[Joint House and Senate Hearing, 109 Congress]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-596
 
                          THE ECONOMIC OUTLOOK

=======================================================================

                                HEARING

                               before the

                        JOINT ECONOMIC COMMITTEE
                     CONGRESS OF THE UNITED STATES

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                               __________

                             APRIL 27, 2006

                               __________

          Printed for the use of the Joint Economic Committee



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                        JOINT ECONOMIC COMMITTEE

    [Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]

HOUSE OF REPRESENTATIVES             SENATE
Jim Saxton, New Jersey, Chairman     Robert F. Bennett, Utah, Vice 
Paul Ryan, Wisconsin                     Chairman
Phil English, Pennsylvania           Sam Brownback, Kansas
Ron Paul, Texas                      John Sununu, New Hampshire
Kevin Brady, Texas                   Jim Demint, South Carolina
Thaddeus G. McCotter, Michigan       Jeff Sessions, Alabama
Carolyn B. Maloney, New York         John Cornyn, Texas
Maurice D. Hinchey, New York         Jack Reed, Rhode Island
Loretta Sanchez, California          Edward M. Kennedy, Massachusetts
Elijah E. Cummings, Maryland         Paul S. Sarbanes, Maryland
                                     Jeff Bingaman, New Mexico

               Christopher J. Frenze, Executive Director
                  Chad Stone, Minority Staff Director


                            C O N T E N T S

                              ----------                              

                      Opening Statement of Members

Hon. Jim Saxton, Chairman, a U.S. Representative from New Jersey.     1
Hon. Jack Reed, Ranking Minority, a U.S. Senator from Rhode 
  Island.........................................................     6

                               Witnesses

Statement of Hon. Ben Bernanke, Chairman, Board of Governors of 
  the Federal Reserve System.....................................     2

                       Submissions for the Record

Prepared Statement of Representative Jim Saxton, Chairman........    35
Prepared Statement of Senator Robert Bennett, Vice Chairman......    35
Prepared Statement Senator Jack Reed, Ranking Minority...........    36
Prepared Statement of Hon. Ben Bernanke, Chairman, Board of 
  Governors of the Federal Reserve System........................    37
Chart entitled ``Inflation,'' submitted by Chairman Jim Saxton...    41
Letter from Chairman Jim Saxton to Chairman Ben Bernanke with 
  written questions for the record...............................    42
Response from Chairman Ben Bernanke to written questions 
  submitted by Chairman Jim Saxton...............................    44
Letter submitted by Senator John Sununu from Chairman Alan 
  Greenspan to Senator John Sununu, January 3, 2006..............    47


                          THE ECONOMIC OUTLOOK

                              ----------                              


                             APRIL 27, 2006

             Congress of the United States,
                          Joint Economic Committee,
                                                    Washington, DC.
    The Committee met at 10:02 a.m., in room 216 of the Hart 
Senate Office Building, the Honorable Jim Saxton (Chairman of 
the Committee) presiding.
    Representatives present: Saxton, Ryan, English, Paul, 
Brady, Maloney, Hinchey, and Cummings.
    Senators present: Bennett, Sununu, Sessions, Reed, and 
Sarbanes.
    Staff present: Chris Frenze, Robert Keleher, Brian Higgin-
botham, Colleen Healy, Katie Jones, Jeff Schlagenhauf, Jeff 
Wrase, Chad Stone, Matt Salomon, and Pamela Wilson.

        OPENING STATEMENT OF HON. JIM SAXTON, CHAIRMAN, 
             A U.S. REPRESENTATIVE FROM NEW JERSEY

    Representative Saxton. Good morning. Chairman Bernanke, 
it's a pleasure to welcome you here this morning. We appreciate 
your appearance today and we look forward to hearing your views 
on the economic outlook.
    According to the official data, a healthy economic 
expansion has been underway for several years. The U.S. economy 
advanced 4.2 percent in 2004, and 3.5 percent in 2005.
    As I have noted many times, the pickup in economic growth 
since the middle of 2003 is mostly due to a rebound in 
investment activity, which had been weak prior to that. This 
rebound was fostered by a mix of Federal monetary policy and 
the 2003 tax legislation and its incentives for investment.
    The continued economic expansion has created 5.2 million 
payroll jobs since 2003. The unemployment rate, at 4.7 percent, 
is below the averages of the 1970s, the 1980s, and the 1990s.
    The Federal Reserve and private economists forecast that 
business investment and the overall economy will continue to 
grow this year.
    As the Fed noted in a policy report last February, ``The 
U.S. delivered a solid performance in 2005.'' The Fed also 
stated that ``the U.S. economy should continue to perform well 
in 2006 and 2007.''
    Recent data indicate that the economic growth rate for the 
first quarter of this year will be quite robust when it is 
released tomorrow.
    According to a broad array of economic data, the outlook 
remains positive. Consumer spending is expected to be solid in 
2006; home ownership has reached record highs; household net 
worth is also at record levels; the trend in productivity 
growth remains strong.
    Although oil prices have raised business costs and imposed 
hardships on many consumers, these prices have not derailed the 
expansion.
    Meanwhile, long-term inflation pressures are contained. As 
a result, long-term interest rates such as mortgage rates, are 
still relatively low, although these rates have edged up in 
recent weeks.
    According to the Fed's preferred price index, inflation is 
well under control.
    One point that I would like to mention, however, is that 
it's important to examine the price of energy, the causes for 
increased prices, the relationship between supply and demand, 
the relationship between the pump price of gasoline and oil 
companies' profits, and the effect of these items on the 
economy as we go forward.
    In sum, current economic conditions are strong. While 
economic growth is expected to exceed 3 percent this year, the 
economic outlook remains positive.
    Mr. Chairman, at this point, we would normally hear from 
the Ranking Member, Senator Reed, however, he's tied up on the 
floor, and so we're going to turn to you now for your 
testimony, and then we'll get into questions.
    [The prepared statement of Representative Jim Saxton 
appears in the Submissions for the Record on page 35.]

STATEMENT OF HON. BEN BERNANKE, CHAIRMAN, BOARD OF GOVERNORS OF 
                   THE FEDERAL RESERVE SYSTEM

    Chairman Bernanke. Thank you. Mr. Chairman and Members of 
the Committee, I am pleased to appear before the Joint Economic 
Committee to offer my views on the outlook for the U.S. 
economy, and on some of the major economic challenges that the 
Nation faces.
    Partly because of last year's devastating hurricanes and 
partly because of some temporary or special factors, economic 
activity decelerated noticeably late last year. The growth of 
the real gross domestic product, or GDP, slowed from an annual 
average rate of nearly 4 percent over the first three quarters 
of 2005, to less than 2 percent in the fourth quarter.
    Since then, however, with some rebound in activity underway 
in the Gulf Coast region and continuing expansion in most other 
parts of the country, the national economy appears to have 
grown briskly. Among the key economic indicators, growth in 
non-farm payroll employment picked up in November and December, 
and job gains averaged about 200,000 per month between January 
and March. Consumer spending and business investment, as 
inferred from data on motor vehicle sales, retail sales, and 
shipments of capital goods, are also on track to post sizable 
first-quarter increases.
    In light of these signs of strength, most private sector 
forecasters such as those included in the latest Blue Chip 
survey, estimate that real GDP grew between 4 and 5 percent at 
an annual rate in the first quarter.
    If we smooth through the recent quarter-to-quarter 
variations, we see that the pace of economic growth has been 
strong for the past 3 years, averaging nearly 4 percent at an 
annual rate since the middle of 2003.
    Much of this growth can be attributed to a substantial 
expansion in the productive capacity of the U.S. economy, 
which, in turn, is largely the result of impressive gains in 
productivity, that is, in output-per-hour-worked.
    However, a portion of the recent growth reflects the taking 
up of economic slack that had developed during the period of 
economic weakness earlier in the decade. Over the past year, 
for example, the unemployment rate has fallen nearly one-half 
percentage point, the number of people working part-time for 
economic reasons, has declined to its lowest level since August 
of 2001, and the rate of capacity utilization in the industrial 
sector has moved up 1.5 percentage points.
    As the utilization rates of labor and capital approach 
their maximum sustainable levels, continued growth in output, 
if it is to be sustainable and non-inflationary, should be at a 
rate consistent with the growth in the productive capacity of 
the economy.
    Admittedly, determining the rates of capital and labor 
utilization consistent with stable long-term growth is fraught 
with difficulty, not least because they tend to vary with 
economic circumstances.
    Nevertheless, to allow the expansion to continue in a 
healthy fashion and to avoid the risk of higher inflation, 
policymakers must do their best to help to ensure that the 
aggregate demand for goods and services does not persistently 
exceed the economy's underlying productive capacity.
    Based on the information in hand, it seems reasonable to 
expect that economic growth will moderate toward a more 
sustainable pace as the year progresses. In particular, one 
sector that is showing signs of softening is the residential 
housing market. Both new and existing home sales have dropped 
back, on net, from their peaks of last Summer and early Fall, 
and while unusually mild weather gave a lift to new housing 
starts earlier this year, the reading for March points to a 
slowing in the pace of homebuilding as well.
    House prices, which have increased rapidly during the past 
several years, appear to be in the process of decelerating, 
which will imply slower additions to household wealth, and, 
thereby, less impetus to consumer spending.
    At this point, the available data on the housing market, 
together with ongoing support for housing demand from factors 
such as strong job creation and still-low mortgage rates, 
suggests that this sector will most likely experience a gradual 
cooling, rather than a sharp slowdown. However, significant 
uncertainty attends the outlook for housing, and the risk 
exists that a slowdown more pronounced than we currently expect 
could prove a drag on growth this year and next. The Federal 
Reserve will continue monitoring housing markets closely.
    More broadly, the prospects for maintaining economic growth 
at solid pace in the period ahead, appear good, although growth 
rates may well vary, quarter-to-quarter, as the economy 
downshifts from the first-quarter spurt.
    Productivity growth, job creation, and capital spending are 
all strong, and continued expansion on the economies of our 
trading partners, seems likely to boost our export sector.
    That said, energy prices remain a concern. The nominal 
price of crude oil has risen recently to new highs, and 
gasoline prices are also up sharply. Rising energy prices pose 
a risk to both economic activity and inflation. If energy 
prices stabilize this year, even at a high level, their adverse 
effects on both growth and inflation should diminish somewhat 
over time. However, as the world has little spare oil 
production capacity, periodic spikes in oil prices remain a 
possibility.
    The outlook for inflation is reasonably favorable, but 
carries some risks. Increases in energy prices have pushed up 
overall consumer price inflation over the past year or so. 
However, inflation in core price indexes, which, in the past 
has been a better indicator of long-term inflation trends, has 
remained roughly stable over the past year.
    Among the factors restraining core inflation, are ongoing 
gains in productivity, which have helped to hold unit labor 
costs in check, and strong domestic and international 
competition in product markets, which have restrained the 
ability of firms to pass cost increases on to consumers.
    The stability of core inflation is also enhanced by the 
fact that long-term inflation expectations, as measured by 
surveys and by comparing yields on nominal and indexed Treasury 
securities, appear to remain well anchored.
    Inflation expectations will remain low only so long as the 
Federal Reserve demonstrates its commitment to price stability. 
As to inflation risks, I have already noted that continuing 
growth in aggregate demand in excess of increases in the 
economy's underlying productive capacity would likely lead to 
increased inflationary pressures. In addition, although pass-
through from energy and commodity price increases to core 
inflation has thus far been limited, the risk exists that 
strengthening demand for final products could allow firms to 
pass on a greater portion of their cost increases in the 
future.
    With regard to monetary policy, the Federal Open Market 
Committee, or FOMC, has raised the Federal Funds rate in 
increments of 25 basis points at each of its past 15 meetings, 
bringing it to its current level to 4.75 percent.
    This sequence of rate increases was necessary to remove the 
unusual monetary accommodation put in place in response to the 
soft economic conditions earlier in this decade. Future policy 
actions will be increasingly dependent on the evolution of the 
economic outlook, as reflected in the incoming data. 
Specifically, policy will respond to arriving information that 
affects the Committee's assessment of the medium-term risk to 
its objectives of price stability and maximum sustainable 
employment. Focusing on the medium-term forecast horizon is 
necessary because of the lags with which monetary policy 
affects the economy.
    In the statement issued after its March meeting, the FOMC 
noted that economic growth had rebounded strongly in the first 
quarter, but appeared likely to moderate to a more sustainable 
pace. It further noted that a number of factors have 
contributed to the stability in core inflation.
    However, the Committee also viewed the possibility that 
core inflation might rise as a risk to the achievement of its 
mandated objectives, and it judged that some further policy 
firming may be needed to keep the risk of attainment of both 
sustainable economic growth and price stability, roughly in 
balance.
    In my view, data arriving since the meeting, have not 
materially changed that assessment of the risks. To support 
continued healthy growth of the economy, vigilance in regards 
to inflation, is essential. The FOMC will continue to monitor 
the incoming data closely, to assess the prospects for both 
growth and inflation. In particular, even if, in the 
Committee's judgment, the risks to its objectives are not 
entirely balanced, at some point in the future, the Committee 
may decide to take no action at one or more meetings, in the 
interest of allowing more time to receive information relevant 
to the outlook. Of course, a decision to take no action at a 
particular meeting does not preclude actions at subsequent 
meetings, and the Committee will not hesitate to act when it 
determines that doing so is needed to foster the achievement of 
the Federal Reserve's mandated objectives.
    Mr. Chairman, the remainder of my testimony, which I submit 
for the record, discusses two longer-term challenges to the 
U.S. economy: The first is the long-run sustainability of the 
Federal budget deficit. Given the aging of our population, 
we're going to see increasing stress on transfer programs as a 
share of GDP, and I argue that Congress needs to make difficult 
choices about what share of the GDP is to be devoted to Federal 
programs, and to set taxes accordingly to match that share of 
GDP.
    The second issue that I discuss--and I'm simply 
summarizing--is the U.S. current account deficit, which is now 
at about 6.5 percent of GDP, and which cannot be sustained 
indefinitely at that level.
    Recent discussions with the G7 have made the important 
point that the U.S. current account deficit is not a U.S. 
problem alone, but is a global problem, and one which requires 
action and response, not only by the United States, but by our 
trading partners, as well. There are a number of steps that 
both we and our trading partners can take to improve the 
current account situation over a period of time. On our side, 
again, improved fiscal balance would be helpful, but, in 
addition, other countries need to take action, as well.
    In conclusion, Mr. Chairman, the economy is performing 
well, and the near-term prospects look good, although, as 
always, there are risk to the outlook. Monetary policy will 
continue to pursue its objectives of helping the economy to 
grow at a strong, sustainable pace, while keeping inflation 
firmly under control.
    And while many of the fundamental factors that determine 
long-term economic growth appear favorable, actions to move the 
Federal budget toward a more sustainable position will do a 
great deal to help ensure the future prosperity of our economy.
    Thank you, and I'd be happy to take any questions you might 
have.
    [The prepared statement of Hon. Ben Bernanke appears in the 
Submissions for the Record on page 37.]
    Representative Saxton. Mr. Chairman, normally we would 
begin our questions at this point, but let me just ask Senator 
Reed, who was tied up on the floor previously, if he has an 
opening statement.

