    [Senate Hearing 109-325]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 109-325

            FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 2006

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

                                    HEARING

                                   before the

                                  COMMITTEE ON
                       BANKING,HOUSING,AND URBAN AFFAIRS
                              UNITED STATES SENATE

                           ONE HUNDRED NINTH CONGRESS

                                 SECOND SESSION

                                       ON

          OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU-
           ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978

                                   __________

                               FEBRUARY 16, 2006

                                   __________

      Printed for the use of the Committee on Banking, Housing, and Urban
                                    Affairs

          Available at: http: //www.access.gpo.gov /congress /senate/
                                senate05sh.html

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                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      RICHARD C. SHELBY, Alabama, Chairman

    ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
    WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
    MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
    CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
    RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
    JIM BUNNING, Kentucky                EVAN BAYH, Indiana
    MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
    JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
    ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
    MEL MARTINEZ, Florida

                 Kathleen L. Casey, Staff Director and Counsel

         Steven B. Harris, Democratic Staff Director and Chief Counsel

                             Mark Oesterle, Counsel

                   Peggy R. Kuhn, Senior Financial Economist

                     Dean V. Shahinian, Democratic Counsel

                      Aaron D. Klein, Democratic Economist

       Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                           George E. Whittle, Editor

                                      (ii)

                                C O N T E N T S

                                  ----------

                          THURSDAY, FEBRUARY 16, 2006

                                                                       Page

    Opening statement of Chairman Shelby.............................     1

    Opening statements, comments, or prepared statements of:
        Senator Reed.................................................     2
        Senator Bunning..............................................     3
        Senator Menendez.............................................     4
        Senator Sununu...............................................     4
        Senator Stabenow.............................................     4
        Senator Dole.................................................     5
        Senator Carper...............................................     6
        Senator Crapo................................................     7
        Senator Sarbanes.............................................     8
        Senator Bayh.................................................     8

                                    WITNESS

    Ben S. Bernanke, Chairman, Board of Governors of the Federal
      Reserve System, Washington, DC.................................     9
        Prepared statement...........................................    35
        Response to written questions of:
            Senator Menendez.........................................    39
            Senator Crapo............................................    43
            Senator Enzi.............................................    43

                  Additional Material Supplied for the Record

    Monetary Policy Report to the Congress, February 15, 2006........    46
    Letter to Senator John E. Sununu from Alan Greenspan, Chairman,
      Board of Governors of the Federal Reserve System dated January
      3, 2006........................................................    74

                                     (iii)

            FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 2006

                                  ----------

                          THURSDAY, FEBRUARY 16, 2006

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.

        The Committee met at 10:02 a.m., in room SD-538, Dirksen
    Senate Office Building, Senator Richard C. Shelby (Chairman of
    the Committee) presiding.

            OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

        Chairman Shelby. The hearing will come to order. We are
    very pleased this morning to welcome Chairman Bernanke before
    the Committee on Banking, Housing, and Urban Affairs to provide
    his first testimony on the Federal Reserve Semiannual Monetary
    Policy Report to the Congress. On behalf of this Committee, I
    want to congratulate Dr. Bernanke on becoming only the 14th
    Chairman of the Federal Reserve Board. This Committee has had
    the opportunity to work with you in your previous tenure as
    Board Governor and as Chairman of the Council on Economic
    Advisors. We look forward to continuing that good and
    productive relationship as you guide the Federal Reserve System
    over the next years.
        Our hearing this morning serves as an important part of the
    Committee's oversight function over the Federal Reserve System.
    It is also an important mechanism for assuring that Congress
    maintains accountability over the Fed's policies and
    operations. Within broad statutory parameters, the Fed sets and
    implements U.S. monetary policy independent from the Congress
    and the President. This hearing, which is also required by
    statute, provides the Congress an opportunity to have an open
    and detailed discussion and debate about the Fed's monetary
    policy goals and their implementation.
        Chairman Bernanke, your testimony and report this morning
    note the economy's impressive performance in 2005. GDP growth
    continues to be strong and core inflation remain moderate. We
    also saw continued improvement in the labor markets with the
    number of jobs created and a low unemployment rate.
        At its meeting on January 31, the Federal Open Market
    Committee raised its target for the Federal funds rate by 25
    basis points to 4.5 percent. This is the 14th increase since
    June 2004 when the FOMC began raising the target rate from a
    low of 1 percent. The Federal Open Market Committee will meet
    next at the end of March, its first session under your
    leadership. Clearly, new economic data will be reported and
    other events will transpire between now and then so you cannot
    tell us exactly what will happen at that meeting and you should
    not. However, our discussion this morning gives us the
    opportunity to discuss which factors will be significant in
    your deliberations leading up to that meeting. In that sense,
    we hope our hearing and discussion this morning can add to the
    transparency of the FOMC process.
        Mr. Chairman, this Committee is eager to hear your views on
    the future direction of our Nation's economy and how you plan
    to guide the Federal Reserve System in the months and years
    ahead. I look forward to raising a number of issues during our
    discussion this morning.
        Senator Reed, do you have an opening statement?

                     STATEMENT OF SENATOR JACK REED

        Senator Reed. Thank you very much, Mr. Chairman, and thank
    you, Chairman Bernanke. Welcome and congratulations. You come
    to this job, Mr. Chairman, with considerable bipartisan
    goodwill, with very strong academic credentials, and a
    reputation for independent thinking, and you will need to draw
    on all these resources as you confront an economy that seems to
    be humming along on the surface, but in fact there is a number
    of lurking problems, problems such as large budget deficits, a
    record trade deficit, negative household saving rate, high
    energy prices, and a disappointing labor market recovery. All
    of these pose tremendous challenges in setting monetary policy.
        We welcome your championship of greater openness and
    demystification of the Fed. You really assured us during the
    confirmation process that you are sensitive to the multiple
    goals of monetary policy so I hope that you will continue the
    Greenspan model of responding to changing economic
    circumstances with flexibility rather than a rigid adherence to
    a predetermined policy.
        Now, critical tests will be balancing the goals of fighting
    inflation with allowing sufficient employment growth. These are
    difficult economic times for many Americans who are facing
    stagnant incomes, rising costs for health care, rising costs of
    home heating, rising costs for education, and so I hope,
    Chairman Bernanke, that you will look hard at the economic data
    at the FOMC meetings rather than allowing some type of rigid
    plan to take hold.
        GDP is growing, but the typical American worker has been
    left out of the economic gains of this recovery. Strong
    proprietary gains have shown up in the bottom lines of
    shareholders but not in the paychecks of many workers. Clearly,
    there is room for real wages to catch up with productivity
    before the Fed needs to worry about inflationary pressure from
    the labor market.
        Finally, I hope you keep your promise to not comment on the
    public policy matters beyond the realm of monetary policy and
    to remain politically independent. I think that will be a major
    service to the Nation. I look forward to your discussion about
    the issues that are important to all of us today and thank you,
    again, for not only attending but also your service.
        Chairman Shelby. Senator Bunning.

                    STATEMENT OF SENATOR JIM BUNNING

        Senator Bunning. Thank you, Mr. Chairman. Welcome, Chairman
    Bernanke, to your first appearance before this Committee as
    Chairman of the Federal Reserve.
        I would like to point out that at the beginning of your
    hearing yesterday, the stock market indexes jumped and then
    fell throughout the hearing. Fortunately, after it was over
    they recovered and ended up back in positive territory.
        On the way out the door last month, Chairman Greenspan left
    us with another hike in interest rates to 4.5 percent. His
    recent comments, which came at a much higher price to his
    fellow diners than the taxpayers, seem to have tied your hands
    at the beginning of your term.
        You will not chair your first FOMC meeting until next
    month, but it is already taken for granted that another rate
    hike is coming and probably more after that. As I told Mr.
    Greenspan at his last appearance before this Committee, I do
    not think that increases are needed, especially with your
    projections of reasonable inflation for the coming year.
        I hope they do not continue until it is too late and damage
    is done. Our economy is strong and inflation is low, despite
    high energy prices. Several other factors pose dangers to
    sustained economic growth in the short and long terms.
        We all know that inverted yield curves have been a reliable
    indicator of trouble ahead. Increased Federal budget deficits
    cause uncertainty and long-term obligations will begin to soak
    up more and more capital that could be put to other productive
    uses. And our trade deficit means that we are more dependent on
    other countries to sustain our lifestyle and could lead to job
    loss if we do not begin to close the gap. Even with those
    negative factors hanging out there, the Fed paints a strong
    picture of the economy.
        During your confirmation process, I urged you to be
    independent of the other Fed Members, as well as Congress and
    the executive branch. I also stressed the importance of further
    openness at the Fed and the tolerance of other viewpoints. In
    other words, I would like to see less group-think.
        I criticized your predecessor for speaking out of place
    when it comes to policy matters that do not belong to the Fed.
    I encourage you to stay away from those discussions and I am
    glad that to some extent you did so yesterday.
        Something about this town makes people want to be liked.
    The longer someone stays here, the more they seem to want to be
    liked. Maybe it has something to do with one day getting paid
    more than your previous salary for attending a few dinners and
    not even having to pay for your own food.
        Do not fall into that trap and do not be afraid to tell
    people ``no.'' It is an uncommon thing to say around here, but
    do not try to follow in the footsteps of your predecessor. In
    other words, be yourself, do not be ``Greenspan-lite.'' I hope
    when your time at the Fed is over people will look back and see
    a record of doing no harm. I think the decisions you and the
    other Board Members make in the next few months will have a lot
    to do with the success of your leadership at the Fed.
        Thank you, Mr. Chairman, and I look forward to asking some
    questions.
        Chairman Shelby. Senator Menendez.

                  STATEMENT OF SENATOR ROBERT MENENDEZ

        Senator Menendez. Thank you, Mr. Chairman. Mr. Chairman,
    welcome, congratulations. We are pleased to welcome you, as a
    fellow New Jersian, and we know that you will do an exceptional
    job in this regard. I certainly look forward to your testimony
    today and to some of the challenges I think we face: The
    cooling off of the housing market and what that may mean,
    rising energy prices, consequences of deficit and debt, a
    variety of global influences, and a dynamic, modern economy
    that we have.
        Those are all the challenges that you face before you and
    so we look forward to your stewardship in meeting, having a
    steady hand in the midst of all of the dynamic realities that
    we face, so we look forward to hearing your testimony, and once
    again congratulations on your appointment, Mr. Chairman.
        Chairman Shelby. Thank you. Senator Sununu.

                  STATEMENT OF SENATOR JOHN E. SUNUNU

        Senator Sununu. Thank you, Mr. Chairman, and welcome,
    Chairman Bernanke. Yesterday, you touched briefly on issues
    related to the GSE's, better regulation of Fannie Mae and
    Freddie Mac. This is something that has been of interest to the
    Committee.
        We enacted legislation that you spoke to at the hearing
    yesterday, and I note that you emphasized two specific concerns
    with the portfolios held by the GSE's, one, the systemic risk
    that they create inevitably because of the nature of the
    portfolios carrying interest rate risk and prepayment risk, and
    two, the fact that they really do not contribute directly to
    the GSE's fulfilling their mission.
        I appreciate you making these points, some points that are
    very consistent with testimony and presentation by other
    representatives from the Fed in the past, and I think it is
    important because we have an opportunity to take up legislation
    this year, probably the best opportunity to improve the
    regulation of these large institutions that we will have in a
    long time.
        Mr. Chairman, I have a letter that I received from the
    outgoing Fed Chairman speaking to these issues at the beginning
    of January. I would ask that that be included in the record so
    that I do not have to belabor these points in any greater
    detail.
        Chairman Shelby. It will be part of the record without
    objection.
        Senator Sununu. I appreciate the comments that you made
    yesterday. Perhaps we will have an opportunity to get into them
    in more detail, but not surprisingly you were very direct and
    plain-spoken and I appreciate having you on the record.
        Thank you, Mr. Chairman.
        Chairman Shelby. Senator Stabenow.

                  STATEMENT OF SENATOR DEBBIE STABENOW

        Senator Stabenow. Thank you, Mr. Chairman, and welcome,
    Chairman Bernanke. This is an important time and we wish you
    all of the best as we all work together on so many issues that
    relate to our economy and what is happening in terms of
    monetary policy.
        The Annual Monetary Policy Report comes at a very important
    time for many middle class Americans, and I know in my home
    State right now, the headlines everyday relate to manufacturing
    loss in Michigan and families are feeling squeezed on all sides
    from concerns about losing their job, losing their pension,
    their health care costs rising, businesses, manufacturers
    seeing their health care costs go through the roof basically,
    and it relates to their ability to compete internationally.
        We also know that issues of unfair trade practices are not
    just words for us in manufacturing. In Michigan, things like
    currency manipulation are real with Japan or with China when we
    look at the differences in costs coming in. Counterfeiting,
    counterfeit auto parts, which is a $12 billion business costs
    us 200,000 jobs.
        So when we look at all of the issues, the fact that we have
    lost 2.4 million jobs, 2.4 million people plus their families.
    Since 2000, we have lost over 200,000 jobs, families
    experiencing layoffs in the last 5 years in my State alone.
    Just last year, 21,000 manufacturing jobs were lost. I say this
    because the trade deficit is a critical issue for us, a trade
    deficit now that is about twice as much as the budget deficit,
    the budget deficit being the highest in our Nation's history,
    but the trade deficit now hitting $726 billion.
        This is real for us and so I know your basket of economic
    metrics, the international component, is just a piece of the
    analysis, but I want to stress with you that this is extremely
    important piece to us in manufacturing and in Michigan.
        And I hope your analysis now and in the future will
    consider the global issues that are devastating middle class
    families and devastating American businesses. We need to be
    focused on that. We need your leadership, your thoughts, and
    your recommendations as it relates to this global economy now
    and the international pressures, the unfair trade practices,
    the currency manipulation, other kinds of issues in the
    economy, the way we fund health care which is different than
    any other country in the world, and the impact on our
    businesses.
        All of these issues come down on the people that I
    represent, my own family in Michigan and the others that I
    represent, and so I hope this international component of your
    analysis is something that you will place an emphasis on and
    work with us on as we address monetary issues and the economy
    in America.
        Thank you.
        Chairman Shelby. Thank you, Senator. Senator Dole.

                  STATEMENT OF SENATOR ELIZABETH DOLE

        Senator Dole. Thank you, Mr. Chairman. Chairman Bernanke, a
    very warm welcome to you. I certainly look forward to working
    with you very closely in the months and years to come, and I
    have every confidence in you. I want to underscore what Senator
    Sununu said about the GSE's, and one of the issues that I
    raised when we met in November was the economic transition that
    we are going through in North Carolina.
        We continue to experience job loss, especially in textiles
    and furniture manufacturing. The national economy is indeed
    trending positively, but I think we must continue to focus
    special attention on the areas where people have lost their
    jobs, where companies struggle to compete with foreign firms,
    and their dramatically lower cost structures.
        We have to work toward trade agreements that benefit
    American workers and consumers and support jobs and growth in
    our domestic industries.
        One issue I was focused on during my days as Secretary of
    Labor was addressing the growing gap between skilled and
    unskilled workers. Today in our changing economic environment,
    this gap has unfortunately widened, and as our economy moves
    forward, the opportunities for lower skilled workers are
    diminishing. We have to do everything in our power to ensure
    that these people realize new opportunities, educate our less
    skilled workers so they can take advantage of the new jobs that
    are being created.
        To this end, I believe that we should take steps to improve
    trade adjustment assistance and continue to make strengthening
    our community colleges a top priority, and I might add that the
    Labor Department has estimated that 80 percent of new jobs that
    are going to be created over the next decade will require
    postsecondary education.
        Now, in my conversations with many North Carolinians, I
    hear concerns about job creation, high energy and health care
    costs, and our growing trade imbalance. I continue to have
    confidence that the very forces that stimulate economic
    growth--tax relief to spur investment, free but fair trade,
    ever-improving global communications, higher education and
    training for our workforce, and of course hard work--these
    forces indeed will put us on a course toward greater
    opportunity for North Carolina and this Nation.
        Mr. Chairman, thank you for being here today. I look
    forward to your testimony and again to working closely with
    you. Thank you.
        Chairman Shelby. Senator Carper.

