oil supplies have been marked down in recent months. Longdated oil futures prices have risen along with spot prices, suggesting that market participants also
see oil supply conditions remaining tight for years to come.
The decline in the foreign exchange value of the dollar has also contributed somewhat to
the increase in oil prices. The precise size of this effect is difficult to ascertain, as the causal
relationships between oil prices and the dollar are complex and run in both directions. However,
the price of oil has risen significantly in terms of all major currencies, suggesting that factors
other than the dollar, notably shifts in the underlying global demand for and supply of oil, have
been the principal drivers of the increase in prices.
Another concern that has been raised is that financial speculation has added markedly to
upward pressures on oil prices. Certainly, investor interest in oil and other commodities has
increased substantially of late. However, if financial speculation were pushing oil prices above
the levels consistent with the fundamentals of supply and demand, we would expect inventories
of crude oil and petroleum products to increase as supply rose and demand fell. But in fact,
available data on oil inventories show notable declines over the past year. This is not to say that
useful steps could not be taken to improve the transparency and functioning of futures markets,
only that such steps are unlikely to substantially affect the prices of oil or other commodities in
the longer term.
60
-7Although the inflationary effect of rising oil and agricultural commodity prices is evident
in the retail prices of energy and food, the extent to which the high prices of oil and other raw
materials have been passed through to the prices of non-energy, non-food finished goods and
services seems thus far to have been limited. But with businesses facing persistently higher input
prices, they may attempt to pass through such costs into prices of final goods and services more
aggressively than they have so far. Moreover, as the foreign exchange value of the dollar has
declined, rises in import prices have put greater upward pressure on business costs and consumer
prices. In their economic projections for the June FOMC meeting, monetary policy makers
marked up their forecasts for inflation during 2008 as a whole. FOMC participants continue to
expect inflation to moderate in 2009 and 2010, as slower global growth leads to a cooling of
commodity markets, as pressures on resource utilization decline, and as longer-term inflation
expectations remain reasonably well anchored. However, in light of the persistent escalation of
commodity prices in recent quarters, FOMC participants viewed the inflation outlook as
unusually uncertain and cited the possibility that commodity prices will continue to rise as an
important risk to the inflation forecast. Moreover, the currently high level of inflation, if
sustained, might lead the public to revise up its expectations for longer-term inflation. If that
were to occur, and those revised expectations were to become embedded in the domestic wageand price-setting process, we could see an unwelcome rise in actual inflation over the longer
term. A critical responsibility of monetary policy makers is to prevent that process from taking
hold.
At present, accurately assessing and appropriately balancing the risks to the outlook for
growth and inflation is a significant challenge for monetary policy makers. The possibility of
higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets
all represent significant downside risks to the outlook for growth. At the same time, upside risks
61
-8to the inflation outlook have intensified lately, as the rising prices of energy and some other
commodities have led to a sharp pickup in inflation and some measures of inflation expectations
have moved higher. Given the high degree of uncertainty, monetary policy makers will need to
carefiilly assess incoming information bearing on the outlook for both inflation and growth. In
light of the increase in upside inflation risk, we must be particularly alert to any indications, such
as an erosion of longer-term inflation expectations, that the inflationary impulses from
commodity prices are becoming embedded in the domestic wage- and price-setting process.
I would like to conclude my remarks by providing a brief update on some of the Federal
Reserve's actions in the area of consumer protection. At the time of our report last February, I
described the Board's proposal to adopt comprehensive new regulations to prohibit unfair or
deceptive practices in the mortgage market, using our authority under the Home Ownership and
Equity Protection Act of 1994. After reviewing the more-than 4,500 comment letters we
received on the proposed rules, the Board approved the final rules on Monday.
The new rules apply to all types of mortgage lenders and will establish lending standards
aimed at curbing abuses while preserving responsible subprime lending and sustainable
homeownership. The final rules prohibit lenders from making higher-priced loans without due
regard for consumers' ability to make the scheduled payments and require lenders to verify the
income and assets on which they rely when making the credit decision. Also, for higher-priced
loans, lenders now will be required to establish escrow accounts so that property taxes and
insurance costs will be included in consumers' regular monthly payments. The final rules also
prohibit prepayment penalties for higher-priced loans in cases in which the consumer's payment
can increase during the first few years and restrict prepayment penalties on other higher-priced
loans Other measures address the coercion of appraisers, servicer practices, and other issues.
We believe the new rules will help to restore confidence in the mortgage market.
62
-9In May, working jointly with the Office of Thrift Supervision and the National Credit
Union Administration, the Board issued proposed rules under the Federal Trade Commission Act
to address unfair or deceptive practices for credit card accounts and overdraft protection plans.
Credit cards provide a convenient source of credit for many consumers, but the terms of credit
card loans have become more complex, which has reduced transparency. Our consumer testing
has persuaded us that disclosures alone cannot solve this problem. Thus, the Board's proposed
rules would require card issuers to alter their practices in ways that will allow consumers to
better understand how their own decisions and actions will affect their costs. Card issuers would
be prohibited from increasing interest rates retroactively to cover prior purchases except under
very limited circumstances. For accounts having multiple interest rates, when consumers seek to
pay down their balance by paying more than the minimum, card issuers would be prohibited
from maximizing interest charges by applying excess payments to the lowest rate balance first.
The proposed rules dealing with bank overdraft services seek to give consumers greater control
by ensuring that they have ample opportunity to opt out of automatic payments of overdrafts.
The Board has already received more than 20,000 comment letters in response to the proposed
rules.
Thank you. I would be pleased to take your questions.
Monetary Policy Report
to the Congress
July 15, 2008
Board of Governors of the Federal Reserve System
64
Monetary Policy Report
to the Congress
Submitted pursuant to section 2B
of the Federal Reserve Act
July 15,2008
Board of Governors of the Federal Reserve System
65
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 15, 2008
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES
The Board of Governors is pleased to submit its Monetary Policy Report to the Congress
pursuant to section 2B of the Federal Reserve Act.
Sincerely,
Ben Bernanke, Chairman
66
Contents
Parti
1 Overview: Monetary Policy and the Economic Outlook
Part 2
3 Recent Economic and Financial Developments
3 The Household Sector
3
Residential Investment and Finance
1
Consumer Spending and Household Finance
10 The Business Sector
10
Fixed Investment
10
Inventory Investment
11
Corporate Profits and Business Finance
13 The Government Sector
13
Federal Government
14
Federal Borrowing
15
Stale and Local Government
15
State and Local Government Borrowing
16 National Saving
16 The External Sector
16
International Trade
17
The Financial Account
19 The Labor Market
19
Employment and Unemployment
20
Productivity and Labor Compensation
21 Prices
23 Financial Markets
23
Market Functioning and Financial Stability
25
Debt and Financial Intermediation
28
Equity Markets
29
Policy Expectations and Interest Rates
30
Money and Reserves
30 International Developments
30
International Financial Markets
32
Advanced Foreign Economies
33
Emerging Market Economies
67
Part 3
35 Monetary Policy over the First Half of 2008
Part 4
39 Summary of Economic Projections
39 The Outlook
41 Risks to the Outlook
42 Diversity of Participants' Views
Boxes
6 Recent Federal Reserve Initiatives to Address Problems in the Mortgage Market
18 Commodity Prices
26 The Federal Reserve's Liquidity Operations
45 Forecast Uncertainty
68
Parti
Overview:
Monetary Policy and the Economic Outlook
The U.S. economy remained sluggish in the first half of
2008, and steep increases in commodity prices boosted
consumer price inflation. The housing market continued to contract, weighing on overall economic activity.
Against a backdrop of mounting losses incurred by
major financial institutions, financial market conditions
deteriorated sharply further toward the end of the first
quarter—a development that threatened to severely
impair the functioning of the overall financial system
and to hinder economic growth. In response, the Federal
Reserve undertook a number of significant actions to
address liquidity pressures faced by banks and other
financial institutions, thereby augmenting the liquidityenhancing measures implemented in the second half
of 2007. Taken together, these measures fostered some
improvement in the functioning of financial markets,
but considerable strains persist. In view of the implications of the substantial reduction in credit availability
and the continuing decline in housing activity for the
economic outlook, the Federal Open Market Committee
(FOMC) further eased the stance of monetary policy.
After cutting the target federal funds rate 100 basis
points in the second half of 2007, the FOMC reduced
rates another 225 basis points over the first four months
of 2008. The further easing of policy was seen as consistent with fostering price stability over time, given the
Committee's expectation that aflattening-outof energy
prices and increasing economic slack would damp inflationary pressures.
The most recent economic projections of participants in FOMC meetings (Board members and Reserve
Bank presidents) are presented in part 4 of this report.
According to these projections, the economy is expected
to expand slowly over the rest of this year. FOMC participants anticipate a gradual strengthening of economic
growth over coming quarters as the lagged effects of
past monetary policy actions, amid gradually improving financial market conditions, begin to provide additional lift to spending and as housing activity begins to
stabilize. FOMC participants marked up their forecasts
of inflation for 2008 as a whole, reflecting the upward
pressure on inflation from rising commodity prices.
However, with longer-run inflation expectations antici-
pated to remain reasonably well anchored, with futures
markets indicating that commodity prices are expected
to flatten out, and with pressures on resources likely
to ease, inflation is projected to moderate appreciably
in 2009. FOMC participants indicate that considerable uncertainty surrounds the outlook for economic
growth and that they see the risks around that outlook
as skewed to the downside. They also see prospects for
inflation as unusually uncertain, and they view the risks
surrounding their forecasts for inflation as skewed to
the upside.
In the second half of 2007, the deteriorating performance of subprime mortgages in the United States triggered a reassessment of credit and liquidity risks across
a broad range of assets, leading to widespread strains
and turbulence in domestic and international financial
markets. During the first quarter of 2008, reports of
further losses and write-downs at major financial institutions intensified concerns about credit and liquidity
risks and resulted in a further sharp reduction of market
liquidity. Risk spreads -particularly for structured credit products—widened dramatically, and securitization
activity all but shut down in a number of markets. By
March, many securities dealers and other institutions
that had relied heavily on short-term financing in markets for repurchase agreements were facing much more
stringent borrowing conditions.
In mid-March, a major investment bank, The Bear
Stearns Companies, Inc., was pushed to the brink
of failure after suddenly losing access to short-term
financing markets. The Federal Reserve judged that a
disorderly failure of Bear Stearns would have threatened overall financial stability and would most likely
have had significant adverse implications for the U.S.
economy. After discussions with the Securities and
Exchange Commission and in consultation with the
Treasury, the Federal Reserve determined that it should
invoke emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by
JPMorgan Chase & Co. The Federal Reserve also used
emergency authorities to establish the Term Securities
Lending Facility and the Primary Dealer Credit Facility
to support the liquidity of primary dealers and financial
1
69
2 Monetary Policy Report to the Congress U July 2008
markets more generally, which would bolster the availability of credit to the overall economy.1 (See the box
entitled "The Federal Reserve's Liquidity Operations"
in part 2, page 26.) Other steps taken by the Federal
Reserve in recent months to address strains in financial
markets include a further easing in the terms for bank
borrowing at the discount window and an increase in
the amount of credit made available to banks through
the Term Auction Facility. The FOMC also authorized
increases in its currency swap arrangements with the
European Central Bank and the Swiss National Bank to
facilitate an expansion of dollar lending operations to
banks in their jurisdictions.
Over the second quarter, financial market conditions improved somewhat—credit spreads generally
narrowed, liquidity pressures ebbed, and financial
institutions made progress in raising new capital. Still,
assei prices continue to be volatile, and many financial
markets and institutions remain under considerable
stress. Very recently, the share prices of Fannie Mae
and Freddie Mac dropped sharply on investor concerns
about their financial condition and capital position. The
Treasury announced a legislative initiative to bolster the
capital, access to liquidity, and regulatory oversight of
the government-sponsored enterprises (GSEs). As
a supplement to the Treasury's existing authority to
lend lo the GSEs, the Board of Governors established
a temporary arrangement that allows the Federal
Reserve to extend credit to Fannie Mae and Freddie
Mac, if necessary.
The sluggish pace of economic activity in the first
half of 2008 was accompanied by a further deterioration
in the labor market. Private-sector payroll employment
declined at an average monthly pace of 94,000, and the
unemployment rate rose to 5'/2 percent. Moreover, real
labor income appears to have been flat in the first half
of the year. Although wages rose in nominal terms, the
1. Primary dealers are firms that Srade in U.S. government securities wiih the Federal Reserve Bank of New York. On behalf of the
Federal Reserve System, the New York Fed's Open Market Desk
engages in such Irades to implement monetary policy.
purchasing power of those nominal gains was eroded
by the rapid increases in consumer prices. Declining
employment, stagnant real wages, and lower equity
and home values weighed on consumer sentiment and
spending. In addition, amid falling house prices and
rising foreclosures, activity in the housing sector continued to decrease. The resulting softness in business
sales and profits also made the environment for capital spending less hospitable. The weakness in overall
domestic demand was partly offset by strong growth of
exports, which were supported by a sustained expansion
of foreign activity and a lower dollar.
The substantial further rise this year in the prices of
many commodities, especially oil and agricultural products, largely reflected strong growth of physical demand
that outstripped supply in these markets. Although
weakening economic activity and rising prices have
tempered demand for commodities in many industrialized nations, demand has continued to grow in booming emerging market economies. However, supplies of
commodities have generally not kept pace for a variety
of reasons, including political tensions in some oilproducing nations, higher input costs, lags in the development of new capacity, and more recently, floods in
the Midwest. To varying degrees, the resulting increases
in materials prices have passed through into retail prices
of energy, food, and some other items.
Overall consumer price inflation, as measured by
the price index for personal consumption expenditures,
remained elevaied in the first half of 2008, largely
because of the sharp increases in the prices of many
commodities. The decline in the foreign exchange value
of the dollar has boosted import prices more generally and thus has also put upward pressure on inflation.
Nonetheless, increases in lahor costs and core consumer
prices (which exclude the direct effects of movements
in energy and food prices) have remained moderate.
The rapid advance in overall prices has boosted some
measures of inflation expectations: Near-term inflation
expectations have risen considerably in recent months,
and some indicators oflonger-term inflation expectations have also moved up—a development that will
require close monitoring in the period ahead.
70
Part 2
Recent Economic and Financial Developments
The growth of economic activity, which slowed sharply
in the fourth quarter of 2007, remained subpar in the
first half of 2008. Although the restraint on activity
late in 2007 was concentrated in the housing sector,
spillovers to other areas of the economy began to show
through more clearly in the first half of 2008. Meanwhile, consumer price inflation has remained elevated
this year, primarily because of steep increases in the
prices of many commodities. Probably in response to
the sizable rise in headline price indexes, some indicators of longer-term inflation expectations have risen in
recent months. However, increases in labor costs and
core prices have been fairly stable, reflecting in part the
softening in aggregate activity.
Financial market stress that had developed over the
second half of last year intensified in the first quarter
of this year. Increased concerns about the possibility of
a global economic slowdown and a generalized flight
from riskier assets contributed to sharply wider risk
spreads, heightened volatility, and impaired liquidity across a range of markets. The Federal Reserve
responded to these developments and their potential
adverse implications for the economy by aggressively
easing the stance of monetary policy and by taking a
number of steps to bolster liquidity and enhance market
functioning. Conditions infinancialmarkets improved
Change in real gross domestic product, 2002-08
Change in the chain-type price index for personal
consumption expenditures, 2002-08
Q Total
B Excluding food and e
Mill
2002
2003
2004
2005
2006
2007
2008
NOTE: Through 2007, change is from December io December; f
change is from December to May,
SOURCE: Department of Commerce, Bureau of Economic Analysis
somewhat in the wake of these actions, but significant
strains remain. With credit conditions tight, equity and
home values falling, and rapidly rising commodity
prices boosting costs and consumer prices, growth of
household and business spending appears to have been
sluggish over the first half of the year.
The Household Sector
Residential Investment and Finance
2002
2003
200<1
2005
2006
2007
2008
NOTE: Here and in subsequent figures, except as noted, change for a given
period is measured to irs final quarter from the final quarter of the preceding
period,
SOURCE; Department of Commerce, Bureau of Economic Analysis,
Housing demand, residential construction, and home
prices have all continued to fall so far this year. Following a decline at an annual rale of 43 percent in the
second half of 2007, sales of new homes decreased at
an annual rate of 32 percent in the first five months of
2008. However, sales of single-family existing homes,
which dropped at an annual rate of 26 percent in the
second half of last year, have been about unchanged
this year. Moreover, pending home sales, which provide a glimpse of the pace of existing home sales in the
months ahead, on net leveled out in the spring, hinting
at some stabilization in transactions in the resale market. Still, for the overall housing sector, the challenging
mortgage fending environment and the concerns of
71
4 Monetary Policy Report to the Congress • July 2008
prospective homebuyers about further declines in house
prices are likely continuing to depress housing demand.
As new home sales have continued to decline,
homebuilders have struggled to work down their substantial overhang of unsold houses. As a consequence,
residential construction activity has been pared further
this year. In the single-family housing sector, new units
were started at an annual rate of 674,000 in May—
down more than 13 percent this year and roughly
60 percent since the peak reached in the first quarter
of 2006. Despite these deep production cuts, the stock
of unsold homes has moved down only 20 percent from
its record high in early 2006. When evaluated relative
fo the three-month average pace of sales, the months'
supply of unsold new homes has continued to rise and
stood at lO'/z months in May. In the multifamily sector,
starts averaged an annual rate of about 320,000 units
during (hefirstfivemonths of 2008, a level of activity
at the lower end of its range in the past several years.
AH told, the decline in residential investment trimmed
the growth rate of real gross domestic product (GDP)
about 1 percentage point in the first quarter of 2008 and
appears to have held down the second-quarter growth
rate by about the same amount
House prices also have continued to fall. The monthly price index published by the Office of Federal Housing Enterprise Oversight dropped at a 6 percent annual
rate in the first four months of 2008 (the latest available
data), a slightly faster rate of decline than in the second
half of 2007.2 In May, the average price of existing
2. This index is Ihe purcPiase-only version of the repeat-transactions price index for existing single-family homes published by the
Office of Federal Housing Enterprise Oversight
Private housing starts, 1995-2008
NOTE: The data are quarterly and extend through 2OG8:Q2; ihe n
2008:Q2 are the averages for April and May.
SOURCE: Department of Commerce, Bureau of the Census.
Change in prices of existing single-family houses,
1988-2008
1990
I I I I 1 I i i I i i 1 I i
1993
1996
1999
2002
200S
2008
NOTE: The data are quarterly and extend through 2008;Ql; changes are
from one year earlier. For tile years preceding 1991, the repeat-transact ion
index includes appraisals associated with mortgage refinancings; beginning in
1991, it includes purchase transactions only. The S&P/Case-S hitler index
reflects all arm s-length sales transactions in the metropolitan sreas of
Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San
Diego, San Francisco, and Washington, D.C.
SOURCE: For repeat transactions. Office of Federal Housing Enterprise
Oversight, for S&P/Case-Shiikr, Chicago Mereaniile Exchange.
single-family homes sold—which does not control for
changes in the mix of houses sold but is available on a
more timely basis—was about Vk percent below that
of a year earlier. Although lower prices should eventually help bolster housing demand, survey and anecdotal
reports suggest that expectations of further house price
declines are quite prevalent, a consideration that may
make potential buyers reluctant to purchase homes until
prices show signs of stabilizing.
