The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
MONETARY POLICY AND THE STATE
OF THE ECONOMY, PART I
HEARING
BEFORE THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
FEBRUARY 15, 2007
Printed for the use of the Committee on Financial Services
Serial No. 110-3
U.S. GOVERNMENT PRINTING OFFICE
34-673 PDF
WASHINGTON : 2007
For sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800
Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001
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
JULIA CARSON, Indiana
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
ALBIO SIRES, New Jersey
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
ROBERT WEXLER, Florida
JIM MARSHALL, Georgia
DAN BOREN, Oklahoma
SPENCER BACHUS, Alabama
RICHARD H. BAKER, Louisiana
DEBORAH PRYCE, Ohio
MICHAEL N. CASTLE, Delaware
PETER T. KING, New York
EDWARD R. ROYCE, California
FRANK D. LUCAS, Oklahoma
RON PAUL, Texas
PAUL E. GILLMOR, Ohio
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
RICK RENZI, Arizona
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
MARSHA BLACKBURN, Tennessee
MICHELE BACHMANN, Minnesota
PETER J. ROSKAM, Illinois
JEANNE M. ROSLANOWICK, Staff Director and Chief
(II)
Counsel
CONTENTS
Page
Hearing held on:
February 15, 2007
Appendix:
February 15, 2007
1
61
WITNESSES
THURSDAY, FEBRUARY 15, 2007
Bernanke, Hon. Ben S., Chairman, Board of Governors of the Federal Reserve
System
7
APPENDIX
Prepared statements:
Neugebauer, Hon. Randy
Waters, Hon. Maxine
Bernanke, Hon. Ben S
62
64
71
ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD
Hon. Ben S. Bernanke:
Board of Governors of the Federal Reserve System, Monetary Policy
Report to the Congress, dated February 14, 2007
Responses to questions submitted by Hon. Ruben Hinojosa
Responses to questions submitted by Hon. Albio Sires
(HI)
81
112
115
MONETARY POLICY AND THE STATE OF THE
ECONOMY, PART I
Thursday, February 15, 2007
U.S. HOUSE OF REPRESENTATIVES,
COMMITTEE ON FINANCIAL SERVICES,
Washington, D.C.
The committee met, pursuant to notice, at 10 a.m., in room 2128,
Rayburn House Office Building, Hon. Barney Frank [chairman of
the committee] presiding.
Present: Representatives Frank, Kanjorski, Waters, Maloney,
Gutierrez, Watt, Ackerman, Sherman, Moore of Kansas, Capuano,
Hinojosa, Clay, McCarthy, Miller of North Carolina, Green, Cleaver, Bean, Moore of Wisconsin, Davis of Tennessee, Sires, Hodes,
Ellison, Klein, Mahoney, Wilson, Perlmutter, Murphy, Donnelly,
Wexler, Marshall; Bachus, Baker, Pryce, Castle, Royce, Lucas,
Paul, Gillmor, Jones, Biggert, Shays, Capito, Feeney, Hensarling,
Garrett, Pearce, McHenry, Campbell, Bachmann, and Roskam.
The CHAIRMAN. Today's hearing of the Committee on Financial
Services will come to order. This is the semi-annual hearing that
we have on the Humphrey-Hawkins Act, with testimony by the
Chairman of the Board of Governors of the Federal Reserve System, Hon. Ben S. Bernanke. Chairman Bernanke will be testifying
on the state of the economy and discussing the Federal Reserve's
2007 Monetary Policy Report to the Congress. Under the procedures, Chairman Bernanke alternates between the House and the
Senate. This is done twice a year—once a year, the chairman goes
to the Senate first, and once a year, he goes to the House first.
Since, in this rotation, he went to the Senate first, one assumes
that there will be no opportunities to game the stock market today.
Those all happened yesterday, so people can stay through the
whole hearing. Reporters won't have to leave to run to report to the
wire services so people can hysterically overreact to the Chairman's
perfectly sensible statements, which, of course, is the pattern. Although I know people who are in the market explain that they are
not overreacting themselves—they are, in fact, reacting to other
people's overreaction—the consequences are the same.
I say that because, in the interest of being able to have rational
policy discussions unconstrained by irrelevant factors, I just would
plead with people not to read excessively into what the Chairman
says, and not to read excessively into what we say. We ought to
be able to have rational conversations about the important topic of
today's hearing without the overreactions. And I would say, since
that may not be possible, as far as I am concerned, people overreact at their own peril. And I don't think the Chairman or any(l)
body else should be held accountable because people engage in this
form of anticipatory hysteria.
As to the subject at hand, and under the rules, there will be four
opening statements—by myself, the ranking member of the full
committee, the chairman of the Subcommittee on Domestic and
International Monetary Policy, and the ranking member of the subcommittee—and the Chairman has very graciously agreed to stay
until 2 p.m. I am deeply appreciative of this.
This is a very large committee. We will take one 15- to 20-minute
break, and members can gauge appropriately. And we will be able
to accommodate more of the members if we can. Mr. Chairman,
again, I appreciate your willingness to do this.
I will be asking the Chairman about some of the specifics of his
testimony, and of the areas particularly relevant to monetary policy, but I want to begin with an expression of disappointment, not
in Chairman Bernanke, but in the business community and many
of my conservative colleagues. I believe that we are at a very sensitive point in the making of economic policy in this country.
There is, on the part of the business community and many of its
supporters, the view that a full embrace of globalization—of technological change, essentially of public policies that allow capital to be
fully mobilized and fully mobile, and able to be employed to its best
use—is in the best interests of society as a whole.
For some time now, until fairly recently, that was the governing
policy in the United States, and in much of the rest of the world.
That has now come to an end, I believe temporarily, perhaps for
a long temporary period, because increasingly, average citizens, in
America and in other countries, have come to doubt that the
growth that results from this policy of entirely free capital to move
to wherever it finds its best return, people have come to doubt that
this is in their interest. Indeed, there are a large number of people
throughout the world who believe that they are being hurt by this.
And in consequence, we are at a policy deadlock. I think people
should understand that the chances of an extension of trade promotion authority going through are quite slender at this point, unless there is some change in the attitude of many who are its advocates.
My own view is that if they were, in fact, to come to an agreement in the Doha Round, that the resulting agreement—if they
reach it as they currently talk about it—wouldn't pass the House
of Representatives. There is resistance, in my view unfortunately,
to the general approach that the President took on immigration.
In almost all of the important areas in which—and let me just
say, this committee reported out earlier this week on a voice vote
a bill for foreign investment, and there was a paradox. Because if
you talk to the people in the business community, as the ranking
member and I, and the former chairman of that subcommittee, and
others involved in that, if you talked to them, they were, on the
whole, pleased with the result because it was better than they had
expected.
If you read some of the business press, they were concerned that
it was too restrictive. Well, that is an example of where we are. It
is a bill that was more restrictive than some might have liked on
foreign investment, but better than some people expected reflecting
this mood.
So I want to reiterate what I said earlier. Many of us are prepared to work towards policies that are pro growth, that do take
advantage of what you have when capital is allowed to reach its
best level and find its greatest return, when technology can be fully
taken advantage of, but only if we put in place public policies that
make sure that is more fairly shared, and in particular, that reverse the tendency which the Chairman has acknowledged, and I
appreciate that, and which the President has acknowledged, that
inequality has been growing.
As I said before, inequality is an essential part of a capitalist
economy—no one is trying to get rid of it, at least no one sensible.
But it can also become excessive to the point where it is socially
harmful and economically beyond what is needed for the capitalist
system.
We are at that point. We are at a point where there is an excessive amount of inequality in this economy. And it is growing, and
not just in this economy. I recently read an article which said that
in the last set of state elections in India, every chief minister who
was seen as pro foreign was defeated in terms of the economy. So
there is a worldwide concern. We see in Latin America where an
anti-democratic left is threatening the democratic left in part because of this economic unhappiness.
I don't see any recognition of that. I regret that. But people who
will continue to resist trying to do something about healthcare or
trying to do something about the right of employees to join unions,
even something as minimalist as the minimum wage should not be
surprised when they run into absolute resistance to other things
which they will argue are good for the economy.
With that, I call on the ranking member.
Mr. BACHUS. Thank you, Mr. Chairman, and I appreciate you
holding this hearing. And Chairman Bernanke, thank you for your
report. As you can see, on this committee, we share the same concerns, but we have different views on how to address those concerns and different philosophies. And as you come before us today,
we are interested in your insights regarding not only monetary policy but also the state of the economy, and as the chairman specifically mentioned, global competitiveness and trade and issues of
that nature.
Of course, when we talk about differences of philosophy—as the
chairman and I have—on how to approach these issues, how one
perceives the state of the economy greatly depends on one's point
of view.
From my perspective, the economy appears strong and vibrant,
and absent some unforeseen shock, likely to remain so. When I look
at your report and the supporting economic data, I see vigorous 3.4
percent growth. I see low unemployment of 4.6 percent and inflation of 2.5 percent.
And in a society where opportunity awaits anyone who uses their
talents and efforts to improve the standard of living for their family—opportunities are there, educational opportunities, and work
opportunities, that is what I see from your report. I see IVz million
new jobs created since 2003.
I see a structurally sound economy performing as well as it did
in the 1990's in what we now know is an artificial economic bubble.
Currently, I see strong 2.2 productivity increases and record
stock market levels not fueled by unrealistic dot.com speculation,
but by globally competitive businesses.
I also see most Americans benefiting from the stock market
growth through individual stock ownership and retirement funds.
In this environment, claiming that record corporate profits do not
benefit most Americans—as some on this committee do—is not a
valid argument.
Others have a different perspective. You have heard the chairman's perspective. And they see another reality. Some on this committee believe that the best way to create jobs and promote economic growth is through aggressive trade restrictions and barriers.
While I recognize the need to help those economically displaced
or as the chairman says, hurt, by global forces beyond their control,
economic experience does not lead me to the conclusion that protectionism or isolationism is an appropriate response.
Some think we need to somehow mandate the elimination of income disparities. While I share the exasperation of the chairman
over some of the outrageous CEO compensation recently reported,
I believe our corporate governance system works and that shareholders will correct these abuses without Government interference.
I believe education, not government attempts to redistribute income, is the proven route to improve wages for all workers.
Chairman Bernanke, the members of this committee, Republicans and Democrats alike, respect your experience, your judgment
and your obvious commitment to keeping America's economy strong
and competitive. We all share a goal of doing that and doing what
is best for American workers. We appreciate you being here and
look forward to hearing your comments.
The CHAIRMAN. The gentleman from Illinois, the chairman of the
Subcommittee on Domestic and International Monetary Policy is
recognized.
Mr. GUTIERREZ. Thank you, Mr. Chairman. And thank you,
Chairman Frank. Chairman Bernanke, I think it is safe to say that
you and I have different backgrounds and that we bring disparate
perspectives to the table when dealing with economic and monetary
issues. But after taking over the chairmanship of the Monetary
Policy Subcommittee, I am getting a sense of the significant and
daunting task that you face.
You should rest assured, however, that I will be here over the
next 2 years, along with 443 Members of the House and 100 Members of the other body, to second-guess your every move.
When it comes to economic and monetary policy, we are entering
a very crucial and complex period, especially for the Federal Reserve and its mandate of maximum employment, stable prices, and
moderate long-term interest rates.
For example, the housing boom has taken a substantial downturn. Energy prices have climbed and we are facing some serious
issues about our long term energy security. Some economists warn
the threat of inflation is on the horizon. Yet others appear less worried about inflation than the rising mortgage delinquencies and
foreclosures effecting a wider economy.
The two major Asian currencies are undervalued, and the U.S.
trade deficit is at record highs, while accusations of currency manipulations are frequently leveled against both China and Japan.
And perhaps most important of all, we face a huge Federal deficit
at a time when baby boomers are reaching retirement age and
healthcare costs are at an all time high.
While I am anxious to hear from you, Mr. Bernanke, what concerns me most is retirement insecurity. When it comes to kitchen
table issues, retirement insecurity is the obstacle for many American families. The U.S. economy is now producing over $13 trillion
a year. But many American families are struggling just to maintain
their living standards and they are up against stagnating wages,
diminishing healthcare, and retirement benefits that are just disappearing.
More and more families are living paycheck-to-paycheck with
very little in their bank accounts or none at all, and paying higher
interest rates and more fees than they should. And hanging over
their heads is retirement.
I know, Chairman Bernanke, that you have publicly addressed
the related issues of retirement insecurity, the budget deficit, and
the looming retirement of 78 million baby boomers on several occasions. But from what I have heard and read, you have approached
the problem only in terms of entitlement reform. Entitlement reform is needed. No question. But this is not just an issue of entitlement reform. The skyrocketing cost of healthcare are not just going
to disappear if we reduce entitlement spending. The costs will just
be shifted to already strapped family budgets. Many baby boomers
are simply not financially ready for retirement. If we substantially
cut healthcare, and Social Security spending for the baby boomer
generation, many will face healthcare crises that will drive them
into bankruptcy.
The correlation between rising healthcare expenses and personal
bankruptcy filings is well-documented. And merely moving these
expenses from the public sector to the American families, in my
opinion, is not good for long-term economic growth. We need more
than entitlement reform to give Americans retirement security. I
would like to hear your views on this today.
Clearly, no single political party and no single body, the Fed, the
Congress, or the Administration, has the answers to the problems
we face. We must work together. And I look forward to an open
frank dialogue with the Federal Reserve, my subcommittee counterpart, Dr. Paul, and the Treasury Department on all these issues.
And I yield back the balance of my time.
The CHAIRMAN. The gentleman from Texas, the ranking member
of the subcommittee.
Dr. PAUL. Thank you, Mr. Chairman, and welcome, Chairman
Bernanke. I am very pleased to be here today as the ranking member. In the midst of a great optimism of monetary policy and how
the economy is doing, I still have some concerns. And of course, one
of my long-term goals has always been to emphasize maintaining
the integrity of the monetary unit, rather than looking superficially
at some of our statistics. But I also share the concern of the chairman of the committee of our responsibilities for oversight and your
interest as well, Chairman Bernanke, on having the transparency
that I think we all desire.
Transparency in monetary policy is a goal we should all support.
I have often wondered why Congress has so willingly given up this
prerogative over monetary policy.
Congress, in essence, has ceded total control of the value of our
money to a secretive central bank. Congress created the Federal
Reserve, yet it had no constitutional authority to do so. We forget
that those powers not explicitly granted to the Congress by the
Constitution are inherently denied to the Congress, and thus, the
authority to establish a central bank was never given.
Of course, Jefferson and Hamilton had that debate early on and
the debate seemingly was settled in 1913. But transparency and
oversight are something else, and they are worth considering. Congress—although not by law—essentially has given up all its oversight responsibilities over the Fed.
There are no true audits. Congress knows nothing of the conversations, the plans, and the action taken in concert with other
central banks. We get less and less information regarding the
money supply each year, especially now that we don't even have access to M3 statistics.
The role the Fed plays in the President's secretive working group
on financial markets goes essentially unnoticed by Congress. The
Federal Reserve shows no willingness to inform Congress voluntarily about how often the working group meets, what action it
takes that affects the financial markets, or why it takes these actions.
But all these actions directed by the Federal Reserve alter the
purchasing power of our money, and that purchasing power is always reduced. The dollar today is worth only 4 cents compared to
the dollar that the Federal Reserve started with in 1913. This has
significant consequences on our economy and our political stability.
All paper currencies are vulnerable to collapse and history is replete with examples of great suffering caused by these collapses,
especially to the Nation's poor and middle class.
This can lead to political turmoil as well. Even before a currency
collapses, the damage done by a fiat system is significant. Our
monetary system insidiously transfers wealth from the poor and
the middle class to the privileged rich. Wages never keep up with
profits on Wall Street and the banks, thus sowing the seeds of class
and discontent.
When economic trouble hits, free markets and free trade are
often blamed, while the harmful effects of a fiat monetary system
are ignored.
We deceive ourselves that all is well with the economy and ignore the fundamental flaws that are a source of growing discontent
among the various groups. Few understand that our consumption
and apparent wealth is dependent on a current account deficit running at approximately $800 billion a year.
This deficit shows that much of our prosperity is based on borrowing rather than a true increase in production. Statistics show
year after year that our productive manufacturing jobs continue to
go overseas. This phenomenon is not seen as a consequence of the
international fiat money system where the U.S. Government benefits as the issuer of the world reserve currency.
Government officials consistently claim that inflation is in check
at barely 2 percent, but middle class Americans know that their
purchasing power—especially when it comes to housing, energy,
medical care, and school tuition—is shrinking much faster than 2
percent per year.
Even if prices are held in check in spite of our monetary inflation, concentrating on the CPI statistics distracts from the real
issue.
We must address the important consequences of the Fed manipulation of interest rates. When interest rates are artificially low,
below market rates, insidious malinvestment, and excessive indebtedness inevitably brings about the economic downturns that everyone dreads.
We look at GDP figures and reassure ourselves that all is well.
Yet a growing number of Americans still do not enjoy the high
standard of living that monetary inflation brings to the privileged
few. Those who benefit the most are the ones who get to use the
newly created credit first—
The CHAIRMAN. The gentleman's time has expired. If the gentleman will come to a conclusion.
Dr. PAUL. I will yield back.
The CHAIRMAN. I will now turn to the Chairman. And he is recognized for his opening statement.
Thank you.
STATEMENT OF HON. BEN S. BERNANKE, CHAIRMAN, BOARD
OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. BERNANKE. Chairman Frank, Representative Bachus, and
other members of the committee, I am pleased to present the Federal Reserve Monetary Policy Report to the Congress. Real activity
in the United States expanded at a solid pace in 2006, although the
pattern of growth was uneven.
After a first quarter rebound from weakness associated with the
effects of the hurricanes that ravaged the Gulf Coast in the previous summer, output growth moderated somewhat on average
over the remainder of 2006. Real Gross Domestic Product is currently estimated to have increased at an annual rate of about 2%
percent in the second half of the year.
As we anticipated in our July report, the U.S. economy appears
to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable average pace of growth.
The principal source of the ongoing moderation has been a substantial cooling in the housing market which has led to a marked
slowdown in the pace of residential construction.
However, the weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to
any significant extent to other sectors of the economy.
Consumer spending has continued to expand at a solid rate, and
the demand for labor remains strong. On average, about 165,000
jobs per month have been added to nonfarm payrolls over the past
6 months. And the unemployment rate, at 4.6 percent in January,
remains low.
Inflation pressures appear to have abated somewhat following a
run-up during the first half of 2006. Overall, inflation has fallen in
large part as a result of declines in the price of crude oil. Readings
on core inflation—that is inflation excluding the prices of food and
energy—have improved modestly in recent months. Nevertheless,
the core inflation rate remains somewhat elevated.
In the five policy meetings since the July report, the Federal
open market committee, or FOMC, has maintained the Federal
funds rate at 5Vi percent. So far, the incoming data have supported
the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing of core inflation.
However, in the statement accompanying last month's policy decision, the FMOC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected, and that
it is prepared to take action to address inflation risks, if developments warrant.
Let me now discuss the economic outlook in a little more detail
beginning with developments in the real economy and then turning
to inflation. I will conclude with some brief comments on monetary
policy.
Consumer spending continues to be the mainstay of the current
economic expansion. Personal consumption expenditures, which account for more than two-thirds of aggregate demand, increased at
an annual rate of around 3V2 percent in real terms during the second half of last year, broadly matching the brisk pace of the previous 3 years.
Consumer outlays were supported by strong gains in personal income reflecting both the ongoing increases in payroll employment
and a pickup in the growth of real wages.
Real hourly compensation, as measured by compensation per
hour in the nonfarm business sector deflated by the personal consumption expenditures price index, rose at an annual rate of about
3 percent in the latter half of 2006.
The resilience of consumer spending is all the more striking,
given the backdrop of the substantial correction in the housing
market that became increasingly evident during the spring and
summer of last year.
By the middle of 2006, monthly sales of new and existing homes
were about 15 percent lower than a year earlier, when the previously rapid rate of house price appreciation had slowed markedly.
The fall in housing demand in turn prompted a sharp slowing in
the pace of construction of new homes. Even so, the backlog of
unsold homes rose from about 4V2 months' supply in 2005 to nearly
7 months' supply by the third quarter of last year.
Single family housing starts have dropped more than 30 percent
since the beginning of last year. And employment growth in the
construction sector has slowed substantially.
Some tentative signs of stabilization have recently appeared in
the housing market. New and existing home sales have flattened
out in recent months. Mortgage applications have picked up. And
some surveys find that homebuyers' sentiment has improved.
However even if housing demand falls no further, weakness in
residential investment is likely to continue to weigh on economic
growth over the next few quarters as homebuilders seek to reduce
their inventory of unsold homes to more comfortable levels.
Despite the ongoing adjustments in the housing sector, overall
economic prospects for households remain good. Household finances
appear generally solid. And delinquency rates on most types of consumer loans and residential mortgages remain low. The exception
is subprime mortgages with variable interest rates for which delinquency rates have increased appreciably.
The labor market is expected to stay healthy. And real incomes
should continue to rise, although the pace of employment gains
may be slower than those to which we have become accustomed in
recent years.
In part, slower average job growth may simply reflect a moderation in economic activity. Also, the impending retirement of the
leading edge of the baby boom generation, and an apparent leveling
out of women's participation in the workforce, which had risen for
several decades, will likely restrain the growth of the labor force
in coming years.
With fewer job seekers entering the labor force, the rate of job
creation associated with the maintenance of stable conditions in
the labor market will decline.
All told, consumer expenditures appear likely to expand solidly
in coming quarters, albeit a little less rapidly than the growth in
personal incomes if, as we expect, households respond to the slow
pace of home equity appreciation by saving more out of current income.
The business sector remains in excellent financial condition with
strong growth in profits, liquid balance sheets, and corporate leverage near historical lows. Last year, those factors helped support
continued advances in business capital expenditures.
Notably, investment in high tech equipment rose 9 percent in
2006. And spending on nonresidential structures such as office
buildings, factories, and retail space increased rapidly through
much of the year after several years of weakness.
Growth in business spending slowed toward the end of last year,
reflecting mainly a deceleration of spending on business structures,
a drop in outlays in the transportation sector where spending is notably volatile, and some weakness in purchases of equipment related to construction and motor vehicle manufacturing.
Over the coming year, capital spending is poised to expand at a
moderate pace, supported by steady gains in business output and
favorable financial conditions. Inventory levels in some sectors,
most notably in motor vehicle dealers and in some construction-related manufacturing industries, rose over the course of last year
leading some firms to cut production to better align inventories
with sales. Remaining imbalances may continue to impose modest
restraints on industrial production during the early part of this
year.
Outside the United States, economic activity in our major trading
partners has continued to grow briskly. The strength of demand
abroad helped spur a robust expansion in U.S. real exports, which
grew about 9 percent last year. The pattern of real U.S. imports
10
was somewhat uneven partly because of fluctuations in oil imports
over the course of the year. On balance, import growth slowed in
2006 to 3 percent.
Economic growth abroad should further support steady growth in
U.S. exports this year. Despite the improvements in trade performance, the U.S. current account deficit remains large, averaging
about 6V2 percent of nominal GDP during the first three quarters
of 2006.
Overall, the U.S. economy seems likely to expand at a moderate
pace this year and next with growth strengthening somewhat as
the drag from housing diminishes.
Such an outlook is reflected in the projections that the members
of the Board of Governors and presidents of the Reserve Banks
made around the time of the FOMC meeting late last month. The
central tendency of those forecasts—which are based on information available at that time and on the assumption of appropriate
monetary policy—is for real GDP to increase about 2V2 to 3 percent
in 2007, and about two- or three-quarters to 3 percent in 2008.
The projection for GDP growth in 2007 is slightly lower than our
projection last July. This difference partly reflects an expectation
of somewhat greater weakness in residential construction during
the first part of this year than we anticipated last summer.
The civilian unemployment rate is expected to finish both 2007
and 2008 around 4V2 to 4% percent.
The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate.
Similarly, spillover effects from the developments in the housing
market onto consumer spending and employment and housing related industries may be more pronounced than expected.
To the upside, output may expand more quickly than expected if
consumer spending continues to increase at the brisk pace seen in
the second half of 2006.
I turn now to the inflation situation. As I noted earlier, there are
some indications that inflation pressures are beginning to diminish.
The monthly data are noisy, however, and it will consequently be
some time before we can be confident that underlying inflation is
moderating as anticipated.
Recent declines in overall inflation have primarily reflected lower
prices for crude oil, which have fed through to the prices of gasoline, heating oil and other energy products used by consumers.
After moving higher in the first half of 2006, core consumer price
inflation has also edged lower recently reflecting a relatively broadbased deceleration in the prices of core goods. That deceleration is
probably also due, to some extent, to lower energy prices, which
have reduced costs of production, and thereby lessened one source
of pressure on the prices of final goods and services.
The ebbing of core inflation has likely been promoted as well by
the stability of inflation expectations.
A waning of the temporary factors that boosted inflation in recent years will probably help foster a continued edging down of
core inflation.
In particular, futures quotes imply that oil prices are expected to
remain well below last year's peak.
11
If actual prices follow the path currently indicated by futures
prices, inflation pressures would be reduced further as the benefits
of the decline in oil prices from last year's high levels are passed
through to a broader range of core goods and services.
Nonfuel import prices may also put less pressure on core inflation particularly if price increases for some other commodities, such
as metals, slow from last year's rapid rates. But as we have been
reminded only too well in recent years, the prices of oil and other
commodities are notoriously difficult to predict. And they remain a
key source of uncertainty in the inflation outlook.
The contribution from rents and shelter costs should also fall
back following a step up last year. The faster pace of rent increases
last year may have been attributable in part to the reduced affordability of owner-occupied housing which led to a greater demand
for rental housing. Rents should rise somewhat less quickly this
year and next reflecting recovering demand for owner-occupied
housing as well as increases in the supply rental units. But the extent and pace that of that adjustment is not yet clear.
Upward pressure on inflation could materialize if final demand
were to exceed the underlying productive capacity of the economy
for a sustained period. The rate of resource utilization is high, as
can be seen in rates of capacity utilization above their long term
average, and most evidently, in the tightness of the labor market.
Indeed anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in certain occupations.
Measures of labor compensation—though still growing at a moderate pace—have shown some signs of acceleration over the last
year, likely, in part, as the result of tight labor market conditions.
The implications for inflation of faster growth in nominal labor
compensation depend on several factors. Increases in compensation
might be offset by higher labor productivity or absorbed by a narrowing of firm's profit margins rather than passed on to consumers
in the form of higher prices. In these circumstances, gains in nominal compensation would translate into gains in real compensation
as well. Underlying productivity trends appear favorable. And the
markup of prices over unit labor costs is high by historical standards, so such an outcome is certainly possible.
Moreover, if activity expands over the next year or so at the moderate pace anticipated by the FOMC, pressures in both labor and
product markets should ease modestly. That said, the possibility
remains that tightness in product markets could allow firms to
pass higher labor costs through to prices, adding to inflation and
effectively nullifying the purchasing power of at least some portion
of the increase in labor compensation. Thus, the high level of resource utilization remains an important upside risk to continued
progress on inflation.
Another significant factor influencing medium term trends in inflation is the public's expectations of inflation. These expectations
have an important bearing on whether transitory influences on
prices, such as those created by changes in energy costs, become
embedded in wage and price decisions, and so leave a lasting imprint on the rate of inflation.
It is encouraging that inflation expectations appear to have remained contained. The projections of the members of the Board of
12
Governors and the presidents of the Federal Reserve Banks are for
inflation to continue to ebb over this year and next. In particular,
the central tendency of those forecasts is for core inflation—as
measured by the price index for personal consumption expenditures
excluding food and energy—to be 2 to 2Vi percent this year and to
edge lower to 1% to 2 percent next year. But as I noted earlier,
the FMOC has continued to view the risk that inflation will not
moderate as expected as the predominant policy concern.
Monetary policy affects spending and inflation with long and
variable lags. Consequently, policy decisions must be based on an
assessment of medium term economic prospects. At the same time,
because economic forecasting is an uncertain enterprise, policy
makers must be prepared to respond flexibly to developments in
the economy when those developments lead to a reassessment of
the outlook.
The dependence of monetary policy actions on a broad range of
incoming information complicates the public's attempts to understand and anticipate policy decisions. Clear communication by the
central bank about the economic outlook, the risk to that outlook,
and its monetary policy strategy, can help the public to understand
the rationale behind policy decisions and to anticipate better the
central bank's reaction to new information. This understanding
should, in turn, enhance the effectiveness of policy and lead to improved economic outcomes.
By reducing uncertainty, central bank transparency may also
help anchor the public's longer term expectations of inflation. Much
experience has shown that well-anchored inflation expectations
help to stabilize inflation and promote maximum sustainable economic growth.
Good communication by the central bank is also vital for ensuring appropriate accountability for its policy actions, the full effects
of which can be observed only after a lengthy period.
A transparent policy process improves accountability by clarifying how a central bank expects to attain its policy objectives and
by ensuring that policies are conducted in a manner that can seen
to be consistent with achieving those objectives.
Over the past decade or so, the Federal Reserve has significantly
improved its methods of communication, but further progress is
possible. As you know, the FOMC last year established a subcommittee to help the full committee evaluate the next steps in
this continuing process. Our discussions are directed at examining
all aspects of our communications and have been deliberate and
thorough. These discussions are continuing and no decisions have
been reached. My colleagues and I remain firmly committed to an
open and transparent monetary policy process that enhances our
ability to achieve our dual objectives of stable prices and maximum
sustainable employment.
I will keep members of this committee apprised of developments
as our deliberations move forward. I look forward to continuing to
work closely with the members of this committee and your colleagues in the Senate and the House on the important issues pertaining to monetary policy and the other responsibilities with
which the Congress has charged the Federal Reserve. Thank you.
I would be happy to take questions.
13
[The prepared statement of Chairman Bernanke can be found on
page 71 of the appendix.]
The CHAIRMAN. Thank you, Mr. Chairman. I have to say that
when you say you would be happy to take questions, you were
somewhat more persuasive than when your predecessor used to say
that.
And I will apologize in advance to the media, because you have,
I think, over the past months in particular, said some very reasonable things from my standpoint, so I have less to complain about
than they might have hoped, I am sure, in Karl Rove's eyes, so
they should not lose heart.
I particularly want to begin by thanking you for the very appropriately nuanced discussion of wages. It has troubled me for some
time, and particularly when I read some of the financial pages,
that there is a good news, bad news story. The good news is that
profits are up; the bad news is that wages are up. And wages are
too often written about as if they were simply a constraint on prosperity.
I particularly appreciate on page 7 of your testimony where you
note that an increase in wages, certainly to the level of productivity, should not be a problem, and that in general, there is nothing automatic about a rise in wages leading to inflation.
It depends on the impact on prices. And in that context, I especially welcome your noting that not only the underlying productivity trends appear favorable—and this is in your discussion of
wages and inflation. Underlying productivity trends appear favorable and the markup of prices over unit labor costs is high by historical standards.
I hope this is widely noted, your statement that, in fact, it would
not appear to be wage driven pressure to raise prices, because as
you note, the markup of prices over cost in this regard is high by
historical standards.
I would add you did not cover that, it was not in your topic, that
there has also been a reduction in the tax burden. So we ought to
be clear that this simplistic notion that if wages go up, that is
going to cause inflation, is not the case, and that, in fact, there is,
as you say, and I appreciate this, some reason, some room for legitimate wage increases to be absorbed without that being inflationary.
Now, there is, however, some bias still in the way we talk about
things. And I did note that there was great relief that you apparently indicated yesterday that it is unlikely that you will be presiding over increases in interest rates in the future. But as I read
your report, it seems to me that frankly, the question ought to be
whether or not there are decreases. In the Monetary Policy Report,
on the first page of your—let me read two statements: "On balance
growth of real Gross Domestic Product appears likely to run slightly below that of the economy's potential over the next few quarters,
and then to rise to a pace around that of the long run trend."
Next paragraph. "Regarding inflation increases in core consumer
prices are expected to moderate on balance over the next 2 years."
In other words, the prediction is, economic growth below the economy's potential for a while, and then reaching potential but not
going above it.
14
Similarly, "inflation is going to moderate an economy performing
somewhat", not enormously, but "somewhat below potential tending towards potential and inflation that is expected to moderate."
I suppose that would be an argument for balance if nothing
changes. But I don't see how we get a concern of inflation as the
major concern here.
And as you say, well, but you're still worried more about inflation and the sense is, stop him before he raises again, but no likelihood of a drop.
I don't understand why this shouldn't make it at least as likely
as a drop. Again, we have an economy that is running below potential and we have moderating inflation. Why is that not at least an
equal chance for there to be a reduction in the time ahead?
