[Senate Hearing 109-615]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-615

 
        FEDERAL RESERVE'S SECOND 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

                               __________

                             JULY 19, 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

               Peggy R. Kuhn, Senior Financial Economist

                         Mark Oesterle, Counsel

           Mark A. Calabria, Senior Professional Staff Member

                  Lee Price, Democratice Chief Counsel

              Stephen R. Kroll, Democratic Special Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, JULY 19, 2006

                                                                   Page

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

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     2
    Senator Bennett..............................................     4
    Senator Reed.................................................     4
    Senator Bunning..............................................     5
    Senator Menendez.............................................     6
    Senator Dole.................................................     7
    Senator Stabenow.............................................     8
    Senator Allard...............................................     9
    Senator Carper...............................................    10
    Senator Sununu...............................................    12
    Senator Martinez.............................................    12
    Senator Hagel................................................    12
    Senator Dodd.................................................    13

                                WITNESS

Ben S. Bernanke, Chairman, Board of Governors of the Federal 
  Reserve System, Washington, DC.................................    13
    Prepared statement...........................................    46
    Response to written questions of:
        Senator Shelby...........................................    49
        Senator Reed.............................................    51
        Senator Stabenow.........................................    51
        Senator Crapo............................................    54

              Additional Material Supplied for the Record

Monetary Policy Report to the Congress, July 19, 2006............    56

                                 (iii)


        FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2006

                              ----------                              


                        WEDNESDAY, JULY 19, 2006

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

    The Committee met at 10:06 a.m., in room SD-106, 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 Ben Bernanke 
before the Committee on Banking, Housing, and Urban Affairs, to 
deliver the Federal Reserve's Semi-Annual Monetary Policy 
Report to the Congress.
    Chairman Bernanke, your testimony and report this morning 
note the economy's strong performance in the first half of 
2006. Real gross domestic product, GDP, increased at an annual 
rate of 5.6 percent in the first quarter of 2006. Federal 
Reserve data released earlier this week showed U.S. industrial 
production rising 0.8 percent in June with capacity utilization 
now at 82.4 percent, the highest rate since June 2000. We 
continue to enjoy a low unemployment rate, both historically 
and relative to other industrialized nations.
    Some of the most recent economic data make it clear the 
balancing act that the Federal Reserve now faces. Energy 
prices, including oil, have increased over the past year and 
the turmoil in the Middle East adds to concerns in this area. 
Housing markets seem to be catching their breath, with the pace 
of rapid price appreciation slowing and in some markets showing 
small declines. Both factors lead to questions about the 
ability of consumers to continue consumption growth in our 
economy.
    At its most recent meeting on June 29, the Federal Open 
Market Committee raised its target for the Federal funds rate 
by 25 basis points to 5.25 percent, the seventeenth one-quarter 
point increase since June 2004 when the FOMC began raising the 
target rate from a then low of 1 percent.
    Fed watchers noted that the latest FOMC statement seemed to 
leave open the question of whether the FOMC will increase the 
Federal funds target at its next meeting, referencing ``the 
extent and timing of any additional'' rate increases. Although 
the minutes of that meeting will not be released until July 20, 
our hearing this morning gives us the opportunity to discuss 
which factors were significant in your deliberations and what 
factors you may be looking at as the FOMC prepares for its next 
monetary policy hearing on August 8. Our hearing this morning 
can thus add to the transparency of the FOMC process.
    Mr. Chairman, we are pleased to have you with us this 
morning. We look forward to discussing in greater detail the 
Federal Reserve's performance in carrying out monetary policy 
and its views on the future direction of our Nation's economy. 
We all look forward to raising a number of questions with you 
then.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Chairman Shelby. I 
welcome Chairman Bernanke before the Committee.
    I think it is fair to say this hearing comes at a 
particularly pivotal time for monetary policy. The economy is 
slowing down and the run-up in oil prices is contributing to 
that slowdown. An oil price spike has preceded a number of 
recessions since 1973, but some spikes have occurred without a 
subsequent recession. We look to the Federal Reserve to help 
avoid a recession this time around.
    There are a number of signs of economic weakness. Job 
growth has been anemic for the last 3 months, averaging just 
over 100,000 jobs per month. The pace is less than 1 percent a 
year. Over the last half century we have tended to have such 
slow job growth when we are going into or coming out of a 
recession. It is less than half the pace of job growth for the 
10 years of expansion from March 1991 to March 2001.
    Not only are jobs growing slowly, but also all the measures 
of wages and compensation show gains below inflation over the 
last year. Total compensation, including wages and benefit 
costs, have risen 2.8 percent in the last year. Such pay gains 
are not putting upward pressure on inflation because they are 
almost entirely offset by productivity gains, which are up 2.5 
percent. Unit labor costs, which adjust hourly labor costs for 
productivity gains, are up by a negligible 0.3 percent in the 
last year.
    That is shown rather dramatically in this chart, which 
shows compensation, productivity, and unit labor costs.
    Unfortunately, the only people with pay gains that are 
keeping ahead of inflation are those at the top of the ladder. 
By this stage in previous business cycle expansions, people at 
the middle and bottom of the wage ladder have typically been 
enjoying healthy pay gains. This was certainly the case from 
1995 to 2000. We need to keep the expansion going so that those 
at the middle and the bottom of the pay scale can finally share 
in the exceptional productivity gains that they have helped to 
create.
    With the higher cost of fuel and little room to cut back on 
fuel use, consumers have been forced to cut back on other types 
of spending and they go into debt. Consumer spending has risen 
at less than a 2 percent rate over the last 4 months. To manage 
even that modest increase, households have had to reduce 
savings and increase borrowing. The household savings rate has 
plunged to an unprecedented minus 1.7 percent.
    Where is the rise in inflation coming from? Although higher 
prices for oil and other commodities have contributed, much 
more important is the surge in profit margins. At this hearing 
2 years ago, Chairman Greenspan drew attention to this, stating 
``from an accounting perspective, between the first quarter of 
2003 and the first quarter of 2004 all of the 1.1 percent 
increase in the prices of final goods and services produced in 
the nonfinancial corporate sector can be attributed to a rise 
in profit margins rather than cost pressures.''
    He predicted at the time that competition to create new 
capacity and hire more workers would bring down the profit 
share to more normal levels, but that has not happened. In 
fact, the profit share of GDP hit 12.7 percent in the first 
quarter, the highest profit margin since 1950. With inflation 
racing ahead of wages and rising interest rates, we see a 
serious downturn in the housing industry. The housing 
affordability index has plunged to the lowest level since 1989 
when declining housing led to a recession in 1990.
    New home sales so far this year are running 11 percent 
below the rate for the same period last year. With sales down, 
builders have cut back on new home construction. They are 
obtaining permits at a rate of more than 1.7 million a year for 
5 months last year, but that rate fell below 1.5 million in the 
latest months. We are now down below 1.4 million. This is new 
single family home permits, and it shows a rather marked 
decline over the last year.
    Last week's report on the consensus of blue chip economic 
forecasters should also give Federal Reserve policymakers 
pause. The consensus expects growth below the trend line 
starting with the just-completed second quarter through the end 
of 2007. In addition, the blue chip economic forecasters expect 
inflation to slow down to about 2.5 percent next year.
    I am hopeful that this morning Chairman Bernanke can put to 
rest some troubling concerns about monetary policy. The Fed's 
statements that future changes in interest rates will depend on 
new data, not an all together unreasonable statement I might 
say, but it has been interpreted by some commentators to mean 
that the Federal Reserve will raise interest rates at every 
meeting until inflation comes down.
    The headlines of the last two weekly reports from Goldman 
Sachs are ``The Stance of Monetary Policy, Enough is Enough.'' 
And the other one ``Bernanke Preview, Monetary Policy Begins to 
Bite.'' Two recent headlines from Merrill Lynch state that its 
``getting tougher for the Fed to justify what it is doing'' and 
``nearly every indicator showing signs of a slowdown.''
    Merrill Lynch Economist David Rosenberg, in a report last 
Friday entitled, ``To Pause Or Not To Pause: That Is The 
Conundrum,'' expressed this concern: ``The Fed has managed to 
elevate a pause to something that is a pretty major event. What 
was normal in prior cycles, up or down, is now something that 
grabs headlines. The Fed paused twice in the 1999-2000 cycle 
and three times in the 1994 cycle, and it elicited a yawn from 
the markets. This time around a `pause' is being treated as an 
`ease,' which has basically put the Fed in a pickle.''
    The 17 Fed rate hikes over the last 2 years are having an 
effect. You can see that in the housing sector, job growth, the 
blue chip forecast. Both for subdued growth and for falling 
inflation over the next year.
    I look forward to the opportunity to pursue these concerns 
with the Chairman in the question period. I also, just to send 
a warning, hope to be able to ask you about the Basel II 
situation which I think is a matter that calls for very close 
attention, which I do not think it has been receiving.
    Thank you very much, Mr. Chairman.
    Chairman Shelby. We have established a quorum and at this 
time, if you will bear with us, Mr. Chairman, I would like to 
move the Committee to executive session to consider a number of 
nominations that we have had hearings on.
    [Recess.]
    Chairman Shelby. We will now resume the hearing.
    Senator Bennett.