 OPENING STATEMENT OF HON. JACK REED, RANKING MINORITY, A U.S. 
                   SENATOR FROM RHODE ISLAND

    Senator Reed. Well, thank you very much, Chairman Saxton, 
and welcome, Chairman Bernanke, and thank you for your 
testimony today and for your service.
    All eyes are on you as you embark on a very delicate 
balance in terms of allowing the economy to grow and employment 
to reach its full potential, while you remain mindful of the 
risks of inflation.
    For some time, the Fed's job has been easier. It had room 
to raise interest rates from very low levels, with little risk 
of derailing the economic recovery, while inflation and other 
lurking economic problems were at bay.
    Today, soaring energy prices, record budget and trade 
deficits, negative household savings rates, and a disappointing 
labor market recovery, all pose tremendous challenges to 
setting monetary policy.
    The Fed has raised its target for the Federal Funds rate by 
25 basis points at each of the last 15 FOMC meetings, and, 
according to the minutes of the March meeting, most members of 
the FOMC thought that the end of the tightening process was 
near. The question on everyone's mind is, are we there yet?
    The phrase we are hearing is that interest rate changes 
will now be data-driven, so I hope that means, Chairman 
Bernanke, that the Fed will look hard at the full range of data 
on economic growth, employment, and inflation, to determine the 
best course for monetary policy.
    GDP is growing, but the typical American worker has been 
left out of the economic gains of this recovery. Strong 
productivity growth has shown up in the bottom lines of 
shareholders, but not in the paychecks of workers.
    Too many Americans are being squeezed by stagnant incomes 
and rising costs for gasoline, healthcare, and education. It 
seems to me that there is still room for real wages to catch up 
with productivity, before the Fed needs to worry about 
inflationary pressures from the labor market.
    However, there are many other downside risks to the economy 
on the horizon. You have mentioned some of them.
    Energy prices have been pushing up overall inflation for 
some time, but last month, we saw an uptick in core inflation, 
which might be an early sign that businesses are starting to 
pass on their higher energy costs to customers.
    Rising oil prices and interest rates, coupled with a 
weakening housing sector, could take their toll on consumers 
and businesses alike, and slow down the economy.
    Your task in setting the right course for monetary policy 
is complicated by fiscal policy and international imbalances, 
which you discuss in the bulk of your statement, which you put 
into the record.
    We no longer have the fiscal discipline that we had in the 
1990s, which allowed for monetary policy that encouraged 
investment and long-term growth. The President's large and 
persistent budget deficits have led to an ever-widening trade 
deficit that forces us to borrow vast amounts from abroad, and 
puts us at risk of a major financial collapse if foreign 
lenders suddenly stop accepting our IOUs.
    Even assuming we can avoid an international financial 
crisis, continued budget and trade deficits will be a drag on 
the growth of our standard of living, and leave us ill prepared 
to deal with the effects of the retirement of the Baby Boom 
generation.
    Strong investment financed by our own national saving, not 
foreign borrowing, is the foundation for strong, sustained 
economic growth and rising living standards.
    There is final issue that I'd like to raise, and that is 
the growing inequality of income, earnings, and wealth in the 
U.S. economy. Your predecessor, Chairman Greenspan, regularly 
raised that issue as one of the concerns for our political 
economy. It is not good for a democracy to have widening 
inequality.
    I know you share those concerns. Recently the Federal 
Reserve published the results of the 2004 Survey of Consumer 
Finances. They show that the growth in median income and wealth 
have slowed substantially, and the top 1 percent of families 
hold more wealth than the bottom 90 percent of families.
    Mr. Chairman, I hope you can concentrate on that issue as 
you continue to develop policy, and, I again encourage and 
welcome your presentation here today. Thank you, Mr. Chairman.
    [The prepared statement of Hon. Jack Reed appears in the 
Submissions for the Record on page 36.]
    Representative Saxton. Thank you very much, Senator Reed.
    Mr. Chairman, let me begin with a question that I think is 
central to the subject that we're discussing here, and that is 
the Fed's role in managing our Nation's monetary policy.
    In both your statement and in Senator Reed's statement, the 
subject of inflation was mentioned prominently. As a matter of 
fact, the Fed's monetary policy for many years has focused on 
price stability and trying to control inflation.
    Under such policy, inflation and interest rates are kept 
low. As this low inflation persists, the central bank's policy 
becomes increasingly credible in the eyes of investors, as well 
as in the eyes of savers.
    As a consequence, inflationary expectations recede and 
interest rates decline. These movements, in turn, encourage 
economic growth and lower unemployment, and just better 
economic outcomes for everyone.
    My question is this: If the United States were to move 
toward explicit inflation targeting, would this be largely a 
movement for greater transparency, or mostly a significant 
change in the substance of Fed monetary policy?
    Chairman Bernanke. Thank you, Mr. Chairman. Let me first 
address the point on inflation. The Federal Reserve has a 
three-part mandate: Price stability; moderate long-term 
interest rates; and maximum employment.
    Clearly, keeping inflation low and stable addresses 
directly the first two of those, in particular, since long-term 
interest rates can only be low if investors expect inflation to 
remain low. I would argue, in addition, that there's very 
strong evidence that low and stable inflation and well-anchored 
inflation expectations also contribute mightily to the third 
objective, which is strong and stable employment growth.
    For example, we have seen since the mid-1980s, what 
economists refer to as the great moderation, the fact that 
recessions have been somewhat less frequent and milder, that 
quarter-to-quarter variation in output and employment has been 
lower. Many scholars attribute that to the fact that inflation 
in that last 20-year period, has been low and stable.
    Therefore, it is very much in the interest of all of the 
objectives, including the employment objectives of the Federal 
Reserve, to keep inflation low and stable. So, then, the 
question is, how to do that?
    The Federal Reserve already has established strong 
credibility for keeping inflation low and stable, and I 
anticipate we will retain that credibility.
    I have discussed, and will be discussing with the Federal 
Open Market Committee, ways in which we can continue Chairman 
Greenspan's movement toward greater transparency and better 
communication, to further anchor inflation expectations and 
reduce uncertainty in financial markets.
    One of the ideas that's been discussed in that context, is 
the idea of defining, quantitatively, what the optimal long-
term inflation rate might be. In doing so, the hope would be to 
reduce uncertainty and to help anchor inflation expectations 
more tightly.
    Clearly--and I'd like to emphasize this point--taking this 
step would in no way repudiate the employment part of the dual 
mandate; to the contrary, it would provide the Fed with a 
stronger tool and better ability to meet this very important 
objective.
    So, to answer your question most directly, I don't see, and 
I don't desire, any change in the basic operating procedures of 
the Fed, nor in its objectives; rather, I think that we need to 
work on our communication, broadly speaking, to make sure that 
inflation expectations remain low and stable, as a tool for 
meeting all three of the Federal Reserve's mandated objectives.
    Representative Saxton. Mr. Chairman, thank you. Some worry 
about Fed policy, which has focused on price stability over the 
last couple of decades. Recently, under this policy we have 
seen a relatively long period of Fed tightening, which resulted 
in higher overnight interest rates.
    Some would worry that this translates into higher interest 
rates in the economy, particularly in long-term interest rates, 
and, most recently, that has not happened. As a matter of fact, 
we have seen stable long-term interest rates, in spite of the 
fact that short-term rates have increased rather significantly.
    Why is it that long-term rates have remained stable and 
even come down during this period of time, on occasions, when 
Fed policy has been to tighten and the net result of that is 
short-term rate increases?
    Chairman Bernanke. Mr. Chairman, first I'd like to 
reiterate the point that increasing short-term rates to control 
inflation has the effect actually, in the long run certainly, 
of keeping long-term rates lower, rather than higher.
    I can only draw the contrast between the 1970s and the 
early 1980s when people paid 18 percent for mortgages, vis-a-
vis today where they are paying 6 percent-plus, in an 
environment where inflation is low and stable and under 
control, and in that respect, meeting our objective of low to 
moderate long-term interest rates is best achieved by keeping 
inflation low and stable.
    With respect to the recent behavior of long-term interest 
rates, it's useful to think about the long-term interest rate 
as consisting of a series of short-term rates, the rates for 
the next few years and then the rates that investors expect to 
be maintained further out into the future.
    Over the last almost 2 years, as the Fed has been 
tightening, the short-term component of that has been rising, 
as the policy rate has risen, but the further-out short-term 
rates, at the far end of the yield curve, have been declining 
and offsetting that effect and leaving the overall 10-year rate 
more or less stable.
    The declines in the far-out yields, further out in the term 
structure, seem to result from both an increase of saving in 
the global economy, which has been looking for returns--and 
some of that has come to the United States and to other 
industrial countries, driving down returns--and also some 
reduction in term premiums, reflecting the reduced sense of 
risk that investors feel about the general economy, about 
inflation, and about the bond market, specifically.
    Now, recently, we have seen a turnaround, in that the far-
out short-term rates, the rates that investors expect to be 
maintained, 5 or 10 years from now, have risen fairly 
significantly, leading to an overall increase in long-term 
interest rates.
    I think there are basically two reasons for that: First, 
there has been some return of the term premium back to more 
normal levels, after a period of unusually low levels.
    But, second, and, I think, importantly for our economy, it 
appears that the world economy is growing this year at a very 
healthy pace. We're seeing strength in Japan; we're seeing some 
incipient strength in Europe; China continues very strong, as 
well as Southeast Asia; emerging markets are doing well, so 
general strength in the world economy is providing some 
increased upward pressure on long-term interest rates, and 
that, I think, explains what's been happening in the last 
couple of months.
    Representative Saxton. Thank you. Let me just change the 
subject for just a moment.
    The price of oil has reached a price in excess of $70 a 
barrel. Just let me ask quickly before we turn to the next 
Member, how does the oil price increase affect your outlook on 
the economy? Are you worried or extremely worried? What is your 
general outlook on this subject?
    Chairman Bernanke. Yes, Mr. Chairman, higher oil prices do 
create problems for monetary policy. On the one hand, they 
directly affect the cost of living, inflation, on the other 
hand, by taking purchasing power away from consumers, they tend 
to slow economic activity, and so they do produce a difficult 
problem.
    For the Federal Reserve, one issue we will be looking at 
very carefully is whether the increases in energy prices that 
we have already seen and that we may see in the future pass 
through into core inflation--that is, whether they go beyond 
the energy sector itself and begin to be seen in higher prices 
for other goods and services. If that were to happen and if 
expectations of inflation were thereby to rise, that would be 
very deleterious to the long-term growth of the economy.
    By contrast, if inflation expectations remain stable and 
core inflation is not infected, so to speak, by high energy 
prices, that gives the Fed considerably more leeway to respond 
to any changes that may happen in the real economy related to 
the higher oil prices.
    In particular, we do expect to see a slight slowing in 
growth, perhaps a couple of tenths, this year and next 
associated with the higher oil prices and their effects on 
consumer spending. And we are very aware of that and are paying 
attention to those developments.
    Representative Saxton. Thank you, Mr. Chairman.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman. Because Senator 
Sarbanes has to leave, I would yield him 5 minutes for 
questions.
    Senator Sarbanes. Thank you very much, Senator Reed. I will 
be very brief and I apologize to Chairman Bernanke that I 
cannot stay. I have been looking forward to this hearing, but I 
have another commitment.
    I am drawn to the sentence at the bottom of page 3 of your 
statement: ``Of course, inflation expectations will remain low 
only so long as the Federal Reserve demonstrates its commitment 
to price stability.'' And the question I want to raise to you 
is that in order for the Federal Reserve to demonstrate its 
commitment to price stability, is it necessary for the Open 
Market Committee to raise interest rates 25 basis points every 
time they meet?
    Chairman Bernanke. No, Senator.
    Senator Sarbanes. Well that is fine. All I need is an 
answer, just so I----
    Chairman Bernanke. If that satisfies----
    Senator Sarbanes [continuing]. Just so I know that we are 
not on an irreversible treadmill here, since we have seen 15 
meetings in a row in which the Open Market Committee has taken 
the interest rates up. But it has not built itself in so that 
you have to do that at every meeting in order to show that 
you're inflation fighters, is that correct?
    Chairman Bernanke. Yes, Senator. Our assessment currently 
is that the risks to inflation are perhaps the most significant 
at the moment and we need to address that. But as I emphasized 
in my statement--I make two points: first is that now that we 
have taken away most of the extraordinary accommodation that we 
had in the system back from 2003, we are much more data-driven, 
we need to continually reevaluate our forecasts and think about 
the prospects for the economy and make our decisions based on 
the information that is coming into our hands.
    And second, as I noted in my written testimony, there is 
always the possibility that if there is sufficient uncertainty 
that we may choose to pause simply to gain more information to 
learn better what the true risks are and how the economy is 
actually evolving.
    Senator Sarbanes. Well, I see that the minutes of your most 
recent meeting on March 28th did say, ``Most members thought 
that the end of the tightening process was likely to be near 
and some expressed concerns about the dangers of tightening too 
much, given the lags in the effects of policy.'' I very much 
share that concern, and so I welcome that statement and I hope 
the Open Market Committee will, in effect, act off of that 
statement in the upcoming meetings.
    The other point I would like to raise to you is I want to 
again urge you, as we did when we held your confirmation 
hearing, on the issue of Federal statistics and the importance 
of having appropriate and accurate Federal statistics. A number 
of us in the Congress--71 Members, 29 Senators and 42 House 
Members--have written to the President about the elimination of 
the Survey of Income and Program Participation series, and we 
urge the Administration to try to find money with which to 
continue that particular program.
    I think if the Chairman of the Fed would take a keen 
interest in Federal statistics, it would be very helpful in 
assuring ourselves that we have accurate and reliable data upon 
which to make some of these decisions. Major decisions are 
being made that have vast economic implications, and yet the 
amount of money going into the methodologies is very, very 
limited. We were never able to get Chairman Greenspan to agree 
to any spending program except Federal statistics. He did on 
one occasion say that he thought we ought to do more. So I 
would just leave that idea with you. Thank you very much.
    And thank you, Senator Reed.
    Representative Saxton. Thank you very much, Senator 
Sarbanes.
    Senator Bennett.
    Senator Bennett. Thank you very much, Mr. Chairman.
    I would note your comment with respect to rate hikes. 
Everybody wants to read into what you are saying to get an 
advance understanding of what is going to happen tomorrow. My 
own sense is that the economic information tomorrow is going to 
be very strong with respect to GDP growth in the first quarter; 
you indicated your assumption that that will be the case. My 
market watchers say that could be really bad for the market, 
because when the GDP numbers come out very strong, that means 
the Fed is going to raise interest rates and they are all going 
to sell off in anticipation of that.
    I recognize that there is no way you or I can anticipate 
what you are going to do at the next FOMC meeting but, 
following up on Senator Sarbanes, I would just reassure the 
people who were concerned about this, Chairman Bernanke has 
said that even if in the Committee's judgment the risk to its 
objectives are not entirely balanced, at some point in the 
future the Committee may decide to take no action at one or 
more meetings in the interest of allowing more time to receive 
information relevant to the outlook.
    That is a very Greenspan-type statement, sufficiently 
tipped in both directions, but I take it as a signal that what 
you have said to Senator Sarbanes here is correct, that we are 
getting to the point where this almost automatic increase is 
not going to occur. And Chairman Greenspan made it very clear 
in his statements that there was going to be an automatic 
increase every single time they met when the rate was 1 
percent. And he tried to be as clear as he ever could be that 
that was going to happen, and I welcome this statement and I 
think in this conversation we have had, we ought to highlight 
it one more time, as I have done.
    Now, let's talk about the global savings glut. You have 
made mention of that, suggesting that one of the explanations 
for the persistence of relatively low long-term interest rates 
has come from a global savings glut. And as long as we are 
looking into crystal balls and trying to predict what is going 
to happen, let's get out of the FOMC crystal ball and look 
around the world. Do you think there is still a global savings 
glut and what is your sense as to how long it is going to 
continue? Because that has a great deal to do with the current 
account deficit and people investing in the United States and 
so on.
    Chairman Bernanke. Thank you, Senator. Just to provide a 
little bit of background, I have argued in the past that there 
is an excess of saving over investment in our trading partners 
around the world and that extra saving has come to the United 
States, has driven down world real interest rates, and has been 
part of the reason for our current account deficit. And I do 
believe that is part of the explanation for why the current 
account deficit of the United States has risen and part of the 
reason why, as I argued earlier, it is really a global issue 
and not just a United States issue to deal with this deficit.
    In terms of whether the savings glut still exists, there is 
a short-term and a long-term answer to that question. Relevant 
to my earlier comment, I think we are seeing a bit of a decline 
in that glut in that interest rates--global interest rates, not 
just those in the United States--long-term rates have risen in 
the last couple of months, suggesting some reduction in the 
excess of savings over investment outside of the United States, 
and I think that is perhaps a small step in the direction 
toward the moderation of the savings glut.
    Longer-term, though, I think there is still a long way to 
go. And, in particular, what is needed is for our trading 
partners, including those in southeast Asia, and also oil 
producers, emerging markets generally, to rely more heavily on 
their own domestic demand as a source of growth rather than on 
exports to the United States.
    To take one example, I do see some encouragement that the 
Chinese are at least talking about these issues, that they have 
recognized that it is not in their interest to run their 
economy as an export-led economy indefinitely, and that they 
are at least discussing some approaches to increase domestic 
consumption in order to reduce the amount of saving that they 
put into the world capital markets.
    So these are steps that are promising. It is still very 
early; there is not much to be seen from it yet. But that is 
the kind of development that, over a number of years, will help 
rebalance the world economy so that the U.S. is not importing 
goods and capital at such a high rate and other countries are 
growing more from their domestic demand and less from exports.
    Senator Bennett. So if I can summarize without putting 
words into your mouth, the solution to the current account 
deficit given the scenario you have outlined, could very well 
come in slowly over time rather than dropping off a cliff, and 