Mr. BERNANKE. Mr. Chairman, first of all, policy is going to respond to new information. We are going to be continually reassessing our outlook and responding appropriately as we see the
economy evolving. Policy also has to respond to risks. There are
risks in both directions. On the real side, I talked about housing
as a downside risk, but there is also some upside risk.
We have seen very strong consumer spending numbers. We have
seen some strong income growth which suggests that the economy
may be stronger than we think. It is possible. And in a sense, aggregate spending may exceed our capacity and put pressure on
product markets, and that would be a concern.
The other issue is on inflation. We have had a period where inflation has been above where we would like to see it as far as consistency with price stability is concerned.
In order for this expansion to continue in a sustainable way, inflation needs to be well-controlled. If inflation becomes higher for
some reason, then the Federal Reserve would have to respond to
that by raising interest rates. That would not contribute to the continued—
The CHAIRMAN. I understand that, Mr. Chairman, but you know,
I am a little puzzled—you tell me that your report says production
below potential rising to potential. But then you say, well, you
think it might be more than you think. I mean, if you think it
might be more than you think, why didn't you think it? It does
seem to be a little odd for you to say that here is what I think,
but I also think it might be worse than I think.
That is literally double-think.
And what particularly concerns me, I read those two sentences,
production now below potential, and prediction only to get to potential not above it, and inflation moderating, and I don't see how that
computes with, as I noted earlier, the FOMC has continued to view
the risk that inflation will not be moderated as the predominant
policy concern.
I can understand it being a concern. I don't understand how,
given this, it outweighs the other.
And let me say in that regard, and I more or less stick to time
limits, I appreciate your discussion about transparency on—and
your discussing this. And I do want to—let me point—there he is.
When I came to Congress, in 1981, the open market committee
was, from the standpoint of publicity, the closed market committee
because it did not even announce on the day of the vote what the
15
vote was. And that gentleman up there, Mr. Gonzalez of Texas,
crusaded, I think, effectively and appropriately, for some transparency. We have much more.
Here is my concern. When you talk about changing the way you
communicate uncertainty, here is the problem. It is easier for you
to be certain about what you want the interest rate to be than
about what you want employment to be, because you have more
control of one than the other. I admire the desire for more transparency. I express my concern that procedure and substance may
intermix here and that the argument for greater certainty can become—and you say we have the two objectives, stable employment—stable prices and employment.
But one of those might—I appreciate the fact that you have two
children and you love them both. But I am afraid that one of them
might get a little bit more for Hanukkah than the other if we are
not careful. So I do want to ask that we be kept involved in this
process.
But I also want to reiterate from the standpoint of what I talked
about before from the social health of this country—and I will
close. I know there are people saying that the economy is very
good. Let me be partisan for a minute. I say to my Republican
friends, keep telling the American people how good the economy is,
because the disparity between what you tell them is happening and
what they feel themselves makes them even angrier.
But if inflation is the predominant concern, given your own statements, it seems to me that you have made an argument that it
ought to be at least balanced; that is troubling to me.
Mr. BACHUS. Thank you. Chairman Bernanke, the chairman
mentioned the economy and our different perspectives and our
viewpoints. The chairman and others have said that all these 7.5
million new jobs that have been created are all low-income workers. They are not higher paying jobs. I notice that the Bureau of
Labor statistics job data that was released just yesterday indicates
that job creation was roughly distributed across the income spectrum.
Can you tell me why there is a perspective and whether it is true
that this viewpoint that all these new jobs are low income, when
I say that the recovery is benefiting the middle class and the creating higher paying jobs?
Mr. BERNANKE. Well, in terms of the distribution of jobs, as I
mentioned in my testimony, there is an enormous demand for highly skilled workers and of high-paying jobs. And the constraints on
the highest paying jobs, for example in manufacturing, is not the
demand but the supply. Firms can't find workers of sufficient qualifications in many different areas. So there certainly has been job
creation at the high level as well as throughout the distribution of
wages.
Mr. BACHUS. SO the economy is, in fact, creating so many highly
paid, skilled jobs that there simply is not the workforce to fill those
jobs?
Mr. BERNANKE. AS I have indicated recently, I think one of the
major constraints in our economy and one of the sources of concern
about equality and inequality has to do with educational differentials. And the more that we can help people acquire sufficient skills
16
so that they can be eligible for those high-paying jobs, the better
off we are going to be.
Mr. BACHUS. Thank you.
The chairman said he was more pleased with you than he has
been in the past. And I am sure that he read the same article I
read in The American Banker, where it was titled that you had endorsed the GSE housing fund—that the affordable housing fund
that the chairman put forward.
When I saw your testimony I didn't see that in it at all. But let
me ask you this question. There is a philosophical debate going on
in this committee about the creation of these funds, government
control, government mandate, government-directed funds. There
really are two of them. One that has gotten all the publicity is the
affordable housing fund, to which the GSE's will be required to pay
a portion of their revenue.
And members of this committee, at least Republican members,
we see this as an added cost to low- and middle-income homeowners. Now, I think across the—I will call this the divide, across
the divide, there is an agreement that the GSE's could do a better
job on their affordable housing mission. But we are very skeptical
that if you take money that is designated to provide liquidity for
people to buy homes, you either increase the cost of that home, of
that home mortgage, or the availability of that home mortgage, and
we think there is a better way than a government-dictated plan.
Clearer maybe than that is the other proposal that has achieved
almost no publicity, and we had a spirited debate in this committee
2 days ago, is that my Democratic colleagues are endorsing an insurance company's funding of a community reinvestment fund.
Massachusetts created such a fund in 1998 where insurance companies are directed to pay a part of their income into a fund which
the, I guess the State of Massachusetts, directs into affordable
housing or community investment projects.
And we debated that because we Republicans felt that when we
pay our premiums to an insurance company, we want that money
to be invested at the highest possible return so that claims can be
paid. We feel like the proper role of an insurance company is not
to take our money, an insured's money, and invest it in some community's project, we feel that the proper role for them is to pay
claims.
So I just ask you, first of all, would you clarify your remarks over
in the Senate, or is there any clarification needed, and do you have
any unease over the creation of more government funds of this nature, and the cost on American homeowners or any of us who pay
premiums to insurance companies?
Mr. BERNANKE. Congressman, the story was misreported, and
you misunderstand my position. I did not address the affordable
housing fund, either pro or con. The concern that the Federal Reserve has had for a long time about GSE's is the potential for their
portfolios to create systemic risk in our financial system. I should
say that we very much support the GSE's housing mission, and we
believe, in particular, that the securitization function contributes to
liquidity in the mortgage market. Again, our concern is about the
portfolios and their enormous size and the complex derivative exercises that are needed to maintain the balance of those portfolios.
17
My comment was one that built on suggestions that Chairman
Greenspan had made in previous testimonies, which was that one
way to limit the growth of the portfolios, but also to achieve the
stated public purpose of the GSE's was, in some way, to anchor the
portfolios in the public purpose, which is affordable housing.
According to OFHEO, only about 30 percent of the portfolios are
related in any way to affordable housing. So I think what I would
like to see would be the portfolios to be more directly connected to
a public purpose, perhaps holding affordable housing mortgages or
another way, more directly promoting affordable housing rather
than acquiring all different kinds of assets that are not related to
affordable housing.
Mr. BACHUS. Thank you.
The CHAIRMAN. The gentleman from Pennsylvania.
Mr. KANJORSKI. Mr. Chairman, welcome to the committee. It is
fascinating to listen to the discussion, and obviously long-ranging,
but I have a few questions in regard to the emphasis in the public
press over the last several months on executive salaries and what
the appropriate response would be to them.
First of all, I would like your opinion as to how they rate on that
scale of fair or unfair—whether or not they should be subjected to
oversight, and if subjected to oversight, should they be subjected to
some curative action by the Congress? In particular, we are looking
at the U.K.'s shareholders' rights approach and their ability to give
advisory opinions on executive packages.
If you can summarize, in some way, your views and what the effect of that would be, positively or negatively on the market and
the economy, it would be most appreciated.
Mr. BERNANKE. Thank you. I think it is very important for shareholders to be aware of compensation packages that CEO's are receiving. So if they are displeased, they can register that displeasure
through the directors or through selling stock. So I strongly support disclosure efforts. The Securities and Exchange Commission
recently built on the efforts of the exchanges, the NYSE, for example, in requiring more extensive disclosure of compensation packages on details. I think that is a very important step in the direction of making sure that shareholders have full information so they
can make appropriate decisions about whether these packages are
in the interest of the company or not.
Mr. KANJORSKI. DO you have any opinion as to the United Kingdom's approach of actually enacting advisory opinions expressed by
shareholders and whether or not that has had any positive effect
on the reduction of some of these packages and/or other shareholders rights, litigation, and other things that may have been
modified? When you look at the numbers, the U.K. is significantly
lower than the American market. We are wondering whether that
is something that has been reviewed by the Federal Reserve?
Mr. BERNANKE. In general, the CEO salaries are lower in Europe
than the United States, and, to some extent, it is a puzzle why that
is the case. I think there are a lot of reasons for it. But certainly,
one thing we want to be sure we are doing is ensuring good disclosure and good oversight.
I don't really have an opinion on the advisory council. I think we
should be sure that the compensation decisions are being made in
18
a disinterested independent way, and that the directors who are involved in compensation are independent, and not subject to the influence of the management.
Mr. KANJORSKI. Very good. If you rate on a scale of what is economically fearful in our society today, particularly the domestic
economy, what would be the greatest fear that you have?
Mr. BERNANKE. There is a set of issues that are interconnected,
having to do with savings and deficits and current account and so
on. We are a low-saving society in general, and we are facing a demographic transition which will mean that a much larger share of
our population is of retirement age or outside the workforce. That
is going to pose enormous challenges to our fiscal budget. It is also
going to pose enormous challenges to our economy as a whole, because with fewer workers, we need to have more capital, more savings, and more preparation for the economy to be able to absorb a
larger number of retired workers. Related to that, of course, is the
increase in medical care costs which also puts pressure on fiscal
policy.
So the fiscal issues in the low savings rates, which also contribute to the current account deficit, I think are at the center of
the issues we should be concerned about. We really need to address
our savings issues and the implications of the demographic transition that we are seeing not very far in the future.
Mr. KANJORSKI. What role should Congress or the government
play in that?
Mr. BERNANKE. The government needs to address both the fiscal
implications of aging—certainly a part of that is the cost of medical
care, which is a big part of the economic cost of aging—and also
of the fiscal burden. And to the extent that outside of the fiscal
arena we can find ways to encourage savings more broadly, and
asset-building, I think that would be very constructive.
Mr. KANJORSKI. SO you see a very positive role for government
to play?
Mr. BERNANKE. Good policies would certainly be helpful, yes.
The CHAIRMAN. The Chair wants to announce, in recognizing
members, that the two parties follow different patterns, and the
Chair is accepting the ranking member's suggestions. So you may
notice some disparity. We go by seniority; they go by, I guess, when
members arrive.
I want to explain that part because a recent analysis of what I
am thinking made a great deal of the fact that a certain witness
will be testifying tomorrow, and the witness is the choice of the
gentleman from Texas. So I realize that people may not be fully
aware of what we are doing.
Next on the list is the gentleman from Louisiana.
Mr. BAKER. I thank the chairman.
Chairman Bernanke, following up in some measure on the course
relative to problems of significance going forward, there are undoubtedly negative effects of the inversion in the workforce, where
we have more people retired, and less people working.
At the same time, though, there has been an offsetting growth
that has been, frankly, surprising to me at the number of investors
in equities over the last 2 decades. I was particularly struck by the
fact, according to the mutual fund industry, that in households
19
with aggregate annual incomes of less than $35,000, 31 percent
hold mutual fund holdings. What it triggers for me is an understanding by working families that for their long-term financial security, they need to be invested in the markets.
Now, we can debate whether it is index investing, whether or not
actively managed is good or not. The bottom line is, if you are
going to do something beyond your earnings from salary, investing
in overall economic growth is a very sound policy, particularly for
the younger and newer entries into the workforce.
There are now issues, I believe, in international competitiveness
that are overhangs that cause concern, whether it be potential for
class action litigation, whether it is the wage—excuse me, the tax
rates here as contrasted with those in Europe, and there seems to
be certainly an outflow of manufacturing-type employment to other
countries, leaving us with a more technology-based economy going
forward.
Having said all of that, it seems that with the percentage of Federal spending in 1956 at—20 percent of Federal spending was on
Social Security and related entitlements; today we see that crossing
over 60 percent. Given your comment and concern as to the biggest
problem facing us, how do we provide for retirement security for
working families?
It seems most Americans have figured that out; they need to be
in the markets. Isn't it time for this Congress to really seriously
consider voluntary, not saying mandated requirement, but voluntary flexibility and directing your Social Security or retirement
savings into market-invested, market-based investments? It would
seem to me that the sooner we get out or away from these enormous entitlement obligations with the inversion in the workforce
and the expectations of most people to retire at age 65, that there
isn't a way out of this morass without allowing people to share in
the overall economic prosperity of this Nation through some sort of
equities investment.
If we don't do that, what is the solution to the retirement problem we face?
Mr. BERNANKE. I think it is very valuable for people to have the
opportunity to own an account, to have some exposure to investment even if it is in index funds which you point out, so that people
have the pride of knowing that they are providing for their own retirement. So I think it is a very good idea to encourage people to
begin to build wealth, and to begin to hold assets.
As you know, the Social Security aspect of this is a very complex
debate. The diverting of funds the way you describe has some of
the benefits of giving people the opportunity to have control over
their own accounts, but it also doesn't really directly address the
long-term imbalance on the fiscal side of the spending and revenues of the Social Security system.
Another approach, which is related and might work better without addressing the Social Security concern directly would be to
have add-on accounts where people would have the option to put
in additional moneys that could be invested in—
Mr. BAKER. If I may before my time expires, just as a quick follow-up, the rate of return, though, on the Social Security investment is currently so low that if you were to divert any portion of
20
that into an active investment account, the yield would be so much
greater than what you currently earn—and I know of your concern
that current earnings are paying current retirees' benefits. I believe
with the proper managed investment account over time, you could
pay those current retirees' benefits and still have a yield sufficient
left as a net margin that would beat the current rate of return for
a Social Security recipient. In essence, we can accomplish both
goals with a very carefully managed investment.
Mr. BERNANKE. I understand that position has been espoused. I
think just one concern is that the historical outperformance of equities relative to bonds may reflect to some extent the higher riskiness of stocks. To some extent it is a risk premium, and you
know—
Mr. BAKER. But there has never been a 10-year period when the
market didn't beat Social Security.
The CHAIRMAN. It is a very deep issue about why equities have
performed better than bonds. But if you look at stock markets in
czarist Russia, they wouldn't look so good today. The United States
has been very successful. We have had a growing economy. We
have succeeded in escaping the Depression and World War II and
so on. So in that respect our stock market may not be representative of the world's equities in some sense.
It is a very difficult question. I would only make the point that
you cannot assume that equities will pay the high rate of return
in the future that they have in the past. There certainly is some
risk to that.
The gentlewoman from California.
Ms. WATERS. Thank you very much, Mr. Chairman. I would like
to thank Chairman Bernanke for being here this morning.
It is always good to have you before this committee discussing
the important economic issues of the day. I worked to prepare a
statement last evening, but I have decided not to read that statement because my staff just gave me this morning, remarks by
Chairman Ben S. Bernanke on the level and distribution of economic well-being.
I just read it. I am extremely moved by your remarks, and I do
think that you have taken a rather complicated issue and helped
to remove it from simply a discussion of you either have education
or you don't, you either are going to make it, pull yourself up by
your bootstraps, kind of the government has no responsibility for
that.
It is not that simple. And you talk about opportunity and ensuring a fairness and opportunity, but not guaranteeing any outcomes,
and you talk about the responsibility of the individual, but in this
discussion it was quite expansive.
I watched the closing of a Goodyear plant in Los Angeles when
I first ran for office, and I saw people who had worked at that
plant for 20, or 25 years who paid taxes, sent their kids to school,
and had mortgages, suddenly out of a job, and I watched men go
to the bar across the street from the plant for the next 5 or 6 years
and just drink themselves into oblivion—not being retrained, unable to get jobs because of their age, etc. You kind of allude to that.
You also talk about the importance not only of formal education,
K through 12, but also the other opportunities in our society for job
21
training, the community colleges. You even allude to and talk a little bit about preschool, and of course, I am from Head Start. Having taught and worked in Head Start, I think that is extremely important, building self-esteem and certain kinds of values at an
early age.
But I would like to hear you talk a little bit more about policy
implications. Aside from that which you alluded to, you know, education through job training, etc., do you think there is room for perhaps tax incentives to corporations and businesses that do on-thejob training to make sure that people are trained for real jobs that
are sustainable?
I would like to hear a little bit more about what you think we
could do with public policy to close this growing income and wage
gap. You discussed the superstars and CEO's and globalization and
trade and all of that, and the bottom line is, there is this growing
wage and income gap. What other policy possibilities can you share
with us for helping to close this gap?
Mr. BERNANKE. Thank you for taking the time to read my
speech. I know it wasn't a short set of remarks.
The broad point I am trying to make in those remarks is that
I believe that technology and trade, which are tremendously important forces for American economic growth, unfortunately have the
side effect that they sometimes cause dislocations, like the one you
were just describing, and I think it is very important that we not
respond to those dislocations by saying, "Well, we are going to stop
trade, we are going to stop technological improvement." That is
really doing more harm than good, I think.
So then the logical consequence is, if we want to protect people
and help them deal with these dislocations, and we don't want to
stop the processes that generate growth in our economy, we have
to find other ways to help people adjust and adapt. And I talked
about a number of general approaches in my remarks.
I do sincerely believe that what you know and what you can do
is critical, that training—not just K-12 education, but all kinds of
training—community colleges, junior colleges, online courses, training on the job—all those things are critical to getting people the
skills they need so they will be in demand and be able to find good
work when changes in the global economy mean that their Goodyear plant has shut down.
I also indicated in my remarks that we could perhaps reduce
some of the anxiety about job loss if we didn't tie all benefits so
directly to employment. So, for example, I think it is an issue that
healthcare is so directly tied to employment.
Ms. WATERS. Portability of healthcare?
Mr. BERNANKE. Portability of health insurance would be, I think,
a positive development. It would reduce the anxiety that people
face when they worry about their jobs, and indeed, some of the
anxiety which I hear a great deal about may be less what has actually happened than what people fear may happen. It is the insecurity rather than the actual outcome so far that people are worried
about. So I think there are, you know, a number of general things
we should try to do.
Now, one thing I also said in my remarks is that solving this
problem is very, very difficult. How exactly we can make sure that
22
training programs work effectively instead of just wasting money
is very difficult. Finding the best way to make health insurance
portable; there are lots of ways to approach it, but it is difficult.
So I turn it back to you, unfortunately. I think the Congress is
going to have to think hard about the best ways to address these
things, but they need to think about them.
Ms. WATERS. Mr. Chairman, I would like to ask unanimous consent to submit these remarks for the record.
The CHAIRMAN. Without objection.
The gentleman from Texas, Mr. Paul.
Dr. PAUL. Thank you, Mr. Chairman.
I would like to pursue the issue of the current account deficit. It
seems like almost all economists express concern, some worry
about it, but I can't find anybody who tells us that we should totally ignore it. And we do now borrow approximately $800 billion
every year. We have a foreign debt of several trillions of dollars,
and to me it represents an imbalance which is the consequence of
the monetary system and presents a potential problem for us. Likewise, I see that potential problem in the number of derivatives out
there. There is one figure that says there are $236 trillion of derivatives, and it seems like very few people understand exactly
what that means, and it certainly is so huge and diverse. I don't
even think the Congress that we have that is always anxious to
regulate everything has offered a scheme for regulating derivatives
because, quite frankly, I don't think they are capable of doing that.
Foreigners now own 43 percent of our debt, approximately twice
as much as the Fed has been required to borrow. And one of the
questions I have is how much pressure would it put on you if—I
guess in even a theoretical sense, what if they didn't buy any of
our debt, and all of a sudden you had to deal with that problem?
Right now, there is a sign that maybe they are buying less. We
have heard rumors and innuendos in the media and hints from
China that, yes, they are not going to be buying as much, and yet
there hasn't been really a crisis. There has been no panic, and we
know there is self-interest on their part to maintain the dollar because they hold so many.
But in many ways I think we get a free ride. We get to export
our dollars. We don't have to monetize them here. We get to export
our inflation, but it potentially has a problem for us if all of a sudden they buy less, and these dollars come home or these dollars go
into goods and services.
Also the other concern that I have that I would like you to address is the subject of the revaluation of the yuan. I understand
you and Secretary Paulson went over to China to put pressure—
at least the media presented it that way—put pressure on them to
increase the value of the yuan and decrease the value of the dollar
in relationship, which in reality, it seems to me, would put pressure on our interest rates and push our interest rates up and raise
our prices. And some people have reported that couldn't possibly be
our policy where we would deliberately want to do that. And then
again, it would put more pressure on—I know it is an artificial arrangement right now.
But in some ways what the Chinese have done is they have revived the old Bretton Woods standard of fixing their currency to
23
our dollar, and some people look longingly to the Bretton Woods
days where we worked with fixed exchange rates. Of course, there
were different conditions then.
But if you would, if you would address both what our position is
with the Chinese yuan as well as what happens if they significantly—if the foreigners, especially Japan and China, start to buy
a lot fewer dollars and how that would affect your policy.
Mr. BERNANKE. Thank you. You are correct that we are to some
extent dependent on capital inflows to support the trade and current account deficits we currently have. The current demand for
U.S. assets from abroad both from public and private sources remains strong, so there doesn't seem to be any immediate concern
that will not continue. However, there is a risk sometime in the future that there would be less demand for dollar assets, and that
could cause some movements in currency and bond markets that
might be disruptive. And for that reason I have advocated, as many
others in Congress have, that we have tried gradually to move our
current account deficit down to a more sustainable level.
The way to do that essentially, it is a very complex subject, but
essentially the current account deficit arises because of
asymmetries in the saving investment balance here and abroad. In
the United States we have a decent rate of investment, including
construction of new homes, but relatively low saving rates, and
that difference we have to borrow abroad, whereas in many other
countries in East Asia, and among oil producers and the like, they
have an excess of saving over investment, and they are lending us
that difference, and that is why the capital flows are moving from
abroad to the United States.
The way to adjust that, over time, is to create a better balance
of savings and investment both in the United States, which would
be through primarily greater saving, but also abroad by creating
more reliance on domestic demand for growth. So, for example, in
China there is a long-term plan, which we support, to try to reduce
the reliance of the economy on exports and increase its reliance on
domestic consumption, thereby reducing their savings rate to a
more appropriate level, which also increases the living standard of
their people. So I think with that process we can move gradually
toward a greater balance.
With respect to the yuan, I think there are several reasons to
move towards greater flexibility in the yuan, and I described them
in a speech I gave in China. First, China is a very large country,
and it should at some point have an independent monetary policy
of its own rather than being tied to the United States. In order to
do that, they have to have a flexible currency.
Secondly, the flexibility of the yuan is needed to accomplish this
rebalancing from export orientation to domestic demand that I was
referring to earlier.
And thirdly, yuan appreciation and flexibility makes some contribution to helping us to rebalance the current account deficit we
currently have, although I think the larger force quantitively would
be the rebalancing of demand from exports towards domestic demand in China.
The CHAIRMAN. The gentlewoman from New York.
Mrs. MALONEY. Thank you, Mr. Chairman.
24
And welcome back, Chairman Bernanke. Many of my colleagues
have been quoting "American Banker." I would like to show you
"The Hill." There you are on the cover. It says your testimony
sparked a stock price rally, and the Dow is up 87 percent, and
there is great optimism for our economy, and I hope you are right.
I hope the stock market is right.
But regrettably, some of my constituents are not feeling optimistic. They feel that the economic expansion has not ended up in
their take-home pay, and some are very concerned about losing
their homes, and I share that concern. They are concerned about
the rising rate of mortgage defaults and home foreclosures. In my
district employment is high and stable, yet I am being told that
foreclosures are at rates that are up by an order of magnitude—
they have jumped up dramatically from what they were last year.
Some of my colleagues tell me that they are experiencing the same
thing in their districts around the country, and they are being told
that homeowners are losing their homes in very stable neighborhoods, and some say that this is due to various causes such as unemployment. Yet in my district and others where employment is
high, and in some other areas, it is due to the decline in the housing market.
But many also ask whether certain mortgage products, particularly in the subprime market, have contributed to this foreclosure
crisis or challenge. In particular, many point to the so-called 2/28
ARM's, and some have described them—and I quote—as an inherent predatory product. And as you have told me and others, these
2/28 ARM's are 80 percent of the subprime market.
Recently the Fed wrote back to Senator Dodd, taking the position
that in its recent guidance on nontraditional mortgages, they did
not extend to 2/28 for similar projects. And since these are what
many people think is the problem, my question is why is the Fed
not addressing the 2/28's and issuing guidance for what many people feel is the main problem in the foreclosure rates and the loss
of homes of many people?
You eloquently have said many times that homeownership leads
to participation in our economy and increased wealth for Americans, yet if you are losing your home, it is leading you to a personal
crisis, and if it continues, we will be facing a tremendous crisis in
our economy and in our districts. And now for your comments on
whether or not the Fed plans to extend guidance to the 2/28
subprime project, products.
Mr. BERNANKE. YOU are correct, Congresswoman. There has been
a surge in delinquencies and foreclosures, particularly—as I mentioned in my testimony—in subprime lending with variable rates,
rates that adjust with short-term interest rates, and that is a concern to us. We certainly have been following it carefully. It is obviously very bad for those who borrow under those circumstances,
and it is not good for the lenders either, who are taking losses.
We have tried, together with the other banking agencies, to address some of these concerns. We recently issued a guidance on
nontraditional mortgages, which had three major themes. The first
was that lenders should underwrite properly, that is, they should
make sure that borrowers had the financial capacity to pay even
when rates go up, and not simply underwrite based on the initial
25
rate but also deal with the possible payment shock. Secondly, that
lenders should give full disclosure and make sure that people understand the terms of the mortgages they are getting into. And I
would add that the Federal Reserve provides a number of documents, booklets, and descriptions that are required to be included
along with mortgage applications for adjustable rate mortgages.
And thirdly, and this is more on the issue of the lenders rather
than the borrowers, that lenders should make sure they appropriately risk manage these exotic mortgages, which we don't have
much experience with, so some caution is needed in managing
them, as we are now seeing. So those, I think, are very good principles, and I think we would stand by those principles.
Now the question has arisen whether the 2/28's, 3/27's are covered by this guidance, and I think the answer is yes and no. The
guidance as written refers to specific types of mortgages, including
those that have negative amortization, that is, the amount owed
can actually go up for a period, which is not usually the case with
2/28's and 3/27's. So in that respect, those types of mortgages were
not, you know, literally included in that initial guidance.
We, the Federal Reserve, along with the other banking agencies,
are currently preparing a clarification to the initial guidance which
will say that these same principles apply also to mortgages of this
type that have variable rates, and particularly those that are of a
subprime nature. But I would just say now that I hope that in our
guidance, in our supervision, that we have conveyed to lenders that
those three principles, good underwriting, good disclosure, and good
risk management, are broad, good business principles, and they
should be applying those to all mortgages they make.
Mrs. MALONEY. My time is up, but, Mr. Chairman, can I just ask
when will this guidance be up? Because it is very important. What
is the time frame for my constituents?
Mr. BERNANKE. Very soon, very soon.
The CHAIRMAN. The gentlewoman from Ohio.
Ms. PRYCE. Well, thank you, Mr. Chairman.
Welcome, Mr. Bernanke. It is great to have you here. I would
like to actually discuss for a moment the cost of healthcare in this
country, it is definitely one of the major concerns when I talk to
business and industry in my district. It certainly drives up the cost
of doing business in our country. Certainly not the only thing, regulation, litigation and other factors, but it is more important because
it affects families everywhere.
The greatest problem is that people just can't find health insurance that they can afford; therefore, they don't get the medical
treatment that they need. And it occured to me, and many others
that one of the reasons for this is because there is really no consumer factor in healthcare in this country. We don't shop for our
benefits. We take what our insurance companies provide for us.
Market forces seem to work very well in all other aspects of our
society. Is this what is wrong with our healthcare delivery system,
this lack of market force, so to speak? And as I am sure you are
aware, the President has proposed a very ambitious healthcare
plan designed to provide enhanced tax benefits to individual purchasers, and I assume that is so that more people will purchase insurance, more people will shop for insurance, and therefore they
26
will pay more attention to their healthcare needs, and it would
bring healthcare more in line with how we make other purchases
in this country.
I just would like to know if you think that would be a good way
to go, how it might affect international competitiveness, and then,
of course, your thoughts on portability. I assume you made mention
in response to Mrs. Maloney, or I guess it was Ms. Waters, that
pensions and healthcare should be portable, and if you have time
on my time, would you further your response? Thank you.
Mr. BERNANKE. Congresswoman, you are correct in pointing out
a very serious, serious problem, and I think you are also correct
that one of the main reasons why healthcare is so expensive in the
United States has to do with the fact that we are always buying
it with somebody else's money and not with our own money. We
have a system where technology is advancing rapidly, where our
ability to do new and sophisticated tests, and provide new and sophisticated drugs, and new procedures is advancing rapidly. In
most industries, new technologies save costs, but not in medicine
because of third-party payment, and the doctor and the patient are
not making a cost-based decision. The cost efficiency is not perhaps
what it should be.
Now, one approach to this is to increase market forces in the determination of what test to order and what costs and how much to
shop and so on. There are ways to do that. The health saving accounts, for example, create a catastrophic coverage, ask for a catastrophic coverage, and ask people to save money within this account to buy coverage for medical care below the catastrophic level.
Some people may be uncomfortable with having to make those
kinds of decisions, so an alternative is to have competition between,
say, HSA catastrophic plans and other types of medical management, HMO's, PPO's, traditional insurance and the like. By creating more competition, I think there would be some benefits.
But, again, it is a complex subject. There are a lot of other things
we could do. I think we could increase transparency in terms of
hospitals and doctors letting us know what they charge, what their
quality is, and improving information technology in healthcare,
which I think would reduce errors and create more consistency
across the country. We currently have very big differences in the
cost of managing a certain kind of condition in different parts of
the country. More uniformity and more best practice would help reduce costs as well. So I think markets could have a useful role to
help reduce, or at least control, the cost.
Portability is a difficult question. One approach to portability is
to have insurance companies insure workers rather than insure
employers, so to speak. That would require somehow creating different kinds of pools rather than employer-based pools. You need
pools in order to share risk, and there are some issues associated
with that.
The main alternative would be to give people the ability to take
their policy from their current employer and then move over to another employer with the same policy. These are all things we
should be looking at, but none of them is a really simple problem
because in each case we want to make sure that people are buying
as part of the pool, a risk pool, rather than buying on an individual
27
basis where, if they are ill or have a preexisting condition, they
won't be able to afford insurance.
Ms. PRYCE. Thank you very much.
The CHAIRMAN. The gentleman from North Carolina.
Mr. WATT. Thank you, Mr. Chairman.
Welcome, Chairman Bernanke. I am over here. I happen to like
your predecessor. The problem is I didn't understand a thing he
ever said. So you are a breath of fresh air in the sense that, whether I agree with you or not, at least you are speaking in English,
and I can understand what you are saying. And I especially want
to thank you for your response to Ms. Waters' question.
Let me follow up quickly on Mrs. Maloney's question, because I
am not clear, and I hope you can answer this question just with
a yes or a no answer. Does the guidance that the underwriting—
the guidance that you are issuing regarding 2/28 and 3/27 mortgages require that those mortgages be underwritten to the fully indexed rate just like you do with traditional mortgages, or does it
not?
Mr. BERNANKE. This is a joint guidance. We are still working on
it with the other banking agencies. We have not yet determined
that.
Mr. WATT. But the one that you put out previously, did it require—
Mr. BERNANKE. Yes.
Mr. WATT. SO if it were the same, it would require—
Mr. BERNANKE. Same principle, yes.
Mr. WATT. Okay. The increase in foreclosures is a serious
problem, and one of the concerns we have is that the Fed has never
adopted a final rule under its authority under the truth and lending act to prohibit practices or acts that it found to be unfair or
deceptive or designed to evade the purposes of HOPA over the entire class of mortgage loans. There has never been a real rule on
these things, and I think that is one of the things that is putting
pressure on us to be more aggressive in having a Federal predatory
lending standard, or at least a Federal predatory lending floor.
I am wondering whether you view that as a problem, and maybe
I could just get you to discuss with me why the Fed has never used
that more aggressive, unfair, deceptive trade practices language to
be more aggressive in this area in light—and especially in light of
the increasing number of foreclosure that we are experiencing.