                 STATEMENT OF SENATOR THOMAS R. CARPER

        Senator Carper. Thanks, Mr. Chairman. Welcome. It is good
    to have you back. Thank you for joining us today and again for
    your service to our country.
        I think others have indicated that they have an interest in
    questioning you on some of these same subjects. I will mention
    them again. I will be asking you about our savings rate or
    really our lack of savings or negative savings rate and what
    you think we are doing right to turn that around and maybe what
    more we could do or should do.
        I want to also visit the issue, the interplay between the
    trade deficit and the budget deficit, and the potential effect
    of doing the wrong thing or not doing the right thing with
    respect to interest rates going forward.
        Playing into the trade deficit, our growing reliance on
    foreign oil. I think I read the other day that our trade
    deficit for last year topped out at a little bit more than $700
    billion and roughly a third of that is now our reliance on
    foreign oil.
        And others have suggested--I think Senator Dole and I
    believe Senator Sununu have mentioned the regulatory structure
    for Government Sponsored Enterprises, Fannie Mae, Freddie Mac,
    and some of our Federal Home Loan Banks--and I understand, I
    read in a news account that you addressed that in your
    testimony before the House of Representatives, but I want us to
    have a chance maybe to talk with you a bit further about that
    today.
        And finally, just some general thoughts. Maybe put on your
    old hat from one of your last jobs about economic policy, and
    just to talk about some steps we need to take if our country is
    going to continue to be an economic superpower in this century,
    what we are doing right and what we are doing wrong, and what
    we need to do differently, more of or less of.
        Welcome. Thanks for coming.
        Chairman Shelby. Senator Crapo.

                    STATEMENT OF SENATOR MIKE CRAPO

        Senator Crapo. Thank you very much, Mr. Chairman, and
    Chairman Bernanke, I welcome you to your first appearance
    before this Committee. I look forward to many more and
    appreciate the opportunity we have already had to work together
    on important issues, and I am certain that the forecast and
    information that you will give us today will be very helpful to
    us.
        I share a lot of the other feelings that have already been
    expressed to you so I will not repeat them now. There are two
    issues that I wanted to raise in addition to those, and if I am
    here when it is time for questions, I will go through this a
    little more in questions, but I have three hearings going on
    today, one with a member of the cabinet, one with the U.S.
    Trade Ambassador, and one with yourself. And they are all going
    on right now.
        So if I slip out to try to catch a little bit of one of
    those other hearings and miss the chance to ask you questions,
    I wanted to just toss these two things out right now.
        We are getting very close to a markup on the regulatory
    reform legislation that we have been working on for several
    years now, and we are talking, I think, in terms of weeks, not
    months, before we are going to move forward, and I would like
    to have some kind of an indication from you as to when the
    Federal Reserve will be able to give us its comments on the
    proposals that are out there.
        So, I just toss that one out to you.
        And then the second issue is one which you will probably
    hear me talk to you a lot about as we have opportunities, and
    that is the question of derivatives. I am very concerned about
    the potential efforts in this Congress to change the manner in
    which we regulate derivatives or to impact the manner in which
    derivatives operate in the economy, and I would like to have
    your comments on the importance of having a strong, stable, and
    dynamic derivatives market in this country and what it means to
    our economy.
        So, again, in addition to the other issues that we have
    talked about, those are just a couple specific ones that I
    would like you to think about. If I am not here to ask
    questions, maybe we can talk later at a different time.
        Thank you.
        Chairman Shelby. Senator Sarbanes.

                 STATEMENT OF SENATOR PAUL S. SARBANES

        Senator Sarbanes. Thank you very much, Mr. Chairman. I join
    my colleagues in welcoming Chairman Bernanke before the
    Committee. I think we had him last year at his nomination
    hearing in November, and given the schedule, he went to the
    House first, not by his choice. That was the process, I hasten
    to add, so that the Members of the Committee do not feel
    slighted in any way, but actually I want to say just a word
    about that.
        We think the Semiannual Report by the Fed is a very
    important step forward in the transparency and oversight with
    respect to monetary policy. It was a change that Chairman
    Greenspan welcomed at the time, and I think I recall we had
    talked about that, and you indicated very strong support for
    that process as well.
        And I think it does give the public a chance on a regular
    basis for the Fed to come before the Congress and spell out its
    views with respect to monetary policy and the health of the
    economy.
        And Mr. Chairman, I want to thank you for your oversight
    and focus in that regard. It is clearly important.
        Chairman Shelby. I had a good trainer.
        Senator Sarbanes. The Federal Reserve has a double mandate,
    as we all know: Stable prices and maximum employment. And we
    have seen in recent years that the goals are not inherently in
    conflict, as some had argued in the past, and we got
    unemployment down to below 4 percent actually, inflation below
    3 percent, and at his hearing, Dr. Bernanke told the Committee,
    and I quote him, that he ``subscribes entirely to the Humphrey-
    Hawkins mandate which puts employment growth and output growth
    on a fully equal footing with inflation in terms of the Federal
    Reserve's objectives.''
        And we look forward to working with him in that regard. I
    am a little concerned about how sanguine we are about the
    economy. Paul Volcker not long ago in an editorial in the
    Washington Post said this about our economy:

        Under the placid surface, there are disturbing trends, huge
    imbalances, disequilibria, risks, call them what you will,
    although the circumstances seem to me as dangerous and
    intractable as any I can remember, and I can remember quite a
    lot.
        Of course, the Commerce Department recently reported that
    our Nation ran a record trade deficit of over $725 billion last
    year. Warren Buffett summarized the situation: ``Right now the
    rest of the world owns [$] three trillion more of us than we
    own of them. In my view, it will create political turmoil at
    some point. Pretty soon, I think there will be a big
    adjustment.''
        And I hope to go into that with Chairman Bernanke when we
    reach the question period or in subsequent meetings, but we
    welcome you back before the Committee as Chairman of the Fed,
    and we wish you well in this new responsibility.
        Thank you, Mr. Chairman.
        Chairman Shelby. Senator Bayh.

                     STATEMENT OF SENATOR EVAN BAYH

        Senator Bayh. Thank you, Mr. Chairman. Welcome, Chairman
    Bernanke. Just two quick things. First, congratulations on
    apparently being able to speak in plain English and still not
    moving the markets. That is quite an accomplishment.
        Second, I want to follow up on something that Senator
    Sarbanes mentioned. I am increasingly concerned with some of
    the global imbalances that are accumulating and their effect
    not only on our potential economic performance but also on our
    Nation's security. I am going to save my time for questions,
    but I would like to delve into that with you later today and
    perhaps at a later point.
        Having said that, I have learned from hard experience that
    we are all here to hear from you, not from me, and so I would
    just congratulate you and welcome you again.
        Chairman Shelby. If you will put up with us for a few
    minutes, Mr. Chairman, we have established a quorum, and at
    this time I would like to move----
        Senator Sarbanes. Does he have an alternative to putting up
    with us?
        [Laughter.]
        Chairman Shelby. I am not going to say. If you will stay
    put just a few minutes, Mr. Chairman.
        [Recess.]
        Chairman Shelby. Chairman Bernanke, your written testimony
    will be made part of the record. You may proceed. Welcome again
    to the Committee.
        Chairman Bernanke. Thank you.