we could see this thing resolve itself in the next, say, within 
the next decade or so.
    Chairman Bernanke. I would not expect it to resolve in a 
short period. It is going to take quite a few years for these 
balances to readjust internationally.
    Senator Bennett. But you do not see it dropping off a 
cliff.
    Chairman Bernanke. I do not expect any such change.
    Senator Bennett. Good. Thank you.
    Representative Saxton. Thank you very much, Senator.
    We are going to go now to Mrs. Maloney, the gentle lady 
from New York.
    Representative Maloney. Thank you.
    Welcome, Mr. Bernanke, and thank you for your testimony. 
Democrats are concerned not only about price stability and 
maintaining and controlling inflation, but also jobs, wages, 
and continuing to grow our economy. We are very concerned that 
in the recovery the economic positive impact has not shown up 
in the wages of the average worker and there has been a decline 
in the past 2 years, and we hope you will take that into 
consideration as you develop monetary policy.
    My constituents are very concerned, I would say even 
nervous about this continued clip or pace in the increase in 
interest rates--it has been raised 15 times since June of 2004, 
and there is a feeling that maybe we should step back a few 
steps and just assess where we are. And there is a deep concern 
about it and I wanted to relay that to you. My question is can 
we continue to increase interest rates without having a 
negative impact on our economic growth?
    Chairman Bernanke. Thank you for the question. Let me just 
address a few parts of it, if I might.
    On wages, real wages have not grown at the pace we would 
like to see. There are a number of reasons: energy prices have 
clearly sapped consumer buying power. There has been a spread 
between real wages and compensation reflecting increased health 
costs, health insurance costs, for example, and, most puzzling, 
real wages have not apparently caught up with the productivity 
boom that we have seen going on in the economy.
    My suspicion is that as the economy continues to strengthen 
and labor markets continue to strengthen, we will see further 
increases in real wages and that will be very desirable. I 
would also add that I do not believe that higher real wages are 
inflationary. Higher real wages can be offset by higher 
productivity and they can be offset by lower margins between 
costs and selling prices. And so I do hope to see higher real 
wages going forward.
    With respect to the Fed's mission, as I argued before, it 
is like the seventies when inflation was out of control and 
those were not good times for workers either. I think we all 
benefit from price stability. The Fed has a very important 
objective in maintaining price stability and credibility that 
is going to keep prices at a stable point. And I believe that 
doing so supports strong and stable employment growth, and that 
is the other part of our mandate, to which we are going to pay 
very serious attention.
    Representative Maloney. Do you believe we can continue to 
raise interest rates without having a negative impact on our 
economy?
    Chairman Bernanke. I think we will try to raise rates, if 
we do, in a way that maximizes the attainment of our 
objectives, which are price stability and maximum sustainable 
employment growth. Employment growth that is not sustainable 
and which leads to----
    Representative Maloney. Mr. Chairman, are we not near full 
employment now, so----
    Chairman Bernanke. But the underlying growth of the 
economy, which is being determined by a very robust 
productivity increases, is still going to be quite healthy, and 
so my anticipation is that for example, in 2006 we are still 
going to see growth in the range between 3 and 4 percent, a 
very healthy pace of growth, and I believe that would be 
consistent with our attempts to keep inflation well anchored.
    Representative Maloney. In your testimony you said our 
accounts deficit, our trade deficit, was 6-6\1/2\ percent of 
GDP and that this was unsustainable and that our world 
partners, our global partners, are saying the same thing. Right 
now we have very low national savings and also this large trade 
deficit. What role does fiscal discipline have in addressing 
these problems and, second, what will happen if we do not get 
control of the Federal budget? What will happen?
    Chairman Bernanke. Well first of all, it is very important 
that we get control of the fiscal situation, particularly over 
the longer term. As my testimony elaborates, in particular as 
our society ages, the share of GDP going to the three major 
transfer programs is going to go from about 8 percent of GDP 
today to about 16 percent in 2040. And if that were to 
transpire as forecast, we would be faced either with 
essentially cutting all other types of spending or raising 
taxes quite substantially. So there are some very hard choices 
to be made if our Federal budget is going to be sustainable 
into the next few decades. That is very important, and we need 
to be thinking about that soon. The sooner we make these hard 
choices, the better the economy will be able to adjust whatever 
changes we make.
    With respect to the current account, there is a link, a 
somewhat weak link, between fiscal and current account 
deficits. To the extent that fiscal deficits reduce national 
saving, that in turn contributes to the need to borrow abroad, 
which a part of what the current account deficit is about. 
Unfortunately, most of the research suggests that fiscal 
consolidation by the United States on its own will only have 
modest impacts on the current account deficit. Every dollar or 
so by which the fiscal deficit is reduced by most estimates 
would only reduce the current account deficit by 20 or 30 cents 
for various reasons that I could get into.
    But the implication is that the United States really cannot 
solve the current account deficit problem by itself. It is a 
global issue. We need the cooperation of our trading partners. 
And all together, by taking actions which are in our own 
individual interest, we can also help create a better balance 
in terms of trade flows as well.
    Representative Maloney. My time is up. I did want to ask 
what we could do about this growing inequality, but maybe the 
next round.
    Chairman Bernanke. Sure.
    Representative Saxton. We are going to go to Mr. Ryan next, 
but I cannot help but talk a little bit here just for a minute 
about a real-life experience that I had relative to interest 
rates and inflation expectations. In 1965, I graduated from 
college and in 1966, I became a real estate salesman. And I 
remember for quite a few years whether I went to Bank A, B, or 
C, the interest rate on home mortgages was 6 percent. And as we 
got to the late 1970s all of a sudden inflation became an 
issue. And by the end of the seventies, 1978, 1979, inflation 
had reached double digits. And when we went to the bank with 
the person who wanted to buy the house, they were told the 
interest rate was 18, 19 or 20 percent. And when I asked the 
bankers why that was, they said because we don't know what 
inflation is going to be next year. Our expectation is that we 
don't know, and therefore we have to hedge against even higher 
inflation than 10 or 11 percent.
    Today's interest rates are back where they were essentially 
in 1966, when I was a young guy and a real estate salesman. And 
today home mortgage interest rates are at 6 percent because the 
expectations of inflation going forward are that inflation is 
under control. And I credit the policy of the Fed over the past 
couple of decades for bringing us back to 1966 levels of 
mortgage interest rates.
    I wanted to note that because everyone in the public should 
have the opportunity to understand what it is that the Fed has 
been successful in doing over these years. And I don't know 
whether you would like to comment further on that, but this is 
an extremely important element going forward with respect to 
economic growth.
    Chairman Bernanke. I would just add that it's often 
neglected that the third part of our legal mandate is to 
maintain low to moderate long-term interest rates and that is, 
of course, best achieved by keeping inflation not only low, but 
keeping a high degree of confidence among bond traders and the 
like that it will stay low.
    Representative Saxton. We have a chart over here that shows 
the path of inflation during the decades of the 1980s and 1990s 
and into 2000. It very clearly shows that during the early 
1990s inflation peaked out at a very moderate 4.5 to 5 percent 
and today we are down to a rate that appears to be under 2 
percent. And so these are what creates the environment in which 
long-term rates are set. And so to the extent that we thank you 
and your predecessor for helping us to understand this, it has 
been a very, very healthy process.
    [The chart entitled ``Inflation'' appears in the 
Submissions for the Record on page 41.]
    Mr. Ryan.
    Representative Ryan. Thank you, Chairman. We have belabored 
monetary policy so I am going to switch to fiscal policy, but I 
want to just make one point. Chairman Bernanke, I am very 
pleased and encouraged with what you had to say about inflation 
targeting. To the extent that the Fed can institutionalize 
expectations and smooth out the investment horizons and remove 
further uncertainty by being more transparent with inflation 
targeting, I think that is a fantastic contribution you can 
bring to the Federal Reserve, so I am very encouraged with your 
statements on that.
    On fiscal policy, we are in the midst of considering tax 
legislation right now as to whether or not to extend the tax 
cuts that passed in 2003. Many of us are concerned that large 
tax increases at this time, during our economic recovery, would 
be a bad idea. I just want to go through a few statistics, 
because we have seen people make points to the contrary which 
don't necessarily add up.
    Since the 2003 tax cuts--first of all, our unemployment 
rate was 6.3 percent at that time. Now it is at 4.7 percent. 
Since the 2003 tax cuts, we have gained net in the employment 
survey 5.2 million new jobs. Our economic growth rate, the 10 
quarters preceding the tax cuts was 1.3 percent, the 9 quarters 
since then it has been 3.9 percent; so we have seen a 
remarkable turnaround I would say due in large part to the 
fiscal policy of our country. But now is the time to talk about 
whether or not to extend these things. And people have been 
talking about revenues.
    When we passed it--I serve on the Ways and Means Committee, 
and we looked at these revenue projections quite a bit. And we 
thought, according to our estimates, that we would increase the 
deficit or that we would actually see a reduction in revenues. 
And what actually ended up turning out was that our revenue 
projections by the Joint Committee on Taxation didn't 
materialize; actually revenues increased at these lower tax 
rates. Economic revenues from the individual side in 2004 were 
up 1.9 percent at the lower tax rates and the corporate income 
tax receipts were up 43.7 percent in 1904. In 1905, revenues 
were up 14.6 percent on the individual side and 47 percent on 
the corporate side.
    At this moment, we are debating tax legislation as to 
whether or not to extend the 2008 deadline on capital gains and 
dividends. And that is where some people are saying the 
dividends--the capital gains tax cuts cost us money.
    The Joint Committee on Taxation at the time, in 2003, told 
us that we would lose $27 billion in revenue in lower receipts 
over the years 2004-2005. What actually materialized, the 
actual revenues were, realization surged and receipts went up. 
The receipts increased by $26 billion. So we went from a 
projection of a $27 billion loss over 2004 and 2005 to actually 
increasing tax receipts from capital gains at the lower tax 
rate by $26 billion over that, so an enormous difference.
    The question I basically have is do you agree that the tax 
cuts have been helpful to economic growth, and do you see a 
benefit in providing predictability to investors on tax rates? 
I clearly can tell that you believe there is a benefit to 
providing certainty with respect to monetary policy, thus the 
discussion on inflation targeting. Do you believe that there is 
a benefit to the economy and to investors by providing 
certainty on tax rates given the fact that virtually every 
corner of the Tax Code is up for grabs in either 2008 or 2010?
    Chairman Bernanke. Mr. Ryan, I highly value the nonpartisan 
nature of the Federal Reserve, and for that reason I have 
decided that I will not be advising on specific individual tax 
and spending programs. I will make a couple of comments, 
though, which I hope will be useful.
    One is that I do agree that fiscal policy, along with 
monetary policy, was an important factor in helping to restart 
the economic engine in this latest episode, and some of the 
statistics you quoted suggest that we did go from a very weak 
situation early in 2003 to a much stronger growth path after 
that.
    The other comment I would make on your issues with respect 
to revenues I have addressed in a recent letter, and that 
concerns the issue of dynamic versus static scoring. To the 
extent that tax cuts, for example, promote economic activity, 
the loss in revenues arising from the tax cut will be less than 
implied by purely static analysis which holds economic activity 
constant.
    There is currently an important and interesting debate 
going on to the extent to which so-called dynamic scoring 
should be used in the Congress. I don't want to come down with 
a definite recommendation. One issue is that any dynamic 
scoring model requires some assumptions about what theory, what 
model, you are going to use to make the assessment, and, 
therefore, you are going to have to look at different 
alternatives in coming up with an outcome. But I do think it is 
worth considering an alternative range of scoring mechanisms to 
give Congress a sense of what the possible outcomes would be on 
the revenue side from different tax changes.
    Representative Saxton. And as to promoting certainty in the 
investment markets and in households and businesses to the tax 
climate in the future?
    Chairman Bernanke. Well again, I don't want to make a 
definite recommendation. The specifics of the dividend tax 
extension, for example, would involve not only considerations 
of efficiency, but also considerations of equity and revenues. 
But looking strictly at the efficiency side, clearly more 
certainty about the tax code--and I think this applies to any 
tax regulation--when people know the tax rules are going to be 
stable, they are going to have stronger effects and more 
positive effects than if they are worried that they are going 
to be changing from year to year.
    Representative Saxton. Thank you.
    Senator Bennett. Senator Reed.
    Senator Reed. Thank you, Mr. Chairman. Thank you for your 
testimony today. And just in line with the question about the 
effect of tax cuts, the former chairman of the Council of 
Economic Advisors, Greg Mankiw, wrote in his macroeconomic 
textbook that there is no credible evidence that tax cuts pay 
for themselves and that an economists who makes such a claim 
is--quote--``a snake oil salesman who is trying to sell a 
miracle cure.'' Do you agree with that?
    Chairman Bernanke. I don't think that as a general rule tax 
cuts pay for themselves. What I have argued instead is that to 
the extent the tax cuts produce greater efficiency or greater 
growth, they will partially offset the losses in revenues. The 
degree to which that offset occurs depends on how well-designed 
the tax cut is.
    Senator Reed. If you will let me--this goes out of the 
realm, I think, of macroeconomics to simple arithmetic. We are 
running a huge deficit, so over time if the tax cut doesn't pay 
for itself and we cut taxes again, we are not likely to help 
the deficit. Is that a fair judgment?
    Chairman Bernanke. Well, the issue as always is whether the 
deficit should be adjusted on the spending side or on the tax 
side, and I have to leave that to Congress, those are very 
difficult value judgments.
    Senator Reed. Well you are very clear in that statement, 
but I can assume that those tough choices that must be made 
include choices on the revenue side as well as the spending 
side, is that your view?
    Chairman Bernanke. I would say that if you are one of those 
who supports low taxes that you also have to accept the 
implication that spending also has to be controlled in a 
commensurate way, whereas if you are in favor of a larger 
government, then you have to accept the corollary that taxes 
have to be higher. So, I think the specific law I am arguing 
for here is the law of arithmetic, which says----
    Senator Reed. Well so am I, but right now the arithmetic is 
not running favorably in terms of those people who want fiscal 
discipline.
    Chairman Bernanke. And I am agreeing that people need to be 
consistent in their choices.
    Senator Reed. Thank you.
    One of the issues that Congresswoman Maloney mentioned and 
I am concerned about also is this growing inequality.
    Your recent survey of consumer finances has some very 
disturbing data. According to the statistics, the top 1 percent 
of families hold more wealth than the bottom 90 percent of 
families combined. And that is accurate, I presume?
    Chairman Bernanke. Yes.
    Senator Reed. It suggests that in most families wage is the 
main source of income. Is that true also?
    Chairman Bernanke. Yes.
    Senator Reed. These figures on wages are not encouraging. 
After accounting for inflation, the median usual weekly 
earnings of full-time wage and salary workers fell by 0.9 
percent between the end of 2000 and the end of 2004, and the 
earnings at the 10th percentile fell by 2.1 percent. But 
meanwhile, earnings for the 90th percentile, the upscale 
workers, were up 4 percent.
    We are seeing a divergence between low-income/moderate-
income Americans, who are losing ground, and very wealthy 
Americans, who are gaining ground. And that has not only 
economic consequences, it has social and moral consequences in 
many respects.
    What do we do about this? What policies can we adopt to, as 
you indicated in your statement, not only increase wages, but 
make sure that those benefits are more equally distributed?
    Chairman Bernanke. Senator, first of all, I agree that the 
increasing inequality in wages is an important social problem, 
first, because we care about our fellow citizens and want to be 
sure that they are living in a decent way, but second, from a 
political point of view our society is based on opportunity, it 
is based on flexibility in labor markets and product markets, 
it is based on open and fair trade, and all of those things are 
at risk if a growing portion of the population feels they are 
not sharing in the benefits from those changes.
    So, I am very concerned about rising inequality. It is a 
very difficult problem. I think it should be made clear that 
the growing inequality in wages which we are seeing is not a 
new phenomenon. It has been going on for about 25 years or so. 
And indeed a good bit of it occurred in the early 1980s.
    There are a number of arguments and analyses about why 
these increases are taking place. My own view, and I think that 
of most economists, is that the dominant factor is the increase 
in the return to skills; the fact that as our society becomes 
more technologically oriented, people who have not necessarily 
formal education, but other kinds of skills, on-the-job kinds 
of training, will get a higher return, get a higher wage.
    So, for a given distribution of education, these changes, 
this skill-biased technical change, is going to cause the wage 
distribution to widen.
    In addition, it has been pointed out in some recent 
research that there is a phenomenon at the very top, the so-
called ``super stars phenomenon,'' which suggests that, given 
the size of our markets and the interconnectedness of our world 
economy, those people who have extraordinary skills can command 
tremendous premiums for their work.
    Consider what a star baseball player receives today versus 
20 years ago, the fact that that player can now play before 
much larger markets and through an international market; that 
affects their wages, as well.
    So again, my main explanation for this phenomenon is the 
higher return to education, the higher return to skills. What 
can we do about it?
    Well first of all, the Federal Reserve will do what it can, 
which is primarily to try to maintain strong and stable 
employment growth, and that is going to keep providing 
opportunities for people and give them on-the-job experience 
that will allow them to have higher wages.
    But more broadly, the only really sustainable response to 
this problem is to alleviate the skills deficit. Sometimes that 
is taken as a counsel of despair because it takes such a long 
time to improve our school system and to bring a whole new 
generation through the system, but I would like to point out 
that skills can be acquired through a whole variety of programs 
and mechanisms, including on-the-job occupational training, 
community colleges, technical schools, and all kinds of other 
vehicles which would allow people to upgrade their skills 
relatively quickly.
    In our current labor market, people with skills like 
commercial drivers' licenses, or practical nursing degrees, are 
at a premium. They have sufficient skills that they are in high 
demand. So, I do think that it is feasible within a medium-run 
period of time to upgrade our skill base sufficiently to make a 
noticeable dent in this inequality.
    I agree it is a very difficult problem, and I hope that we 
will address it because it does pose issues for our political 
economy, as well as for our society.
    Senator Reed. Just a final point. Do you believe it should 
be the conscious policy, for all the reasons you espoused, of 
this Government to raise wages and distribute them more equally 
in terms of our economic performance?