             STATEMENT OF SENATOR ROBERT F. BENNETT

    Senator Bennett. Thank you, Mr. Chairman.
    Chairman Bernanke, welcome to the Committee. I look forward 
to hearing what you have to say today. I will not recite a 
bunch of statistics as my colleagues have because I think we 
will get into those.
    I will look for to your comments with respect to how the 
economy is changing. We are in the midst of the Information 
Revolution, and just as the Industrial Revolution changed 
things rapidly, so I believe the Information Revolution is 
changing things, and we need to recognize that sometimes past 
benchmarks in the new, changed environment in which we find 
ourselves may not be the best benchmarks to look at. We should 
look around for new ones and the signs of the changes.
    I am particularly focused on the impact of productivity 
gains. Productivity has gone up much more rapidly in the 
information age than it did in the industrial age and it is 
affecting a number other economic indicators.
    So, I welcome you here and look forward to a dialogue with 
you on these and other related issues.
    Chairman Shelby. Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman. I would 
make three points.
    Gross domestic product has spiked up in the first quarter 
but there is evidence that the economy is slowing even before 
most Americans have benefited from the growth we have seen thus 
far in the recovery. As my colleagues have pointed out, strong 
productivity growth has shown up in the bottom lines of 
shareholders but not in the paychecks of workers. We are also 
facing soaring energy prices, record budget and trade deficits, 
and a negative household saving rate. All of these pose 
tremendous challenges to setting monetary policy which the 
Chairman and his colleagues are charged to do.
    We also have a situation where we no longer maintain the 
fiscal discipline that we had in the 1990's which allowed for 
monetary policy that encouraged investment and long-term 
growth. We have, I think, squandered that fiscal discipline and 
that complicates your job also, Mr. Chairman.
    I would also associate myself with the comments that 
Senator Sarbanes made with respect to the growing inequality of 
income, earnings, and wealth in this economy. It is 
particularly troublesome because as we pursue some of these tax 
policies which further increase the deficit and further erode 
the ability to provide basic support to middle-income 
Americans, like Pell grants and other programs, the difficulty 
of workers in this country to support their families is 
infinitely complicated and I think that is something that the 
Fed has to be concerned about, even if it does not have direct 
policy leverage to use.
    So, Mr. Chairman, I look forward to Chairman Bernanke's 
testimony. I thank him for his service.
    Chairman Shelby. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman.
    This is a very important hearing that we do twice a year 
and I cannot remember when it came at a more critical time for 
our markets and our economy. It has been a long time since I 
have seen a stock market that is as sensitive and unstable as 
this one.
    Chairman Bernanke, you have only been on the job for 5\1/2\ 
months but it has been a wild ride. I am disappointed in your 
leadership of the Fed so far but I am not surprised. During 
your confirmation process, I warned my colleagues that you were 
going to be much the same as former Chairman Greenspan, and so 
far you have been. The string of interest rate increases 
started by Chairman Greenspan has continued, and just as he did 
in 2000, I think you are going to overshoot.
    Also, you have not ended the group think at the Fed. In 
fact, it seems you have gone so far as to hand-pick new Fed 
Members that think just as you do.
    Some commentators point to the situation in the Middle East 
and North Korea as driving the market down, but those tensions 
have been around a lot longer than the current market downturn. 
Others say high energy prices are hanging over the economy. 
Yes, oil is expensive, but it is still below all-time highs 
when adjusted for inflation, and our energy expenses are a 
smaller percentage of our total expenses than in the past. 
Those are not the market's problems.
    What is dragging the market down is interest rates and 
uncertainty about Fed action. The Fed can do three things with 
its interest rate actions. It can overshoot, it can undershoot, 
or it can get it just right. It is much easier to mess up than 
to get it just right.
    The Fed has raised rates at 17 straight meetings. The Fed 
funds rate stands at 5.25 percent today and could go higher. 
There has been no pause to see how the economy reacts to those 
rate hikes. It has been one increase after another. At the 
current pace the Fed is going to overshoot and not even know 
it. By the time the full impact of interest rate increases is 
evident it will be too late. The U.S. economy will be damaged, 
and for that matter, the world economy could follow.
    The decisions of our central banks are often followed by 
foreign central banks and many have raised rates to keep pace 
with the United States. So many foreign economies rely on a 
strong U.S. economy for their growth and stability. The Fed is 
marching into dangerous territory and not looking back. There 
is a lot of speculation that the Fed may pause at the next 
meeting, but that is another way of saying that the Fed is 
still considering another increase. The markets do not know 
what the Fed is going to do and they will be on edge until 
there is certainty.
    Public statements by Fed Members over the last few months 
have not helped either. Many Governors have raised concerns 
that inflation is growing and said that interest rate hikes 
should continue. Others have said that it may be time to pause 
but have not dissented in Fed actions.
    The most recent official Fed statement has even caused more 
uncertainty. It was softer than the tough talk of the Chairman 
and others leading up to the meeting yet it does not rule out 
further rate increases. I still do not understand what all this 
talk and uncertainty is for. Inflation is not out of control. 
And I say it definitely, one more time. Inflation is not out of 
control. And if you think it is, we will further pursue it in 
the question and answer period.
    All indicators of inflation show that while it may be 
higher than in the past few years, it is still far below what 
we saw in the past few decades. Key indicators like gold are 
off their highs from earlier in the year and productivity has 
kept unit labor costs in check. The Fed is chasing an inflation 
monster that is just not there. I hope the Fed realizes that 
before it is too late.
    Thank you, Mr. Chairman. I look forward to asking some 
questions.
    Chairman Shelby. Thank you.
    Senator Menendez.

              STATEMENT OF SENATOR ROBERT MENENDEZ

    Senator Menendez. Thank you, Mr. Chairman.
    Welcome, Chairman Bernanke. Let me say, recently we learned 
that the anticipated deficit for the fiscal year 2006 is down 
from what had been projected and for that we should all be 
happy. However, we are still talking about a deficit of $296 
billion. And though that is better than the original estimated 
deficit of $423 billion, which some considered was an inflated 
estimate in the first instance, it is a far cry from the $600 
billion budget surplus for 2006 that was predicted by the White 
House back in 2001.
    Now that discussion certainly belies the $10 trillion to 
$12 trillion debt that the Congressional Budget Office tells us 
we are headed to by 2011. So while some in this country believe 
that are our economy is chugging along quite well because our 
gross domestic product continues to grow, there seems to be an 
increasing gap between the average citizen and those at the top 
of our economic ladder. The disparity between the haves and 
have-nots seems to be widening at an alarming rate.
    When I am back in New Jersey, I hear more and more from New 
Jerseyians that they are working harder and longer just to try 
to keep their heads above water, whether it is because of 
higher costs for college, soaring health care costs, increasing 
energy prices, gas prices, stagnant and flat wages, or pensions 
being underfunded and in some cases totally abandoned, there is 
a huge disconnect between growth in our GDP and the situation 
that the average American finds themselves and their families 
in.
    So the question is, who is this economy working for? I look 
forward to your testimony today and to hearing your thoughts on 
some of those items I have just mentioned and other challenges 
we face as a Nation, such as the cooling off of the housing 
market and what that may mean, rising energy prices, 
consequences of deficit and debt, record trade deficits, real 
wages remaining flat, negative household and national savings, 
a variety of global influences and how these factors affect the 
dynamic of the modern global economy that we have. Those are 
the challenges I hear from average New Jerseyians and Americans 
that they are currently facing and that you have before you.
    So as we wish you well in the stewardship of the economy, 
we look forward to hearing your testimony and hopefully 
reflecting upon some of those items. If not, I will pursue it 
in my questions.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you.
    Senator Dole.

              STATEMENT OF SENATOR ELIZABETH DOLE

    Senator Dole. Thank you, Chairman Shelby.
    Mr. Chairman, I join my colleagues in extending a very warm 
welcome to you this morning. We have seen very strong growth in 
our economy over the last few years even as our Nation as has 
faced some extremely challenging times. I expect the positive 
economic trends will continue in the coming months and years. 
Still, we have hard work ahead indeed to ensure that all levels 
and sectors of the economy benefit from this prosperity.
    In just the past year, the economy has created nearly 2 
million new jobs and the national unemployment rate remains 
lower, as we have said so often, than the average of the 
1970's, the 1980's and 1990's. While we are seeing a cooling of 
the housing sector, the other pistons of our economic engine 
are firing.
    There have been recent reports that wages are going up, 
which I hope signals that wages are beginning to catch up with 
the very dramatic increases in productivity. Also, consumer 
confidence has continued to rise. The first-quarter GDP results 
of this year were revised upward to an impressive 5.6 percent, 
as we have heard already this morning. This has resulted in 
higher than expected tax revenues and a decline in the deficit. 
In fact in the first 9 months of fiscal year 2006, we have seen 
one of the highest growth in tax revenues in 25 years, second 
only to last year. These are indeed indicators of a robust and 
expanding economy.
    Still, I share the concerns of the American people that 
energy prices continue to increase. There is no question these 
costs are putting a real strain on families and businesses. 
Folks also are concerned about the availability and 
affordability of health care.
    In order to address this broader problem, I believe we must 
empower families to make health care decisions based on their 
specific needs and allow them greater choice over how their 
health care dollars are spent. We must also work to improve 
transparency, portability, and efficiency to better meet 
consumers' needs.
    In addition, as our overall economy is thriving, we must be 
mindful that there are areas in some of our States like North 
Carolina where the economic picture is not quite as bright, 
where factories and businesses have closed and people are out 
of jobs. In North Carolina, we have experienced a transition 
from our tradition tobacco and manufacturing industries of 
textiles and furniture to new high-growth industries like 
biotechnology and pharmaceuticals. These new jobs, as we all 
know, require a well-educated and highly trained workforce. To 
this end, we must make education and job training a priority 
and focus our efforts on closing the gap between skilled and 
unskilled workers.
    Unfortunately, this gap has only widened since my days as 
Secretary of Labor. As our economy moves forward, the 
opportunities for lower-skilled workers are simply diminishing. 
It is imperative that we educate our less-skilled workers so 
that they can take advantage of the new jobs that are being 
created.
    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 workforce, and of course, hard work, 
these will ensure that we stay on course toward greater 
opportunity for North Carolina and for the Nation.
    Mr. Chairman, thank you for being here today. I look 
forward to hearing from you and working closely with you on 
these and other important issues. Thank you.
    Chairman Shelby. Senator Stabenow.

              STATEMENT OF SENATOR DEBBIE STABENOW

    Senator Stabenow. Thank you, Mr. Chairman, and welcome, 
Chairman Bernanke. It is good to have you with us again. I look 
forward to your testimony. I have read your statements recently 
and have become increasingly concerned about the slowdown you 
are referring to, as my other colleagues have as well. I 
recognize that while this may be good for inflationary purposes 
to hold down interest rates certainly, and slows down growth to 
make sure the economy is not moving too fast, in my home State 
of Michigan this just means more bad news because we are 
already experiencing a slowdown.
    As Senator Menendez spoke, he was really speaking about the 
squeeze that middle-class families are feeling on all sides 
right now, being hit by slowdown in terms of their wages, maybe 
losing a job, health care costs going up, if they get health 
care at all, maybe faced with losing a pension, and the cost of 
college, and the cost of gas, and so on.
    So we are feeling that, certainly, in Michigan as we look 
at not just one or two plants or one or two jobs but entire 
communities that are struggling as we, as a country, try to 
figure how we are going to compete in a global economy in a way 
that does not lose our way of life.
    There are certainly two different views. One says, compete 
down to the lowest wage, lowest health care, lose a pension. 
And the other says, which I espouse, which is race up, which 
means you level the playing field on trade and you address the 
costs you can, health care, energy, protect pensions, and then 
you race like crazy on education and innovation. That is the 
American way.
    My concern right now is that in a State like mine, because 
we make things, grow things, and have been the leaders in doing 
that, we now find ourselves struggling in a global economy 
because we do not have those elements in place. We have lost 
another 19,000 manufacturing jobs just in the first half of 
this year. What I cannot seem to grasp in the graphs and 
numbers that you have is really the impact of this as it 
relates to middle-class jobs, good-paying jobs in manufacturing 
in America. I do not believe we can have a strong economy 
unless we make things in this country. That is what we do, make 
things and invent things, in Michigan. So, I am interested in 
knowing about how you view us in terms of the industries that 
have created the middle class of America.
    What I do see in your analysis is a growing trade deficit 
which is on track to make history again. And we are in a path 
in another year of a record trade deficit for the entire 
country which means more lost American jobs.
    More concerning is the fact that one-third of that deficit 
is with one country, China. On Monday, I had an opportunity to 
go to a hearing that I was pleased to testify at in Michigan, 
in Dearborn, the United States-China Commission came into 
Michigan to hear about the concerns from business and labor in 
the community about what is happening with China, and our 
relationship and how it affects the auto industry and other 
industries. And I want you to know there is tremendous concern. 
I was very impressed with the Commission. Tremendous concern 
across the board, both on the Commission and those who 
testified, about what is happening and why we are not enforcing 
our trade laws.
    We can compete with anybody if it is a level playing field. 
China cheats. Other countries cheat. They steal our ideas. They 
steal our patents. They manipulate their currency. They dump 
counterfeit products. I recognize, Mr. Chairman, this is not in 
your jurisdiction but I do want to know what role you believe 
our increasing trade deficit has on our ability to enforce our 
trade laws.
    Furthermore, in your recent testimony at the International 
Monetary Conference on June 5 you stated, sustaining global 
expansion will require a greater reliance by our trading 
partners on their own domestic spending as a source of growth. 
This tells me we are going to be increasingly beholden to other 
countries in order to reverse the trade deficit. So, I am 
hoping to hear more about that in your testimony.
    But as I interpret your statement, we are allowing 
countries to ignore our trade laws and hurt good-paying, 
middle-class jobs while we simultaneously become more reliant, 
to use your description, on their spending habits. This is of 
great concern to me and I certainly welcome your thoughts and 
would appreciate your leadership.
    Thank you.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, thank you for holding this 
hearing. This is one of the hearings I always look forward to 
hearing participation and hearing from the Chairman of the 
Federal Reserve. You have been on the job about 5\1/2\ months 
now, Chairman Bernanke, and you are settling into the job and I 
look forward to hearing what your comments will be.
    I am not as down on the economy as some of my colleagues 
would express here today. I do think that our pro-growth tax 
policies we put in place that were implemented in 2003 have had 
a positive impact. And I am interested in hearing from you and 
your comments on how we are comparing worldwide. If you look at 
our growth in the last 2\1/2\ to 3 years, 20 percent growth, 
somewhere around $2.2 trillion in growth, that is almost the 
size of the entire Chinese economy. And if you look at the 
share of product that we have throughout the world, gross 
domestic product might be a way of expressing that, we have 
grown 2 percent during that time period.
    So it looks to me like we remain competitive in a world 
environment and our economy is doing better than other 
countries. And I would like to hear some comments that you have 
in that regard.
    It does not mean that we do not have some problems with our 
economy, and things that we need to watch. Areas that I feel 
particularly distressing is our runaway spending that we are 
having here with the Federal budget, particularly in the area 
of mandatory spending. Interest rates are part of that. We must 
also, I think, find ways to deal with the rising energy costs. 
But historically, it does not seem like energy has had as 
adverse an impact on the economy as perhaps other times in our 
Nation's history when we have had high energy costs. And also I 
am concerned about low personal savings rates.
    Now while the Federal Reserve is an independent agency, 
Congress must maintain a careful oversight role, particularly 
given the importance of the Fed's responsibility. And Chairman 
Bernanke, we are eager to hear your assessment of our economy 
and we look forward to your economic insights which will be 
helpful as we consider various policy issues.
    Thank you for taking the time to appear before the 
Committee.
    Chairman Shelby. Thank you.
    Senator Carper.