                 STATEMENT OF BEN S. 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 be here today to present the
    Federal Reserve's Monetary Policy Report to the Congress. I
    look forward to working closely with the Members of this
    Committee on issues of monetary policy as well as on matters
    regarding the other responsibilities with which the Congress
    has charged the Federal Reserve System.
        The U.S. economy performed impressively in 2005. Real gross
    domestic product increased a bit more than 3 percent, building
    on the sustained expansion that gained traction in the middle
    of 2003. Payroll employment rose two million in 2005 and the
    unemployment rate fell below 5 percent. Productivity continued
    to advance briskly.
        The economy achieved these gains despite some significant
    obstacles. Energy prices rose substantially yet again in
    response to the increasing global demand, hurricane-related
    disruptions to production, and concerns about the adequacy and
    reliability of supply. The Gulf Coast region suffered through
    severe hurricanes that inflicted a terrible loss of life,
    destroyed homes, personal property, businesses and
    infrastructure on a massive scale, and displaced more than a
    million people. The storms also damaged facilities and
    disrupted production in many industries with substantial
    effects on the energy and petrochemical sectors and on the
    region's ports. Full recovery in the affected areas is likely
    to be slow. The hurricanes left an imprint on aggregate
    economic activity as well, seen in part in the marked
    deceleration of real GDP in the fourth quarter. However, the
    most recent evidence, including indicators of production, the
    flow of new orders to businesses, weekly data on initial claims
    for unemployment insurance, and the payroll employment and
    retail sales figures for January, suggest that the economic
    expansion remains on track.
        Inflation pressures increased in 2005. Steeply rising
    energy prices pushed up overall inflation, raised business
    costs, and squeezed household budgets. Nevertheless, the
    increase in prices for personal consumption expenditures
    excluding food and energy, at just below 2 percent, remained
    moderate, and longer-term inflation expectations appear to have
    been contained.
        With the economy expanding at a solid pace, resource
    utilization rising, cost pressures increasing, and short-term
    interest rates still relatively low, the Federal Open Market
    Committee over the course of 2005 continued the process of
    removing monetary policy accommodation, raising the Federal
    funds rate 2 percentage points in eight increments of 25 basis
    points each. At its meeting on January 31 of this year, the
    FOMC raised the Federal funds rate another one-quarter
    percentage point, bringing its level to 4\1/2\ percent.
        At that meeting, monetary policymakers also discussed the
    economic outlook for the next 2 years. The central tendency of
    the forecast of Members of the Board of Governors and the
    Presidents of the Federal Reserve Banks is for real GDP to
    increase about 3\1/2\ percent in 2006 and 3 percent to 3\1/2\
    percent in 2007. The civilian unemployment rate is expected to
    finish both 2006 and 2007 at a level between 4\3/4\ percent and
    5 percent. Inflation, as measured by the price index for
    personal consumption expenditures excluding food and energy, is
    predicted to be about 2 percent this year and 1\3/4\ percent to
    2 percent next year. While considerable uncertainty surrounds
    any economic forecast extending nearly 2 years, I am
    comfortable with these projections.
        In the announcement following the January 31 meeting, the
    Federal Reserve pointed to risks that could add to inflation
    pressures. Among those risks is the possibility that to a
    greater extent than we now anticipate, higher energy prices may
    pass through into the prices of nonenergy goods and services or
    have a persistent effect on inflation expectations. Another
    factor bearing on the inflation outlook is that the economy
    appears now to be operating at a relatively high level of
    resource utilization. Gauging the economy's sustainable
    potential is difficult and the Federal Reserve will keep a
    close eye on all the relevant evidence and be flexible in
    making those judgments. Nevertheless, the risk exists that with
    aggregate demand exhibiting considerable momentum, output could
    overshoot its sustainable path, leading ultimately--in the
    absence of countervailing monetary policy action--to further
    upward pressure on
    inflation. In these circumstances, the FOMC judged that some
    further firming of monetary policy may be necessary, an
    assessment with which I concur.
        Not all of the risks to the economy concern inflation. For
    example, a number of indicators point to a slowing in the
    housing market. Some cooling of the housing market is to be
    expected and would not be inconsistent with continued solid
    growth of overall economic activity. However, given the
    substantial gains in house prices, and the high levels of home
    construction activity over the past several years, prices and
    construction could decelerate more rapidly than currently seems
    likely. Slower growth in home equity, in turn, might lead
    households to boost their saving and trim their spending
    relative to current income by more than is now anticipated. The
    possibility of significant further increases in energy prices
    represents an additional risk to the economy. Besides affecting
    inflation, such increases might also hurt consumer confidence
    and thereby reduce spending on nonenergy goods and services.
        Although the outlook contains significant uncertainties, it
    is clear substantial progress has been made in removing
    monetary policy accommodation. As a consequence, in coming
    quarters, the FOMC will have to make ongoing, provisional
    judgments about the risks to both inflation and growth, and
    monetary actions will be increasingly dependent on incoming
    data.
        As I noted, core inflation has been moderate despite sharp
    increases in energy prices. A key factor in this regard has
    been confidence on the part of public and investors in the
    prospects for price stability. Maintaining expectations of low
    and stable inflation is an essential element in the Federal
    Reserve's effort to promote price stability, and thus far the
    news has been good. Measures of longer-term inflation
    expectations have responded only a little to larger
    fluctuations in energy prices that we have experienced, and for
    the most part they were low and stable last year.
        Inflation prospects are important, not just because price
    stability is in itself desirable and part of the Federal
    Reserve's mandate from the Congress, but also because price
    stability is essential for strong and stable growth of output
    and employment. Stable prices promote long-term economic growth
    by allowing households and firms to make economic decisions and
    undertake productive activities with fewer concerns about large
    or unanticipated changes in the price level and their attendant
    financial consequences. Experience shows that low and stable
    inflation and inflation expectations are also associated with
    greater short-term stability and output and employment, perhaps
    in part because they give the central bank greater latitude to
    counter transitory disturbances to the economy. Similarly, the
    attainment of the statutory goal of moderate long-term interest
    rates requires price stability, because only then are the
    inflation premiums that investors demand for holding long-term
    instruments kept to a minimum. In sum, achieving price
    stability is not only important in itself; but it is also
    central to attaining the Federal Reserve's other mandated
    objectives of maximum sustainable employment and moderate long-
    term interest rates.
        As always, however, translating the Federal Reserve's
    general economic objectives into operational decisions about
    the stance of monetary policy poses many challenges. Over the
    past few decades, policymakers have learned that no single
    economic or financial indicator or even a small set of such
    indicators can provide reliable guidance for the setting of
    monetary policy.
        Rather, the Federal Reserve, together with all modern
    central banks, has found that the successful conduct of
    monetary policy requires painstaking examination of a broad
    range of economic and financial data, careful consideration of
    the implications of those data for the likely path of the
    economy and inflation, and prudent judgment regarding the
    effects of alternative courses of policy action on the
    prospects for achieving our macroeconomic objectives. In that
    process, economic models can provide valuable guidance to
    policymakers and over the years substantial progress has been
    made in developing formal models and forecasting techniques.
    But any model is by necessity a simplification of the real
    world and sufficient data are seldom available to measure even
    the basic relationships with precision. Monetary policymakers
    must therefore strike a difficult balance, conducting rigorous
    analysis informed by sound economic theory and empirical
    methods while keeping an open mind about the many factors
    including myriad global influences at play in a dynamic modern
    economy like that of the United States. Amid significant
    uncertainty, we must formulate a view of the most likely course
    of the economy under a given policy approach while giving due
    weight the potential risks and associated costs to the economy
    should those judgments turn out to be wrong.
        During the 3 years that I previously spent as a Member of
    the Board of Governors of the Federal Open Market Committee,
    the approach to policy that I have just outlined was standard
    operating procedure under the highly successful leadership of
    Chairman Greenspan. As I indicated to the Congress during my
    confirmation hearing, my intention is to maintain continuity
    with this and the other practices of the Federal Reserve in the
    Greenspan era. I believe that with this approach, the Federal
    Reserve will continue to contribute to the sound performance of
    the U.S. economy in the years to come.
        Thank you, Mr. Chairman.
        Chairman Shelby. Mr. Chairman, we are in our last few
    minutes of a vote on the floor. We are going to recess and we
    will probably be back in 15 or 20 minutes, soon as we can get
    here.
        The hearing will stand in recess.
        [Recess.]
        Chairman Shelby. The hearing will come back to order. Mr.
    Chairman, some Fed watchers speculate that the Federal Open
    Market Committee may--may--continue to increase its Federal
    funds rate target to 5 percent while others seem to believe
    that 5.5 percent may be likely.
        Do you regard either of these speculations regarding the
    level as more likely than the other giving the FOMC forecast
    that you have outlined today?
        Chairman Bernanke. Mr. Chairman, as I mentioned, in the
    statement following the January 31 meeting, the Committee
    pointed to some potential pressures on inflation and suggested
    that some additional firming may be necessary.
         However, as you know, it is still about 6 weeks until the
    next FOMC meeting.
        Chairman Shelby. You will have to examine the data at
    that----
        Chairman Bernanke. We will be examining the data as it
    comes in and, of course, my colleagues and I will have an
    extensive discussion and we will be thinking about both our
    inflation mandate and our full employment mandate as we make
    our decision.
        Chairman Shelby. To what extent, Mr. Chairman, does the
    Federal Open Market Committee consider the long-term interest
    rate in pursuing changes to the Federal funds rate? For
    example, would the FOMC continue raising the Federal funds rate
    even if the yield curve remains inverted in the months ahead
    and will that be a factor or is that bothersome to you, the
    inverted yield?
        Chairman Bernanke. Mr. Chairman, the inversion of the yield
    curve is due to a number of different factors which have
    different implications for policy.
        Chairman Shelby. But historically they meant something?
    Senator Bunning alluded to that earlier.
        Chairman Bernanke. That is true that historically an
    inverted yield curve has often predicted slowing economic
    activity. That relationship seems to have weakened in the past
    15 years or so.
        Chairman Shelby. Why?
        Chairman Bernanke. Well, one of the reasons, as we looked
    into it, is that the inverted yield curve is more likely to be
    indicative of coming slowing when interest rates in general are
    high, when real rates in general are high, because when real
    rates in general are high, that tends to restrain activity.
        We have an inverted yield curve at this point. It is due to
    a number of factors which I can go into, if you are interested,
    but the short-term, real interest rate is in a fairly normal
    range and the long-term real interest rate is actually
    relatively low historically speaking. So we are not overly
    concerned about the implications of the inverted yield curve
    for future economic activity.
        Chairman Shelby. Mr. Chairman, your testimony also notes
    the possibility of some risk which could add to inflationary
    pressures such as high energy prices feeding into the prices of
    nonenergy goods and services.
        Your testimony further notes the risk to our economy due to
    a slowing housing market you reference. What would be the
    impact on the economy if both of these effects materialize to a
    greater degree than is currently anticipated? How would the
    Federal Reserve be likely to respond to such a scenario if you
    found the pressure there from a double hit?
        Chairman Bernanke. That would be a difficult situation
    because, on the one hand, higher energy prices would put
    pressure on inflation, but higher energy prices would also hurt
    consumer budgets and would probably or could possibly lead
    consumers to spend less. Together with weakening of the housing
    market, which might also lead to a higher savings rate and
    slower consumption spending, we would be in a situation with
    pressures in both directions, and I cannot really offer much
    more guidance other than to say that we would have to weigh the
    relative severity of the two risks.
        Chairman Shelby. If they were to come about?
        Chairman Bernanke. If they both were to come about, and
    then try to manage those risks in a way that would give us the
    best outcome.
        Chairman Shelby. You reference further in your testimony
    your thoughts on global savings glut, with this glut being part
    of the reason that the real interest rate in global markets is
    low. In other words, there is a lot of money out there.
        How does this factor into the Federal Reserve's growth
    projections and how would you envision economic events
    unfolding to bring returns back to more historical normal
    levels?
        Chairman Bernanke. Well, we were just discussing the
    relatively low level of long-term real interest rates. I think
    one of the factors relevant to the long-term, low, real
    interest rates is that there is a lot of savings coming into
    the global capital market, from emerging market economies and
    from oil producers, which is looking for returns.
        I think that over time, as the global economy continues to
    grow and as those economies find more investment opportunities
    in their domestic economies, that some of this global savings
    glut may begin to dissipate, but I think that is likely to be a
    relatively gradual process.
        Chairman Shelby. Yesterday, did the market behavior reflect
    an accurate interpretation of the Federal Reserve's report and
    your comments? Do you think it is a good outcome when markets
    receive enough signals to know what to expect about monetary
    policy? Is that a prediction?
        Chairman Bernanke. We are trying, and we have been for some
    time trying, to be transparent and as clear as we can about our
    strategy, our objectives, and our approach, and one of the
    implications of that has been that interest rate moves have
    been highly predicted by the markets, and I think, as a general
    matter, that is good. It reduces volatility in financial
    markets and makes policy actually more effective.
        Chairman Shelby. Senator Bunning.
        Senator Bunning. Thank you, Mr. Chairman. I would like to
    go back to the inverted yield curve for a minute. You were a
    professor at this time. Maybe you remember this at Princeton.
    In 1989, if I am wrong, I think you were a professor at
    Princeton.
        Chairman Bernanke. Yes, sir.
        Senator Bunning. In 1989, even as the economy slowed, the
    Fed continued to raise interest rates, and we had a recession.
    The signs of the economic problems were ignored. Yesterday, you
    stated that the inverted yield curve was ``not signaling'' a
    slowdown. Those were your words--``not signaling.'' But in
    recent economic history, the inverted yield curve has predicted
    a recession, not just sometimes, but almost every time.
        Now, the Fed has pushed interest rates to the highest level
    in 4\1/2\ years. The January rate hike was the 14th consecutive
    25 basis point move since the Fed began raising interest rates
    in June 2004. You said you think we are not facing a downturn
    because interest rates are lower now than in past inversions.
        Do you have any other reason to think that this inverted
    yield curve is not a warning, any other reason, other than we
    started lower?
        Chairman Bernanke. Yes, Senator. As I was indicating in my
    testimony, we look at a wide variety of indicators. We do look
    at the structure of interest rates and other financial asset
    market prices, but we also look at a wide variety of indicators
    in the real economy, and we are seeing very low unemployment
    insurance claims, for example, and we are seeing strong retail
    sales. We are seeing increased industrial production.
        My comments notwithstanding about slowing of the housing
    market, the level of activity in housing construction remains
    strong, and so the economic expansion appears still to be on a
    solid track. When we make policy, we have to think not only
    about all these indicators, but we also have to think in terms
    of a forecast. We look ahead and try to think where the economy
    is likely to be at a period 6 months, a year, 18 months in the
    future, and based on that forecast and the risk to that
    forecast, we try to pick the best policy.
        Senator Bunning. You know as well as I do that normal
    everyday citizens do not borrow at the Fed funds rate, but
    about a 300 basis point markup from that. So if Fed funds get
    to 5\1/2\ percent, the prime rate for borrowing would be about
    8\1/2\ percent. I do not know too many Americans that can
    borrow at 8\1/2\ percent on prime rate. Most Americans pay
    prime plus. So we are getting to the point, if the Fed moves
    two more times, and Fed funds increase 25 basis points and 25
    basis points, we are to that point, eight plus on prime.
        Do you find that disturbing to the economy or would that be
    just normal for our economic outlook?
        Chairman Bernanke. Well, Senator, again, the choices we
    make will be conditioned on our views of where the economy is
    going and what interest rates are needed to give us the best
    combination of growth and low inflation. The interest rates we
    currently see are in some cases historically low. Take mortgage
    rates, for example; they are about 6\1/4\ percent right now
    which is relatively low historically.
        It is not really a question of comparing it to rates at
    another period of time, but rather asking, given those rates,
    what will be the level of activity in the economy? Will we be
    on a path that is strong and sustainable going forward? So we
    will try to do our very best to get the best outcome we can for
    the American people.
        Senator Bunning. Do you not think with the past history of
    the Fed and looking at interest rates, when we get them too
    high, the economy kind of does a little swan song and turns
    over for awhile and we have some kind of a recession? I am
    talking on Fed funds. Do you see that happening in the future
    or do you see that you would anticipate that before it
    happened?
        Chairman Bernanke. Senator, there are two possible
    mistakes. One is to go on too long and one is not to go on long
    enough, and it is a very difficult balancing act, and as I said
    earlier, we do not have any kind of mechanical rule. We do not
    have built in any kind of set of future moves. As we go along,
    we are going to be looking carefully at all the data, trying to
    make our best assessment where the economy is, where it is
    going, and respond to that.
        Senator Bunning. Last question. Is there a lot of
    discussion at the FOMC meeting on this very topic when you
    meet? In other words, it is not that the Chairman leads and
    everybody follows?
        Chairman Bernanke. There is extensive discussion and I look
    forward to getting a lot of input from my colleagues on the
    FOMC.
        Senator Bunning. Thank you.
        Chairman Shelby. Senator Bayh.
        Senator Bayh. Mr. Chairman, I would like to follow up on my
    brief comment in the introductory component here about our
    increasing global interdependence, some advantages, benefits
    that come from that, also some potential threats to both our
    economy and our national security, potentially even our
    sovereignty, and that is what I would like to ask you about.
        And increasingly, these are not hypothetical risks. Let me
    start by remembering, it was a year or so ago, maybe a year and
    a half, there was a rumor going through Seoul, Korea that they
    were going to begin to diversify out of dollar denominated
    assets, and for a brief period of time, that sent the U.S.
    dollar into a free fall.
        Sometime after that, a matter of months, the Prime Minister
    of Japan misspoke, and similar phenomenon followed. He said we
    perhaps will start diversifying out of dollar denominated
    assets; the dollar headed straight down. Someone from the
    ministry comes out and says, no, no, the Prime Minister
    misspoke.
        My question to you is twofold. Number one, does it trouble
    you that a mere statement by a foreign leader could have such a
    profound effect on our Nation's currency? And number two, what
    if the Chinese were to misspeak? Or even more, what if they
    were to announce a similar policy? What kind of impact would
    that have on our currency and should we be concerned about
    that? Is there not a loss of sovereignty involved in such a
    situation? So does this bother you that a mere misstatement can
    impact in our currency in a tangible way? And what about the
    Chinese and their possible course of action in the future?
        Chairman Bernanke. Senator, as you know, the Chinese
    central bank and other Asian central banks do hold large
    quantities of U.S. dollar assets in the form of foreign
    exchange reserves. They hold those assets because they are very
    attractive assets to hold. They are highly liquid, they are
    very safe, and they are very good assets to hold in that form
    as reserves. I am not aware of any significant changes in the
    plans to hold U.S. dollar assets by foreign central banks and
    my belief is that moderate changes in the holding of dollar
    assets would not have significant impact on U.S. asset values.
        You have to remember that whereas Chinese holdings of U.S.
    dollar reserves of about $800 billion is an enormous number----
        Senator Bayh. Could I interject just for a moment, Mr.
    Chairman, with my apologies? Boy, when the rumor was going
    through Seoul and the Japanese Prime Minister misspoke, the
    markets seemed to disagree with your evaluation and we are more
    reliant on the Chinese than we are either of them. So I want
    to--look, I do not expect you in an open forum here to give
    me--let me just fall back on my first question, and we will
    kind of save the others for a little bit later.
        Does it trouble you that a mere statement could have that
    kind of impact at least in the marketplace?
        Chairman Bernanke. Well, I cannot speak to the marketplace,
    but I think that over a longer period of time, always there is
    information that comes in that can affect markets. Perceptions
    can affect markets. Psychology can affect markets. But over a
    longer period of time, the holdings of U.S. dollar assets by
    foreigners are only a portion of the very deep, very large
    markets in U.S. dollar assets, not only in treasuries but also
    in other high quality assets, such as corporates and the like,
    and I believe that those markets are sufficiently deep and
    liquid that they can withstand moderate changes in the holdings
    of any group, whether it be domestic or foreign.
        Senator Bayh. I have time for one more question so I will
    move on. And I hope you are right. But with the kind of
    imbalances that we are building up, we may be testing the
    definition of moderate adjustments and that is my concern going
    forward, that the longer these things accumulate, the greater
    risk we run that there will be a disorderly rather than an
    orderly adjustment of some kind and that does put us--last
    comment I would make is I always hear the argument, well, they
    have to consider their own financial interests and that is
    true.
        But nation states sometimes have interests other than their
    own pecuniary gain, and I am concerned that we rely upon their
    financial interests perhaps at our peril because there are
    other interests that might motivate their actions moving
    forward. That is my concern as these balances pile up.
        My final thing is somewhat related. It is the energy front.
    This is no longer a hypothetical concern. Russia used their gas
    exports to leverage Ukraine and possibly Western Europe. Iran
    has now said, well, if you pressure us unduly on our nuclear
    program, we will just shut off the oil spigot. Does that
    concern you, and if so, what would the impact be on our economy
    if the Iranians were to make good on their threat?
        Chairman Bernanke. Once again, of course, it cuts two ways.
    It would hurt the Iranians quite a bit to stop exporting their
    oil. It hurt the Russians quite a bit to stop exporting their
    natural gas. But I agree in the following general sense, that
    whereas there are substantial reserves of oil and natural gas
    in the world, a large share of them are in areas where there is
    geopolitical uncertainty or geopolitical risk, and that means
    that is a risk factor for the economy.
        We do not have a wide range of spare capacity in these
    energy areas so that a major change in the supply of energy
    available could make prices move a lot and that could have a
    major impact on the economy. That is a concern that we are
    going to have, I think, for a number of years. My view, in the
    long-run, is that with energy prices at current levels, over a
    longer period of time, there are going to be substantial new
    substitutes, alternative sources of energy, as well as new ways
    of conserving and reducing the use of energy.
        But over the next few years, our room for error is modest
    and we do face the risk that energy prices may fluctuate with
    changes in supply.
        Senator Bayh. Thank you. My closing comment, Chairman
    Bernanke, would be, you know, interdependence is one thing,
    increasing dependency is another, and it raises potential risks
    that we best think about in advance so that we do not face a
    potentially difficult situation at some point down the road.
    That is the underlying theme of my remarks. Thank you very
    much.
        Chairman Shelby. Senator Sarbanes.
        Senator Sarbanes. Thank you, Mr. Chairman. Actually, I want
    to pursue a line of questioning that just follows along with
    what Senator Bayh has been examining in the course of his
    questioning, which I thought was right on target and, of
    course, this is an issue--he chairs our Subcommittee in the
    international arena--and this is an issue on which he has
    focused and made some very substantial and positive
    contributions.
        Chairman Bernanke, you said to Senator Bayh, they like to
    hold our dollar assets. They are attractive to hold. I am
    interested whether there is not something more than that here.
    Now, these dollar assets, at least according to Marty
    Feldstein, are being purchased by foreign governments
    primarily, not by foreign individuals. Feldstein writing in the
    Financial Times on January 10 said:

        My own belief, based on widespread conversations with
    officials and with private bankers, is that the inflow of
    capital that now finances the U.S. current account deficit is
    coming primarily, perhaps overwhelmingly, from governments and
    from institutions acting on behalf of those governments.