Mr. BERNANKE. Congressman, we have found that it is very difficult to write rules in advance that strike out entire practices
under all circumstances. We find it is more effective to be flexible
and work on a case-by-case basis. It is one of these things like,
"You know it when you see it."
And so what we have done rather than write specific rules, is to
work with the FDIC to develop a set of principles, and there has
been much talk lately about principles-based regulation. One of the
principles on which we are making these decisions provides guidance to the banking agencies for implementing to take action
against unfair and deceptive acts and practices, and we believe
that set of principles provides full authority for not only us, but
also the OCC and other agencies to take actions to prevent unfair
and deceptive acts or practices. So, for example, the OCC has re-
28
cently taken substantial action, I think it was a credit card case,
based on this, and they were not inhibited from taking those actions because of any lack of rulemaking. Again, whether an act is
unfair and deceptive depends often frequently on the context and
circumstances.
Mr. WATT. Can I just interrupt you long enough to ask you to
comment on whether you think we need a Federal predatory lending statute?
Mr. BERNANKE. I think good progress has been made in trying
to understand how to distinguish predatory lending from legitimate
subprime lending. That is always the challenge. How do you define
the rules in a way to address predatory lending without driving out
legitimate subprime lending? And what we have seen lately is that
a number of States, and your own State, North Carolina, has been
one of the pioneers there, have introduced legislation which have
moved the ball forward in terms of achieving that objective. And
I was very pleased to see that because I think the States are good
laboratories. They can really try out different things, and we can
see what works and what doesn't work.
At some point when we understand well enough how to distinguish between predatory and legitimate lending, probably a Federal standard would be a good idea because it would eliminate the
many differences across States and make it more costly for lenders
to lend on a national basis. I don't really have a good judgment as
to whether the States have reached a point where we feel, you
know, we are ready to do that, but at some point we should really
consider—
Mr. WATT. In the meantime should we be talking about a Federal floor as opposed to a preemptive stand?
Mr. BERNANKE. I have no objection at all to your discussing those
issues. I think the question is making sure that you are making a
clear distinction between predatory—
The CHAIRMAN. I would ask the gentleman to yield. I just want
to say, first of all, the question he raises is a very important one
that is widely—is of great concern to the civil rights community.
I will say a couple of things, if I could, because this is really essential.
First, the State versus Federal has been complicated by the very
strong preemptions of State law issued by both the Office of the
Comptroller of the Currency and the Office of Thrift Supervision.
So part of the problem we face is that some of those State laws
that we agree are good ideas don't reach, for instance, operating
subsidiaries of national banks. So the argument for me being at the
State level would have been stronger if it hadn't been for those preemptions.
Secondly, with regard to the rule—and the gentleman's question
is one many feel strongly about. I understand your argument that
you can still reach these after the fact, but some people feel, and
I am inclined to agree with them, that there might be a greater deterrent effect if there was to be some rulemaking. It is one thing
to go to people's rescue after the fact, but it does seem to be a proliferation here, and that is why we think we may need more. But
we will be continuing this discussion.
Mr. WATT. I yield back, Mr. Chairman.
29
The CHAIRMAN. The gentleman from California.
Mr. ROYCE. Thank you, Mr. Chairman, and thank you, Chairman
Bernanke.
This committee has been debating GSE reform now for some
time, I think for about 4 years now. Surprisingly, while debating
reform with Fannie Mae and Freddie Mac, we have not heard testimony from the Federal Reserve on this topic, and we are going to
re-engage in this debate next month, and I was wondering if you
would be willing to come up and to testify as to the Federal Reserve's view on GSE reform. I think it would be very helpful for
all of us.
Mr. BERNANKE. The Federal Reserve has testified in the past, I
believe. I believe Chairman Greenspan has testified, but if that is
not the case—
Mr. ROYCE. He has testified as to the subject, but I am thinking
about the hearings we are going to hold specifically on GSE reform.
And that was my question as to whether you might testify on that.
Mr. BERNANKE. We would be very interested in having our perspective heard on this issue.
Mr. ROYCE. I hope the committee leadership can accommodate
you on that.
I also wanted to say that it is not just New York that has grown
quite concerned about the disadvantage competitively that our capital markets face and the flight of capital. I think all over the
United States, people are getting worried. We saw the BloombergSchumer report, and then the Committee on Capital Markets Regulation report that came out, and they have really stressed this
issue.
And I also noticed last November, the late Dr. Milton Friedman
said this, and I would just like to read it quickly. He said, "Sarbanes-Oxley is very unfortunate. It tells every entrepreneur in
America, don't take risks, that is not what we want. The function
of the entrepreneur is to take risks, and if he is forced not to take
risks and spend on accountants rather than products, the economy
is not going to expand or grow."
And then also the same month, Alan Greenspan said that most
of Sarbanes-Oxley is, "a cost creator with no benefit I am aware."
And he went on to say that regulatory and statutory, statutory
changes need to be made as well if we are going to move forward.
And he concluded with something that I thought was rather forceful. He said, "I hope it happens before the whole financial system
walks off to London."
It seems to me that Dr. Greenspan and others were concerned
that the regulatory climate will not only deter investment in the
country, but that it is also going to suppress future entrepreneurship and suppress innovation. And I was going to ask you because,
you know, if they are correct, that could have a very harmful effect
not only on future U.S. productivity, but as a result of that will reduce the potential standard of living gains in this country.
And so, Chairman Bernanke, do you share the concerns of Dr.
Greenspan and Dr. Friedman on this issue?
Mr. BERNANKE. Let me say this: I think it is very important that
as we try to achieve the objectives of greater clarity and transparency in corporate governance and internal controls and so on
30
that we do it at the lowest cost we can, and I think that it is a
good development that the Public Company Accounting Oversight
Board along with the SEC has recently promulgated for a comment
a new audit standard which would be less "checking of the box"
and more focused on the major concerns of the company, and also
that would take into account the size and complexity of the company, so we wouldn't be putting these costs on the smaller companies. I think that is an important step in the right direction. I
would be curious to see how that goes.
More generally, you know, as a regulator, I think it is very important that we have to achieve the objectives that Congress gives
us, and there are some very important ones, but we also need to
do the best we can to minimize the cost and unnecessary burden
created by those regulations.
Mr. ROYCE. But going back to my question, and quoting former
Chairman Greenspan again, he spoke to the regulatory changes
that you spoke to, but he also spoke to statutory changes that he
thought were necessary. And that very much concerns us going forward in terms of whether or not we addressed these recommendations made by the Bloomberg-Schumer report or made by the Committee on Capital Markets Regulation report.
Mr. BERNANKE. We are continuing to monitor the application and
effectiveness of Sarbanes-Oxley. I am not prepared at this point to
call for any specific legislation changes. I would like to see how the
audit standard works.
Mr. ROYCE. Well, in the meantime, to paraphrase Dr. Greenspan,
hopefully it will happen before the financial system walks off to
London, because as I read the papers every week, that egress, that
exit, is becoming more and more pronounced, and we have an arithmetical increase not just of capital flight, but also a resistance
of companies coming into the public market in the United States.
Capital is basically avoiding our capital markets with very dire
consequences, I think, in the long term, to the standard of living
here in the United States and our competitive position.
Mr. Chairman, thank you.
The CHAIRMAN. Thank you.
The gentleman from California.
Mr. SHERMAN. I would like to comment first on the gentleman—
the other gentleman from California, and that is that we have in
our capital markets kind of a one-size-fits-all approach. You are either a private company, or you are so public that your statements
are so good that if widows and orphans want to put 100 percent
of their net worth into your stock, it is entirely legal to do so. We
might want to explore some intermediary category where the
amount of disclosure does not meet full-blown Sarbanes-Oxley on
the one hand, and investment, while publicly traded, is only among
highly accredited investors who are investing less than 1 percent
of their net worth. I think as long as—to be a public company, you
have to be a company that I want my mother to, legally at least,
be able to put 100 percent of her net worth in means that you are
going to have to meet a very high standard.
I have a number of questions for you. One is to respond to that,
and I will lay out a few others, and you will probably have to re-
31
spond for the record, Mr. Bernanke. But if I talk fast, maybe you
will be able to comment orally.
The first is, you have talked about the problem of income
inquality. Do you know of any systematic economywide approach
with a near-term effect to deal with such income inequality other
than making our tax system more progressive?
Second, we have a lot of smart, educated young people. They go
and get college educations, but they only have the slightest information about which careers will be in demand by our economy.
Should we publish an official guide that is forward-looking, that
uses our best economic resources to project for the guidance of
young people what careers will be in demand in the decades to
come?
Third, over in the Senate you talked about your concern that the
ILC loophole could be used to mix banking and commerce. I wonder
if you have an equal concern—I hope you have an equal concern—
about the exploitation of other loopholes that combine real estate
brokerage with banking, or auto sales with banking, or any kind
of sales with banking on just on the pretext that the sale—that the
consumer needs financing. And I hope that you are as strong at
preventing bankers from getting into commerce as you are in preventing commercial firms like Wal-Mart from getting into banking.
Last year we talked about the need for certain—my perceived
need for an emergency plan to be available to deal with a precipitous decline of the dollar. You responded to me in the letter of
April 25, 2006, noting that from 1985 to 1988, we had a roughly
40 percent decline in the value of the dollar, and the sky did not
fall. But do you think that the risk of a 40 percent decline in the
U.S. dollar in 4 weeks, rather than 4 years, is so remote that we
shouldn't think about it, or are you just confident that our society
and the world trading system could adjust to it? Or should we be
doing some planning, given that we have had another year since
we have talked last of record trade deficits?
Finally, the New York Fed processes dollar transactions. We recently stopped two Iranian banks from having access to that
through U-turn transactions. What would be the effect if we prevented all Iranian banks from having such access? I ask for you to
comment from a technical monetary policy, you know, banking regulatory policy. Obviously we have other venues to talk about,
whether that would be a good approach in negotiating with Iran.
Or could we cause significant concern in Tehran if we didn't stop
at the two banks, but went with all Iranian banks in banning their
access to transactions through the Fed? Do you have any other
comments?
Mr. BERNANKE. I can respond quickly to a few. Multiple standards for Sarbanes Oxley is an interesting idea, but I would note
that the audit standard that allows size and complexity to be a consideration does to some extent do that.
On income inequality, this is a very long-term trend. At least
since the 1970's, and according to some measures from the 1950's,
we have been seeing this trend, and I don't think there is any really good way to reverse it overnight. I think it is going to be a slow
progress.
32
Mr. SHERMAN. Although a more progressive income tax system
would do a lot to change the ultimate flows of income, or do you
disagree?
Mr. BERNANKE. It would not do so without some cost to incentives and the like.
On official guides to future skills, I think the best thing we can
do for young people is to make sure they have good general analytical skills, and that they are not—it has turned out well for us that
we don't necessarily put kids in the eighth grade—
Mr. SHERMAN. SO if we had lots of people with good analytic
skills—
The CHAIRMAN. I'm sorry. We don't have time for further questioning. I will give the gentleman 30 seconds.
Mr. SHERMAN. Please continue.
Mr. BERNANKE. I would focus on general problem-solving skills
that are most flexible.
On real estate brokerage, the Federal Reserve and the Treasury
have never had an opportunity to make a determination about
whether this fits under the Gramm-Leach-Bliley law. Congress has
not permitted us to go ahead with that, and so we have had an opportunity to look at it.
With respect to financial crises, I would just say that the Federal
Reserve takes financial crisis management extremely seriously, and
we have made a number of efforts to improve our monitoring of the
financial markets to study and assess vulnerabilities, and to
strengthen our own crisis management procedures and our business continuity plans. And, I hope we never have another financial
crisis, but should one ever occur, we want to be well prepared for
that.
I would have to get back to you on the Iranian question.
The CHAIRMAN. Thank you.
The gentleman from Connecticut. And the Chair will announce
that the Chairman has been very gracious to agree to give us until
2 p.m.—we will take a break for about 15 minutes at noon. So the
gentleman from Connecticuit will—after his questioning and answers, we will take a 15-minute break.
Mr. SHAYS. Thank you for being here.
I want to kind of agree with Congressman Watt. I thought the
responsibility of the Fed Chair was to speak in tongues, so I have
been a little shocked that I can actually understand you. The only
other person I have trouble understanding is sometimes the chairman when he gets excited.
I want to ask you, I think of ourselves as a consuming Nation
that drives our economy, and yet I wrestle with the fact that we
talk about how we should save. Now, I am a consumer. The only
savings I have is my house and my Thrift Savings Plan. Should I
feel guilty?
Mr. BERNANKE. It is not a question of feeling guilty. The question
you want to ask yourself is, are you well prepared for retirement?
Mr. SHAYS. Well, really what I am trying to say is if I want my
country to be stable, are we asking Americans to stop consuming
and to save? What are we asking them to do?
Mr. BERNANKE. Well, I think the issue is at the national level.
Your question is at the individual household level. At the national
33
level, low rates of savings create the need to borrow from abroad,
and it does have some risks involved. The most direct way to address savings is to try to improve the saving of the government sector.
Mr. SHAYS. What confuses me is that we are trying to get consumers to consume so that our economy moves forward. So I just
wonder how you would wrestle with that, and how do you wrestle
with it?
Mr. BERNANKE. There is no inconsistency. In short-term business
cycle dynamics, consumer spending can drive growth. But over a
longer period, if people save more, then that can be replaced by
higher, stronger investment spending, for example, and that would
be a desirable way to go.
Mr. SHAYS. Okay. With regard to tax cuts, I believe that dividends and capital gains in particular have had a huge impact in
getting us to have constant growth since we have lowered these
rates. I am concerned that my Democratic colleagues are going to
allow these tax rates to go up. I am interested to know your opinion.
Mr. BERNANKE. I think most economists would say that lower
dividend and capital gains tax rates have efficiency gains. They are
providing centers for saving. They reduce distortions in capital
structure. They allow retained earnings to be circulated back into
the capital markets, and there are many other areas where I think
they contribute to efficiency in the economy.
As always, with any tax measure, there are competing considerations of revenue and progressivity and so on. And as you know,
given my position as the head of a nonpartisan central bank, I can't
really take positions on specific measures.
Mr. SHAYS. Well, okay. It just seems to me that you can give us
advice as to whether or not you believe that continuing these low
rates will contribute to a stronger economy. And if you don't think
that, then you should tell us. If you think that letting them go up
will not impact our economy, you should tell us that. I think that
is a fair question.
Mr. BERNANKE. Well, let me say this, which is that there needs
to be a balance between spending and taxes. So I think that welldesigned lower taxes can contribute to a stronger economy. But
there is also a responsibility to make sure that the spending is
commensurate with that.
Mr. SHAYS. Right.
Let me get to the next one. When I am encouraged to refinance
my house and pay 2 percent to 3 percent, you know, and then you
look at the fine print, and you are paying 7 percent or more. So
I see this, and think that—well, I am not following them. I think
a lot of people are. What is the role of the Fed to try to address
that issue, if" any?
Mr. BERNANKE. The size of the cost to refinancing?
Mr. SHAYS. The incredible amount of effort to get consumers to
basically use their homes, thinking that they are only going to pay
a 2 percent or 3 percent rate, when in actual effect they are going
to pay 7 percent or 8 percent. They have to pay it. They just don't
have to pay it each year.
Mr. BERNANKE. Adjustable-rate mortgages and the like.
34
Mr. SHAYS. Adjustable rates, but where they actually pay less
each year, less than the rate they are being charged.
Mr. BERNANKE. Those are option ARM's and so on. Those have
negative amortization.
Mr. SHAYS. I shouldn't have said it that way. But the bottom line
is that I am scared many people are just going to fall into that
trap.
Mr. BERNANKE. I share your concern. As I was discussing earlier,
our nontraditional mortgage guidance is very clear that lenders
should, first of all, make sure people understand what it is they are
signing, what they are getting involved in, and secondly should underwrite in such a way that if the borrower stays in that mortgage
and rates go up, then the borrower will be able to make the payments and not be foreclosed.
Mr. SHAYS. Thank you. I yield back.
The CHAIRMAN. We will now take a 15-minute recess.
[Brief recess]
The CHAIRMAN. We are going to convene a minute early, but the
next person on our list here is from Kansas, Mr. Moore. Would
someone please close the doors—thank you—and Mr. Chairman, we
appreciate, again, your giving us all this time.
The gentleman from Kansas is recognized for 5 minutes.
Mr. MOORE OF KANSAS. Thank you.
Mr. Chairman, thank you and welcome to the committee, and I
appreciate your coming here and taking our questions.
I want to follow up on kind of an area at least that the gentleman from Texas asked you about, and that was our debt as a
Nation and what that is going to do to future generations in our
country.
I have seven grandchildren, and I am very concerned that we are
accumulating a debt in this country that presently stands at $8.7
trillion. I understand it has gone up approximately $3 trillion in
the past 6 years, and I was at the White House about 6 weeks ago,
and I had a chance to talk with the President. I said, Mr. President, I am not pointing a finger at your Administration, and saying
it is your fault, because this goes back 25 years, 30 years, but
through a process of borrowing and accumulating debt, interest on
our national debt now stands at $8.7 trillion, and as I think Mr.
Paul pointed out, over 40 percent of our debt is held by foreign nations.
Should we, as a Nation, be concerned about that much debt?
Should we, as a Nation, be concerned about the fact that more than
40 percent of our debt is held by foreign nations? If for any reason,
whatever reason, foreign nations decide to sell off our debt, what
impact, if any, would that have on interest rates in our country?
Mr. BERNANKE. The Federal debt that I am most concerned
about is sort of the implicit debt, the debt associated with our
promises to future retirees for Social Security and Medicare. If we
were to stop here in some sense, it would not be quite so bad. The
amount of government debt held by the public currently is about
37 percent of the GDP, which is fairly normal across industrial
countries, lower than some in fact, but the situation is going to get
a lot worse as we have retirements of the baby boomers and so on
and medical care costs go up.
35
According to the Congressional Budget Office, in the immediate
scenario, by 2030, the debt, instead of being 37 percent of GDP,
will be 100 percent of GDP, and the deficit will be 9 percent of
GDP instead of being a little under 2 percent as it is this year. So,
if we allow things to continue, the debt interest cycle will continue
to build up, and we will hurt our fiscal position to the detriment
of our children and grandchildren.
On the issue of holding the treasury debt, the reason that foreign
countries hold our debt is, for the most part, because they find it
beneficial to themselves to have ownership of this very safe, liquid,
and convenient form of assets, and I find it unlikely that anywhere
in the foreseeable future there will be a major sell-off of any kind.
If there were to be some sell-off, there would probably be some
short-term effects, but—
Mr. MOORE OF KANSAS. What kind of short-term effects, Mr.
Chairman?
Mr. BERNANKE. We would have movements in the asset financial
markets, responding to the sale of the treasuries and other securities.
Mr. MOORE OF KANSAS. Would interest rates respond to the sale
of securities?
Mr. BERNANKE. The impact effect of large sales of treasuries
would be to raise interest rates, yes, but over a longer period of
time, I believe interest rates are determined by fundamentals, by
Federal Reserve policy, and I would also point out that the ownership, say, by the Chinese, of dollar-denominated assets is less than
5 percent of all of the fixed-income dollar assets in the world, even
though it is a larger share, as you point out, of the treasury market. So I do not consider that to be a major concern.
As I mentioned earlier in response to a question, there could
come a point where foreign investors become less willing to accumulate more of our debt and would begin to drive up interest rates,
and in order to avoid that contingency down the road, we should
probably be trying to bring our current account down gradually
over time.
Mr. MOORE OF KANSAS. Well, I understand, and I appreciate the
fact that you, I am sure, feel a responsibility not to alarm people
by any statements you might make, but my concern again is if foreign nations decide for whatever reason to sell off our debt, that
is going to—there is the old law of supply and demand in effect,
and if foreign nations are not going to hold our debt, that means
that we are going to have to finance that, and I would think that
would cause interest rates to go like this.
I remember 30 years ago there was a guy named Jimmy Carter,
who was President of the United States. We had interest rates
going up to 12-, 14-, 16 percent. That would be absolutely devastating for our Nation right now, and I am not trying to be an
alarmist here. I just do not want to see us get in a position where
anything like that happens again to our country, because that
would be devastating, I think, for small businesses, for consumers,
for people in this country, and that is my concern, I guess.
One more question. Oh, we are out of time. Sorry.
Mr. Chairman, thank you very much.
The CHAIRMAN. Would the Chairman like to respond?
36
Mr. BERNANKE. NO.
The CHAIRMAN. Well, then we will take one more question.
Mr. MOORE OF KANSAS. Okay. I understand that you all have a
rule that says that the presidents of your banks have to retire at
a certain age.
Is that consistent with what some people are saying, that because of life expectancy going up that we should require people to
retire at a certain age?
Mr. BERNANKE. We have thought it valuable to have some turnover there. We do not have quite the same pressures that the private market would have, you know, with leadership in a company,
so we think that getting new leadership is beneficial, but if there
are concerns I would be certainly willing to ask our committees to
look at that. I have found, basically, that there has been a reasonable amount of turnover in the sense that people do not stay so
long as to stagnate, but they stay long enough that their knowledge
and experience can accumulate.
The CHAIRMAN. Of course, they could always retire, rest for a few
years, and then run for the Senate.
The gentleman from Texas.
Mr. HENSARLING. Thank you, Mr. Chairman, and Chairman
Bernanke, thank you for your patience.
To some extent, I would like to follow up a bit on a line of questioning from my colleague from Kansas, and I know that his commitment to the long-term fiscal health of our Nation is a very sincere one. We sometimes come about it in different ways, but I know
his commitment is sincere.
I was reviewing testimony you gave before the Senate Budget
Committee recently on entitlement spending, and you have alluded
to it today. I have had the occasion now to hear from the heads of
OMB, GAO, CBO, and the Secretary of the Treasury, and there
seems to be consensus among all of them that the number one fiscal challenge we face as a Nation is the pace of growth in entitlement spending.
Would you concur in that assessment that it is, indeed, our number one fiscal challenge?
Mr. BERNANKE. Yes, or, more broadly, how to deal with the aging
of the population.
Mr. HENSARLING. YOU spoke earlier about the percentage of debt
to GDP by 2030, and you mentioned, I guess, the challenges of trying to, without entitlements, reform the level of spending decreases
or tax increases, some combination of the two. I think I heard you
say before we are not going to grow our way out of this challenge,
is that correct?
Mr. BERNANKE. That is correct.
Mr. HENSARLING. If Congress ignored any entitlement spending
reforms and chose no other offsets within the Federal budget, using
2030 as our guideline—it is kind of a good placeholder for the next
generation—have you looked at models on what type of tax burden
would be necessary to be placed on our people to balance the budget, say, in 2030?
Mr. BERNANKE. Well, the projection would be that in 2030 the
entitlement programs would be about 15 percent of GDP, which
means that the entitlement programs and interest on the debt to-
37
gether would be something about our total budget today. So increases would have to be related to how much additional spending
you would have. If you want to keep nonentitlement spending constant, you would have to raise tax rates approximately 6 or 7 percentage points of GDP, from about 18 percent now to about 25 percent of GDP, with no other changes in order to retain about the
same deficit.
Mr. HENSARLING. The Comptroller General has previously testified that if that happens, in his opinion, we are on the verge of
being the first generation in our Nation's history to leave the subsequent generation with a lower standard of living, less opportunity.
Would you agree with that assessment?
Mr. BERNANKE. Those are very high tax rates, and they would
have adverse effects on growth.
Mr. HENSARLING. Changing subjects, Mr. Chairman, the debate
about trade versus protectionism is as old as our Republic is. It is
a debate that has certainly reared its head again in our Congress,
many believing that somehow present trade policies have negative
impacts on low income. I recently saw some Bureau of Labor statistics figures that indicate, within the last 5 years, the price of durable goods have dropped 8.7 percent, appliances 6.5 percent, toys
25.8 percent, and televisions 55.4 percent. Low-income people in
the Fifth Congressional District of Texas, whom I represent, buy
televisions, toys, durable goods, and appliances, and last I looked,
each of these had a very heavy trade component.
If trade barriers were erected, might the cost of these actually go
up instead of decrease, and might that have a detrimental impact
on low-income Americans?
Mr. BERNANKE. Certainly. Yes, I agree.
Mr. HENSARLING. That was such a quick answer that I was not
ready for the next question.
Mr. BERNANKE. Well, I can elaborate.
Mr. HENSARLING. NO. I think I will quit while I am ahead, Mr.
Chairman. I think I will quit while I am ahead.
To the extent that I have any time left, subprime lending—you
mentioned that there is a great challenge in figuring out the difference between predatory and subprime. I believe the world works
off of incentives.
Are subprime lenders incented to actually take back the collateral, to take back the house, to repossess it, particularly since, I
think you testified, we are now in a softening real estate market,
and if that is not the incentive structure might the competitive
marketplace help ameliorate what we are seeing as far as some of
the high foreclosure rates?
Mr. BERNANKE. TO some extent, that is correct. It is certainly the
case that subprime lenders, certainly the legitimate subprime lenders, are not looking to have foreclosures. It is bad for their business—they lose money—and we have seen some failures of small
lenders, and we have seen credit default swaps that measure the
risk of subprime mortgages, those spreads widen considerably, and
so, clearly, it is not in the interest of lenders to make bad loans.
Mr. HENSARLING. I am out of time. Thank you for your testimony.
38
The CHAIRMAN. The gentleman from North Carolina.
Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman, and
Mr. Chairman.
Mr. Chairman, I also read your remarks in the Greater Omaha
Chamber of Commerce that Ms. Waters spoke of. She said she was
very moved in reading it. I am not sure I have ever really been
moved by a speech by an economist, but I have found a fair amount
to agree with in what you have said, and there were things that
we had discussed earlier when you testified here before and, actually before that, things that—topics about which I had questioned
Chairman Greenspan earlier.
You talked about the widening inequality, that between 1979 and
2006 the wages of the people who are right in the middle had gone
up by a total of 10.5 percent, the people in the bottom quintile, the
bottom 20 percent, 4 percent, and those in the top quintile had
gone up 34 percent, that the share of after-tax income for the top
1 percent had almost doubled as a percentage of all wages, all compensation from 8 percent to 14 percent over a slightly lesser period
of time, and that even within that 1 percent there was a widening
inequality.
I asked you then about what programs we could get at, and you
mentioned education again and specifically community colleges,
life-long learning, job training, how to make sure that our workers
have the skills to be personally responsible for increasing productivity so they might be compensated better. In the President's most
recent budget, all line items for career and technical education in
2007 were $1,312 billion, and in the proposed budget it is $617 million. So it is being cut by more than half.
Does that show a commitment—is that what we need to be doing
if we do recognize income inequality as a significant problem for society?
Mr. BERNANKE. One point I tried to make in my remarks was
that solving these problems of retraining and job search in life are
difficult, and people may differ on how best to accomplish it. I do
not know from your numbers whether there were offsets in other
programs or different approaches—I simply do not know—but I
think there is a legitimate debate among all of us about what are
the most cost-effective, effective ways, to help people overcome the
skills gap so that they can get better work.
Mr. MILLER OF NORTH CAROLINA. Actually, Mr. Sherman mentioned a systematic economic approach to approaching income inequality. I think before, I just asked if you could name any program that addressed anything Congress was doing and the President was doing that seemed to be addressing economic inequality,
growing differences in income, and you mentioned specifically education. That was what you talked about.
If we are serious about closing economic inequality, isn't that exactly what we should be looking to, making a real commitment to
job training, to adult education, to education from pre-kindergarten
all the way through life-long learning?
Mr. BERNANKE. I think we should, but I do not want to support
or attack any specific program because there are many approaches
to doing it. The President will, no doubt, reply that he has the No
39
Child Left Behind Program, which is an attempt to increase the
quality of schools.
Mr. MILLER OF NORTH CAROLINA. Which has also been funded at
much less the level than what was promised, dramatically less, and
actually the very programs within No Child Left Behind that are
most clearly directed at closing achievement gaps are the very programs that have been cut the most.
Chairman Bernanke, you also, in your speech in Omaha, talked
about the kind of superstars in the world economy and how much—
given what the economy is like now, relatively small differences in
ability or in appeal from the very, very best and people who are
just very, very good but not the very, very best—resulted in dramatic differences in income, and then you also mentioned CEO pay
and said that in many cases CEO's who had failed spectacularly,
who had appeared to have crashed and burned, had still done very
well or were still compensated at breathtaking levels, and in earlier testimony you said that European CEO's appeared to be paid
significantly less than American CEO's.
Are European companies doing significantly less well because
they do not have the superstars? Is there anything that suggests,
really, that there is a difference based upon skill level between
American CEO's and European CEO's?
Mr. BERNANKE. I have not really studied that. I think that there
are some CEO's in Europe who are paid lower levels, and probably
there are fewer in sort of the same league as the American CEO's.
I think it is very important that boards of directors take shareholder interests very seriously when they make these compensation
decisions, and that they try to attract the very best talent, and that
they pay in a way that will motivate good performance.
The CHAIRMAN. The gentleman from New Jersey.
Mr. GARRETT. Thank you, Mr. Chairman, and thank you, Mr.
Chairman, for your testimony today. I appreciate your spending the
time with us.
I would like to go back and begin my questioning with a topic
that is of great importance to me, and we have already touched on
it, at least with one series of questioning, and that is dealing with
GSE reform.
On the one hand, I am pleased to see that the Administration is
taking what I would say is a slightly tougher tone, if you will, on
pushing for a brighter line test between what is appropriate and
what is inappropriate between the primary and the secondary markets and what the GSE's are involved in. That is on the positive
side.
On the negative side, from my position, I have seen something
of a softening with the Treasury stance with regard to portfolio
limitations, which I believe should be a true concern to us. I know
that there are ongoing negotiations, if you will, between the Treasury and our esteemed and gracious chairman behind us to try to
reach a compromise on this issue, and as part of the negotiations
there is consideration of what has been dubbed the MTI, the mortgage tax increase, better known as the "Housing Fund," and I
would be curious to have your take on an aspect of that.
I raised a similar question to you when you were here before the
committee a year ago and new on board, but I know since that time
40
you have had an opportunity to get into the weeds a little bit more
on this topic. You have already testified here and before other committees with regard to the importance of the housing market in
general to our boom in the economy that we have had and the
slight slowness of the housing market and what impact that could
have on the overall economy.
My first question to you is: What additional impact could we see
if we did have a tax, if you will, on that marketplace by having a
fee or an assessment on the GSE's for this new Housing Fund, or
the MTI?
Mr. BERNANKE. SO you are arguing that the Housing Fund would
raise the cost of mortgages because we are putting a tax on the
GSE's?
Mr. GARRETT. Yes. Well, we know the corporations in general do
not pay their taxes in one way or another. The cost of doing business is not borne by the business but is passed on to the consumers
in one sense or another.
Here, the business that it is being passed on is to the low- and
moderate-income homeowner who is trying to get into the market,
which is the whole idea behind GSE's.
Mr. BERNANKE. Well, I have not done any analysis of that particular issue.
I would reiterate what I said before, which is I think, that it is
important for the GSE's to support affordable housing. The way I
would recommend it would be to tie their portfolios to affordable
housing products, for example, by holding MBS that are based on
affordable housing mortgages, for example. That would seem to be
a direct way to both create some limits, some limitation on the rapidity of the expansion of their portfolio, while still having a direct
impact on the affordable housing.
I have not taken a position on the Housing Fund, and I am
afraid, if I do so, it will be portrayed as a change in position, because the Fed is focused very much on the safety and soundness
and the systemic risk implications of the portfolios, and I think
that is where the Federal Reserve needs to keep its focus.
Mr. GARRETT. DO you agree with my basic economic assessment
that when you have a corporation such as GSCR or any corporation
in general that the taxes that we assess on them are not borne, in
essence, by them, but it has to be passed on to someone?
Mr. BERNANKE. Well, it could be passed on to the shareholders
in terms of a lower share price. That is another possibility. So I
would have to think about the incidence of that.
Mr. GARRETT. And, of course, the economic philosophy to that is,
when you put a cost onto the share price of a company where they
have to get their investments from, that impacts upon the economy. We can go into that.
Can you elaborate a little bit more on the portfolio idea that you
were talking about? I am limited in my time here. Are you suggesting that you allow them to increase the—or have an increase
in the portfolio size of those holdings for the low- and moderateincome portfolios, and if that is the case, doesn't that go beyond
what the GSE's were intended for—or what the portfolios were intended for in the first place? They were just for securitizing the
41
loans, and they were just there to be in and out, if you will. Why
would we need that to occur?
Mr. BERNANKE. I think the ideal situation would be one in which
the portfolios did exactly what you said. They were to be the weigh
station for securitized mortgages, and they would contain mostly
liquid assets for the purpose of purchasing mortgages and then
selling them back to the market.
Mr. GARRETT. Right.
