[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.



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