        Do you agree with that statement? Is that your perception
    as well?
        Chairman Bernanke. We do not have complete information on
    these numbers, as you know, Senator, but I do not agree with
    the thrust of the statement. I think that there are substantial
    private sector inflows that play a big role in the financing of
    the U.S. current account deficit.
        Senator Sarbanes. If Feldstein were right, that the holders
    or that this inflow is primarily from foreign governments,
    would that raise your concern, or do you have any concern about
    the current account deficit? Let me start there first. I mean
    it is now at, well, the trade deficit is at $725 billion last
    year. That is the largest figure we have ever had for a trade
    deficit. Is that a matter of concern for you?
        Chairman Bernanke. Yes, Senator, it is.
        Senator Sarbanes. Okay. All right. Now, if Feldstein is
    right, that it is foreign governments that are putting in the
    capital, would that cause you added concern?
        Chairman Bernanke. I do not think he is correct, Senator.
    There is something on the order----
        Senator Sarbanes. No, I understand that, and that would
    require presumably some factual examination, but if he were
    right, would that heighten your concern?
        Chairman Bernanke. It depends really on which type of
    investor is more sensitive to changes in yields. Central banks
    have actually been less sensitive to changes in yields than
    private sector investors.
        So, I cannot say a priori which situation would be one of
    more concern. I think it is really not so much the portfolio
    situation; it is the fact that we are accumulating foreign debt
    over time, year by year. We can do that because foreigners are
    willing to finance that debt, but I do not think that we can
    continue to finance the current account deficit at 6 or 7
    percent of GDP indefinitely, and it is desirable for us to
    bring down that ratio over a period of time.
        Senator Sarbanes. Now it is your view, I take it, that they
    are doing this because these are attractive investments; is
    that right?
        Chairman Bernanke. Attractive in not only the return sense
    but also in the sense that they are safe, liquid, and easily
    negotiated.
        Senator Sarbanes. Well, now if the governments are doing
    it, would it not have an added significance in terms of trying
    to gain a trade advantage? Now this is the change in foreign
    currencies versus the dollar, the appreciation.
        [Chart.]
        Senator Sarbanes. This line is the euro, which generally is
    seen as free floating, responding in a market forces and so
    forth, the euro-dollar relationship. And this line down here is
    the Chinese currency, the yuan, right down here.
        Now that is a pretty dramatic contrast. And China, which of
    course is holding more and more of our Government debt,
    actually our trade deficit with China last year was a record in
    terms of the trade deficit ever recorded with a single country;
    is that correct?
        Chairman Bernanke. I believe so.
        Senator Sarbanes. Over $200 billion. Does this not enable
    them to gain an unfair trade advantage?
        Chairman Bernanke. Senator, if you are asking me whether I
    would support or advocate that the Chinese go to greater
    flexibility in their exchange rate, I certainly would.
        Senator Sarbanes. Yes.
        Chairman Bernanke. I think it is, in fact, in their own
    long-term interest to do so for a number of reasons. It will
    give them more monetary policy independence. It will reduce the
    overdependence of their economy on exports and I think it will
    be commensurate with their increasing global role for them to
    take an interest in the overall stability of global financial
    markets and trade.
        Senator Sarbanes. But if they can do this on the currency
    relationship, does it not give them a step up in the trade
    relationship?
        Chairman Bernanke. To the extent that their currency is
    undervalued, it does, yes.
        Senator Sarbanes. Yes. In fact, we are becoming more and
    more dependent. Tennessee Williams has that wonderful line in
    ``A Streetcar Named Desire'' where Blanche DeBois says
    dependent upon the kindness of strangers, and there are some
    who look at the American economy and are increasingly concerned
    that that is what is happening.
        I quoted Warren Buffett earlier in my opening statement
    saying right now the rest of the world owns $3 trillion more of
    us than we own of them. In my view, it will create political
    turmoil at some point. Pretty soon, I think there will be a big
    adjustment.
        Aren't the Chinese accumulating a leverage over our
    decisionmaking as a consequence of increasing so substantially
    these holdings of our Government debt?
        Chairman Bernanke. First, Senator, I think the $3 trillion
    should be put in some context. If I recollect, there is
    something like $15 trillion gross holdings of U.S. assets from
    foreigners and U.S. holders own about $12 trillion foreign
    assets, so that is a net number, part of a much bigger flow of
    in and out of capital.
        Senator Sarbanes. But that is a big change from what it
    used to be----
        Chairman Bernanke. We have much more open capital markets.
        Senator Sarbanes. --not so long ago; is it not?
        Chairman Bernanke. Yes, we have much more open capital
    markets, much greater capital flows, and it is worth noting
    that U.S. national wealth as of the third quarter was $51
    trillion to compare that to the $3 trillion.
        Now, as I said, I think that we should work to reduce the
    current account deficit over time. I think that would reduce
    the possibility of an uncomfortable adjustment process. But,
    again, as I said earlier in response to Senator Bayh, I do not
    think that the Chinese ownership of U.S. assets is so large as
    to put our country at risk economically.
        Senator Sarbanes. You do not think they could use it for
    political purposes?
        Chairman Bernanke. It would be very much against their own
    interest to do so.
        Senator Sarbanes. Well, it would be against their economic
    interest. It might not be against their political interests in
    the particular context of what the issue might be. I mean we
    are struck by the fact--Senator Bayh, I think, made reference
    to it--a South Korean Government official, and of course their
    holdings are much less, but still substantial, made a comment
    about South Korea continuing to hold the dollar, maybe that
    they would not do it and so forth, and it sent the stock market
    down over 150 points. Of course, then everyone scrambled and he
    pulled the statement back and so forth.
        But if it can have that kind of impact, is it not
    suggestive of the leverage that the Chinese may have in this
    situation, or others as well for that matter, but I mean since
    the deficit with China was at a record last year, I am focusing
    on them?
        Chairman Bernanke. Again, information, psychology, and news
    can always affect markets in the short-term, but I think that
    over a longer period of time that the depth and liquidity of
    U.S. financial markets would be sufficient to sustain changes
    in holdings by foreign central banks.
        Senator Sarbanes. Mr. Chairman, I see my time is up. I just
    want to, in closing----
        Chairman Shelby. Take another minute.
        Senator Sarbanes. --when we talk about the deterioration
    and the net international investment position, when you talk
    about so much, this is the chart which illustrates what has
    happened.
        [Chart.]
        Senator Sarbanes. The first line back there is 1980. We had
    a positive net position. We then went into a negative position,
    but look at what has happened to it in recent years. I mean if
    you regard a minus or a negative position as something to worry
    about, it seems to me we have very good reason to be worried
    about what has happened to our net international investment
    position.
        It is no wonder Buffett is saying this or Volcker says,
    ``Under the placid surface there are disturbing trends, huge
    imbalances, disequilibria, risk, call them what you will. All
    together the circumstances seem to me as dangerous and
    intractable as any I can remember, and I can remember quite a
    lot.''
        Thank you, Mr. Chairman.
        Chairman Shelby. Thank you, Senator Sarbanes. I want to
    shift to Basel II capital requirements, Mr. Chairman. The
    Federal Reserve is presently in the process of implementing the
    Basel II Capital Accord, which will establish new capital
    requirements for our largest banks.
        Capital requirements play a vital role in protecting the
    safety and soundness of the U.S. banking system. I think it is
    very important that there be no surprises to this Committee and
    others in the implementation of Basel II, especially
    unanticipated reductions in capital requirements.
        Last year, Chairman Bernanke, this Committee held a hearing
    at which several witnesses here expressed concerns that the
    adoption of Basel II would result in the lowering of capital
    requirements. In addition, last year, the Fourth Quantitative
    Impact Study, unexpectedly, Mr. Chairman, showed that Basel II
    would result in substantially lower capital requirements which
    gives then this Committee concern.
        What steps, Mr. Chairman, need to be taken to make sure
    that Federal banking regulators, and you are one of these
    regulators, Congress and the public at large are confident that
    the implementation of Basel II will not, will not adversely
    impact the safety and the soundness of the banking system that
    we know today?
        Chairman Bernanke. Mr. Chairman, let me just assure you
    that the Federal Reserve does not want to see a significant
    reduction in capital in the U.S. banking system. We are
    prudential supervisors. We have a very strong interest in
    maintaining a safe and sound banking system and a stable
    financial system.
        We are planning a very slow phase-in process, one that will
    involve considerable consultation, will involve a variety of
    safeguards such as floors that will be phased out over a period
    of time. Moreover, there are a number of other safeguards such
    as the leverage ratio and Pillar II which allows the
    supervisors to evaluate the overall safety and soundness of the
    bank and look at such things as compliance risk or interest
    rate or liquidity risk.
        We are very much on the same page as you are, Mr. Chairman.
    We think Basel II is very important because it will allow
    banks' capital holdings to be sensitive to the risks that they
    take, and it will be consistent with modern risk management
    techniques, so we think it is important to move forward with
    Basel II. But we do not see this, we certainly do not want
    this, to be a source of a significant reduction in aggregate
    capital in the U.S. banking system.
        Chairman Shelby. Senator Sarbanes wants to be recognized
    now. Go ahead.
        Senator Sarbanes. Mr. Chairman, I just want to observe that
    is kind of calming the waters in terms of assurance. Vice
    Chairman Ferguson did that when this Basel II was under his
    jurisdiction. Mrs. Bies has it now, I think, in her portfolio.
    And he told us that they were not going to lower capital and so
    forth and so on.
        But you ran the formula in the QIS-4 and it resulted in
    very substantial capital reductions. Everyone said, the
    regulators all rushed to say, well, we do not want that; that
    is not where we want to go. We do not intend to do that if the
    Congress raises questions about it. But you are moving ahead
    with a proposed regulation, as I understand it, that is still
    utilizing the same formula that produced the QIS-4 result, and
    you are saying, well, if it produces these bad results, we will
    take all kinds of band-aid measures in order to contain it.
        But why would you not pull the regulation back, develop a
    revised formula as part of the proposed regulation, which upon
    testing did not produce these kind of results about which
    everyone says, oh, we are very concerned about it, and yet they
    move ahead with the proposed regulation, still encompassing the
    formula that everyone admitted created a terrific problem?
        Chairman Bernanke. Senator, the QIS-4 results were on a
    best efforts basis. The banks did the best they could with the
    information they had. They had not yet developed the models.
    They do not have all the data they need. It was just a very
    experimental kind of study. In order for this to be really put
    to the test, the banks need to have the guidance from the
    regulators about what our expectations are so that they can
    actually go ahead and develop the models, get the data, and
    take this to the next level.
        They really cannot proceed with the process and allow us to
    do further analysis without some guidance from us. This is very
    much a dialectical process. We are going to provide guidance,
    we are going to see the results, we are going to get
    commentary, and we are going to work together with the banks to
    make sure that the bank capital is adequate.
        Senator Sarbanes. I understand all that, but why are you
    moving ahead with a formula that has been shown to be faulty?
    Why do you not pull back and develop a different formula?
        Chairman Bernanke. We are adjusting the formulas based on
    what we have learned and we will continue to do so.
        Senator Sarbanes. What is going to happen, and I just sound
    a warning, is you are going to continue down this path, you are
    going to become more committed, as it were, to your
    international partners. You are already very heavily committed,
    I think overcommitted, because you have moved way ahead there,
    created a problem, and then one day the Congress is going to
    say to you wait a minute, this is not the path we want to go
    on; this path is going to lead to a significant reduction in
    capital. And somehow or other we are going to put a stop to it.
        Now that is the potential that I see developing by what I
    think is a faulty process. I think once you had these bad
    results from the QIS, you should have pulled back, revised the
    formula, and gone back into a--so when you moved ahead on the
    process, you had some confidence it was meeting all of these
    concerns. You are moving ahead on a process now that still has
    within it the very seeds from which all this concern flows.
        Chairman Bernanke. Senator, first, we cannot really
    evaluate the formulas unless we see the results from the banks'
    own models and their own analyses. There needs to be a dialogue
    process going on so that we can continue to learn, and second,
    it is, after all, a very flexible framework that allows for
    capital under Pillar II. It allows for multipliers and other
    changes.
        I hear you very clearly and I assure you once again that it
    is not in the Federal Reserve's interest to allow inadequate
    capital in the banking system because financial stability is
    one of our primary objectives.
        Senator Sarbanes. Let me just add. Is it a conflict for the
    banks, to look to the banks to develop the model since the
    banks stand to benefit in significant ways if they can lower
    the capital requirement? It will enhance their competitive
    position vis-a-vis other banks in the U.S. and it will keep
    them, or they would argue presumably, in a competitive position
    vis-a-vis banks in other countries that are moving to Basel II.
        So you keep telling me, well, we are looking for the banks
    to give us the models, but don't the banks have a particular
    vested interest in what they want the models to produce?
        Chairman Bernanke. Well, actually we are looking for them
    to give us statistical indicators of their own loss experience
    in their past credits. And part of the process will be
    validation. That is, they have to show us that their numbers
    were derived from their actual experience over a period that
    encompasses both strong and weak credit conditions and that
    they are using those models for their own internal analysis of
    capital. So there will be a lot of checks and we will continue
    to work with the banks and with the Congress on this issue.
        Chairman Shelby. Mr. Chairman, before I recognize Senator
    Carper for his first found of questions, I just want to
    emphasize that Senator Sarbanes and I have talked at length to
    our counterparts in the House, Democrats and Republicans. They
    have the same concerns we do. We have all been on this
    Committee--Senator Sarbanes and I have been on this Committee
    during the thrift bailout and everything. We believe that
    capital is very, very important for the safety and soundness of
    our banking system, period.
        Senator Carper.
        Senator Carper. Mr. Chairman, I think I would like to ask
    you a human question before we get into some of the other
    things I mentioned earlier. I told you I wanted to talk about
    our savings rate, our poor savings habits in this country, and
    I wanted to talk about the interplay between the trade deficit
    and the budget deficit and potential impact on interest rates.
        But just really a human question at first. You have been in
    your new job for how long?
        Chairman Bernanke. Oh, about 14 days now.
        Senator Carper. And we were talking in the anteroom before
    we came in, and I was asking you how you are doing as a human
    being. And you mentioned jumping right into these hearings 2
    weeks into the job was a challenge, and I can understand that.
    But where does so far 2 weeks into this job, where does it meet
    your expectations; maybe where is it a little bit different
    from the expectations you had for it?
        I say that recognizing that you are probably uncommonly
    well prepared for this position.
        Chairman Bernanke. Well, it has been very challenging and
    very interesting, and I do have the benefit of having spent
    almost 3 years at the Board as a Governor, and that experience
    has been invaluable in trying to address the wide range of
    issues the Federal Reserve deals with.
        Senator Carper. You will be scheduled to come back before
    us when? About 6 months or so from now?
        Chairman Bernanke. That is correct.
        Senator Carper. And one of the questions--this is
    telegraphing my pitch--but one of the questions I will ask you
    then is with 6 months of experience under your belt, how do you
    see the world or this job, your responsibilities, differently,
    if at all, then than you do as you assume these
    responsibilities?
        Let us talk about savings rates. Just share with us, if you
    will, your view of the kind of job we are doing as savers in
    this country, where we might do better, and some things that
    not just the Federal Reserve but those of us in the Congress
    should be thinking about to encourage a better savings rate?
    And why should this or should this not be a concern to us?
        Chairman Bernanke. Senator, this actually ties back to the
    questions raised about the current account, for example. The
    reason we have a current account deficit is that we invest
    more, including housing, than we save, and we have to make up
    the difference by borrowing abroad, so our national saving is
    not sufficient to fund our domestic investment opportunities.
        It is a good thing in a sense that we are able to go to the
    international capital markets and find funding for good
    domestic investment opportunities, but we would be better off
    in some sense if we ourselves could fund those investment
    opportunities creating more wealth for Americans and greater
    capacity in the future for us to deal with the long-term
    challenges associated with demographic changes and the like.
        So, I think it is desirable for us to try to raise our
    national saving. There are various dimensions to that. One is
    on the fiscal side. We are looking in the next 5, 10, 15 years
    to increasing obligations and entitlement spending, for
    example, and increasing challenges in the Government's budget.
        Congress is going to have to make some very tough decisions
    about controlling the deficit, and by doing so, to the extent
    that the deficit can be reduced, that is a direct contribution
    to national saving and would be constructive.
        In addition, Americans, in part because of the increased
    wealth they have gained through increased home values and
    through other asset price increases, have not saved too much
    out of current income. In fact, the current saving out of
    disposable income is a negative rate.
        Senator Carper. Say that one more time.
        Chairman Bernanke. The savings rate, the ratio of household
    savings to after-tax income, is currently less than zero. That
    is, spending is more than income. Our expectation is that that
    saving rate will increase over time for a number of natural