Mr. BERNANKE. I would like to see a bill. I think we need to have
a strong regulator in this arena, and we need to find some way
that we can limit the growth of the portfolios. As a practical matter, I think that restricting portfolios to mortgages related to affordable housing might be an appropriate compromise and an appropriate approach that would provide some limitation, but the
Federal Reserve has always been concerned about the size of portfolios. It never has found a substantial benefit to homeowners from
large portfolios.
Mr. GARRETT. Does the Treasury have the authority—
The CHAIRMAN. Gentlemen, we are into the timing.
The gentleman from Missouri.
Mr. CLAY. Thank you, Mr. Chairman, and thank you for holding
this hearing.
Mr. Bernanke, welcome. I represent the First Congressional District of Missouri, which is comprised of north St. Louis City and
north St. Louis County.
Continuing with the same line of questioning as the gentleman
from New Jersey about housing, in my district, and in many other
districts across the country, we have a tremendous housing crisis.
This must be addressed, and it must be done with urgency, especially when it comes to affordable housing.
What changes in housing policy can be made that the United
States can better foster an urban housing policy that puts people
in homes in the inner cities so that they can build wealth through
ownership and pass it on to future generations? What are your
ideas on this, and what is your approach to this housing crisis?
Mr. BERNANKE. Well, I recently had the opportunity to visit Anacostia in the District of Columbia and to see some of the projects
going on there, and we saw the actions of community development
financial institutions, CDFI's, who have worked together with
banks, private investors, and with government sources to finance
some very impressive projects, some new apartments, and some social centers for the community, with very good results, and I think
that collaboration that we saw with the CDFI's, managing together
with some nonprofit institutions, other nonprofit institutions, and
private sector input, is a very promising approach to this.
Mr. CLAY. It sounds like we have to be creative in order to rebuild our inner cities and to come up with creative concepts so that
people can take ownership of their neighborhoods, of their communities. It sounds like that is what you are saying, and you promote
those policies.
Mr. BERNANKE. Ownership is very important because people then
feel they have a responsibility for their community and for their
home, and it is also valuable to try to develop a community, not
house by house but in a broader sense, because unless you have a
42
retail area and a school and a social area and other amenities, the
house property values are not going to justify the cost. So you need
to build a neighborhood rather than just an individual house.
Mr. CLAY. Thank you for that response. Let me shift over to a
worker issue.
Yesterday, DaimlerChrysler, throughout the United States and
particularly in St. Louis, announced plans that will affect approximately 1,300 jobs at our Fenton plant in St. Louis County. They
are losing an entire shift which makes the minivans. There have
been other massive layoffs by the other automakers. Additionally,
these corporations are trying to do away or drastically reduce legacy cost, healthcare, retirees' benefits, and pensions. Many of these
employees have lost benefits that were promised them in exchange
for working their careers at their workplace. They earned them,
and now, as they approach retirement, they are not there.
Do you have new approaches or plans for long-term employee
healthcare, retirement benefits and pensions, and how do we address the problem facing our industrial workers in the automobile
industry and manufacturing sector? We can include the airline employees and many other workers throughout this economy in that.
What new systems will we put in place to replace these traditional
safety nets that they have worked for and depended on all of their
lives? What solution do you think we should be putting in place,
and what are your thoughts on this? Could you elaborate?
Mr. BERNANKE. Well, first, if firms make promises to workers
with respect to retirement benefits or healthcare benefits, we
should make sure that those promises are kept. The recent legislation on pensions that Congress passed tried to toughen up the requirements for funding pensions, tried to make them more transparent, and to increase the premium paid to the Pension Benefit
Guarantee Corporation. Those kinds of measures can help ensure
that companies will not renege on the promises that they have
made to their workers, so that is very important.
I would say, more generally, that we need to diversify, to have
more than one source of retirement security. Some people rely on
defined benefit pensions. We need to expand access to defined contribution plans like 401(k)s and other kinds of private savings, and
then there is, of course, Social Security, which we want to make
sure is on a sustainable, long-term path. So if we put all of those
things together, you can help people finance a reasonable retirement.
The CHAIRMAN. The gentlewoman from West Virginia.
Mrs. CAPITO. Thank you, Mr. Chairman.
I have a question. You mentioned in your opening statement that
there has been a large amount of consumer spending. We see a lot
of credit card debt by individuals, a lot of higher education loan
debt for young people coming out of college, also into the professions, medical school.
How are people going to be able to overcome this debt when the
wages are only rising a certain percent? Do you see this as a longterm problem that seems to be concentrated—I mean, if you are a
college student, you can get a credit card like that and run it up
to the maximum quite quickly and pay $20 a month, probably, for
43
the rest of your life. What kind of problem do you think that presents to our economy?
Mr. BERNANKE. Well, the incidence of delinquencies and bankruptcies for the economy as a whole remains quite low. Because the
job market is pretty good and incomes have gone up, wealth has
gone up, the stock market is up, and so on. Most families, many
of them, have home equity built up and have been able to manage
their finances pretty effectively, and as I said, we have not seen
any significant increase in financial stress in the broader economy.
Now, there are pockets of problems, as I mentioned already several times, such as the variable rate subprime mortgage area. I
think there are a number of approaches. The one that the Federal
Reserve is particularly involved in is disclosures. We are responsible for Regulation Z, which implements the Truth in Lending Act,
and it includes such things as the famous Schumer Box and other
things that show to potential credit card applicants what are the
terms, you know, what are the fees and so on.
We are in the process now of completely reworking Reg Z for
credit cards, for revolving debt, and we anticipate going out with
a proposed rule in the next couple of months, and we have worked
very hard on that. In particular, one thing we have done—people
find it very difficult to understand the legalese that they see in the
credit card applications, the credit card contracts, and yet of course
the legal information has to be there. Otherwise, it is not a legitimate contract, and so the challenge is to create disclosures that
meet the legal standards but that are also understandable, and so
we have gone out and done a lot of consumer focus group testing
and those kinds of things to try to find disclosures that will actually work in practice, and we hope that these new disclosures we
are going to put out for comment in just a couple of months will
be helpful in helping people understand, you know, the terms and
conditions of credit cards and make them use them more responsibly.
Mrs. CAPITO. Well, I will look forward to that, and I think it is
an excellent idea, and I think that it is difficult when you turn it
over and look at the fine print. I am admitting to not reading my
credit card disclosures as closely as I should.
I do not often mention it, but I am from the State of West Virginia, and it is very reliant on coal, and the energy production is
extremely vital to our State economy, but we also have a population that is very sensitive to gas prices, to the price of healthcare,
to all of the things that hit your pocketbook immediately.
When you look at the long term, what do you see in terms of—
and I know, in some of your statements, you sort of exclude the energy prices. Is that because of the volatility of that or, in trying to
move from nonreliance on foreign sources of oil, do you think we
are ever going to make an impact on the pocketbook of the individual citizen?
Mr. BERNANKE. Well, in the short term the demand for oil is inelastic; that is, it does not respond much to price changes, and so
when there are fluctuations in the demand for oil, you get these big
spikes and movements in oil prices, and we have seen quite an increase in oil prices in the last few years, as you know. Over the
longer term, higher oil prices actually have a benefit, which is that
44
they encourage conservation, and they encourage alternative supply sources. Coal, of course, is actually a very promising source. It
is, of course, a traditional source of energy, but assuming we can
find ways to address the environmental implications—and there
are many promising directions there—coal could be a very big part
of our energy diversification in the future.
So my expectation is that as long as the markets are allowed to
work, together with some support for research and development
from the Government, together with clear and effective regulation,
that we will solve our energy problems and that solution is going
to come not just from one single magic bullet; it is going to come
from a wide variety of different alternative sources, including, I
think, coal.
Mrs. CAPITO. Thank you.
Do I have time for one more?
The CHAIRMAN. YOU do. Go ahead.
Mrs. CAPITO. I have one more quick question, and this is sort of
an educational question for me.
When I read your statistics and I see the large, you know, macro
view that you have, living in a small State that has fluctuations
always sort of at the bottom end of the economic scale in terms of
per capita income, we always feel in small States that sometimes
all of the statistics that we read are sort of driven by New York,
California, Florida, and Texas.
When you are formulating your data that you bring before us,
what kind of considerations do you make for smaller States or does
just the population number drive all of your statistics?
Mr. BERNANKE. Well, we see a lot of State data, for example, unemployment rate data by State, but the other important thing
about the Federal Reserve is that it is a Federal—that is, a regionalized—system, and as I am sure you know, we have 12 Reserve
Banks around the country—
Mrs. CAPITO. Right.
Mr. BERNANKE. —and one of the most important elements of our
monetary policy meetings is when we go around the table and ask
each Bank president from each part of the country what is going
on in your State, what is going on in your region, what is going
on in various industries, various sectors, and various geographic
areas within your Federal Reserve district; that gives us an awful
lot of detailed information about what is happening in different
parts of the country. This is a very large, diverse economy. The aggregate statistics really cover up a huge amount of heterogeneity
in terms of economic activity and developments in the economy. So
we pay a lot of attention to regional information in trying to understand what is happening in the economy.
Mrs. CAPITO. All right. Thank you.
The CHAIRMAN. The gentleman from Missouri.
Mr. CLEAVER. Thank you, Mr. Chairman, Mr. Bernanke.
We are very likely going to have as a part of the upcoming elections a great deal of divisive language based on people's concerns
about immigration, and in June of 2006, 500 American economists,
including 5 Nobel laureates, signed an open letter on immigration
and sent it to President Bush and to Members of Congress, and in
that letter we are reminded, sir, that we are a nation of immi-
45
grants, and it talks about the economic benefits of immigration and
speaks to the power of immigration to strengthen America and to
lift the poor out of poverty, and the consensus reached is that most
Americans, contrary to what is being said on the nightly news, benefit from immigration, but there is one portion of the letter that I
think is extremely significant, and if you do not mind, I will just
read from the letter:
"Immigrants do not take American jobs. The American economy
can create as many jobs as there are workers willing to work so
long as labor markets remain free, flexible and open to all workers
on an equal basis."
Now, shortly after this letter was sent to us, Jack Kemp, George
Shultz, Jeane Kirkpatrick, and 30 other non-liberals, including the
former RNC Chairman, signed a separate open letter on immigration, and it embraced Ronald Reagan's view of allowing open, sensible immigration, and they go on to recite Reagan's quote from
Winthrop about the city on the hill.
Now, the statistics support these letters, and recent studies show
that since 1980, immigrants have boosted the U.S. GDP by $10 billion per year, and during the 1990's, when the labor force grew by
16.7 million workers, 38 percent of those workers were foreignborn. In other words, at a time when U.S. unemployment was hitting record lows, immigrants filled 4 out of every 10 jobs. Now, in
January of 2000, your predecessor, Chairman Greenspan, commented that easing restrictions on immigration would go a long
way in solving labor shortages.
Now, without going on, I am more interested in finding out
whether or not you believe that immigration has a positive or a
negative impact on our economy. Do you share in the philosophy
of the 500 economists, and what do you think should be done with
regard to the American workforce and immigration?
Mr. BERNANKE. Well, it is certainly true, as they say, that immigrants built the country. All of my grandparents were immigrants,
and they came and they had new lives, and they contributed to our
economy. So immigrants have played, historically, a very important
role in U.S. economic development.
I agree with you that they do not take jobs, and the labor market
does adjust to the number of people available to work. We have had
a lot of immigration. The unemployment rate is quite low. It is
somewhat more controversial. Do they affect wages? One concern
that some people have had is that because many of the more recent
immigrants have relatively low skills that they compete, to some
extent, with low-skilled workers in the United States and may have
some effect on their wages. Most estimates are that those are pretty small effects, but there may be some effects. So I certainly agree
that immigrants have played a big role. They continue to play a big
role, and we need to have a national policy on that.
I think I would stop short of recommending a specific program.
This is a very tough issue and one I think Congress really has to
take the lead on about how many people and under what conditions we admit, but it is certainly the case today that immigrants
are playing a major role in our economy. There is no question
about that.
46
The CHAIRMAN. If the gentleman would yield, could I just ask:
Would it also have implications—you have talked about the decline
in the labor rate participation. Would it also have implications for
our ability to deal with the entitlement issue?
Mr. BERNANKE. It goes in the right direction, but the CBO has
done some simulations that suggest even fairly large increases in
immigration, say from 1 million to 2 million, would not solve the
problem by any means, but it does go in the right direction.
The CHAIRMAN. It alleviates it.
Mr. BERNANKE. Yes.
The CHAIRMAN. I thank the gentleman.
Mr. CLEAVER. Mr. Bernanke, have you seen the movie, "A Day
Without Mexicans?"
Mr. BERNANKE. I have seen it, yes.
Mr. CLEAVER. Would you recommend that for all Members of
Congress and for people running for public office?
Thank you very kindly.
The CHAIRMAN. Did you say, "A Day without Questions?"
Mr. CLEAVER. "A Day without Mexicans." It is a new motion picture that—
The CHAIRMAN. The gentlewoman from Minnesota.
Mrs. BACHMANN. Thank you, Mr. Chairman, and thank you, Mr.
Chairman, for being here before this committee.
I have appreciated your responses to the questions, and in particular, my colleague, Mr. Hensarling from Texas, had asked you
about the entitlement problem that we will be having, and that is
where my question is going as well. He had mentioned the Comptroller General and some of the comments that the Comptroller
General had made. One of those that really captured my attention
was the statistics that he gave that already our Federal Government's net liabilities exceed $43 trillion or about $350,000 for every
full-time worker in the United States.
Without fundamental changes and absent any movement by the
Congress on changes in our entitlement, I am just wondering, Mr.
Chairman, do you believe that there is any plausible amount of tax
increases that could possibly deal with the coming crisis in our entitlement programs?
Mr. BERNANKE. Well, the tax increases would have to be quite
large. The Congressional Budget Office has done some simulations,
assuming 25 percent tax increases, which do not quite solve the
problem. So it would have to be a pretty large increase in taxes to
solve it.
Mrs. BACHMANN. And that is something that, I think, haunts all
of us as we are looking toward the future, especially toward 2030.
We are concerned about that. I appreciate your response on that.
My next question deals with a happier subject of productivity,
and that is something where the United States has been phenomenal in the area of productivity. You are quite familiar with
the President's economic report that noted that between 2000 and
2005, here in America, we had a productivity increase of about 3
percent, which far outpaced the productivity growth levels in the
other G7 nations. Whereas many of them suffered a slowdown in
productivity growth, the United States, in fact, accelerated and is
at an enviable level.
47
I am just wondering, sir, if you have insight into perhaps what
some of the factors are that led to this remarkable productivity
growth given that Western European nations as well as the other
G7 nations have the same access to technological improvements as,
say, the broad capital markets that we have. I am just wondering
if you could state for this committee why we have seen better results here in the United States than we have seen in the other G7
countries.
Mr. BERNANKE. That is an issue that has received a lot of attention. It is a good puzzle why we have gotten differential results. I
think the answer is the interaction of the technologies and the economic system.
To go back to themes we have already addressed today, technology creates change, and the system has to be able to adapt to
change in order to make full use of the technology, and in the
United States the combination of very deep capital markets which
have been able to fund new start-up firms or venture capital support for entrepreneurial activities and a flexible labor market
which has allowed for changes in the way people work and the distribution of workers across industries and across occupations has
allowed these new innovations, these technological innovations and
information communication technologies not only to lead to increased productivity within the narrow sphere of high technology
industries but to spread out through the whole economy and to increase productivity in financial services, in retailing, in wholesaling, and in manufacturing.
As firms have been able to apply effectively these technological
innovations, in some countries there is a great deal of rigidity in
the structure of labor and product markets, and those rigidities
have prevented the technological innovations from being applied as
effectively or as quickly as in the United States.
Mrs. BACHMANN. Thank you.
My final line of questioning goes to the legislation that Congress
may very soon pass, and that would be the increase in the minimum wage. We are looking at increasing perhaps at the level of
40 percent minimum wage in the upcoming bill.
First, I am wondering if you could estimate how close we are currently to full employment here in the United States. I know, in
Minnesota, we have just enjoyed wonderful low levels of unemployment. I think, for 2 months last summer, we were the job creators
for about 10 percent of all new jobs across the country. We have
a wonderfully strong, diverse economy.
I was wondering first if you could comment, sir, on where you believe we are at in terms of full employment in this country, and
second, I was wondering if you could share with us what your opinion would be on the impact of raising the minimum wage on employment. First, at the level that we are looking at now to go to
$7.25, there were comments made by one of our United States Senators that he may be introducing a bill in perhaps 6 months to
raise that minimum wage up to over $9 an hour.
So, if you could, just comment on the impact of raising the minimum wage on employment and where you believe we are at in
terms of full employment now.
48
Mr. BERNANKE. On the full employment issue, I do not know precisely where full employment is or whether we have reached it or
not. I do know that the economy has come a ways in the last few
years in increasing the utilization of underutilized resources. The
unemployment rate has come down. Capacity utilization has gone
up, and so we are certainly closer than we were a year or two ago,
and, indeed, as you point out, in some areas labor markets are
pretty tight and skilled workers have a lot of opportunities for
work.
On the minimum wage, economists generally agree that a higher
minimum wage will have an adverse effect on employment of lowskilled workers, but they disagree extremely on how big that effect
would be. Some are saying it would be very small. Others are saying it would be more significant. So I can only say that probably
there will be some employment effect, but it is very difficult to
know how big it would be. Given that a relatively small number
of workers today are at the Federal minimum wage, in part because State minimum wages or many of them are higher than the
Federal minimum wage, I do not think that the employment implications of the proposed bill for the Nation as a whole would be very
significant one way or the other.
Mrs. BACHMANN. And—
The CHAIRMAN. We are over time.
Mrs. BACHMANN. Thank you.
The CHAIRMAN. The gentleman from Tennessee.
Mr. DAVIS OF TENNESSEE. Mr. Chairman, thank you very much.
I have a comment and then a question.
We hear a lot about undocumented workers in our country, and
we hear between 12 million and 15 million working today who may
or may not have legal documentation to indicate that they are actually here working as authorized by the certain laws that we have
in this country, and then I hear that we have 4V2 percent unemployment. The 4V2 percent unemployment means we have roughly
6 million people in this country not working—is that about right?—
135 million people working.
So, if we were to round up those 15 million undocumented workers and send them back wherever they came from, would we have
a deficit of 9 million employees to work in America's job market?
What would that do to our economy?
Mr. BERNANKE. Well, it is certainly true that where we are today
is that there are a lot of immigrant workers, many of them undocumented, who are working in various industries ranging from manufacturing to agriculture to leisure and hospitality and construction
and other areas, and if they were all to leave immediately then
there would be obviously a disruption in those industries and labor
shortages in those industries.
Mr. DAVIS OF TENNESSEE. I ask that mainly to make a point.
We have a lot of folks out here today who have a lot of ideas
about America's economy, and we have a lot of ideas about some
of the comments that have been made by many about the illegal
immigration situation.
My real question to you is this: As I go back from about the
1970's, late 1960's, up through about right now, we have gone from
having a balance of trade in our favor to where we have gradually
49
gone to a whole other level, over $700 billion for the last 2 or 3
years in deficits in trade. Now that means that we are sending
$700-some billion more out of America's economy to other nations
of the world that are holding that money. They are our dollars. It
is a part of our capital assets of this country that is showing that
up, and when I look at that, I get kind of frightened at it, and I
look at the district that I represent and I see a Saturn plant in
Spring Hill that has temporary layoffs, perhaps, and I fear that
they may become more permanent than temporary, those 5,000 or
6,000 jobs that we may be losing. The Carrier Corporation just left
my district.
So when I look at my Congressional district, which is the fourth
most rural in America, this great booming economy that we seem
to have throughout America does not exist in my district, and it
does not exist I believe, perhaps, in most rural areas of America.
As to the trade deficits and the budget deficits that we continue
to elevate, are we just looking for a train wreck to happen, and are
we sitting here in Congress kind of like Nero did in Rome as it
burned, doing nothing about it? How do we stop this bleeding of
huge deficit spending? Because we have seen us grow from 18.5
percent in a gross domestic spending percentage of government to
about 20 percent in the last 5 or 6 years. We have seen an increase
in spending, a dramatic increase, and our revenues have gone down
to fund government as the Congress for the last 5 or 6 years has
seen fit to spend.
So, in essence, there are two or three problems that I have, and
I think it is hurting a lot of the more rural areas and maybe not
the more urban areas, but we have lost 3 million industrial jobs.
We are no longer producing. In export and production, we are consuming someone else's production. So how do the trade deficits, the
budget deficits impact us, and when will we be in a situation where
we no longer enjoy the great economy supposedly that we have,
and when will it become a threat even to the world economy if that
does happen?
Mr. BERNANKE. That is a very wide-ranging question. I think I
would like to separate that into two issues. One is the trade aspect,
and the other is the budget/current account deficit issue.
On trade, as I have discussed several times today, trade can create painful dislocations, painful changes. Competition from abroad,
movements of firms out of the country, can cause people to lose
jobs, and that is a serious problem. On the other hand, trade also
creates a lot of benefits to the country. It creates a lot of jobs both
in terms of exports, and in terms of transplants. Like you mentioned Saturn. Well, there are also transplanted auto firms that
hire Americans here in the United States, and as someone mentioned here, it does allow Americans to purchase goods and services
at a lower price than they otherwise would. So there are disruptions caused by trade. There are also a lot of benefits from trade,
and one of the messages I have been trying to convey is that the
right solution is not to stop trade or to block trade but, rather, to
try to find ways to help people adjust or to retrain as necessary to
deal with these very real—and I take them very seriously—dislocations and problems that arise because of this changing, dynamic
economy we have.
50
A somewhat different question is about the trade deficit and the
current account deficit, and to some extent, it is related to the
budget deficit in the sense that, as I have indicated, the current account deficit reflects the fact that our savings rate is low relative
to our investment, and therefore we have to borrow the difference
abroad. In order to mitigate that situation over time, we need to
raise our national saving, and that could be done either in terms
of private saving or it could be done in terms of reducing budget
deficits or increasing surpluses at both the Federal and the State
and local government levels. That is going to take some time. I
think, you know, we do not have to solve this problem overnight,
but we should be, I think, working to reduce the current account
deficit over time and at the same time that we continue to allow
trade and technology to help our economy grow more quickly.
Mr. DAVIS OF TENNESSEE. We have actually tripled our budget—
The CHAIRMAN. I am sorry. The gentleman's time is up. We cannot ask a new question.
The gentleman from Delaware.
Mr. CASTLE. Thank you, Mr. Chairman.
Chairman Bernanke, I thank you for being here. I would also
like to thank you for the cooperation of the Federal Reserve in the
new dollar gold coin which we passed through this particular committee. I happen to be the sponsor of it. I think this is the issuance
date today, as a matter of fact. Although we did something with
the Treasury and the Mint people with George Washington and the
Statue of Liberty on the other side, but your acquisition of $300
million is a nice start. We hope to make some $5 billion. So this
is something that actually produces revenue for the U.S. Government.
Going to a subject I want to ask you a question about, though,
this committee, in a bipartisan way, passed the Sarbanes-Oxley Act
in 2002, and you have heard, I am sure, a lot of criticism on that
law—and I have read about it—and some praise of it one way or
another, but they talk about the rising cost of regulation, and this,
according to some people, is creating an incentive for firms to be
listed on foreign markets or to withdraw from public markets altogether. We have more private capital and that kind of thing going
on in the United States of America now, and there are other measures besides Sarbanes-Oxley that are attributed with those problems.
In your opinion, has rising regulatory costs or other regulatory
blocks of some kind or another weakened the international competitive position of our stock exchanges, and do they pose a threat
to our competitiveness in the future?
Mr. BERNANKE. TO some extent, the declining relative position of
the American exchanges reflects the natural growth and development of exchanges abroad, in London, in Asia and so on, and as
those economies, those exchanges become larger, more efficient,
and deeper; that is actually not a bad thing because it gives, for
example, American companies more alternatives for raising money.
On the other hand, to the extent that business is being driven
offshore by high regulatory costs, which was the conclusion of these
two recent studies on capital market competitiveness, then that is
a problem and we need to begin to address those costs.
51
The Sarbanes-Oxley issue that you raised earlier has been cited
by a number of these studies, and the SEC and the Public Company Accounting Oversight Board have recently issued a new audit
standard which will attempt to reduce the costs of implementing
Sarbanes-Oxley's Section 404 on internal controls and, in particular, to make it more focused on the most important matters
rather than on trivial matters and also more appropriate for smaller and less complex firms. So I think that is going to be an important step in reducing that particular set of costs.
There are many other issues, some of which Congress could address—issues of tort reform and litigation, the CFIUS bill about
foreign investment coming to the United States, and striking the
appropriate balance there between keeping a flow of foreign investment into the United States versus appropriate national security
considerations. The Federal Reserve is working on the Basel II
bank capital accord regulation, and we are working on that, and we
want to make sure that does not put American banks at a capital
disadvantage in the capital markets.
So it is certainly important for us across a whole variety of regulatory areas to try to keep those costs down and to keep working
to reduce the burden of regulation on American public companies.
Mr. CASTLE. Well, thank you. I do not mean to speak for our
chairman or ranking member here, but I think these issues are of
great importance to this particular committee. So, hopefully, we
can be kept informed.
Changing subjects, I am looking at page 2 of your testimony in
which it says that the Federal Open Market Committee has maintained Federal fund rates, etc., of 5Vi percent, and it says that,
more or less, the risk of inflation is not overwhelming at this point.
Then it goes on to say—and again, you have indicated this—the
"predominant policy concern is the risk that inflation will fail to
ease as expected and that it is prepared to take action to address
inflation risks if developments warrant." I suppose I should have
learned this in Economics 101, but in addition, if there is an addition to dealing with interest rates, are there other things that the
Federal Open Markets Committee can do with respect to that
issue?
Mr. BERNANKE. NO. That is the basic tool.
The CHAIRMAN. If the gentleman would yield.
Mr. CASTLE. I yield.
The CHAIRMAN. He said he could not speak for me, but he just
asked essentially the same question I asked. So, on those two questions about the congruity of those two statements, I agree with the
gentleman.
Mr. CASTLE. And I also apologize for being absent and not here
when you asked, Mr. Chairman. I had a good reason for it, though.
The CHAIRMAN. Submit it in writing.
Mr. CASTLE. I have last year introduced legislation about transparency in hedge funds. I am concerned about hedge funds. You
answered this yesterday in Senate testimony and basically indicating that the liquidity of hedge funds could be very important. I
don't have a problem with that either, but I do have a problem in
terms of what hedge funds could do with respect to commodity
markets and a variety of things they get into because of the enor-
52
mity of it and the number of them that have opened in recent years
and where they are going.
I am not one who looks for overregulation or overtransparency,
if there is such an expression, but I think proper transparency is
in order. I would like your thoughts, if you could, about where we
are with respect to hedge funds, and what do you think the role
of the—regulatory role or perhaps our committee role in this area
should be.
Mr. BERNANKE. Well, the approach that regulators have taken
since the report of the President's Working Group after the LTCM
crisis has been a market-based approach, an indirect regulation approach, whereby we put a lot of weight on good risk management
by the counterparties to the hedge funds such as the prime dealers,
the lenders, as well as the good oversight of the investors, the institutions and so on that invest in hedge funds. And we found that
is a very useful way to control leverage and to provide market discipline on those funds.
The original report of the President's Working Group also suggested disclosures, and that never went anywhere in Congress, and
I think part of the problem was it was difficult to agree upon what
should be disclosed and what would be useful. The hedge funds are
naturally reluctant to disclose proprietary information about their
trading strategies and approaches, and their positions change very
quickly, and so therefore position information can be overwhelming
and perhaps not very useful.
I think it is important to continue to think about hedge funds.
They certainly play an important role in our financial system. Exactly, you know, what a disclosure regime would look like, though,
is not yet clear to me how that best would be organized.
The CHAIRMAN. The Chair is about to recognize the gentleman
from Minnesota. I do want to thank the Chairman. It is the first
time in my memory that freshman members of this extremely large
committee are able to ask questions because—I appreciate the
chairman being around because we are going to be able to accommodate our four remaining members, but the ranking member had
one very specific brief question he wanted to ask, and if there is
no objection, I will recognize him for that.
Mr. BACHUS. Mr. Chairman, this is more of a concern. Governor
Susan Bies recently announced her retirement. I am very concerned about that in that she was expert on not only risk management, but on Basel, and I felt like under her leadership we made
tremendous strides in Basel. She had real banking experience with
a regional bank. And with Mark Olsen gone, too, I am just concerned that as that process goes forward—you know, he has a community banking background—that we had people who were bankers that we deal with as this process goes forward, because those
are two major losses.
Mr. BERNANKE. We will miss Governor Bies, as well. She was an
extraordinary colleague and very, very knowledgeable about banking matters, as you indicate.
I think we will have good continuity. We have the skills at both
the Board level and at the staff level to continue to move forward
effectively with Basel II. And we will, of course, wait for the President to nominate two people to the Board.
53
The CHAIRMAN. I would like to say to the Chairman that I hope
that you can, in fact, bring the Basel process to a conclusion and
I never have to think about it again for about 6 years.
The gentleman from Minnesota.
Mr. ELLISON. Thank you, Mr. Chairman.
And thank you, Mr. Chairman.
Mr. Chairman, in your remarks on page 2, you noted that real
hourly compensation rose at an annual rate of about 3 percent in
the latter half of 2006.
Could you describe how the longer period of time, for example,
over the past 10 or, say, 15 years, what have real wages looked
like?
Mr. BERNANKE. I don't know the exact number over the last 10
years, but there has been a pattern, we have seen this time and
we saw before, in the late 1990's, when productivity picked up
quickly during that period in the late 1990's, real wages lagged behind productivity for a while, and then they began to catch up to
it.
I think in the current episode a couple of things have been at
work. One is that the labor market remains somewhat weak even
after the recession ended in 2001. A second concern has been the
oil price increases, given nominal wage increases, modest nominal
wage increases, when oil prices go up so much that it takes away
from the buying power of real wages. And then thirdly I think it
is, again, somewhat normal for real wages to catch up later in the
business cycle to—and particularly when there have been periods
of increased productivity growth as we have seen in the last 3
years.
So I am encouraged to see this increase in real wages. Barring
new shocks, new increases in oil prices, I would think we would see
further increases in real wages going forward. And I would just add
that the 3 percent number is for the whole nonfarm business sector, but you get about the same number for average hourly earnings for production workers, which is more representative of the
broader middle of the middle distribution.
Mr. ELLISON. I am encouraged by the increase in real wages, too,
since the middle of 2006, but I have heard people describe the real
wages over the longer period, maybe 20 years or so, as flat. And
so I don't know if that conflicts with what you are saying or if it
is—or if what you are saying is more descriptive of more recent
events.
Mr. BERNANKE. The behavior of real wages depends on the skill
levels. I have some discussion of this in this speech that Representative Waters referred to on inequality. Over the last 25, 30 years,
we have seen really modest increases in real wages for those with
less than a high school education, much more significant increase
in real wages for those who have a college education or better, and
intermediate increases for high school graduates. So it depends
very much on where you are in the wage scale.
Mr. ELLISON. Thank you.
I want to ask you a little about loans. What is your best prescription or recommendation to fix what I would generally describe as
predatory loans? And I am not only referring to the mortgage market, but what could also—some phenomena in the credit card area?
54
It sounds like what you are saying what we need is more disclosure
to the consumer. Did I understand your views accurately on that?
Mr. BERNANKE. Well, I indicated that it is very difficult. And I
am not just trying to hedge here, because we want to eliminate
predatory and abusive lending, but we don't want to shut down the
legitimate subprime market. And that is sometimes a difficult task,
and that is why I was praising some of the State efforts that represent good experiments along those lines.
So approaching that I think involves disclosure, it may involve
barring certain practices as well. The Federal Reserve, I should
say, is very much involved in trying to control predatory lending.
We are responsible for the Home Mortgage Disclosure Act. We recently added information requirements there on pricing so we can
find out whether pricing is varying across, for example, minorities
and nonminorities. We are responsible for the Home Ownership
Equity Protection Act and other things, Regulation Z. So we are
very much involved in that from the Federal level.
But again, I think there is still a lot of creativity we can see at
the State level to try to understand better how to address this
problem.
Mr. ELLISON. Thank you, Mr. Chairman. I only have 5 minutes.
So is the proposal—the rule proposal regarding regulation Part D,
is that basically a rule—do you anticipate that rule focusing on disclosure, or will it include barring certain practices?
Mr. BERNANKE. Did you say Regulation Z?
Mr. ELLISON. Yes.
Mr. BERNANKE. Yes.
That is part of the Truth in Lending Act.
By nature of the act, it is focused on disclosures, and it will be focused on short-term credit like credit cards.