    Chairman Bernanke. Well, in the current Administration?
    Senator Reed. Well, in any Administration.
    Chairman Bernanke. Well, administration after 
administration have tackled the educational issues. This 
Administration has its own program. Others have had others. 
There is a significant amount of money being put into job 
training programs and there have been suggestions for reform 
about how to make that more effective and more efficient.
    There has been a lot of support for community colleges. 
Your colleague, Senator Dole, for example, has often talked 
about the benefits of community colleges.
    I make just one additional comment, which is that one area 
where we are quite deficient is in financial literacy. Many 
people who earn even a moderate income are not able to save and 
to build wealth in part because they may not understand enough 
about banking and financial markets to allow them to do that.
    So, I am very much in favor of activities through the 
Congress, the Federal Reserve, and through the financial sector 
itself to help train people to understand better how to save, 
how to budget, and how to build wealth for themselves and for 
their children.
    Senator Reed. Thank you.
    Thank you, Mr. Chairman.
    Senator Bennett. Thank you very much.
    Senator Sununu.
    Senator Sununu. Thank you.
    Chairman Bernanke, a number of economists and regulators, 
including members of the Fed, have testified to Congress on a 
number of occasions that the business models of Fannie Mae and 
Freddie Mac effectively amount to privatized profits coupled 
with socialized risk that stems from the implied guarantee 
behind their securities.
    Your predecessor spoke clearly of the need for Congress to 
anchor the companies more firmly in their housing mission--
which we all agree is very important but from which they have 
strayed at times--and he noted the danger and the risks that 
are presented to our financial system and the economy by Fannie 
and Freddie's very large, maybe more fairly put, massive 
investment portfolios.
    I have a letter from Chairman Greenspan, Chairman Bennett, 
that I would like to be included in the record----
    Senator Bennett. Without objection.
    Senator Sununu. [continuing]. Which addresses the 
relationship between these portfolios and the housing mission.
    [The letter from Chairman Alan Greenspan to Senator John 
Sununu appears in the Submissions for the Record on page 47.]
    Senator Sununu. But in short, the research done by Fed 
economists has shown that their investment portfolios simply 
act as investment vehicles whereby they can arbitrage their low 
borrowing rates against higher yields for mortgage-backed 
securities. As a result, they earn great profits, but they do 
so in a way that does not result in better accessibility for 
30-year mortgages, and lower interest rates for consumers.
    That is a very profitable arbitrage operation and, as a 
result, we should not be surprised that Fannie and Freddie do 
not support provisions in our GSE legislation that passed the 
Senate Banking Committee that would give a regulator power to 
set limits on those portfolios consistent with their mission.
    Now in the coming months, as they square away the many 
financial and accounting irregularities that have delayed their 
issuing of financial statements, OFAO, their current regulator, 
will lift its requirement that they put aside additional 
capital.
    For Fannie Mae, for example, that is going to result in a 
release of $5 to $6 billion. When that capital is leveraged by 
what is typical for these institutions 30 or 40 times, that 
means that they could potentially grow their portfolios 
dramatically--$250 billion or more.
    This causes me great concern given the very significant 
systemic risks that exist, but I think, fortunately for the 
taxpayers, the Treasury does have some power to limit the size 
of the portfolios, and in particular the statutes governing 
Fannie and Freddie state that the corporation is authorized to 
issue, upon the approval of the Secretary of the Treasury, and 
have outstanding, at any one time, obligations having such 
maturities and bearing such rate or rates of interest as may be 
determined by the corporation--again, with the approval of the 
Secretary of the Treasury.
    So obviously the Secretary has the power in statute to 
clearly limit the issuance of GSE debt.
    My question is that, given the nature of the implied 
guarantee, is this power that has been given to the Secretary 
in statute an important power to have, given the structure of 
these corporations? And under what circumstances should the 
power be exercised?
    Chairman Bernanke. Thank you, Senator.
    I would like first just to comment on the S. 190 
legislation on portfolios. There is a misperception, I believe, 
that the legislation calls for hard caps, or for specific 
numbers, and that is absolutely not the case, as you well know.
    What the legislation tries to do is specifically to anchor 
the size of the portfolio in the housing mission so that it 
serves the mission and not other purposes.
    In particular, the portfolio would be allowed to hold 
affordable housing mortgages that are not otherwise 
securitizable. They would be allowed to hold as much liquidity 
as they wished in order to intervene perhaps in the housing 
markets during periods of stress, but it would be limited in 
securitizable MBS which, beyond a moderate amount for inventory 
purposes and the like, is really not a direct or obvious 
affordable housing reason for those holdings.
    You are correct, as far as I understand, that the Treasury 
does have the power to limit the debt issued by the GSEs, and 
perhaps some power even over the terms or maturities, as you 
suggested.
    My preference, in terms of making sure that this is done 
right would be to ask the Congress to, or hope the Congress 
could, make clear to the regulator what the expectations of the 
Congress were and what the powers of the regulator were. That 
would be, I think from a political economy point of view, the 
right first step.
    If we were unable to achieve progress through Congress, I 
don't think Treasury should abandon that power. I think it 
should consider using it if it believes that the systemic risks 
being generated by the portfolios greatly outweigh the benefits 
that are mandated by the affordable housing mandate.
    Senator Sununu. So in structuring the language in the 
legislation--and you have spoken about the legislation I think 
in past hearings--one, to reiterate, you would not recommend a 
hard cap, and we have no such hard cap in the legislation; are 
certainly comfortable with maintaining portfolios in the kinds 
of securities that you describe; and feel that the portfolio 
should be consistent with the housing mission, as everything 
that they do should be consistent with their mission as 
chartered by Congress.
    One, is that a fair representation of the key elements that 
we consider in the legislation?
    And is there anything else that you think would be 
important to maintaining an appropriate level of flexibility?
    Chairman Bernanke. No, I think that is a fair 
characterization and I agree with that characterization. I 
would just add that the S. 190 bill also has some important 
provisions relating to capital and receivership which are part 
of making the GSE regulator more like a bank regulator with 
adequate supervisory powers.
    Senator Sununu. Thank you.
    Thank you, Mr. Chairman.
    Senator Bennett. Thank you.
    Mr. Hinchey.
    Representative Hinchey. Thank you, Senator.
    Thank you very much. Mr. Chairman. Thank you for your 
testimony here today and for your service. I very much 
appreciated listening to you. It has been very instructive.
    We have heard a lot about the positive aspects of the 
economy, including things like low interest rates, and it may 
have been mentioned also that the productivity rate is now I 
think more than 3 percent. There are a lot of positive aspects 
to that.
    But there are also a conflux of circumstances that need to 
be addressed, I think, as well. We live in a demand economy. I 
think every successful entrepreneur, at least since Henry Ford, 
has understood that. But we are not doing much to deal with 
that end of our economy.
    As you pointed out just a few moments ago, for the last 25 
years or so the median household income of American families 
has been stagnant or declining during that period of time. But 
it has dramatically dropped in the last few years.
    In the last few years, that median household income has 
gone down by almost 4 percent.
    So we are facing a number of circumstances that we are not 
really addressing. Rising income inequality has been mentioned 
on a number of occasions here. We also have very low and 
declining personal savings rates. We have a huge and growing 
debt. And the current account deficit, which you talked about a 
moment ago, is also placing a heavy burden on our economy.
    These rising imbalances are seemingly at the moment 
peculiar to America. You have no other industrial country that 
has this conflux of circumstances in the way that we do. And it 
seems to me that they are essentially impracticable and 
unsustainable.
    So I just would like to hear your opinion on what we ought 
to be doing to deal with these circumstances on the demand 
side. We have this huge tax cut, the benefits of which have 
flown to people who are already very secure, and these benefits 
have made them even more so.
    The primary beneficiaries of that tax cut are the richest 1 
percent and those just a few percentage points below that 
group. But it has little or no effect, obviously, based upon 
these statistics, on the average working family.
    What should we be doing to deal with those economic 
circumstances?
    Chairman Bernanke. Thank you, Congressman. The United 
States is unique in some respects and not in others. We do have 
an unusually large current account deficit. There are some 
smaller countries with large deficits, Japan and Germany have 
surpluses, and I have discussed some of the ways in which we 
can address that particular problem.
    On the long-term issues of the fiscal deficit, one of the 
main drivers there is the aging of the population. In that 
regard, we are perhaps no worse off than some of the other 
major industrial countries which are aging quickly. Even China, 
surprisingly, because of their one-child policy, will become as 
old as the United States by the middle of this century.
    So the aging and the demographic transition and the 
implications that that has for fiscal policy is a broader 
issue, a difficult one, but one that we share with others.
    I have already addressed to some extent the inequality 
issue. We are not the most unequal country in the world by any 
means, but this trend is a disturbing one and it has I think 
unfortunate consequences for our political economy.
    I am not quite sure what you mean by ``demand policies.'' I 
think that if you mean fiscal and monetary policies to bring 
the economy to full employment, I think we have worked hard on 
that and the economy is approaching a sustainable growth path 
consistent with maximum sustainable employment.
    But I do think that if we are going to address wages, and 
in particular inequality in wages, we have to to do that I 
would say on the supply side. That is, by addressing the skills 
gaps that exist among different groups of people in our 
society.
    Senator Reed. Well if that is the case, then we are going 
in the opposite direction because we are cutting back on 
education and training, and we are cutting back on various ways 
in which we can enhance the skill sets of our personnel. We are 
doing that in the context of the Federal budget.
    We are also seeing a decline in pensions as we move away 
from defined benefit to defined contribution benefit pension 
programs. These are going to reduce the economic circumstances 
of people who are working today and those who are about to 
retire.
    So I think the point is that while the emphasis of this 
particular Government, this Congress and this Administration, 
has been on tax cuts and enormous amounts of spending, it is 
not in ways that are going to enhance the economy.
    We are not doing anything, for example, to increase the 
amount of goods that we produce that are marketable both here 
in America and around the world. In fact, the amount of goods 
that we produce that fall into both of those categories is 
declining, and that of course is a major contributor to the 
current account deficit that we are experiencing.
    So are there not other things that we could be doing, and 
should be doing, to deal with those aspects of this economy?
    And although you mentioned that there are other countries 
that have similar circumstances discretely in one or two of 
those categories, I do not think there is any other country in 
the industrial world--no other advanced country--that is 
confronting this confluence of circumstances. And I do not know 
how this economy is going to continue to prosper unless we 
begin to deal with those circumstances which are unique in the 
industrial world.
    Chairman Bernanke. A point on which I am very much in 
agreement is that in thinking about the budget, it is not 
enough just to say what is the total amount that we are 
spending; it is really how well are we spending it?
    The programs we are spending it on, are they effective? Are 
they delivering results? So I would urge Congress to look very 
hard at the mix of programs that you authorize to make sure 
that they are producing returns for the dollar.
    So in particular looking at education, are there ways to 
increase accountability? To increase flexibility? To allow 
schools to do a better job?
    With regard to job training programs: We spend on the order 
of $15 to $20 billion a year on job training programs. Is that 
money being well used? I think it is enormously important for 
us to review those programs on a regular basis to make sure 
that the benefits are flowing to the people who need them and 
not just being lost in the bureaucracy.
    Senator Reed. Thank you.
    Senator Bennett. Mr. English.
    Representative English. Thank you, Mr. Chairman.
    Mr. Chairman, your testimony here has been actually a 
source of not only interest to me today but also a source of 
great encouragement. But I would like to pursue a couple of the 
specific issues that you have brought up in your testimony.
    I first of all found it refreshing that you focused as 
heavily in your printed remarks as you did on the challenge of 
the U.S. current account deficit.
    On that point, you specifically mentioned that you think it 
is appropriate for some of our trading partners to pursue 
exchange rate flexibility.
    In your view, given that China now has massive currency 
reserves, is China in a position to move seamlessly toward a 
position of exchange rate flexibility to benefit themselves, as 
well as presumably to stop dictating for their goods an 
artificial price advantage?
    Chairman Bernanke. China certainly could and should do more 
toward increasing the flexibility of its foreign exchange 
regime. A point I think that is worth emphasizing and that we 
have tried in our bilateral discussions to make with the 
Chinese, and Treasury of course takes the lead on this, is that 
increased currency flexibility is in China's interest.
    It is a very large country. They need to have an 
independent monetary policy. They cannot really run an 
independent monetary policy without a flexible exchange rate.
    Moreover, their current policies are distorting prices 
domestically as well as internationally. And in particular that 
means that their economy is becoming devoted toward export 
production and not toward the production of domestic goods and 
services.
    Finally, as an emerging power in the world trading system, 
China has an interest in global stability, as do we, and by 
reducing its overall trade surplus, by increasing its focus on 
domestic demand, and by increasing the flexibility of its 
currency, it can help improve global stability.
    So for all those reasons, I think they should move further. 
There are technical issues that they are trying to address, but 
they are quite conservative, let's say, in terms of their 
willingness to move further on this issue.
    Representative English. And a remark that you made that I 
found particularly intriguing had to do with your comment about 
the fact that simply reducing the fiscal deficit will have a 
limited impact on the reduction of the current account deficit.
    You know, I know there has been a great deal of political 
rhetoric linking the two deficits together. Could you explore 
for us why there is a limited interaction where a reduction in 
the budget deficit has only a limited impact on the trade 
deficit?
    Chairman Bernanke. Yes, I would be glad to.
    I would first point out that, just looking around the 
world, there is no obvious correlation between trade deficits 
and budget deficits.
    Japan and Germany have budget deficits which are equal to 
or larger than ours and they have large trade surpluses. The 
U.S. trade deficit began to expand in the 1990s at a time when 
we had a budget surplus. And so there is not an obvious 1 to 1 
correlation.
    The issue in this case is: If the United States were to 
reduce its own deficit, if no other action is taken by any 
other country, that would tend to slow down economic activity 
by reducing aggregate demand. The Fed, following its mandate 
for full employment, would lower interest rates, stimulating 
investment spending in the United States.
    And so the investment/savings imbalance would not be much 
changed if that were the only action being taken. And the 
estimates that have been made by not only the Federal Reserve, 
but by the OECD and others, are that a dollar reduction in the 
U.S. budget deficit only would by itself lead to about a 20 to 
30 cent reduction in the current account deficit.
    By contrast, if the U.S. budget deficit reduction were 
accompanied by increased demand abroad so that the Fed would 
not have to respond--that is, exports would take the place so 
to speak of Government spending--then you could get a much 
bigger pass-through from deficit reduction into current account 
deficit reduction.
    Representative English. That is an excellent analysis.
    Mr. Chairman, I had not planned to bring up this final 
point, but in response to some of the strawmen that have been 
brought up earlier in previous questions, I wanted to explore 
the issue of whether tax cuts can actually promote enough 
economic growth to pay for themselves.
    I note that in 2003, before the reduced rates of tax on 
capital gains were passed, the CBO estimated the total capital 
gains liabilities in 2004 and 2005 would be $125 billion.
    Following the passage of the new tax rates, CBO revised its 
estimates and at that point their estimate for capital gains 
tax liabilities in '04 and '05 had fallen to $98 billion, a 
drop of $27 billion.
    Earlier this year, however, CBO reported on actual capital 
gains liabilities in '04 and '05. Rather than falling by the 
projected $27 billion, they actually rose by $26 billion to a 
total of $151 billion.
    Mr. Chairman, I recognize that many factors influence 
capital gains realizations, including the strength of the 
economy, but as many experts have speculated the lower rates 
clearly are partially responsible for improving the economic 
outlook and rising stock prices.
    You know, accordingly, can we look at these actual revenue 
numbers and not conclude that, at least at some level, these 
tax rate reductions have actually produced added revenue for 
the Treasury?
    And, accordingly, slapping on a tax increase because it is 
a tax increase, that some on the other side have suggested in 
this area, might actually generate--might actually not generate 
the revenue that we need in order to deal with the deficit?
    Chairman Bernanke. As you point out, Congressman, this is a 
complex issue. There are a lot of factors affecting both the 
increase in the stock market and realizations. And one of the 
issues here is the question whether or not some realization is 
taking place today which otherwise might have taken place in 
the future.
    And so in that sense the increase in tax revenue is 
reflecting a one-time gain as opposed to a permanent gain. So 
that is one of the issues that you would have to address in 
analyzing the revenue effect.
    But I go back to what I said before, which is that well-
designed tax cuts which stimulate economic activity will at 
least partially offset the revenue losses by stimulating the 
tax base.
    Representative English. Thank you, Mr. Chairman.
    And thank you, Mr. Chairman.
    Senator Bennett. Thank you.
    Mr. Paul.
    Representative Paul. Thank you, Mr. Chairman. I would ask 
for unanimous consent to submit some written questions, if I 
don't get through this.
    Senator Bennett. Without objection.
    Representative Paul. Thank you, and welcome. Mr. Chairman. 
I have a question dealing with inflation targeting, but I 
wanted to make a few assumptions first and have you comment on 
these assumptions, as well.
    You state that inflation is under reasonable control at the 
moment. I have a lot of constituents that would disagree with 
you, and would disagree with the chart because if you look at 
energy and medicine and education and taxes, there's a lot of 
price inflation out there that they are concerned about.
    I think there is a discrepancy in who suffers the most from 
higher prices. Sometimes the wealthy suffer less than the poor 
and the middle class because of the way they spend their money. 
So, one index is not a perfect answer to how people respond to 
inflation.
    One assumption I would have, I think it was Milton Friedman 
who said that inflation is first and foremost a monetary 
phenomenon, and I sort of ascribe to that. And many other 
economists, you know--there's a consensus among many economists 
that would go along with that.