    reasons, including the possibility that house prices will no
    longer rise as quickly as they have and so people will be
    forced to turn to saving out of current income in order to
    build their assets.
        But in addition, it would be desirable for Americans to
    save more to prepare better for the future. The problem is we
    do not have really good effective tools to achieve that. There
    are obviously ways of providing tax incentives or other kinds
    of tax-favored vehicles to help people save.
        There is a lot of debate about how effective those actually
    are and I really cannot give you a strong answer there. One
    thing which I think can be done and would be positive would be
    on the financial literacy front. When I was on the school board
    in New Jersey many years ago, I argued for more economics in
    the schools. I thought that it was very important for young
    people to understand early on that they need to put something
    away; they need to develop a habit of saving, and they need to
    understand enough about financial markets and financial
    instruments that they can save effectively.
        So that is one dimension where I think we can be helpful,
    but I agree that saving is something that needs to be promoted
    and that it is good for our long-term future to have greater
    wealth accumulation.
        Senator Carper. I would just say, Mr. Chairman, and to my
    colleagues and to Chairman Bernanke, in our experience in
    Delaware, trying to get people to save through the State of
    Delaware's deferred compensation program, State employees,
    people who were higher income, and there are not very high-
    income State employees in Delaware, but people whose incomes
    are higher tend to save a lot. They maxed out in the deferred
    comp program.
        But in order to get the people who were at the lower end to
    save, we had to be able to provide some incentives for them,
    and to say for every dollar that you save, we will like match
    it with two dollars, and to get to prime the pump, and once we
    did, they would participate.
        And the other thing I would say, for most of us, the
    biggest source of savings is really the equity in our homes,
    and to the extent that we can include homeownership
    opportunities not for people like $150,000 or $200,000, but to
    the people who are making $25,000, then we do a very good thing
    for them as they prepare for their golden years.
        Thank you, sir.
        Chairman Bernanke. Thank you.
        Chairman Shelby. Senator Schumer for your first round.
        Senator Schumer. Thank you, Mr. Chairman, and I thank you,
    Chairman Bernanke--that has a nice ring to it. I am glad you
    are here. I thought your confirmation process was both a
    tribute to you and a model of how we should do other
    confirmations, particularly on other Committees on which I
    might serve or do serve, with a lot of consultation,
    bipartisanship, et cetera.
        I have a bunch of questions. The first relate to the
    overall global situation of the United States and as it relates
    to China. You said yesterday that we need to increase national
    savings as one of the ways to deal with our big trade deficit
    with the rest of the world and China.
        Yet, the budget we passed 2 weeks ago increased the debt we
    have further and there is a push to put new tax cuts in that.
    Now, I am not asking you to opine on tax cuts. I know you do
    not want to do that.
        I do want to ask you does it make sense, from a global
    perspective, for us to continue to increase this deficit,
    whether it is by tax cuts or increased savings? Does that not
    weaken the position of the United States in trying to
    accomplish many of our other international economic goals?
        Chairman Bernanke. As I indicated to Senator Carper, I
    think reducing the fiscal deficit is an important priority. It
    is important because looking forward 10, 15, 20 years, we have
    a demographic challenge coming, and we need to be prepared for
    that, and it does contribute to national savings which enhances
    our wealth creation and the strength of our economy in the
    future.
        So, I do think that we should look at that. There really
    are two separate questions. I just would note the first one is
    the size of the Government itself. I mean what we should agree
    on how big the Federal Government, that is the Federal budget,
    should be, and then we need to make sure that the revenues we
    collect are commensurate with those expenditures over a period
    of time.
        Senator Schumer. You do agree that, again, now looking more
    at the type of actions that Senator Graham and I have been
    active in, not commenting on our methodology, that it would be
    better for the world economy and for the United States if China
    were after some point of time to allow its currency to float,
    which would adjust for trade imbalances that would occur. Do
    you agree with that?
        Chairman Bernanke. Yes, Senator, I do. I think China should
    move toward a more flexible exchange rate.
        Senator Schumer. And why do you think we are making so
    little progress with China right now?
        Chairman Bernanke. That is a good question. They have, I
    think, mixed views about the benefits to their own economy of
    making that change.
        Senator Schumer. Right.
        Chairman Bernanke. They see some benefits in what they view
    as stability. They see an advantage in exports from keeping
    their exchange rate where it is. But as I was suggesting, I
    think, to Senator Sarbanes, it is very much in their interest
    to move toward a more flexible exchange rate to increase their
    monetary independence, to reduce their reliance on exports, and
    just to continue to play an appropriate role in contributing to
    global financial and trade stability.
        Senator Schumer. Right. And I agree with the thrust of your
    comments there. The Chinese seem to want a lot of the benefits
    of being part of the global system, but are much less quick to
    take their responsibilities.
        What would you suggest to people like Senator Graham and I?
    Now make no mistake about it, our legislation is very popular
    in Congress, but lots of economists and people I respect say
    you are right on your goals and you are right that China is not
    moving quickly enough, but this is the wrong way to go.
        The problem is we are ready to tear our hair out. There
    seems to be no other way to go. The Administration has tried
    talking softly and talking loudly. It just seems nothing gets
    them to move. Do you have any suggestions on how we can get the
    Chinese to let the currency float? No one is saying it has to
    float freely, completely, immediately. There have to be
    adjustments. But what can we do other than the legislation that
    Senator Graham and I have introduced?
        We do not see any other solution at this point. The Chinese
    say to us if you put pressure on us, we will not move, and then
    when we do not put pressure on them, they do not move.
        Chairman Bernanke. I appreciate your frustration, Senator
    Schumer. As you probably know, I think it is not a good idea to
    break down some of the gains we have made in terms of free and
    open trade in the world economy. We should be very careful
    about that.
        But in terms of working with China, there are really two
    things we can do. We can continue to try to be persuasive and
    we can try to offer technical assistance in helping them. They
    have taken some steps in terms of increasing their trading
    platforms and their capacity to allow the exchange rate to
    float. I agree they need to do more and we just need to
    continue to work with them and be as persuasive as possible.
        Senator Schumer. One final question on this, if I might,
    Mr. Chairman.
        Chairman Shelby. Go ahead.
        Senator Schumer. Doesn't the fact that China and other
    countries, Japan, have such large amounts of American reserves
    mean that they could, if they wanted, actually have a little
    bit of your job, have some effect over interest rates in the
    United States by what they do?
        Chairman Bernanke. As I indicated already this morning, I
    think that the capital markets for U.S. dollar assets are
    sufficiently large, deep, and liquid that the impact of such
    changes would be mostly transitory and could be managed.
        Senator Schumer. Thank you, Mr. Chairman.
        Chairman Shelby. Senator Bunning.
        Senator Bunning. Thank you, Mr. Chairman. We are on 5
    minute round of questions, are we not?
        Chairman Shelby. Or as much time as you need.
        Senator Bunning. Thank you. Just to follow up on Senator
    Schumer's discussion about China. We took six Senators to China
    to talk trade with the Chinese. They would not even visit with
    us. Six U.S. Senators, five were on the Trade Subcommittee of
    the Finance Committee, and we got number six in line in the
    Chinese bureaucracy and he knew nothing about trade.
        So, I just want you to know what a problem there is, and we
    worked like the devil to get them into the WTO, and I wish that
    they would just follow the rules of WTO. That is an aside.
        Yesterday, you talked a lot about our budget deficits and
    particularly our long-term obligations that are only going to
    increase. You also rightly said those decisions are ones that
    Congress needs to make. How much of a factor are those long-
    term entitlements in your economic forecast? I am speaking
    about Medicare, Medicaid, and Social Security.
        It looks like by the year 2030 that they will take up about
    70 to 75 percent of our budget. So we will be squeezed down to
    about 25 percent for discretionary spending. So how much do
    they come into your forecast?
        Chairman Bernanke. Senator, your basic facts are absolutely
    right. The numbers I have are that in the next 40 years the
    share of GDP being devoted to Social Security, Medicare, and
    the Federal part of Medicaid is going to go from about 8
    percent today to about 16 percent 40 years from now.
        Since the historical share of GDP collected as tax revenues
    is something in the order of 18.2 percent, that suggests there
    will be very little room in the budget for anything other than
    entitlement spending and suggests it is very important for
    Congress to begin thinking about how it wants to reorder or set
    its priorities.
        It is important to get that going soon, first of all, to
    assure financial markets that Congress will be responsible and,
    second, and perhaps even more importantly, to give people the
    time they need to plan for retirement and make provision based
    on any changes that Congress might decide to make.
        In terms of our forecast, as I reported today, are usually
    only a year or two in the future, uncertainty being what it is.
    So only the near-term effects are reflected in our forecasts.
    We are already beginning to see some effects of entitlement
    spending on the budget deficit. We factor that in, but since we
    are only looking at the near-term effects, we obviously are not
    incorporating these very large, long-term entitlement
    obligations into the near-term forecasting exercise.
        Senator Bunning. If nothing is done to shore up these
    programs, and I am speaking about entitlements, for several
    more years, what kind of impact is this going to have on our
    economic growth and employment and how will that affect your
    ability to act?
        Chairman Bernanke. Well, the widening deficits over a
    period of years will reduce national savings, will probably
    exacerbate the current account deficit, may raise interest
    rates, and will probably inhibit the dynamism of the economy.
        I do not foresee, in the near-term, that these factors are
    going to substantially affect monetary policy or the way
    monetary policy functions in the economy, but from a broader
    perspective, the health of our economy, in the long-run,
    requires that we achieve a better fiscal situation and higher
    national saving.
        Senator Bunning. In reference to the trade deficit, how
    long do we have to reduce trade imbalances before our economy
    starts to suffer because of them?
        Chairman Bernanke. Senator, it is very hard to judge. It
    took us about 10 years to get where we are today from about
    1995 when the current account deficit began to open up. It
    might take that long to reverse. It might take a number of
    years to reverse, and I think that it is certainly possible to
    have a decline in the current account taking place over a
    number of years, but it is very hard to judge exactly how long
    the process is going to take.
        Senator Bunning. Thank you, Chairman.
        Chairman Shelby. Mr. Chairman, the January survey of senior
    loan officers indicated that 40 percent of respondents felt
    that the outlook for delinquencies and chargeoffs of
    nontraditional mortgages was likely to deteriorate somewhat.
        Would this type of credit quality deterioration be
    consistent with the forecast that you outlined for a soft
    landing in housing markets? And do you believe that bank
    regulators including the Fed, yourself, acted quickly enough in
    putting out supervisory guidance regarding these types of
    nontraditional mortgage products?
        Chairman Bernanke. I cannot really speak to the timing. We
    have put out----
        Chairman Shelby. First of all, I realize you have just gone
    to the Fed.
        Chairman Bernanke. We have put out guidance for comment on
    nontraditional mortgages and I think that it is good guidance.
    It addresses what I think are the main issues. First, are banks
    underwriting nontraditional mortgages in an appropriate way? In
    particular, are they selling these mortgages to people who are
    able to manage them effectively?
        Chairman Shelby. Will you as a regulator at the Federal
    Reserve require banks to take any additional steps to mitigate
    the risk and how might these steps affect the economy if you
    see it is necessary?
        Chairman Bernanke. Mr. Chairman, as I was saying, the
    guidance includes several components, including both
    underwriting and consumer disclosure to protect consumers, but
    also safety and soundness. The banks should manage the risks
    associated with nontraditional mortgages in a way that
    maintains their capital at a safe and sound level.
        Chairman Shelby. Your report this morning, Chairman
    Bernanke, indicates that growth in labor productivity over the
    past 5 years has averaged over 3 percent per year.
        For the fourth quarter of 2005, it declined 0.2 percent in
    the business sector and 0.6 percent in the nonfarm business
    sector. The productivity declines were unexpected by most
    market watchers.
        What is your assessment of these numbers? Do they represent
    a one time aberration or are they indicative of things to come?
    Do you believe it is possible for us to sustain the pace that
    we have seen over the past 5 years?
        Chairman Bernanke. Mr. Chairman, the fourth quarter appears
    to have been a transitory decline in growth related to a number
    of special factors, including effects of the hurricanes, the
    seasonal pattern of sales of automobiles, and some other
    factors as well.
        So with output down more than the underlying trend would
    indicate, productivity, which of course is output per worker,
    also declined in the fourth quarter.
        Chairman Shelby. Think that will continue?
        Chairman Bernanke. It appears that the first quarter will
    see significant rebound from the fourth quarter and likely
    productivity will come back with it. We, in the Federal
    Reserve, pay most attention to productivity growth over the
    longer-term, and the ability of the U.S. economy to generate
    ongoing productivity gains through use of technology, through
    the flexibility of our labor and capital markets has been most
    impressive. And we expect good productivity gains to continue
    for the next few years.
        Chairman Shelby. Thank you. Senator Bennett for your first
    round.
        Senator Bennett. Thank you, Mr. Chairman. I apologize for
    coming in late. I have been over in the House side chairing the
    meeting of the Joint Economic Committee to hear the President's
    Annual Economic Report from the Council of Economic Advisors,
    and they miss you, Mr. Chairman, but they acquitted themselves
    extremely well, and your former colleagues did a great job.
        Let me focus on an area where you had questioning on the
    House side where some of your comments were, shall I say, not
    the ones that I would have wanted. I want to talk to you about
    ILC's. I am sure that comes as no surprise to you. Being the
    Senator from Utah, I represent the State where the ILC's are a
    very significant industry.
        I have not had a chance to review the transcript directly.
    I have been told by one of the Members of the House who was
    there that you were told that some ILC's have failed, and that
    is not true.
        Chairman Bernanke. I was not told that.
        Senator Bennett. Okay. I want to get the record straight on
    that. The ILC's are back in the news right now because of Wal-
    mart's application, and people are saying, well, we have to
    prevent Wal-mart from getting an ILC charter. That is just
    awful. No one wanted to prevent Target from getting an ILC
    charter, and I have a hard time understanding why it is okay
    for one large retailer to have such a charter and not for its
    competitor to have such a charter.
        I have talked with the Wal-mart executives. I believe they
    are sincere in their statement that they do not intend to go
    into the banking business. Indeed, they are signing long-term
    leasing contracts with community banks, community banks
    entering Wal-mart with their own branches. The Wal-mart people
    told me we have looked at this, but we are not bankers, we are
    retailers, they are different businesses, and we do not want to
    go into a business we do not understand.
        However, simply getting an ILC charter will save Wal-mart
    $30 million a year in processing fees to a bank. If they are
    technically a bank, they do not have to pay another bank to
    process all the charges, all the credit card charges, all the
    checks, and money orders, et cetera, that they process. They
    will process them themselves through their ILC. It is worth $30
    million a year to them.
        I do not see anything wrong with that, and I hope the FDIC
    does not see anything wrong with that. They are the regulator
    of the ILC's. For years, the staff at the Federal Reserve has
    felt strongly that the FDIC is not capable of regulating the
    ILC's and they either want them destroyed or short of that,
    they want them transferred to the Fed, so that the Fed oversees
    them.
        I see no market reasons why that is necessary, no
    circumstances in the real world that says the Fed could do a
    better job than the FDIC. So, I would like your responses to
    that and your comments about the ILC's, your attitude as to how
    dangerous they may be, and any data that you might have to back
    that up, and then your sense of what would happen to the ILC's
    if indeed the Fed were to succeed in its crusade to get the
    regulatory responsibility shifted away from the FDIC?
        Chairman Bernanke. Senator, first of all, as you point out,
    the specific case at hand, the Wal-mart case is the FDIC's
    decision. I understand they are going to have a public hearing
    and will evaluate the merits of that individual case.
        The concerns that the Federal Reserve have had about ILC's
    have turned largely on recent proposals that ILC's would have
    additional powers including interest on business checking and
    out-of-State branching which would de facto make ILC's the
    functional equivalent of banks.
        And our concern has been that if ILC's are to be the
    functional equivalents of banks, that they receive parallel
    treatment in terms of consolidated supervision and other
    responsibility requirements that banks face. And it may be that
    I have only been in the job 2 weeks, but I am not aware that
    the Fed has lobbied to become the regulator of the ILC's.
        Senator Bennett. I think the staff will make you aware of
    that fairly soon.
        Chairman Bernanke. Perhaps they will. The main thing is
    that Congress should try to be consistent, make sure that rules
    that they apply are applied consistently across similar types
    of organizations, and that is the concern that we have had, and
    we have been concerned about the ownership of ILC's by
    nonfinancial institutions and whether or not that poses risks
    to the safety net or creates an unlevel playing field with
    other kinds of financial institutions.
        Senator Bennett. I think those are legitimate questions,
    and I believe the ILC's qualify for their present circumstance
    in the face of all of those questions. In 1997, Chairman
    Greenspan said, quote:

        The case is weak in our judgment for umbrella supervision
    of a holding company in which the bank is not the dominant unit
    and is not large enough to induce systemic risk should it fail.

        And that, of course, is the case with the ILC's. If Wal-
    mart were to get its charter, the bank would clearly not be the
    dominant unit. And its size would not indicate systemic risk.
    Taking that statement from your predecessor, do you have any
    ideas about how it no longer applies or any reaction or, again,
    is this issue, and I am not saying this to put you down in any
    sense, I think it is very possible that this issue is simply
    too new for you to feel comfortable commenting on it, and I
    would not complain if you said that was the case. But we do
    have this comment by Chairman Greenspan, which he has
    subsequently recanted, but which we really like. And I would
    like your reaction to it.
        Chairman Bernanke. Again, I think that it would probably
    not be appropriate for me to comment on the Wal-mart case given
    its status of being adjudicated by the FDIC.
        Senator Bennett. Just comment about this whole idea
    generally because this statement was made before Wal-mart
    applied for their charter.
        Chairman Bernanke. The general concern is that if a
    commercial firm owns a bank, would there not be a possibility
    that the safety net would be inadvertently extended to the
    commercial firm? Would we be able to segregate the financial
    condition of the commercial firm from the bank and would it be
    possible for not just the FDIC but for any bank supervisor to
    adequately supervise not only the bank but also the owning firm
    to ensure that the safety and soundness rules were being met?
        Senator Bennett. Now we are edging into Gramm-Leach-Bliley
    and the conversation about banking and commerce. I used Wal-
    mart as the example because they put a specific number on it.
    Simply having an ILC charter is worth $30 million to them a
    year if they do absolutely nothing as far as the consumer is
    concerned and it does not change the safety and soundness of
    anything to me.
        Many of the largest ILC's in Utah are owned by automobile
    companies. GMAC, Volkswagen, Mercedes, they do very large
    financing operations, and they find that having an ILC charter
    is enormously valuable to them even if they do not issue
    checkbooks and they do not open branches, and they do not do
    the traditional kinds of things that banks do. This is a
    device, created by the Congress, that is helping the
    marketplace, making things more efficient, saving money all the
    way around, which presumably means that consumers benefit
    because there is less money going into it.
        We do not have to continue this, but I just want to lay
    this issue on the table before you because I think you will see
    down at the Fed that there is an effort on the part of some
    members of the staff to, if not curtail the ILC's all together,
    to bring them under Fed jurisdiction, and that is certainly
    former Chairman Leach's desire. He is not fond of ILC's and I
    think would like to see them eliminated, and I am laying down
    again the marker, I am very fond of them, and I want to see
    them continued.
        Chairman Bernanke. Senator, the thrust of the Leach bill
    would be essentially to restrict the kind of firm that could
    own an ILC and that was the part that I commented on favorably
    yesterday. Again, the Federal Reserve is not in itself looking
    to find new areas, new domains, but having a financial holding
    company or a financial company owning the ILC mitigates some of
    the concerns that I have talked about relating to consolidated
    supervision.
        Senator Bennett. Thank you. I am sure we will be having
    more conversations about this.
        Thank you, Mr. Chairman.
        Chairman Shelby. Senator Sarbanes, you have any other
    questions?
        Senator Sarbanes. Senator Bennett having laid the issue on
    the table, I think I should continue with it for a bit just to
    be clear. As I understand it, the FDIC does not have
    consolidated supervisory authority and that is the problem with
    these ILC's, unlike the role the Fed has with respect to
    regular financial institutions under the Federal Bank Holding
    Company Act; is that correct?
        Chairman Bernanke. That is correct.
        Senator Sarbanes. And, of course, Chairman Greenspan was
    quite outspoken about this issue. I do not know. You cited him
    for something, but it is----
        Senator Bennett. I acknowledge he has changed his mind
    since he said that.
        Senator Sarbanes. He has been quite strong about it. In
    fact, he expressed a concern that the ILC's, which are
    chartered in just a handful of States, represented a breach in
    the traditional separation of banking and commerce in the
    United States, and unlike the financial institutions with
    banking subsidiaries, the owners of the ILC's are not currently
    subject to the supervisory requirements of the Bank Holding
    Company Act.
        So you have a very significant loophole here. I mean these
    ILC--I understand Senator Bennett's interest in this matter--
    but, you know, they have grown at an incredible rate. The
    aggregate amount of assets controlled by Utah-chartered ILC's
    is 16 times the total of all the banks, savings associations,
    and credit unions chartered in Utah.
        Senator Bennett. We are very grateful.
        Senator Sarbanes. It has become a huge business there. One
    ILC has more than $58 billion in assets. I do not think Target
    should have a bank. I mean you said no one questions that. I
    question that.
        Senator Bennett. Okay.
        Senator Sarbanes. In Gramm-Leach-Bliley, we closed the
    unitary thrift loophole as a way to further the separation of
    banking and commerce, and this one loophole remained and is now
    being exploited and expanded to the hilt, and I think it is a
    very serious problem.
        Now, the Leach legislation, as I understand it, would
    simply subject the ILC's to the same prudential constraints
    including consolidated supervisory requirements, bank level
    capital, managerial criteria, enforcement mechanisms, as
    applied to financial holding companies. And the GAO was asked
    to do a study and they concluded that the ILC's were not
    adequately regulated under current law.
        The problem may come somewhere down the line, just like it
    did with the savings and loans. I mean we had the savings and
    loans people came in and said, well, we need to accommodate
    here, it is an important part of our economy. And 50 percent of
    the savings and loans that failed were in the State of Texas.
    So we had Members of the Committee who were deeply interested
    in that and so we went along, went along, and whammo.
        I think the taxpayers paid $132 billion for the savings and
    loans. So, I am concerned about these loopholes and the
    exploitation of these loopholes because there is not around
    them the kind of regulatory examination, the regulatory
    framework, which helped to assure the safety and soundness of
    the system. So the matter having been put on the table, I
    thought I should contribute to the discussion.
        Senator Bennett. I am always grateful for your
    contribution.
        Senator Sarbanes. I want to very quickly, Mr. Chairman, ask
    you two or three quick questions, just as kind of an alert of
    our interest. One is the remittances, an issue that you have
    taken an interest in. I want to underscore that. Is there a
    greater role for the Fed to play in expanding the service of
    its international automated clearinghouse? There is some
    opinion that think that.
        I mean you have just reached an understanding with the
    Mexican central bank and it is felt that that is going to make
    a difference. What about expanding it?
        Chairman Bernanke. It is correct that we have reached an
    agreement with Mexico, and to the best of my knowledge we are
    exploring further opportunities and we are open to your
    comments or suggestions.
        Senator Sarbanes. Okay. Everyone thinks of you as primarily
    a monetary policy, and that is understandable, but the Fed has
    a very significant role, of course, as a bank regulator.
    Privacy and data security, something the Chairman has focused a
    great deal of attention on. Last year, we had these incredible
    instances of several financial institutions--actually
    Government agencies, private companies as well--reporting these
    breaches of Social Security numbers, credit and debit card
    numbers, security codes, and bank account information.
        What can the Fed do to help tighten up data privacy and
    security and enhancing the privacy rights of consumers?
        Chairman Bernanke. The Federal Reserve together with the
    other banking regulators already has issued, I believe, its
    regulations to the banking system concerning management of
    data. There are really two parts to it. First, that banks are
    required to have good internal controls, to make sure the data
    are protected. And second, that banks are required, and other
    financial institutions are required, to inform customers if
    there is a data breach that has caused, or is likely to cause,
    or be a source of fraud.
        So we have created a structure in the banking system to
    address these issues, and to my knowledge, I believe that
    Congress is looking to some extent at our approach as a model
    for thinking about extending these rules to other kinds of
    organizations.
        Senator Sarbanes. And finally this Committee has held a
    number of hearings on money laundering and terrorism financing.
    Actually, you know, the Department of Justice has undertaken
    criminal investigations of bank officials in these areas. But
    that suggests that the regulatory authorities, the bank
    regulatory authorities of whom the Fed is one, somehow fell
    behind the curve, so to speak. What can be done to boost that
    oversight with respect to money laundering and terrorism
    financing?
        Chairman Bernanke. We consider it a very important issue,
    and we are putting a lot of resources into it. Our approach is
    again to assess information management systems that banks have
    to make sure that they know their customer or they know the
    source of a transaction. That is the best way we have to
    approach this and again we will continue to work hard to make
    sure that the Anti-Money Laundering and Bank Secrecy Act rules
    are obeyed.
        Senator Sarbanes. Is there a special unit at the Fed that
    focuses on this?
        Chairman Bernanke. I think it is part of the general Bank
    Supervision Division, but there are certainly quite a number of
    individuals who are specially involved in it, who have special
    backgrounds.
        Senator Sarbanes. Do you think it has a high enough profile
    within the Fed organization or the Fed hierarchy?
        Chairman Bernanke. Would you allow me more time to learn
    more about the structure of the organization?
        Senator Sarbanes. Fine. Thank you, Mr. Chairman. I do want
    to commend the Fed on the work it is doing in the area of
    financial literacy and in particular Chairman Bernanke's
    commitment to that effort. He made reference to when he was on
    the school board. It was an elected school board, as I recall;
    correct?
        Chairman Bernanke. Yes, sir. I received over 1,000 votes.
        [Laughter.]
        Senator Sarbanes. We are always impressed by that.
        Senator Sarbanes. Thank you, Mr. Chairman.
        Chairman Shelby. Chairman Bernanke, we look forward to
    working with you in many areas, and we know you will be back
    before the Committee. We wish you the best as you undertake
    your new opportunities and responsibilities.
        The hearing is adjourned.
        Chairman Bernanke. Thank you, Mr. Chairman.
        [Whereupon, at 12:23 p.m., the hearing was adjourned.]
        [Prepared statements, response to written questions, and
    additional material supplied for the record follow:]

                     PREPARED STATEMENT OF BEN S. BERNANKE
           Chairman, Board of Governors of the Federal Reserve System
                               February 16, 2006