Mr. ELLISON. DO you have any views on things like universal default? This is a credit card practice I am sure you are familiar with.
If you default, if you are late on one credit card, a credit card company you are not late on can jack up your rate. Do you have any
views on that practice and how Congress might approach that kind
of phenomena?
Mr. BERNANKE. That is a difficult one. We don't want to rule out
the possibility that when someone's creditworthiness drops for a
variety of reasons, that their creditors get that information and use
it.
However, I think some of the concern about universal default
provisions is that people don't get enough warning or notice that
this condition is going to kick in. So that might be one direction
to go, which is to increase the amount of warning that consumers
get when their credit histories deteriorate and when that may affect their pricing and their credit cards.
Mr. ELLISON. Thank you.
The CHAIRMAN. The gentleman from Illinois.
Mr. ROSKAM. Thank you, Mr. Chairman.
Mr. Chairman, I am a new Member of Congress and a new member of the committee, and I appreciate the detailed questions that
my colleagues have asked. I guess I would ask a broader question,
and that is, you know, it seems to me that economic strength and
weakness, success and failure is mysterious in a lot of ways, and
it is difficult for somebody outside of this arena to gaze in and real-
55
ly discern all the factors that go into a good, successful mix. And
I realize there is really nobody who can do that.
But for purposes of this committee and future committees that
have this responsibility of oversight for you, Mr. Chairman, and the
Fed, what are the things that you are responsible for? What are
the tools that you have at your disposal? And can you sort of, and
maybe in an Econ 101 sort of fashion, in the remaining 4 minutes
just break that down and say, look, maybe start—these are the
things that we frankly have no influence over, that are just off the
table. I think that would help me and maybe some other members
of the committee in the future.
Mr. BERNANKE. Well, the Federal Reserve has multiple responsibilities. The one that is best known is our responsibility for monetary policy, which we use to pursue the Congressional mandate of
price stability and maximum sustainable employment.
It is important that the Federal Reserve be independent and be
able to make independent decisions about interest rates in order to
preserve the credibility of the central bank. However, it is also important that Congress exert oversight over the Federal Reserve to
make sure that we are following our stated mission, and that we
are pursuing coherent and rational plans.
The other areas include banking supervision, where we are involved in developing the new capital accord, providing various guidances and regulations together with the other banking agencies,
and there we are more like the other agencies in terms of the kinds
of responsibilities we have.
We have considerable responsibility in the consumer protection
area—that has come up a lot today—for various regulations that
provide disclosures to consumers on credit cards, on mortgages, and
that provide some tools to address predatory lending, or high-cost
lending. And there, like other agencies, we are given instruction by
the Congress, by the law, in terms of what the Congress wants us
to achieve and with what instruments. And then it is our job to implement the regulations that will most effectively accomplish
Congress's goals.
So we have a range of activities, all of which fall into the underside of Congress obviously.
The CHAIRMAN. I thank the gentleman. The Chair will now exercise his prerogative. We have four Members left who haven't asked
questions. We have about a half hour. That is going to be the end
of it. So I will go to the gentleman from Colorado, the gentleman
from Ohio, the gentleman from Indiana, and the gentlewoman from
Wisconsin. Anyone who is within the sound of my voice or whose
staff is here, don't bother to show up because we are going to end
it at this. And the gentleman of Ohio is recognized—I am sorry the
gentleman from Colorado.
Mr. PERLMUTTER. Thank you, Mr. Chairman, and Chairman
Bernanke, thank you for your stamina and patience. I have several
questions.
The CHAIRMAN. What about mine?
Mr. PERLMUTTER. Well, yours has been remarkable, Mr. Chairman. Thank you.
On page 2 of your report, you say that consumer spending continues to be the mainstay of the current economic expansion.
56
Where are we on consumer debt? I mean, have you seen a trend
in that, and can you tell me where we are?
Mr. BERNANKE. Consumer debt has risen quite a bit. It is rising
more slowly recently mostly because home mortgages aren't rising
as quickly due to the flattening out of prices and the slower
amount of home purchase.
Generally speaking, though, as we said in the testimony, households are in reasonable financial shape. Offsetting their debt is an
increase in wealth; the stock market is up. House prices over the
last few years have gone up a lot, and so many people have a considerable amount of equity in their home. And moreover, the
strength of the labor market means that the job availability, incomes, wages are also pretty strong. So for the larger part of the
population, finances seem reasonably good relative to historical
norms.
Now, of course, there are always some people who are having
problems, and as I noted in testimony, there are some sectors, notably the subprime lending sector, where we were seeing some distress, and we are watching that very carefully.
Mr. PERLMUTTER. SO no alarm bells in the trend of consumer
debt, because I guess my perception has been that we have had significant increase to consumer debt really as compared to over the
last 10 years, and that there have been some concerns about that.
Mr. BERNANKE. There have been increases in consumer debt.
There have been even larger increases in consumer assets, and so
our wealth has grown. Our wealth is now at the highest level ever.
So, again, for most people there is a reasonable balance between
assets and liabilities.
Again, there are some pockets of concern, but I don't think that
at this point that they have significant implications for the behavior of the overall economy, although we obviously have to watch the
individual sectors.
Mr. PERLMUTTER. Okay. Any exact pro or con by the recent
changes in the Bankruptcy Code now that we have had a year,
year-and-a-half under our belts? And, you know, if you don't, if it
is too early to tell, then that is fine, too.
Mr. BERNANKE. It is a bit early to tell. We saw a big spike in
bankruptcy filings in advance of the law because people, if they
were thinking of going bankrupt, they wanted to get that done before the law change. Since then we have seen a moderate rate of
bankruptcy, I think somewhat lower than in the past, but whether
that is due to the change in the law or just to generally good financial conditions in the last few years is hard to say. Again, we have
seen, for example, very few delinquencies in consumer credit or in
mortgages outside the subprime market, so there has been a generally good credit situation in the last couple of years, and that
seems to be reflected in a relatively low rate of bankruptcies.
Mr. PERLMUTTER. Speaking of the subprime market, last week
the bottom kind of fell out of that market, or there was a tremendous drop in that market. Has that leveled off? I haven't read anything since Friday, but it seems there was a tremendous loss of
value in that market.
Mr. BERNANKE. There have been a few small companies that
have gone out of business, and others that have lost money. Now-
57
adays, mortgages are not just made and held by individual firms,
they are then securitized and sold into the general financial markets. And so we can look at financial market prices and see what
the market more broadly thinks is happening in this area. And the
value of subprime-mortgage-backed securities has dropped pretty
significantly, suggesting that financial market investors are concerned about the loss probabilities in this area.
Mr. PERLMUTTER. My last question, I had a number of organizations, interest groups, approach me on the issue of banks getting
into the real estate business as opposed to remaining in the lending
business. Does the Fed have an opinion on that, or do you have an
opinion on that?
Mr. BERNANKE. The Federal Reserve is charged, along with the
Treasury, in determining whether allowing banks to enter the real
estate brokerage business is consistent with Gramm-Leach-Bliley.
However, the Congress every year has essentially forbidden that
consideration, so we have not yet had an opportunity to consider
whether, based on the law, that should be allowed, so we have not
had the opportunity to try to evaluate that.
Mr. PERLMUTTER. DO you have an opinion on it, or if the answer
is no, it is premature, that is fine.
Mr. BERNANKE. Since I am charged with making a determination, it would certainly be inappropriate for me to speak about it
until such time as I have a chance to look at the information and
data.
The CHAIRMAN. The gentleman from Ohio.
Mr. GlLLMOR. Thank you, Mr. Chairman, and also thank you,
Mr. Chairman, for spending so much time with us.
I want to touch on the question of ILC's. As you know, a lot of
retail firms are trying to make an end run around the banking
laws. Chairman Frank and I have had legislation in now for three
Congresses. In the past you have always—also your predecessor,
Mr. Greenspan, made comments in favor of closing that loophole.
Would that still be your opinion?
Mr. BERNANKE. Yes, it would.
Mr. GlLLMOR. Let me ask you another question regarding the
economy, which has been generally good by all historical standards
and when you have a good economy for a long time, you have low
interest rates, thank goodness. We are all happy to see that. You
see some of the economic commentators talking about whether it
is time for the Fed to take the punch bowl away, and I guess my
question is while the party is still going good economically, do you
think we are still sober enough to leave the punch bowl there? So
my question is what are you going to do with the punch bowl?
Mr. BERNANKE. We are going to conduct monetary policy so as
to satisfy the chairman and meet our congressionally mandated responsibility for maximum employment and price stability.
Mr. GlLLMOR. Thank you.
One other question, and I don't know if you are familiar with
this recent report, but many of us are worried about America's
global competitiveness, and the World Economic Forum recently released its Global Competitiveness Report in which the United
States dropped from first to sixth.
58
I guess my question is, do you agree with that assessment and
the recommendations made therein?
Mr. BERNANKE. First, I think that notion of competitiveness between countries is a little bit deceiving. It is not quite the same as
GM and Ford. Any country that is successful in increasing its productivity will increase its wages and living standards independent
of whether other countries are doing the same.
I have looked at that report. It seems to me that the change in
ranking is based on relatively small changes in the numbers. Some
macroeconomic factors like our savings rate have entered into that
calculation. So I don't take that in particular as an alarm bell. I
don't think it is particularly significant, but, as always, we need to
find ways to improve our macropolicies, improve our regulatory
policies, and keep the country as productive and efficient as possible.
Mr. GlLLMOR. Thank you very much, Mr. Chairman, and thanks
again for spending so much time with us.
Mr. BERNANKE. Thank you.
The CHAIRMAN. And thanks to the gentleman from Ohio for dropping in.
Mr. GlLLMOR. I was on the Floor, Mr. Chairman.
The CHAIRMAN. The gentleman from Indiana.
Mr. DONNELLY. Thank you, Mr. Chairman.
Thank you, Chairman Bernanke.
My district has Chrysler plants, Delphi plants, and small manufacturers, the heartland of this country, and in your testimony you
talked about painful changes that are taking place. What the people of my district have asked me to tell you is that the changes are
even more painful when the competition isn't fair. And we see
China manipulating their currency, having no labor standards, no
environmental standards, and intellectual piracy. And I guess my
question to you, Mr. Chairman is do you see this as unfair competition, and if so, why do we let this continue?
Mr. BERNANKE. Well, I have spoken about the yuan, about the
Chinese currency, and I think that it is undervalued. And I think
that the Chinese ought to allow it to be more market-determined,
that they should move in that direction.
I also think that we should continue to work with them to enforce their intellectual property rights and to make sure that both
sides are living up to trade agreements.
So going forward, I agree that trade agreements need to be enforced, and intellectual property rights are important, and we
should continue to apply pressure to China on those issues.
Mr. DONNELLY. I appreciate that. There is a feeling back home
and on my part that the Chinese don't take us seriously in that respect—that we talk and we talk and we talk, and while we talk,
more jobs leave my district from manufacturers who have shaved
every corner they can, who have put in all the computer integration they can, and they see product coming into this country at
costs they can't even touch to manufacture.
And so there is a feeling that you are the home team, our Treasury Secretary, he is the home team. He was over in China recently,
and there is a dispiritedness both on Republicans and Democrats,
this is bipartisan, that the home team has walked away. Our own
59
coaches have left us on the field all by ourselves. And so when I
go back and say, well, they are talking, my manufacturers laugh
and say, well, they will talk us until our doors are closed. So what
do I tell them about that, Mr. Chairman?
Mr. BERNANKE. The Chinese have recognized that the large trade
surplus is, in fact, a problem for them as well, and they understand
that there is a risk of reaction, protectionism perhaps, and they
have made it part of their official economic plan to try to reduce
the trade surplus that they currently have.
Greater exchange rate flexibility is part of the way to do that,
but in addition, the Chinese are currently trying to increase the reliance of their economy on domestic consumption, domestic spending, and reduce reliance on exports. If they can make that adjustment towards a domestically driven economy, reduce their export
reliance, that will help more, I think, even than some other measures to create a better global balance. So that is one step that they
are taking.
I would also say in terms of our conversations in discussions with
the Chinese that I think that while the exchange rate is a very,
very important issue, there is a wide range of issues that we as
Americans have to discuss with the Chinese including issues of
trade; you mentioned intellectual property rights and trade agreements, but things like the environment. For example, I think there
is a lot of mutual benefit if, for example, we were able to provide
equipment and technology to the Chinese to help them clean up
their air, that would be beneficial to both parties. Similarly energy
security is another interest we have in common.
So another way to look at this is that, yes, we have to keep working on the exchange rate, but we also have a lot of other things
that we need to be talking about, and I think it is important to
keep that conversation going.
Mr. DONNELLY. And I guess I would ask you to discuss with the
Chinese when you talk to them, and the Secretary of Treasury
when he talks to them, that the folks back home who are running
these shops, who are supplying families with the money to purchase their home, and we have increasingly high foreclosures back
home, have said to me, Joe, we sent you there to do something
about this, and if the Treasury Secretary and the Fed and the
President aren't willing to do it, then we are looking to Congress
to step up and take the steps necessary to make this a fair
ballgame, again because they feel it is a rigged game, and our team
won't step up for the people at home.
Thank you very much, Mr. Chairman.
The CHAIRMAN. The gentlewoman from Wisconsin.
Ms. MOORE OF WISCONSIN. Well, thank you very much, Mr.
Chairman, and thank you very much, Mr. Chairman, for your patience here today.
Thank you, Mr. Chairman. I did have an opportunity to review
your testimony before the committee, and I do want to thank you.
I have a reached some conclusions, which I guess I want to sort of
vet with you.
As others have mentioned, you mention several times in your testimony that consumer spending continues to be the mainstay in the
current economic expansion, and you also seem to indicate that the
60
resilience of this consumer spending is important towards sustaining our economic growth.
You also indicate that increase in people's compensation accounts
for this, and that our higher labor productivity and perhaps a narrowing of corporate profits might offset the higher labor productivity and that narrowing—I am sorry—profit margins of companies might prevent higher prices from occurring, and people might
experience a real higher compensation.
A couple of questions come to mind when I review this testimony.
First of all, I guess I want to ask you if you account for this stronger gain in personal income as many of us do, foresee that it is all
aggregated kind of at the top, that this increase in consumer
spending is a very narrow number of consumers, and that imposes
some kind of risk unless we spread the purchasing and consumer
spending power a little bit broader.
And secondly, leading into that sort of executive compensation,
if we were to—again, if we are depending—if our economy is depending on consumer spending, wouldn't it be better if we sort of
spread the wealth a little bit and, in keeping with your testimony,
resist raising prices by narrowing corporate prices, profits?
Mr. BERNANKE. Well, as I discussed, there has been a long-term
trend toward increased inequality in the United States that has
been going on for a long time, but it is certainly an issue. I think
most recently there has been some improvement just in terms of
general earnings in the broader economy. I mentioned the statistic
of the average hourly earnings which are for production workers,
so that does not exclude the top 20 percent of wage earners, and
that has grown recently at a pretty reasonable pace. So I think
that real wage gains currently are going to help support consumption spending. But I agree that we want to see a broad-based consumption in order to make this sustainable.
Ms. MOORE OF WISCONSIN. I am glad that you mentioned, because there seems to be a lot of resistance toward things like raising the minimum wage. I think we talk a lot about minimum-wage
workers, but there are people who don't make the minimum wage
that could benefit and would spend if they had more so-called disposable income. And I think your testimony really contributes a
great deal to the discussion of how important it is to support our
economy through elevating people's wages, and that is what I took
away from your testimony. Thank you.
Mr. BERNANKE. Thank you.
Ms. MOORE OF WISCONSIN. I yield back, Mr. Chairman.
The CHAIRMAN. I thank the gentlewoman, and I want to thank
the Chairman, and I want to say that I thank the members of the
committee. This has been a very thoughtful discussion. I appreciate
the Chairman. I think these are issues that we will continue to
talk about. And the hearing is adjourned.
[Whereupon, at 1:50 p.m., the hearing was adjourned.]
APPENDIX
February 15, 2007
(61)
62
Statement and Questions for Humphrey-Hawkins Hearing
Rep. Randy Neugebauer, Deputy Ranking Member
House Financial Services Committee
February 15, 2007
Chairman Frank, Ranking Member Bachus, thank you for holding this important hearing.
Chairman Bernanke, thank you for appearing before the committee today and for your thoughtful
testimony.
Mr. Chairman, over the past several years, smart fiscal policies, including tax relief and spending
restraint, have contributed to tremendous economic growth and deficit reduction. In short, our
economy is strong.
With 111,000 new jobs created in January, and more than 2.1 million new jobs created over the past
12 months, our workforce continues to grow. Since August 2003, more than 7.4 million jobs have
been created - more jobs than all the other major industrialized countries combined. In addition,
our economy grew by a solid 3.4 percent last year.
This economic growth has generated increased tax revenues and has dramatically improved the
budget outlook. If Congress continues to show restraint in spending, and our economy continues to
climb as a result of extended tax cuts, we will eliminate the budget deficit in five years, and reap a
surplus in the year 2012.
Despite the successes we have enjoyed, however, more needs to be done. In order to sustain
economic growth, entitlement spending must be restrained. It is imperative that we make
meaningful reforms to control the rapid growth of these outlays, and I am pleased President Bush's
budget proposal includes several reform options for Congress to consider.
63
It is also important for Congress to promote a stable housing market. As our nation's housing
market continues to show tremendous resiliency and strength, we must work to ensure that
Government Sponsored Enterprises, such as Fannie Mae and Freddie Mac, are financially and
ethically sound.
In addition, we must work to reform our health care system, diversify our energy resources, and
promote a more balanced trade position. We must also focus on the fiscal education of America's
youth, and work with state and local leaders to implement common sense education priorities that
promote a basic understanding of finance.
With these things in mind, 1 would like to ask you three unrelated questions:
1.
The personal savings rate of Americans has recently fallen to a 73-year low. In your
estimation, how does this impact our current housing situation?
2.
Can you give me an indication of your level of concern about the default rates on
home mortgages — especially as it applies to subprime mortgages?
3.
In your estimation, has Congress shown adequate concern about the growth of
entitlement spending?
Again, thank you for your testimony. I look forward to reading your responses to my questions.
64
OPENING REMARKS of the HONORABLE MAXINE
WATERS D-CA 35th
COMMITTEE ON FINANCIAL SERVICES
HEARING TO RECEIVE TESTIMONY of the CHAIRMAN,
BEN BERNANKE,
OF THE FEDERAL RESERVE BOARD OF GOVERNORS
THURSDAY, FEBRUARY 15, 2007
Good morning. Mr. Chairman and ladies and
gentlemen, it has been exactly one year since we first heard
from the then-new Chairman of the Federal Reserve Board
of Governors, Ben Bernanke. Mr. Bernanke, I want to
congratulate you on this milestone and thank you for your
willingness to work closely with the Members of the
Committee on Financial Services. Indeed, I have watched
you during this first year of your tenure as the Chairman of
65
the Fed and have been most interested in your ideas about
income inequality, investment in education, community
investment and other economic issues.
As you know, when you appeared before the
Committee in July 2006 to present your midyear report to
Congress, you identified three issues that you felt could
influence the economy—energy prices, stagnation of the
housing market and resources utilization. In July 2006, the
price of a barrel of oil was $ 78.00, representing a 30
percent increase from six months earlier when oil was
$55.00. The current price of oil is approximately $59.00 per
barrel, but oil price volatility must be factored into any
predictions about the future of the U.S. economy. The U.S
housing market has slowed considerably. Scarce resources
are being stretched even thinner because of worldwide
66
demand for those resources, led by China, India and other
growth economies. Chairman Bernanke, you were
undoubtedly correct in identifying the three issues that
would impact the U.S. economy moving forward. And here
we are six months later with what could be the beginning
stages of a major slowdown in the U.S. economy because
housing is no longer robust, oil prices are likely to increase,
and resources are not unlimited. Something has to give, and
maybe it is the end of the ride for this economic growth
cycle.
It has been more than five years since the expansion
began in November 2001, and working Americans are still
waiting for their share. According to some reports, "the
economy is showing remarkable parallels to the situation of
a decade ago." The first five years of the expansion in the
67
1990s brought with it record corporate profits, a robust
stock market, and increased wealth for the very few. That
expansion would ultimately last for ten years.
Wage increases have been almost nonexistent for the
American worker. In December 2006, five years after the
economy started to grow, the wages of the American
worker were approximately 1.7 percent higher, adjusted for
inflation, than when the economy sank in November of
2001. Most of the gains experienced by workers were
realized in the last few months of that expansion. In April
1996, five years after that expansion, wages were actually
worth four tenths of a percent less than when the expansion
began. In addition, we have to take into account that
productivity growth for 2006 was 2.1 percent and has not
been that low since 1997. These two indicators might
68
suggest to some that we are in for along ride unless you
believe that we will have five uninterrupted years of growth
in both productivity and wages.
These economic indicators tell us a lot about why
there is growing income inequality in the U.S. I am afraid
that if the economy continues to turn in the opposite
direction from where it has been these last five years,
income inequality will increase. As income inequality
grows, we will see more people slip into poverty, while
unemployment will add to the economic woes of the
already strapped American worker.
Finally, Chairman Bernanke, I am really interested in
the policy debate around the U.S. trade imbalance. We have
had a trade imbalance for the last five years. Just two days
69
ago we learned that the trade deficit of $763.3 billion for
2006 - a 6.5 percent increase over 2005 - is the largest in
our history. Imported oil and vast amounts of consumer
goods from China and other major importers account for
the large part of the U.S. trade imbalance. We hear that
trade deals are good and that trade deals are bad.
Whatever view you accept, it is clear that U. S.
exports are not substantial enough to offset the imbalance,
although we increased exports over last year by 13 percent.
Of course, we know that the Administration is pro-Free
Trade and believes that the loss of American jobs is solely
a result of technology, rather than to flood of inexpensive
goods coming into the country from
abroad. Unemployment is extremely high in communities
affected by the loss of manufacturing jobs. Some of the
70
unemployment is intractable, and many of the unemployed
for years instead on months.
As Chairman now for one year, what can you tell us
about the role of the Federal Reserve in addressing these
problems? Is it just a matter of monetary and fiscal policy,
or are is there a real policy fix for the problems that we are
facing in the US? What will we experience if the current
expansion has come to an end and growth slows? Once
again, I am extremely pleased to be able to hear your views
and prescriptions for our economy, particularly the
neglected segments of the population — the poor, the
unemployed and underemployed. Many of these people
missed out on the benefits of the recent expansion. Thank
you.
71
For release on delivery
10:00 a.m. EST
February 15,2007
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
February 15, 2007
72
Chairman Frank, Representative Bachus, and other members of the Committee, I am
pleased to present the Federal Reserve's Monetary Policy Report to the Congress.
Real activity in the United States expanded at a solid pace in 2006, although the pattern
of growth was uneven. After a first-quarter rebound from weakness associated with the effects
of the hurricanes that ravaged the Gulf Coast the previous summer, output growth moderated
somewhat on average over the remainder of 2006. Real gross domestic product (GDP) is
currently estimated to have increased at an annual rate of about 2-3/4 percent in the second half
of the year.
As we anticipated in our July report, the U.S. economy appears to be making a transition
from the rapid rate of expansion experienced over the preceding several years to a more
sustainable average pace of growth. The principal source of the ongoing moderation has been a
substantial cooling in the housing market, which has led to a marked slowdown in the pace of
residential construction. However, the weakness in housing market activity and the slower
appreciation of house prices do not seem to have spilled over to any significant extent to other
sectors of the economy. Consumer spending has continued to expand at a solid rate, and the
demand for labor has remained strong. On average, about 165,000 jobs per month have been
added to nonfarm payrolls over the past six months, and the unemployment rate, at 4.6 percent in
January, remains low.
Inflation pressures appear to have abated somewhat following a run-up during the first
half of 2006. Overall inflation has fallen, in large part as a result of declines in the price of crude
oil. Readings on core inflation—that is, inflation excluding the prices of food and energy—have
improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat
elevated.
73
-2In the five policy meetings since the July report, the Federal Open Market Committee
(FOMC) has maintained the federal funds rate at 5-1/4 percent. So far, the incoming data have
supported the view that the current stance of policy is likely to foster sustainable economic
growth and a gradual ebbing of core inflation. However, in the statement accompanying last
month's policy decision, the FOMC again indicated that its predominant policy concern is the
risk that inflation will fail to ease as expected and that it is prepared to take action to address
inflation risks if developments warrant.
Let me now discuss the economic outlook in a little more detail, beginning with
developments in the real economy and then turning to inflation. I will conclude with some brief
comments on monetary policy.
Consumer spending continues to be the mainstay of the current economic expansion.
Personal consumption expenditures, which account for more than two-thirds of aggregate
demand, increased at an annual rate of around 3-1/2 percent in real terms during the second half
of last year, broadly matching the brisk pace of the previous three years. Consumer outlays were
supported by strong gains in personal income, reflecting both the ongoing increases in payroll
employment and a pickup in the growth of real wages. Real hourly compensation—as measured
by compensation per hour in the nonfarm business sector deflated by the personal consumption
expenditures price index—rose at an annual rate of around 3 percent in the latter half of 2006.
The resilience of consumer spending is all the more striking given the backdrop of the
substantial correction in the housing market that became increasingly evident during the spring
and summer of last year. By the middle of 2006, monthly sales of new and existing homes were
about 15 percent lower than a year earlier, and the previously rapid rate of house-price
appreciation had slowed markedly. The fall in housing demand in turn prompted a sharp slowing
74
-3-
in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about
four-and-a-half months' supply in 2005 to nearly seven months' supply by the third quarter of
last year. Single-family housing starts have dropped more than 30 percent since the beginning of
last year, and employment growth in the construction sector has slowed substantially.
Some tentative signs of stabilization have recently appeared in the housing market: New
and existing home sales have flattened out in recent months, mortgage applications have picked
up, and some surveys find that homebuyers' sentiment has improved. However, even if housing
demand falls no further, weakness in residential investment is likely to continue to weigh on
economic growth over the next few quarters as homebuilders seek to reduce their inventories of
unsold homes to more-comfortable levels.
Despite the ongoing adjustments in the housing sector, overall economic prospects for
households remain good. Household finances appear generally solid, and delinquency rates on
most types of consumer loans and residential mortgages remain low. The exception is subprime
mortgages with variable interest rates, for which delinquency rates have increased appreciably.
The labor market is expected to stay healthy, and real incomes should continue to rise, although
the pace of employment gains may be slower than that to which we have become accustomed in
recent years. In part, slower average job growth may simply reflect the moderation of economic
activity. Also, the impending retirement of the leading edge of the baby-boom generation, and
an apparent leveling out of women's participation rate in the workforce, which had risen for
several decades, will likely restrain the growth of the labor force in coming years. With fewer
jobseekers entering the labor force, the rate of job creation associated with the maintenance of
stable conditions in the labor market will decline. All told, consumer expenditures appear likely
to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal
75
-4-
incomes if, as we expect, households respond to the slow pace of home-equity appreciation by
saving more out of current income.
The business sector remains in excellent financial condition, with strong growth in
profits, liquid balance sheets, and corporate leverage near historical lows. Last year, those
factors helped to support continued advances in business capital expenditures. Notably,
investment in high-tech equipment rose 9 percent in 2006, and spending on nonresidential
structures (such as office buildings, factories, and retail space) increased rapidly through much of
the year after several years of weakness. Growth in business spending slowed toward the end of
last year, reflecting mainly a deceleration of spending on business structures; a drop in outlays in
the transportation sector, where spending is notably volatile; and some weakness in purchases of
equipment related to construction and motor vehicle manufacturing. Over the coming year,
capital spending is poised to expand at a moderate pace, supported by steady gains in business
output and favorable financial conditions. Inventory levels in some sectors—most notably at
motor vehicle dealers and in some construction-related manufacturing industries—rose over the
course of last year, leading some firms to cut production to better align inventories with sales.
Remaining imbalances may continue to impose modest restraint on industrial production during
the early part of this year.
Outside the United States, economic activity in our major trading partners has continued
to grow briskly. The strength of demand abroad helped spur a robust expansion in U.S. real
exports, which grew about 9 percent last year. The pattern of real U.S imports was somewhat
uneven, partly because of fluctuations in oil imports over the course of the year. On balance,
import growth slowed in 2006, to 3 percent. Economic growth abroad should support further
steady growth in U.S. exports this year. Despite the improvements in trade performance, the
76
-5U.S. current account deficit remains large, averaging about 6-1/2 percent of nominal GDP during
the first three quarters of 2006 (the latest available data).
Overall, the U.S. economy seems likely to expand at a moderate pace this year and next,
with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is
reflected in the projections that the members of the Board of Governors and presidents of the
Federal Reserve Banks made around the time of the FOMC meeting late last month. The central
tendency of those forecasts-which are based on the information available at that time and on the
assumption of appropriate monetary policy—is for real GDP to increase about 2-1/2 to 3 percent
in 2007 and about 2-3/4 to 3 percent in 2008. The projection for GDP growth in 2007 is slightly
lower than our projection last July. This difference partly reflects an expectation of somewhat
greater weakness in residential construction during the first part of this year than we anticipated
last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around
4-1/2 to 4-3/4 percent.
The risks to this outlook are significant. To the downside, the ultimate extent of the
housing market correction is difficult to forecast and may prove greater than we anticipate.
Similarly, spillover effects from developments in the housing market onto consumer spending
and employment in housing-related industries may be more pronounced than expected. To the
upside, output may expand more quickly than expected if consumer spending continues to
increase at the brisk pace seen in the second half of 2006.
I turn now to the inflation situation. As I noted earlier, there are some indications that
inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will
consequently be some time before we can be confident that underlying inflation is moderating as
anticipated. Recent declines in overall inflation have primarily reflected lower prices for crude
77
-6oil, which have fed through to the prices of gasoline, heating oil, and other energy products used
by consumers. After moving higher in the first half of 2006, core consumer price inflation has
also edged lower recently, reflecting a relatively broad-based deceleration in the prices of core
goods. That deceleration is probably also due to some extent to lower energy prices, which have
reduced costs of production and thereby lessened one source of pressure on the prices of final
goods and services. The ebbing of core inflation has likely been promoted as well by the
stability of inflation expectations.
A waning of the temporary factors that boosted inflation in recent years will probably
help foster a continued edging down of core inflation. In particular, futures quotes imply that oil
prices are expected to remain well below last year's peak. If actual prices follow the path
currently indicated by futures prices, inflation pressures would be reduced further as the benefits
of the decline in oil prices from last year's high levels are passed through to a broader range of
core goods and services. Nonfuel import prices may also put less pressure on core inflation,
particularly if price increases for some other commodities, such as metals, slow from last year's
rapid rates. But as we have been reminded only too well in recent years, the prices of oil and
other commodities are notoriously difficult to predict, and they remain a key source of
uncertainty to the inflation outlook. The contribution from rents and shelter costs should also fall
back, following a step-up last year. The faster pace of rent increases last year may have been
attributable in part to the reduced affordability of owner-occupied housing, which led to a greater
demand for rental housing. Rents should rise somewhat less quickly this year and next,
reflecting recovering demand for owner-occupied housing as well as increases in the supply of
rental units, but the extent and pace of that adjustment is not yet clear.
78
-7-
Upward pressure on inflation could materialize if final demand were to exceed the
underlying productive capacity of the economy for a sustained period. The rate of resource
utilization is high, as can be seen in rates of capacity utilization above their long-term average
and, most evidently, in the tightness of the labor market. Indeed, anecdotal reports suggest that
businesses are having difficulty recruiting well-qualified workers in certain occupations.
Measures of labor compensation, though still growing at a moderate pace, have shown some
signs of acceleration over the past year, likely in part the result of tight labor market conditions.
The implications for inflation of faster growth in nominal labor compensation depend on
several factors. Increases in compensation might be offset by higher labor productivity or
absorbed by a narrowing of firms' profit margins rather than passed on to consumers in the form
of higher prices; in these circumstances, gains in nominal compensation would translate into
gains in real compensation as well. Underlying productivity trends appear favorable, and the
markup of prices over unit labor costs is high by historical standards, so such an outcome is
certainly possible. Moreover, if activity expands over the next year or so at the moderate pace
anticipated by the FOMC, pressures in both labor and product markets should ease modestly.
That said, the possibility remains that tightness in product markets could allow firms to pass
higher labor costs through to prices, adding to inflation and effectively nullifying the purchasing
power of at least some portion of the increase in labor compensation. Thus, the high level of
resource utilization remains an important upside risk to continued progress on inflation.
Another significant factor influencing medium-term trends in inflation is the public's
expectations of inflation. These expectations have an important bearing on whether transitory
influences on prices, such as those created by changes in energy costs, become embedded in
79
wage and price decisions and so leave a lasting imprint on the rate of inflation. It is encouraging
that inflation expectations appear to have remained contained.