The rising volume of foreclosures likely has contributed to falling house prices. Continuing the upward
trend that began in late 2006, about 550,000 loans
began the foreclosure process in the first quarter of
2008—more than double the average quarterly rate
from 2003 to 2005. This rise in foreclosure starts will
increase the supply of houses for sale unless borrowers
can make up the missed payments or arrange with the
lenders or mortgage servicers to have their loans modified.3 Lenders and mortgage servicers have increasingly been working with borrowers to modify loans to
allow borrowers io remain in their homes. However,
some borrowers may not be able to afford even reduced
monthly payments, and other borrowers may not wish
to keep their properties in an environment of falling
house prices. Thus, the share of foreclosure starts that
3. A loan may be modified hy reducing Ihe principal balance,
reducing ihe jnteresl rale, or extending ihe term so as lo make monthly payments more affordable.
72
Board of Governors of the Federal Reserve System
ultimately result in the loss of a home seems Likely to be
higher in the current episode than customarily has been
the case. {See the box entitled "Recent Federal Reserve
Initiatives to Address Problems in the Mortgage Market" on page 6.)
The rates of delinquency continued (o rise in the
first few months of 2008 across all categories of mortgage loans. Problems remained especially severe for
subprime loans. However, Ihe growth rate of subprime
delinquencies has slowed this year, while that of prime
and near-prime delinquencies—particularly on
adjustable-rate loans—has picked up. Credit quality
is strongly related to the origination date of mortgage
loans, with loans originated in 2006 and 2007 much
more likely to experience delinquency and default than
loans originated in previous years. The poorer performance of the more recent loan vintages reflects a general deterioration in underwriting standards through early
2007 and Die decline in house prices since 2007, which
has increased the occurrence of negative homeowner
Mortgage delinquencyrates,2001-08
_
L_l
• Alt-A pools
2002
2004
Loan age (months)
NOTE: Figure is based on monthly data through March 2008. Each curve
represents the fraction of loans originated in ihe indicated year thai had
defaulted by the indicated loan age; for example, roughly 8 percent of all
loans originated sometime in the years 2003 to 2004 had defaulted by the
lime they were 24 monihs old. Tile iast 9 points of the curves for 2005
through 2007 are based on incomplete dam. A 2/28 loan is a 30-year loan
with a fixed rate for the first 2 years and an adjustable rate for the remaining
28 years.
SOURCE: Staff calculations based on data from First American
Loan Performance.
equity for houses purchased near the peak of the real
estate market.
New subprime mortgage loans remained largely
unavailable in the first half of 2008, and borrowers with
higher credit risk had to turn to government guarantee
programs, such as that of the Federal Housing Administration, to obtain mortgage ioans. The availability of
prime mortgage credit has been held down by a further
tightening of lending standards at many commercial
banks, according to the Senior Loan Officer Opinion
Survey on Bank Lending Practices conducted in January and April. Securitization of mortgages by the government-sponsored enterprises (GSEs), Fannie Mae and
Freddie Mac, was robust through April, although the
GSEs tightened standards and increased guarantee fees.
For prime loans, interesl rates on conforming fixed-rate
mortgages were up slightly, on net, over the fust half of
2008 after declining moderately late last year.4 Rates on
conforming adjustable-rate mortgages dropped in January but have since reversed a portion of that decline.
Offered rates on jumbo fixed-rate loans—which ran
up in the second half of last year as the securitization
Prime and near prime
LJ
Cumulative defaults on subprime 2/28 loans,
by year of origination, 2001-07
2006
2008
NOTE: The data are monthly. For subprime, prime, and near-prime
mortgages, !he data extend through Aprii 2008; for mortgages in alt-A pools,
which are a mix of prime, near prime, and subprime mortgages, the data
extend through March 2008. Delinquency rate is ihe percent of loans 90 days
or more pas: due or in foreclosure.
SOURCE: First American Loan Performance.
A. Conforming mortgages are those eligible For purchase by Fannie Mae and Freddie. Mac; they must be equivalent in risk io a prime
mortgage with an 80 percent loan-to-value raiio, and they cannot
exceed the conforming loan limit.
73
6
Monetary Policy Report to the Congress LJ July Z008
Recent Federal Reserve Initiatives to Address Problems in the Mortgage Market
The high rate of mortgage foreclosures is creating
personal, economic, and social distress for many
homeowners and communities. The Federal
Reserve is collaborating with other regulators,
community groups, policy organizations, financial instituiions, and public officials to identify
solutions to prevent unnecessary foreclosures
and their negative effects. The Federal Reserve
also has taken a number of regulatory and supervisory actions to reduce [he likelihood of such
problems in the future.
In 2007, She Federal Reserve and other banking agencies called on mortgage lenders and
mortgage servicers to work closely with borrowers who are having difficulty meeting their mortgage payment obligations. Foreclosure cannot
always be avoided, but prudent loan workouts
and other loss-miiigation techniques that help
troubled borrowers can be less costly to lenders
than foreclosure.
The Federal Reserve's Homeownership and
Mortgage Initiatives reflect a comprehensive
strategy across the Federal Reserve System to
provide information and outreach to prevent
unnecessary foreclosures and to stabilize communities. Under these initiatives, the Federal
Reserve has been providing community coalitions, counseling agencies, and others with
detailed analyses identifying neighborhoods
at high risk of foreclosures. With this information, community leaders can target their scarce
resources to borrowers in need of counseling
and other interventions that may help prevent
unnecessary foreclosures. One example of this
effort is the online dynamic maps and data that
illustrate nonprime loan conditions across the
United States {available at www.newyorkfed.org/
mortgagemaps). In addition, community affairs
offices across the Federal Reserve System have
sponsored or cosponsored more than 75 events
related to foreclosures since January 2007,
reaching more than 5,800 attendees including
lenders, counselors, community development
specialists, and policymakers.
The Federal Reserve also is helping to address
the challenges that foreclosed homes present,
such as decreased home values and vacant
properties that can deteriorate from neglect.
Toward this end, the Federal Reserve entered into
a partnership this spring with NeighborWorks
America, a national nonprofit organization, to
work together in identifying strategies to mitigate
the effect of foreclosures and vacant homes on
communities. In June 2007, the Federal Reserve
began hosting a series of forums in severa! cities across the country to examine the effects
that foreclosures have on neighborhoods in
both strong and weak housing markets and to
{continued on noxl page!
market for such loans dried up—remained elevated in
the first half of Z008, and spreads between rates offered
on these loans and on conforming loans stayed unusually wide,5 To support the market for larger loans, the
Congress raised the conforming loan limit temporarily
for 2008, which allowed the GSEs to back these mortgages. However, because the prepayment characteristics of jumbo mortgage borrowers are different from
those of other borrowers, the GSEs and other market
participants decided not to pool these "jumbo conforming" mortgages with other mortgages when creating
mortgage-backed securities (MBS). As a result, the
secondary market for soch mortgages has thus far failed
to thrive. Concerns expressed by public policymakers
persuaded Fannie Mae and Freddie Mac to make great-
Mortgage rates, 1 9 9 5 - 2 0 0 8
NOTE: The data, which
:kiy and extend through July 9, 2008, a
contract rates on 30-year mortgages.
SOURCE: Federal Home Loan Mortgage Corpi
5. Jumbo mortgages are those ihat exceed the maximum size of a
conforming loan; [hey are typically exfended (o borrowers with relatively slrong credit histories.
74
Board of Governors of the Federal Reserve System
(continued from preceding page)
assess ihe tools available to local communities to
address the consequences of foreclosures.
The Federal Reserve is committed to fostering
an environment that supports the homeown-.
ership goals of creditworthy borrowers with
appropriate consumer protection and responsible lending practices. It is using its regulatory
and supervisory authorities to help avoid future
problems in mortgage markets. In coordination
with other federal supervisory agencies and the
Conference of State Bank Supervisors, the Federal
Reserve issued principles-based guidance on specific types of adjustable-rale subprime mortgages
in June 2007. The guidance is designed to help
ensure that borrowers who choose an adjustablerate mortgage get a loan that they can afford to
repay and can refinance without prepayment
penalty for a reasonable period before the first
interest rale reset. The Federal Reserve issued
similar guidance on nonlradifionaf mortgages in
2006.
Strong uniform enforcement of the consumer
protection regulations that govern mortgage lenders is criiicai to avoid future problems in mortgage markets. Together with other federal and
state supervisory agencies, the Federal Reserve
launched a pilot program to review consumer
protection compliance and impose corrective or
enforcement actions, as warranted, at selected
er efforts to jump-sfart trading in the market for jumbo
conforming loans, and the GSEs have recently taken a
variety of actions to encourage the development of that
market
The weakness in the housing market was associated with a sharp slowing in the growth of household
mortgage debt (o an annual rate of 3 percent in the first
qnarterof 2008, down from 6% percent in 2007 and
IIVJ percent in 2006. The available indicators suggest
that mortgage debt likely slowed further in the second
quarter.
nondepository lenders with significant subprime
mortgage operations.
In December 2007, the Board proposed new
rules under the Home Ownership and Equity
Protection Act to ban unfair and deceptive mortgage lending practices. The Board received about
4,500 comments on the proposal and, taking into
consideration these comments, issued new rules
in (uiy. For consumers receiving higher-priced
mortgages, the final rules prohibit lenders from
extending credit without regard to a borrower's
ability to repay, require lenders to verify income
and assets they rely upon in making loans,
require lenders to establish escrow accounts for
taxes and insurance, and prohibit prepayment
penalties unless certain conditions are met. In
addition, the rules also are designed to curtail
deceptive mortgage advertising and to ensure
that consumers receive mortgage disclosures at
a time when the information is likely to be most
useful to them.
Finally, the Board also is undertaking a broad
and rigorous review of the Truth in Lending Act,
which involves extensive consumer testing of
mortgage disclosure documents. Clearer and
easier-to-understand disclosures should heip consumers better evaluate the loans that are offered
to them and thus make more-appropriate choices
when financing their homes,
Change in real income and consumption, 2002-08
Disposable persona! ir
Personal consumption
Consumer Spending and Household Finance
2O02
The growth rate of consumer spending slowed some
in the first half of 2008 from its solid pace in the second half of 2007. The slowing reflected a number of
restraining influences. The growth rate of real labor
income has stepped down substantially since last sum-
2003
2004
2005
2006
2007
200S
SOURCE: Department of Commerce, Bureau of Economic Analysis.
mer as labor market conditions have weakened and
as rising prices for food and energy have put a sizable
7
75
8
Monetary Policy Report to the Congress G July 2008
Consumer sentiment, 1995-2008
996
199R
2000
2002
2004
2006
2008
NOTE: The Conference Board data are monthly and expend through June.
2008. The Reuters/University of Michigan data arc monthly and extend
through a preliminary estimate for July 2008,
SouRCt: The Conference Board and Reufcrs/Udiversity of Michigan Sur-
denf in consumers' purchasing power. At the same time,
household wealth has been reduced by declining values
of bofh equities and houses. In addition, borrowing
at banks tofinanceoutlays has become more difficult
as terms and standards on consumer credit have been
tightened. Although the tax rebates that households
began receiving in the spring are likely cushioning
these effects to some extent, consumers appear to be
quite downbeat. Measures of consumer confidence,
which had dropped sharply in the second half of 2007,
plnnged further in the first half of this year and now
stand at or below the low levels reached in the early
1990s.
Real personal consumption expenditures (PCE) rose
at a modest annual rate of 1 percent in the first quarter.
The available data suggest that spending picked up in
the second quarter, reportedly boosted by tax rebates.
Spending on light motor vehicles was lackluster in the
first half of the year, as high gasoline prices curbed
demand for sport-utility vehicles and pickup trucks.
Outlays for other types of goods fell slightly in the first
quarter but appear to have turned back up in recent
months. Spending on services has held up well in recent
quarters.
Following a sharp deceleration in the second half
of last year, real labor income has been fiat so far this
year, as nominal wage gains have been eroded by rising
consumer prices. Average hourly earnings, a measure
of wages for production or nonsupervisory workers,
rose at the same rate as the PCE price index in the five
months through May; thus, wages were unchanged in
real terms. In the past couple of months, part of the
strain on household incomes caused by the stagnation
in real wages was likely alleviated temporarily by the
tax rebates that were paid out in May and June. As a
result of these rebates, growth in real disposable personal income (DPI)—that is, after-tax income adjusted
for inflation—which was subpar in the fourth quarter of
2007 and the first quarter of 2008, likely jumped in the
second quarter. Despite an increase in transfers reflecting the recently passed extension of unemployment
insurance benefits, real DPI is likely to fall back in the
third quarter as the disbursement of rebates slows considerably.
After several years of providing an impetus to spending, household wealth has been a negative influence
this year. Changes in household net worth tend to influence consumer spending most heavily over a period
of a year or two. Accordingly, the drop last year in the
ratio of household net worth relative to income probably weighed on consumption outlays in the first half
of 2008. Moreover, this year's declines in residential
real estate values and in equily prices have exacerbated
me situation. Flagging wealth has likely left households less inclined to raise their spending at a rate that
exceeds income growth, and the personal saving rate
hasflattenedout over the past few quarters. In May, the
saving rate jumped to 5 percent, as the immediate effect
of tax rebates in many households was to boost savings.
Overall household debt increased at an annual rate of
about 3'/z percent in the first quarter of 2008, a notable
deceleration from the 6% percent advance in 2007.
Household debt appears to have slowed further in the
Wcalth-to-income ratio, 1985-2008
e quarterly ai d extend through 2008:QL The
s rario of hoi schold net worth 10 disposable f
SOURCE: Far net worth. Federal Reserve Board, flow of funds data; for
income. Department of Commerce, Bureau of Economic Analysis.
76
Board of Governors of (he Federal Reserve System
Personal saving rate, 1985-200S
Non:: The daia are quarterly and extend through 20O8:Q2; the r
2Q08:Q2 is the average for April and May.
SOURCE: Departmen! of Commerce. Bureau of Economic Analys
second quarter. Because the growth of household debt
was slightly less than the growth in nominal DPI in the
first quarter and interest rates on mortgage and consumer debt declined a bit, the ratio of financial obligations
to DPI ticked down.
Consumer (nonmortgage) debt expanded at an annual rate of 5% percent in the first quarter, about the same
pace as in H007, Consumer debt growth held up despite
a reported tightening of lending terms and standards at
banks. In part, this pattern may reflect some substitution away from mortgage credit. Also, interest rates on
auto loans and on credit cards generally declined in the
first half of this year but by less than short-term market
interest rates.
Overall credit quality of consumer loans has deteriorated somewhat in recent months. Delinquency rates on
consumer loans at commercial banks and captive aulo
finance companies rose in the first quarter but stayed
within the range experienced over the past 10 years.
Although household bankruptcy filings remained
low relative to the levels seen before the changes in
bankruptcy law implemented in late 2005, the bankruptcy rate rose modestly in the first few months of
2008.
Secondary-market data suggest that funding for
credit card and auto loans has been well maintained
in recent months. Notably, issuance of asset-backed
securities (ABS) tied lo credit card loans and auto loans
has remained robust, despite spreads of yields on these
securities over com parable-maturity swap rates that
continue to be near historically high levels. In contrast,
pressures in secondary markets for student loan ABS
have reportedly affected the availability of such credit.
The reimbursement formula for government-guaranteed
student loans did not adequately compensate lenders
for the higher funding cost in securitization markets,
and issuance of guaranteed student loan ABS dropped
sharply early in 2008. Legislation enacted in May gave
Ihe Department of Education and the Treasury the
authority to provide short-term liquidity to institutions
that lend to students, and availability of student loans
appears to have improved. However, concerns persist
about access to loans by students at community and
career colleges, as these loans tend to be less profitable
for lenders.
Household financial obligations ratio, 1992-2008
Delinquency rates on consumer loans, 1996-2008
I
I._]_. L_l
1992 1994
I I
!996
1 I I I I I I I 1
1998 2000 2002 2004 2006 2008
NOTE: The data arc quarterly and exlend through 2008:Ql. The financial
obligations ratio equals the sum of required payments on mortgage and consumer debt, automobile leases, rent on tenant-occupied property, homeowner's insurance, and property taxes, all divided by disposable persona!
Sou
Federal Reserve Board.
1_J L
1996
1998
2000
2002
20(14
2006
NOTE: The data are quarterly and extend through 2008:Q1. Delinquency
rate is the percent of loans 30 days or more past due.
SOURCE: Federal Financial Institutions Examination Council, Consolidated
Reports of Condition and Income (Caii Repon).
9
77
10 Monetary Policy Report to the Congress • July 2008
The Business Sector
Fixed Investment
After having posted robust gains in the middle of last
year, real business fixed investment lost some sfeam in
the fourth quarter and eked out only a small advance in
the first quarter of 2008. Economic and financial conditions that influence capital spending deteriorated appreciably late last year and early this year: Business sales
slowed, corporate profits fell, and credit conditions for
some borrowers tightened. In addition, the heightened
concern about the economic outlook may have caused
some firms to postpone or abandon plans for capital
expansion this year.
Real business outlays for equipment and software
were flat in the first quarter. Growth in real spending on
high-tech equipment and software slowed to an annual
rate of about 10 percent, down from the 13 percent pace
recorded in 2007. In addition, business spending on
motor vehicles tumbled. Investment in equipment other
than high tech and transportation dropped at an annual
Change in real business fixed investment, 2002-08
Q Siruciures
B Equipmem and software
Inventory Investment
Jjll
Despite sluggish final sales, inventories declined again
in the first quarter of 2008 as firms acted promptly to
—J—i
•
|
rate of 3% percent in the first quarter after a smaller
decline in the previous quarter. The available indicators
suggest that capital spending on equipment and software fell in the second quarter:' Business purchases of
new motor vehicles reportedly slipped again; shipments
of nondefense capital goods (adjusted to exclude both
transportation items and goods that were sent abroad)
were lower, on average, in April and May than in the
first quarter: and the tone of recent surveys of business
conditions remained downbeat.
Nonresidential construction activity, which exhibited
considerable vigor in 2006 and 2007, slowed appreciably in the first quarter of 2008. Real oudays for
new commercial buildings declined sharply in the first
quarter, and increases in outlays for most other types of
building stepped down. More-recent data on construction expenditures suggest that spending on nonresidential structures may have bounced back in the second
quarter. However, deteriorating economic and financial
conditions indicate that this rebound may be shortlived. In addition to the weakening of business sales
and profits, vacancy rates turned up in the first quarter
(the latest available data). Moreover, the financing
environment has remained difficult: bank lending officers have reported a significant tightening of terms and
standards for commercial real estate loans, and funding
through the commercial mortgage-backed securities
(CMBS) market has continued to be extremely limited.
Change in real business inventories, 2002-0
High-tech equipment and software
Olher equipment excluding transportatia
iiihons of chained (3000) dollars, annual ra
• • I
2002
2003
2004
2005
2006
2007
2008
NOTE; High-tech equipment consist of computers and peripheral equipment and communications equipment.
SOURCES Department of Conunfirce, Bureau of Economic Analysis.
2002
2003
2004
2005
2006
2007
2008
SOURCE: Department of Commerce, Bureau of Economic Anaiysi
78
Board of Governors of the Federal Reserve System
prevent inventory imbalances from arising. Automakers, which had worked to bring days' supply down to a
sustainable level last year, have moved aggressively to
keep production aligned with demand in recent quarters. Excluding motor vehicles, real inventory investment fell in the fourth quarter of 2007 to its lowest
level in several years and then turned negative in the
first quarter of this year. According to the limited available data, nonauto businesses continued to liquidate
real inventories early in the second quarter. Business
surveys suggest that companies are generally comfortable with their current stock levels. Nonetheless, a few
industries, most notably those producing construction
supplies, are showing some evidence of inventory
overhangs.