    Another assumption that I would make is that the role of 
the Fed in dealing with the money supply has to do with 
increasing or decreasing the money supply, and yet we mostly 
talk about interest rates, we're raising interest rates or 
we're lowering interest rates. But my assumption is that we're 
manipulating increases or decreases in the money supply in 
order to secondarily affect interest rates.
    Assuming that we did not have an Open Market Committee and 
they ceased purchasing securities, my assumption would be that 
interest rates would go a lot higher, but we don't know exactly 
how high. So the Fed's job, generally speaking, is to keep 
interest rates lower than the market and that the point is 
there's only one way they can do that and that is increasing 
the money supply so, therefore, the money supply is the most 
direct measurement that we need to look at to find out what to 
anticipate with price increases, also recognizing that 
productivity obviously influences that.
    Traditionally we've always measured our dollar in terms of 
gold. The dollar was worth $20--gold was worth $20 an ounce 
when the Fed came into existence. Today that dollar, pre-Fed 
dollar is worth 4 cents. We've had tremendous depreciation and 
devaluation and a lot higher prices since then.
    We had major events throughout history that were monetary 
events. During the Roosevelt era, gold going from $20 to $35, 
and this was considered a devaluation. And then twice under 
Nixon, an 8 percent devaluation and then a 10 percent 
devaluation. And then of course when gold was put into the 
marketplace we had again a lot of devaluation. Gold settled 
down after that, around $250 an ounce, and that's what the 
price of gold was in the early--in 2001. Since that time, gold 
has gone from $250 up to $630, plus or minus. That represents 
more than a 60 percent devaluation of the currency.
    Now in your job in looking at inflation and targeting 
inflation and looking at prices, how important is this? We do 
know that central banks around the world--and our central bank 
is still very much aware of the fact that gold is an important 
monetary element, it is not like we've thrown it away or sold 
it. We hold more gold than anybody else. So it is a monetary 
issue.
    But how do you look at this price? Does this concern you? 
Is it meaningless? What if gold would go to a thousand dollars 
an ounce, how would that affect your thinking about what to do 
with interest rates and the money supply?
    Chairman Bernanke. Thank you, Congressman. You raise a lot 
of interesting questions there. I can address a few of them.
    It's true that we look at core inflation, which leaves out, 
for example, energy and food and the question, as you know, is 
whether that really is representative of the consumer basket 
that the average person is facing. The answer is no. And we are 
interested in maintaining stability of overall inflation.
    Our focus on core inflation is mostly a technical thing, 
because generally speaking energy and food prices are more 
volatile and tend to stabilize more quickly than other parts of 
the inflation basket. That hasn't been true lately, as you 
know, and we really need to pay attention I think to the 
overall inflation rate as well as the core inflation rate.
    You're also quite correct that our interest rate policy is 
closely linked to our control of the money supply, and during 
periods like the recent one where interest rates have been 
rising, you also expect to see slower money growth and that in 
fact has been generally the case, and those two things do go 
together.
    I don't think it's really the case that we keep the 
interest rate lower than the market. If we were doing that, 
then financial conditions would be excessively easy and we 
would probably see more inflation. In fact, although we're 
obviously not perfect at controlling inflation, not only the 
Fed, but other central banks around the world have done a much 
better job in the last few decades at targeting and managing 
inflation and that at least is positive.
    You raise the question of gold, and if your question is do 
I look at the gold price, it's on my screen, I look at it every 
day. I think there is information in gold prices, as there is 
in other commodity prices. But there are also other indicators 
of inflation. For example, there is the spread between indexed 
and nominal bonds--the so-called break even inflation 
compensation, which suggests that inflation expectations are 
relatively well controlled.
    So the puzzle is why are gold prices rising so fast? There 
is probably some fear of inflation; there certainly is some 
speculation about commodity price increases in general, which 
is being driven by world economic growth. But clearly a factor 
in the gold price has got to be global geopolitical uncertainty 
and the view of some investors that, given what's going on in 
the world today, that gold is a safe haven investment and for 
that reason they purchase it.
    So to summarize in trying to forecast inflation, I strongly 
believe that you need to look at lots of different things. The 
commodity and gold prices and oil prices, energy prices, are 
all part of the matrix of things that a good central banker has 
to pay attention to. But no single variable I think is going to 
be adequate for judging the inflation situation.
    Representative Paul. Thank you.
    Senator Bennett. Mr. Brady.
    Representative Brady. Thank you, Chairman Bennett.
    Mr. Chairman, I'm Kevin Brady, a five-term Member from the 
Texas area, east Texas and part of the Houston region. 
International trade is a big job creator for our State and 
obviously helps stretch families' budgets by giving them lower 
prices and more choices when they shop. As a Nation we are a 
fairly open market. How important is it economically that we 
continue to pursue more open markets overseas, more trade 
agreements that lower those barriers and continue to offer more 
consumer choices here at home? How important is it that we 
continue to follow that policy?
    Chairman Bernanke. Congressman, it's extremely important, 
and for more reasons than the textbook will tell you, I think. 
The textbook tells us about comparative advantage, the idea 
that some countries can produce some things cheaper than others 
and therefore it pays them to trade to take advantage of that. 
And that's certainly going on in the world today, we're getting 
specialization across different countries.
    But I think also that an open trading system increases 
competition, it increases the flow of ideas, increases the flow 
of capital, and makes the world overall a more dynamic and 
effective economic environment. And so I think it's a terrible 
mistake to try to shut out the world, to embrace economic 
isolationism and, even though it's not always popular, 
economists and I hope Congress will try to keep trade open.
    There is an issue which is an important one, not to be 
neglected, that while trade provides broad benefits to our 
society and to our economy, there are sometimes people who are 
made worse off by trade, workers who lose their jobs because a 
certain factory goes overseas or because the competition from 
imports is reducing their market. We need to pay attention to 
that concern.
    But rather than attempting to freeze their jobs in place by 
preventing any change in the economy, we're much better off 
allowing the change to take place, but helping people retrain 
or otherwise provide for themselves so that they can join the 
global economy rather than be isolated by it. So I certainly 
agree with your proposition with the proviso that we need to 
pay attention to those who are adversely affected by trade as 
well as those who benefit.
    Representative Brady. I agree. People oftentimes look at 
the trade deficit and proclaim it a failure of our trade 
policy, but your testimony, written testimony, makes the point 
it's much more complex than just how much we buy and how much 
we sell. America is a key investment target overseas. But, it 
is also our failure to save as a Nation is--a factor we can 
control as a solution on current accounts and the trade 
deficit. Is it your view that our best solution or approach is 
increase our savings and increase our sales abroad, which also 
requires other countries to boost their spending and lower 
their barriers? Is that the solution to how we approach this 
problem? It's not to stop free trade, it is to increase our 
savings and our sales.
    Chairman Bernanke. Absolutely. And I think one of the 
reasons to be concerned about the current account deficit is 
that it may promote protectionist impulses which would be very 
counterproductive to our economy.
    Representative Brady. Mr. Chairman, let me finish with this 
thought. I was not going to ask this question, but in the last 
week we've seen a spate of ideas on how to deal with current 
energy prices, from a windfall profits tax to today where I 
read about $100 rebates and gas tax holidays. I won't ask you 
if these are political gimmicks, but I will ask you are these 
substantive? Do these substantively, positively impact the 
fundamental drivers of our energy prices?
    Chairman Bernanke. Congressman, unfortunately the high 
prices we're seeing are due to a multitude of factors, but 
they're driven primarily by supply and demand conditions in the 
world today. We have substantial economic growth which 
generates increased demand, and supply has been very insecure 
for a variety of reasons. And unfortunately there's nothing 
really that can be done that's going to affect energy prices or 
gasoline prices in the very short run. This situation has been 
building up for a long time.
    And what we need to do is think about whether there are 
actions we can take that, over a number of years, will put us 
on a more secure footing and allow for either increased supply 
or reduced demand that will help keep prices down. 
Unfortunately, after many years of not really doing as much as 
we should on the energy front, this situation has arisen and I 
don't see any way to make a marked impact on it in the very 
short run.
    Representative Brady. Does a windfall profits tax increase 
production or in any way lower our gas prices?
    Chairman Bernanke. I don't think it would. Profits taxes 
have the adverse effect of removing one of the major incentives 
of our market system. If people think that their profits are 
going to be taxed away, that reduces their incentive to engage 
in certain activities.
    So I would like to let the market system work as much as 
possible to generate new supplies, both of oil but also of 
alternatives, and for the prices, as painful as they may be, to 
help generate more conservation and alternative uses of energy 
on the demand side.
    Representative Brady. Thank you, Chairman. Thank you, 
Chairman Bennett.
    Senator Bennett. Thank you, Mr. Chairman. This has been a 
most illuminating morning.
    Representative Hinchey. Mr. Chairman, are you concluding?
    Senator Bennett. Did you want a second round?
    Representative Hinchey. If you don't mind. It's not quite 
20 of.
    Senator Bennett. All right. Well, in that case, I'll use my 
prerogative to comment and then yield to you.
    I'm on my way tonight to Brussels, where I will be 
addressing, with some other Members of both the House and the 
Senate, economic issues with members of the European Union. As 
your testimony makes clear, the United States would not trade 
its place economically with any other country in the world. If 
you look at the level of unemployment, if you look at the level 
of deficit computed as a percentage of GDP--rather than in 
total dollars--and if you look at the aging populations and the 
demographic projections in other developed countries of the 
world, and every other country would like to be where we are, 
which is not to say we don't have serious problems.
    But I think we should put it in that perspective, and 
that's going to be, I think, some of the conversations we will 
have in Brussels.
    With your predecessor, Chairman Greenspan and I used to 
have a kabuki dance that we went through every time he appeared 
before this Committee, and I had not planned to do it here, but 
it keeps coming up. I would always ask him, stroking my chin in 
a thoughtful fashion, as if it has just occurred to me, Mr. 
Chairman, what is the ideal capital gains rate?
    And he would stroke his chin and say, Senator, the ideal 
capital gains rate is zero. And I would say, thank you, and, 
you know, we would do that every time he came, because capital 
gains means if there's a capital gains tax rate, it locks the 
capital to the degree that the rate is high, in its current 
investment.
    And it may well be that the entrepreneur or the venture 
capitalist who has built, by his investment, Business A, now 
wants to sell Business A to the pension fund that's perfectly 
happy with the mature investment, and move that venture capital 
to Business B, that creates an opportunity for more 
entrepreneurial activity, and, thereby, more wealth.
    But there is a barrier to making that movement from a 
mature business to an entrepreneurial activity, in the form of 
a tax. As we lower that tax barrier from 28 percent to 20 
percent, we see more capital flowing over the wall, if you 
will.
    And when we lowered it again to 15 percent, we saw more 
capital flowing over the wall, and I would like to see the 
barrier disappear altogether, because the two things that are 
essential to create wealth, are accumulated capital and risk-
taking.
    And if the accumulated capital is held in one place where 
the risk-taking--it can't join with the risk-taking in another 
place, the economy, as a whole, doesn't get the benefit of the 
growth.
    Now, that's my non-professional economic analysis, and 
having done that dance with Chairman Greenspan, I now give you 
an opportunity to comment on it one way or the other, and 
disagree with your predecessor, if you will, but let's at least 
discuss that, because I think that is the major issue with 
respect to capital gains.
    It has to do with the movement of capital to the place 
where it can produce within the economy, ultimately the most 
wealth.
    And I would add this comment: When we asked Chairman 
Greenspan, during the great expansion of the late 1990s, who is 
benefiting the most, even though the statistics were showing 
the great growth at the top, he very instantly said, the people 
who benefited the most from this booming economy, is the bottom 
quintile, because they have jobs.
    And the difference in lifestyle for Bill Gates, by this 
growth, is really nothing, but the difference in lifestyle by 
people who can't get jobs who now can, because there's a 
booming economy, is night and day.
    So, regardless of the statistics, the people who benefit 
the most from a growing economy and the creation of wealth are 
the people at the bottom. And that's what we all need to be 
concerned about, so I'd be interested in your responses.
    Chairman Bernanke. Well, Senator, I think most public 
finance economists would agree that, on an efficiency basis, 
the zero tax rate on capital gains is the optimal one. You can 
see that, for example, in the President's Tax Panel, which 
tried to push our system toward a consumption-based tax; that 
is, one which exempts from taxation returns to savings, 
including dividends and capital gains, the idea being that by 
exempting savings from taxation, you create more rapid capital 
accumulation and that does generate broader economic growth.
    So, as a theoretical matter, I think that's correct. Again, 
I want to be very careful not to make an unambiguous 
recommendation, and I would just point out that people may 
differ about the equity implications in terms of who benefits 
the most from a cut in capital gains taxes, and that to the 
extent that there are revenue effects--and we just had some 
discussion about how big they might be and whether they are 
temporary or permanent--issues of the deficit and funding and 
government spending, would also arise.
    So, the final policy decision is a complex one, but I think 
that purely from an efficiency perspective, it's a fairly broad 
view among public finance economists, that capital income 
should be taxed at a low rate.
    Senator Bennett. Thank you.
    Mr. Hinchey.
    Representative Hinchey. Thank you very much, Mr. Chairman, 
and, thank you, Mr. Chairman. I have a number--actually, I 
think, a large number of constituents who take the position 
that the optimum tax rate on wages should be zero percent. 
That's a slightly different point of view, from a different 
perspective.
    I want to----
    Senator Bennett. I'll be happy to join them----
    (Laughter.)
    Senator Bennett [continuing]. If we find another way to 
finance the government. I don't think wages is the most 
efficient way to do it.
    Representative Hinchey. Let's talk, Mr. Chairman, let's 
talk.
    I very much appreciate your solid and straight answers to 
the questions that were delivered today, including the one 
about the payback on tax cuts. Your predecessor said something 
very similar in testimony before the House Budget Committee. He 
said: ``It's very rare and few economists believe that you can 
cut taxes and you will get an equal amount of revenues. When 
you cut taxes, you gain some revenue back. We don't know 
exactly what this amount is, but it's not small, but it's also 
not 70 percent or anything like that.''
    And we have similar statements from the Congressional 
Budget Office and the Congressional Research Service. The one 
that I liked the best was the one from the former Chairman of 
the Council of Economic Advisors, Greg Mankiw, who wrote in his 
macroeconomic textbook, and he says and I quote, ``There is no 
credible evidence that tax cuts pay for themselves and an 
economist who makes such a claim, is a snake oil salesman who 
is trying to sell a miracle cure.''
    So we have some interesting points of view on this 
particular issue.
    I wanted to just ask you about the dollar. We have a 
national debt now which is about $8.33 trillion. Congress just 
raised the debt ceiling a couple of weeks ago--3 weeks ago, to 
just below $9 trillion.
    Projections are now that within the next 5 years, that the 
national debt is going to exceed $11 trillion, based upon the 
circumstances that are prevailing currently. This year, we're 
anticipating a budget deficit of $379 billion.
    The circumstances here have got to be putting enormous 
pressure on the value of the dollar. We've seen the value of 
the dollar decline recently, and I'm wondering what you would 
say about the potential for the strength of the dollar, given 
these economic circumstances of huge growing debt and these 
huge annual budget deficits that are fueling that growing debt, 
and the current accounts deficit, which--I'm not sure what that 
number is, but I think it's something in excess of, what--what 
is the current accounts deficit?
    Chairman Bernanke. Eight hundred billion dollars.
    Representative Hinchey. Eight hundred billion, yes, a 
little over $800 billion.
    What does this mean for the value of the dollar? Is the 
value of the dollar going to go down?
    We have the situation and an interesting report from the 
IMF. They report that the internal purchasing parody of the 
Chinese currency is more than five times its external value. 
Given the outcome of the recent visit of the President of 
China, there doesn't seem to be any indication that those 
circumstances are likely to change.
    What do we have to anticipate with regard to the pressure 
on the value of our dollar?
    Chairman Bernanke. Well, Congressman, I just wanted to say 
a word about the Federal debt, which you mentioned, first of 
all. There are different ways of measuring it, and you get 
somewhat different answers.
    The debt limit includes a lot of debt with the government, 
like the Social Security Trust Fund, for example, and if you 
look at the debt held by the public, including the Federal 
Reserve, you find that it's something on the order of 40 
percent of GDP, which is lower than a number of other 
industrial countries.
    From that perspective our current deficit last year was 2.6 
percent of GDP, so in a short-term sense, we are in a 
comparable situation with other industrial countries.
    I think we have a much larger problem, if you take an 
unfunded liability approach and say, well, what is it that we 
really owe to our senior citizens, based on the promises we've 
made in Social Security and Medicare, and there you get a much 
larger number, so that that's an issue.
    I don't think the Federal debt has a great deal to do with 
the dollar. The usual arguments have to do with the current 
account deficit and the dollar, and here, I'd like to, I guess, 
make a clarification.
    There was some media report that the discussions of the G7 
over the weekend, had discussed some kind of depreciation of 
the dollar or managed depreciation of the dollar as part of the 
strategy for addressing the U.S. current account.
    That is not correct. The G7 supports a market-determined 
dollar, not a managed dollar.
    In terms of making forecasts, as I think Chairman Greenspan 
often said in this context, you can forecast the dollar and 
half the time, you're going to be right.
    The experience is that forecasting the dollar is very 
difficult, and we want to just leave it to market forces to 
determine where the dollar is going to be.
    Representative Hinchey. Thank you.
    Senator Bennett. Thank you very much, Mr. Chairman. We 
appreciate your being here, and look forward to continued 
meetings with you, with the JEC.
    This Committee was created by the Humphrey-Hawkins Act, as 
Senator Humphrey wanted to increase the connection between the 
Fed and the Congress, and established these regular reports.
    We know you have other things to do, but we're grateful for 
your willingness to come spend the morning with us on the Hill. 
The hearing is adjourned.
    Chairman Bernanke. Thank you, Senator.
    (Whereupon, at 11:55 a.m., the hearing was adjourned.)