             STATEMENT OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks, Mr. Chairman.
    Welcome, it is good to see you and you are good to join us. 
I like to sometimes telegraph my questions and use an opening 
statement for that purpose. I say this partly with tongue-in-
cheek but some of my colleagues will recall a recently departed 
Cabinet Secretary who used to come and appear before us and as 
we would give our opening statements he would sit there with 
papers spread all around him and read this and that and would 
kid him and say, he came and he would read the newspaper and he 
would work his Blackberry. And you sit here; you are very 
attentive and listen to everyone, writing notes.
    So one of the questions I am going to ask you is, what do 
you actually think about when we give our opening statements, 
because you give every impression of paying great attention, 
which we hope is true.
    I am going to ask you about your assessment. You have been 
in the job for about 6 months. You had big shoes to fill. And I 
think most fair-minded, objective people say that you seem to 
have settled in pretty well, but just your own assessment. How 
is the job similar to what you expected, maybe different than 
what you anticipated?
    Some of my colleagues have touched on the budget deficit 
which is for me still troubling. I think we can all celebrate 
strong GDP growth. We should be happy about that. We are. We 
should celebrate strong revenue growth and we are. But as we 
look ahead I am troubled by the fact that, you know, it is 
great that the deficit is down to only $300 billion. That is a 
heck of a lot of money in my view.
    As we look down the road I do not know that we are really--
assuming any kind of expenditures in Iraq, any kind of 
expenditures in Afghanistan, I do not think we assume at all 
that we are going to ever fix the AMT problem. I do not think 
we are assuming that we are going to do anything about these 
tax extenders that are about to expire. And if we do all of 
those things, continue to fund Iraq, continue to fund 
Afghanistan, fix the AMT, continue these tax extenders, we are 
back in the soup again. And that does not even assume that the 
boomers ever retire which we are about to, as you know.
    I was reading the paper coming down today and it said that 
trade numbers are out for June and they reported that the trade 
deficit was about $63 billion for the month of June. They said 
we are on track for the biggest trade deficit in the history of 
our country. And they mentioned one country, I think Senator 
Stabenow might have mentioned that country, China. And I 
believe the deficit with China for 1 month might have been $17 
billion. I think that is what it was.
    In any event, I thought to myself, that is a bigger trade 
deficit with one country in 1 month than we used to have in a 
whole year. When does the rest of the world start to look at 
our trade deficit and our inability to balance our budget and 
say that if they are going to continue to invest money here 
they want a higher interest rate? I just want to talk a little 
bit about that when we have a chance.
    Maybe the last thing is, in addition to saying grace over 
monetary policy and a whole bunch of other duties, you have a 
major responsibility as a regulator. We are familiar with those 
responsibilities. We have had before this, and hopefully we 
will have before the full Senate later this year, legislation 
dealing with the regulation of Government Sponsored 
Enterprises, Fannie Mae, Freddie Mac, and the Federal Home Loan 
Banks.
    There are two issues that seem to divide us on that. One is 
affordable housing fund, and the second deals with the 
portfolio. What should be in the portfolio? Who should be in 
the position to say whether portfolios can grow, what kind of 
items can be included in those portfolios? In the interest of 
telegraphing another pitch I just want you to know that I would 
welcome your comments as we get into that.
    I think my time has expired. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Sununu.

              STATEMENT OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Chairman Shelby, I have no comment at this 
time. I would just like to welcome the Chairman.
    Chairman Shelby. Senator Martinez.

               STATEMENT OF SENATOR MEL MARTINEZ

    Senator Martinez. Thank you, Mr. Chairman. I will not be 
nearly that disciplined in my approach.
    Mr. Chairman, thank you for being here and thank you for 
coming to share with us. I will be very brief actually. I was 
noting with particular interest the area of labor in your 
report. I noted, in spite of what some would profess to be 
gloom and doom that there are a lot of good news in the 
economic report and the forecast terms of the labor statistics.
    For instance, it seems like this past quarter we were able 
to reach a low unemployment level that had not been seen in 5 
years, and 4.7 in the second quarter of the year, below 5 
percent. That is consistent, and even not quite as good as what 
we are experiencing in Florida where I think our unemployment 
rate is probably around 2.7 percent. Which gives rise to an 
issue that I do not know if you will address but hopefully in 
the questioning I will have an opportunity to discuss with you, 
which is whether in fact we may not have, in some aspects of 
our economy, a labor shortage.
    Recently, in the agricultural sector in Florida it was 
reported that there will be probably 3 million to 6 million 
boxes of citrus that will not be harvested this year because 
there simply was not the labor there to pick the fruit. I have 
heard of similar reports coming from California. I know in the 
housing industry, which seems to have slowed down a bit in 
Florida, but still housing construction is strong, that there 
is great competition for labor to be able to get the work done.
    So as some of us have been struggling to try to put some 
sense into our immigration laws one of the issues that we have 
repeatedly discussed is some type of a guest worker program and 
whether there is the need for such. In fact some Americans, I 
think mistakenly believe that if only wages rose a bit that 
there would be plenty of people to do many of the tasks that 
today we rely on foreign workers to do. The fact is that I 
think a healthy combination of a guest worker program as well 
as encouraging job training and so forth are part of what needs 
to be for our future economic needs.
    But I do hope that I get an opportunity to discuss with you 
some of these labor issues that I think are also an important 
component part of our economic picture.
    Thank you very much for being here.
    Chairman Shelby. Senator Hagel.

                STATEMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you.
    Chairman Bernanke, welcome. Just a comment regarding your 
testimony and the questions that will follow.
    As you have heard and as you know because you live with 
this every day and have for many years, the strength of our 
economy has essentially revolved around, over the last few 
years, high productivity, strong housing market, strong 
consumer spending, and in my opinion over the last few years 
since 2001, tax cuts.
    Now the reality is, as has been noted here this morning, we 
are facing significantly rising and unstable energy costs. 
There is some question about continuation of a strong housing 
market. As has been noted this morning, record high personal 
debt, record low savings, continued deficit spending by 
Government, and I would add to all of this, a rather dangerous 
and unstable world environment today. And I do not think it is 
isolated just in the Middle East. I happen to believe the 
Middle East represents the most combustible time since 1948, 
where we are today.
    Now I would hope in your testimony that you would give this 
Committee some sense of proportion and balance in how all of 
this is mixing, and some of these realities are going to 
affect, in your opinion, our economy and our growth over the 
next year or two, realizing that you cannot predict. That is 
not your job. We do want you to do that.
    But I do think we need to integrate all these dynamics that 
are in play, as well as you can, into a comprehensive economic 
fabric as to how you are approaching this at the Fed, as how 
you are intending to deal with these things on a comprehensive 
monetary policy basis.
    I know you understand these things and I would hope that 
you could integrate these issues and will in your testimony. I 
know we will get to some of these things during the question-
and-answer period.
    Thank you very much, Mr. Chairman. Thank you.
    Chairman Shelby. Senator Dodd.

            STATEMENT OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Thank you, Mr. Chairman. I have no statement.
    Chairman Shelby. I believe that is everybody.
    Mr. Chairman, you may proceed as you wish. Your written 
statement will be made part of record.