Before-tax profits of nonfinancial corporations
as a percent of sector gross domestic product, 1992-2008
1 l
I__L.J_J. J
1992
Corporate Profits and Business Finance
The sluggish pace of business investment in recent
months is due in part to the weakening of domestic
profitability and the tighter credit conditions faced
by some businesses. In the first quarter of 2008, total
economic profits for all U.S. corporations were down
slightly from their level four quarters earlier; a nearly
20 percent rise in receipts from foreign subsidiaries was
not sufficient to offset a 2l/z percent fall in domestically
generated profits. Although profits as a share of output
in the nonfinancial corporate sector have declined in
recent quarters, they remain well above previous cyclical lows. For companies in the S&P 500, operating
earnings per share fell 17 percent over the year ending
in the first quarter. This decline was more than accounted for by plummeting earnings atfinancialfirms,which
reported large write-downs on leveraged loans and
mortgage-related assets,6 For nonfinancial firms in the
S&P 500, earnings rose nearly II percent over the four
quarters ending in the first quarter of 2008; energysector firms had a strong 31 percent increase in earnings, whereas earnings at other nonfinancial firms rose
^h percent.
Although credit has remained available to the business sector, yields on corporate bonds increased significantly over the first half of the year, and banks reported
tighter terms and standards on commercial and industrial loans and on commercial real estate loans. All told,
the growth rate of the debt of nonfinancial businesses
fell from H3/4 percent in 2007 to 9% percent in the first
) 994
1996
1998
2000
2002
~!004
2006
2008
NOTE: The data are quarterly and extend through 2008:Q1. Profits arc from
domestic operations of nonllnancia! corporations wifh adjustments for
inventory valuation and capital consumption.
SOURCE: Department of Commerce, Bureau of Economic Analysis.
quarter of 2008; the available data point to a further
deceleration in the second quarter of this year.
On balance, the composition of borrowing by nonfinancial businesses has shifted this year toward longermaturity debt. Net bond issuance by nonfinancial firms
has been strong. Speculative-grade issuance, which
dropped sharply late last year and was practically nil
in the first quarter, rebounded markedly in the second
quarter, while investment-grade issuance has continued
to be robust. Spreads between yields on mvestmentand speculative-grade bonds and those on comparablematurity Treasury securities climbed in January and
then surged in March. After narrowing in April and
Selected components of net financing for nonfinancia!
corporate businesses, 2003-08
Dili tun;
D C lomirai •cial
_
paper
n
• Blonds
m alank to;ins
500
n n
—
400
••••III.
1!
2003
6- Asset wrile-downs and capital losses are generally excluded
from tlie calculation of economic profits but are inciuded as an
expense in the operating earnings per share of financial firms.
11
2004
2005
2006
2007
2008
NOTE: The data for the components except bonds are seasonally adjuste
The data for 2008 Q2 are estimated.
SOURCE: Federal Reserve Board, flow of funds data.
79
12 Monetary Policy Report to the Congress D July 2008
May, bond spreads jumped again in iate June. Outstanding commercial paper (CP) for ndnfinancial firms has
been little changed, on net, this year. Yields on nonfinancial CP have moved down since (he beginning of
the year, roughly in line with other short-term interest
rates, although spreads between yields on lower-rated
and higher-rated nonfinancial CP remain well above the
levels prevailing before the onset of the financial difficulties last summer.
Commercial and industrial (C&I) loans at banks
expanded briskly in the first quarter and then slowed
markedly in the second quarter. In the Senior Loan Officer Opinion Survey taken in January and April, considerable net fractions of banks reported that they had
tightened credit standards and boosted spreads on C&T
loans. According to the respondent banks, the move
to a more stringent lending posture mainly reflected a
less favorahle or more uncertain economic outlook and
a reduced tolerance for risk; a significant fraction also
noted concerns about the capital position of their own
bank as a reason for tightening standards. The secondary market for syndicated leveraged loans remained
relatively weak, but loans associated with some prominent buyouts were sold, albeit at a discount.
Gross equity issuance by nonfinancial firms dipped
in the first quarter and rebounded in the second quarter.
A sharp decline in share repurchases and cash mergers
Net percentage of domestic banks tightening standards
and increasing spreads on commercial and industrial
loans to large and medium-sized borrowers, 1992-2008
Components of net equity issuance, 2004-08
NOTE: Net equiry issuance is ihe difference between equity issued by
domestic companies in public or privaie markets and equity retired through
share repurchases, domestic cash-Financed mergers, or foreign takeovers of
U.S. firms. Equity issuance includes funds invested by private equity
partnerships and slock option proceeds.
SOURCE: Federal Reserve Board, flow of hinds data.
led to a notable reduction of net equity retirement in the
first quarter.
The credit quality of nonfinancial corporations generally has remained solid. The six-month trailing bond
default rate was very low despite a small tick up in
June. The delinquency rate on C&T loans at commercial
banks continued the mild increase that began last year,
but it remained subdued by historical standards. Ratings downgrades in the first five months of this year
were modest, only slightly exceeding upgrades. Balance
sheet liquidity at nonfinancial corporations remained
Default rate on outstanding corporate bonds, 1992-2008
1996
1999
2002
2005
2008
NOTE: The data arc drawn from a survey generally conducted four times
per year; the last observation is from the April 2008 survey, which covers
2OO8:Ql, Net percentage is the percentage of hanks reporting a tightening of
standards or an increase in spreads less ihe percentage reporting an easing or
a decrease. Spreads are measured as the loan rate less the bank's cosi of
funds. The definition for firm size suggested for, and generally used by,
survey respondents is !iiat large and medium-sized firms have annual sales of
$50 million or more.
SOURCE: Federal Reserve Board, Senior Loan Officer Opinion Survey on
Bank Lending Practices.
1993
1996
1999
2002
2005
2008
NOTE: The data are monthly and extend through June 2008. The rate for a
given month is the face value of bonds That defaulted in ihe six ntoniiis
ending in thai month, multiplied by 2 So annuaiize the defaults and then
divided by the face value of ail bonds outstanding at the end of the calendar
quarter immediately preceding the six-monlh period.
SOURCE: Moody'* Investors Service.
80
Board of Governors of the Federal Reserve System
Delinquency rates on commercial real estate loans,
1991-2008
13
Spreads of 10-year investment-grade commercial
mortgage-backed securities over swaps,
by securities rating, 1997-2008
Commercial banks
NOTE: The daia are weekly and extend through July 9, 2008.
SOURCE: Bloomberg.
1998 2000 2002 2004 2006 2008
NOTE; The data for commercial banks and life insurance companies are
quarterly and extend through 2OO8:Q1. The daia for commercial
mongage-backed securities (CMBS) arc monthly and extend through June
2008. The delinquency rales for commercial banks and CMBS are the perceni
of Joans 30 days or more past due or no! accruing interest. The delinquency
rate for life insurance companies is the percent of loans 60 days or more past
due o
ing interest.
SOURCE: For commercial banks, Federal Financial institutions
Examination Council, Consolidated Reports of Condition and Income {Call
Report); for life insurance companies, American Council of Life Insurers; for
CMBS, Citigroup.
widening of spreads reportedly reflected heightened
concerns regarding standards for underwriting commercial mortgages over the past few years and likely also
investors' wariness of structured finance products more
generally. After hitting a record level in early 2007,
issuance of CMBS dropped sharply late last year and
slowed to a trickle so far this year.
The Government Sector
Federal Government
high through the first quarter of 2008, and leverage
stayed very low.
In the April 2008 Senior Loan Officer Opinion
Survey, a large fraction of banks reported having tightened credit standards on commercial real estate loans.
Delinquency rates on commercial real estate loans for
construction and land development projects extended
by commercial banks moved sharply higher in the first
quarter of 2008 after rising noticeably last year. In
contrast, delinquency rates on bank loans that finance
existing commercial properties moved up only slightly.
Delinquency rates on commercial mortgages held by
life insurance companies and Ihose in CMBS pools,
which mostly finance existing commercial properties,
remained low.
Despite the generally solid performance of commercial mortgages in securitized pools, spreads of
yields on CMBS over comparable-maturity swap rates
soared to unprecedented levels early in 2008. In recent
months, these spreads have narrowed somewhat, but
they remain well above levels seen before this year. The
The deficit in the federal unified budget has widened
during the current fiscal year after having narrowed in
Ihe preceding few years. A substantial portion of the
rebates authorized by the Economic Stimulus Act of
2008 was distributed in May and June, which caused
a significant widening of the deficit. In addition, the
growth of receipts has slowed in response to the weaker
pace of economic activity, and the growth of outlays
has stepped up. Over the first nine months of fiscal year
2008—from October through June—the unified budget
recorded a deficit that was $148 billion greater than during the comparable period ending in June 2007. When
measured relative to nominal GDP, the deficit moved up
from Vk percent in fiscal 2007 to 2'/4 percent during
the 12 months ending in June 2008; a continued slow
pace of economic activity and additional revenue fosses
associated with the Stimulus Act are expected to widen
the deficit further in the final three months of fiscal
2008.
The Economic Stimulus Act is estimated to result in
about $115 billion of rebates being sent to households
81
14 Monetary Policy Report to the Congress G July 2008
Federal receipts and expenditures, 1988-2008
Change in real government expenditures
on consumption and investment, 2002-08
Percent of nominal GDP
NOTE: Through 2007, receipts and expenditures are on a unified-budget
basis and are for fiscal years (October through September); gross domestic
product (GDP) is for the (bur quarters ending in Q3. For 2008, receipts and
expenditures
are for the 12 monihs ending in June, and GDP is ihe average of
p
2007:Q4and20OB:Qi
B:Qi.
2007:Q4and
SOURCE: Offi e of Management and Budget.
in 2008 and 2009. The rebates began to be distributed
in the last few days of April, and by the end of June,
approximately $80 billion worth of rebates had been
disbursed, accounting for more than half of the widening of the budget deficit in the first nine months of fiscal
2008 relative to the same period in fiscal 2007.
The slower pace of economic activity has cut into
receipts. Excluding the budgetary effects of stimulus
rebates, federal revenues in Ihe first nine months
of fiscal 2008 were only 2 percent higher than in the
same period in fiscal 2007, down from a rise of
6% percent in fiscal 2007 and considerably smaller
than the double-digit gains recorded in fiscal 2005 and
fiscal 2006. The slowdown in federal revenues has been
most pronounced for corporate receipts, reflecting the
decline in corporate profits since the middle of 2007.
Individual income and payroll tax receipts—excluding
(he stimulus rebates—also have slowed, likely because
of the smaller gains in personal income during the current fiscal year.
Nominal federal outlays in the first nine months
of fiscal 2008 were 6% percent above their level in
the comparable period in fiscal 2007, a faster pace of
increase than was recorded in fiscal 2007 but generally
below the rapid increases seen in fiscal 2002 through
2006. So far this fiscal year, the growth of outlays for
defense has stepped up relative to fiscal 2006 and 2007,
and spending has continued to rise apace in most major
nondefense categories. In the months ahead, outlays
will be bumped up further by the extension of eligibil-
2002
2003
2004
2005
2006
2007
2008
SOURCE' Department of Commerce, Bureau of Economic Analysis
ity for unemployment insurance benefits to individuals
who have exhausted their benefits.
As measured in the national income and product
accounts (NIPA), real federal expenditures on consumption and gross investment—the part of federal spending
that is a direct component of GDP—increased at an
annua! rate of 414 percent in the first quarter, a contribution of 0.3 percentage point to real GDP growth. Real
defense spending accounted for almost the entire rise,
as nondefense outlays only edged up. In the second
quarter, defense spending appears to have posted
another sizable increase, aud given currently enacted
appropriations, it is likely to rise further in comiug
quarters.
Federal Borrowing
Federal debt rose at an annual rate of Vfz percent in the
first two quarters of fiscal year 2008—from October
through March—a notable step-up from the 414 percent
pace in fiscal 2007. As of the end of March, the ratio
of federal debt held by the public to nominal GDP
was about 37 percent, slightly higher than in recent
years.
The deterioration in the budget position of the federal government led the Treasury to reintroduce the oneyear Treasury bill, which was last issued in 2001. The
initial auction on June 3 was very well received, with a
bid-to-cover ratio above 3. Issuance also increased for
both shorter- and longer-maturity Treasury securities.
The proportion of nominal coupon securities purchased
at Treasury auctions by foreign investors changed little
82
Board of Governors of the Federal Reserve System
Federal government debt held by the public, 1960-2008
15
State and local government net saving, 1988-2008
Percent of nominal GDP
1993
NOTE: The data extend through ZOOgrQL The data for debt through 2007
are as of year-end, and the corresponding values for gross domestic product
{GDP! are for Q4 at an annual rate; the Final observation refers to debt at the
end of 200o:QI, and the corresponding value of GDP is for 2008:Q! at an
annua! rale. Excludes securities held as investments of federal government
accounts.
SOURCE: Federal Reserve Board, (low of funds data.
over the first half of 2008 and remains in the range of
10 percent to 25 percent observed over the past several
years. However, holdings of Treasury securities by
foreign official institutions at the Federal Reserve Bank
of New York increased more rapidly in the first half of
2008 than over any of the previous three years.
State and Local Government
The fiscal positions of state and local governments
began to weaken last year and have continued to deteriorate in 2008. After having improved significantly
from 2003 to 2006. net saving by the sector - which is
broadly similar to the surplus in an operating budget—
turned slightly negative in 2007, and this measure
moved further into negative territory in the first quarter
of 2008. The deterioration in budget conditions has
occurred as increases in revenues have slowed while
nominal expenditures have risen at a brisk pace. The
slowdown in state income tax revenues has followed a
pattern similar to the one that has emerged at the federal
level. Corporate receipts have declined, and the rise in
individual income taxes has become more subdued. At
the same time, state receipts from sales taxes have softened markedly. At the local level, Ihe decline in house
prices has not yet begun to curb local property tax revenues appreciably, but increases in local receipts from
this source seem likely to slow more noticeably in the
next few years.
1996
]999
2002
2005
2008
NOTE: The data, which are quarterly, are on a national income and product
account basis and extend through 200a:Ql.
SOURCE: Department of Commerce, Bureau of Economic Analysis.
On the outlays side of the accounts, nominal spending has continued to rise, particularly for expenditures
on health care and energy items. In real terms, expenditures on consumption and gross investment by state and
local governments (as measured in the NIPA) rose only
a bit in the first quarter, as increases in expenditures on
current operations were largely offset by a decline in
outlays on structures. However, construction expenditures are volatile from quarter to quarter, and the data
through May suggest that real state and local expenditures for structures picked up in the second quarter.
Meanwhile, state and local hiring remained elevated
through June.
State and Local Government Borrowing
Bond issuance by state and local governments slowed
moderately in the first quarter of 2008 as the cost of
borrowing rose. Investors demanded higher returns, in
part because of concerns about the strength of financial
guarantors that insure many municipal bonds and in
part because of concerns about the effect of a potential
economic slowdown on state and local government revenues.7 Beginning in February, these investor apprehen-
7. Concerns about die financial guarantors arose in 2007. but
significant downgrades did not occur until early this year. in June,
Moody s and Standard & Poor's downgraded MBIA and Ambac, two
of the largest guarantors, from AAA to AA or lower. New bond insurance business has shifted to guarantors lhal are viewed as financially
stronger, and some municipalities have stated their intention (o dispense with guarantors and issue on the strength of their own ratings.
83
16 Monetary Policy Report to the Congress D July 2008
sions also led to widespread failures of rate-resetting
auctions for auction rate securities (ARS) issued by
state and local governments.8 Pressures in the municipal securities market eased somewhat in the second
quarter, along with the broader relaxation of financial
market strains. In addition, ratings upgrades of municipalities greatly exceeded downgrades in the second
quarter. Since March, municipal bond issuance has
rebounded, and a significant fraction of failing ARS
issues have been paid down with the proceeds of standard bond issues.
widened, the fiscal positions of state and local governments deteriorated, and business saving decreased.
Accordingly, total national saving as a share of nominal
GDP, which has been declining, on balance, since the
late 1990s, has fallen to a historic iow (apart from the
third quarter of 2005, which was marked by sizable
hurricane-related property losses). If not reversed over
the longer run, persistent iow levels of saving will be
associated with either slower capital formation or continued heavy borrowing from abroad, either of which
would retard the rise in the standard of living of U.S.
residents over time and hamper the ability of (he nation
to meet the retirement needs of its aging population.
National Saving
Total net national saving—-that is, the saving of households, businesses, and governments excluding depreciation charges—dipped below zero in the first quarter of
2008, After having stood at an already low rate of 1%
percent of nominal GDP in (he second quarter of 2007,
the national saving rate declined steadily over the
subsequent three quarters, as the federal budget deficit
8. ARS are long-term securities whose interest rates are reset
through regularly scheduled auctions, typically every 7. 28, or
35 days. As of the end of 2007. the size of the ARS marker in the
United States was about $330 billion, about half of which was
accounted for by municipal securities. A resetting auction fails when
investors do not bid for the entire issue at an Interest rate below the
contract maximum. Upon auciion Failure, the asset holders from
before tlie auction retain ownership of the securities and receive a
specified ceiling interest rate, which is usually, but not necessarily,
equal lo (he maximum bid rate.
Net saving, 1988-2008
The External Sector
International Trade
Foreign demand has continued to be an important
source of strength for the U.S. economy. Net exports
contributed 3A percentage point to the growth of real
GDP in the first quarter of 2008 after adding a similar
amount to growth in 2007. The growth of real exports
of goods and services expanded at a SVz percent pace in
the first quarter, moderating from the I2V6 percent surge
recorded in the second half of 2007. Export growth
in the first quarter was supported by higher exports of
agricultural products, consumer goods, industrial supplies, and services. In contrast, exports of both aircraft
and automobiles moved down after rising rapidly in
the second half of 2007. Exports to Europe and Latin
America rose robustly (in current dollars), while
Change in real imports and exports of goods and services,
2000-08
Nonfcderdl saving
1 I ! 1
19X8
1992
1996
2000
2004
M
2008
NOTE: The data arc quarterly and extend through 2008:Qi. Nonfederal
saving is the sum of personal and ne( business saving and the ne! saving of
state and local governments.
SOURCE: Department of Commerce, Bureau of Economic Analysis.
2000
2002
2004
2006
2008
NOTE: Daia for200S:Qt are expressed as percent change from2007:Q4,
SOURCE: Department of Commerce.
84
Board of Governors of the Federal Reserve System 17
U.S. trade and current account balances, 20O0-0
o
— i
NOIL: The daia are quarterly and extend through 20O8;Ql.
SOURCE: Department of Commerce.
exports to Canada and to OPEC countries fell back.
Data for April and May suggest that exports continued
to expand in the second quarter, with exports of industrial supplies showing particular strength.
The positive contribution of nei exports in the first
quarter reflected, In part, a 3A percent decline in real
imports of goods and services. Imports of automotive
products and consumer goods fell in line with slowing
U.S. domestic demand, more than offsetting higher real
imports of oil and a slight increase in imports of capital
goods. Imports from China and Mexico declined {in
current dollars), whereas imports from Canada, Japan,
and OPEC countries expanded. After falling sharply
Prices of oil and nonfue] commodities, 2003-08
January 2003 = 100
140
in March, imports rebounded, on average, in April and
May, as imports of capital equipment and consumer
goods increased strongly.
In thefirstquarter of 2008, the U.S. current account
deficit was $706 billion at an annual rate, or 5 percent
of GDP, $25 billion narrower than its level in 2007;
the narrowing largely reflects higher net investment
income. A large improvement in the non-oil trade deficit
was offset by a sharp increase in the bill for imported
oil, which resulted from the jump in oil prices.