                       Submissions for the Record

=======================================================================

       Prepared Statement of Representative Jim Saxton, Chairman

    Chairman Bernanke, it is my pleasure to welcome you this morning 
before the Joint Economic Committee (JEC). We appreciate your testimony 
on the economic outlook.
    According to the official data, a healthy economic expansion has 
been underway for several years. The U.S. economy advanced 4.2 percent 
in 2004, and 3.5 percent in 2005. As I have noted many times, the pick-
up in economic growth since the middle of 2003 is mostly due to a 
rebound in investment activity, which had been weak. This rebound was 
fostered by a mix of Fed monetary policy and the 2003 tax legislation 
and its incentives for investment.
    The continued economic expansion has created 5.2 million payroll 
jobs since August of 2003. The unemployment rate, at 4.7 percent, is 
below its average levels of the 1970s, 1980s, and 1990s. Federal 
Reserve and private economists forecast that business investment and 
the overall economy will continue to grow this year.
    As the Fed noted in a policy report last February, ``the U.S. 
delivered a solid performance in 2005.'' The Fed also stated that the 
``U.S. economy should continue to perform well in 2006 and 2007.'' 
Recent data indicate that the economic growth rate for the first 
quarter of this year will be quite robust when it is released tomorrow.
    According to a broad array of economic data, the outlook remains 
positive. Consumer spending is expected to be solid in 2006. 
Homeownership has reached record highs. Household net worth is also at 
a record level. The trend in productivity growth remains strong. 
Although high oil prices have raised business costs and imposed 
hardship on many consumers, these prices have not derailed the 
expansion.
    Meanwhile, long-term inflation pressures are contained. As a 
result, long-term interest rates, such as mortgage rates, are still 
relatively low, although these rates have edged up in recent weeks. 
According to the Fed's preferred price index, inflation is well under 
control.
    In sum, current economic conditions are strong. With economic 
growth expected to exceed 3 percent this year, the economic outlook 
remains positive.