            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 again to present the 
Federal Reserve's Monetary Policy Report to the Congress.
    Over the period since our February report, the U.S. economy 
has continued to expand. Real gross domestic product is 
estimated to have risen at an annual rate of 5.6 percent in the 
first quarter of 2006. The available indicators suggest that 
economic growth has more recently moderated from that quite 
strong pace, reflecting a gradual cooling of the housing market 
and other factors that I will discuss. With respect to the 
labor market, more than 850,000 jobs were added, on net, to 
nonfarm payrolls over the first 6 months of the year, though 
these gains came at a slower pace in the second quarter than in 
the first. Last month, the unemployment rate stood at 4.6 
percent.
    Inflation has been higher than we has anticipated in 
February, partly as a result of further sharp increases in the 
prices of energy and other commodities. During the first 5 
months of the year, overall inflation, as measured by the price 
index for personal consumption expenditures, averaged 4.3 
percent at an annual rate. Over the same period, core 
inflation--that is, inflation excluding food and energy 
prices--averaged 2.6 percent at an annual rate. To address the 
risk that inflation pressures might remain elevated, the 
Federal Open Market Committee continued to firm the stance of 
monetary policy, raising the Federal funds rate another three-
quarters of a percentage point to 5.25 percent in the period 
since our last report.
    Let me now review the current economic situation and the 
outlook in a bit more detail, beginning with developments in 
the real economy and then turning to the inflation situation. I 
will conclude with some comments on monetary policy.
    The U.S. economy appears to be in a period of transition. 
For the past 3 years or so, economic growth in the United 
States has been robust. This growth has reflected both the 
ongoing reemployment of underutilized resources as the economy 
recovers from the weakness of earlier in the decade, and the 
expansion of the economy's underlying productive potential, as 
determined by such factors as productivity trends and the 
growth of the labor force. Although the rates of resource 
utilization that the economy can sustain cannot be known with 
any precision, it is clear that, after several years of above-
trend growth, slack in resource utilization has been 
substantially reduced. As a consequence, a sustainable, 
noninflationary expansion is likely to involve a modest 
reduction in the growth of economic activity from the rapid 
pace of the past 3 years to a pace more consistent with the 
rate of increase in the Nation's underlying productive 
capacity. It bears emphasizing that, because productivity 
growth seems likely to remain strong, the productive capacity 
of our economy should expand over the next few years at a rate 
sufficient to support solid growth in real output.
    As I have noted, the anticipated moderation in economic 
growth now seems to be underway, although the recent erratic 
growth pattern complicates this assessment. That moderation 
appears most evident in the household sector. In particular, 
consumer spending, which makes up more than two-thirds of 
aggregate spending, grew rapidly during the first quarter but 
decelerated during the spring. One likely source of this 
deceleration was higher energy prices, which have adversely 
affected the purchasing power of households and weighed on 
consumer attitudes.
    Outlays for residential construction, which have been at 
very high levels in recent years, rose further in the first 
quarter. More recently, however, the market for residential 
real estate has been cooling, as can be seen in the slowing of 
new and existing home sales and housing starts. Some of the 
recent softening in housing starts may have resulted from the 
unusually favorable weather during the first quarter of the 
year, which pulled forward construction activity, but the 
slowing of the housing market appears to be more broad-based 
than can be explained by that factor alone. Home prices, which 
have climbed at double-digit rates in recent years, still 
appear to be rising for the Nation as a whole, though 
significantly less rapidly than before. These developments in 
the housing market are not particularly surprising, as the 
sustained run-up in housing prices, together with some increase 
in mortgage rates, has reduced affordability and thus the 
demand for new homes.
    The slowing of the housing market may restrain other forms 
of household spending as well. With homeowners no longer 
experiencing increases in the equity value of their homes at 
the rapid pace seen in the past few years, and with the recent 
declines in stock prices, increases in household net worth are 
likely to provide less of a boost to consumer expenditures than 
they have in the recent past. That said, favorable 
fundamentals, including relatively low unemployment and rising 
disposable incomes, should provide support for consumer 
spending. Overall, household expenditures appear likely to 
expand at a moderate pace, providing continued impetus to the 
overall economic expansion.
    Although growth in household spending has slowed, other 
sectors of the economy retain considerable momentum. Business 
investment in new capital goods appears to have risen briskly, 
on net, so far this year. In particular, investment in 
nonresidential structures, which had been weak since 2001, 
seems to have picked up appreciably, providing some offset to 
the slower growth in residential construction. Spending on 
equipment and software has also been strong. With a few 
exceptions, business inventories appear to be well aligned with 
sales, which reduces the risk that a buildup of unwanted 
inventories might act to reduce production in the future. 
Business investment seems likely to continue to grow at a solid 
pace, supported by growth in final sales, rising backlogs of 
orders for capital goods, and high rates of profitability. To 
be sure, businesses in certain sectors have experienced 
financial difficulties. In the aggregate, however, firms remain 
in excellent financial condition and credit conditions for 
businesses are favorable.
    Globally, output growth appears strong. Growth of the 
global economy will help support U.S. economic activity by 
continuing to stimulate demand for our exports of goods and 
services. One downside of the strength of the global economy, 
however, is that it has led to significant increases in the 
demand for crude oil and other primary commodities over the 
past few years. Together with heightened geopolitical 
uncertainties and the limited ability of suppliers to expand 
capacity in the short-run, these rising demands have resulted 
in sharp rises in the prices at which these goods are traded 
internationally, which in turn has put upward pressure on costs 
and prices in the United States.
    Overall, the U.S. economy seems poised to grow in coming 
quarters at a pace roughly in line with the expansion of its 
underlying productive capacity. Such an outlook is embodied in 
the projections of Members of the Board of Governors and the 
Presidents of Federal Reserve Banks that were made at around 
the time of the FOMC meeting late last month, based on the 
assumption of appropriate monetary policy. In particular, the 
central tendency of those forecasts is for real GDP to increase 
about 3.75 percent to 3.5 percent in 2006 and 3 percent to 3.25 
percent in 2007. With output expanding at a pace near that of 
the economy's potential, the civilian unemployment rate is 
expected to finish both 2006 and 2007 between 4.75 percent and 
5 percent, close to its recent level.
    I turn out to the inflation situation. As I noted, 
inflation has been higher than we expected at the time of our 
last report. Much of the upward pressure on overall inflation 
this year has been due to increases in the prices of energy and 
other commodities and, in particular, to the higher prices of 
products derived from crude oil. Gasoline prices have increased 
notably as a result of the rise in petroleum prices as well as 
factors specific to the market for ethanol. The pickup in 
inflation so far this year has also been reflected in the 
prices of a range of nonenergy goods and services, as 
strengthening demand may have given firms more ability to pass 
energy and other costs through to consumers. In addition, 
increases in residential rents, as well as the imputed rent on 
owner-occupied homes, have recently contributed to higher core 
inflation.
    The recent rise in inflation is of concern to the FOMC. The 
achievement of price stability is one of the objectives that 
makes up the Congress's mandate to the Federal Reserve. 
Moreover, in the long-run, price stability is critical to 
achieving maximum employment and moderate long-term interest 
rates, the other parts of the Congressional mandate.
    The outlook for inflation is shaped by a number of factors, 
not the least of which is the course of energy prices. The spot 
price of oil has moved up significantly further in recent 
weeks. Futures quotes imply that market participants expect 
petroleum prices to roughly stabilize in coming quarters; such 
an outcome would, over time, reduce one source of upward 
pressure on inflation. However, expectations of a leveling out 
of oil prices have been consistently disappointed in recent 
years, and as the experience of the past week suggests, 
possible increases in these and other commodity prices remain a 
risk to the inflation outlook.
    Although the cost of energy and other raw materials are 
important, labor costs are by far the largest component of 
business costs. Anecdotal reports suggest that the labor market 
is tight in some industries and occupations and that employers 
are having difficulty attracting certain types of skilled 
workers. To date, however, moderate growth in most broad 
measures of nominal labor compensation and the ongoing 
increases in labor productivity have held down the rise in unit 
labor costs, reducing pressure on inflation from the cost side. 
Employee compensation per hour is likely to rise more quickly 
over the next couple of years in response to the strength of 
the labor market. Whether faster increases in nominal 
compensation create additional cost pressures for firms depends 
in part on the extent to which they are offset by continuing 
productivity gains. Profit margins are currently relatively 
wide, and the effect of a possible acceleration in compensation 
on price inflation would thus also depend on the extent to 
which competitive pressures force firms to reduce margins 
rather than pass on higher costs.
    The public's inflation expectations are another important 
determinant of inflation. The Federal Reserve must guard 
against the emergence of an inflationary psychology that could 
impart greater persistence to what otherwise would be a 
transitory increase in inflation. After rising earlier this 
year, measures of longer-term inflation expectations, based on 
surveys and on a comparison of yields on nominal and inflation-
index Government debt, have edged down and remained contained. 
These developments bear watching, however.
    Finally, the extent to which aggregate demand is aligned 
with the economy's underlying productive potential also 
influences inflation. As I noted earlier, FOMC participants 
project that the growth in economic activity should moderate to 
a pace close to that of the growth of potential both this year 
and next. Should that moderation occur as anticipated, it 
should also help to limit inflation pressures over time.
    The projections of the Members of the Board of Governors 
and the Presidents of the Federal Reserve Banks, which are 
based on information available at the time of the last FOMC 
meeting, are for a gradual decline in inflation in coming 
quarters. As measured by the price index for personal 
consumption expenditures excluding food and energy, inflation 
is projected to be 2.25 percent to 2.5 percent this year, and 
then to edge lower, to 2 percent to 2.25 percent, next year.
    The FOMC projections, which now anticipate slightly lower 
growth in real output and higher core inflation than expected 
in our February report, mirror the somewhat more adverse 
circumstances facing our economy, which have resulted from the 
recent steep run-up in energy costs and higher-than-expected 
inflation more generally. But they also reflect our assessment 
that with appropriate monetary policy and in the absence of 
significant unforeseen developments, the economy should 
continue to expand at a solid and sustainable pace and core 
inflation should decline from its recent level over the medium-
term.
    Although our baseline forecast is for moderating inflation, 
the Committee judges that some inflation risks remain. In 
particular, the high prices of energy and other commodities, in 
conjunction with high levels of resource utilization that may 
increase the pricing power of suppliers of goods and services, 
have the potential to sustain inflation pressures. More 
generally, if the pattern of elevated readings on inflation is 
more protracted or more intense than is currently expected, 
this higher level of inflation could become embedded in the 
public's inflation expectations and in price-setting behavior. 
Persistently higher inflation would erode the performance of 
the real economy and would be costly to reverse. The Federal 
Reserve must take account of these risks in making its policy 
decisions.
    In our pursuit of maximum employment and price stability, 
monetary policymakers operate in an environment of uncertainty. 
In particular, we have imperfect knowledge about the effects of 
our own policy actions as well as of the many other factors 
that will shape economic developments during the forecast 
period. These uncertainties bear importantly on our policy 
decisions because the full influence of policy actions on the 
economy is felt only after a considerable period of time. The 
lags between policy actions and their effects imply that we 
must be forward-looking, basing our policy choice on the 
longer-term outlook for both inflation and economic growth. In 
formulating that outlook, we must take account of the possible 
future effects of previous policy actions--that is, of policy 
effects still ``in the pipeline.'' Finally, as I have already 
noted, we must consider not only what appears to be the most 
likely outcome but also the risks to that outlook and the costs 
that would be incurred should any of those risks be realized.
    At the same time, because economic forecasting is far from 
a precise science, we have no choice but to regard all our 
forecasts as provisional and subject to revision as the facts 
demand. Thus, policy must be flexible and ready to adjust to 
changes in economic projections. In particular, as the 
Committee noted in the statement issued after its June meeting, 
the extent and timing of any additional firming that may be 
needed to address inflation risks will depend on the evolution 
of the outlook for both inflation and economic growth, as 
implied by our analysis of the incoming information.
    Thank you. I would be happy to take questions.
    Chairman Shelby. Thank you Mr. Chairman.
    Mr. Chairman, your testimony notes the possibility of some 