Compared with 2007, prices for imports of both
material-intensive and finished goods are increasing at
much faster rates so far this year. Although import price
increases also reflect the depreciation of the dollar, rising commodity prices (discussed in more detail in the
box entitled "Commodity Prices" on page 18) have significantly boosted the rate of import price inflation. In
the first quarter, prices of imported goods excluding oil
and natural gas rase at an annual rate of about Vh percent, a pace more than twice that of the previous year.
Available data suggest that import price inflation was
sharply higher in the second quarter.
The Financial Account
In late 2007 and thefirstquarter of 2008, the U.S. current account deficit was financed primarily by foreign
purchases of U.S. securities, as has been the norm in
recent years. The global financial turmoil has continued
to leave an imprint on both the sources and composition
of cross-border financial flows, including a net private
outflow in the first quarter. Meanwhile, foreign official
inflows provided all of the financing from abroad during the first quarter, driven by net purchases of U.S.
Treasury and agency securities by Asian institutions.
U.S. net financial inflows, 2003-08
120
uo
—
T
Nonfiid
commodities
ion
40
-
80
1 1
1
2003
2004
1
2005
1
2006
1
2007
i
20
1
2008
NOTE: Tile data are monthly. The oil price is the spot price of West Texas
intermediate crude oil, and the last observation is the average for July 1-9,
2008. The price of nonfuet commodities is an index of 45
primary-commodity prices, and extends through May 2008.
SOURCE: For oil, the Commodity Research Bureau; for nonfuel
commodities, International Monetary Fund.
_l
2004
L
2005
SODRCt;: Department of Com
85
18
Monetary Policy Report to the Congress G July 2008
Commodity Prices
Prices for crude oil and many other commodities
continued to soar through the first half of 2008.
After shooting up about 60 percent last year,
the spot price of West Texas intermediate crude .
ot! has increased an additional 50 percent thus
far in 2008, climhing from $92 per barrel in
December 2007 to about $140 recently. While
weaker economic growth and the high level
of prices appear to be damping oil demand in
industrialized nations, demand from emerging
market countries remains robust. The continued
strength in emerging market demand reflects, in
part, government subsidies that limit the passthrough of higher crude prices to retail products
and thus mute the response to higher prices.
Furthermore, on the supply side, incoming
information since the beginning of the year has
been decidedly downbeat, with non-OPEC production continuing to fall short of expectations.
Despite additional investment, oil production
capacity has not risen at a pace commensurate
with the growth of global demand. The lack of
spare capacity has led, in turn, to heightened
sensitivity of oil prices to political developments,
such as ongoing tensions in the Middle East and
instability in Nigeria. The price of the far-dated
NYMEX oi! futures contract (currently for delivery in 2016) has also risen to about $ 140 per
barrel and suggests that the balance of supply
and demand is expected to remain tight for some
time to come.
Nearer-term market pressures have been
reflected in domestic inventories of both
crude oil and refined oil products, which have
declined notably in recent months and stand
well below year-earlier levels. Inventories also
appear to be tight in other countries (although
data are less complete for emerging market
countries). Lean inventories increase the vulnerability of petroleum markets to any disruptions in
production, transportation, and refining, which
is of particular concern during hurricane season.
The tightness of inventories suggests that the
recent increases in oil prices reflect near-term
demand and supply pressures, rather than speculative hoarding.
Prices of nonfuel commodities were quite
volatile in the first half of 2008. Through early
(coniinued on next page|
Unusually large net purchases of corporate securities also contributed to foreign official inflows, likely
reflecting sovereign wealth fund activity.
Net private foreign purchases of U.S. securities, 2003-08
2005
2006
2007
NOTE; Other U.S. securiti 5 include corporate equities and bonds, agency
bonds, and municipal bonds.
Sound-: Department of C
Foreign private demand appeared to remain robust
for the safest U.S. investments—net private purchases
of U.S. Treasury securities, which surged in the third
quarter of 2007 when the turmoil began, remained at
near-record levels through April 2008, In contrast, corporate bond purchases by foreign private investors have
been weaker in each quarter of the turmoil than in any
previous quarter since 2002. Corporate equity purchases
have also been very weak in 2008 through April after a
strong rebound in the fourth quarter of 2007. Overall,
total inflows from foreign private acquisitions of U.S.
securities were well below average in the first quarter
of 2008 but slightly above the nine-year low set in the
third quarter of 2007 as the turmoil began.
Inflows from private purchases of U.S. securities in
the first quarter of 2008 were offset by strong outflows
associated with U.S. direct investment abroad and
by interbank flows. Somewhat surprisingly given the
global financial turmoil, the strength seen in U.S. direct
investment abroad in 2007 persisted through the fourth
quarter and into the first quarter of 2008. In addition,
net lending abroad by U.S.-resident banks, which
86
Board of Governors of the Federal Reserve System
19
{continued from preceding page)
March, prices of many commodities rose sharply, including those for some foods {such as corn and wheat) and
metals (in particular, copper and afuminumj. This broadbased price increase appears to have been driven mainly
by growth in global demand. More recently, however,
price movements have been less uniform, and commodities such as wheat and nicke! have seen sharp price
declines. Nevertheless, some other food commodity prices have continued to soar, particularly the price of corn,
which has been affecied by we at her-related concerns,
including She recent floods in the Midwest. The price of
rice has also increased sharply Shis year, which has led a
number of rice-producing countries to enact export bans,
adding lo upward pressure on global prices. Through feed
costs, increased grain prices also have been reflected in
higher prices for meat and dairy products.
The supply response of farm crops to price increases
typically has had a relatively short time lag, usually
through increasing land under cultivation. Although
increases in acreage devoted to one crop have recently
come at the expense of other crops, yields have risen and
should continue to do so as more-advanced seed varieties
and cufiivation techniques are employed.
in addition to supply and demand conditions in the
physical markets, other factors have been cited as con-
tributing to the rise in commodity prices in recent years,
including depreciation of the dollar and Sower interest
rates. All else being equal, a lower value of the dollar
implies a higher dollar price of commodities, but the
causal relationships between the exchange value of the
dollar and commodity prices are complex and run in
both directions. The fact that commodity prices have
risen significantly in terms of all major currencies suggests
that factors other than the depreciation of the dollar have
been important causes of the rise in prices. Similarly, the
relationship between interest rates and commodity prices
may depend on what is driving changes in interest rates.
For example, to the extent that lower interest rates reflect
a relatively weak economy and thus softer demand for
commodiiies, interest rates and commodity prices may
tend to move in the same direction. And irrespective
oi their cause, tower interest rates might also lead to a
buildup in commodity inventories—as a result of reduced
financing costs of holding inventories—polentiaiiy putting upward pressure on prices. However, inventory levels
of key commodities have not risen this year, a fact that
is at odds with such explanations of price increases that
emphasize the role of interest rates.
tends to be quite volatile, has increased with unusual
consistency since the turmoil began; these outflows,
primarily from foreign-owned banks to their European
affiliates, were particularly large in March as conditions
in U.S. and European interbank funding markets
re-intensified.
Net change in private payroll employment, 2002-0
The Labor Market
n n j ; <>[jabs, momMy .TO
• I I,
Q1Q2
2002
2003
2004
2005
2006
2007
2008
NOTE: N'onfami business sector.
SOURCE: Depanment of Labor, Bureau of Labor Statistics
Employment and Unemployment
The demand for tabor has been contracting this year.
After having increased 54,000 per month, on average,
in the second half of 2007, private payroll employment
declined at an average monthly pace of 94,000 in the
first half of 2008. Over the same period, the civilian
unemployment rate moved up more than %k percentage
point, to 5'/2 percent.
Job losses in the first half of 2008 were concentrated
in the construction and manufacturing sectors. Although
husinesses in these industries have been trimming
payrolls for more than two years, the downsizing has
intensified during the past several months. In addition,
job losses have begun to mount this year in the whole-
87
20 Monetary Policy Report to the Congress D July 2008
ilian unemployment rate, 1975-2008
LLLUJJjJ
2008
NOTE: The data are monthly and extend through June 2008.
SOURCE: Department of Labor, Bureau of Labor Statisiics.
sale and retail trade sectors and in the professional and
business services category. Even among me many sectors in which payrolls have confirmed to expand, such
as technical services providers and eating and drinking
establishments, job gains have been less robust so far
this year than in 2007. A notable exception has been
hiring by providers of health and education services,
which has remained strong.
The unemployment rate, which rose Vz percentage
point in 2007, increased another Vz percentage point in
the first half of this year. Initial claims for unemployment insurance and the number of individuals receiving
unemployment insurance benefits moved up considerably over the six months ending in June; accordingly,
the share of unemployed workers who lost their last
jobs (as opposed to Chose who voluntarily left their jobs
or were new entrants to the labor force) rose, on net,
(his spring. In addition, the percentage of persons who
reported that they were working part time for economic
reasons increased sharply. Thus far, the labor force participation rate, which typically falls during periods of
labor market weakness, has remained steady and stood
at 66.1 percent in June, near the middle of the range
that has prevailed since early 2007,
Other indicators also point to further deterioration
in labor market conditions this year: Private surveys
of businesses suggest that firms plan to continue cutting back on hiring in the near term. At the same time,
according to surveys of consumers, assessments of
labor market prospects in the year ahead, which had
worsened late last year, slipped further in the first half
of 2008.
Productivity and Labor Compensation
Gains in labor productivity have moved up significantly
of late. According to the latest available puhiished data,
output per honr in the nonfarm business sector rose
Vk percent during the year ending in the first quarter
of 2008, up from the Vz percent increase recorded over
the preceding four quarters. On average, the rise in productivity over the past two years, although !ess than the
outsized increases posted earlier in the decade, suggest
that the fundamental forces that in recent years have
supported a solid uptrend in underlying productivity
remain in place. Those forces include the rapid pace of
technological change and the ongoing efforts by firms
Change in output per hour, 1998-2008
Labor force parlicipalion rate, 1975-2008
— 3
— 2
Nort: Nonfarm business sector. The data are quarterly and extend through
2008:Qi. Change is over four quarters.
SOURCE: Department of Labor, Bureau of Labor Statistics.
=: The data are monthly and extend ihrough June 2008.
tee; Department of Labor, Bureau of Labor Statistics.
Board of Governors of the Federal Reserve System
Measures of change in hourly compensation, 1998-2008
Nonfarm business
n.sation per hour
_U
1998
2000
2002
2004
2006
2008
NOTE: The data 3re quarterly and extend ihrough 2OO8:QI. For nonfarm
business compensation, change is over four quarters; for the employment cost
index (EC1), change is over the \2 monihs ending in the last month of each
quarter. The nonfarm business sector excludes farms, government, nonprofit
institutions, and households. The sector covered by the ECt used here is the
nonfarm business sector pins nonprofit institutions. A new ECi series was
introduced for data as of 2001, bu! the new series is continuous with the old.
SOURCE: Department of Labor, Bureau of Labor Slatisiics.
to use information technology to improve the efficiency
of their operations. Increases in the amount of capital,
especially high-tech capital, available to each worker
also appear to be providing considerable impetus to
productivity growth.
Broad measures of hourly labor compensation have
not kept pace with the rapid increases in both overall
consumer prices and labor productivity, despite a labor
market that, until recently, had been generally tight. The
employment cost index (ECI) for private industry workers, which measures both wages and the cost to employ-
Change in unit labor costs, 1998-2008
NOTE. Nonfarm business sector. The data are quarterly and extend through
2008:Q 1. Change is over four quarters.
SOURCE: Department of Labor, Bureau of Labor Statistics.
21
ers of providing benefits, rose 3Vi percent in nominal
terms between March 2007 and March 2008 (the latest
available data), the same gain as was recorded over the
preceding 12 months. Although the increase in the wage
and salary component of the ECI edged down, the rise
in benefits costs picked up markedly. Benefits costs
were pushed up by a sharp rise in employer contributions to retirement plans, which likely reflected, in part,
the weak performance of the stock market and an atypical^ small increase in employer contributions in the
preceding year.
According to preliminary data, compensation per
hour in the nonfarm business (NFB) sector—an alternative measure of hourly compensation derived from the
data in the NIPA-—rose 4 percent over the year ending
in the first quarter of 2008, down from a 5 percent gain
in the previous year. Because of the slower growth in
NFB hourly compensation and the faster growth in productivity over the period, unit labor costs rose just
¥4 percent over the year ending in the first quarter of
2008 after having increased 4W percent over the preceding year. On average, the rise in unit labor costs over
the past two years is about on par with the increases
recorded in the preceding two years.
Prices
Headline inflation remained elevated in the first half
of 2008, as prices for both food and energy continued
to surge. The chain-type price index for personal consumption expenditures increased at an annual rate of
3.4 percent between December 2007 and May 2008,
about the same as the brisk pace registered over the
12 months of 2007. Excluding food and energy
items, the PCE price index rose at an annual rate of
1.9 percent over the first 5 months of the year, down
from the 2.2 percent increase over the 12 months of
2007.
Energy prices, which jumped 20 percent over 2007,
continued to soar in the first five months of this year.
Spurred by rising crude oil costs, motor fuel prices continued to move up through May, and increases in prices
of heating fuel and natural gas also jumped appreciably.
Furthermore, the pass-through of the record-high levels
of crude oil prices into retail gasoline prices was only
partial, and wholesale and retail margins were unusually compressed in May. As these margins return to
more typical levels, retail prices are likely to rise further. Indeed, survey evidence suggests that prices at the
pump jumped again in June and early July. The recent
pickup in natural gas prices apparently reflected substitution by utilities and other users away from relatively
89
22 Monetary Policy Report to the Congress • July 2008
Alternative measures of price change, 2007-0:
Change in core consumer prices, 2002-08
Percent
I W mea ure
•
•
Core consumer price index
Chain-type price index for cure
personal consumption expersditt
111
2002
2003
2004
200S
2006
2007
Chain-type (Q! to QI)
Gross domestic product (GDP)
Excluding food and eneigy
fcifoss domes lie purchases
Personal consumption expenditure (PCF)
Excluding food and energy
Market based PCE excluding food and energy
2008
d9
29
2.2
1-9
23
l\
2-2
3.4
2,0
1.8
2.3
2.2
Fixed-weight (Q2 to Q2)
Excluding food and energy
2007
2008
NOTE: Through 2007, change is from December to December; for 2008,
change is from December H> May,
SOURCE: For core consumer price index, Department of Labor, Bureau of
Labor Statistics; for chain-type pnce index. Department of Commerce,
Bureau of Economic Analysis.
expensive crude oil as well as the unexpected shutdown
of some production in the Gulf of Mexico during the
spring.
Food prices have also picked up further this year.
After climbing 4% percent in 2007, the PCE price index
for food and beverages increased at an annual rale of
more lhan 6 percent between December 2007 and May
2008. High grain prices and strong export demand have
been primarily responsible for sizable increases in the
retail prices of poultry, fish, eggs, cereal and bakery
items, fats and oils, and a variety of other prepared
foods. In addition, the index for fruits and vegetables
rose at an annual rate of IVA percent over the first five
months of the year, likely reflecting, in part, higher
input costs. Although world grain production improved
this spring, excessively wet weather and flooding in the
Midwest boosted spot prices for corn and soybeans in
June.
The small decline in core PCE price inflation this
year masked some substantial—but largely offsetting—
crosscurrents. Shelter costs have continued to decelerate
as housing markets have softened farther. In addition, a
moderation in the pace of medical care price increases
has also held down core price inflation ihis year. In contrast, prices of core services besides medical and shelter
costs have increased more rapidly. Similarly prices of
core goods, which declined some in 2007, were about
flat, on net, over the first five months of this year.
More fundamentally, increased slack in labor and
product markets is likely damping price increases this
year. However, a number of other factors are putting
upward pressure on core inflation. Higher prices for
NOTE; Changes arc based on quarterly averages of seasonally afijusied daia.
For (he consumer price index, (tie 2008:Q2 value is calculated as !hc average for
Aprif and May compared with the average for (he second quarter of 2007 and is
expressed at an annual rale.
SOURCE: For chain-type measures. Department of Commerce, Bureau of
Economic Aoaiysis; for fixed-weigtit measures, Department of Labor. Bureau
of Labor Siatisiics.
energy and other industrial commodities continue to
add to the cost of producing a wide variety of goods,
and increases in the prices of non-oil imports have
picked up appreciably. Moreover, inflation expectations,
especially for the near term, have moved up since the
(urn of the year. Probably reflecting the elevated level
of actual headline inflation, the median expectation
for year-ahead inflation in the Reuters/University of
Michigan Surveys of Consumers moved up to aboot
3Yz percent at the end of 2007 and then continued to rise
in 2008; it reached 5.3 percent in the preliminary July
estimate. However, the upward movement in longer-run
inflation expectations has been much less pronounced.
According to the preliminary July result in the Reuters/
University of Michigan survey, median 5- to 10-year
inflation expectations were 3.4 percent for a third
consecutive month, compared with the readings in the
range of 3 percent to V/\ percent that had prevailed for
the preceding few years. Similarly, estimates of 10-year
inflation compensation, as measured by the spreads of
yields on nominal Treasury securities over those on
their inflation-protected counterparts, have moved up
about 20 basis points, on balance, since the turn of the
year. However, most of that increase reflected higher
inflation compensation over the next 5 years; estimates
of inflation compensation 5 to 10 years ahead were up
only 10 basis points by early July. According to the
Survey of Professional Forecasters conducted by the
Federal Reserve Bank of Philadelphia, expectations of
inflation over the next 10 years ticked up in the first
half of 2008, though they remain essentially unchanged
since 1998.
Broader, NIPA-based measures of inflation, which
are available only through the first quarter of this year,
slowed relative to the pace of the past couple of years.
90
Board of Governors of the Federal Reserve System 23
The latest data show a rise in the price index for GDP
less food and energy of about 2 percent over the year
ending in the first quarter, down about 1 percentage
point from the figure for the year ending in the first
quarter of 2007. In addition to a lower reading for core
PCE inflation over the past four quarters, prices for
some other components offinaldemand, especially
construction, decelerated.
Financial Markets
The elevated risk spreads, high volatility, and impaired
functioning that characterized domestic and international financial markets in the second half of 2007 continued through the first half of 2008. Spillovers from the
slumping U.S. housing market were the largest direct
source of Ihese pressures, but a generalized flight from
riskier assets—particularly structured credit products—
and worries about a global economic slowdown also
contributed tofinancialstrains.9 The Federal Reserve
lowered the target federal funds rate an additional
225 basis points over the first four months of 2008 in
response to a deteriorating outlook for economic
activity.
Financial strains increased significantly during the
first quarter, leading (o a liquidity crisis in March at The
Bear Stearns Companies, Inc., a major investment bank,
and to its subsequent acquisition by JPMorgan Chase
& Co. Additional actions taken by the Federal Reserve
to improve market functioning and liquidity, including the introduction of liquidity facilities for primary
dealers, appeared to have an ameliorative effect, and
tensions eased somewhat in the second quarter. (See the
box entitled "The Federal Reserve's Liquidity Operations" on page 26.) Nevertheless, conditions in a broad
range of domestic and international financial markets
remained strained relative to previous years. This
week, the Board of Governors announced a temporary
arrangement that allows the Federal Reserve to extend
credit to Fannie Mae and Freddie Mac, if necessary.
kets in the second half of 2007. Substantial losses on
even the highest-rated structured products based on
subprime mortgages caused market participants to reassess the risks associated with other structured financial
instruments and raised concerns about the exposures of
major financial institutions to these assets. As liquidity
in markets for structured products evaporated, banks
were forced, at least temporarily, to hold more assets
on their balance sheets than they anticipated. In addition, banks' losses on mortgage-related securities and
other assets prompted credit concerns among counterparties. Both of these factors contributed to strains in
bank funding markets. The resulting deleveraging in
the financial sector reduced the availability of credit to
the overall economy. By late 2007, U.S. house prices
had begun to fall, residential investment was contracting sharply, and indicators of overall economic activity
had softened noticeably. These developments induced
investors to pull back from a broader range of financial
assets, leading to impaired liquidity conditions in
many markets, with widened risk spreads and elevated
volatilities.