The projections of the members of the Board of Governors and the presidents of the
Federal Reserve Banks are for inflation to continue to ebb over this year and next. In particular,
the central tendency of those forecasts is for core inflation—as measured by the price index for
personal consumption expenditures excluding food and energy—to be 2 to 2-1/4 percent this year
and to edge lower, to 1-3/4 to 2 percent, next year. But as I noted earlier, the FOMC has
continued to view the risk that inflation will not moderate as expected as the predominant policy
concern.
Monetary policy affects spending and inflation with long and variable lags.
Consequently, policy decisions must be based on an assessment of medium-term economic
prospects. At the same time, because economic forecasting is an uncertain enterprise,
policymakers must be prepared to respond flexibly to developments in the economy when those
developments lead to a re-assessment of the outlook. The dependence of monetary policy
actions on a broad range of incoming information complicates the public's attempts to
understand and anticipate policy decisions.
Clear communication by the central bank about the economic outlook, the risks to that
outlook, and its monetary policy strategy can help the public to understand the rationale behind
policy decisions and to anticipate better the central bank's reaction to new information. This
understanding should, in turn, enhance the effectiveness of policy and lead to improved
economic outcomes. By reducing uncertainty, central bank transparency may also help anchor
the public's longer-term expectations of inflation. Much experience has shown that wellanchored inflation expectations tend to help stabilize inflation and promote maximum
80
-9sustainable economic growth. Good communication by the central bank is also vital for ensuring
appropriate accountability for its policy actions, the full effects of which can be observed only
after a lengthy period. A transparent policy process improves accountability by clarifying how a
central bank expects to attain its policy objectives and by ensuring that policy is conducted in a
manner that can be seen to be consistent with achieving those objectives.
Over the past decade or so, the Federal Reserve has significantly improved its methods of
communication, but further progress is possible. As you know, the FOMC last year established a
subcommittee to help the full Committee evaluate the next steps in this continuing process. Our
discussions are directed at examining all aspects of our communications and have been
deliberate and thorough. These discussions are continuing, and no decisions have been reached.
My colleagues and I remain firmly committed to an open and transparent monetary policy
process that enhances our ability to achieve our dual objectives of stable prices and maximum
sustainable employment. I will keep members of this Committee apprised of developments as
our deliberations move forward. I look forward to continuing to work closely with the members
of this Committee and your colleagues in the Senate and House on the important issues
pertaining to monetary policy and the other responsibilities with which the Congress has charged
the Federal Reserve.
Thank you. I would be happy to take questions.
81
For use at 10:00 a.m., EST
Wednesday
February 14,2007
Board of Governors of the Federal Reserve System
Monetary Policy Report to the Congress
February 14, 2007
82
Board of Governors of the Federal Reserve System
Monetary Policy Report to the Congress
Submitted pursuant to section 2B of the Federal Reserve Act
February 14,2007
83
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., February 14, 2007
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
84
Contents
Page
Monetary Policy and the Economic Outlook
Economic and Financial Developments in 2006 and Early 2007
1
4
85
Monetary Policy Report to the Congress
Report submitted to the Congress on February 14, 2007,
pursuant to section 2B of the Federal Reserve Act
MONETARY
POLICY AND THE ECONOMIC
OUTLOOK
The U.S. economy turned in another solid performance
in 2006, although the pattern of growth was uneven.
After rebounding in the early part of the year from
hurricane-related disruptions in the autumn of 2005, the
pace of expansion during the remaining three quarters
averaged somewhat below that of the preceding two years,
responding in part to the removal of monetary policy
accommodation since 2004. The housing market cooled
substantially, and, in the latter part of 2006, the production
of light motor vehicles also stepped down. Elsewhere in
the economy, activity remained strong. Consumer spending increased vigorously in 2006 as households' real
income made strong gains. Business investment rose at
a solid rate for the year as a whole, although it decelerated late m the year in part because of some softening in
purchases of equipment related to construction and motor
vehicle manufacturing. Demand for U.S. exports rose at a
robust pace in 2006, supported by strong economic activity abroad. Against this backdrop, businesses continued
to add jobs at a steady rate, and the unemployment rate
decreased further.
Total consumer price inflation declined in 2006 from its
elevated pace in 2005, as energy pnces fell, on net, after
rising rapidly over the preceding couple of years. Crude
oil pnces rose dunng thefirsthalf of 2006 but turned down
sharply later in the year. As a result, consumer price inflation climbed in thefirsthalf of the year before slowing in
the second half. The sharp movements in prices of crude
oil appear to have affected not only prices of gasoline and
other petroleum-based types of energy but also prices of a
broader range of goods and services that use petroleumbased inputs. Partly as a result, consumer price inflation
excluding food and energy—so-called core consumer
price inflation—moved up during thefirsthalf of the year
but eased subsequently. On balance, core inflation was a
bit higher over the four quarters of 2006 than in 2005.
Measures of long-term inflation expectations, however,
remained well anchored.
The monetary policy decisions of the Federal Open
Market Committee (FOMC) in 2006 were intended to
foster sustainable economic expansion and to promote
a return to low and stable inflation. In that regard, the
economic outlook for this year and next appears favorable. Although the contraction in homebuilding has been
a drag on growth, that restraint seems likely to diminish
over 2007. Further gains in real wages as well as ongoing
increases in employment should support a solid rise in
consumer spending. In addition, at the beginning of 2007,
households' balance sheets appeared to be in good shape.
Whereas gains in home pnces slowed last year, household
net worth increased moderately as stock market wealth
grew and households lessened their accumulation of debt.
Delinquency rates on consumer loans and on most types
of mortgages remained low, although they increased
markedly for subprime mortgages with variable interest
rates. As for businesses, balance sheets are quite liquid,
credit quality is good, and most firms enjoy ready access
to funds. These favorable financial conditions, along with
further expansion in business output, user costs of capital
equipment that remain attractive, and the potential for further gains in efficiency, should continue to spur business
investment. In addition, sustained expansion in foreign
economies ought to maintain demand for U.S. exports.
On balance, growth of real gross domestic product in the
United States appears likely to run slightly below that of
the economy's potential over the next few quarters and
then to rise to a pace around that of the economy's longrun trend.
Regarding inflation, increases in core consumer prices
are expected to moderate, on balance, over the next two
years. Along with inflation expectations that are well
anchored, some of the factors that boosted inflation in
recent years seem likely to lessen. In particular, the paths
for pnces of energy and other commodities embedded in
futures markets suggest that the impetus to core inflation
from these influences will diminish further. In addition,
the outsized increases in shelter costs that boosted core
inflation last year are not expected to persist. Although
unit labor costs in the nonfarm business sector have been
rising, the average markup of prices over such costs is
high by historical standards. The relatively high markup
suggests that further increases in costs could be absorbed,
86
2
Monetary Policy Report to the Congress D February 2007
at least to some extent, by a narrowing of firms' profit
margins rather than by passing on the costs in the form
of higher consumer prices, especially if pressures on
resources ease modestly as anticipated.
The outlook for real economic activity is uncertain.
An upside risk is that consumer spending, which has been
especially buoyant in recent months, may continue to
expand at a pace that would ultimately lead to an escalation of pressures on resources and prices. Alternatively,
prospects for residential construction, which are difficult
to assess, may pose some downside risks. Although
residential real estate markets have shown some recent
signs of stabilizing, homebuilders' inventories of unsold
homes remain elevated. Further cutbacks in construction
to reduce inventories toward more-comfortable levels
could become steeper and more persistent than currently
anticipated. Moreover, if home values were to depreciate
sharply, the resulting erosion of household wealth could
impose appreciable restraint on consumer spending.
Whether inflation will moderate gradually as expected
is also uncertain. On the one hand, the nation's potential
to produce could increase more rapidly than anticipated,
or product and input markets could work efficiently at
higher rates of utilization, either of which could lead to a
lower trajectory for inflation than currently forecast. On
the other hand, expanding global demand and threats to
supply from actual and potential disruptions pose upside
risks for energy prices. In addition, brisk world demand
for non-energy materials and commodities could lead to
further upward pressures on business costs. Also, if inflation were to persist around the elevated average level of the
past three years, longer-run inflation expectations could
deteriorate, particularly if pressures on resources were to
intensify. At recent meetings, the FOMC indicated that
the risk that inflation will fail to moderate as expected is
its predominant policy concern.
Monetary Policy, Financial Markets,
and the Economy in 2006 and Early 2007
The FOMC firmed the stance of monetary policy
25 basis points at each of its four meetings over the first
half of 2006. The Committee raised its target for the
federal funds rate at its January and March meetings as
available information pointed to accumulating pressures
on inflation and solid economic growth. Although readings on core inflation had remained favorable, increases
in energy prices and the relatively high level of resource
utilization threatened to add to existing inflation pressures.
Meanwhile, underlying aggregate demand, supported
by robust consumer spending and accelerating business
investment, appeared to be growing at a solid rate. By
the time of the May and June meetings, data pointed
to a moderation in the growth of consumer spending
and a further cooling in the housing market. However,
core consumer prices had risen more rapidly. Although
the Committee judged inflation expectations still to
be contained, it was mindful that the rising prices of
energy and other commodities could impart greater
inflationary momentum. Against this backdrop, the
FOMC voted to increase the policy rate a further
25 basis points at both the May and June meetings,
bringing the federal funds rate to 5 lA percent. In the statement accompanying its June decision, the FOMC indicated
that it believed that the moderation in economic activity
would help to limit inflationary pressures over time but
also noted that some upside inflation risks remained. As
Selected interest rates, 2004-07
1/28
3/16
5/4
9/20 10/25 12/12
NOTE The data arc daily and extend through February 7, 2007 The ten-year Trc ;ury rate is the constant-maturity yield based on the most actively traded
securities The dates on the horizontal axis are those of FOMC meetings
SOURCT Department of the Treasury and the Federal Reserve
87
Board of Governors of the Federal Reserve System
it had in its May statement, the FOMC made clear in
June that the extent and timing of additional firming
would depend on the evolution of the outlook for both
inflation and economic growth as implied by incoming
information.
In the second half of the year, a further slowdown
in residential construction activity and a contraction in
motor vehicle production created a significant drag on
economic activity. However, consumer spending held up,
and employment rose at a solid pace. Meanwhile, energy
prices reversed much of their increases of thefirsthalf of
the year, sending headline inflation lower. Core inflation
also eased somewhat, albeit to a rate above its year-earher
level. Against this backdrop, the FOMC left the stance
of policy unchanged at its final four meetings of
2006. Committee discussions in those meetings focused
in part on developments in the housing market and
their implications for the broader economy. Although
the housing market was weakening throughout this
period, the Committee judged that the downturn had
not spilled over significantly to consumer spending.
The economy was expected to expand over coming
quarters at a rate close to or a little below its long-run
sustainable pace. At the same time, FOMC members
noted that, even though core inflation had slowed from the
very rapid rates of the spring and summer, current rates
remained undesirably high. Most members expected core
inflation to moderate gradually, but they were uncertain
about the likely pace and extent of that moderation. Thus,
in statements accompanying each rate announcement
over this period, the FOMC reiterated that inflation risks
remained and that the extent and timing of any additional
policy firming would depend on the outlook for both
inflation and economic growth implied by incoming
information.
Over the period between the December 2006 and January 2007 FOMC meetings, incoming data on inflation and
economic activity were generally more favorable. Core
inflation receded further from the elevated levels reached
in early 2006, and some indicators suggested that the
demand for housing might be stabilizing. Business investment had softened in the fourth quarter, and industrial
production decelerated sharply in the fall, but consumer
spending posted robust gains in thefinalmonths of 2006.
At its January 2007 meeting, the Committee again decided
to leave its target for the federal funds rate unchanged,
reiterated concern about inflation risks, and again cited
the role of incoming data in determining the extent and
timing of any additional firming.
In recent years, the FOMC has worked to improve
the transparency of its decisionmaking process, and the
Committee continues to examine whether further changes
would improve its communications with the public. In
spring 2006, the Chairman appointed a subcommittee to
help the FOMC organize the discussion of a broad range of
communication issues. The FOMC began its consideration
of these issues at its August meeting and has discussed
them at several meetings since then.
Economic Projections for 2007 and 2008
In conjunction with the FOMC meeting in January, the
members of the Board of Governors and the Federal
Reserve Bank presidents, all of whom participate in the
deliberations of the FOMC, provided economic projections for 2007 and 2008. The projections indicate that the
participants expect sustainable expansion of real economic
activity during the next two years, assuming an appropriate course for monetary policy. The central tendency of
the FOMC participants' forecasts for the increase m real
GDP is 2'/2 percent to 3 percent over the four quarters of
2007 and 23A percent to 3 percent over the four quarters
of 2008. The central tendency of their forecasts for the
civilian unemployment rate is 4Vi percent to 43A percent
in the fourth quarter both of this year and of 2008. For
inflation, the central tendency of the forecasts anticipates
an increase in the price index for personal consumption
expenditures excluding food and energy—the so-called
core PCE pnee index—of 2 percent to 2'A percent over
Economic projections of Federal Reserve Governors and Reserve Bank presidents for 2007 and 2008
Percent
2008
2007
Indicator
MF.MO
2006 actual
Range
Central
tendency
Range
Central
tendency
Change, Jaurth quarter tojourth quarter'Nominal GDP
Real GDP
PCF, price index excluding food and energy
59
34
23
4Y4-5 Vt
2'A-VA
2-2W
5-5 lA
2Y2-3
2-2%
4V1-5'/;
2lA -31/,
Vh-TA
43A -5 'A
23/4-3
IV4 2
Average level, fourih quarter
Civilian unemployment rate
4 5
4 1 / J -4V 4
A'A 4V.
4>A-5
A'/i-AV*
rage for fourth quarter of previous year
3
,e for fourth quarter of year indicated
4
Monetary Policy Report to the Congress • February 2007
the four quarters of 2007 and I3/* percent to 2 percent over
the four quarters of 2008.
The economy is projected to expand at a moderate
rate. Although the cooling of the housing market continues to damp economic activity, the drag on economic
growth from declining construction activity is expected
to diminish later this year. Household spending for goods
and services should rise at a solid pace, in part as a result
of ongoing gains in real wages and employment and of
generally strong household balance sheets. Business
outlays for new equipment and software are expected to
increase at a rate consistent with a moderate expansion in
business output and to be supported by continuing declines
in the user cost of high-technology capital equipment and
by favorable financial conditions. In addition, the solid
expansion of economic activity abroad should maintain the
rising demand for U.S. exports of goods and services.
Decreased pressures from the costs of energy and
other commodities, in an environment of moderate economic expansion and well-anchored longer-run inflation
expectations, are expected to contribute to further easing
in inflation. In addition, increases in productivity should
help to limit cost pressures.
ECONOMIC AND FINANCIAL DEVELOPMENTS
IN 2006 AND EARLY 2007
The especially brisk pace of economic activity in early
2006 primarily reflected a rebound after hurricane-related
disruptions in the autumn of 2005. During the rest of the
year, however, economic activity slowed to a pace somewhat below the average rate of recent years. Real GDP
Change in real GDP, 2000-06
LJ III t:
2000
2001
2002
2003
2004
2005
2006
NOTE Here and in subsequent figures, except as noted, change for a given
period is measured to its final quarter from the final quarter of the preceding
period
SOURCE Department of Commerce, Bureau of Economic Analysis
Change in PCE chain-type price index, 2000-06
• Total
•
Excluding food and energy
• 111 r i
2000
2001
2002
2003
2004
2005
2006
NOTE The data arc for personal consumption expenditures (PCE)
SOURCE Department of Commerce, Bureau of Economic Analysis
is reported to have increased at an average annual rate of
2% percent over the final three quarters of 2006, down
from the average VA percent pace in 2004 and 2005. The
slowdown principally was the result of the contraction
in residential construction, which intensified later in the
year, and the marked decline in production of light motor
vehicles in the second half of the year as manufacturers
took steps to trim dealers' inventories. In other sectors
of the economy, consumer spending remained strong as
employment and income made further solid gains, and
business outlays for new structures and equipment rose
considerably over much of the year. Financial market conditions were generally supportive of economic expansion
in 2006. Equity markets recorded sizable gains, and longterm interest rates rose only modestly from historically
low levels. Risk spreads on corporate bonds remained
narrow or declined further. Overall economic conditions were such that businesses maintained a steady
pace of hiring, and the unemployment rate moved down
further.
Consumer price inflation, as measured by the rise in
the PCE pnee index, moved down in the second half of
2006 after having stepped up in the first half. Energy
prices, which rose during thefirsthalf and turned sharply
downward later in the year, played an important role in
shaping the contour of total consumer price inflation. In
addition, core PCE price inflation eased modestly over the
second half of 2006. Apparently influenced by incoming
data on inflation and economic activity, measures of longterm inflation expectations rose early in the year but ended
the year slightly lower than at the beginning. Nonetheless, core PCE price inflation for the year as a whole—at
VA percent—was a bit higher than in the preceding year,
which perhaps reflected in part the high level of resource
utilization.
89
Board of Governors of the Federal Reserve System
The Household Sector
Consumer Spending
The rapid increase in consumer spending in 2006 was
supported by rising employment, gains in real income,
increases in household wealth, and favorable financial
conditions. Over the four quarters of 2006, real PCE
rose ¥A percent—faster than in 2005 and at roughly the
same rate as in 2004. The rise in consumer outlays was
particularly robust in the first quarter of 2006 but then
moderated in the middle of the year, when households'
gains in real income slowed and consumer sentiment
softened. Consumer spending rose briskly again in the
fourth quarter of the year as gains in real income picked
up and consumer confidence improved.
Household spending for new motor vehicles slowed
in 2006; sales of 16.5 million new light vehicles (cars,
sport-utility vehicles, and pickup trucks) were below the
average of nearly 17 million sold in the preceding two
years. Moreover, households' apparent concerns about
elevated gasoline prices, particularly early in the year,
shifted the composition of light vehicle sales toward more
fuel-efficient autos and away from light trucks and SUVs.
The shift helped boost the share of total sales captured by
foreign producers because they tend to offer more fuelefficient vehicles.
Real PCE for goods other than motor vehicles rose
4Vi percent over the four quarters of 2006, about in line
with the brisk average pace in the preceding two years.
Households increased their spending for a broad range of
consumer goods, though the rise was particularly strong
for electronic equipment and other durables. Real spending on gasoline remained about constant in the first half
of the year but increased in the second half as prices fell.
Consumer spending for services maintained a moder-
Change in real income and consumption, 2000-06
•
•
2000
ate pace of growth; expenditures in this category rose
23A percent in 2006, about the same average pace as in
2004 and 2005.
In 2006, real household income was boosted by gains
in wage and salary income and the increased purchasing
power resulting from the deceleration in overall consumer
prices. Labor income received by households rose both
because of gains in real hourly wages and because of
sustained increases in employment. However, the pickup
in real after-tax income was damped because tax payments made by households increased at a rate greater than
that for income. The acceleration in tax payments likely
reflected, at least in part, several factors: tax payments
on larger capital gains realizations, which are excluded
from income in the national income and product accounts
(NIPA); gains in real income that moved some households
into higher tax brackets; and possibly a further shift in the
distribution of income toward high-income households
that typically face higher lax rates. All told, real after-tax
income rose 3 percent over the four quarters of 2006, up
from the negligible gain posted in 2005 but a little below
the average rate of increase in 2003 and 2004.
The rise in after-tax income in 2006 was outpaced by
increases in household spending. As a result, the personal
saving rate declined further in 2006 and averaged negative
1 percent for the year as a whole. Households apparently
were inclined to increase their spending further above
their disposable income, at least in part, because their
wealth continued to rise. The ratio of household net worth
to income, which has been trending higher since 2003,
inched up further in 2006. Although increases in the value
of homes slowed significantly, the value of corporate equities held by households both indirectly—such as in mutual
funds and retirement accounts—and directly appreciated
considerably.
Personal saving rate, 1983-2006
Disposable personal income
Personal consumption expenditures
2001
2002
SOURCE Department of Co
2003
2004
2005
2006
ce, Bureau of Economic Analysis
5
NOTE The data arc quarterly and extend through 2006 Q4
SOURCE Department of Commerce, Bureau of Economic Analysis
90
6
Monetary Policy Report to the Congress • February 2007
Residential Investment
Wcalth-to-mcomc ratio, 1983-2006
1986
1990
1994
1998
2002
2006
NOTF. The data are quarterly and extend through 2006 Q3 The wcalthto-income ratio is the ratio of household net worth to disposable personal
income
SOURCE For net worth, Federal Reserve Board, flow of funds data, for
income, Department of Commerce, Bureau of Economic Analysis
Consumer sentiment deteriorated in the first half of
2006, according to the Reuters/University of Michigan
Surveys of Consumers (Reuters/Michigan). In the spring,
consumer confidence had moved to its lowest level for the
year, probably in part because energy prices had surged.
The subsequent decline in energy prices, along with the
rise in the stock market and reductions in the unemployment rate, boosted consumer confidence in the second
half of the year. On net, the Reuters/Michigan index of
consumer sentiment was a shade higher at the end of
2006 than at the beginning of the year; sentiment moved
up further in early 2007 to near the upper end of its range
since 2003.
Consumer sentiment, 1993-2007
1993
!995
1997
1999 2001 2003 2005 2007
NOTE The data arc monthly and extend through January 2007
SOURCE The Conference Board and Reuters/University of Michigan Sin
The deterioration of conditions in the housing market
played a significant role in restraining the pace of economic expansion in 2006. The demand for new and existing homes began to weaken in the middle of 2005, and
the subsequent decline steepened through the first half
of 2006. As a result, the inventory of unsold new homes
relative to sales rose sharply. Apparently prompted by
lower demand and excessive inventories, homebuilders
began to cut back on the pace of new construction near the
beginning of 2006, and the decline in activity continued
throughout the year. Later in the year, however, some
indicators were hinting that the demand for housing was
starting to stabilize.
By the middle of 2006, sales of both new and existing
homes had fallen dramatically to a pace that was about
15 percent below that of a year earlier. Concurrently,
inventories of unsold homes relative to sales rose considerably above the level that had prevailed during the period
of robust housing demand from the late 1990s into 2005.
By the third quarter of 2006, the backlog of unsold new
homes had reached 6% months' supply, and the stock
of existing homes for sale had risen to about 7 months'
supply—both well above the average of about 41/2 months'
supply of new and existing homes in 2005. By the end of
2006, however, there were tentative signs that the demand
for homes was stabilizing. The decline in sales of new and
existing homes appeared to bottom out in the summer,
and sales were roughly constant over the later part of the
year. In the fourth quarter, builders' inventories of unsold
new homes were reported to have edged down a bit from
their third-quarter level, while the stock of existing homes
for sale remained about the same as in the third quarter.
Despite these developments, the extent of any improvement in the inventories of unsold homes is obscured by
the failure of these figures to account for recorded sales
of new homes that are subsequently canceled.
The drag on new residential construction in 2006
imposed by the contraction in home sales and the buildup
of inventories was significant. Both the number of permits
issued for new single-family homes and the number of
home starts dropped sharply. As of the fourth quarter of
2006, new single-family homes were started at an annual
rate of 1.23 million units, almost 30 percent below the
average pace in 2005; permits were down by a similar
amount. In contrast to the marked slackening in construction of new single-family homes, the rate of starts of new
multifamily homes in 2006, at 337,000 units, was about
the same as in the preceding several years.
Housing activity, as measured by real expenditures on
residential structures in the NIPA, trimmed % percentage point from the rate of real GDP growth in the first
half of 2006, but the drag intensified to subtract about
91
Board of Governors of the Federal Reserve System
7
Mortgage rates, 2002 07
Private housing starts, 1993 2006
Millions ofuniis.ai
Multifamily
—
1998
2000
2002
2004
Adjustable
2006
NOTT The data arc quarterly and extend through 2006 Q4
SOURCT Department of Commerce, Bureau of the Census
NOTE The data, which are weekly and extend through February 7, 2007,
are contract rates on thirty-year mortgages
SOURCE Federal Home Loan Mortgage Corporation
1 VA percentage points from the annual rate of increase
in real GDP in the second half. For 2006 as a whole, the
contraction in real residential investment lowered the
annual rate of growth in real GDP VA percentage point
after having added Vi percentage point, on average, to the
rate from 2003 through 2005.
The rate of house-price appreciation slowed substantially in 2006 after several years of very rapid gains. The
repeat-transactions index of home prices published by the
Office of Federal Housing Enterprise Oversight (OFHEO)
increased at an annual rate of only 11*4 percent in the third
quarter of 2006, down substantially from average gains
of about 10 percent in 2004 and 2005. The OFHEO index
attempts to control for the quality of existing single-family
homes sold by using prices of homes involved in repeat
Change in prices of single-family houses, 1983-2006
Repeat-transaction:
transactions. The increase in the OFHEO house-price
index over the four quarters ending in the third quarter
of 2006 (a calculation that smoothes through some of the
quarterly volatility in the data) was 6 percent, the smallest four-quarter increase since the late 1990s. The average price of existing single-family homes sold, which is
published by the National Association of Realtors (NAR)
and does not control for the types of homes sold, declined
about 2 percent over the four quarters of 2006, compared
with average gains of roughly 9 percent in 2004 and 2005.
The outright decline in the NAR index of home prices
relative to the deceleration in the constant-quality OFHEO
home-price index suggests that the composition of existing
homes sold shifted toward lower-priced homes.
The cost of mortgage financing increased in the first
half of 2006, but rates decreased in the second half.
The average rate for a thirty-year fixed-rate mortgage
was 6V4 percent at the end of 2006, about the same as at
the beginning of the year. The average for a one-year
adjustable-rate mortgage declined also in the second
half and stood at 5V4 percent at the end of 2006, about
'/4 percentage point above the level at the start of the
year. According to respondents to the Reuters/Michigan
survey, relatively low mortgage rates and the perception
that purchase prices were more favorable improved their
assessment of homebuying conditions in the second half
of 2006.
Household Finance
1986
1990
1994
1998
2002
2006
NOTE The data arc quarterly, and change is from one year earlier The
repeat-transactions index extends through 2006 Q3 For the years preceding
1991, that index includes appraisals associated with mortgage refinancings,
beginning in 1991, it includes purchase transactions only The existing home
price index extends through 2006 Q4
SoLFRcr For repeat transactions, Office of Federal Housing Enterprise
Oversight, for existing home prices, National Association of Realtors
Household sector debt is estimated to have slowed from
the robust H3/4 percent increase posted in 2005 to a stillvigorous 8% percent in 2006. The deceleration reflected
a drop in the pace of mortgage debt growth from about
14 percent in 2005 to less than 9 percent in 2006. Despite
92
Monetary Policy Report to the Congress • February 2007
meet their debt service obligations, although there are
indications of growing strains among some borrowers.
Delinquency rates on subprime residential mortgages
with variable interest rates have increased markedly; still,
delinquency rates on other mortgages and consumer loans
have remained low. Household bankruptcy filings during
2006 ran at a pace well below the average of the preceding
several years. Bankruptcies likely were damped in 2006
by the decisions of some households to file before the
implementation of more-stringent bankruptcy requirements in October 2005. However, even allowing for such
an effect, the recent pace is low relative to pre-reform
norms.
Householdfinancialobligations ratio, 1992-2006
1992
1994
1996
1998
2000
2002
2004
2006
NOTE The data are quarterly and c\u.nd through 2006 Q3 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 di\ided b\ di posable personal
SOURCE Federal Reserve Board
the reduction in mortgage borrowing, home equity lending remained active, and the gross volume of cash-out
refinancing exceeded 2005 levels. Meanwhile, consumer
debt expanded only moderately in 2006.
Although household indebtedness increased less rapidly in 2006 than in 2005, it still outpaced the growth of
disposable personal income. In addition, the rise in interest
rates contributed to higher debt service payments, and the
household financial obligations ratio continued its upward
trend of the past decade to reach a record high. Evidence
to date suggests that most households have been able to
The Business Sector
Fixed Investment
Total real business fixed investment rose 63A percent
over the four quarters of 2006, up from a 514 percent
increase in 2005 and about the same pace as in 2004. In
general, the fundamentals supporting business capital
Change in real businessfixedinvestment, 2000-06
Structures
Equipment and softwar
Credit card pools
— 6
/ — "
Auto loaiis at domestic
auto finarice companies
i J i
IF
Delinquency rates on selected types of household loans,
1998-2006
—
5
—
4
High-tech equipment and software
Other equipment excluding transportatio
2002
2004
30
— 20
PL
— 3
Mortgages
2000
—
—
10
0
2006
NOTE The data are quarterly The data for credit card pools and mortgages
extend through 2006 Q3, the rate for auto loans extends through 2006 Q4
SOURCE For credit cards, Moody's Investors Service, for auto loans, the
financing subsidiaries of the three major U S automobile manufacturers, for
mortgages, Mortgage Bankers Association
2000
2001
2002
2003
2004
2005
2006
NOTE High-tech equipment consists of computers and peripheral equipment and communications equipment
SOURCE Department of Commerce, Bureau of Economic Analysis
93
Board of Governors oj the Federal Reserve System
spending remained favorable in 2006: The strong rise in
profits continued to helpfirmsmaintain substantial liquid
assets, user costs for equipment declined further, and
interest rates and credit spreads remained relatively low.
Although the pace of real business outlays for equipment
and software slowed somewhat in 2006, investment in
nonresidential structures rose 1 PA percent. Capital spending was quite robust during most of the year, adding about
1 percentage point to the annual rate of increase in real
GDP over thefirstthree quarters, but it decelerated sharply
in the fourth quarter. The deceleration reflected, in part,
a slowing in spending for business structures from its
brisk pace earlier in the year, a drop in outlays for transportation equipment, and some weakness in purchases
of equipment related to construction and motor vehicle
manufacturing.
Real investment in high-technology equipment rose
9 percent in 2006, about the same average annual pace as
in the preceding two years. Further decreases in the prices
of high-technology equipment continued to reduce the
user cost of this type of equipment. Real business spending for computing equipment increased 14!4 percent, and
software spending posted an 8 percent gain, both roughly
comparable to their average rates of increase in the previous two years. Business outlays for communications
equipment rose almost 7 percent in 2006. Spending for
communications equipment was particularly robust in the
early part of the year and was likely boosted in part by
spending to replace equipment damaged by the hurricanes
in the autumn of 2005. Investment in communications
equipment last year continued to be supported by demand
from telecommunications service providers that were
expanding their broadband networks.
Real business investment in transportation equipment—typically a volatile category of investment—was
about unchanged on net in 2006. For motor vehicles, business spending increased less than 1 percent over the year.
Purchases of light vehicles weakened, partly because of
cutbacks in sales to rental companies. In contrast, business
outlays for medium and heavy trucks accelerated in 2006,
reportedly in anticipation of new emissions regulations
by the Environmental Protection Agency that went into
effect at the beginning of 2007. New orders for medium
and heavy trucks reached new highs early in 2006, and
production and sales remained strong through the end
of the year. Outlays for new aircraft were brisk in early
2006, but they were depressed over the remainder of the
year; all told, aircraft investment declined more than
3 5 percent for the year as a whole.
Real investment in equipment other than high-tech and
transportation goods—a broad category thai represents
about half of total nominal business spending for equipment and software—rose at an average annual rate of
5Vi percent during the first three quarters of 2006. How-
9
ever, spending for these capital goods softened in the
final quarter of the year. Although the declines in the
fourth quarter were generally broad based, they were
led by decreases in spending for equipment related
to construction and motor vehicle manufacturing.
However, the backlog of orders for capital goods such
as industrial machinery and other types of heavy
equipment remained substantial at the end of 2006, and
it should sustain production and shipments of these items
in early 2007.
Real outlays for nonresidential construction increased
11 % percent in 2006 after having been little changed since
2003. However, the rise in business construction spending
slowed near the end of 2006 from its rapid pace earlier in
the year; outlays increased at an annual rate of only about
3 percent in the fourth quarter. For 2006 as a whole, sizable
gains were posted for office, retail, and industrial buildings. In addition, outlays for drilling and mining structures
associated with energy exploration were strong. At the end
of 2006, forward-looking indicators for nonresidential
construction activity appeared to be favorable: Vacancy
rates for buildings in both the office and industrial sectors,
which peaked a few years ago, continued to drift down,
and the vacancy rate for retail buildings remained at the
low level that has prevailed since 2000.
Inventory Investment
In the first half of 2006, dealer stocks of motor vehicles
rose noticeably as sales slowed, particularly for light
trucks. The increase in the prices of gasoline earlier in
the year appeared to have reduced consumers' demand
for light trucks and SUVs, which tend to be less fuel
efficient. Dealers' inventories of these vehicles reached an
elevated 90 days' supply at the end of the second quarter.