risk which could add to inflationary pressures, in particular 
the possibility of higher energy prices feeding into the prices 
of nonenergy goods and services. Your testimony, Mr. Chairman, 
also notes the risk to our economy due to a slowing housing 
market.
    The question is this: What would be the impact, Chairman 
Bernanke, on the economy if both of these effects materialized 
to a greater degree than is currently anticipated? How would 
the Federal Reserve be likely to respond to such a scenario? 
These are not out of the question, either.
    Chairman Bernanke. No, Senator. As I mentioned, we are 
following the data very closely and we revise our forecasts as 
needed. Right now we see, of course, the housing market 
slowing. We see some offsetting strength in some other sectors 
of the economy and our expectation is that the economy is going 
to be growing at or about the pace of its underlying potential.
    We also think that inflation is going to moderate. We see 
some risks to the upside, and that is an issue that we have to 
think about. But of course, if we see changes in the data, we 
will certainly adjust our balance of risk and thinks about it 
accordingly.
    Chairman Shelby. Among that same lines, both your 
testimony, Mr. Chairman, and your written report this morning 
discuss the lag between Fed policy actions and their effects. 
Some analysts have remarked on the trade-offs which may exist 
between spurring economic growth by way of low interest rate 
regime and combating inflation. That is always a challenge.
    How do Members of the Federal Reserve know when your 
changes to monetary policy have been fully incorporated 
throughout the economy?
    For example, how does the FOMC go about assessing whether 
the 17 quarter point rises in the Federal funds rate are fully 
incorporated in the market 3 months from now, 6 months from 
now, or some other time? Is that a judgement on your part?
    Chairman Bernanke. Senator, it is judgment based on a great 
deal of quantitative analysis. We look at extensive models. We 
look at statistical models. We look at financial market data. 
We use our own judgment. We listen to anecdotes. We try to make 
our best judgment about where the economy is heading, including 
the effects of the policy actions that we have already taken.
    Our goal is to achieve a sustainable, noninflationary 
expansion and we are adjusting our policy in a way to try to 
meet that goal.
    Chairman Shelby. In other words, you do not want the 
medicine to destroy the patient; right, in a sense?
    Chairman Bernanke. Senator, that is absolutely right. 
Again, our goal is to achieve a sustainable expansion.
    There are risks in both directions, if I may say so. 
Clearly, we do not want to tighten too much to cause the 
economy to grow more slowly than its potential, and we are very 
aware of that concern, and we think about it and we look at it 
and try to evaluate it.
    The risk in the other direction is that, if we were to stop 
tightening too soon and inflation were to get higher and more 
persistent, then we would be faced with the situation of having 
to 
address that later on with perhaps even more interest rate 
increases.
    So our goal is to achieve a sustainable expansion. We have 
to balance those risks and those two directions. And we do that 
by looking forward to our forecasting process and thinking 
about how actions we have already taken are likely to affect 
the economy in the long-run.
    Chairman Shelby. So whatever you do, you have to keep in 
mind price line stability at every move, do you not?
    Chairman Bernanke. Senator, price stability is part of the 
mandate, of course. And I do believe it is important for 
achieving stability, and also moderate interest rates. For 
example, we talk about mortgage rates and we understand that 
our actions affect mortgage rates. But if you look back 
historically, the periods where mortgage rates were by far the 
highest, were high inflation periods like the 1970's and early 
1980's, when mortgage rates reached 18 percent. So if we want 
to keep mortgage rates low, we need to keep inflation low.
    Chairman Shelby. Mr. Chairman, as the cost of energy, as 
you have noted, is often volatile, in part because of its 
seasonal use and in part because of factors beyond our control. 
Historically, energy prices have been excluded from the measure 
of what you call core prices in the consumer price index. If 
there is a sustained increase in energy prices, would it be 
more appropriate for policymakers to rely upon an inflation 
measure which includes the energy cost?
    In other words, does the exclusion of energy prices from 
the definition of core prices pose any problems for economists 
trying to understand the health of our economy at the present 
time?
    Chairman Bernanke. Mr. Chairman, that is a difficult 
question. As you point out, we have excluded it from one of our 
basic measures, the core measure, because in the past it has 
been a very volatile price. Of course, more recently, instead 
of going up and down, it has just gone up.
    So the question is what is the purpose of our measure? If 
we are trying to forecast inflation over the next couple of 
years, we can still look at the futures markets for energy. And 
although they have not been very reliable, I have to admit, 
they do say that energy prices are likely to be relatively flat 
over that period. If that is true, then the core inflation 
measure is a better forecast of what total inflation will be a 
year or two from now.
    On the other hand, the inflation rate that people see is 
the overall inflation rate. They see the gasoline price at the 
pump. That affects their behavior. That affects their 
expectations. If those high inflation rates, including energy, 
cause people to develop an inflationary psychology, that would 
be a concern that would effect, perhaps, the future course of 
inflation.
    So depending on the purpose, we do have to look at 
different combinations of measures.
    Chairman Shelby. We all like 99 cent gasoline, as you well 
know, all of us.
    Chairman Bernanke. Yes, sir.
    Chairman Shelby. Mr. Chairman, last question here for now, 
dealing with the housing market GSE's.
    In your testimony this morning, you note the cooling down 
in the housing market and its associated effect perhaps on 
consumer spending.
    What effect, Mr. Chairman, if any, would a more significant 
slow down in the housing market and asset-based securities 
industry have on the financial condition of Freddie Mac and 
Fannie Mae? And do you have any concerns regarding effects on 
the banking system in this regard?
    Chairman Bernanke. Senator, so far the credit quality looks 
to be good. We see that mortgages are, for the most part, 
fixed-rate despite the fact that we have seen more 
nontraditional mortgages and ARM's issued recently. We only see 
about 10 percent of all mortgages being repriced during 2006. 
Because of these rapid increases in house prices, a lot of 
homeowners do have a lot of equity. And, therefore, they are 
able to make the payments on their homes. So we do not see any 
near-term significant increase in mortgage delinquencies or 
credit risk.
    The one area that we are watching very carefully is low and 
moderate-income subprime mortgage lending. That area, more than 
the broader market, has seen adjustable-rate mortgage lending. 
And therefore, there is more susceptibility, I think, there to 
increases in interest rates affecting the monthly cost of 
mortgages.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much Mr. Chairman.
    Chairman Bernanke, do you agree that the rate hikes over 
the last 2 years, 17 successive rate hikes, are beginning to 
bite and they have reduce long-term inflation risks?
    Chairman Bernanke. Senator, as you know, we started from an 
extraordinarily low level of about 1 percent, and we had to 
move many times to remove that extraordinary degree of monetary 
accommodation from the system. I would agree we have 
essentially removed that extraordinary degree of monetary 
policy accommodation and we are much more in a more normal 
range of interest rates at this point.
    I do think it is beginning to have some effect. We are 
trying to judge the effect on both real output and inflation, 
and trying to make our best judgment.
    Senator Sarbanes. If there were no further rate hikes, how 
long do you think the negative effects of past rate hikes on 
growth and output in jobs would continue?
    Chairman Bernanke. Senator, the forecasts that I gave you 
earlier are based on our analysis of the future of the economy, 
taking into account the policy actions that we have already 
taken. So based on those actions, or actually based on 
appropriate monetary policy more specifically, the Members of 
the FOMC see the economy cooling slightly relative to the last 
3 years to a sustainable pace consistent with underlying 
productive capacity. And they also see inflation moderating to 
a level more consistent with price stability over the next 2 
years.
    Senator Bennett. Is there a further lag between the slowing 
of the economy and changes in core inflation? If so, how long 
is that lag?
    Chairman Bernanke. Again, our forecasts have tried to 
incorporate those legs. If you were asking about even beyond 
the 2007 forecast horizon, my guess would be that we would see 
some further decline in inflation in 2008.
    Senator Sarbanes. I am concerned about this perception I 
quoted in my outset, ``To Pause or Not to Pause, That is the 
Conundrum,'' and that ``The Fed has managed to elevate a pause 
to something that is a pretty major event. What was normal in 
prior cycles, up or down, is now something that grabs 
headlines.''
    And then the commentator noted ``The Fed paused twice in 
the 1999-2000 cycle, three times in the 1994 cycle. It elicited 
a yawn from the markets. This time it is attracting enormous 
attention.''
    There is an article in this morning's Wall Street Journal 
in which they quote Alan Greenspan, who made this observation 
after a series of rate increases: ``There may come a time when 
we hold our policy stance unchanged or even ease despite 
adverse price data should we see signs that underlying forces 
are acting ultimately to reduce inflation pressures.''
    He made that statement to the Senate days after the Labor 
Department had reported the biggest monthly increase in the 
core CPI since 1992. What is your reaction to that?
    Chairman Bernanke. I absolutely agree with your point, 
Senator. In fact, in my testimony before the Joint Economic 
Committee, I argued that at some point, a point which I did not 
specify, the Fed would have to get off this 25 basis point per 
meeting escalator and adopt a more flexible approach, possibly 
varying its pace of tightening, possibly taking a pause.
    That has been the practice in the past. That is the 
practice of the European Central Bank and the Bank of Japan 
today. They do not move at every meeting. They move based on 
the state of the economy and based on the pace at which they 
wish to tighten.
    So I did make that point. I think it is still relevant. But 
of course, we always look at this meeting by meeting, and we 
will be evaluating all options when we come to meet in August.
    Senator Sarbanes. This development in the housing market 
that I showed earlier, and the drop in the new housing starts, 
that is a 22 percent drop in a matter of months.
    Now the National Association of Home Builders, which 
obviously would be quite concerned about something of this 
sort, has written to Members of the Committee about this. And I 
understand that some forecasters say that this could result in 
a 1.5 percent drop in GDP.
    Now we have relied on the strong housing market to keep the 
economy up in recent times, and now this seems to indicate a 
deterioration in that position.
    Furthermore, in your statement when you talk about higher 
core inflation, you reference increase in residential rents, as 
well as the imputed rent on owner-occupied homes. Now the 
Association of Home Builders makes, it seems to me, a rather 
valid point in communicating with us about this measure, saying 
that the weakness in new housing increases the demand for 
rental housing. Therefore, the price of rental housing goes up 
and the imputed value of the owner's equivalent rent--which 
they are not actually paying, it is a statistical measure--that 
goes up. And therefore, the core inflation goes up. Then the 
reaction to the core inflation going up is to raise the 
interest rates in order to check what is perceived as an 
inflation problem.
    The raise in the interest rates intensifies this trend in 
the decline in new housing, available housing, greater demand 
for rental housing, a greater imputed value into the core 
inflation measure. And you have this vicious circle contributed 
to by the raised interest rates.
    That seems to me to have some validity, that observation. 
What is your reaction to that?
    Chairman Bernanke. Senator, on your first point about 
housing, we are watching housing market very carefully. I would 
point out that there have been some offsets in nonresidential 
construction, in exports, and in investment. So other parts of 
the economy are picking up to offset some of the weakness we 
see in the housing market. But we are watching that very 
carefully.
    Your point on owner-occupied equivalent rent is a good 
point and we are quite aware of it.
    Senator Sarbanes. Seventy percent of the housing in this 
country is owner occupied; correct?
    Chairman Bernanke. Senator, what I was going to say is, and 
I think that is a good reason, that for example we focus more 
on the personal consumption expenditure deflator, which puts a 
much lower weight on that than does the CPI, for example.
    In addition, as I mentioned in my testimony, the increase 
in inflation we have seen is a much broader phenomenon than 
that single component. If that single component was the only 
issue, I would think twice. But I do see movements in inflation 
in a broad range of goods and services.
    Senator Sarbanes. Is it worth thinking one-and-a-half 5 
times when you see that component doing that thing?
    Chairman Bernanke. No, I will think twice, Senator.
    Senator Sarbanes. Mr. Chairman, I want to make one final 
point, if I could, with the Chairman. I want to use two charts 
to show it.
    One is a chart showing that rising profits more than 
account for inflation in the nonfinancial corporations. What 
this shows is the red line represents the increase accounted 
for by higher profits. The blue line is the increase in prices. 
And it goes back to the chart I showed about the labor costs.
    It seems to me it is fair to say, at least up to this 
point, that a rise in labor costs, which had 0.3 percent I 
guess, most of it is we have increased productivity, is not a 
factor in looking at a current inflationary situation. Would 
you agree with that?
    In fact, the whole thing is skewed so that the benefits of 
whatever economic activity is taking place are going very much 
to profits, which then translate out to this growing inequality 
in incomes and wealth in the country.
    Chairman Bernanke. Senator, I agree that there is more of a 
problem in the product markets than in the labor markets. In 
the product markets they are sufficiently tight that firms are 
developing pricing power and they are passing on their energy 