This market turbulence continued into early 2008,
as liquidity in many financial markets continued to be
impaired and risk spreads remained wide. After declining sharply late last year, issuance of non-agencysponsored mortgage-backed securities essentially
came lo a halt by the beginning of 2008, and secondarymarket trades of these assets were rare. Price indexes
of non-agency-sponsored subprime MBS based on
derivatives markets declined further. However, the
unusual pressures that had been apparent in short-term
Gross issuance of securities backed by alt-A and
subprime mortgage pools, 2002-08
is of dollars, monthly™
Subprtm
Market Functioning and Financial Stability
The deteriorating performance of subprime mortgages
in the United States prompted widespread strains and
turbulence in domestic and internationalfinancialmar-
9. in a structured credit product, ihe credit risk of a portfolio of
underlying exposures is segmented into tranches of varying seniority
and risk exposure.
JLI
2002
2003
1
2004
2005
2006
2007
2008
NOTE: Mongages in alt-A pools are a mix of prime, near-prime, and
subprime mortgages; such loans are typically made to higher-quality
borrowers but have noniraditionai amortization structures or other
nonsiandard features.
SOURCE: Inside MBS & ABS.
91
24 Monetary Policy Report to the Congress U July 2008
Price indexes of subprime mortgage-backed securities based
on credit default swaps, 2007-08
Spreads ofcorporaie bond yields over comparable
off-the-ruti Treasury yields, by securities rating, 1998-2008
A
V*, A
July
2007
July
NOTE: The data are daily and extend through July 9, 2008. The
shown refer to pools of mortgages that were originated in 2006:H2.
SOURCE: Marfcit.
investment-grade funding markets in December eased
considerably in January, owing to a combination of
the passing of year-end balance sheet concerns and the
provision of additional liquidity by the Federal Reserve
and foreign central banks.
In February and March, short- and long-term funding markets came under renewed pressure after reports
of further losses and write-downs at major banks,
broker-dealers, and the government-sponsored enterprises. Fears of a weakening economy exacerbated a
generalized flight from all but the safest assets. Repurchase agreement (repo) market investors exhibited a
LCDX indexes, 2007-08
2007
NOTE: The data are daily and extend through July 9, 2008. Each LCDX
index consists of iOO single-name credit default swaps referencing entities
with first-lien syndicated loans that trade in the secondary market for
leveraged loans. Series 8 began trading on May 22,2007, series 9 on OctobcT
3, 2007, and series 10 on April 8, 2008.
SOURCE: Markit.
_L_._L
L_.L_
1998
2000
2002
2004
2006
1 LJ
2008
NOTE: The data are daily and extend ihrough July 9, 2008. The spreads
shown arc the yields on 10-year bonds less (he 10-year Treasury yield.
SOURCE: Derived from smoothed corporate yield curves using Merrill
Lynch bond daia.
marked preference for Treasury collateral and pushed
rates on Treasury general collateral repos to historical
lows that were well below the target federal funds rate.
As liquidity for MBS not sponsored by the GSEs and
for other private-label asset-backed securities dried up,
the heightened uncertainty regarding values of these
instruments led to an unprecedented increase in the
margin, or "haircut," required on repos based on such
collateral; the interest rate spread on these repos also
rose. Spreads of corporate and GSE bond yields over
yields on comparable-maturity Treasury securities
jumped to multiyear highs. Ratios of yields on municipal bonds to yields on Treasury securities spiked, and
failures were widespread in the auction rate securities
markets for municipal securities, student loans, and other assets. Prices fell in the secondary market for leveraged loans, and implied spreads on indexes of loan-only
credit default swaps, or LCDX, reached record levels
in February. Liquidity was strained in many markets;
for example, in the market for Treasury coupon securities, bid-asked spreads and spreads between yields on
off-the-run and on-the-run securities reached multiyear
highs. Bid-asked spreads in the leveraged loan market
also widened noticeably. The orderly resolution of the
Bear Stearns situation along with the implementation of
the Primary Dealer Credit Facility and the Term Securities Lending Facility in March appeared to reduce
strains in short-term funding markets and to relieve
liquidity pressures more broadly across fixed-income
markets (see the box entitled "The Federal Reserve's
Liquidity Operations" on page 26).
Even though conditions in several markets improved
somewhat after mid-March, pressures in some short-
92
Board of Governors of (he Federal Reserve System 25
Commercial paper, 2005-08
Basis points
Basis poir
150
—_ Spreads
120
—
90
_
GO
—
30
_
0
—
h
f V\
J
A2/P2-rate d
" LJ ^
nonfinancial
aL
j Jf V
[
BiiUonso f dollars
280
—_
240
—_
200
—
160
—
120
—
80
— 150
— 120
__ 9fj
— 60
— 30
— 0
1 |
|
AA-rated
1
assei-backedl H
DtDions of dollars
Ouislandings
— 1,200
—1,100
— 1,000
A
~r
\
__ 900
— 800
^ V
J J S / > ~ V A / Unsecured
nonfinancial
— 700
— 600
—
L
!
!
i
2005
2006
!
2007
f
!
2008
NOTE: The data are weekly and extend through July 9, 2008- Commercial
paper yield spreads are for a 30-day maturity and are expressed relalive to the
AA nonfinanciai rate. Outslandings are seasonally adjusted.
SOURCE: Depository Truss and Clearing Corporation.
term funding markets continued to intensify into April.
Yield spreads rose in April on unsecured financial,
asset-backed, and lower-rated nonfinancial commercial paper, fnterbank term funding pressures, as measured by spreads of term London interbank offered
rates over comparable-maturity overnight index swap
rates, peaked in April but have since moved somewhat
lower, at least for terms of three months and less. The
expansion in May of the Federal Reserve's Term Auction Facility and of the associated swap lines with the
European Central Bank and the Swiss National Bank
appears Jo have contributed to this easing of pressures.
However, for interbank funding at terms greater than
three months, transaction volumes are reportedly low,
and spreads remain high.
In longer-term financial markets, pressures generally eased in April and May. Spreads of conforming
mortgage rates and corporate bond yields over yields
on comparable-maturity Treasury securities narrowed,
and prices and liquidity in the secondary market for
leveraged loans increased. However, yield spreads for
corporate bonds and mortgages moved higher in June.
Equity prices offinancialintermediaries, including the
housing-related GSEs, Fannie Mae and Freddie Mac,
dropped sharply in June and early July as concerns
mounted both about their losses and longer-term profitability and about the prospects for earnings dilution
given the considerable new capital that may need to be
raised. Overall, indicators of financial market strains
remain elevated compared with their levels in previous
years.
Debt and Financial Intermediation
The total debt of the domestic nonfinancial sector
expanded at an annual rate of 6M> percent in the first
quarter of 2008, a somewhat slower pace than in 2007.
One-month Libor minus overnight index swap rale, 2007-08
Change in total domestic nonfinancial debt, 1991-2008
Apr.
2008
July
NOTE: The daia are daily and extend through July 10, 2008. An overnight
index swap (OIS) is an interest rate swap with the floating rate tied to an
index of daily overnight rates, such as ihe effective federal funds rate. At
matunryj two parties exchange, on the basts of the agreed notional amount,
the difference between interest accrued at ihe fixed rate and interest accrued
by averaging the floating, or index., rate. Libor is the London interbank
offered rate.
SOURCE: For Libor, British Bankers' Association; for the OIS rate, Prebon.
i
I....J i_J_J
1992 1994 1996 1998 20O0 2002 2004 2006 2008
NOTE: The data extend through 2OO8:Q1. Through 2007, ihe data e
annual and are computed by dividing (he annual flow for a given year by t
level at the end of the preceding year; the final observation refers to 2008:(
at an1 annual
annual rate.
rate.
SOURCE: Federal R
sard, flow o f funds data.
93
26
Monetary Policy Report to the Congress • July 2008
The Federal Reserve's Liquidity Operations
In response to serious financial strains, the Federal Reserve has taken a number of steps since
August 2007 to enhance liquidity and foster the
improved functioning of financial markets and
ihereby promote its dual objectives of maximum
employment and price stability.
The Federal Reserve eased the terms of access
for borrowing by depository institutions under
the regular primary credit program, or discount
window. The spread of the primary credit rate
over the target federal funds rate was narrowed
from 100 basis points to 50 basis points in
August 2007 and to 25 basis points in March.
The maximum loan term was extended to 30
days in August 2007 and to 90 days in March;
institutions have the option to renew term loans
so long as they remain in sound financial condition. Over time, more institutions have used the
discount window, and the more accommodative
terms for borrowing at the window have reportedly improved confidence by assuring depository institutions that backstop liquidity wiS! be
available should they need it.
!n December 2007, ihe Federal Reserve
introduced the Term Auction Facility {TAF),
through which predetermined amounts of discount window credit are auctioned every two
weeks to eligible borrowers for terms of about
one month. In effect, TAF auctions are similar
to open market operations but are conducted
with depository institutions raiher than primary
dealers and against a much broader range of collaieral than is accepted in standard open market
operations. The TAF appears to have overcome
the reluctance to borrow associated with standard discount window lending because of its
competitive auction format, the certainty that
a large amount of credit would be made available, and the fact that it is no! designed to meet:
urgeni funding needs. Indeed, a large number
of banks—ranging at various poinis in time from
around 50 to more than 90—have participated
in each of the 16 auctions held thus far. The size
of individual TAF auctions was raised in several
sleps from an initial level of $20 billion at inception last December to $75 biilion most recently;
ihe amounl of TAF credit currently outstanding is
$150 billion.
in conjunction with the introduction of the
TAF, the Federal Reserve also established swap
lines with the European Central Bank and the
Swiss National Bank to provide dollar funds to
facilitate dollar lending by those central banks
to banks in their jurisdictions. These swap lines
have been enlarged over time and currently
stand at $50 billion with the European Central
Bank and $ 12 billion with the Swiss National
Bank.
In response to the unprecedented pressures in
short-term repurchase agreement (repo) markets
earlier this year, the Federal Reserve initiated
a special program of 28-day term repurchase
agreements; $80 billion of such agreements are
currently outstanding. These agreements were
designed to enhance the ability of primary dealers to obtain term funding for any assets that
are eligible as collateral in conventional open
market operations. Also, on March 11, the Federal Reserve announced plans to create the Term
Securities Lending Facility {TSLF}, in which the
Federal Reserve lends Treasury securities held in
its portfolio at auction against the collateral of
high-grade securities held by dealers. In addition to conventional open market operation
collateral—Treasury securities, agency securities,
and agency-sponsored morlgage-backed securities (MBS)—the Federal Reserve now accepts
AAA-rated residential MBS, commercial MBS,
and other asset-backed securities as collateral at
the TSLF. The Federal Reserve sets a minimum
(conlinued on nexl page!
The moderation in borrowing was mainly accounted
for by a slowdown in the growth of household debt,
particularly mortgage debt. Borrowing by nonfinancial
businesses also decelerated, but at a 9'A percent pace, it
was still high by historical standards. Preliminary data
suggest that overall debt growth slowed further in the
second quarter.
Commercial bank credit increased at an annual
rate of 4% percent in the first half of 2008, down significantly from the IO1A percent expansion registered
in 2007.i0 Commercial and industrial loans decelerated
sharply after growing at an annual rate of more than
25 percent in the fourth quarter of 2007. The surge in
C&I loans late last year reportedly reflected, in part, the
difficulties that banks faced in selling syndicated loans
to nonbank investors; as a result, banks had to fund a
10. The growih rate of hank credit in 2007 has been adjusted to
remove ifie effects of [he conversion of a large commercial bank (o a
thrift instiluiion.
94
Board of Governors of the Federal Reserve System
(coniinuecf from preceding page)
bid rate for each TSLF auction. Bids submitted
at most TSLF auctions have fallen short of the
announced auction quantities. Nevertheless,
market participants have indicated that the TSLF
has contributed to improved functioning in repo
markets.
Pressures in short-term funding markets
worsened sharply in mid-March. On March 13,
The Bear Stearns Companies, Inc., a prominent
investment bank and primary dealer, advised
the Federal Reserve and other government agencies that its liquidity position had deteriorated
significantly and that it would be forced to file
for bankruptcy the next day unless alternative
sources of funds became available. A bankruptcy filing would have forced the secured
creditors and counterparties of Bear Stearns to
liquidate the underlying collateral, and given
the iliiquidity of markets, those creditors and
counterparties might, well have sustained substantial losses, if they had responded to losses or
the unexpected iliiquidity of 1 heir holdings by
pulling back from providing secured financing
to other firms and by dumping large volumes of
illiquid assets on the market, a much broader
financial crisis likely would have ensued with
consequent harm to the overall economy. !n
such circumstances, the Federal Reserve Board
judged that it was appropriate !o use its emergency lending authorities under the Federal
Reserve Act to avoid a disorderly closure of Bear
Stearns. Accordingly, the Federal Reserve, after
discussions with the Securities and Exchange
Commission and in close consultation with the
Treasury, agreed to provide short-term funding
to Bear Stearns through JPMorgan Chase & Co.
Over the following weekend, JPMorgan Chase
agreed to purchase Bear Stearns and assume the
company's financial obligations. The Federal
Reserve, again in close consultation with the
number of previously committed large syndicated deals
on (heir balance sheets. In the first quarter of 2008,
C&I loans grew at a lower but still quite fast rate of
16'/4 percent, with part of the strength reportedly due to
increased utilization of existing credit lines, the pricing
of which reflected previous lending practices. In the
second quarter, C&I lending moderated significantly
further, a pattern consistent with reports from the April
Senior Loan Officer Opinion Survey, which indicated
a further tightening of credit standards and terms and
Treasury, agreed to supply term funding, secured
by $30 billion in Bear Stearns assets, to facilitate
the purchase. JPMorgan Chase completed the
acquisition of Bear Stearns on June 26, and the
Federal Reserve extended approximately $29 billion of funding on that date.
In a further effort to prevent a possible downward spiral in financial markets, the Federal
Reserve also used its emergency authorities to
create the Primary Dealer Credit Facility (PDCF)
in mid-March. The PDCF allows primary dealers
to borrow at the discount window against collateral that includes a broad range of investmentgrade securities. In effect, the PDCF provides primary dealers with a liquidity backstop similar to
(he discount window that is available to depository institutions.
These liquidity measures appear to have contributed to some improvement in financial markets since iate March.
Over recent days, the share prices of Fannie
Mae and Freddie Mac dropped sharply on investor concerns about their financial condition and
capital position. The Treasury announced a legislative initiative to bolster the capital, access to
liquidity, and regulatory oversighi of the government-sponsored enterprises (GSEs). A5 a supplement to the Treasury's existing authority to lend
to the GSEs, the Board of Governors established
a temporary arrangement that allows the Federa! Reserve to extend credit to Fannie Mae and
Freddie Mac, if necessary. In establishing this
arrangement, the Board exercised its authority
under section 13(13) of the Federal Reserve Act.
Credit under this arrangement will be extended
at the primary credit rate and secured by government and federal agency securities.
weakening of demand for C&I loans. Commercial real
estate loans grew at an annual rate of about 9% percent
in the first half of 2008, only slightly slower than their
pace in 2007.
After contracting sharply in the final quarter of
2007, the outstanding stock of residential mortgages at
commercial banks rose V/z percent in the first quarter,
in part because of a sluggish pace of securitization. In
the second quarter, however, banks1 holdings of residential mortgage loans fell again, a pattern consistent
27
95
28 Monetary Policy Report to the Congress D July 2008
Commercial bank profitability, 1988-2008
.5 —
The overall delinquency rate on loans held by commercial banks rose in the first quarter to its highest level
since the early 1990s, and the charge-off rate increased
to the upper end of its range since 2000. The deterioration in credit quality was accounted for primarily by
continued erosion in the performance of residential
mortgages and a considerable worsening in construction
and land development loans, but performance of most
other types of loans also weakened. To bolster equity
positions diminished by asset write-downs and loanloss provisions, commercial banks raised a substantial
volume of capital in the first half of 2008; some banks
reduced dividends to further shore up their capital.
,
I I I U_I_LJ_J_U_ULL.
1990
1993 1996 1999 2002
NOTE: The data extend through 20O8:QL The data are annual through
2007; the final observation refers to 2O08:Ql at an annual rate.
SOURCE: Federal Financial Institutions Examination Council, Consolidated
Reports of Condition and Income (Call Report).
with the ongoing weakness in the housing market and
the reduced availability of mortgage credit. Growth of
home equity lines of credit picked up significantly in
the first half of 2008, likely because of the decline in
short-term market rates to which such loans are generally tied. However, commercial banks have taken steps
to limit their exposure to these loans; according to the
April Senior Loan Officer Opinion Survey, a significant
portion of respondents indicated that they had tightened
their credit standards for approving new applications
for home equity lines of credit, and a notable proportion reported that they had also firmed lending terms
on existing lines, mainly in response to declines in
property values. Despite the reported tightening of
credit conditions in the household sector, consumer
loans grew at a moderate pace in the first half of
2008.
Profitability of the commercial banking sector
improved somewhat in the first quarter of 2008 but
remained well below the levels seen before the summer
of 2007. Many large banks received a significant boost
to their first-quarter profits as a result of their stakes in
Visa—the initial public offering of which occurred in
March. However, continued write-downs of mortgagerelated assets and leveraged loans, along with increasing loan-loss provisions, held profits down in the first
quarter. Concerns about recent and potential losses have
weighed heavily on bank stock prices this year. The
median spread on credit default swaps on the senior
debt of major banks climbed from 50 basis points at
the end of 2007 to more than 100 basis points in midMarch. After declining noticeably in April and May, it
returned close to the March peak in late June.
Equity Markets
Overall, share prices have dropped about 15 percent
from the end of 2007. The declines were led by the
financial sector, especially depository institutions and
broker-dealers, which fell 37 percent and 41 percent, on
average, respectively. The energy and basic materials
sectors avoided the downtrend and have changed little
on net.
Actual and implied volatilities of broad equity price
indexes shot up last year with the onset of financial
strains. The partial easing of financial strains in the
second quarter was associated with modest declines
in the actual and implied volatilities of equity prices
to levels still above those of the past few years. The
12-month-forward expected earnings-price ratio for
S&P 500firmsjumped in the first half of 2008, while
the long-term real Treasury yield rose only slightly. The
difference between these two values- a rough measure
of the premium that investors require for holding equity
Stock price indexes, 1995-2008
January J, 201)5 -
—
140
-
120
Wilsh ire 5000
/" "I
—
-
rwyf
v V—
100
KJ
80
—
—
_
60
Dow Jones firlancia! i ndex
40
—
LJ
too
20
L L
1996
L_j L
! 998
2000
I 1
2002
1 1
2004
! !
2006
NOTE; The data are daiiy and extend through Juiy 9, 2008.
SOURCE: Dow Jones indexes.
1 1 1
2008
96
Board of Governors of the Federal Reserve System
Implied SAP 500 volatility, 1995-2008
i 996
1998
J
2000
L
2002
2004
29
Interest rates on selected Treasury securities, 2003-0
2006
2008
NOTE: The data art weekly and extend through the week ending July 11,
2008- The final observation is an estimate based on daia through July 9, 3008.
The series shown the VEX—is ihe implied 30-day volatility of the S&P 500
stock price index as calculated from a weighted average of opt ions prices.
SOURCE: Chicago Board Options Exchange,
shares—has reached the high end of its range over the
past 20 years.