        Mr. Chairman and Members of the Committee, I am pleased to be here
    today to present the Federal Reserve's Monetary Policy Report to the
    Congress. I look forward to working closely with the Members of this
    Committee on issues of monetary policy as well as on matters regarding
    the other responsibilities with which the Congress has charged the
    Federal Reserve System.
        The U.S. economy performed impressively in 2005. Real gross
    domestic product (GDP) increased a bit more than 3 percent, building on
    the sustained expansion that gained traction in the middle of 2003.
    Payroll employment rose 2 million in 2005, and the unemployment rate
    fell below 5 percent. Productivity continued to advance briskly.
        The economy achieved these gains despite some significant
    obstacles. Energy prices rose substantially yet again, in response to
    increasing global demand, hurricane-related disruptions to production,
    and concerns about the adequacy and reliability of supply. The Gulf
    Coast region suffered through severe hurricanes that
    inflicted a terrible loss of life; destroyed homes, personal property,
    businesses, and infrastructure on a massive scale; and displaced more
    than a million people. The storms also damaged facilities and disrupted
    production in many industries, with substantial effects on the energy
    and petrochemical sectors and on the region's ports. Full recovery in
    the affected areas is likely to be slow. The hurricanes left an imprint
    on aggregate economic activity as well, seen, in part, in the marked
    deceleration of real GDP in the fourth quarter. However, the most
    recent evidence--including indicators of production, the flow of new
    orders to businesses, weekly data on initial claims for unemployment
    insurance, and the payroll employment and retail sales figures for
    January--suggests the economic expansion remains on track.
        Inflation pressures increased in 2005. Steeply rising energy prices
    pushed up overall inflation, raised business costs, and squeezed
    household budgets. Nevertheless, the increase in prices for personal
    consumption expenditures excluding food and energy, at just below 2
    percent, remained moderate, and longer-term inflation expectations
    appear to have been contained.
        With the economy expanding at a solid pace, resource utilization
    rising, cost pressures increasing, and short-term interest rates still
    relatively low, the Federal Open Market Committee (FOMC) over the
    course of 2005 continued the process of removing monetary policy
    accommodation, raising the Federal funds rate 2 percentage points in
    eight increments of 25 basis points each. At its meeting on January 31
    of this year, the FOMC raised the Federal funds rate another \1/4\
    percentage point, bringing its level to 4\1/2\ percent.
        At that meeting, monetary policymakers also discussed the economic
    outlook for the next 2 years. The central tendency of the forecasts of
    Members of the Board of Governors and the presidents of Federal Reserve
    Banks is for real GDP to increase about 3\1/2\ percent in 2006 and 3
    percent to 3\1/2\ percent in 2007. The civilian unemployment rate is
    expected to finish both 2006 and 2007 at a level between 4\3/4\
    percent and 5 percent. Inflation, as measured by the price index for
    personal consumption expenditures excluding food and energy, is
    predicted to be about 2 percent this year and 1\3/4\ percent to 2
    percent next year. While considerable uncertainty surrounds any
    economic forecast extending nearly 2 years, I am comfortable with these
    projections.
        In the announcement following the January 31 meeting, the Federal
    Reserve pointed to risks that could add to inflation pressures. Among
    those risks is the possibility that, to an extent greater than we now
    anticipate, higher energy prices may pass through into the prices of
    nonenergy goods and services or have a persistent effect on inflation
    expectations. Another factor bearing on the inflation outlook is that
    the economy now appears to be operating at a relatively high level of
    resource utilization. Gauging the economy's sustainable potential is
    difficult, and the Federal Reserve will keep a close eye on all the
    relevant evidence and be flexible in making those judgments.
    Nevertheless, the risk exists that, with aggregate demand exhibiting
    considerable momentum, output could overshoot its sustainable path,
    leading ultimately--in the absence of countervailing monetary policy
    action--to further upward pressure on inflation. In these
    circumstances, the FOMC judged some further firming of monetary policy
    may be necessary, an assessment with which I concur.
        Not all of the risks to the economy concern inflation. For example,
    a number of indicators point to a slowing in the housing market. Some
    cooling of the housing market is to be expected and would not be
    inconsistent with continued solid growth of overall economic activity.
    However, given the substantial gains in house prices and the high
    levels of home construction activity over the past several years,
    prices and construction could decelerate more rapidly than currently
    seems likely. Slower growth in home equity, in turn, might lead
    households to boost their saving and trim their spending relative to
    current income by more than is now anticipated. The possibility of
    significant further increases in energy prices represents an additional
    risk to the economy; besides affecting inflation, such increases might
    also hurt consumer confidence and thereby reduce spending on nonenergy
    goods and services.
        Although the outlook contains significant uncertainties, it is
    clear that substantial progress has been made in removing monetary
    policy accommodation. As a consequence, in coming quarters the FOMC
    will have to make ongoing, provisional judgments about the risks to
    both inflation and growth, and monetary policy actions will be
    increasingly dependent on incoming data.
        In assessing the prospects for the economy, some appreciation of
    recent circumstances is essential, so let me now review key
    developments of 2005 and discuss their implications for the outlook.
    The household sector was a mainstay of the economic expansion again
    last year, and household spending is likely to remain an important
    source of growth in aggregate demand in 2006. The growth in household
    spending last year was supported by rising employment and moderate
    increases in wages. Expenditures were buoyed as well by significant
    gains in household wealth that reflected further increases in home
    values and in broad equity prices. However, sharply rising bills for
    gasoline and heating reduced the amount of income available for
    spending on other consumer goods and services.
        Residential investment also expanded considerably in 2005,
    supported by a strong real estate market. However, as I have already
    noted, some signs of slowing in the housing market have appeared in
    recent months: Home sales have softened, the inventory of unsold homes
    has risen, and indicators of homebuilder and homebuyer sentiment have
    turned down. Anecdotal information suggests that homes typically are on
    the market somewhat longer than they were a year or so ago, and the
    frequency of contract offers above asking prices reportedly has
    diminished. Financial market conditions seem to be consistent with some
    moderation in housing activity. Interest rates on 30-year, fixed-rate
    mortgages, which were around 5\3/4\ percent over much of 2005, rose
    noticeably in the final months of the year to their current level of
    around 6\1/4\ percent. Rates on adjustable-rate mortgages have climbed
    more considerably. Still, despite the recent increases, mortgage rates
    remain relatively low. Low mortgage rates, together with expanding
    payrolls and incomes and the need to rebuild after the hurricanes,
    should continue to support the housing market. Thus, at this point, a
    leveling out or a modest softening of housing activity seems more
    likely than a sharp contraction, although significant uncertainty
    attends the outlook for home prices and construction. In any case, the
    Federal Reserve will continue to monitor this sector closely.
        Overall, the financial health of households appears reasonably
    good. Largely reflecting the growth in home mortgages, total household
    debt continued to expand rapidly in 2005. But the value of household
    assets also continued to climb strongly, driven by gains in home prices
    and equity shares. To some extent, sizable increases in household
    wealth, as well as low interest rates, have contributed in recent years
    to the low level of personal saving. Saving last year was probably
    further depressed by the rise in households' energy bills. Over the
    next few years, saving relative to income is likely to rise somewhat
    from its recent low level.
        In the business sector, profits continued to rise last year at a
    solid pace, boosted in part by continuing advances in productivity.
    Strong corporate balance sheets combined with expanding sales and
    favorable conditions in financial markets fostered a solid increase in
    spending on equipment and software last year. Investment in high-tech
    equipment rebounded, its increase spurred by further declines in the
    prices of high-tech goods. Expenditures for communications equipment,
    which had fallen off earlier this decade, showed particular strength
    for the year as a whole. In contrast, nonresidential construction
    activity remained soft.
        Although the financial condition of the business sector is
    generally quite strong, several areas of structural weakness are
    evident, notably in the automobile and airline industries. Despite
    these problems, however, favorable conditions in the business sector as
    a whole should encourage continued expansion of capital investment.
        For the most part, the financial situation of State and local
    governments has improved noticeably over the past couple of years.
    Rising personal and business incomes have buoyed tax revenues,
    affording some scope for increases in State and local government
    expenditures. At the Federal level, the budget deficit narrowed
    appreciably in fiscal year 2005. Outlays rose rapidly, but receipts
    climbed even more sharply as the economy expanded. However, defense
    expenditures, hurricane relief, and increasing entitlement costs seem
    likely to worsen the deficit in fiscal year 2006.
        Outside the United States, economic activity strengthened last
    year, and at present global growth seems to be on a good track. The
    economies of our North American neighbors, Canada, and Mexico, appear
    to be expanding at a solid pace. Especially significant have been signs
    that Japan could be emerging from its protracted slump and its battle
    with deflation. In the euro area, expansion has been somewhat modest by
    global standards, but recent indicators suggest that growth could be
    strengthening there as well. Economies in emerging Asia generally
    continue to expand strongly. In particular, growth in China remained
    vigorous in 2005.
        Expanding foreign economic activity helped drive a vigorous advance
    in U.S. exports in 2005, while the growth of real imports slowed.
    Nonetheless, the nominal U.S. trade deficit increased further last
    year, exacerbated in part by a jump in the value of imported petroleum
    products that almost wholly reflected the sharply rising price of crude
    oil.
        Surging energy prices also were the dominant factor influencing
    U.S. inflation last year. For the second year in a row, overall
    consumer prices, as measured by the chain-type index for personal
    consumption expenditures, rose about 3 percent. Prices of consumer
    energy products jumped more than 20 percent, with large increases in
    prices of natural gas, gasoline, and fuel oil. Food prices, however,
    rose only modestly. And core consumer prices (that is, excluding food
    and energy) increased a moderate 1.9 percent.
        The relatively benign performance of core inflation despite the
    steep increases in energy prices can be attributed to several factors.
    Over the past few decades, the U.S. economy has become significantly
    less energy intensive. Also, rapid advances in productivity as well as
    increases in nominal wages and salaries that, on balance, have been
    moderate have restrained unit labor costs in recent years.
        Another key factor in keeping core inflation low has been
    confidence on the part of the public and investors in the prospects for
    price stability. Maintaining expectations of low and stable inflation
    is an essential element in the Federal Reserve's
    effort to promote price stability. And, thus far, the news has been
    good: Survey measures of longer-term inflation expectations have
    responded only a little to the larger fluctuations in energy prices
    that we have experienced, and for the most part, they were low and
    stable last year. Inflation compensation for the period 5 to 10 years
    ahead, derived from spreads between nominal and inflation-indexed
    Treasury securities, has remained well-anchored.
        Restrained inflation expectations have also been an important
    reason that long-term interest rates have remained relatively low. At
    roughly 4\1/2\ percent at year-end, yields on ten-year nominal Treasury
    issues increased only slightly on balance over 2005 even as short-term
    rates rose 2 percentage points. As previous reports and testimonies
    from the Federal Reserve indicated, a decomposition of long-term
    nominal yields into spot and forward rates suggests that it is
    primarily the far-forward components that account for the low level of
    long rates. The premiums that investors demand as compensation for the
    risk of unforeseen changes in real interest rates and inflation appear
    to have declined significantly over the past decade or so. Given the
    more stable macroeconomic climate in the United States and in the
    global economy since the mid-1980's, some decline in risk premiums is
    not surprising. In addition, though, investors seem to expect real
    interest rates to remain relatively low. Such a view is consistent with
    a hypothesis I offered last year--that, in recent years, an excess of
    desired global saving over the quantity of global investment
    opportunities that pay historically normal returns has forced down the
    real interest rate prevailing in global capital markets.
        Inflation prospects are important, not just because price stability
    is in itself desirable and part of the Federal Reserve's mandate from
    the Congress, but also because price stability is essential for strong
    and stable growth of output and employment. Stable prices promote long-
    term economic growth by allowing households and firms to make economic
    decisions and undertake productive activities with fewer concerns about
    large or unanticipated changes in the price level and their attendant
    financial consequences. Experience shows that low and stable inflation
    and inflation expectations are also associated with greater short-term
    stability in output and employment, perhaps in part because they give
    the central bank greater latitude to counter transitory disturbances to
    the economy. Similarly, the attainment of the statutory goal of
    moderate long-term interest rates requires price stability, because
    only then are the inflation premiums that investors demand for holding
    long-term instruments kept to a minimum. In sum, achieving price
    stability is not only important in itself; but it is also central to
    attaining the Federal Reserve's other mandated objectives of maximum
    sustainable employment and moderate long-term interest rates.
        As always, however, translating the Federal Reserve's general
    economic objectives into operational decisions about the stance of
    monetary policy poses many challenges. Over the past few decades,
    policymakers have learned that no single economic or financial
    indicator, or even a small set of such indicators, can provide reliable
    guidance for the setting of monetary policy.
        Rather, the Federal Reserve, together with all modern central
    banks, has found that the successful conduct of monetary policy
    requires painstaking examination of a broad range of economic and
    financial data, careful consideration of the implications of those data
    for the likely path of the economy and inflation, and prudent judgment
    regarding the effects of alternative courses of policy action on
    prospects for achieving our macroeconomic objectives. In that process,
    economic models can provide valuable guidance to policymakers, and over
    the years substantial progress has been made in developing formal
    models and forecasting techniques. But any model is by necessity a
    simplification of the real world, and sufficient data are seldom
    available to measure even the basic relationships with precision.
    Monetary
    policymakers must therefore strike a difficult balance--conducting
    rigorous analysis informed by sound economic theory and empirical
    methods while keeping an open mind about the many factors, including
    myriad global influences, at play in a dynamic modern economy like that
    of the United States. Amid significant uncertainty, we must formulate a
    view of the most likely course of the economy under a given policy
    approach while giving due weight to the potential risks and associated
    costs to the economy should those judgments turn out to be wrong.
        During the nearly 3 years that I previously spent as a Member of
    the Board of Governors and of the Federal Open Market Committee, the
    approach to policy that I have just outlined was standard operating
    procedure under the highly successful leadership of Chairman Greenspan.
    As I indicated to the Congress during my confirmation hearing, my
    intention is to maintain continuity with this and the other practices
    of the Federal Reserve in the Greenspan era. I believe that, with this
    approach, the Federal Reserve will continue to contribute to the sound
    performance of the U.S. economy in the years to come.

           RESPONSE TO WRITTEN QUESTIONS OF SENATOR MENENDEZ
                          FROM BEN S. BERNANKE

        Chairman Bernanke, you wrote in your macroeconomic textbook
    about the consequences of budget deficits.
        The Congressional Budget Office estimates that the deficit
    for 2006 will be $337 billion--even before including the cost
    of an anticipated supplemental appropriation for Iraq and
    Afghanistan expected early this year. The deficits for 2003,
    2004, 2005, and 2006 are the four largest deficits in American
    history.
        Because of these deficits, the long-term attractiveness of
    the United States as an investment destination could be hurt as
    investors worry about our Nation's ability to manage its debts.
    And the deficits could also cause consumers problems if foreign
    investors stop buying U.S. assets, forcing interest rates to
    rise sharply. Finally with the ongoing wars in Iraq and
    Afghanistan, our budget is going to be under continued
    pressures in the future.
        Over time, large deficits and debt will raise interest
    rates, crowd out private sector investment, and slow long-term
    economic growth.
    Q.1. How much importance do you put on paying down the publicly
    held debt that our Nation currently holds?

    A.1. I am quite concerned about the intermediate to long-term
    Federal budget outlook. In particular, the budget is expected
    to come under severe pressure as impending demographic changes
    fuel rapid increases in entitlement spending. By holding down
    the growth of national saving and real capital accumulation,
    the prospective increase in the budget deficit will place at
    risk future living standards of our country. As a result, I
    think it would be very desirable to take concrete steps to
    lower the prospective path of the deficit. Such actions would
    boost national saving and ultimately the future prosperity of
    our country, as our children and grandchildren would inherit a
    larger capital stock that would support greater productivity
    and higher income. Moreover, steps should be taken soon to
    address the long-term budget pressures so that people have
    adequate time to prepare for whatever changes might occur,
    especially to entitlement programs.
        Although the stock of debt held by the public would decline
    in absolute magnitude only if budget surpluses are run, fiscal
    actions that result in smaller deficits can slow the growth in
    the stock of debt held by the public and reduce the Federal
    debt relative to the size of the economy. The key is not so
    much the absolute level of Federal debt, but rather that we
    take deficit-reducing steps to increase national saving and,
    hence, future living standards.

        As you know, the pay-as-you-go budget provisions of the
    1990's required lawmakers to pay for any increases in
    entitlement spending or decreases in revenues (that is, tax
    cuts); such changes had to be offset either by equivalent
    budget cuts or by revenue increases elsewhere. Since those
    rules expired in 2002, Congress has strived and did enact a
    variation on PAYGO that completely exempts taxes from the
    equation: No tax cuts would require offsetting, and spending
    increases could only be offset by entitlement cuts elsewhere--
    never by tax increases. This despite the fact our Federal
    budgets over the last few years have run recorded deficits.
        This one-sided PAYGO passed despite the recommendations of
    people like Federal Reserve Chairman Alan Greenspan,
    Congressional Budget Office Director Douglas Holtz-Eakin, and
    Government Accountability Office Comptroller General David
    Walker, who all strongly and repeatedly urged Congress to adopt
    full PAYGO rules.
    Q.2.a. Chairman Bernanke, do you support full PAYGO rules over
    spending-only ones?

    A.2.a. As I noted in response to the previous question, I
    believe reducing the Federal deficit is very important,
    especially in light of the need to prepare for the retirement
    of the baby-boom generation. I urge the Congress to proceed on
    that effort in a timely manner and to pay particular attention
    to how its decisions on spending and tax programs will affect
    the U.S. economy over the long-term. However, I also believe
    that in my role as head of the Federal Reserve, I should not be
    involved in making specific recommendations about the internal
    decisionmaking process of the Congress and the structure of its
    budget procedures.