                               __________

      Prepared Statement of Senator Robert Bennett, Vice Chairman

    It is a pleasure to welcome the Honorable Ben Bernanke, Chairman of 
the Board of Governors of Federal Reserve System, before the Committee 
this morning. We view your testimony on the economic outlook as a 
continuation of the longstanding productive exchange between the 
Federal Reserve and the Joint Economic Committee.
    A wide range of economic data confirms that the U.S. economic 
expansion remains on a solid foundation. Growth in the inflation-
adjusted, or ``real,'' gross domestic product increased 3.5% during 
2005, on the heels of over-4% growth in 2004. Real GDP has now been 
growing for 17 consecutive quarters. Most private forecasters believe 
that growth for the first quarter of this year will be a sizeable 
acceleration from the temporary lull in the final quarter of 2005 and 
growth is then expected to return to more trend-like, yet still 
healthy, rates through the remainder of the year.
    The unemployment rate has fallen to 4.7 percent, the lowest level 
in five years and stands below the averages of the 1960s, 1970s, 1980s, 
and 1990s. In 31 consecutive months of job creation, payroll employment 
in the Nation has expanded by over 5.1 million new jobs. Last year 
alone, 2 million new jobs were added to business payrolls.
    While long-term interest rates, including mortgage rates, have 
edged up recently, they remain low by historical standards and 
financial conditions of households and businesses seem to be in 
reasonably good shape. Activity in housing markets has recently been 
showing signs of cooling, but levels of activity remain strong.
    Although headline consumer price inflation has been boosted by 
another round of increased energy prices, so-called ``core'' consumer 
price inflation remains relatively steady and measures of inflation 
expectations remain stable.
    Nevertheless, last year was the third consecutive year of rising 
and volatile energy prices, and we all feel how energy price increases 
have cut into households' purchasing power and the profitability of 
non-energy producing businesses. The economy has remained resilient in 
the face of escalating energy prices, but further increases pose a risk 
to future growth and inflation.
    As I mentioned, the economic expansion remains on a solid 
foundation. And I believe that one important ingredient that helped 
generate the robust economic growth over the past few years is the 
enactment of pro-growth tax relief in 2003.
    We look forward to your review of recent economic developments and 
your outlook for the U.S. economy.
    Welcome, again, Chairman Bernanke.

                               __________

       Prepared Statement of Senator Jack Reed, Ranking Minority

    Thank you, Chairman Saxton. I want to welcome Chairman Bernanke and 
thank him for testifying here today.
    All eyes are on you, Chairman Bernanke, as you embark on a tricky 
high-wire act in which you allow the economy to grow and employment to 
reach its full potential, while you remain mindful of the risks of 
inflation. For some time, the Fed's job had been easier--it had room to 
raise interest rates from very low levels with little risk of derailing 
the economic recovery, while inflation and other lurking economic 
problems were at bay. Today, soaring energy prices, record budget and 
trade deficits, a negative household saving rate, and a disappointing 
labor market recovery all pose tremendous challenges to setting 
monetary policy.
    The Fed has raised its target for the federal funds rate by 25 
basis points at each of the last 15 FOMC meetings. According to the 
minutes of the March meeting, most members of the FOMC thought that the 
end of the tightening process was near. The question on everyone's mind 
is: are we there yet? The phrase we are hearing is that interest rate 
changes will now be ``data driven.'' So I hope that means, Chairman 
Bernanke, that the Fed will look hard at the full range of data on 
economic growth, employment, and inflation to determine the best course 
for monetary policy.
    GDP is growing, but the typical American worker has been left out 
of the economic gains of this recovery. Strong productivity growth has 
shown up in the bottom lines of shareholders but not in the paychecks 
of workers. Too many Americans are being squeezed by stagnant incomes 
and rising costs for gasoline, health care, and education. It seems to 
me that there is still room for real wages to catch up with 
productivity before the Fed needs to worry about inflationary pressures 
from the labor market.
    However, there are many other downside risks to the economy on the 
horizon. Energy prices have been pushing up overall inflation for some 
time. But last month, we saw an uptick in core inflation, which might 
be an early sign that businesses are starting to pass on their higher 
energy costs to customers. Rising oil prices and interest rates coupled 
with a weakening housing sector could take their toll on consumers and 
businesses alike and slow down the economy too much.
    Your task in setting the right course for monetary policy is 
complicated by fiscal policy and international imbalances. We no longer 
have the fiscal discipline that we had in the 1990s, which allowed for 
a monetary policy that encouraged investment and long-term growth. The 
President's large and persistent budget deficits have led to an ever-
widening trade deficit that forces us to borrow vast amounts from 
abroad and puts us at risk of a major financial collapse if foreign 
lenders suddenly stop accepting our IOU's.
    Even assuming we can avoid an international financial crisis, 
continued budget and trade deficits will be a drag on the growth of our 
standard of living and leave us ill-prepared to deal with the effects 
of the retirement of the baby-boom generation. Strong investment 
financed by our own national saving--not foreign borrowing--is the 
foundation for strong and sustained economic growth and rising living 
standards.
    One final issue that I would like to raise is the growing 
inequality of income, earnings, and wealth in the U.S. economy. Your 
predecessor, Chairman Greenspan, regularly raised that issue as one of 
concern for our political economy--it is not good for democracy to have 
widening inequality. I know you share these concerns. Recently, the 
Federal Reserve published the results from the 2004 Survey of Consumer 
Finances. They show that growth in median income and wealth have slowed 
substantially and the top 1 percent of families hold more wealth than 
the bottom 90 percent of families.
    In this environment, it is hard to understand why the 
Administration is continuing to pursue policies that add to the budget 
deficit by providing tax breaks to those who are already well-off, 
including the permanent elimination of the estate tax. Meanwhile, they 
continue to propose budgets that cut programs for those who are 
struggling to make ends meet. Mr. Chairman, I know you don't want to 
get into the specifics of particular policies, but I hope you can offer 
us some insights about the kinds of policies that are likely to be 
effective in addressing the real challenges we face in this economy and 
offering real opportunities for growth that provides widespread 
benefits to the American people.
    I look forward to your testimony on the economic outlook and to a 
discussion of these issues.

                               __________

 Prepared Statement of Hon. Ben Bernanke, Chairman, Board of Governors 
                     of the Federal Reserve System

    Mr. Chairman and members of the Committee, I am pleased to appear 
before the Joint Economic Committee to offer my views on the outlook 
for the U.S. economy and on some of the major economic challenges that 
the Nation faces.
    Partly because of last year's devastating hurricanes, and partly 
because of some temporary or special factors, economic activity 
decelerated noticeably late last year. The growth of the real gross 
domestic product (GDP) slowed from an average annual rate of nearly 4 
percent over the first three quarters of 2005 to less than 2 percent in 
the fourth quarter. Since then, however, with some rebound in activity 
under way in the Gulf Coast region and continuing expansion in most 
other parts of the country, the national economy appears to have grown 
briskly. Among the key economic indicators, growth in nonfarm payroll 
employment picked up in November and December, and job gains averaged 
about 200,000 per month between January and March. Consumer spending 
and business investment, as inferred from data on motor vehicle sales, 
retail sales, and shipments of capital goods, are also on track to post 
sizable first-quarter increases. In light of these signs of strength, 
most private-sector forecasters, such as those included in the latest 
Blue Chip survey, estimate that real GDP grew between 4 and 5 percent 
at an annual rate in the first quarter.
    If we smooth through the recent quarter-to-quarter variations, we 
see that the pace of economic growth has been strong for the past 3 
years, averaging nearly 4 percent at an annual rate since the middle of 
2003. Much of this growth can be attributed to a substantial expansion 
in the productive capacity of the U.S. economy, which in turn is 
largely the result of impressive gains in productivity--that is, in 
output per hour worked. However, a portion of the recent growth 
reflects the taking up of economic slack that had developed during the 
period of economic weakness earlier in the decade. Over the past year, 
for example, the unemployment rate has fallen nearly \1/2\ percentage 
point, the number of people working part time for economic reasons has 
declined to its lowest level since August 2001, and the rate of 
capacity tilization in the industrial sector has moved up 1\1/2\ 
percentage points. As the utilization rates of labor and capital 
approach their maximum sustainable levels, continued growth in output--
if it is to be sustainable and non-inflationary--should be at a rate 
consistent with the growth in the productive capacity of the economy. 
Admittedly, determining the rates of capital and labor utilization 
consistent with stable long-term growth is fraught with difficulty, not 
least because they tend to vary with economic circumstances. 
Nevertheless, to allow the expansion to continue in a healthy fashion 
and to avoid the risk of higher inflation, policymakers must do their 
best to help to ensure that the aggregate demand for goods and services 
does not persistently exceed the economy's underlying productive 
capacity.
    Based on the information in hand, it seems reasonable to expect 
that economic growth will moderate toward a more sustainable pace as 
the year progresses. In particular, one sector that is showing signs of 
softening is the residential housing market. Both new and existing home 
sales have dropped back, on net, from their peaks of last summer and 
early fall. And, while unusually mild weather gave a lift to new 
housing starts earlier this year, the reading for March points to a 
slowing in the pace of homebuilding as well. House prices, which have 
increased rapidly during the past several years, appear to be in the 
process of decelerating, which will imply slower additions to household 
wealth and, thereby, less impetus to consumer spending. At this point, 
the available data on the housing market, together with ongoing support 
for housing demand from factors such as strong job creation and still-
low mortgage rates, suggest that this sector will most likely 
experience a gradual cooling rather than a sharp slowdown. However, 
significant uncertainty attends the outlook for housing, and the risk 
exists that a slowdown more pronounced than we currently expect could 
prove a drag on growth this year and next. The Federal Reserve will 
continue to monitor housing markets closely.
    More broadly, the prospects for maintaining economic growth at a 
solid pace in the period ahead appear good, although growth rates may 
well vary quarter to quarter as the economy downshifts from the first-
quarter spurt. Productivity growth, job creation, and capitalspending 
are all strong, and continued expansion in the economies of our trading 
partners seems likely to boost our export sector. That said, energy 
prices remain a concern: The nominal price of crude oil has risen 
recently to new highs, and gasoline prices are also up sharply. Rising 
energy prices pose risks to both economic activity and inflation. If 
energy prices stabilize this year, even at a high level, their adverse 
effects on both growth and inflation should diminish somewhat over 
time. However, as the world has little spare oil production capacity, 
periodic spikes in oil prices remain a possibility.
    The outlook for inflation is reasonably favorable but carries some 
risks. Increases in energy prices have pushed up overall consumer price 
inflation over the past year or so. However, inflation in core price 
indexes, which in the past has been a better indicator of longerterm 
inflation trends, has remained roughly stable over the past year. Among 
the factors restraining core inflation are ongoing gains in 
productivity, which have helped to hold unit labor costs in check, and 
strong domestic and international competition in product markets, which 
have restrained the ability of firms to pass cost increases on to 
consumers. The stability of core inflation is also enhanced by the fact 
that long-term inflation expectations--as measured by surveys and by 
comparing yields on nominal and indexed Treasury securities--appear to 
remain well-anchored. Of course, inflation expectations will remain low 
only so long as the Federal Reserve demonstrates its commitment to 
price stability. As to inflation risks, I have already noted that 
continuing growth in aggregate demand in excess of increases in the 
economy's underlying productive capacity would likely lead to increased 
inflationary pressures. In addition, although pass-through from energy 
and commodity price increases to core inflation has thus far been 
limited, the risk exists that strengthening demand for final products 
could allow firms to pass on a greater portion of their cost increases 
in the future.
    With regard to monetary policy, the Federal Open Market Committee 
(FOMC) has raised the Federal funds rate, in increments of 25 basis 
points, at each of its past fifteen meetings, bringing its current 
level to 4.75 percent. This sequence of rate increases was necessary to 
remove the unusual monetary accommodation put in place in response to 
the soft economic conditions earlier in this decade. Future policy 
actions will be increasingly dependent on the evolution of the economic 
outlook, as reflected in the incoming data. specifically, policy will 
respond to arriving information that affects the Committee's assessment 
of the medium-term risks to its objectives of price stability and 
maximum sustainable employment. Focusing on the medium-term forecast 
horizon is necessary because of the lags with which monetary policy 
affects the economy.
    In the statement issued after its March meeting, the FOMC noted 
that economic growth had rebounded strongly in the first quarter but 
appeared likely to moderate to a more sustainable pace. It further 
noted that a number of factors have contributed to the stability in 
core inflation. However, the Committee also viewed the possibility that 
core inflation might rise as a risk to the achievement of its mandated 
objectives, and it judged that some further policy firming may be 
needed to keep the risks to the attainment of both sustainable economic 
growth and price stability roughly in balance. In my view, data 
arriving since the meeting have not materially changed that assessment 
of the risks. To support continued healthy growth of the economy, 
vigilance in regard to inflation is essential.
    The FOMC will continue to monitor the incoming data closely to 
assess the prospects for both growth and inflation. In particular, even 
if in the Committee's judgment the risks to its objectives are not 
entirely balanced, at some point in the future the Committee may decide 
to take no action at one or more meetings in the interest of allowing 
more time to receive information relevant to the outlook. Of course, a 
decision to take no action at a particular meeting does not preclude 
actions at subsequent meetings, and the Committee will not hesitate to 
act when it determines that doing so is needed to foster the 
achievement of the Federal Reserve's mandated objectives.
    Although recent economic developments have been positive, the 
Nation still faces some significant longer-term economic challenges. 
One such challenge is putting the Federal budget on a trajectory that 
will be sustainable as our society ages. Under current law, Federal 
spending for retirement and health programs will grow substantially in 
coming decades--both as a share of overall Federal spending and 
relative to the size of the economy--especially if health costs 
continue to climb rapidly. Slower growth of the workforce may also 
reduce growth in economic activity and thus in tax revenues.
    The broad dimensions of the problem are well-known. In fiscal year 
2005, Federal outlays for Social Security, Medicare, and Medicaid 
totaled about 8 percent of GDP. According to the projections of the 
Congressional Budget Office (CBO), by the year 2020 that share will 
increase by more than 3 percentage points of GDP, an amount about equal 
in size to the current Federal deficit. By 2040, according to the CBO, 
the share of GDP devoted to those three programs (excluding 
contributions by the states) will double from current levels, to about 
16 percent of GDP. Were these projections to materialize, the Congress 
would find itself in the position of having to eliminate essentially 
all other non-interest spending, raising Federal taxes to levels well 
above their long-term average of about 18 percent of GDP, or choosing 
some combination of the two. Absent such actions, we would see widening 
and eventually unsustainable budget deficits, which would impede 
capital accumulation, slow economic growth, threaten financial 
stability, and put a heavy burden of debt on our children and 
grandchildren.
    The resolution of the nation's long-run fiscal challenge will 
require hard choices. Fundamentally, the decision confronting the 
Congress and the American people is how large a share of the nation's 
economic resources should be devoted to Federal Government programs, 
including transfer programs like Social Security, Medicare, and 
Medicaid. In making that decision, the full range of benefits and costs 
associated with each program should be taken into account. Crucially, 
however, whatever size of government is chosen, tax rates will 
ultimately have to be set at a level sufficient to achieve a reasonable 
balance of spending and revenues in the long run. Members of the 
Congress who want to extend tax cuts and keep tax rates low must accept 
that low rates will be sustainable over time only if outlays can be 
held down sufficiently to avoid large deficits. Likewise, members who 
favor a more expansive role of the government must balance the benefits 
of government programs with the burden imposed by the additional taxes 
needed to pay for them, a burden that includes not only the resources 
transferred from the private sector but also the reductions in the 
efficiency and growth potential of the economy associated with higher 
tax rates.
    Another important challenge is the large and widening deficit in 
the U.S. current account. This deficit has increased from a little more 
than $100 billion in 1995 to roughly $800 billion last year, or 6\1/2\ 
percent of nominal GDP. The causes of this deficit are complex and 
include both domestic and international factors. Fundamentally, the 
current account deficit reflects the fact that capital investment in 
the United States, including residential construction, substantially 
exceeds U.S. national saving. The opposite situation exists abroad, in 
that the saving of our trading partners exceeds their own capital 
investment. The excess of domestic investment over domestic saving in 
the United States, which by definition is the same as the current 
account deficit, must be financed by net inflows of funds from 
investors abroad. To date, the United States has had little difficulty 
in financing its current account deficit, as foreign savers have found 
U.S. investments attractive and foreign official institutions have 
added to their stocks of dollar-denominated international reserves. 
However, the cumulative effect of years of current account deficits 
have caused the United States to switch from being an international 
creditor to an international debtor, with a net foreign debt position 
of more than $3 trillion, roughly 25 percent of a year's GDP. This 
trend cannot continue forever, as it would imply an evergrowing 
interest burden owed to foreign creditors. Moreover, as foreign 
holdings of U.S. assets increase, at some point foreigners may become 
less willing to add these assets to their portfolios. While it is 
likely that current account imbalances will be resolved gradually over 
time, there is a small risk of a sudden shift in sentiment that could 
lead to disruptive changes in the value of the dollar and in other 
asset prices.
    Actions both here and abroad would contribute to a gradual 
reduction in the U.S. current account deficit and in its mirror image, 
the current account surpluses of our trading partners. To reduce its 
dependence on foreign capital, the United States should take action to 
increase its national saving rate. The most direct way to accomplish 
this objective would be by putting Federal government finances on a 
more sustainable path. Our trading partners can help to mitigate the 
global imbalance by relying less on exports as a source of growth, and 
instead boosting domestic spending relative to their production. In 
this regard, some policymakers in developing Asia, including China, 
appear to have recognized the importance of giving domestic demand a 
greater role in their development strategies and are seeking to 
increase domestic spending through fiscal measures, financial reforms, 
and other initiatives. Such actions should be encouraged. For these 
countries, allowing greater flexibility in exchange rates would be an 
important additional step toward helping to restore greater balance 
both in global capital flows and in their own economies. Structural 
reforms to enhance growth in our industrial trading partners could also 
be helpful. Each of these actions would be in the long-term interests 
of the countries involved, regardless of their effects on external 
imbalances. On the other hand, raising barriers to trade or flows of 
capital is not a constructive approach for addressing the current 
account deficit because such barriers would have significant 
deleterious effects on both the U.S. and global economies.
    In conclusion, Mr. Chairman, the economy has been performing well 
and the near-term prospects look good, although as always there are 
risks to the outlook. Monetary policy will continue to pursue its 
objectives of helping the economy to grow at a strong, sustainable pace 
while seeking to keep inflation firmly under control. And, while many 
of the fundamental factors that determine longer-term economic growth 
appear favorable, actions to move the Federal budget toward a more 
sustainable position would do a great deal to help ensure the future 
prosperity of our country.