Policy Expectations and Interest Rates
The current target for the federal funds rate, at 2 percent, is substantially below the level that investors
expected as of late December 2007. According to
futures quotes at that time, market participants expected
that the federal funds rate would be around 3'A percent
by July. Looking forward, however, investors now
expect that the next policy move will be up, and a small
degree of tightening has heen priced in by the end of
2008. Measures of uncertainty about the path of policy
rose with the onset of financial turbulence last year and
are currently near the high end of their range over the
past 10 years.
Treasury yields fell sharply from the end of 2007
through March amid concerns about the health of financial firms, severe strains in financial markets, a weakening economic outlook, and lower expectations for future
policy rates. Since late March, yields have risen across
the curve as fears of a deep economic contraction have
receded and concerns about the inflation outlook have
increased. On net, 2-year yields are down 65 basis
points, and 10-year yields are down 20 basis points
since the start of the year.
Yields on Treasury inflation-protected securities
largely moved in line with nominal yields—that is, they
fell through mid-March and then rose—but the rise
since March has been somewhat less than that of nominal yields. In addition, shifting liquidity conditions in
NOTK: The data are daily and extend through July 9,2008.
SOURCE: Department of the Treasury.
the markets for nominal and indexed Treasury securities at times affected the spreads between nominal and
indexed yields, also known as inflation compensation.
On net, 10-year inflation compensation has risen about
20 basis points since the end of 2007, suggesting some
increase in investors' concerns about the inflation outlook. Inflation compensation rose over both the near
term and the longer term, but the increase was larger
over the near term, as compensation over the next
5 years rose about 30 basis points whereas compensation over the period from 5 years ahead to 10 years
ahead rose only 10 basis points. In part because of a lag
in the indexation of inflation-protected securities, nearterm inflation compensation can be strongly affected by
TIPS-based inflation compensation, 2003-08
r \l
2003
2004
2005
2006
20OT
2008
NOTt: The data are daily and extend through July 9, 2008 Based on a
comparison of the yield curve for Treasury inflation-prolected securities
(TIPS) with the nominal ofT-the-xun Treasury yield curve.
Sot'RtT: Federal Reserve Board calculations based on data provided by the
Federal Reserve Bank of New York and Barclays.
97
30 Monetary Policy Report to the Congress D July 2008
M2 growth rate, 1991-2008
1 l
I i i I i
(992 1994 1996 199S 2000 2002 2004 2006 2008
NOTE: The data extend through 2OO8:Q1 and are estimated for 2008:Q2.
Through 2007, the data are annual on a fourth-quarter over fourth-quarter
basis; the final observation refers to 2OQ8:Q2 relative to 2007:Q4 at an annual
rate. M2 consists of currency, traveler's checks, demand deposits, other
checkable deposits, savings deposits (including money market deposit
accounts), small-denominaSion time deposits, and balances in retail money
market funds.
SOURCE: Federal Reserve Board, Statistical Release H.6, "Money Stock
Measures."
the latest movements in energy and food prices; these
prices have risen sharply in recent months.
Money and Reserves
M2 is estimated to have expanded at an annual rate of
7% percent over the first half of 2008, notably faster
thau the likely growth rate of nominal GDP. Demand
for money balances was supported by declines in the
opportunity cos( of holding money relative to other
financial assets and by strong demand for safe and
liquid assets amid volatility and strains in financial
markets. Money market mutual fund shares grew particularly rapidly in the first quarter. However, growth
of money market mutual funds dropped considerably in
the second quarter, and small time deposits contracted;
M2 slowed accordingly. Demand for currency continued to be lackluster for the most of the first half-year,
but H picked up noticeably late in the second quarter as
domestic demand grew and foreign demand was estimated to be less weak.
The strains in bank funding markets over recent
months have posed challenges for the implementation
of monetary policy. Banks generally have seemed more
cautious in their activity in the federal funds market
and less willing to take advantage of potential arbitrage
opportunities in that market over the course of a day
and across the days of a reserve maintenance period.
In this environment, the Open Market Desk's decisions
regarding the appropriate quantity of reserves to be supplied each day through open market operations have
been complicated, and volatility in the federal funds
rate has been elevated. The authority to pay interest on
reserves could be helpful to the Federal Reserve in limiting the volatility in the federal funds rate. The ability
to pay interest on reserves would also allow the Federal
Reserve to manage its balance sheet more efficiently
in circumstances in which promoting financial stability required the provision of substantial amounts of
discount window credit to the financial sector. In light
of these considerations, the Federal Reserve has asked
the Congress to accelerate the effective date of statutory
authority to pay interest on reserve balances, which is
currently October 2011.
International Developments
International Financial Markets
Global financial markets remained distressed over the
first half of 2008, primarily because of concerns about
weakness in real estate and slowing global economic
growth. Amid heightened market turbulence in March,
the European Central Bank (ECB), Bank of England,
Bank of Canada, and Swiss National Bank (SNB)
announced a further set of joint actions with the Federal
Reserve to help improve the functioning of short-term
funding markets. The Federal Open Market Committee
increased its temporary swap line to the ECB in March
from $20 billion to $30 billion and its line to the SNB
from $4 billion to $6 billion. In May, these amounts
were increased Further to $50 billion and $12 billion,
respectively, and the lines were extended through January 2009. Meanwhile, the Bank of England and the
Bank of Canada each introduced new term funding
arrangements in their domestic currencies, and the Bank
of England also established a facility to swap government bonds for banks' mortgage-backed securities for a
term of one to three years. The ECB has also continued
to offer longer-term funding in euros, auctioning threemonth funds totaling €270 billion in the first quarter
and €250 billion in the second quarter and adding a
new long-term refinancing operation with a six-month
maturity.
Market volatility has persisted in recent months,
with ongoing concerns about the balance sheets of
financial institutions. Since the middle of last year,
European banks have announced about $200 billion in
write-downs—largely as a result of indirect exposure
to U.S. credit markets through both sponsorship of and
investments in structured credit products—and further
98
Board of Go vernors of the Federal Reserve System
Equity indexes in selected advanced foreign economies,
2007-08
31
Equity indexes in selected emerging market economies,
2007-08
December 3), 2007 = !00
December M, 2007 » 100
130
120
110
80
70
60
I ,...
Jan.
Ncr ; The
2008. Because the Tokyo Exchange was closed on December 31, 2007, she
Japan index is staled so that the December 28, 2007, closing value equals
100.
SOURCE: For euro area, Dow Jones Euro STOXX Index; for Canada,
Toronto Stock Exchange 300 Composite Index; for Japan, Tokyo Stock
Exchange (TOP5X); and for me United Kingdom, London Slock Exchange
(FTSr< 350), as reported by Bloomberg.
losses may be recognized in second-quarter financial
statements. In addition, mortgage lenders in the
United Kingdom have been affected by weakness in
property prices there and by reduced access to capital
market funding. In general, the institutions that have
recognized significant losses have taken prompt
steps to replenish capital from a variety of sources;
more ihan $140 billion had been raised by the end of
June.
Yields on benchmark government bonds in selected
advanced foreign economies, 2007-08
Ncre: The data, which arc for 10-year bonds, are daily. The .
observation for each series is July 9, 2008.
SOURCE: Bloomberg.
July
2007
.....1 .,.,
Jan.
Apr.
2008
2008. Because the Shanghai Stock Exchange was closed on December 3 i,
2007, ihc China index is scaled so that the December 28, 2007, closing value
equals 100. The Latin American economies are Argentina, Brazil, Chile,
Colombia, Mexico, and Peru. The emerging Asian economies are China,
india, Indonesia, Malaysia, Pakistan, the Philippines, South Korea, Taiwan,
and Thailand.
SOURCE: For Latin America and emerging Asia, Morgan Stanley Capital
international (MSCI) index; for China, Shanghai Composite Index, as
reported by Bloomberg.
On net, most major equity indexes in the advanced
foreign economies stand 12 percent to 25 percent lower
in local currency terms compared with the end of 2007,
European stock indexes were led lower by ihe stock
prices offinancialfirms,which declined 34 percent
(measured in euros); Japanese financial stocks are down
9 percent on the year. The financial turbulence has had
less impact on Latin American stock prices. Equity
indexes in Mexico and Brazil were virtually unchanged,
on balance, over Ihe first half of 2008. However, Chinese stock prices have tumbled 44 percent since the end
of 2007, virtually erasing last year's gains, and other
major emerging Asian equity indexes are also down, but
to a lesser extent.
Liquidity in European government bond markets
was impaired in March but seems to have improved in
recent months. Long-term bond yields in the advanced
foreign economies fell in the first quarter but have more
than reversed these declines as investors no longer
expect the ECB and the Bank of England to ease their
policy rates. Since the end of 2007, long-term rates
have risen, on net, 11 basis points in Germany, 38 basis
points in the United Kingdom, and 12 basis points in
Japan, and nominal yield curves have flattened. Meanwhile, implied long-term inflation compensation has
increased 10 basis points in Japan and nearly 30 basis
points in Germany and Canada.
99
32 Monetary Policy Report to the Congress D July 2008
Change in consumer prices for major foreign economies,
2004-08
U.S. dollar nominal exchange rate, broad index, 2001-0
December .31,2007 « 100
105
100
95
90
J
2001
!
2002
1
2003
2004
I
I
2005
J.
2006
J
2007
1J
2008
NOTE: The daia, which are in foreign currency units per dollar, are daily.
The last observation for ihe series is July 9, 2008. The broad index is a
weighted average of the foreign exchange values of the U.S. dollar against
ihe currencies of a large group of ihe most important U.S. trading partners.
The index weights, which change over lime, are derived from U.S. export
shares and from U.S. and foreign import shares.
SOURCE: Federal Reserve Board.
The Federal Reserve's broadest measure of the nominal trade-weighted foreign exchange value of the dollar
has declined about 3 percent, on net, since the end of
last year. Over the same period, the major currencies
index of the dollar has also declined about 3 percent.
The dollar depreciated sharply against the euro and the
yen in February and March but has recovered some
in recent months. On net thus far this year, the dollar
is down about 4 percent against the yen and 7 percent
against the euro. The dollar is 2 percent higher against
the Canadian dollar and slightly higher against sterling.
U.S. dollar exchange rate against
selected major currencies, 2007-08
December 31,200?" 100
inly
2007
NOTE: The data, which are in foreign currency u
The last observation for each series is July 9, 2008.
SOURCE: Bloomberg.
NOTE: The dais are monthly, and cl
extend through May 2008.
SOURCE: Haver.
The dollar has declined 6 percent against the Chinese
renminbi since the end of 2007.
Advanced Foreign Economies
Economic growth in the major advanced foreign
economies appears to have slowed somewhat this year.
Although both the euro area and Japan posted strong
6rst-quarter GDP growth rates, recent monthly indicators have been more subdued. In other countries,
growth rates declined in the first quarter, and firstquarter real GDP even contracted slightly in Canada,
where trade and financial ties to the United States are
strong. Surveys of banks in Europe show a further
tightening of credit standards in the first half of 2008
for both households and businesses. Lending to businesses appears to have remained solid, but household
borrowing has slowed. Housing markets in a number
of countries—including Ireland, Spain, and the United
Kingdom—have continued to soften.
Since the beginning of the year, headline rates of
inflation have continued to move up, on balance, in
most economies, mainly because of increasing prices
for food and energy. The 12-month change in consumer
prices in both the euro area and the United Kingdom
increased further from January to mid-2008, while core
inflation rates (which exclude the changes in the prices
of energy and unprocessed food) have increased much
less. In Canada, where food price increases have been
muted, inflation is little changed, on balance, since the
beginning of the year but has risen in the past couple
of months. Japanese consumer prices arc roughly
100
Board of Governors of the Federal Reserve System
Official or targeted interest rates in selected
advanced foreign economies, 2004-08
_
6
_
5
—
3
—
2
_~ X
— o
2004
_!._
2005
2006
2007
2008
NOTE: The data are daily and extend through July 9, 2008. The daia shown
are, for Canada, the overnight rate; for the euro area, the minimum hid rate on
main refinancing operations; for Japan, the call money rale; and, for ihe
United Kingdom,
Kingdom, the
the official
official ban
bank rate paid on commercial reserves,
United
"
- ' "The
• - central bank of' e '
or country shown.
SOURCE:
unchanged on a 12-month basis when both food and
energy prices are excluded.
Over the first half of this year, the focus of the major
foreign central banks appears to have shifted somewhat
from the impact of financial market strains on growth to
the effect of higher commodity prices on inflation. After
initially lowering official interest rates, the Bank of
Canada and the Bank of England have held their target
rates steady since April, and me Bank of Japan has kept
its policy rate unchanged at 0.5 percent all year. Recent
inflation rates and statements from all of these central
banks have led market participants to expect policy
rates to increase slightly or to remain on hold. On
July 3, the ECB raised its policy rate 25 basis points,
to 4.25 percent, but it hinted that further rate hikes were
not in the offing.
Emerging Market Economies
Recent data suggest that real GDP growth in China
remained strong in the first half of this year. Although
33
export growth slowed, domestic demand appears to
have accelerated.
Elsewhere in emerging Asia, recent performance has
varied but, on balance, indicators suggest that activity
has remained solid in the region. In the first quarter,
real GDP growth moderated in Korea, Malaysia, and
Thailand but was strong in Hong Kong and Singapore.
Exports of the region have generally slowed along
with the deceleration in global economic activity;
however, domestic demand slrengthened in a number
of countries.
Economic activity has decelerated in Lalin America.
In Mexico, output growth slowed to about 2 percent in
the first quarter, in line with the step-down in the pace
of activity in the United States that began toward the
end of last year. In other Latin American countries,
notably Brazil and Venezuela, growth also moderated.
Higher prices for food and energy have continued
to exert upward pressures on inflation across emerging market economies. In China, headline inflation has
risen, reaching roughly 8 percent in recent months.
In response to the inflationary pressures, (he Chinese
authorities have allowed ihe renminbi to appreciate
at a more rapid pace, and the People's Bank of China
has further tightened monetary policy. The Bank has
raised the required reserve ratio five times this year by
a total of 300 basis points, to 17% percent. Elsewhere
in emerging market economies, 12-month headline
inflation in a number of countries continued to rise in
recent months, thereby prompting many central banks
to tighten monetary policy. In some cases, governments
also instituted export restrictions or reduced import
duties for some food products. The rising cost of energy
subsidies has led governments in China, India, Malaysia, Indonesia, and Taiwan to raise administered gasoline prices roughly 10 percent to 40 percent in recent
months.
101
Part3
Monetary Policy over the First Half of 2008
After casing ihe stance of monetary policy 100 basis
points over the second half of 2007, the Federal Open
Market Committee (FOMC) lowered the target federal
funds rate 225 basis points further in the firs! half of
2008." The Federal Reserve also took a number of additional actions to increase liquidity and to improve the
functioning offinancialmarkets.
In a conference call on January 9, the Committee
reviewed recent economic data and financial market developments. The information, which included
weaker-than-expected data on home sales and employment for December as well as a sharp decline in equity
prices since the beginning of the year, suggested that
the downside risks to growth had increased significantly
since the lime of the December FOMC meeting. Participants cited concerns that the slowing of economic
growth could lead to a further tightening of financial
conditions, which in turn could reinforce the economic
slowdown. However, core inflation had edged up in
recent months, and considerable uncertainty surrounded
the inflation outlook. On balance, participants were
1 i. Members of the FOMC in 2008 consist of members of Ihe
Board of Governors of (tie Federal Reserve System plus the presidents
of the Federal Reserve Banks of Cleveland, Dallas. Minneapolis, New
York, and Philadelphia. Participants at FOMC meetings consist of
members of Ihe Board of Governors and all Reserve Bank presidents.
generally of the view that substantial additional policy
easing might well be necessary to support economic
activity and reduce the downside risks to growth, and
they discussed the possible timing of such actions.
On January 21, the Commiltee held another conference call. Strains in some financial markets had
intensified, and incoming evidence had reinforced the
view that the outlook for economic activity was weak.
Participants observed that investors apparently were
becoming increasingly concerned about the economic
outlook and downside risks to activity and that these
developments could lead to an excessive pullback in
credit availability. In light of these developments, all
members judged that a substantial easing in policy was
appropriate to foster moderate economic growth and
reduce the downside risks to economic activity. The
Committee decided to lower Ihe target for the federal
funds rate 75 basis points, to 3Vi percent, and judged
that appreciable downside risks to growth remained.
Although inflation was expected to edge lower over
the course of 2008, participants underscored their view
that this assessment was conditioned upon inflation
expectations remaining well anchored and stressed that
the inflation situation should continue to be monitored
carefully.
The data reviewed at the regularly scheduled FOMC
meeting on January 29 and 30 confirmed a sharp decel-
Selected interest rates, 2 0 0 5 - 0
NoTfc: The data are daily and entend through July 9, 2008. The 10-year Treasury rate is
The dales on the horizontal axis are those of regularly scheduled Federal Open Market Co
SOURCE: Department of the Treasury and tfie Federal Reserve.
aturity yield based on fhe n
35
102
36 Monetary Policy Report to the Congress • July 2008
eration in economic growth during the fourth quarter of
2007 and a continued tightening of financial conditions.
With the contraction in the housing sector intensifying and a range of financial markets remaining under
pressure, economic growth was expected to stay soft in
the first half of 2008 before picking up strength in the
second half. However, the ongoing weaknesses in home
sales and house prices, as well as the tightening of credit conditions for households and businesses, were seen
as posing downside risks to the near-term outlook for
economic growth. Moreover, the potential for adverse
feedback between the financial markets and the economy was a significant risk. Participants expressed some
concern about the disappointing inflation data received
over the latter part of 2007. Although many expected
that a leveling-out of prices for energy and other commodities, such as that embedded in futures markets,
and a period of below-trend growth would contribute
to some moderation in inflation pressures over time,
the Committee believed that it remained necessary to
monitor inflation developments carefully. Agaiost that
backdrop, the FOMC decided to lower the target for
the federal funds rate 50 basis points, to 3 percent. The
Committee believed that this policy action, comhined
with those taken earlier, would help promote moderate
growth over time and mitigate the risks to economic
activity. However, members judged that downside risks
to growth remained.
In a conference call on March 10, the Committee
reviewed financial market developments and considered
proposals aimed at supporting the liquidity and orderly
functioning of those markets. In light of the sharp
deterioration of some key money and credit markets,
the Committee approved the establishment of the Term
Securities Lending Facility, under which primary dealers would be able to borrow Treasury securities from
the System Open Market Account for a term of approximately one month against any collateral eligible for
open market operations and the highest-quality private
residential mortgage-backed securities (MBS)." The
new facility was designed to alleviate pressures in
the financing markets for securities. Iu addition,
the Committee agreed to expand the existing reciprocal currency agreements with the European Central
Bank and the Swiss National Bank to $30 billion and
$6 billion, respectively, and to extend the terms of these
agreements through September 2008. Over the next few
days, financial market strains intensified further. On
March 16, the Federal Reserve announced emergency
measures to bolster liquidity and promote orderly func12. By notation vole completed on March 20, AAA-rateli commercial MBS were added to (he list of acceptable collateral.
tioning in financial markets, including the approval of
the financing arrangement associated with the acquisition of The Bear Stearns Companies, Inc., by JPMorgan
Chase & Co. and the establishment of the Primary
Dealer Credit Facility to improve the ability of primary
dealers to provide financing to participants in securitization markets. In addition, the primary credit rate was
lowered 25 basis points, and the maximum term of primary credit loans was extended to 90 days.