    Q.2.b. The Treasury Department recently issued its first 30-
    year bonds in over 4 years. Do you support this decision to
    bring back the long bond?

    A.2.b. The responsibility for Federal debt management, of
    course, rests with the Treasury Department. However, I do
    support the Treasury's decision to resume issuance of 30-year
    bonds. Given the large current and prospective Federal
    financing needs, it is prudent to distribute the Treasury's
    borrowing across the yield curve. Moreover, long-term interest
    rates are currently quite low, apparently reflecting in part
    strong demand among investors for long-term issues. In these
    circumstances, it is sensible for the Treasury to accommodate
    this demand in part by issuing 30-year securities.

        Last week, when the Treasury issued its first 30-year bond
    since 2001, there was $28 billion in bids for $14 billion of
    bonds being offered. This in turn made it cheaper for the
    Treasury to borrow for 30 years than 6 months.
    Q.3. Do you have any concern that this will contribute to the
    creation of a bond market bubble, which has the potential
    effect of lowering inflation-adjusted interest rates to
    incredibly low levels?

    A.3. I do not have any such concerns. I should note that I do
    not see particular significance to the level of bids relative
    to the size of the recent auction. I attribute the relatively
    low level of long-term interest rates generally to several
    factors, including a tendency in recent years for global saving
    to exceed the amount of
    potential capital investments, yielding historically normal
    rates of return as well as relatively low-term premiums in
    interest rates to compensate investors for interest rate risk.
    In the unlikely event that any of these factors tended to push
    real long-term yields to levels that appeared to be
    incompatible with our macroeconomic objectives, the Federal
    Reserve would respond by adjusting the stance of monetary
    policy appropriately.

    Q.4. What impacts could this have on our economy?

    A.4. No significant adverse effects are likely.

        Last week, the Commerce Department reported that our trade
    deficit rose 17.5 percent to $725.8 billion in 2005, a new
    record for the fourth consecutive year.
        You have stated in the past your belief that what you call
    a ``global savings glut'' is the main driver behind America's
    record trade deficit, and that the ability to reduce our trade
    deficit is largely beyond our control.

    Q.5. Is there nothing we can do to alleviate the pressure
    building up in the global financial system?

    A.5. The emergence of large U.S. trade deficits and
    corresponding surpluses on the part of our trading partners is,
    to an important extent, the outcome of market forces. Several
    factors, including the lingering effects of financial crises in
    emerging market economies and concerns about the outlook for
    growth in some industrial economies, have led saving abroad to
    exceed investment. This excess saving has been attracted to the
    United States by our favorable investment climate, strong
    productivity growth, and deep
    financial markets. Although the U.S. net external debt has been
    growing as a consequence of these inflows, as a fraction of our
    Nation's income it remains within international and historical
    norms. Given the strength and flexibility of our economy, there
    is every reason to believe that, if changes in the foreign
    outlook or in the tone of financial markets were to cause a
    reduction in capital inflows and the trade deficit, economic
    activity, and employment would stay strong.

    Q.6. Wouldn't reducing our budget deficit and getting tough on
    currency manipulators help?

    A.6. All that said, as our net external debt rises, the cost of
    servicing that debt increasingly will subtract from U.S.
    income. Accordingly, it would be helpful to raise our domestic
    saving and reduce our trade deficit while maintaining an
    environment conducive to investment and growth. Reducing the
    budget deficit would release resources for private investment
    and reduce the future burden of repaying the public debt,
    although studies indicate a relatively modest effect of budget-
    cutting on the trade deficit. Pro-growth policies among our
    trading partners would also contribute to some adjustment of
    external imbalances. Finally, more flexible exchange rate
    regimes in some countries would provide greater scope for
    market forces to reduce our trade deficit, and would be in the
    interests of the countries implementing these regimes as well.
    Nevertheless, in the absence of a shift in market perceptions
    of the relative attractiveness of United States and foreign
    assets, government policies would likely have only limited
    effects on the trade balance.

        Chairman Bernanke, under the fiscal year 2006 Congressional
    budget resolution and the two related reconciliation bills,
    Congress has cut Medicaid by $6.9 billion while spending up to
    $70 billion over the next 5 years to repeal some of the sunsets
    of President Bush's 2001 and 2003 tax cut packages. According
    to the Urban-Brookings Tax Policy Center, more than 70 percent
    of the benefits of those tax breaks have gone to the 20 percent
    of taxpayers with the highest incomes, and more than 25 percent
    of the benefits to the top 1 percent. Medicaid's benefits, by
    contrast, go almost entirely to those at the bottom of the
    income scale.

    Q.7. Don't these additional tax breaks (from the fiscal 2006
    reconciliation bills), when combined with the Medicaid cuts,
    amount to a massive redistribution of income from those at the
    bottom to those at the top?

    A.7. As I stated in my testimony on the Monetary Policy Report,
    the Federal Government has an important role to play in
    boosting national saving as a share of national income over
    time. Of particular concern to me is the mismatch between taxes
    and spending in long-term budget projections. This mismatch
    means that over time either taxes will have to be raised or the
    spending increases embedded in current laws will need to be
    scaled back, or some combination of the two. Deciding on the
    mix of policy actions to be
    implemented will require the difficult balancing of sometimes
    conflicting goals regarding the provision of public services,
    the effects on economic efficiency of increasing taxes, and the
    distribution of fiscal burdens among various groups. The
    judgments about how to balance these priorities are ultimately
    political judgments and not ones that I believe I should
    address in my role as Chairman of the Federal Reserve.

        Chairman Bernanke, the 1991 edition of your Macroeconomics
    textbook contains a policy debate on the minimum wage. At the
    end of the debate, the textbook concludes: ``Therefore, the
    total labor income of unskilled workers does increase when the
    minimum wage rises . . . . Overall, taking these various
    effects into account, a recent study finds that raising the
    minimum wage from $3.35 per hour to $4.25 per hour [note: those
    were the amounts under discussion at that time] could reduce
    the number of families in poverty by about 6 percent, on
    balance a reasonably substantial effect.'' The textbook goes on
    to find: ``Thus, the inflationary effects of an increase in the
    minimum wage are relatively small . . . As a result, an
    increase in the minimum wage has negligible effects on
    aggregate employment and output.''
        Your textbook was written in 1991 when the minimum wage was
    $4.25 an hour. Today, in real terms it is below that level
    ($4.25 in 1991 would be $5.89 today).
    Q.8. Do you believe that increasing the minimum wage above its
    current level of $5.15 an hour--where it has been stuck for
    over 8 years--would be good economic policy, along the lines
    that your textbook concluded?

    A.8. I am reluctant to comment on specific proposals regarding
    the minimum wage, but I can offer some general comments. In
    particular, I would note that the minimum wage is a very
    controversial issue among economists. Clearly, if the minimum
    wage were raised, then those workers who retain their jobs will
    benefit from the higher income associated with the higher
    minimum wage. However, economists have raised two concerns
    about minimum wages. The first is whether minimum wages have
    adverse employment effects; that is, do higher wages lower
    employment of low-skilled workers? The second is whether the
    minimum wage is as well targeted as it could be; that is, to
    what extent is the increase benefiting workers other than those
    from low-income families?
        My own view is that an increase in the minimum wage
    probably does lower employment. However, I would note that
    while this is the consensus view among economists, there is
    some research indicating that any such disemployment effects
    could be negligible. In any event, it does seem likely that the
    employment losses from a modest increase in the minimum wage
    would be relatively small from a macroeconomic standpoint and
    thus, at the levels of the minimum wage prevailing in the
    United States, a modest increase would not have sizable
    negative effects on aggregate output.
        The effect of a higher minimum wage on poverty is also a
    hotly debated topic among economists. However, my reading of
    the research that has become available over the past 10 years
    or so is that if there is any reduction in poverty associated
    with a higher minimum wage, it is likely to be quite small. In
    this context, one might consider alternative ways of helping
    low-income workers, such as the Earned Income Tax Credit, which
    delivers money directly to working families and is thus better
    targeted toward poverty reduction than is the minimum wage.

            RESPONSE TO A WRITTEN QUESTION OF SENATOR CRAPO
                          FROM BEN S. BERNAKE

    Q.1. I am very concerned about the potential efforts in this
    Congress to change the manner in which we regulate derivatives
    or to impact the manner in which derivatives operate in the
    economy, and I would like to have your comments on the
    importance of having a strong, stable, and dynamic derivatives
    market in this country and what it means to our economy.

    A.1. Derivatives markets have had important effects on two
    dimensions of our economy. First, as is often noted,
    derivatives enable financial risks to be unbundled and shifted
    to those willing and able to bear them. The U.S. economy has
    proven to be resilient in the face of shocks over the past
    several years. Although no single factor accounts for this
    favorable performance, derivative instruments undoubtedly have
    contributed to this resilience because they offer firms means
    for managing their risks. Second, derivatives have contributed
    to our understanding of the measurement and management of risk.
    Today's sophisticated risk management systems developed in
    tandem with derivatives markets. When individual firms become
    less vulnerable to shocks, the financial system as a whole
    becomes more resilient. Certainly, derivative instruments pose
    challenges to risk managers and to supervisors, but these risks
    are manageable and thus far have generally been managed quite
    well. Market discipline has provided strong incentives for
    effective risk management, the key to ensuring that the
    benefits of derivatives continue to be realized.

             RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI
                          FROM BEN S. BERNAKE

        Mr. Chairman, I noted in a press release dated November 10,
    2005 that the Federal Reserve would cease publication of the M3
    money aggregate, the broadest measure of the U.S. money supply.
    I have carefully read your testimony in the House Financial
    Services Committee on this topic. I have some follow-up
    questions:
    Q.1. You noted in your testimony to the House Financial
    Services Committee that money aggregates are among the many
    indicators that the Federal Reserve Board uses to determine
    monetary policy. In your opinion, would discontinuing the M3
    aggregate deprive the Board of information useful in the
    formation of U.S. monetary policy? Has the M3 aggregate become
    obsolete?

    A.1. Over time, the Federal Reserve continuously assesses the
    usefulness of the various statistics that it monitors in the
    conduct of monetary policy. In cases in which the Federal
    Reserve compiles and publishes the data, the Board seeks to
    revise its statistical program appropriately, taking into
    account ongoing developments in the economy and the financial
    system as well as both the benefits and the costs of data
    collection. For example, in the early 1980's the Federal
    Reserve redefined the monetary aggregates to reflect changes in
    the financial environment. Similarly, for a time research
    suggested that a broad measure of nonfinancial sector debt
    should receive considerable attention in monetary policymaking,
    and the Board began to publish monthly data on such an
    aggregate. Over subsequent years, policy experience and
    accumulating empirical evidence indicated that some of these
    aggregates--in particular, domestic nonfinancial sector debt at
    a monthly frequency, and the broadest monetary aggregate--were
    not particularly useful in the conduct of policy. Accordingly,
    the publication of those aggregates was either scaled back or
    dropped. Similarly, the Board over time recognized that M3 was
    not providing information that was useful to policymakers.
    Recently, the Board decided that discontinuing the compilation
    of that aggregate would not deprive the Federal Reserve of
    information useful in the formulation of U.S. monetary policy
    and, given the costs involved in compiling the aggregate, it
    decided to discontinue M3.

    Q.2. Reducing regulatory burden for our Nation's banks is a
    laudable goal and an effort I support. How many financial
    institutions are currently required to provide data to the Fed
    to calculate the M3? Do these same institutions report data to
    calculate the M1 and M2 aggregates? Is there any quantitative
    data on the savings achieved by reporting institutions once
    publication of the M3 has ceased?

    A.2. A complex system of reports is employed to collect the
    data necessary to compile the monetary aggregates, and
    discontinuing M3 will allow two reports--the FR 2415 and the FR
    2050--to be dropped. The FR 2415 form (Report of Repurchase
    Agreements [RP's] on U.S. Government and Federal Agency
    Securities with Specified Holders) is reported by approximately
    450 institutions (270 reporting annually, 90 quarterly, and 90
    weekly). The FR 2050 form (Weekly Report of Eurodollar
    Liabilities Held by Selected U.S. Addressees at Foreign Offices
    of U.S. Banks) is reported by about 35 institutions. The
    discontinuation of the FR 2415 and the FR 2050 is estimated to
    reduce annual reporting burden by a total of 4,487 hours. These
    reports are used to obtain data only for M3, not M1 or M2.
        I should note that discontinuing M3 will also allow two of
    our fellow central banks, the Bank of Canada and the Bank of
    England, to stop collecting, editing, compiling, and
    transmitting additional data on Eurodollars--a task that no
    doubt involved the expenditure of significant resources for
    which those institutions were not compensated. We do not have
    estimates of the savings that will accrue to the Bank of Canada
    and the Bank of England, or of any of the entities that report
    to those central banks, as a result of the elimination of M3.

    Q.3. Is there any indication of how useful the M3 aggregate is
    to the U.S. public? How did the Fed determine the public's
    demand for this data?

    A.3. Federal Reserve staff conducted a search to determine the
    extent to which M3 was used in the professional literature on
    monetary economics. The staff found that the vast majority of
    academic papers published between 1990 and 2000 that referenced
    ``M3'' actually referred to foreign versions of M3, which
    correspond most closely to the Federal Reserve's M2 aggregate
    rather than our M3 aggregate. The remaining papers, which
    actually did use U.S. M3, fell into the following categories:

     Papers testing new methods of creating monetary
        aggregates (for example, so-called ``Divisia monetary
        aggregates''). These papers did not demonstrate any
        important indicator properties of M3.
     Papers testing new methods of estimating long-run
        econometric relationships. Some of these papers estimated
        equations based on the quantity theory of money for a range
        of monetary aggregates. Again, these papers suggested that
        M3 played no particularly valuable role.
     Papers testing the forecasting properties of various
        financial or other variables. M3 would be one of hundreds
        of variables used in such tests.

        In all cases, M3 was studied only in combination with M2
    and other monetary aggregates. In summary, our review of the
    academic literature revealed no evidence that M3 was
    particularly useful in macroeconomic analysis or forecasting.
        The Board believes that it has a responsibility to the
    taxpayer to weigh carefully the costs and benefits of all of
    the various activities of the Federal Reserve, including data
    collection and publication, to determine whether the Federal
    Reserve is performing its responsibilities most efficiently. In
    the course of such a review, the Board recently judged that the
    costs to the Federal Reserve of collecting and processing the
    data necessary to publish M3 exceeded the benefits. Moreover,
    discontinuing two of the reports that need to be filed in order
    to construct M3 will permit a small reduction in the burden on
    some depository institutions.
        As the Nation's central bank, the Federal Reserve
    recognizes the importance of carefully monitoring as well as
    releasing to the public data on useful concepts of the money
    supply, and the Board will continue to publish timely data on
    the monetary aggregate M2. Of the various monetary and debt
    aggregates, in our view M2 has exhibited the most stable,
    explicable, and useful relationship with measures of nominal
    spending and interest rates. In addition, the Board will
    continue to publish the monetary aggregate M1, which is a
    component of M2, as well as the other components of M2. The
    Board will also continue to publish data on shares issued by
    institution-only money market mutual funds, which are currently
    included in the non-M2 component of M3.