[GRAPHIC] [TIFF OMITTED] T9738.004

[GRAPHIC] [TIFF OMITTED] T9738.005

  Written Questions Submitted by Hon. Jim Saxton to Hon. Ben Bernanke
    Question 1. Your testimony regarding the stance of monetary policy 
indicated that the Fed is not locked into a rigid, predetermined 
schedule of increases in the federal funds rate. Rather, future 
decisions will be data dependent, i.e., made on the basis of the most 
recent economic and financial information available. Your statement did 
not rule out any future increases in the federal funds rate. Is this a 
fair summary of the point you were making?
    Question 2. As you know, there are a number of reasons why 
inflation targeting allows for a good deal of operational flexibility. 
Yet critics of inflation targeting often contend that adopting this 
procedure removes much of monetary policymaker's discretionary powers 
and flexibility.
    This criticism appears questionable given the host of adjustments 
and exceptions used in inflation targeting. For example, numerical 
bands rather than point estimates are usually used as policy targets by 
those countries successfully implementing inflation targeting. 
Similarly, multi-year targets are often employed. The inflation indices 
normally used are adjusted for volatile components as well as for other 
factors. In practice, countries adopting inflation targeting have all 
used a flexible approach in implementing monetary policy. Doesn't this 
suggest that inflation targeting is quite flexible?
    Question 3. What is the role of asset prices in a monetary policy 
focused on price stability? Should the central bank respond to asset 
price ``bubbles'' or disturbances such as a bubble in the stock market 
or a bubble in the real estate market? Or should it ignore such 
movements in asset prices?
    Are there ``moral hazard'' problems associated with highly 
predictable central bank attempts to respond to asset price bubbles?
    Question 4. Federal Reserve officials often refer to the PCE 
(personal consumption expenditure) deflator in addressing measures of 
price changes. What are the advantages of the PCE deflator over the 
CPI? Does the CPI overstate inflation to some extent?
    What does the core PCE deflator currently tell us about the degree 
to which inflationary forces are being contained at present? 

[GRAPHIC] [TIFF OMITTED] T9738.006

 Response from Chairman Ben Bernanke to Written Questions Submitted by 
                          Chairman Jim Saxton

    Chairman Bernanke subsequently submitted the following in response 
to written questions received from Chairman Saxton in connection with 
the Joint Economic Committee hearing on April 27, 2006:
    Question 1. Your testimony regarding the stance of monetary policy 
indicated that the Fed is not locked into a rigid, predetermined 
schedule of increases in the Federal funds rate. Rather, future 
decisions will be data dependent, i.e., made on the basis of the most 
recent economic and financial information available. Your statement did 
not rule out any future increases in the Federal funds rate. Is this a 
fair summary of the point you were making?
    Answer. Yes. As conveyed in my testimony, monetary policy must be 
forward looking and depend on the Federal Reserve's best assessment of 
the economic outlook as inferred from economic and financial 
information. Indeed, the Federal Open Market Committee was quite 
explicit on this point in the statement issued after its meeting on May 
10. The statement explained that ``the Committee judges that some 
further policy firming may yet be needed to address inflation risks but 
emphasizes that the extent and timing of any such firming will depend 
importantly on the evolution of the economic outlook as implied by 
incoming information.''
    Question 2. As you know, there are a number of reasons why 
inflation targeting allows for a good deal of operational flexibility. 
Yet critics of inflation targeting often contend that adopting this 
procedure removes much of monetary policymaker's discretionary powers 
and flexibility.
    This criticism appears questionable given the host of adjustments 
and exceptions used in inflation targeting. For example, numerical 
bands rather than point estimates are usually used as policy targets by 
those countries successfully implementing inflation targeting. 
Similarly, multi-year targets are often employed. The inflation indices 
normally used are adjusted for volatile components as well as for other 
factors. In practice, countries adopting inflation targeting have all 
used a flexible approach in implementing monetary policy. Doesn't this 
suggest that inflation targeting is quite flexible?
    Answer. By definition, an inflation targeting framework focuses on 
keeping inflation low and stable, and on clearly communicating to the 
public both the objectives of monetary policy and the strategy for 
achieving those objectives. The key advantage of such a framework is 
that it can help anchor inflation expectations more firmly and 
therefore promote greater stability in both inflation outcomes and 
resource utilization. As you point out, however, inflation targeting 
frameworks can be quite flexible. For example, in practice, all 
inflation-targeting central banks pay important attention in their 
policy decisionmaking not only to inflation but also to output and 
employment. Objectives generally are set for some date in the future, 
in recognition of the fact that monetary policy affects the economy 
only with a considerable lag. Some inflation-targeting central banks 
set multi-year targets, while others set policy so as to keep their 
inflation projection at a certain horizon close to its target; yet 
others aim to keep inflation close to its target on average over the 
business cycle. Specifying the inflation objective as a band may help 
convey the reality that inflation cannot be controlled perfectly at 
every instant, though a band may also increase the challenges around 
the communication of objectives and strategies to the public. These are 
a few of the key design features that can be used to build flexibility 
into the overall policy framework.
    Question 3. What is the role of asset prices in a monetary policy 
focused on price stability? Should the central bank respond to asset 
price ``bubbles'' or disturbances such as a bubble in the stock market 
or a bubble in the real estate market? Or should it ignore such 
movements in asset prices?
    Are there ``moral hazard'' problems associated with highly 
predictable central bank attempts to respond to asset price bubbles?
    Answer. In setting monetary policy to achieve price stability, a 
central bank should take account of all factors influencing the 
economic outlook. Accordingly, a central bank cannot ignore movements 
in stock prices, home values, and other asset prices, but should 
respond to them only to the extent that they have implications for 
future output and inflation. Some observers have argued that a central 
bank should respond more aggressively to asset-price booms thought to 
have an important speculative component. In so doing, so the argument 
goes, a central bank can limit the future expansion of the bubble, 
thereby mitigating the fallout from its eventual bursting. However, the 
validity of this argument rests on several conditions for which there 
is little or no empirical evidence, including the presumptions that the 
central bank is better able than the market to identify speculative 
bubbles and that it can successfully ``deflate'' such bubbles without 
harming the broader economy. Given our limited knowledge of the forces 
driving speculative bubbles, the more prudent approach is to respond 
only as the overall outlook for output and inflation merits. Such a 
limited approach should also mitigate potential moral hazard problems 
that might arise were a central bank to, in effect, take responsibility 
for the appropriateness of asset prices.
    Question 4. Federal Reserve officials often refer to the PCE 
(personal consumption expenditures) deflator in addressing measures of 
price changes. What are the advantages of the PCE deflator over the 
CPI? Does the CPI overstate inflation to some extent?
    What does the core PCE deflator currently tell us about the degree 
to which inflationary forces are being contained at present?
    Answer. While the PCE price index generally moves roughly in line 
with the CPI--and indeed is derived largely from CPI source data--it 
does have some advantages relative to the CPI as a measure of 
inflation. The PCE chain-type index is constructed from a formula that 
reflects the changing composition of spending and thereby avoids some 
of the upward bias associated with the fixed-weight nature of the CPI. 
In addition, there is some evidence that the PCE weights are measured 
more accurately than the CPI weights. The PCE price measure also has 
some disadvantages relative to the CPI; most important, its broader 
scope necessitates the inclusion of some prices that are not derived 
from market transactions and so may add some noise to the overall index 
as a proxy for the cost of living.
    Most analysts believe that changes in the CPI overstate changes in 
the cost of living to some extent. In 1996, the Senate Advisory 
Commission to Study the CPI (The Boskin Commission) assessed the bias 
in CPI inflation as centering on 1.1 percentage points per year, with a 
range of 0.8 to 1.6 percentage points per year. This result was similar 
to the findings of other analysts. Since the time of these studies, the 
BLS has made several improvements to the CPI that have, on balance, 
served to reduce that bias. In part for this reason, more recent 
estimates of bias in CPI inflation have generally been a little smaller 
than estimated by the Boskin Commission. For example, a recent study by 
Federal Reserve economists judged the bias in CPI inflation currently 
to center around 0.9 percentage point per year. The PCE price index 
likely is also biased upward, though probably by less than the CPI in 
light of the PCE measure's advantages cited above.
    Although increases in energy prices have pushed up overall consumer 
price inflation over the past couple of years, core inflation has been 
more stable. The core PCE price index increased 2 percent over the 
twelve months to March of this year, about the same as the increase 
over the preceding twelve months. Similarly, the core CPI has increased 
21 percent over each of the past 2 years. The stability of core 
inflation, even as many firms have faced substantial cost increases for 
energy products, has been enhanced by the fact that long-term inflation 
expectations appear to remain well contained. Of course, inflation 
expectations will remain low only so long as the Federal Reserve 
demonstrates its commitment to price stability.

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