When the Committee met on March 18, financial
markets continued to be under great stress, particularly
the markets for short-term collateralized and uncollateralized funding. Spreads on interbank loans and lowerrated commercial paper had widened over the intermeeting period, and obtaining credit through repurchase
agreements hacked by agency and private-label MBS
had become more difficult amid reports of increased
margin, or "haircuts," being required by lenders. Yields
on Treasury bills and repurchase agreements backed by
Treasury securities had plummeted, reflecting investors'
heightened demand for the safest assets.
Participants at the March 18 FOMC meeting noted
that prospects for both economic activity and near-term
inflation had deteriorated since January, and many
thought that some contraction in economic activity in
the first half of 2008 was likely. Although the economy
was expected to recover in the second half and to grow
further in 2009, considerable uncertainty surrounded
this forecast. Some participants expressed concern
that falling house prices and financial market stress
might lead to a more severe and protracted downturn
than anticipated. Recent readings on inflation had been
elevated, and some indicators of inflation expectations
had risen. However, aflattening-outof prices for oil and
other commodities—as implied by futures prices—and
the projected easing of pressures on resources were
expected to contribute to some moderation in inflation.
All in all, most members judged that a 75 basis point
reduction in (he target federal funds rate, to 2'A percent,
was appropriate to address the combination of risks of
slowing economic growth, inflationary pressures, and
financial market disruptions. In its statement, the Committee highlighted the further weakening in the outlook
for economic activity, but it also emphasized the importance of monitoring inflation developments carefully.
The data reviewed at the meeting on April 29 and
30 indicated that economic growth had been weak in
the first three months of 2008 and that core consumer
price inflation had slowed, but that overall inflation had
remained elevated. FOMC participants indicated that
these developments had been broadly consistent with
their expectations. Conditions across a number of financial markets were judged to have improved since the
103
Board of Governors of the Federal Reserve System
March meeting, but financial markets remained under
considerable stress. Although the likelihood that economic activity would be severely disrupted by a sharp
deterioration in financial markets had apparently receded, most participants thought that the risks to economic
growth were still skewed to the downside. All participants expressed concern about upside risks to inflation
posed by rising commodity prices and the depreciation of the dollar, but some participants noted that the
downside risks to economic activity also implied that
there were downside risks to price pressures as well.
Participants expressed significant uncertainty concerning the appropriate stance of monetary policy in these
circumstances. Some participants noted that the level
of the federal funds target, especially when compared
with the current rate of inflation, was relatively low by
historical standards. Others noted that financial market
strains and elevated risk spreads had offset much of the
effects of policy easing on the cost of credit to borrowers. On balance, most members agreed that the target
for the federal funds rate should be lowered 25 basis
points, to 2 percent. The Committee expected that the
policy easing would help to foster moderate growth
over time without impeding a moderation in inflation.
The Committee agreed that, in light of the substantial
policy easing to date and the ongoing measures to foster
financial market liquidity, the risks to growth were now
more closely balanced by the risks to inflation.
In view of persisting strains in funding markets, the
FOMC also approved proposals to expand the liquidity arrangements that had been put in place in previous
months. The reciprocal currency agreements with the
European Central Bank and Swiss National Bank were
increased to $50 billion and $12 billion, respectively,
and both were extended through January 2009. The collateral accepted by the Term Securities Lending Facility
37
was expanded to include ail AAA-rated asset-backed
securities. In addition. Chairman Bernanke announced
his intention to expand the Term Auction Facility to
$150 billion under authority previously delegated by
the Board of Governors.
At the time of the meeting held June 24 and 25, the
available indicators suggested that economic activity
in the first half of the year had not been as weak as had
been expected in April. Nevertheless, several factors
were viewed as likely to restrain activity in the near
term, including the contraction in the housing sector, sharply higher energy prices, and continued tight
credit conditions. Although financial market conditions
generally appeared to have improved modestly since
the April meeting, participants noted that the potential
for adverse financial market developments still posed
significant downside risks to economic activity. The
further large increase in energy prices also prompted
an upward revision of projections for overall inflation
in the second half of 2008. Most participants expected
that a leveling-out of energy prices and continued slack
in resonrce utilization would lead inflation to moderate
in 2009 and 2010, but tbe persistent tendency in recent
years for commodity prices to exceed the trajectory
implied by futures market prices engendered considerable uncertainty around tbe projected moderation of
inflation. Memhers generally agreed that the downside
risks to growth had eased somewhat since the previous FOMC meeting while the upside risks to inflation
had intensified. Against this backdrop, most members
judged that maintaining the current stance of policy at
this meeting represented an appropriate balancing of the
risks to the economic outlook. Nonetheless, policymakers recognized that circumstances could change quickly
and noted that they might need to respond promptly to
incoming information about the evolution of risks.
104
Part 4
Summary of Economic Projections
The following material appears as an addendum to the
minutes of the June 24-25, 2008, meeting of the Federal
Open Market Committee.
Table I. Economic projections of Federal Reserve Governors
and Reserve Bank presidents, June 2008
Percent
Variable
2009
2010
Cenrral tendency'
In conjunction with the June 2008 FOMC meeting, the
members of the Board of Governors and the presidents
of the Federal Reserve Banks, ail of whom participate
in deliberations of the FOMC, provided projections for
economic growth, unemployment, and inflation in 2008,
2009, and 2010. Projections were based on information
available through the conclusion of the June meeting,
on each participant's assumptions regarding a range
of factors likely to affect economic outcomes, and on
his or her assessment of appropriate monetary policy.
"Appropriate monetary policy" is defined as the future
policy that, based on current information, is deemed
most likely to foster outcomes for economic activity and
inflation that best satisfy the participant's interpretation
of the Federal Reserve's dual objectives of maximum
employment and price stability.
FOMC participants generally expected that, over the
remainder of this year, output would expand at a pace
appreciably below its trend rate, owing primarily to
continued weakness in housing markets, the substantial
rise in energy prices in recent months, and the reduction in the availability of household and business credit
resulting from continued strains in financial markets. As
indicated in table 1 and figure 1, output growih further
ahead was projected to pick up sufficiently to begin
to reverse some of the increase in the unemployment
rate by 2010. In light of the recent surge in the prices
of oil and agricultural commodities, total inflation was
expected to rise further in coming months and to be elevated for 2008 as a whole. However, many participants
expected that persistent economic slack and a flattening
out of energy and other commodity prices in line with
futures market prices would cause overall inflation to
decline noticeably in 2009 and 2010. Most participants
judged that greater-than-normal uncertainty surrounded
their projections for both output growth and inflation.
A significant majority of participants viewed the risks
to their forecasts for output growth as weighted to the
downside, and a similar number saw the risks to the
inflation outlook as skewed to the upside.
Change inrealGDP..
April projection.
Unemployment rate...
April projection,
PCE inflation ,
April projection.
Core PCE inflation....
Aprii projection.
3,8 to 4,
3.1 to 3.'
2.2 So 2.<
2.2 so 2.4
5.3 to 5.8
5,2 to 5.7
2.0 lo 2.3
1.9 to 2.3
2.0lo2.2
I.9(o 2.1
1.8 to
1.8 lo
1.8 to
I.7(o
Change in real GDP
April projection
Unemployment rale
April projer'ioi
PCE inflation..
April projection
Core PCE inflation
April projection
0 9 lo 1.8
0 0 to 1.5
5 5 (o 5.8
a i to 6.0
3 4 to 4.6
1 8 to 3.8
2 0 to 2.5
1 9 to 2.5
!.!)lo3.0
1.8 to 3.0
5.2 to 6.1
5.2 to 6.3
1.7 to 3.0
1.7 to 3.0
I.Bio 2.3
1.7 to 2.2
2.0 in 3.5
2.0 to 3.4
5.0 to 5,8
1 8 to 5.9
1.6 to 2.1
1.5 to 2.0
1.5 to 2.0
I.3lo 2,0
2.0
2.0
2.0
1.9
NOTE: Projections of change in real gro« domestic product (GDP) and or
inflation are from the fourth quarter ol the previous year to (he fourth quarter of
the year indicated. PCt inflation and core PCX inflation are the percentage rates
of change in, respectively, llie price index for personal consumptioo expenditures
(PCE) and the price index for PCE excluding food and energy. Projections for the
unemployment rale are for (he avenge civilian unemployment rate in the fourth
quarter of the year indicaicd. Each participant's projections are based on his or
her assessment of appropriate monetary policy.
1. The centraf tendency excludes the (tuet highest and three lowest projections
for each variable in each year.
2. The range for a variable in a giveo year includes all participants' projections,
from lowest lo highest, for thai variable in (hat year.
The Outlook
The central tendency of participants' projections for
real GDP growth in 2008, at 1.0 percent to 1.6 percent,
was noticeably higher than the central tendency of
the projections provided in conjunction with the April
FOMC meeting, which was 0.3 percent to 1.2 percent.
The upward revision to the 2008 outlook stemmed
primarily from better-than-expected data on consumer
and business spending received between the April and
June FOMC meetings. Nonetheless, several participants
noted that the recent firmness in consumer spending could well prove transitory and that the ongoing
housing market correction, tight credit conditions, and
elevated energy prices would damp domestic demand
in the second half of this year. Still, the substantial eas39
105
40
Monetary Policy Report to the Congress n July 2008
Figure 1. Central tendencies and ranges of economic projections, 2008-10
Percent
Change in real GDP
0 Central tendency of projections
—
'.*: Range ofprojeclions
6
—
5
— 4
__ 3
LJ
—
S
—
2
—
1
L_
2003
2004
2005
2006
2007
2008
2009
20 i 0
Unemployment rate
UJ
2003
I
2004
2005
2006
2007
2008
2009
2010
2004
2005
2006
2007
2008
2009
20 i 0
I
2003
Core PCE inflation
2
gSS-iS3a
1
2003
2004
I
2005
2006
2007
2008
2009
NOTE: Definitions of variables are in the notes to table L The daLa for the actual values of the variables arc annual
2010
106
Board of Governors of the Federal Reserve System 41
ing of monetary policy since last year and the continued
strength in exports should help to support economic
growth; in addition, strains had eased somewbat in
somefinancialmarkets since April. Real GDP growth
was expected to increase in 2009 as the adjustment
in the housing sector ran its course, financial markets
gradually resumed more-normal functioning, and the
downward pressure on real incomes stemming from
increases in energy and food prices in the first half of
2008 began to fade. In 2010, economic activity was
projected to expand at or a little above participants'
estimates of the rate of trend growth.
With output growth continuing to run below trend
in the second half of 2008, most participants expected
that the unemployment rate would move up somewhat
over the remainder of this year. The centra! tendency of
participants' projections for the average rate of unemployment in the fourth quarter of 2008 was 5.5 percent
to 5.7 percent, unchanged from the central tendency of
projectious that were provided in conjunction with the
April FOMC meeting and consistent with some slack
in resource utilization. The centra! tendency of participants' projections was for the unemployment rate to stabilize in 2009 and to edge down in 2010 as output and
employmeut growth pick up.
The surge in the prices of oil and agricultural commodities since April led participants to revise up
noticeably their projections for total inflation in the
near term. However, the central tendency of participants' projections for core PCE inflation in 2008 was
2.2 percent to 2.4 percent, unchanged from the central
tendency in April, as lower-than-expected rates of core
inflation over recent months offset the expectations of
some pass-through of ihe recent surge in energy prices
into core inflation over the next few months. Rates of
both overall and core inflation were expected to decline
over ihe next two years, reflecting aflatteningout of
the prices of oil and other commodities consistent with
futures market prices, slack in resource utilization, and
longer-term iuflation expectations that were expected to
remain generally well anchored.
The contour of participants' projections for output
growth, unemployment, and inflation was importantly
shaped by their judgments about the measured rates
of inflation consistent with the Federal Reserve's dual
mandate to promote maximum employment and price
stability and about the time horizon over which policy
should aim to attain those rates given current economic
conditions. Most participants judged that it might take
a substantial period of time for output and inflation to
recover from the recent shocks, which had elevated
inflation and damped economic activity. A number of
participants projected that the rate of unemployment
might remain slightly above its longer-run sustainable
level even in 2010; total inflation in 2010 was also
judged likely to continue to run a bit above levels that
most participants saw as consistent with the price stability objective of the Federal Reserve's dual mandate.
Most participants saw further declines in both unemployment and inflation as likely in the period beyond
the forecast horizon. {See table 1 on page 39 and
figure 1 on page 40).
Risks to the Outlook
Most participants viewed the risks to their projections for GDP growth as weighted to the downside
and the associated risks to their projections for the
unemployment rate as tilted to the upside. The possibility that house prices could decline more steeply
than anticipated, further reducing households' wealth,
restricting their access to credit, and eroding the capital
of lending institutions, continued to be perceived as a
significant downside risk to the outlook for economic
growth. Although financial markets had shown some
further improvement since April, conditions in those
markets remained strained; a number of participants
also pointed to the risk that further improvement could
be quite slow and subject to relapse. The potential for
current tight credit conditions to exert an unexpectedly
large restraint on household and business spending was
also viewed as a significant downside risk to economic
activity. An adverse feedback loop, in which weaker
economic activity led to a further worsening of financial
conditions, which in turn could damp economic growth
even further, continued to be viewed as a worrisome
possibility, though less so than in April. Indeed, some
participants pointed to the apparent resilience of the
U.S. economy in the face of recent financial distress and
suggested that the adverse effects of financial developments on economic activity outside of the housing sector could prove to be more modest than anticipated.
Most participants viewed the risks to their inflation
projections as weighted to the upside. Recent sharp
increases in energy and food prices and the passthrough of dollar depreciation into import prices could
boost inflation in the near term by more than currently
anticipated. Although participants generally assumed
that commodity prices will flatteu out, roughly in line
with the trajectory implied by futures prices, the fact
that futures markets had persistently nnderpredicted
commodity prices in recent experience was viewed as
an upside risk to the outlook for inflation. Participants
also saw a risk that inflation expectations could become
lessfirmlyanchored, particularly if the current elevated
107
42 Monetary Policy Report to the Congress • July 2008
rates of headline inflation did not moderate as quickly
as they expected.
Participants continued to view uncertainty about the
outlook for economic activity as higher than normal,
with a number pointing to uncertainly about the duration and effects of the ongoing financial strains on real
activity. In addition, participants expressed noticeably
more uncertainty about their inflation projections than
they had in January and April, a shift in perception that
they attributed importantly to increased uncertainty
about the future course of energy and food prices and
to greater uncertainty about the extent of pass-through
of changes in those prices into core inflation. (Table 2
provides estimates of forecast uncertainty for real GDP
growth, unemployment, and inflation since 1987.l3)
Table 2. Average historical projection error ranges
Percentage poinu
Variable
Change in real GDP1
Unempfnymeni rate'
2
Total consumer prices ..
2008
2009
2010
±0.9
±0,3
±0.6
±1.3
±0,7
±1.0
tl.4
±1.0
±1.0
NOTE: Error ranges shown are measured as plus or minus the root mean squared
error of projections that were released in the summer from 198? through 2007 for
the current and following two years by various private and government forecasters.
As described in the box "Forecast Uncertainly," under certain assumptions, there is
about a 70 percent probability that actual outcomes for real GDP. unemployment
and consumer prices will be in ranges impbed by the average size of projection
errors made in Ihe past. Further information is in David Reifschneider and Peier
Tulip (2007), "Gauging the Uncertainty of the Economic Outlook from Historical
Forecasting Errors," Finance and Economics Discussion Series 20D7-60 {Board
of Governors of the Federal Reserve System, November).
L i:or definitions, refer to genera! note in table !,
2. Measure is the overall consumer price index, the price measure that has
been most widely used in government and private economic forecasts, Projectioo is percent change, fourth quarter of the previous year to the fourth quarter
of ihe year indicated.
Diversity of Participants' Views
Figures 2.A and 2.B provide more detail on the diversity of participants' views regarding likely economic
outcomes over the projection period. The dispersion of
participants' projections for real GDP growth in 2008
was noticeably narrower than in the forecasts provided
in April, reflecting primarily the accumulation of data
about the actual performance of the economy in the
first half of the year; their views about output growth
in coming quarters and in 2009 continued to exhibit
appreciable dispersion. The dispersion of participants'
projections for real activity next year seemed largely to
reflect differing assessments of the effects of adverse
financial market conditions on economic growth, the
speed with which credit conditions might improve, and
the depth and duration of the correction in the housing
market. Indeed, views differed notably on the pace at
13. The box "Forecast Uncertainly" at (he end of this summary
discusses the sources and interpretation of uncertainty in economic
forecasts and explains trie approach used lo assess the uncertainty and
risks attending participants' projections.
which output and employment would recover in 2009,
with some participants expressing a concern that growth
might be constrained by the persistence of financial
strains over a considerable period. The dispersion of
participants' longer-term projections was aiso affected
to some degree by differences in their judgments about
the economy's trend growlh rate and the unemployment
rate that would be consistent over time with maximum
employment. The dispersion of the projections for PCE
inflation in the near term reflected in large part differing views on the extent to which recent increases in
energy and food prices would pass through into higher
consumer prices, in addition, participants held differing views on the degree to which inflation expectations
were anchored and the role that expectations might play
in the inflation process over the short and medium term.
Participants' inflation projections further ahead were
shaped by the views of the rate of inflation consistent
with the Federal Reserve's dual objectives and the time
it would take to achieve these goals given current economic conditions and appropriate policy.
108
Board of Governors of the Federal Reserve System
Figure 2, A. Distribution of participants' projections for the change in real GDP and for the unemployment rate, 2008-10
Numbci of participants
Change in real GDP
_ 2008
E3 June projeeiioiis
— April projections
— 16
— 14
Number of participants
Unemployment rate
__ 2008
0 June projections
- - April projection;
__ 16
— 14
— 12
0.0 0.3 0.4 0.6 0.8 l.O 1.2 i.4 1.6 I.S 2.0 2.2 2.4 2.6 2.S 1.0 3.2 3
O.I 0 3 0.5 0.7 0.9 1.1 1 .5 !,5 i.T i.9 2 ! 2.3 2.5 2.7 2.9 3 ! 3.3 3
Percent range
Number of participants
Numbcrofparticipanls
-— 16
48
4.9
0OO2O4O60SI0 1214!6 182O2224262S
0.1 0 3 0.5 D.7 0.V ) . ! J.J 1 5 !,J 1.9 2.! 2.3 2.5 2.7 1 9
50
5J
Percent range
52
54
56
5.3 5.5 5.7
Percent range
58
5,9
60
6.)
62
6.3
Number of participants
— 16
— 14
— 14
"<•,,!
-1
'-" ' -
— 2
4.8
4.9
NOTE: Deflniiions of variables are in the genei
50
5 1
52
53
54
55
56
57
58
59
6,0
6.1
6,2
6,3
43
109
44
Monetary Policy Report to the Congress G July 2008
Figure 2.B. Distribution of participants' projections for PCE inflation and for core PCE inflation, 2008-10
Number of [wniapanis
PCE inflation
— 2008
HI June projections
- - April projections
'- rMtr
f
Core PCE inflation
— 2008
@ June projections
~~ - - April projecfions
—
34
—
12
— 12
—
10
— 10
1 i
1.7
1.8
1.9
20
Percent range
2009
-
—
_
16
-
14
—
]2
_
10
i
-
_
" \
i
[
J|
np
6
_
4
_
2
j
1 2 3 2S 27 21
!1 2
i *> i M ~n 2 2 4 2fr 2S 3 0
I 3.3 3.5 3.7 3.9 4 t 4 3 4.5
2 3 4 3.6 3.8 4.D 4.2 4 4 4 6
1.3
1.4
Percent r nge
Number o,>rtic, P
_
12
— 10
— 8
— 6
„
4
—. 2
1.7 1.9 2.1 2.3 2.5 2.7 2.9 3 1 3.3 J.S 3-7 1.9 4.1 4.3 4.5
Percent range
NOTE: Definitions of variables are in the general n
i.s
1.6
i -
1 X
Percent rang
2.1
2.2
23
2.4
2.S
2.6
110
Board of Governors of the Federal Reserve System 45
Forecast Uncertainty
The economic projections provided by the
members of the Board of Governors and the
presidents of the Federal Reserve Banks inform
discussions of monetary policy among policymakers and can aid public understanding of the
basis for policy actions. Considerable uncertainty attends these projections, however. The
economic and statistical models and relationships used to help produce economic forecasts
are necessarily imperfect descriptions of the real
world. And the future path of the economy can
be affected by myriad unforeseen developments
and events. Thus, in setting the stance of monetary policy, participants consider not only what
appears to be the most likely economic outcome
as embodied in their projections, but also the
range of alternative possibilities, the likelihood
of their occurring, and the potential costs to the
economy should they occur.