and materials costs.
    It still is an inflation problem because if inflation 
rises, it is still going to have the same adverse affects. It 
is going to get into expectations. I am not saying that is 
going to happen. Our forecast is for inflation to decline over 
time. But it is a risk. And nevertheless, if it is coming from 
product markets more than labor markets, it is still a risk to 
inflation.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bennett.
    Senator Bennett. Thank you.
    Chairman Bernanke, we have had a lot of conversations about 
wage growth compared to inflation. I find it hard to get a 
single statistic on this. If you look at the narrow measure of 
labor compensation that is labeled average hourly earnings, 
which does not include any benefits, then you get one answer. 
If you look at the more comprehensive measures of labor 
compensation, such as those that come from the Bureau of Labor 
Statistics, productivity statistics, and the employment cost 
index from the International Compensation Survey, you get 
another answer.
    If you take those BLS measures that include benefits as 
well as that which shows up in the W-2, suggesting that 
benefits sometimes very often comprise 30 percent of 
compensation. So leaving them out of the figure would be kind 
of misleading. If you take the information from the BLS 
statistics, you find that workers have made gains, in some 
cases very healthy gains, after adjusting for inflation.
    Now, what statistics do you use when you look at this? And 
can you give me some help as to where I should go?
    Chairman Bernanke. Senator, we look at them all. I am sorry 
that I cannot point to one in particular.
    But you do make a valid point, which is that if you look at 
nonfarm business compensation per hour, you have real increases 
about 2.5 percent over the past few years. If you look at real 
average hourly earnings, it is much closer to zero.
    The difference, as you point out, is really two things. One 
is the fact that the former, the nonfarm business compensation, 
includes benefits. But it also includes the full universe of 
workers, not just production workers. So depending on what 
sector you are looking at, you might use one or the other.
    For purposes of looking at household income, that is how 
much income consumers have to spend, you would probably look at 
the nonfarm business compensation. If you are looking at costs 
affecting manufacturing, for example, you would look at some of 
the average hourly earnings numbers.
    Senator Bennett. When I was an employer, I learned very 
quickly you cannot look at your labor costs in terms of what 
shows up on the W-2. Your labor costs are based on the entire 
compensation package, which includes all of the benefits. And 
you learned very quickly that if you did not recover enough 
value added from the employee's work to cover everything, what 
is in the W-2 plus the Social Security plus the health care, 
plus the unemployment compensation, plus, plus, plus all of the 
other things that got added on. If you did not get sufficient 
value added from the work of the employee to cover all of that, 
you could not afford the employee. And all of that was always 
significantly higher than the earnings that was reported in the 
W-2.
    So, I have to continue to look at that when we have these 
arguments about compensation and where it really goes.
    Let me shift completely from that argument to another one 
that we have had maybe in some of the opening statements. You 
have suggested that persistently low, long-term interest rates, 
even as short-term rates have risen significantly, comes as a 
result of a global savings glut with respect to global 
investment opportunities. And it is that global savings glut 
that has allowed large amounts of savings to flow into the U.S. 
investments.
    I was at the Aspen Ideas Festival and one economists there 
said people send their money here because, number one, it is 
the safest place to do it. And number two, they get a higher 
rate of return in the United States than they get elsewhere.
    Do you still believe there is a global savings glut and 
that we can expect people to continue to want to put their 
money here?
    Chairman Bernanke. I think there still is a global savings 
glut. It may have moderated somewhat because of increased 
growth in some of our trading partners. But on the other hand, 
there has also been, of course, these large revenues that the 
oil producers are accumulating because of the high price of 
oil. They are not able to absorb, or use those revenues at 
home, very quickly. So they are taking that money and putting 
it back into the global financial system. So that is 
contributing to this overall global savings glut.
    I would say that real interest rates at the long end have 
recent risen a bit recently. And I think that some moderation 
in the global savings glut, together with some return toward 
normalcy in term premiums, may account for that. So, I think 
there has been some change. But the broad idea that the global 
savings glut is out there, I think, is still valid.
    Senator Bennett. So you are suggesting that foreign 
investment in the United States is not about to dry up at any 
point soon?
    Chairman Bernanke. I do not think it is going to dry up. I 
do think that over a period of time we should become more 
reliant on our own saving and reduce the current account 
deficit.
    Senator Bennett. Surely.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman.
    Thank you, Mr. Chairman, for your testimony today. You have 
indicated that you expect inflation to moderate going forward. 
Is that a consequence of the slowing economy or moderating 
economy?
    Chairman Bernanke. That is one part. But in addition, we 
are seeing, we are hoping at least that these energy price 
increases will not continue at the same pace as they have been 
going on in the past. And that would remove a source of 
inflation pressure, as well.
    Senator Reed. If the economy moderates, what will that do 
to already, from my perspective, inadequate job growth? Would 
you anticipate job growth to also moderate?
    Chairman Bernanke. I think that job growth will continue to 
be close to what the labor force growth demands, in some sense. 
There has been a change in the last few decades in terms of the 
rate of growth of the labor force, in part because, for 
demographic and other reasons, the share of the population that 
participates in the labor force has flatted out and now looks 
to be declining.
    It therefore appears that the number of jobs we need to 
create each month to keep the unemployment rate roughly 
constant is lower today than it would have been, say, in the 
early 1990's. And so I think job growth will be lower than it 
has been over the last 15 years. But I think it will be close 
to where it needs to be to keep the unemployment rate at a 
healthy, low level.
    Senator Reed. But that is a function of the participation 
rates. And for some reasons, demographic rates, an older 
population you would have a lower participation rate. But you 
still have a significant number of Americans that are looking 
for both work or looking to move up. And with a job rate that 
simply replaces the new entrants in the job market, that is not 
going to provide the type of robust job growth that most people 
associate with a vibrant economy.
    Chairman Bernanke. What we see in the labor market, and it 
is a very difficult problem, is a bifurcated market. What we 
see is people who are skilled, who are machinists, registered 
nurses, truck drivers with a commercial driver's license, and 
so on, are finding a lot of opportunities. People with less 
skills are finding it more difficult.
    That is, of course, a serious problem for our economy. But 
it is one probably that needs to be addressed more by education 
and skill training and other approaches rather than monetary 
policy.
    Senator Reed. I think that is a conclusion we have all 
reached. But in the short to intermediate run, it is hard to 
reeducate a workforce. And people have to be able to live and 
work. And that is a dilemma that we both face.
    Is it accurate to say that some of the productivity gains 
have been increased not by upgrading the skills of Americans or 
the equipment they have, but by simply shipping jobs overseas? 
That as you lower the unit cost of labor, for example, and your 
output is constant that would seem to me to increase 
productivity. Are some of these productivity gains a direct 
result of outsourcing American jobs?
    Chairman Bernanke. I do not think we have clear knowledge 
of which direction that effect is working. It depends on the 
composition of jobs that have been outsourced. It depends on 
how it affects the productivity of firms that remain in the 
United States. For example, if they are able to improve their 
global supply chains and the like.
    I think the primary source of the productivity gains are 
two. First is the improvements in information communication 
technology we have seen over the last 20 years or so.
    But second, the United States has done a lot better at 
using those technologies than a lot of other industrialized 
countries. I think that relates to the fact that we do have 
very flexible product and labor markets. We have deep capital 
markets that provide funding for new ventures. And we have an 
economy that has an entrepreneurial spirit.
    So we have made better use of those technological changes 
than some other countries. I think that is the primary source 
of our productivity gains.
    Senator Reed. But is it worth, in terms of just an 
analytical approach, to look at the effect on productivity of 
outsourcing jobs? We take great pride in increased 
productivity. But I think if part of the story is it represents 
the loss of American jobs, it is not as compelling or as 
desirable a notion.
    Chairman Bernanke. We could look at that. As I said, I do 
not think we have clear evidence on that point. I think a 
broader issue is competition.
    There is some very interesting research done by the 
McKinsey Corporation that has looked at firms around the world 
and looks at their productivity gains. What it finds is that 
firms that are exposed to competition, as unpleasant as that 
might feel, increase their productivity gains much more 
rapidly.
    And so one of the benefits, I think, of a more open trading 
system, a more open economy where we compete with, and trade 
with, countries around the world, despite the fact that it does 
create stress and sometimes changes and dislocations, is that 
competition forces productivity gains and has been, I think, a 
source of growth for us as well as for our trading partners.
    Senator Reed. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Chairman Bernanke, as I said in my opening statement, the 
stock market has been on a wild ride since you took over in 
February. I have a chart here that I would like to share with 
you.
    Since you were sworn in, the Dow is down 65 points, 0.61 
percent. Standard & Poor's is down 43.22 points, 3.49 percent. 
The Nasdaq has suffered what we call a severe drop. It is down 
262 points or 12.85 percent.
    Since your lapse in judgment, in your words, took place, 
the Dow is down 567 points, a total of 5.26 percent. Standard & 
Poor's is down 73.75, almost 6 percent. The Nasdaq is down 279 
points, 13.67 percent.
    But even more importantly, since the May 10 Fed rate 
increase, the Dow is down 840 points, 7.78 percent. Standard & 
Poor's is down 88.28, 7.14 percent. And the Nasdaq is off 
295.02, or 14.4 percent.
    My question, to follow that up, why do you think the 
markets have reacted so drastically to the Fed's actions?
    Chairman Bernanke. Senator, I do not think it follows 
necessarily that they are reacting to the Fed's actions. There 
are a lot of factors in the world that could explain why the 
markets are down. We have geopolitical uncertainty and oil 
prices going on. We have, around the world, many other central 
banks raising interest rates. And that has led to a clear 
reduction in the amount of risk that people willing to take on. 
We have seen that in lots of markets, in other stock markets in 
other countries, as well. There is greater uncertainty now 
about inflation and growth in the U.S. economy. I think all of 
those things can help explain why the markets are down.
    I would add that the literature suggests that stock markets 
do not do well in periods of inflation. I think the best thing 
the FOMC can do, to strengthen, to get the stock market up, 
although that is not one of our mandated goals but I think it 
would be a good thing, but to help get the market up, would be 
to go toward our mandated goals and create stable growth and to 
keep inflation low. And that is what we intend to do.
    Senator Bunning. Do you know how this translates for the 
average American? Into the higher interest rates, which the 
FOMC has done, into lower values on their pension plans? This 
is average America. Lower 401(k) values by billions of dollars.
    It seems like a straw horse to use higher energy costs when 
higher energy costs have been occurring off and on since 1974, 
we have had an unstable energy market, sometimes to the extreme 
of $12 or $8 per barrel to $78 plus per barrel, which it hit 
this past week. So that is not a real factor. That is one that 
is coming and going. That is why it is not in the core 
inflation rate.
    These are real problems that everyday Americans are facing. 
And your action on the FOMC, and your 11 other people that are 
with you, deciding interest rates on a given day, trying to 
project 9 months down the road how it will affect the U.S. 
economy is just breathtaking.
    Last week, a writer for one of our wonderful business 
publications, Business Week, said if you, as a Chairman of the 
Federal Reserve, expect growth to moderate and inflation to 
ease, why do you even consider another rate hike?
    Chairman Bernanke. Senator, again, I do not think you have 
made the case that this is not a fundamental set of factors 
affecting the stock market. If we had stopped raising rates at 
4.25 or 4.50, I think there would be a lot of concern in the 
market and in the economy about inflation at this point. We 
have tried to balance those inflation concerns against growth 
concerns. We are looking at both very carefully.
    As far as the future policy, as I said, we have not made 
any future decisions. We are going to be looking at the 
situation at each meeting. We do have to take into account, 
though, the possible risks, as well as the expected path that 
we are looking forward to, because if there is a chance that a 
very bad outcome might occur, there is a risk management 
approach, which Chairman Greenspan and other central bankers 
apply, which suggests that you need to lean a bit against that 
possible outcome.
    But again, we will be looking at all the data and thinking 
hard about it when the time comes for us to meet again.
    Senator Bunning. Thank you, Mr. Chairman. My time has 
expired. I will wait for the next round.
    Chairman Shelby. Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman.
    Mr. Chairman, I want to return to some of the issues I 
raised in my opening statement. It appears to me that we have 
an economy in which increasing productivity and large tax 