As a result, motor vehicle manufacturers scaled back the
production of light trucks over the second half of 2006,
which helped to reduce dealers' inventories during that
period. Nonetheless, at the end of 2006, inventories of
light vehicles still appeared to be above desired levels.
Manufacturers cut production further in January of this
year, helping them make additional progress in reducing
the stock overhang.
Excluding motor vehicles, inventories held by businesses in the manufactunng and trade sectors appeared
generally to be well aligned with sales in the first half of
2006. However, later in the year, a variety of indicators
suggested that some businesses accumulated an undesired
level of stocks. The book value of manufacturing and trade
inventories (excluding motor vehicles) rose relative to
sales from September through November. The increases
were particularly noticeable for firms that supply the
construction and motor vehicle sectors, although increases
94
10 Monetary Policy Report to the Congress u February 2007
Change in real business inventories, 2000-06
Financing gap and net equity retirement
at nonfinancial corporations, 1991-2006
Billions ol chained (2000) dollars.
I -I.
Fir lancing
\
gap
0
\
/
-
—
2000
2001
2002
2003
2004
2005
2006
- 200
1 1
1991
SOURCE Department of Commerce, Burc&u of Economic Analysis
were apparent in a few other sectors as well. Survey
data also suggested that inventories for some businesses
were viewed as too high. However, manufacturers outside
of the motor vehicles sector appear to be making
relatively prompt adjustments to their production, which
to date seem to be limiting the extent of undesired
stockbuilding.
Corporate Profits and Business Finance
Profits of nonfinancial corporations extended their upward
move, pushing the ratio of before-tax profits to income in
this sector to nearly 14 percent, the highest level reached
since 1969. In the third quarter, operating earnings per
share for S&P 500 firms came in 20 percent above levels
Before-tax profits of nonfinancial corporations
as a percent of sector GDP, 1979-2006
—
14
—
12
—
10
—
8
—
6
I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I ll
1982
1986
1990
1994
1998 2002
2006
NOTE The data are quarterly and extend through 2006 Q3 Profits are from
domestic operations of nonfinancial corporations, with inventory valuation
and capital consumption adjustments
SOURCE Department of Commerce, Bureau of Economic Analysis
- 100
1 1
1994
1 1
1997
I I
2000
2003
1 1
2006
NOTE The data are annual, the observations for 2006 are based on partially
estimated data Trie financing gap is the difference between capital expenditures and internally generated funds, adjusted for inventory valuation Net
equity retirement is the difference between equity retired through share repurchases, domestic cash-financed mergers, or foreign takeovers of U S firms
and equity issued by domestic companies in public or private markets Equity
issuance includes funds invested by private equity partnerships and stock
option proceeds
SOURCE Federal Reserve Board, flow of funds data
of a year earlier. About two-thirds of firms in the S&P
500 have reported earnings for the fourth quarter. Current
market estimates of earnings per share for S&P 500 firms
call for roughly 10 percent growth in the fourth quarter
over year-earlier levels. Earnings growth was widespread
across sectors in 2006 but was particularly strong for
financial firms.
Firms' capital expenditures exceeded internal funds
raised in 2006, an indication that businesses funded
investments not only with current cash flow but also with
external funds and liquid assets. Borrowing by nonfinancialfirmspicked up in 2006 in association with increased
real investment as well as with extensive retirements of
equity, which resulted from record share repurchases and
heavy merger and acquisition activity. Net bond issuance
proceeded at a faster clip than in the past several years.
Similarly, commercial paper issuance was the strongest
it had been since 2000, and commercial and industrial
lending by banks was rapid as well. The Federal Reserve's
Senior Loan Officer Opinion Survey on Bank Lending Practices revealed that a significant net fraction of
respondents to that survey eased credit standards and
terms on commercial and industrial loans during 2006.
Bankers indicated that they were responding to moreaggressive competition and greater liquidity in the secondary market for such loans. Loan officers also reported that
a contributing factor was an increased tolerance for risk.
The expansion of commercial mortgage debt in 2006
remained rapid by historical standards but fell off from
the swift pace of 2005. The deceleration likely reflected
95
Board of Governors of the Federal Reserve System
Selected components of net financing
for nonfinancial corporate businesses, 2003-06
11
Net interest payments of nonfinancial corporations
as a percent of cash flow, 1979-2006
Btlhon* of 4o1!a». annual ra
Q Commercial paper
9 Bonds
B Bank loam S u m o t
^ ^
components
2004
2003
NOTE: The data for the com[
The data for the sum of selec
2006 Q4 are estimated
SOURCE Federal Reserve B<
Financial Institutions Examinat
tion and Income (Call Report)
1990
jncnts except bonds are seasonally adjusted
ed components arc quarterly The data for
ard, Securities Data Company, and Federal
on Council, Consolidated Reports of Condi-
the rise in mortgage rates and a net tightening of credit
standards for these loans—an explanation consistent with
responses to the loan officer survey.
Gross public issuance of equity by nonfinancial
corporations in 2006 roughly maintained the moderate
pace of the past couple of years, and private equity issuance appears to have risen a bit to finance buyouts and
other restructurings. Still, net equity issuance turned
more negative as equity retirements from cash-financed
Net percentage of domestic banks tightening
standards on commercial and industrial loans
to large and medium-sized borrowers, 1992-2007
1994
1998
2002
2006
NOTE The data are quarterly and extend through 2006 Q3
SOURCE Department of Commerce, Bureau of Economic Analysis
mergers and acquisitions and share repurchases increased
considerably.
On balance, despite increased borrowing and net equity
retirements, the strength of corporate earnings growth has
left the credit qualify of nonfinancial firms solid. Balance
sheet liquidity remains high, and corporate leverage is near
historical lows. In addition, net interest payments relative
to cash flow remained near the low end of the range seen
over the past two decades. The six-month trailing bond
default rate fell during the first half of the year as defaults
by some largefirmsin the troubled airline and automobile
sectors in late 2005 dropped out of the series, and it was
near zero throughout the second half of 2006. Delinquency
rates on business loans remained quite low.
Default rate on outstanding corporate bonds, 1992-2006
1992
1995
1998
2001
2004
2007
NOTE The data are drawn from a survey generally conducted four times
per year, the last observation is from the January 2007 survey, which covers
2006 Q4 Net percentage is the percenlage of banks reporting a tightening of
standards less the percentage reporting an easing The definition for firm size
suggested for, and generally used by, survey respondents is that large and
medium-sized firms have sales of $50 million or more
SOURCE Federal Reserve, Senior Loan Officer Opinion Survey on Bank
Lending Practices
1994
1997
2000
2003
2006
NOTE The data arc monthly and extend through December 2006 The rate
for a given month is the face value of bonds that defaulted in the six months
ending in that month, multiplied by two to annuahze the defaults and then
divided by the face value of all bonds outstanding at the end of the calendar
quarter immediately preceding the six-month period
SOURCE Moody's Investors Service
96
12 Monetary Policy Report to the Congress • February 2007
The Government Sector
Federal Government
The deficit in the federal unified budget narrowed further
during the past year. The unified budget recorded a deficit
of $248 billion in fiscal year 2006—$70 billion smaller
than in the previous fiscal year. The federal deficit in fiscal
2006 was a bit less than 2 percent of nominal GDP, significantly lower than its recent fiscal year peak of more than
3'/2 percent of GDP in 2004. In fiscal 2006, outlays rose
about in line with nominal GDP, but receipts increased
at a faster pace. From October through December—the
first quarter offiscal2007—the federal deficit was almost
S40 billion less than in the same period a year earlier, as
the rise in receipts continued to outpace the growth in
outlays. The latest projections from the Congressional
Budget Office and the Administration anticipate that the
unified deficit infiscal2007 will be smaller as a percentage of nominal GDP than it was in fiscal 2006. Although
the unified deficit has improved recently, the federal
budget will face the mounting pressures of providing
Social Security and health benefits to a rapidly growing
number of beneficiaries as the baby-boom generation ages
in coming years.
In fiscal 2006, nominal federal receipts rose 1VA percent and were equivalent to almost 18/4 percent of nominal
GDP, substantially higher than their recentfiscalyear low
of 161/4 percent of GDP in 2004. Income tax receipts from
individuals outpaced the rise in taxable personal income
(as measured in the NIPA), while surging corporate tax
payments about matched the robust growth in profits.
As noted above, the increase in individual income tax
liabilities relative to taxable income in the NIPA appears to
have reflected, at least in part, taxes on larger capital gains
realizations (which are excluded from NIPA income), the
effect of some taxpayers moving into higher tax brackets
as their real incomes increased, and possibly a further
shift in the distribution of income toward high-income
households that typically face higher tax rates. In the
first quarter of fiscal 2007, revenues were more than
8 percent greater than in the same period a year earlier,
as both individual and corporate tax payments continued
to rise briskly.
Nominal federal outlays increased about T/2 percent
in fiscal 2006 and were about 20% percent of nominal
GDP, well above their most recent fiscal year low of less
than 18/2 percent of GDP in 2000. Net interest payments
increased 23 percent in fiscal 2006, as interest rates rose
and federal debt continued to grow. Outlays for Medicare
increased IOV2 percent, reflecting in part new benefits
payments associated with the Part D prescription drug
program, which started in January 2006. At the same
time, outlays for Medicaid declined a bit, to some extent
because of a shift of some Medicaid payments to Medicare
Part D. Spending for disaster relief and national flood
insurance was almost $28 billion greater in fiscal 2006
than in the previousfiscalyear, pnmarily owing to the federal government's response to the hurricanes in the autumn
of 2005. Outlays for defense infiscal2006 slowed to their
lowest rate of increase sincefiscal2001, although the rise
was still about 6 percent. In thefirstquarter offiscal2007,
total federal outlays were only 1 percent greater than those
in the same period a year earlier; in this period, defense
spending was 12 percent above its year-earlier level, but
outlays related to disaster relief and flood insurance were
markedly lower than they were a year earlier.
As measured in the NIPA, real federal expenditures
on consumption and gross investment—the part of federal spending that is a direct component of real GDP—
Federal receipts and expenditures, 1986-2006
Change in real government expenditures
on consumption and investment, 2000-06
•
•
Expenditui
1986
1990
1994
1998
2002
Federal
State and local
2006
NOTE The receipts and expenditures data are on a unified-budget basis and
are for fiscal years (October through September), GDP is for the four quarters
ending in Q3
SOURCE Office of Management and Budget
2000
2001
2002
2003
2004
2005
2006
SOURCE Department of Commerce, Bureau of Economic Analysi
97
Board oj Governors of the Federal Reserve System
13
Net saving, 1986-2006
Federal government debt held by the public, 1960-2006
NO-IT The data arc quarterly and extend through 2006 Q3 Nonfcdcral
saving is the sum of personal and net business saving and the nci saving of
NOTE: The final observation is for 2006 Q3 For previous years, the data
for debt arc as of year-end, and the corresponding values for GDP arc for Q4
at an annual rate Excludes securities held as invesiments of federal govcmSouRcr Federal Reserve Board, How of funds data
increased 2 'A percent over the four quarters of calendar
year 2006 and contributed about XA percentage point to the
growth rate of real GDP in that year. The increase was the
result of a pickup in real defense purchases, which rose
more than 4 percent during calendar 2006 after two years
of smaller increases. At the same time, real nondefense
purchases declined more than 1 percent after having risen,
on average, about 2 percent per year over the preceding
two years.
The reduction in the unified deficit in the past two years
implies that the federal government required less national
saving to finance its operations. However, nonfederal saving, which excludes borrowing by the federal government
from total net national saving, remained relatively low.
Although the saving rate for private business and state
and local governments has increased in recent years, the
improvement has been offset by declines in the personal
saving rate. Total national saving, net of depreciation, was
2 percent of nominal GDP in the third quarter of 2006.
The recent national saving rate is an improvement from
the lows of a few years ago, but it has been insufficient
to avoid an increasing reliance on borrowing from abroad
to finance the nation's capital spending.
Early in the first quarter of 2006, federal debt subject
to the statutory limit reached the then-current ceiling of
$8.2 trillion. The Treasury employed various methods to
avoid breaching the limit until the Congress increased it
to nearly $9 trillion in March. As of the end of December,
the total amount of federal debt subject to the limit was
$8.6 trillion.
In February, the Treasury auctioned thirty-year bonds
for the first time since 2001. The offering was apparently well received, as was the reopening of the issue in
August. The Treasury announced in August that it would
issue thirty-year bonds on a quarterly basis beginning in
2007.
The acquisition of Treasury debt by foreigners slowed
further in 2006 from its peak in 2004. However, outTreasury securities held by foreign investors
as a share of total outstanding, 1998-2006
Federal Borrowing
The Treasury responded to the reduction in the federal
deficit in 2006 by paying down Treasury bills over the
course of the year and by trimming the gross issuance of
marketable Treasury coupon securities. As of the third
quarter of 2006, the quantity of federal debt held by the
public as a percentage of nominal GDP had declined about
V% percentage point, to about 36 percent.
1999 2000 2001 2002 2003 2004 2005 2006
NOTE The data are quarterly and extend through 2006 Q3
SOURCE Federal Reserve Board, flow of funds data
98
14 Monetary Policy Report to the Congress • February 2007
standing Treasury debt also grew more slowly, leaving
the share of outstanding debt held by foreign investors
little changed, on balance, from Us average level over
the preceding two years. According to Treasury data on
international capital flows, foreigners (official and other)
purchased considerably fewer U.S. Treasury coupon
securities in 2006 than in 2005. The average proportion
of nominal coupon securities purchased by foreign and
international investors at auctions in 2006 about matched
the average from the previous year at 16 percent, but it
was down noticeably from an average level of 25 percent
in 2004.
State and Local Government
The fiscal positions of state and local governments
improved further in 2006. Apart from federal grants-inaid, revenues rose at an annual rate of 7 percent over the
first three quarters of 2006 after posting relatively strong
gains in the preceding two years. Receipts from taxes on
retail sales and on individual and corporate incomes continued to rise at a brisk pace; however, decreasing gains in
house prices slowed the rise in property tax revenues in the
third quarter of 2006 from the rapid pace in the previous
two years. The sustained strength in total revenues, along
with the efforts of states and localities to restrain spending
for health care, has enabled these jurisdictions to step up
spending on other programs and still rebuild their reserve
funds. As measured in the NIPA, net saving by state and
local governments excluding social insurance funds—a
measure that is broadly similar to the surplus in an operating budget—was almost $4 billion during the first three
quarters of 2006. States and localities generally have seen
improvement in theirfiscalpositions recently, but in coming years most governments will have to face the budget
pressures of providing pension and health benefits to an
expanding number of retired employees, and the states'
costs for Medicaid are expected to rise substantially as
the baby-boom generation ages.
Real expenditures by state and local governments
on consumption and gross investment, the component
of these governments' spending that enters directly into
the calculation of real GDP, rose 3 percent over the four
quarters of 2006. That increase was the largest since 2001
and contributed about % percentage point to the change
in real GDP during the year. Real expenditures for investment rose 4% percent, largely because of a strong increase
in real construction spending in the first half of the year.
Spending for current consumption in real terms increased
214 percent over the four quarters of 2006. Hiring by
state and local governments stepped up last year. Of the
cumulative increase in employment of 254,000 in 2006,
about two-thirds of the jobs were in education.
State and Local Government Borrowing
Borrowing by state and local governments dropped below
its rapid 2005 pace amid improved fiscal positions and
fewer advance refunding issues. Nonetheless, bond issuance for new capital expenditures, particularly for education and transportation, boosted long-term borrowing.
Credit quality in the state and local sector rose substantially in 2006, as the number of credit-rating upgrades far
exceeded the small number of downgrades.
The External Sector
State and local government net saving, 1986-2006
The U.S. current account deficit averaged $875 billion at
an annual rate, or about 6/2 percent of nominal GDP, in
the first three quarters of 2006 (the latest available data).
The deficit was wider than in 2005, partly because of a
larger deficit on trade of goods and services. In addition,
net investment income, which turned negative in the
fourth quarter of 2005, remained negative in the first
three quarters of last year, further expanding the current
account deficit.
International Trade
1988
1991
1994
1997
2000
2003
2006
NOTE The data, which are quarterly, are on a national income and product
iccouni basis and extend through 2006 Q3 Net saving excludes social insurance funds
SOURCE Department of Commerce, Bureau of Economic Analysis
After widening through most of 2005, the nominal trade
deficit leveled out in thefirsthalf of 2006, rose to a record
high in August, and then narrowed noticeably through
November (the latest available data). On average, the
99
Board of Governors of the Federal Reserve System
15
Change in real imports and exports of goods and services,
1999 2006
U.S. trade and current account balances, 1999- 2006
Pcra:.lDrnom, nalGUP
Pete
0
•
•
Imports
Exports
n
1999
2000
2001
2002
2003
2004
2005
—
15
—
10
—
5
0
2006
Nmr The data are quarterly For the trade account, the observation for
2006 Q4 is estimated The data for the current account extend through
2006 Q3
SOURCE Department of Commerce
nominal trade deficit was wider in 2006 than in the previous year. Nominal imports of goods grew more slowly
than exports did early last year and, after reaching latesummer peaks, dropped because of declines in both the
price and volume of imported oil. Meanwhile, imports of
services decelerated sharply in the second half of last year.
In contrast, nominal exports of goods and services pushed
upward steadily throughout the year and grew significantly
faster than did nominal imports. Given that the level of
exports was smaller than the level of imports, the faster
export growth during 2006 was not enough to narrow the
nominal trade deficit. Although the nominal trade deficit
last year (through November, annualized) was wider in
dollar terms, the trade deficit as a share of GDP, at just
under 6 percent, was about the same as in 2005.
Real exports of goods and services grew a robust
9VA percent last year. In the first quarter, growth was
boosted by a catch-up of exports affected by hurricane
damage in late 2005. Throughout the year, exports were
supported by strong foreign economic activity. Real
exports of goods rose 10% percent last year, a little faster
than in the previous year. Export growth was spread fairly
evenly across all major end-use categories, though exports
of computers and semiconductors expanded noticeably
more slowly than in 2005. By destination, exports to China
and other emerging Asian economies grew very rapidly,
as did those to South America. Exports to Mexico and
western Europe rose at a more modest pace. Real exports
of services were up a solid 6% percent for the year, double
the pace of 2005.
Prices of exported goods rose at a VA percent rate last
year, a little faster than their pace in 2005. Reflecting the
effects of very large jumps in prices of industrial supplies,
particularly fuels and metals, export prices moved up
1999
2000
2001
2002
2003
2004
2005
2006
SOURCE Department of Commerce
sharply in the second and third quarters; they decelerated
toward the end of the year as prices of exported fuels
retreated from their high levels and as prices of exported
metals moved up more slowly.
Real imports of goods and services rose 3 percent last
year, more slowly than in the previous year. As with the
growth in real exports, real import growth got off to a
quick start last year amid robust domestic growth. But
import growth slowed, on average, in the middle quarters
of the year, along with U.S. real GDP growth, and real
imports fell in the fourth quarter as a result of a sharp
drop in oil and natural gas imports. Despite some fourthquarter declines, for the year imports increased in every
major end-use category except petroleum and natural gas.
Imports of services rose more than 5 percent last year, a
step-up from the previous year's sluggish pace.
Prices of imported non-oil goods increased less than
1 percent, on balance, in 2006 despite some wide gyrations. After falling in the first quarter, prices reversed
course, surged upward, and then cooled in the fourth
quarter. The quarterly pattern was driven by movements in
nonfuel commodity prices, which soared in the second and
third quarters before leveling off in the fourth quarter.
Metals figured prominently among the nonfuel commodities that boosted trade prices last year. Prices for a
variety of metals—including copper, aluminum, nickel,
and zinc—skyrocketed in the second quarter. Factors
contributing to the surge in prices included growing
demand, particularly from developing countries, low levels of inventories for some metals, and perhaps increased
speculative demand. Prices for nickel and zinc continued
to move up throughout the year. In the second half of the
year, aluminum prices trended sideways, and copper prices
moved down from their peaks as inventory and supply
conditions improved somewhat. For most of these metals,
100
16 Monetary Policy Report to the Congress • February 2007
Prices of oil and of nonfuei commodities, 2003-07
2004. Oil demand over the past year has also increased
modestly in developing countries despite high prices.
The Financial Account
2003
2004
2005
2006
2007
NOTC The data are monthly and extend through January 2007 The oil
price is the spot price of West Texas intermediate crude oil The price of
nonfucl commodities is an index of forty-five primary-commodity prices
SOURCE For oil, the Commodity Research Bureau, for nonfuei commodities. International Monetary Fund
those price trends have continued this year. An exception
is zinc, the price of which has plummeted.
The spot price of West Texas intermediate crude oil
averaged $66 per barrel in 2006, nearly $10 per barrel
higher than in 2005; moreover, crude oil prices were
especially volatile last year. The spot price climbed from
around $61 per barrel at the end of 2005 to a peak of $77
per barrel in August as violence in the Middle East, a shutdown of the Prudhoe Bay oilfieldin Alaska, and forecasts
of an active hurricane season led to increased demand. In
the event, oil supply was affected far less than anticipated
by these factors, and oil prices declined over the next
few months as demand dropped and elevated petroleum
inventories were drawn down. Oil demand for heating was
depressed by above-average temperatures in the Northern
Hemisphere in the fourth quarter and in the early weeks
of 2007, and the spot price fell further, to around $50 per
barrel in mid-January, before moving back up to $58 per
barrel at the end of the month. Far-dated futures prices
began last year at about $60 per barrel, moved in a pattern
similar to spot prices throughout most of the year, and
averaged just over $61 per barrel in January 2007.
Notwithstanding the decrease of global oil prices since
August, several factors continue to support these prices at
historically elevated levels. Ongoing violence has diminished oil production in Iraq and Nigeria. The continuing
dispute with Iran over its nuclear program threatens a
possible curtailment of Iranian exports. Energy investment
by international oil companies has been hampered in some
countries, such as Russia and Venezuela, by increased government control of domestic energy industries. Moreover,
in response to the recent decline in oil prices, OPEC has
reduced its crude oil production to the lowest level since
Foreign official inflows in the first three quarters of 2006
were above their 2005 pace but remained below the
record levels of 2004. Most of these official inflows were
attributable to Asian central banks and took the form of
purchases of U.S. government securities, primarily bonds
and mortgage-backed securities issued by governmentsponsored enterprises (GSEs). Preliminary data indicate
a slight easing of official purchases in the fourth quarter
of 2006. Net private inflows slowed in thefirstquarter but
have changed little since then.
U.S. netfinancialinflows, 2003-06
•
•
Official
Private
—
250
—
200
—
150
—
100
—
50
0
NOTE The data are quarierly and extend through 2006 Q3
SOURCE Department of Commerce
Net private foreign purchases oflong-term U.S. securities,
2003-06
ofd<
•
•
Bonds
Eqmtic
NOTE The data are quarterly and extend through 2006 Q3
SOURCE Department of Commerce
—
200
—
150
—
100
101
Board of Governors of the Federal Reserve System
Foreign private purchases of U.S. securities in the
second and third quarters of 2006 slowed slightly from
the extraordinary pace set in the second half of 2005 and
early 2006, but preliminary fourth-quarter data show
recent demand to have been strong. More than half of
private flows last year took the form of purchases of
corporate bonds, and most of the remainder went toward
investment in GSE bonds and corporate equities. On net,
private foreigners purchased few U.S. Treasuries. Foreign
direct investment flows into the United States remained
robust.
Net purchases of foreign securities by U.S. residents,
a financial outflow, set a record pace in the first three
quarters of 2006. Preliminary data show a further surge
in net purchases in the fourth quarter. Demand for foreign
bonds by U.S. residents slightly exceeded that for foreign
equities. After the expiration of the partial tax holiday
implemented in the Homeland Investment Act of 2004,
U.S. direct investment abroad dropped back to more
normal levels.
The Labor Market
Employment and Unemployment
Labor markets remained strong in 2006. Nonfarm payroll
employment increased 186,000 per month, on average,
during the second half of 2006, a rate essentially the
same as in the first half of the year. Employment rose
111,000 in January of 2007. The unemployment rate in
the fourth quarter of last year—4/4 percent—was at its
lowest quarterly level since 2001, and it was little changed
in January 2007.
In response to the contraction in homebuilding, hiring in the construction sector slowed considerably in the
Net change in payroll employment, 200 f-07
Thousands of jobs, monthly average
2001
2002
2003
2004
2005
2006
2007
NoTr Nonfarm business sector
SOURCT. Department of Labor, Bureau of Labor Statistics
17
Civilian unemployment rate, 1974-2007
NOTE The data a z monlhly and extend through January 2007
SOURCE Departir ;nt of Labor, Bureau of Labor Statistics
second and third quarters of 2006, and this sector shed
workers in the fourth quarter. Although hiring for nonresidential building construction remained brisk for most of
the year, the steep decline in housing starts curtailed the
overall demand for construction workers. Employment in
the manufacturing sector, which rose in the first half of
2006, declined in the second half as factory output slowed.
From July to December, many of the factory layoffs were
at makers of motor vehicles and parts and at producers
closely tied to the construction industry. Outside of the
construction and manufacturing sectors, employment
generally increased at a solid pace in the second half of
2006, and hiring was particularly rapid in a number of
service industries—especially those providing education
and health services, professional and technical business
services, and financial services.
As a result of the continued expansion of labor demand
in 2006, the unemployment rate fell further. After remaining around 4% percent in the first three quarters of 2006,
the unemployment rate edged down to 4/4 percent in the
fourth quarter. The tighter labor market was associated
with a noticeable increase in employment among individuals who had not been participating in the labor force. In
line with this cyclical tightening of the labor market, the
labor force participation rate ticked up during 2006, from
66 percent in thefirstquarter to 66% percent in the fourth
quarter, after a % percentage point rise during 2005. The
recent rise in the participation rate follows a period of
decline beginning in the late 1990s that in part reflected
some longer-term secular trends in labor force behavior.
Those trends included a leveling off in the participation
rate of women and an increase in the proportion of the
workforce in older age groups, which have lower average
participation rates.
Other indicators also suggest that labor market conditions remained generally favorable during the second half
102
Monetary Policy Report to the Congress • February 2007
Labor force participation rate, 1974-2007
NOTE The data arc monthly and extend through January 2007
SOURCE Department of Labor, Bureau of Labor Statistics
of 2006. Layoffs remained low as new claims for unemployment insurancefluctuatedaround a relatively subdued
level of 315,000 per week. In addition, data reported by
the Bureau of Labor Statistics showed a further increase
during the later part of the year in the rate ofjob openings
as a percentage of private-sector employment.
Productivity and Labor Compensation
The growth rate of labor productivity in the nonfarm business sector, which had slowed in 2004 and 2005 from an
exceptionally rapid pace earlier in the decade, remained
relatively subdued in 2006. Over the four quarters of
2006, output per hour of work in the nonfarm business
sector increased 2 percent, compared with about a 3 per-
cent average annual rate of increase during the first half
of this decade and the second half of the 1990s. During
that earlier period, productivity gains were spurred by
the rapid pace of technological change, the growing ability of firms to use information and other technology to
improve the efficiency of their operations, and increases
in the amount of capital per worker. Despite the recent
slowing in productivity growth, these underlying factors
do not appear to have waned. Accordingly, the recent
slowdown in labor productivity may be at least in part a
temporary cyclical response to the moderation in the pace
of economic activity in 2006 rather than a meaningful
downshift in the longer-run trend.
As the labor market tightened in 2006, the rise in
hourly labor compensation, which includes both wages
and employer payments for employee benefits, stepped
up for workers in the nonfarm business sector. In nominal
terms, compensation per hour increased almost 5 percent
over the four quarters of 2006, compared with an average
4 percent rise in the preceding two years. After adjusting
compensation for increases in the PCE price index, real
compensation per hour rose 3 percent in 2006, up from
an average gain of about 1 percent in 2004 and 2005.
An alternative measure of employee compensation
is the employment cost index (ECI) for private nonfarm
businesses, which is based on a survey offirmsconducted
by the Bureau of Labor Statistics. According to this measure, nominal hourly compensation increased 3Vi percent
in 2006, VA percentage point faster than in 2005. In real
terms, the ECI for hourly compensation rose 1 % percent
last year after averaging a !4 percent increase over the
Measures of change in hourly compensation, 1996-2006
Change in output per hour, 1948-2006
1996
NOTE Nonfarm business sector Change for each multiyear period is
measured from the fourth quarter of the year immediately preceding the
period to the fourth quarter of the final year of the period
SOURCE Department of Labor, Bureau of Labor Statistics
1998
2000
2002
2004
2006
NOTE The data are quarterty and extend through 2006 Q4 For nonfarm
business compensation, change is over four quarters, for the employment cost
index (ECI), change is over the twelve months ending in the last month of
each quarter The nonfarm business sector excludes farms, government,
nonprofit institutions, and households The sector covered by the ECI used
here is ihc same as the nonfarm business sector plus nonprofit institutions A
new ECI series was introduced for data as of 2001, but the new series is
continuous with the old
SOURCE Department of Labor, Bureau of Labor Statistics
103
Board of Governors of the Federal Reserve System
Change in unit labor costs, 1996-2006
19
Alternative measures of price change, 2004-06
Percent
Pnce measure
. 5
•—•
4
— 3
Chain-type
Gross domestic product (GDP)
jross domestic purchases
Personal consumption expenditures {PCE)
Excluding food and energy
Market-based PCE excluding food and
energy
Fixed-weight
Consumer price index
Excluding food and energy
2004
2005
2006
32
37
30
22
3 1
36
3 I
2 1
I 9
23
1 7
] 8
20
33
2 1
37
2 I
1 9
26
25
Changes are based on quarterly averages of seasonally adjusted data
SOURLF For chain-type measures. Department of Commerce, Bureau o
Economic Analysis, forfixed-weigh!measures. Department of Labor, Bureau o
Labor Statistics
1996-2000
2001 2002
2003
2004
2005
2006
NOTT. Noniarm business sector The change for 1996 to 2000 it
from 1995 Q4 to 2000 Q4
Soi'KCR Department of Labor, Bureau of Labor Statistics
preceding two years. The nominal wages and salaries
component of the ECI rose VA percent in 2006, while the
benefits component advanced 3 percent.
From the perspective of employers, the acceleration
in hourly compensation in the nonfarm business sector
last year boosted the average labor costs associated with
producing a unit of output 2% percent, up from increases
of about VA percent in both 2004 and 2005. Although the
rise in unit labor costs increased, firms' profit margins
appeared to remain elevated in 2006 relative to longer-run
standards.
Prices
Headline inflation slowed in 2006. The PCE chain-type
price index rose 2 percent over the four quarters of
Change in core consumer prices, 2000-06
•
•
Core consumer price index
Chain-type price index for core PCE
lllllll
2000
2001
2002
2003
2004
2005
2006
SOURCE For core consumer pnee index, Department of Labor, Bureau of
Labor Statistics, for core PCE price index, Department of Commerce, Bureau
2006, a step-down from the 3 percent increase recorded
in 2005. The drop in energy prices in the latter part of
2006 accounted for the deceleration in the headline
number. Core inflation moved higher in the first part
of 2006 but then eased toward the end of the year.
On balance, core PCE prices rose about 2% percent
over the four quarters of 2006, a little faster than the
2 percent increase in 2005. The market-based component
of the core PCE price index—which excludes imputed
prices that are not observed in market transactions and
that often change irregularly—increased 2 percent in
2006, about yA percentage point more than in the previous year.
Energy prices recorded dramatic swings during 2006.
PCE energy prices increased at an annual rate of about
15 percent in the first half of the year and declined at
an annual rate of almost 17 percent in the second half.
The sharp movements in consumer energy prices in
2006 were associated primarily with fluctuations in
prices for crude oil. The changes in energy prices also
were amplified by a widening in the margin of the retail
pnce of gasoline over the associated cost of crude oil in the
first half of the year and by some narrowing of that margin
in the second half. On balance, the PCE energy price index
decreased 4 percent over the four quarters of 2006.
Food price inflation remained fairly moderate in 2006.
The PCE index for food and beverages increased 2 lA percent, roughly the same pace as in the preceding year. Retail
prices of meat and poultry rose modestly for 2006, as
robust demand was met by ample supplies of meat. Prices
of wheat rose over the course of the year, and prices of
corn and soybeans spiked at the end of the year in the wake
of downward revisions to estimates of crop production.
Prices of corn also were boosted during the year by
increased demand for corn to produce ethanol. But the
small share of wheat, corn, and soybeans in the total value
of food production limited their effect on retail food prices.
Prices for food consumed away from home, which are
104
20
Monetary Policy Report to the Congress • February 2007
influenced importantly by the costs of labor, energy, and
other business inputs, increased 3 lA percent in 2006, a more
rapid pace than that for prices of food consumed at
home.