Tabfe 2 (see page 42) summarizes the average historical accuracy of a range of forecasts,
including those reported in past Monetary Policy
Reports and those prepared by Federal Reserve
Board staff in advance of meetings of the Federal
Open Market Committee. The projection error
ranges shown in the table illustrate the considerable uncertainly associated with economic
forecasts. For example, suppose a participant
projects that real gross domestic product (GDP)
and total consumer prices will rise steadily at
annual rates of, respectively, 3 percent and
2 percent, if the uncertainty ailending those
projections is similar to that experienced in me
past and the risks around the projections are
broadly balanced, the numbers reported in table
2 would imply a probability of about 70 percent
that actual GDP would expand 2.1 percent to
3,9 percent in the current year, 1.7 percent to
4.3 percent in the second year, and 1.6 percent
to 4.4 percent in the third year. The corresponding 70 percent confidence intervals for overall
inflation would be 1.4 percent to 2.6 percent in
the current year and 1.0 percent to 3.0 percent
in the second and third years.
Because current conditions may differ from
those that prevailed on average over history,
participants provide judgments as to whether the
uncertainty attached to their projections of each
variable is greater than, smaller than, or broadly
similar to typical levels of forecast uncertainty
in the past as shown in table 2. Participants
also provide judgments as to whether the risks
to their projections are weighted to Ihe upside,
downside, or are broadly balanced. That is, participants judge whether each variable is more
likely to be above or below their projections of
the most likely outcome. These judgments about
the uncertainty and the risks attending each
participant's projections are distinct from the
diversity of participants' views about the most
likely outcomes. Forecast uncertainty is concerned with the risks associated with a particular
projection, rather than with divergences across a
number of different projections.
111
8DARD DF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON. 0. C. 50551
BEN 5. OEBNAN KE
August 25, 2008
The Honorable J. Gresham Barrett
House of Representatives
Washington, D.C. 20515
Dear Congressman:
I am pleased to enclose my responses to the questions you submitted
following the hearing on July 16 before the Committee on Financial Services. A copy has
also been forwarded to the Committee for inclusion in the hearing record.
Please let me know if I can be of further assistance.
Sincere
Enclosure
112
Chairman Bernanke subsequently submitted the following in response to written questions
received from Congressman Barrett in connection with the hearings before the House Financial
Services Committee on July 16, 2008:
Many analysts have compared our current economy with economic climates of the past.
What are the important similarities between our current economic climate and past
economic troubles? What lessons should we take from those similar past economic
disruptions that we should apply to this discussion given the skyrocketing price of oil and
other commodities, an enormous budget deficit and a weakening dollar?
For some analysts, today's rapidly rising energy prices recall the "stagflation" of the
1970s. However, there are some important differences between that period and today's
economy. Although rising prices of crude oil have, as in the 1970s, put downward pressure on
economic growth and upward pressure on inflation, the U.S. economy is much less energy
intensive today, which has likely diminished the effects of higher oil prices relative to that earlier
episode. In addition, the public's expectation that inflation beyond the near term will be little
affected by recent energy price increases has thus far helped to limit the current shock's
inflationary effect. Among the lessons that can be drawn from a comparison of these episodes is
that a Central Bank's commitment to price stability—by anchoring expectations of future
inflation-can help to contain the inflationary effect of oil shocks. In this context, it will be
important to ensure that the current elevated level of total inflation does not lead to upward
pressure on longer-term inflation expectations. As a result, the Federal Open Market Committee
is monitoring inflation and inflation expectations very carefully.
The current housing market downturn and financial market disruptions also bear some
similarities to earlier periods of financial market stress, such as occurred during the early 1990s.
However, the current disruptions are greater in magnitude and scope, affecting a broader array of
institutions and markets than in the past. Among the important lessons from earlier episodes of
financial stress is that policymakers should strive to contain the economic fallout from such
episodes, in part by promoting a return to more normal functioning financial markets. In
addition, it is clear from the current and earlier episodes of financial stress that balanced financial
market regulation—allowing the pursuit of important innovation but at the same time preventing
excessive risk taking—is fundamental to economic growth and stability.
Does the size of the United States' budget deficit change the available range of policy
options?
Fiscal policy can, in principle, be a valuable tool to help combat periods of economic
weakness. However, policy must be designed in a way that will maintain fiscal sustainability
over time. In this sense, the size of recent budget deficits and the current level of federal debt
may limit the set of current and future fiscal policies that are sustainable in the long-run.
Do you foresee any danger foreign lenders and investors will lose confidence in the U.S.
economy or in the United States' creditworthiness?
113
-2Despite recent volatility, the U.S. financial system is still pre-eminent in its depth,
breadth, and safety, and there is little indication that foreign lenders and investors are losing
confidence in the U.S. economy or that foreign perceptions of U.S. creditworthiness are
deteriorating. As evidenced by data on international capital flows and international investment
positions, foreign investors-both official and private-continue to increase the scale of their
investments in the United States, and U.S. assets still occupy the predominant share of foreign
external portfolios. Prudent economic policies, including those that maintain the openness of our
markets and allow the free flow of international capital to seek its most efficient uses, will help
maintain that attractiveness going forward.
At the same time, American consumers seem to be following their government's lead and
borrowing increasingly large amounts of money, which in turn has helped fuel economic
growth. Do you foresee a problem arising from the large amounts of debt that consumers
have amassed? Given that both consumers and financial institutions are saddled with large
amounts of debt, what kind of economic growth can be expected? Do you think that there
is an over reliance on US domestic consumption to fuel economic growth? What can be
done to spur economic recovery and organic growth without increasing consumer debt?
Our nation's large magnitude of debt, both public and private, reflects an excess of
consumption over saving that, in the aggregate, is mirrored in our current account deficit. The
eventual need to reduce the magnitude of that deficit implies that, over time, our nation will
require a significant increase in public and private saving. Reductions in the federal budget
deficit must be one important component of this increase in national saving. But, given the large
share of consumer spending in GDP, increases in private household saving will also likely be an
important component.
When equity and home prices were rising rapidly in previous years and boosting
households' net worth, many individuals felt comfortable increasing their spending by more than
the growth in their incomes even if that meant incurring additional debt; accordingly, the
personal saving rate moved lower over this period. Given the declines in house prices and equity
prices over the past year, as well as the greater reluctance of financial institutions to extend credit
to households, it seems likely that consumer spending will slow in the period ahead, limiting the
growth of consumer debt. This slowing will weigh on economic growth for a time as well.
However, increasing our national saving rate can help to lower interest rates, increase domestic
investment, and reduce our reliance on borrowing from abroad, all of which will help to promote
economic growth over the longer term. For our part, maintaining a monetary policy that
promotes price stability and maximum sustainable employment, and that fosters the soundness of
the financial system, is the best way for the Federal Reserve to contribute to general economic
welfare.
Do you think that there has been a fundamental change in the monetary value of consumer
and corporate debt? Or has some of the financial crisis that we have been facing stem from
panic rather than a rational assessment of the economic fundamentals underlying the
housing market and mortgage backed securities?
114
-3-
Over the past several quarters, there has been a deterioration in the performance of a
range of loans to households and businesses in the United States. Delinquency and foreclosure
rates for residential mortgages have risen significantly, and by more than expected, prompting a
sizable rise in risk spreads on securities exposed to mortgage-related credit risk. Issuance of
private-label mortgage-backed securities has virtually halted. In addition, commercial banks and
thrifts have generally reported increased charge-off rates on other mortgage-related and
consumer loans, and a modest increase for C&I loans. As loan performance has deteriorated,
banks have, on balance, reported tightening their lending standards and terms for many types of
loans. In the corporate bond market, defaults have remained low, but risk spreads on corporate
bonds have risen appreciably oveT the past year, reflecting in part expected increased losses from
future defaults in light of the slowdown in economic activity.
The observed increase in risk spreads for a range of securities appears to reflect a
deterioration in credit fundamentals and demand by investors for greater compensation for
bearing risk, as is typical in such times. In addition, the higher risk spreads likely reflect
compensation for the uncertainty of the effects of sharply tighter lending standards and a
pullback from some structured financial products.
Do you think that the tax code creates enough incentives for saving and would creating new
incentives to save earlier in life be helpful for increasing the American savings rate?
I share your concerns about our nation's low saving rate, which has trended down over
the past two decades despite numerous policies implemented to try to increase household
savings. IRAs and 401(k) plans, along with other types of tax-preferred saving vehicles,
generally have been popular. However, despite their popularity, much of the evidence suggests
that tax-preferred savings plans tend to substitute for other forms of household savings and have
done little to boost total net saving. Greater net saving by households requires them to spend
less, holding incomes the same. But, reducing spending is not easy, especially for lower-income
and many younger households.
That said, we should continue to look for policies that would help bolster the U.S. saving
rate. In this regard, the Pension Protection Act of 2006 contained a provision to encourage
employers to automatically enroll employees in their 401(k) plans by default, but allow them to
opt out if they do not want to participate. Several studies have shown that automatic enrollment
plans have increased the percentage of employees that participate in their 401(k) plan and also
have increased total contributions amounts. Although these studies have yet to assess whether
these contributions represent net new saving, if this automatic enrollment policy ultimately
proves to be effective in encouraging individuals to save more, it may also provide some
guidance in developing other policies that induce more people to start saving earlier in life.
Right now, the issue that lies heaviest on all my constituents' minds is the high price of
energy, especially gasoline. Without major structural changes, can the American economy
continue to grow with oil above $140 a barrel and gasoline above $4.50 a gallon? How
much have high energy prices impeded American economic growth? What might a growth
pattern for the American economy look like with sustained high commodity prices?
115
-4Since my testimony in July, the spot price of a barrel of oil has dropped from over $ 140
per barrel to under $120 per barrel. Even with this drop, the rise from roughly $65 per barrel in
2006 has been considerable. By reducing the purchasing power of households and the
profitability of many businesses, higher oil prices restrain both consumer spending and business
investment. Although imprecise, a reasonable estimate of the negative effect of the rise in oil
prices since 2006 on real GDP growth might be around 1/4 percentage point both last year and
this year. If prices for crude oil and other commodity prices remain at their current levels, the
effect on GDP growth after this year should be small. However, some small adverse effect on
growth could persist into the future, as businesses adjust the size and composition of their capital
stocks in light of energy and commodity costs that are higher than they originally expected.
My colleagues and I are concerned about the strategic geopolitical realities generated by
our dependence on foreign oil. What are the financial and macroeconomic effects of our
dependence on foreign oil? How important is energy independence to the long-term health
of the economy?
The long-term health of our economy will depend, as it has in the past, on the, caliber of
our labor force, the condition of our capital equipment and structures, the pace of technological
advancement, and the availability of dependable sources of energy. At present, about two-thirds
of the oil used in the United States is imported. With much of the world's oil reserves located in
potentially unstable regions, this dependence on imported oil exposes us to disruptions in the oil
market from around the globe. Moreover, rising oil prices have boosted our oil import bill,
thereby widening our trade deficit and contributing to an increase in our external indebtedness.
It is not the case, however, that we would be better off if we artificially limit our access to
the bulk of the world's sources of oil. Energy is a fundamental input into economic activity, and
reducing its availability would only serve to diminish productivity and impair living standards.
In addition, as oil is highly tradable, disruptions to supply in any particular country lead to
increases in prices in all countries, so it is not the ease that lower imports by themselves would
lead to less price volatility. Indeed, less scope for trade may have the opposite effect.
Nonetheless, there may be good reasons to reduce our reliance on oil, including
geopolitical considerations and environmental concerns. The best way to reduce the
vulnerability that stems from our reliance on oil supplies from abroad is through greater
diversification of energy supply, in terms of both the types of energy that are available and the
locations from which we obtain it. On the demand side, conservation should play an important
role as well. Technological advancements and the opportunities afforded by international trade
will likely play an important role in this process.
116
BOARD O f GOVERNORS
DF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, 0. C. 2 0 S S I
August 20, 2008
The Honorable John Campbell
House of Representatives
Washington, D.C. 20515
Dear Congressman:
Thank you for your letter of August 11, 2008, in which you submitted
additional questions in connection with the July 16 hearing before the House Financial
Services Committee. The questions, regarding measures of expected inflation, are as
follows:
•
Given your comments and the recently released June inflation numbers,
could you please describe how the Federal Reserve measures and determines
long-term inflation expectations and whether or not they are becoming
embedded in the domestic wage- and price-setting processes?
•
Also, could you then describe how these long-term inflation calculations are
used to predict growth and inflation in future periods?
We obtain evidence on long-term inflation expectations from a variety of
sources. For example, we monitor surveys of households, the most prominent of which is
conducted by Reuters and the University of Michigan, in which individuals are asked how
much they expect prices to increase over the next year and their expectations of price
inflation over the next five to ten years. We also follow surveys of the inflation projections
of professional economic forecasters. Finally, the difference between yields on nominal
Treasury securities and on the Treasury's inflation-indexed securities provides a measure of
the inflation compensation required by investors. This measure reflects investors'
expectations of price inflation as measured by the CPI as well as investors' degree of
aversion to inflation risk and the different liquidity characteristics of the securities.
Since early this year, the survey measures have pointed to a small increase in
long-term inflation expectations, while measures derived from Treasury securities have
been little changed on net. Moreover, to date, measures of hourly labor compensation
117
The Honorable John Campbell
Page Two
have been increasing moderately and do not provide much evidence that higher rates of
price inflation are becoming embedded in inflation expectations and, through those
expectations, in the wage and price setting process. As I said in my testimony, the FOMC
will remain alert to indications that the inflationary impulses from the earlier run up in
commodity prices are leading to an erosion in inflation expectations that could risk
compromising our goals of achieving price stability and maximum sustainable employment.
Please let me know if I can be of further assistance.
Sincerely,
118
JOHN CAMPBELL
f
_
" 3 8 ^ ^ S W N G T ^ N Ixfrasis
1949) ?
of tije tHnittb
n, 3BC 20515-0548
August 11, 2008
The Honorable Ben Bemanke
Chairman
Board of Governors
Of the Federal Reserve System
20!h Street and Constitution Avenue, NW
Washington, DC 20551
Dear Chairman Bemanke,
I was giad to be in attendance and hear you testify before the House Financial Services
Committee during the Humphrey Hawkins hearing on July 16ih, 2008. Unfortunately, due to
time constraints, I was unable to ask a question. In response, I would like to submit a written
question pertaining to your testimony given at the hearing. Any light you can shed on the
subject is greatly appreciated.
Chairman Bernanke, in your testimony before the House Financial Services Committee on
July 16th, 2008, you said:
"However, in light of the increased persistent escalation of commodity
prices in recent quarters, FOMCparticipants viewed the inflation outlook
as unusually uncertain and cited the possibility that commodity prices will
continue to rise as an important risk to the inflation forecast. "
"Moreover, the currently high level of inflation, if sustained, might lead the
public to revise up its expectations for longer-term inflation. If that were to
occur, and those revised expectations were to become embedded in the
domestic wage- and price-setting process, we could see an unwelcome rise
in actual inflation over the longer term. A critical responsibility of monetary
policy-makers is to prevent that process from taking hold...
"...Given the high degree of uncertainty, monetary policy-makers will need
to carefully assess incoming information bearing on the outlook for both
inflation and growth.
"In light of the increase in upside inflation risk, we must be particularly
alert to any indications — such as an erosion of longer-term inflation
expectations — that the inflationary impulses from commodity prices are
becoming embedded in the domestic wage- and price-setting process. "
119
•
Given your comments and the recently released June inflation numbers, could you please
describe how the Federal Reserve measures and determines long-term inflation
expectations and whether or not they are becoming embedded in the domestic wage- and
price-setting processes?
•
Also, could you then describe how these long-term inflation calculations are then used to
predict growth and inflation in future periods?
Thank you for your attention to this matter and I look forward to your response.
I remain respectfully,
>^
Tr\LJxr n A * if m
JOHN
CAMPBELL
Member of Congress
120
BOARD OF GDVERNDR5
OF THE
FEDERAL RESERVE 5Y5TEM
WASHINGTON, D. C. 2D551
SEN S. SERNANKE
CHAIRMAN
August 25, 2008
The Honorable Adam Putnam
House of Representatives
Washington, D.C. 20515
Dear Congressman:
I am pleased to enclose my responses to the questions you submitted
following the hearing on July 16 before the Committee on Financial Services. A copy has
also been forwarded to the Committee for inclusion in the hearing record.
Please let me know if I can be of further assistance.
Sincerely,
Enclosure
121
Chairman Bemanke subsequently submitted the following in response to written questions
received from Congressman Putnam in connection with the hearings before the House Financial
Services Committee on July 16,2008:
1. Are you satisfied with the joint action that you and Secretary Paulson took this
weekend? Specifically, do you believe it had the desired stabilizing effect?
The actions taken by the Department of the Treasury and the Federal Reserve Board
helped reassure market participants that two government-sponsored entities, the Federal National
Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie
Mac), would have sufficient liquidity to meet their obligations and to continue to perform their
important roles in the mortgage markets. The subsequent action by the Congress in passing GSE
reform legislation further reassured market participants that the GSEs would meet all senior debt
and MBS obligations.
2. What are the ramifications if Congress fails to bless the deal?
Congress has passed GSE reform legislation and thus I will not speculate about what
might have happened if it did not.
3. Yesterday the President said, "there is an implicit government guarantee" of Fannie and
Freddie. What are the long term consequences of maintaining such a guarantee?
The financial markets have long perceived that the GSEs have an implicit government
guarantee. The recent actions by the government have only strengthened this belief. The long
term consequence of such a persistent belief is moral hazard, which means that market
participants, as well as GSE managements, may not adequately monitor the GSEs' financial
performance because these participants believe the government will bail them out if the GSEs
cannot honor their commitments. To offset these concerns about moral hazard, the new GSE
regulator needs to be sure that the GSEs have a strong capital position and that their portfolios of
investments assets are managed in a very conservative manner in order to avoid systemic risks.
4. The current legislation creates a Federal Housing Enterprise Board that would include
the Secretary of HUD and the Secretary of Treasury - the Senate would also include the
Chairman of the SEC. The Board would advise the Director of the Federal Housing
Finance Agency on overall strategies and policies. This weekend's proposal called for the
Fed to have a consultative role in the new GSE regulator's process for setting capital
requirements and other prudential standards. First, is the Board unable to do this as it is
currently proposed in the legislation? Second, do you believe that the Fed should be
included on the Board? Finally, do you believe that if the Fed were to have a consulting
role that this would lessen the powers of the new regulator or negate the efforts of the
Board?
The Congress has determined that the Federal Reserve Board will have a consulting
relationship with the GSE regulator during the next 18 months. We will strive to do our best in
undertaking the responsibilities given to us in the recently passed housing legislation (the
Housing and Economic Recovery Act of 2008).
o
@FedFRASER