revenues are driving up our gross domestic product. But that, 
in turn, has benefited a very small number of people who own 
capital.
    As I said to you in my opening statement, in New Jersey 
when I talk to people, they tell me that they are constantly 
feeling squeezed by higher tuition rates as they try to send 
their kids to college, facing the challenges of the costs of 
taking care of a loved one, facing higher energy prices to heat 
or cool their homes, facing higher gas prices, facing higher 
insurance premiums and copays, and yet finding their median 
incomes are flat over the last 5 years.
    And so, with all of those challenges and negative personal 
savings, who is this the economy working for?
    Chairman Bernanke. Senator, I think what you are addressing 
is the issue of inequality. I agree that inequality is 
potentially a concern for the U.S. economy. We want everybody 
in the society to have a chance to participate in the American 
Dream. We want everybody to have a chance to get ahead. And to 
the extent that incomes and wealth are spreading apart, I think 
that is not a good trend.
    That however is a development, a trend, that has been going 
on for about 25 years now, according to most of the studies. It 
is therefore, a big challenge to think about what to do about 
it. I could go into some of the literature, if you would like, 
about some of the research on why this is happening. But I do 
think that fundamentally the increased importance of skilled 
jobs and of technology in our society puts a higher premium on 
people with more education, more experience, and more skills.
    I think really the only long-term solution to this problem 
is to try to upgrade the skill levels of our workers. And I 
think that is not necessarily a 10, 15, or 20 year process 
because people can learn, as Senator Dole often says, in 
community colleges or technical schools. They can learn on the 
job. There are all kinds of adult training and various things 
that can be done. I think we need to take that seriously 
because I think that is really the only way we can address this 
issue on a long-term basis.
    Senator Menendez. Often when we talk about inequality, we 
think about the people at the lowest level. I am talking about 
middle-class families who are facing those squeezes of all of 
these higher costs. Many of them are pretty well-educated. And 
yet their incomes remain relatively stagnant.
    Our global challenge is it used to be that the casualties 
of global trade were those at the lowest skill levels. But I 
have software engineers telling me that they are losing their 
jobs, and they make some pretty significant incomes. And that 
the certainty of their job employment has moved. One guy told 
me he is in his third different company in the last 18 months, 
not because he is not a good employee, but because the global 
challenges are either consolidation or offshoring of the 
services that he provides.
    So it seems to me that we have to look at the underpinnings 
of this in terms of middle-class families increasingly being 
squeezed.
    And we talk about inflation. If all of these prices are 
going up and yet your incomes remaining relatively flat is not 
inflationary to the average family, it seems to me they are 
pretty inflationary.
    The other question I would like to ask you is what do you 
see currently as the most significant threat to economic 
expansion, in your view?
    Chairman Bernanke. Economic expansion in the short term?
    Senator Menendez. Yes.
    Chairman Bernanke. I think it is the risk that we are 
considering, and again it is just a risk, that inflation might 
move up and might force us to be more aggressive, which we do 
not want to do, because we hope that inflation will stay under 
control or come down as we expect it to. I think that is a 
risk.
    We also have the geopolitical issues. We have seen the 
latest in the Middle East, for example. Oil prices are a risk 
and a concern, and we are paying very close attention to that 
situation as well.
    Senator Menendez. And last, I had asked you in a written 
question which you answered about paying down publicly held 
debt and the importance of that. Now we see where CBO tells us 
we are headed to $12 trillion worth of debt by 2011. How much 
importance do you place on paying down that publicly held debt 
in the context of long-term economic health?
    Chairman Bernanke. Senator, I think it is really important 
to think about the long-run. And what we are facing going 
forward is an aging population, increasing costs of medical 
care, and the costs for our entitlement programs that are going 
to be rising very seriously.
    So, I think the strongest case for trying to pay down some 
debt sooner is to try and provide some buffer or some savings 
that will help us meet those challenges as we go forward. I 
think that the most serious long-term issue for our budget, is 
these growing transfer programs.
    Senator Menendez. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Dole.
    Senator Dole. Mr. Chairman, are there signs that wages are 
beginning to catch up to past productivity growth? And if not, 
when do we expect this to happen? And would it be a concern to 
the Fed? Can you have a period in which wages catch up to 
productivity without an increase in inflation?
    Chairman Bernanke. Senator, we see some evidence of this, 
but it is not very overwhelming. For example, the average 
hourly earnings number is up about a percentage point this last 
year versus the previous year. We are seeing anecdotally that 
firms are finding it harder to hire skilled workers and are 
either giving or contemplating wage increases. So our forecast 
is for increase in wage growth going forward.
    But again, it has been slow coming. I want to be clear 
about that.
    As far as inflation is concerned, I want to also be very 
clear that increases in the real buying power of workers are 
not inflationary.
    For example, if it happens because the inflation rate is 
going down and a given wage buys more, there you have an 
increase in real wages without any inflation.
    Similarly, if wages go up but they are offset by 
productivity gains, which has been the case for the last few 
years, you have higher real wages but no inflation.
    And third, another possibility is that markups go down, the 
margins go down.
    So, I do think the wages will rise. I am a little surprised 
they have not risen more already. I believe that real wage 
increases, though, are not at all inconsistent with our 
prediction that inflation is going to moderate over the next 
couple of years.
    Senator Dole. Congress has been engaged in a debate over 
increasing the minimum wage. As a former Labor Secretary who 
has testified on this issue, I know that increasing the minimum 
wage is not an effective mechanism for lifting people out of 
poverty. I have long advocated for increasing the earned income 
tax credit and jobs and skills training, which I think are far 
more effective at relieving poverty.
    Would you share with this Committee your thoughts on the 
most effective ways that Congress can act to reduce poverty?
    Chairman Bernanke. Senator, the minimum wage is 
controversial because economics suggests that, when you raise 
the minimum wage, you would pay a higher wage to some workers, 
but then some workers would not get work because of the higher 
wage. The research on this is controversial. Some people have 
argued that the effect is very small. Others think it is 
larger.
    My inclination is to say that you would like to find ways 
of increasing the return to work, which do not have the effect 
of potentially shutting some people out of the workforce. So, I 
think I would agree, and I have said this in previous 
testimony, that the earned income tax credit, which provides 
extra income to people who are working, and increased training 
for increased skills and productivity, are in my opinion 
probably more effective ways to approach this question.
    Senator Dole. Thank you.
    Another question. Do you believe that Fannie Mae and 
Freddie Mac's regulator should have the authority to allow the 
GSE's to increase their portfolios when there is a downturn in 
the housing market?
    Chairman Bernanke. This is another controversial issue. The 
point is sometimes made that the GSE's can enter into a 
situation where there is a downturn and provide extra liquidity 
in the market through their portfolios to support the mortgage-
backed security market, for example.
    In our research at the Federal Reserve, we have not found 
that to be a very important effect. We have really found very 
little effect in that direction. We would also point out that 
if you are going to do that, what you want to have in your 
portfolio is liquid assets like treasuries, not MBS, because 
you cannot increase liquidity if you buy MBS with other MBS. So 
we have been some concerns about that.
    Now having said that, I think it is worth, for the purposes 
of trying to come to some kind of agreement on GSE's 
legislation, we could perhaps discuss or consider the 
possibility that the director might provide some emergency 
ability to GSE's to make extra purchases during times in which 
the director judged the housing market to be in distress for 
some reason, but then to get rid of that extra portfolio, get 
rid of the extra MBS, over a period of time when the emergency 
was eliminated.
    Again, we do not really see much evidence that this is 
necessary. But if that were part of an overall agreement that 
brought a strong and effective regulator to the GSE's, it might 
be worth considering.
    Senator Dole. Thank you. I believe my time has expired, Mr. 
Chairman.
    Chairman Shelby. Thank you. Senator Carper.
    Senator Carper. Thank you very much.
    I had indicated several questions I was going to ask you. 
One is what do you think about when we give our opening 
statements. I will ask you that in private on another day.
    I want to go back to this issue of GSE regulations, of 
Fannie Mae and Freddie Mac and the Federal Home Loan banks. I 
know our Chairman has raised this issue and Senator Dole has 
just raised it and I suspect others have as well.
    As Chairman of the Federal Reserve, you regulate some of 
our biggest entities and holding companies in the country. I 
want to just come back and ask you for some advice as we try to 
find--we have really differences in two principal areas. One of 
those is with respect to an affordable housing fund and how to 
structure that. The House has passed legislation, by a pretty 
wide margin, where they establish one.
    I think they ask for setting aside I want to say 5 percent 
of net income from Fannie Mae and Freddie Mac to go into an 
affordable housing fund, that monies would be apportioned from 
there into affordable housing in our different States.
    The other issue, of course, is the portfolio, what could be 
in it? How much can it grow? What powers do we give the 
regulator with respect to regulating what is in the portfolio?
    If you are giving us advice, and you have given us a little 
bit but I am going to ask you just, sitting back, looking at it 
as a regulator yourself, what would you want to have as a 
strong regulator and legislation that would enable you to do a 
good job? If you were regulating the GSE's.
    Chairman Bernanke. Senator, I do not have much to offer on 
the affordable housing. I know that is an item for negotiation. 
I would just point out that an alternative would be to put it 
directly on budget rather than to do it indirectly through the 
GSE's.
    With respect to the portfolios, as you know, the Federal 
Reserve has argued for a substantial time that the portfolios 
are larger than is needed to serve the fundamental housing 
mission of the GSE's. My advice would be not to set a hard cap 
or a number and restrict the portfolio in that way, but to give 
strong guidance to the regulator about how to relate the 
portfolio to the mission of the GSE's.
    For example, it would make perfectly good sense for the 
GSE's to hold affordable housing mortgages that are difficult 
to securitize in their portfolio, for example, or maybe to hold 
liquidity for some of the issues that Senator Dole is raising.
    But I think by grounding the size of the portfolio in the 
mission of the GSE's, you would bring down, over time, the 
portfolio to a safer level and not hurt the underlying mission 
of the GSE.
    Senator Carper. How important do you think it is that we 
find common ground and actually regulate in this area this year 
before we call it a day?
    Chairman Bernanke. I do think it is very important. The 
Federal Reserve was drawn to this issue initially because we 
felt that while the securitization function of the GSE's is 
extremely valuable and constructive, we felt that the large 
portfolios exceeded what was needed for the housing purpose, 
and indeed posed a threat to the stability of the financial 
system.
    The reports we have seen recently on GSE accounting by 
OFHEO and so on, which cast into doubt the underlying 
accounting and internal controls of these agencies, I think 
just heightens my concern that those large portfolios at some 
point might create serious problems for financial markets.
    Senator Carper. Thank you.
    I suspect others have already talked to you about, as you 
have raised short-term interest rates, and we have actually 
seen the emergence of an inverted yield curve. Why is that 
happening? Do you think it is going to persist? Is it something 
we should be concerned about?
    Chairman Bernanke. Senator, there appears to be a 
structural tendency for the yield curve to be flatter than it 
was in the past. Part of it, as I answered to Senator Bennett, 
is the global savings glut which is keeping long-term real 
interest rates lower than they otherwise would be.
    The second is, for a variety of reasons that I went into in 
a speech earlier this year and talked about in some detail, for 
a variety of reasons the term premium, the risk premium on 
long-term debt, seems to have been lower recently than 
historically.
    And for those reasons, the term structure seems to be 
flatter structurally than has been the case historically, 
although there has been a bit of an increase, I think, in the 
long rates in both the term premium and the portion 
attributable to the savings glut, I think, since the beginning 
of the year.
    Senator Carper. A question on energy independence, if I 
could. I mentioned in my earlier comments that over a third of 
the trade deficit this year now is imported oil. When we look 
at inflation, a significant part of what is pushing up prices 
is the cost of energy.
    Our neighbors down to the south in Brazil, about 15 years 
or so ago they had said they wanted to become energy 
independent. And they have done a fair amount of work. We hear 
a lot about what they have done with flexible fuel vehicles and 
greater reliance on ethanol.
    We, meanwhile, have gone in the other direction over the 
last 15 years. We have become more and more dependent on 
foreign oil and it takes an ever larger bite out, in terms of 
with respect to the trade deficit.
    Your advice for our country with respect to moving toward 
energy independence and whether or not it is something we 
should be taking seriously? And if so, what counsel would you 
have for us there?
    Chairman Bernanke. I think as a practical matter being 