The core PCE price index accelerated to an annual
rate of about 2V2 percent in the first half of 2006 on
the strength of pickups in the price indexes for both goods
and services. In the spring, increases in housing rents
were particularly sharp. The rise may have reflected in
part a shift in demand toward rental housing as rising mortgage rates and lofty home prices made home
purchases less affordable. The pass-through of higher
energy costs to a broad range of goods and services also
probably contributed to the acceleration in core consumer
price inflation in the first half of 2006.
In the second half of 2006, core PCE price inflation
edged down to an annual rate of just below 2% percent.
The deceleration was the result of a decrease in core goods
prices, which likely reflected in some measure the waning influence of energy prices. In contrast, core services
inflation in the second half of the year remained at about
the same pace as in the first half. Although housing rents
rose more slowly in the second half of the year, their effect
on the PCE for core services was mostly offset by faster
price increases for medical care and a number of other
services.
The swings in energy costs in 2006 were apparent in
the prices of inputs used in the production and sale of final
goods and services, especially of items for which energy
costs represent a relatively large share of total production
costs, including industrial chemicals, plastics, fertilizer,
and stone and clay products. In addition, the prices of some
commodities, such as a variety of metals, rose significantly
in 2006 in response to strong worldwide demand. As a
result, the core producer price index for intermediate
goods, which excludes food and energy, rose 5 % percent
in 2006, up from the 43/4 percent increase in 2005. The
index increased at an annual rate of 1'A percent in the
first half of 2006, but it decelerated to an annual rate
of about 3'/4 percent in the second half as energy costs
declined.
For the year as a whole, measures of long-term inflation
expectations remained well anchored, although short-term
expectations were heavily influenced by fluctuations in
energy prices. The Reuters/Michigan survey measure of
the median expectation of households for inflation over
the next twelve months was about 3 percent in December,
down from its peak of 3VA percent in August. Longer-term
inflation expectations recorded in the Reuters/Michigan survey showed less variability. The median survey
respondent in December expected the rate of inflation
during the next five to ten years to be 3 percent, down
from its peak of VA percent in August. Other indicators
TIPS-based inflation compensation, 2003-07
—
Five-year, five-year ahc:
2003
2004
2005
2006
2007
NOTC The data are daily and extend through February 7, 2007 Based on a
comparison of the yield curve for Treasury inflation-protected securities
(TIPS) with the nominal off-the-run Treasury yield curve
SouRcr. Federal Reserve Board calculations based on dala provided by the
Federal Reserve Bank of New York and Barclays
likewise suggest that longer-run inflation expectations
have remained contained. According to the Survey of Professional Forecasters, conducted by the Federal Reserve
Bank of Philadelphia, expectations of inflation over the
next ten years remained at 214 percent in 2006, a level that
has been essentially unchanged since 1998. In addition,
inflation compensation implied by the spread of yields on
nominal Treasury securities over their inflation-protected
counterparts stayed within the relatively narrow range of
2 percent to 23A percent during the year.
U.S. Financial Markets
Financial conditions in the United States supported
economic growth in 2006. Yields on long-term Treasury
securities climbed a bit, on balance, but stayed low by
historical standards, while strong corporate profits helped
fuel substantial gains in equity markets. Liquid corporate
balance sheets and low corporate leverage helped keep risk
spreads on corporate bonds narrow. Meanwhile, business
borrowing picked up to a rapid pace, spurred in part by a
rise in merger and acquisition activity. In the residential
real estate sector, mortgage borrowing slowed markedly,
as house prices decelerated, especially in the second half
of the year. Consumer credit expanded at a moderate pace.
Nonetheless, household debt growth outpaced the growth
of disposable personal income, and the financial obligations of households inched higher. Although households
generally appeared able to meet their obligations, signs
offinancialstrain were apparent in subprime variable-rate
mortgages. The M2 monetary aggregate expanded at a
moderate pace in 2006.
105
Board of Governors of the Federal Reserve System 21
Interest rates on selected Treasury securities, 2003-07
NOTE The data arc daily and extend through February 7, 2007
SOURC I. Department of the Treasury
Interest Rates
Market interest rates rose modestly, on balance, in 2006—
yields on two- and ten-year nominal Treasury securities
increased about 40 and 30 basis points respectively.
Changes in interest rates seemed largely tied to changes
in the outlook for economic growth and inflation. Rates
across the maturity spectrum increased notably over the
first half of the year, as incoming data on activity and
inflation came in higher than markets had expected and
as the FOMC raised the target federal funds rate 25 basis
points at each of its first four meetings. At the time of the
June FOMC meeting, interest rate futures market quotes
indicated that market participants perceived considerable
odds of an additional rate tightening by year-end. However, market interest rates declined, on net, over subsequent
months in response to incoming data suggesting that inflation pressures were moderating and that economic growth
was slowing. Market expectations for the trajectory of
the federal funds rate over the next several years shifted
down considerably during the second half of the year.
More recently, market participants have backed away from
expectations of a substantial easing of monetary policy as
incoming data on economic activity have been stronger
than expected. Investors now expect the FOMC to ease
policy only slightly over the next two years. Although
investors modestly revised their medium-term policy
expectations over the course of the year, the Committee's
interest rate decisions were largely anticipated in financial
markets by the time of each meeting. Throughout the year,
forward-looking measures of uncertainty about monetary
policy inferred from interest rate options remained near
the low end of historical ranges.
Yields on inflation-indexed Treasury securities
increased about as much as those on their nominal
Spreads of corporate bond yields over
comparable off-the-run Treasury yields, 1998-2007
1999
2001
2003
2005
2007
Norn The data are daily and extend through February 7, 2007 The
ten-year high-yield, tcn-ycar BBB, and ten-year AA indexes arc compared
with the ten-year Treasury yield
SOURCE Derived from smoothed corporate yield curves using Merrill
Lynch bond data
counterparts in 2006. Medium- and long-term inflation
compensation—-measured from spreads between yields
on nominal and inflation-indexed securities—were about
unchanged to a little lower, on net, and during the year
these measures exhibited only modest swings in response
to incoming inflation data and oil price movements.
In the corporate bond market, yields on investmentgrade securities moved about in line with those on comparable-maturity Treasury securities. In contrast, yields
on speculative-grade securities fell slightly, pulling risk
spreads lower in that segment of the market. The narrowness of investment- and speculative-grade spreads seems
to reflect investors' sanguine perceptions of corporate
credit quality over the medium term, which likely reflect
in large part the strength of business balance sheets and a
benign economic outlook. The term structure of forward
risk spreads for corporate bonds supports this view, as
forward spreads one and two years ahead are low, while
the spreads further out the curve arc more in line with
historical norms.
Equity Markets
Broad equity indexes soared 10 percent to 20 percent in
2006, boosted by strong growth in corporate earnings.
Share prices rose across a wide range of sectors, but
increases in telecommunications and security brokerage stocks were especially noteworthy. The difference
between the twelve-month forward earnings-price ratio
for the S&P 500 and the long-term real Treasury yield—a
crude measure of the premium that investors require for
holding equity shares—was little changed on balance. The
106
22 Monetary Policy Report to the Congress • February 2007
Stock price indexes, 2 0 0 5 - 0 7
January 3. 2005 - 100
NOTF The data arc daily and extend through February 7, 2007
SOURCE Frank Russell Company, Dow Jones Indexes
Implied S & P 500 volatility, 2 0 0 0 - 0 7
2000
2001
2002
2003
2004
2005
2006
2007
NOTE The data arc weekly and c\tcnd through February 9, 2007 The
series shown is the implied thirty-day volatility of the S&P 500 slock price
index as calculated from a weighted average of options prices
SOURCE Chicago Board Options Exchange
implied volatility of the S&P 500 calculated from options
prices spiked temporarily in the late spring in connection
with a period of strain in several markets but remained near
historical lows for the remainder of the year. Net inflows
into domestic equity mutual funds were quite modest in
2006, while inflows into international equity funds were
exceptionally strong.
Market Functioning and Financial Stability
Overall, financial markets functioned smoothly over
the year and proved resilient to several shocks. Equity
markets in the United States and currency and fixedincome markets in several emerging-market economies
experienced heightened volatility late in the second
quarter, but the turbulence was short lived. The liquidation of a few sizable hedge funds attracted considerable
attention for a time but had little discernible effect on the
broad functioning of markets. Even the liquidation of
Amaranth—a hedge fund that was wound down in the
fall after reporting a loss in excess of $6 billion, mostly
in energy trades—left little imprint onfinancialmarkets,
although it raised some concerns about risk-management
practices. Implied volatilities, risk spreads, and various
other potential measures of financial stress generally
stayed at very low levels throughout the year, suggesting
that investors were comfortable taking on risk, likely in
part because they were confident about the economic and
financial outlook.
Throughout the year, bid-ask spreads on the most
actively traded Treasury securities remained within narrow
ranges. Some instances of questionable trading activities
occurred in the secondary market for Treasury securities
over the course of the year. The Interagency Working
Group for Treasury Market Surveillance monitored these
situations closely.1 In November, the Federal Reserve
Bank of New York arranged a meeting with all primary
dealers to discuss developments in Treasury markets and
to encourage the firms to review their internal oversight
of trading operations. Subsequently, a private-sector group
sponsored by the Federal Reserve Bank of New York
released a draft report laying out a set of best practices
for firms active m the Treasury market on topics such as
appropriate trading strategies and internal controls.
In July, the Federal Reserve Board implemented a
revision to the treatment of GSEs and certain international
organizations under its Policy on Payments System Risk.
Under the change, interest and redemption payments on
securities issued by these institutions are now released
only when the issuer's Federal Reserve account contains
sufficient funds to cover the payments; that is, these institutions no longer may employ daylight credit to fund such
payments. The Board of Governors determined that the
change represents an appropriate risk-management policy
for the central bank and is consistent with the general
practices of private issuing and paying agents. In addition,
GSEs and international organizations are now subject to a
penally fee for daylight overdrafts resulting from general
corporate payment activity (activity other than interest and
redemption payments). This change aligns the policy for
GSEs and international organizations with that for other
Federal Reserve account holders that do not have regular
access to the Federal Reserve's discount window and thus
are not eligible for intraday credit. The transition to the
1 The group was established in 1992 and includes representatives
from the Board of Governors of the Federal Reserve System, the Treasury, the Securities and Exchange Commission, the Commodity Futures
Trading Commission, and the Federal Reserve Bank of New York
107
Board oj Governors of the Federal Reserve System
new policy occurred smoothly with minimal effects on
the functioning of the payments system and no notable
adverse effects on short-term funding markets.
Following up on a meeting with the Federal Reserve
Bank of New York in the fall of 2005, the largest participants in the fast-growing market for credit derivatives
agreed to a series of steps to strengthen that market's
infrastructure. Over the course of 2006, credit derivatives
dealers phased out the practice of transferring positions to
a different counterparty without first obtaining the consent
of the original counterparty. They also reduced by 85 percent the number of trade confirmations outstanding more
than thirty days; they doubled the share of trades that arc
confirmed via an electronic platform, to 80 percent of total
trade volume; and they agreed upon a new protocol for
the settlement of such derivatives after a credit event.
Debt and Financial Intermediation by Banks
Total debt of the domestic nonfinancial sectors expanded
an estimated 73A percent in 2006, well below the pace in
2005 but still faster than that of nominal income. Debt
growth slowed markedly in the household and government
sectors, but business debt accelerated.
About 30 percent of the growth in nonfinancial
sector debt in 2006 was intermediated by the banking
sector. This share is about even with the average over
Change in domestic nonfinancial debt, 1991-2006
Federal,
held by public
I
1994
the past ten years and is about 5 percentage points
above the average observed in the 1980s and early
1990s. Commercial bank credit expanded 914 percent
in 2006, supported by brisk growth in loans to businesses. Bank credit also was boosted in the autumn by
a consolidation of a substantial volume of thrift assets
onto a commercial bank's balance sheet that had resulted
from an internal reorganization at a large bank holding
company.
Bank lending to businesses through commercial and
industrial loans increased at a rapid pace last year. The
growth was fueled by vigorous merger and acquisition
activity, rising outlays for investment goods, ongoing
inventory accumulation, and an accommodative lending
environment. Bank loans secured by commercial real
estate, though strong, decelerated over the course of the
year. The moderation in commercial real estate lending
was consistent with responses by large and medium-sized
banks to the Senior Loan Officer Opinion Survey on Bank
Lending Practices, which pointed to slowing demand and
a net tightening of credit standards for such loans in the
second half of the year. Consumer loans and residential
mortgages held by banks grew at a moderate rate for the
year as a whole. However, excluding the effects of the
thrift consolidation, residential real estate lending slowed
considerably in the fourth quarter, no doubt reflecting in
part the downturn in the housing market.
Commercial bank profits as a percentage of average
assets were strong in 2006 and rose slightly above 2005
levels. Net interest margins declined a bit further, likely
in response to continued competitive pressures and a
modest inversion of the yield curve, but bank profitability
was supported by growth in non-interest income and by
well-contained costs. Continued strong asset quality also
helped to support profitability in 2006 by allowing banks
to reduce their loan-loss provisioning. Robust asset quality was reflected in loan delinquency and charge-off rates
that remained at low levels through the end of 2006.
The M2 Monetary Aggregate and Reserves
Components
1992
23
1996
1998
2000
2002
I
—
I
2004
I
5
IQ
I I
2006
credit market debt or state and local governments, households, nonprofit
organizations, and nonfmancial businesses Federal debt held by the public
excludes securities held as investments of federal government accounts
SOURCF. Federal Reserve Board, flow of funds data
M2 expanded at a 5 percent rate last year, somewhat faster
than in 2005. Typically, as short-term interest rates rise,
deposit rates lag somewhat, increasing the opportunity
cost of holding money. In 2006, this effect apparently
slowed money growth less than would have been expected
on the basis of historical norms, and the velocity of M2
rose only about V* percent. Retail money market mutual
funds and small time deposits, components of M2 whose
yields move most closely with market rates, grew rapidly.
However, liquid deposits, which constitute the largest
component of M2, and whose yields adjust more gradually, were about flat on net. Currency expanded a modest
108
24 Monetary Policy Report to the Congress • February 2007
Official or targeted interest rates in selected
foreign industrial countries, 2004-07
M2 growth rate, 1991-2006
1992
1994
1996
1998
2000
2002
2004
2006
NOTE The data arc annual on a Q4 ovcrQ4 basis M2 consists of currency,
traveler's checks, demand deposits, other checkable deposits, savings
deposits (including money market deposit accounts), small-denomination
time deposits, and balances in retail money market funds
SOURCF Federal Reserve Board, Statistical Release H 6, "Money Stock
Measures "
3/2 percent, an increase similar to that in 2005, reflecting
weak, possibly negative, net demand from overseas.
Part of the Financial Services Regulatory Act of 2006
gave the Federal Reserve authority, beginning in October
2011, to pay interest on reserve balances and to further
reduce or eliminate reserve requirements. At the October
FOMC meeting, the Chairman asked the staff to prepare
for the implementation of this legislation.
International Developments
Foreign economic growth was generally strong in 2006,
as expansion continued in all major regions of the world.
The Japanese economy decelerated somewhat but maintained positive growth, and the pace of activity in the euro
area picked up. Labor market conditions in both areas
improved. Emerging-market economies also recorded
solid growth last year and experienced no apparent lasting ill effects from the brief period of financial market
volatility that hit some of them particularly hard in the
late spring. Although there are signs that steps taken to
slow growth of investment in China have been effective,
the Chinese economy continued to grow rapidly. Rising
energy prices boosted consumer price inflation in many
areas of the world early last year, but monetary tightening
appears to have prevented inflation from moving significantly higher, and the effects of higher energy prices on
core prices were modest.
Industrial countries tightened monetary policy in 2006.
Some countries paused around the same time as the Federal Reserve, and others continued to tighten throughout
the year. After ending its policy of quantitative easing in
2004
2005
2006
2007
NOTE The data are daily The last observation for each series is February
7, 2007 The data shown are the overnight rate for Canada, the refinancing
rate for the euro area, the call money rate for Japan, and the repurchase rate
for the United Kingdom
SOURCE The central bank of each area or country shown
the spring, the Bank of Japan (BOJ) raised its policy rate
25 basis points in July. Weak consumer spending and low
inflation have apparently deterred the BOJ from tightening since then. With growth in the European economies
firming, concerns over inflationary pressures prompted the
European Central Bank to raise its policy rate five times
last year, to 3.5 percent. The Bank of Canada tightened
75 basis points in several steps over the first half of the
year but has left the overnight rate unchanged since then.
After keeping its policy rate constant in thefirsthalf of the
year, the Bank of England tightened policy 25 basis points
in August and November 2006 and in January 2007. The
statements accompanying each tightening cited the upside
risks to inflation posed by low levels of spare capacity.
During thefirsthalf of 2006, ten-year sovereign yields
in the euro area, Canada, and Japan rose sharply on balance: Increases ranged from 45 basis points in Japan to
75 basis points in Germany. Yields on inflation-protected
long-term securities in these economies also rose during
the first half of 2006 but not as much as nominal yields
and thus implied a noteworthy rise in inflation compensation. These developments occurred largely in reaction to
continuing upward pressures on inflation, which stemmed
from a further run-up in energy prices and indications that
global economic growth remained robust.
From their midyear highs, nominal government benchmark bond yields fell noticeably until about the beginning of December in most major advanced economies,
as investors reacted to moves in U.S. rates and evaluated
the implications for the global economy of the economic
slowdown that seemed to be under way in the United
States. Over this period, yields on ten-year nominal bonds
declined by amounts that ranged from about 25 basts
109
Board of Governors of the Federal Reserve System
25
U.S. dollar exchange rate against
selected major currencies, 2004-07
Yields on benchmark government bonds tn selectei
foreign industrial countries, 2004-07
ending January 2, 2004 = 100
United Kingdom
— 3
— 2
—
I
NOTE The data arc for tcn-ycar bonds and are weekly The last obscn
for eaeh series is the average for February 5 through February 7, 2007
SOURCE Bloomberg L P
NOTE The data are weekly and are in foreign currency units per dollar
1 he last observation tor eaeh series is the average for February 5 through
February 7, 2007
SOUKCL Bloomberg L P
points in the United Kingdom to about 70 basis points in
Canada. Yields on inflation-indexed securities dechned
less; modest declines in inflation breakeven rates were
attributed in part to lower energy prices in the second half
of the year.
Since the beginning of December, however, nominal
and indexed government bond yields have risen once
again in most advanced economies, partly because new
data releases appeared to alleviate investors' concerns that
global economic growth might slow appreciably. Yields on
both ten-year nominal and indexed securities have risen
15 basis points in Japan and 25 to 50 basis points in the
euro area, the United Kingdom, and Canada since their
December lows. As a result, inflation breakeven rates have
been little changed.
The Federal Reserve's broadest measure of the nominal trade-weighted exchange value of the dollar declined
3
3 /4 percent from the beginning of last year through early
February of this year. Over that period, the dollar appreciated 2 lA percent against the yen and 1 lA percent against the
Canadian dollar, but it depreciated about 9 percent, on net,
against the euro, almost 13 percent against sterling, and 4
percent against the Chinese renminbi. The renminbi's rate
of appreciation stepped up in late 2006 and early 2007,
but daily fluctuations in the dollar-renminbi exchange
rate were very small.
Most of the dollar's overall decline in 2006 occurred
between mid-April and early May. During this period,
market participants reportedly sensed that the FOMC was
approaching the end of its series of policy tightenings,
and interest rate differentials moved against the dollar.
Traders also refocused on the large and persistent U.S.
current account deficit, which was further boosted by
crude oil prices that had moved above $70 per barrel. To
date in 2007, the dollar's broad nominal exchange value
has risen 1 percent on balance.
In the wake of strong advances in 2005, major global
equity indexes posted solid gains, on balance, in 2006
and in early 2007. After rising 5 percent to 10 percent in
the first quarter of 2006, most global indexes fell sharply
beginning in early May to reach intra-year lows in midJune. Market participants attributed the drops in share
prices to increased uncertainty about prospective inflation,
caused in part by the run-up in energy prices, and to a
retreat fromrisk-taking.Broad-based gains in stock prices
since midsummer appear to be associated with a scaling
U.S. dollar nominal exchange rate, broad index, 2004-07
Week ending January 9, 2004 = 100
—
104
102
2004
2005
2006
2007
NOTE The data are weekly and are in foreign currency units per dollar
The last observation is the average for February 5 through February 7, 2007
The broad index is a weighted average of the foreign exchange values of the
U S dollar against the currencies of a large group of the most important U S
trading partners The index weights, which change over time, are derived
from U S export shares and from U S and foreign import shares
SOURCE Federal Reserve Board
110
26 Monetary Policy Report to the Congress • February 2007
Equity indexes in selected foreign industrial countries,
2004-07
Week ending January 2, 2004 = 100
Japan
NOTF The data arc weekly The last obscrvalio
average for February 5 through February 7,2007
Somcr. Bloomberg I. P
back of expectations for future tightening of monetary
policy in several countries and with declines in energy
prices. Since mid-June, broad stock market indexes have
gained 10 percent to 20 percent in Europe, Japan, and
Canada.
7.5 percent in December, continuing a downward movement that began in 2004. Wages and salaries in the manufacturing and services sector grew at an average annual
rate of 2% percent in thefirstthree quarters of the year—a
bit lower than their rate of growth in 2005. Higher energy
prices boosted euro-area consumer price inflation, which
rose to about 2!4 percent in the first half of 2006; late in
the year, it dropped below the European Central Bank's
target ceiling of 2 percent. Core inflation remained near
1 Yz percent.
Real GDP in the United Kingdom grew 3 percent last
year, and real GDP in Canada grew 3 percent, on average, through the first three quarters. Despite declining
consumer confidence in the United Kingdom, the pace
of consumption growth over the year was slightly higher
than in 2005, and consumer spending in Canada, supported
by moderate employment growth, also remained robust.
Declines in energy prices brought Canadian consumer
price inflation down after the middle of the year to a
twelve-month change of about 1 Yi percent in December,
below the Bank of Canada's 2 percent inflation target.
Inflation in the United Kingdom edged up throughout the
year, partly because of increases in electricity and natural
gas prices that were implemented in the fall.
Emerging-Market Economies
Industrial Economies
After increasing at an annual rate of roughly 2 percent
in the first half of 2006, Japanese real GDP grew only
VA percent in the third quarter, largely because of slower
growth of consumption. Capital spending was an important contributor to growth of output throughout the year,
supported by strong corporate profitability. Labor market
conditions continued to improve; the unemployment rate
was about 4 percent in December, its lowest level since
1998, and the ratio of job offers to applicants remained
close to a thirteen-year high. However, wage growth was
very subdued, asfirmscontrolled cost increases, and unit
labor costs continued to fall. In 2006, consumer prices
started toriseagain, posting small twelve-month increases
after June, and land prices in Japan's six largest cities rose
for the first time since 1991. However, the GDP deflator
continued to decline slowly.
Real GDP in the euro area accelerated somewhat in
2006, posting average growth of 3% percent at an annual
rate over the first three quarters. Output growth was supported in part by strong consumer spending, which grew
substantially faster than in 2005. The stronger performance of the economy was reflected in improving labor
market conditions: The unemployment rate in the euro
area fell 0.8 percentage point during the year to reach
Real GDP growth in China remained strong but moderated
a bit in the second half. The mild slowdown suggests that
the administrative measures put in place by the Chinese
authorities to cool investment have had an effect. The
trade surplus recorded a substantial increase in 2006.
Four-quarter inflation picked up near the end of last year
to over 2 percent, reflecting higher food prices.
Elsewhere in emerging Asia, economic performance
was generally solid in 2006. In Korea, GDP growth slowed
from the strong pace registered in 2005, partly because
of monetary tightening, and consumer price inflation
remained modest. The pace of growth in other countries
stayed strong throughout 2006 as a result of robust exports
and, in some cases, strengthening domestic demand.
Four-quarter inflation moderated across the region. That
moderation resulted from the waning effects of earlier
reductions or removals of domestic fuel subsidies, but the
previous tightening of monetary policy in the region and
an appreciation of exchange rates also made a contribution. Capital inflows into several Asian emerging-market
economies—particularly Thailand—in late 2006 and
early this year put upward pressure on local currencies.
Measures taken by Thai authorities seemed to succeed in
limiting upward movement of the baht, but share prices
in the Thai stock market fell sharply. Financial markets
in other countries in the region were less affected
Ill
Board of Governors of the Federal Reserve System
Equity indexes in selected emerging-market economies,
2004-07
Week ending January 2, 2004 = 100
Latin American
emerging-market
2004
2005
2006
2007
NOTE The data are weekly The last observation for each sencs is the
average for February 5 through February 7, 2007 The Latin American economics arc Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela
The Asian economics are China, India, Indonesia, Malaysia, Pakistan, the
Philippines, South Korea, Taiwan, and Thailand, each economy's index
weight is its market capitalization as a share of the group's total
SOURCE Morgan Stanley Capital International (MSCI) index
27
and showed no noticeable spillovers from events in
Thailand.
Output growth in Mexico was exceptionally strong in
the first half of last year, especially in the manufacturing,
construction, and services sectors. Growth stepped down
in the second half; construction activity remained robust
but was offset by a slowdown in exports of manufactured
goods to the United States. Mexican consumer price inflation was elevated during the second half by higher food
prices and reached rates above the 4 percent upper limit
of the central bank's inflation target range; at year-end,
inflation was still at the top end of the range.
Brazilian output growth was solid in the first quarter
but slowed noticeably later in the year, partly because of
weak manufacturing performance. Brazilian four-quarter
inflation fell markedly, from almost 6 percent at the end
of 2005 to just over 3 percent in December. In Argentina,
steady growth in investment and consumption kept real
GDP on a solid uptrend throughout 2006. The Argentine
government continued to attempt to bring down inflation
through voluntary price agreements with producers in
several sectors; although inflation had edged down to the
single-digit range by year-end, it was still high.
112
BOARD DF DQVERNQR5
OF TH£
FEDERAL RESERVE SYSTEM
WASHINGTON. D, C. 30551
March 5, 2007
The Honorable Ruben Hinojosa
House of Representatives
Washington, D.C. 20515
Dear Congressman:
I am pleased to enclose my responses to your additional questions
following the February 15 hearing before the Committee on Financial Services. I
have also forwarded a copy to the Committee for inclusion in the hearing record.
Sincerely,
Enclosure
113
Chairman Beraanke subsequently submitted the following in response to questions received
from Congressman Ruben Hinojosa in connection with the February 15, 2007, hearing
before the House Financial Services Committee:
Q.I. On the Education and Labor Committee, on which I serve as Chairman of the
Higher Education Subcommittee, we constantly struggle to set the parameters of the
student loan programs to provide the lowest costs to student borrowers and to the
government while ensuring that there is sufficient capital either through subsidizing
private lenders or through direct loans from the Department of Education.
It is very difficult for the Congress to receive information from the Department of
Treasury and Education Department as to their true costs of subsidizing private
lenders versus direct loans. Do you or your staff know why this is the case? And, can
you please speak to the issue of subsidized private loans versus direct loans.
A. 1. The student loan programs are quite complex and well outside the range of
expertise and operational responsibility of the Federal Reserve. The complexity of the
programs substantially complicates the analysis of the relative cost of the loan guarantee
program versus the direct lending program. One very recent paper that undertakes that
analysis is by Deborah Lucas of the Kellogg School of Management at Northwestern
University and Damien Moore of the Congressional Budget Office. It is entitled
"Guaranteed vs. Direct Lending: The Case of Student Loans," and can be found at
http://www.kellogg.northwestern.edu/research/risk/federal/lucas moore.pdf.
Q.2. Chairman Bernanke, as Chairman Frank noted during his opening remarks,
our economy is becoming increasingly global in nature every day. In light of this
situation, some countries will benefit from globalization more than others.
At present, the United States has a large trade deficit with China, a country that helps
finance our national debt, which I believe is now approaching $8.5 trillion.
I realize that China, in turn, has its own trade deficit with its neighbors, but overall,
it is my understanding that China still has a trade surplus with a majority of the
world. Am I correct in this assertion?
A.2. In 2006, China's bilateral trade surplus in goods with the United States was
$233 billion, based on U.S. Census Bureau data. Although China ran a trade deficit with
many of its neighbors, China's overall multilateral balance (as reported in Chinese customs
basis statistics) was a surplus of $177 billion. Chinese data show a significantly smaller
bilateral surplus between China and the United States than do U.S. data, reflecting, among
other factors, differences in the treatment of shipments through Hong Kong. However,
either source of data suggests that trade with the United States accounts for a very large
114
-2portion of China's overall multilateral balance, and China's trade with the rest of the world
excluding the United States is accordingly much closer to balance.
Q.3. Recently, I learned that South Africa has fairly large investments in China. In
fact, South Africa has more investments in China than China has in South Africa,
which seems to be unique.
Just how powerful economically is South Africa compared to India and China?
A.3. Data on bilateral flows between China and other countries are not generally
available for portfolio investment, that is, transactions in financial instruments such as
stocks or bonds. However, such data are available for bilateral flows of direct foreign
investment. They show that South African foreign direct investment into China amounted
to $130 million U.S. dollars in 2005 (the latest available year), well above Chinese direct
investment flows into South Africa of $45 million in that year. Even so, inflows from
South Africa have represented less than a percent of total Chinese direct investment inflows
in recent years. Inflows from India have been even smaller, at roughly $20 million in
2005. In contrast, the United States' direct investment inflows into China have been
averaging 10 percent of total Chinese direct investment inflows in recent years ($3 billion
in 2005).
South Africa is not unique in channeling more direct foreign investment flows into
China than it is receiving from China. The same is true of many countries.
There is no common standard for measuring a country's economic power, nor even
for defining what economic power might mean. One candidate for measuring economic
power might be a country's gross domestic product (GDP) as a share of world GDP.
Using this measure, South Africa represents only Vz percent of world GDP. (South
African GDP was about $240 billion U.S. dollars in 2005, measured at market exchange
rates.) This is about one third of India's share, and an even smaller proportion of China's
5 percent share (Chinese nominal GDP was $2,244 billion in 2005). By comparison, U.S.
GDP was $12,456 billion U.S. dollars in 2005, 28 percent of world GDP.
115
BOARD DF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D C. ED55I
March 29, 2007
The Honorable Albio Sires
House of Representatives
Washington, D.C. 20515
Dear Congressman:
I am pleased to enclose my response to your additional question
following the February 15 hearing before the Committee on Financial Services. I
have also forwarded a copy to the Committee for inclusion in the hearing record.
Sincerely,
Enclosure
116
Chairman Bernanke subsequently submitted the following in response to a written question
received from Congressman Albio Sires in connection with the February 15, 2007, hearing
before the Committee on Financial Services:
Small banks play a large role in this renewed commitment to our communities and I
want to ensure that our small community banks are stabilized.
Chairman Bernanke, can you please tell me what the FED is doing to ensure that our
community banks stay strong?
The Federal Reserve firmly believes that community banks play an important role in
the U.S. economy, as they have throughout our history. Although significant consolidation
in the banking industry has occurred over the past two decades, community banks continue
to thrive by providing traditional relationship banking services to members of their
communities. Their local presence and personal interactions give community bankers an
advantage in providing financial services to customers for whom information remains
difficult and costly to obtain by large out-of-market institutions, despite technological
advances.
The Federal Reserve and the other federal banking agencies maintain a robust
supervision program for community banks that is far more proactive than the programs in
place during the late 1980s and early 1990s. The agencies today practice "risk-focused"
supervision, which focuses on identifying weaknesses in bank practices and processes
(e.g., underwriting, credit administration) so that corrective action can be taken before any
such weaknesses are manifested in poor financial performance. Every community bank is
subject to a full-scope, on-site examination at least once every 18 months, and at least once
every 12 months if the bank has assets of $500 million or more. This asset threshold limit
was recently raised from $250 million to $500 million. The Federal Reserve is sensitive to
the regulatory burden on community banks, and has supported relief from this and other
regulatory requirements over the past few years, consistent with safe and sound banking
principles.
The Federal Reserve also maintains extensive surveillance systems to identify
specific institutions whose financial performance may have changed between examinations,
as well as to identify any trends in financial performance across various regions and
nationally. If surveillance information detects possible issues with a specific institution,
supervisory follow-up is initiated, which may include an on-site review or acceleration of
the regularly scheduled examination. As a result of these efforts and the aforementioned
risk-focused approach, issues are generally identified at an earlier stage when they are
more easily corrected. While some banks do encounter more serious financial difficulties,
to date, these have been a very small proportion.
117
-2-
Overall, the financial condition of community banks in the United States remains
strong. The condition of community banks tends to reflect that of the local economies in
which they operate. Should economic conditions in those markets encounter adverse
change, the Federal Reserve is prepared to expand and accelerate normal supervisory
programs to assure that communities remain served by healthy financial institutions.
@FedFRASER