literally energy independent is not something that is feasible 
in the near-term.
    Senator Carper. It will not happen in my term and probably 
not yours either.
    Chairman Bernanke. I think what we should do broadly is to 
diversify our portfolio, to have a wider range of energy 
sources including ethanol, coal, nuclear, and other 
possibilities.
    And I think there are a number of ways Government can help, 
but in two ways in particular. The Government has, in the past, 
been effective in helping in basic research. That is research 
that individual companies do not find it profitable to 
undertake because they cannot appropriate the returns.
    I think we also need to try to increase the amount of 
regulatory certainty. It is certainly appropriate to have 
regulations that offset environmental and other concerns. That 
is totally appropriate. But there is so much uncertainty about 
what the regulations will be when the time comes to apply them 
that many projects simply do not get undertaken.
    So if we can provide clearer mechanisms by which those who 
wish to build new energy sources can understand what is 
expected of them, I think we will see, given the very high 
prices we are seeing for oil, we will see, over the next few 
years, a lot of alternative energy sources coming forward.
    Senator Carper. Thank you.
    I would just share with you and our friends, I think it was 
106 years ago this year that the very first diesel engine was 
introduced. I believe it was at an exhibition in Paris, France. 
It was powered by peanut oil.
    We now just opened up last month, in the central part of my 
State, not too far from where Senator Sarbanes is from, Dover, 
a biodiesel refinery which is run entirely on soybean oil, 
which we have a lot of on the Delmarva Peninsula, as Senator 
Sarbanes knows.
    The other thing, we just got a new air conditioner at our 
house, and we also got a new air-conditioning standard, a new 
SEAR standard for air-conditioning efficiencies this year. The 
new standard is SEAR-13, as opposed to SEAR-8. And we had a 
battle over whether we were going to go to SEAR-10 or SEAR-13. 
We ended up at SEAR-13.
    What that means, just the difference between a SEAR-10 and 
a SEAR-13 with respect to energy consumption, it means roughly 
50 or so power plants we will not have to build over the next 
15 or 20 years, simply by having SEAR-13 standards for new air 
conditioners, as opposed to SEAR-10.
     Thank you.
    Chairman Shelby. Senator Sununu.
    Senator Sununu. Thank you, Mr. Chairman.
    Chairman Bernanke, in your testimony you used what seems to 
me to be an interesting phrase in a couple of places. That is 
the phrase ``appropriate monetary policy,'' ``reflect our 
assessment that, with appropriate monetary policy--the economy 
should continue to expand at a sustainable pace and core 
inflation--from its recent level over the medium term.'' You 
use it in another place.
    Could you elaborate a little bit on what appropriate 
monetary policy is? Is that not too hot, not too cold?
    Chairman Bernanke. I wish I could, Senator. The forecasts 
are made under that assumption, and each person who is 
submitting their forecast makes their own assumption about what 
that would be.
    So what I take this to be is really a summary view of what 
we can achieve, where we should be heading with policy.
    Senator Sununu. If everything goes perfectly?
    Chairman Bernanke. No, not perfectly, but if things go as 
generally expected.
    I think there is a lot we could do to make those forecasts 
more informative and that might be one direction to go in the 
future. But I understand that is an ambiguous phrase.
    Senator Sununu. You also say in your testimony that ``It 
bears emphasizing that, because productivity growth seems 
likely to remain strong.'' So you were assuming that 
productivity growth will remain strong.
    On what are you basing that assumption?
    Chairman Bernanke. I am basing it on looking at the pattern 
of recent years. First, we saw the productivity gains mostly in 
the industries producing high-tech equipment, as companies 
learned how to build ships faster, for example.
    Then we saw it moving into the users. That is firms that 
were not high-tech producers but were using and consuming those 
goods to increase their own productivity. And what we see as we 
talk to people in the industries and the like is we see first 
that there is continuing innovation and improvement at the 
level of high-tech producers.
    And moreover, what we hear from CEO's and the like is that 
they feel there is a lot more diffusion to take place before 
they have fully exhausted the benefits of new technologies in 
terms of increased productivity.
    As a historical matter, when productivity changes from a 
high level to a low level, it does tend to last for a while. 
And that is another piece of encouraging evidence.
    Senator Sununu. So you have what you feel to be some pretty 
good anecdotal evidence.
    Chairman Bernanke. It is mostly anecdotal, a little 
statistical. The fact is that as our society relies more and 
more on productivity gains as a source of growth, the 
forecasting is going to get tougher because it is more 
difficult to forecast in say the size of the workforce.
    Senator Sununu. Which are you more worried about with 
regard to the medium term prospects for inflation: Inflationary 
expectations or the absolute level of inflation based on 
changes in energy prices or labor prices?
    Chairman Bernanke. Senator, the two interact because if 
there was just a one-time pass-through and the public were 
completely convinced that the Fed would keep inflation low and 
expectations were low and the Fed were perfectly credible, then 
that inflation would be just a temporary thing and would come 
back down.
    So the risk is the interaction of the two. The risk is that 
inflation will go up because of energy prices, because of 
greater pass-through, and that will feed into inflation 
expectations, which then will feed into a round of additional 
price increases and the like.
    You really cannot get a permanent increase in inflation 
unless people increase their inflation expectations. That is 
why the Fed's credibility is, I think, such a major asset of 
the United States.
    Senator Sununu. It seems to me to the extent that you are 
in the midst of a little bit of a dilemma it is as follows. 
Right now, inflation is above what has been stated in different 
ways your target range. We have still got high energy prices. 
So that would suggest that the absolute level of inflation 
remains a concern.
    On the other hand, you have a forecast for moderating 
growth. You have a slowdown in the housing industry. So while 
the inflation numbers may push you toward a rate increase, the 
moderating growth that has been forecast might encourage you to 
pause or to forgo further rate increases. That is a dilemma. I 
think we all understand that.
    To what extent is the fact that you now find yourself in 
this dilemma the result of a slowness or a delay to action in 
beginning this cycle of rate increases?
    Chairman Bernanke. To comment on your first part of your 
question, we cannot do anything about this month's inflation 
number because our policy works with a lag. And so we have to 
be looking at a forecast or a future to make those judgments 
and to assess the risks.
    I do not know the answer to your second question.
    Senator Sununu. First of all, the second question was the 
good one. I did not have a first question.
    I think we are working under the assumption that the 
forecast for inflation is in the, I think you said 2.25 
percent, 2.5 percent, that is still above the 1 to 2 percent 
target.
    Chairman Bernanke. We do not have a target, Senator.
    Senator Sununu. I stand corrected.
    But the answer to the second question, is this the result 
of slowness to act or delay to act initially in the tightening 
cycle?
    Chairman Bernanke. I think certainly an important part of 
what has happened has been the increases in energy and 
commodity prices. That has directly added to total inflation, 
and now we are seeing it passing through, to some extent, to 
core inflation. I think if energy prices were $40, I think 
things would be much better. I would say that.
    Whether policy has been optimal or not, I really cannot 
judge.
    Certainly, along with fiscal stimulus and other measures we 
did succeed in getting the economy back on a strong growth 
track in the middle of 2003. And we have seen 3 years of strong 
growth. It took a while for jobs to come back but eventually 
the labor market also began to improve.
    Senator Sununu. When you say I cannot judge, is that 
because you are not technically suited to do that evaluation? 
Or because you do not think it would be productive in your 
current occupation?
    Chairman Bernanke. We could try to do an evaluation with 
our models and the like. I am not sure how accurate it would 
be. In addition, the interesting thing about the energy price 
increases is that if you go back for 3 or 4 years and you look 
at each month at what the futures market was expecting, it was 
always expecting these things. We have had these increases, the 
energy prices are going to finally stabilize. And every single 
month it has been wrong.
    And so this increase in energy prices and commodity prices 
certainly has been a significant contributor. And I think that 
we would not really be talking about this now if energy prices 
were still $30 or $40 a barrel.
    Senator Sununu. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Dodd.
    Senator Dodd. Thank you, Mr. Chairman. And thank you, Mr. 
Chairman, for your presence here today.
    I want to raise three quick issues if I can with you. I 
think all three of them could normally consume significant more 
time than will be allotted to me here to talk about him. And I 
realize we are here today to talk about monetary policy, but 
obviously fiscal policy has a direct bearing on monetary 
policy.
    I am concerned, along with I presume many of my colleagues, 
about the rising level of our debt. I recall only a few years 
ago having a hearing in this Committee with your predecessor on 
which we actually had a hearing about what the effects would be 
about eliminating the national debt.
    Here we find yourselves today, 5 years later, with $8.4 
trillion in debt, $2.6 trillion of it occurred in the last 4 or 
5 years. In fact, more debt accumulated, I gather, in this 
period of time than all of our previous administrations 
combined, and the implications of that.
    It has been reported that our Vice President allegedly 
commented that deficits just do not matter. I am quoting him 
here, that is what I am told he said. I disagree with that. I 
would like to know how you feel about this.
    I want to raise with you, in the conjunction of this rising 
level of debt, and the accumulation of it, the implications 
about how much of it is being held offshore. I noted when you 
consider some of the problems we are wrestling with today, 
whether it is the presence of a--the possibility of a presence 
of a growing weapons of mass distraction on the Korean 
Peninsula and obviously the problems we are facing as we speak 
here in the Middle East, the issue of immigration and the 
policy on our southern border.
    I note that of the 10 top holders of our national debt are 
China at some $326 billion, oil exporters of $103 billion, 
Korea at $69 billion, Hong Kong at $51 billion. And coming in 
at number 10 is Mexico at $43 billion.
    My experience has been that when you are trying to lecture 
your banker, it can be dangerous in a sense. And I wonder if 
you are as worried, as many of us are, about this trend and 
whether or not we should be more concerned about this growing 
problem, a trillion dollars of it now or more of our debt being 
held offshore, and what the implications could be here, and 
what these implications mean in terms of the monetary policy 
for the country.
    Chairman Bernanke. That was a lot of questions, Senator.
    Senator Dodd. I realize that, and I apologize.
    Chairman Bernanke. First, I think I will comment that, in 
retrospect, the idea that the national debt would disappear was 
never all that realistic. The share of GDP that was collected 
in taxes in the late 1990's was over 21 percent, compared to a 
historical average of about 18 percent. A lot of that came 
basically from the stock market, which we know now was not 
sustainable at the pace it was rising.
    Nevertheless, I do think that deficits matter. I think the 
size of Government also matters. But deficits matter because 
they represent additions to debt that our children and 
grandchildren will either have to pay through higher taxes or 
reduced services. And so I think they do matter.
    I would add, though, that one must also think about the 
size of the Government and what share of the GDP we want to 
devote to Government services.
    With respect to the offshore holdings, you can look at it 
two different ways. From one perspective, it is a good thing 
that countries that are holding reserves want to hold them in 
the form of U.S. Treasuries because we have a deep and liquid 
capital market which is very attractive and very safe and very 
low cost to people as a way of holding wealth. And we do not 
want to do anything that would disturb that. We want people to 
want to hold our assets. It is good for our country.
    On the other hand, from a different perspective, I think 
that part of what you are getting at is the fact that with a 
large current account deficit, the external debt that the 
United States owes, whether it be held in the form of treasury 
debts or MBS or whatever, is growing over time.
    And as I agreed, I think it would be very desirable for us 
over a period of time to reduce that current account deficit 
and reduce, therefore, the growth in the holdings of U.S. 
assets abroad.
    Senator Dodd. Just a related quick question here. You 
mentioned earlier our trading partners and the economic 
circumstances in those countries where, in fact, some of the 
very nations that are purchasing a lot of this debt may find 
more attractive markets elsewhere than the United States. Does 
that pose a problem, in your mind, for the United States in the 
shorter term?
    Chairman Bernanke. That is what I was saying, that it is in 
our interest to keep our debt attractive both because the 
capital markets are deep and liquid and because our economy is 
strong. I do not really see a good alternative right now. I 
think that the great majority of the international reserves are 
held in U.S. dollars and I think that will continue to be the 
case.
    However, from a current account perspective, if we look 
forward 5 or 10 years at the rate we are going, there will be 
increasing reluctance of foreigners to hold U.S. assets. And 
that will have effects on our economy and we need to address 
that.
    Senator Dodd. Mr. Chairman, I will come back to the savings 
rate and the consumer debt issue, which is a concern of mine as 
well. And I want to just quickly raise this issue about the job 
creation issue, because it seems to me based on indications--
this did not happen, by the way, in the last 4 or 5 years. 
There has been a trend, as you pointed out, over the last 20 or 
30 years where we are seeing job growth occurring at the very 
low level of the lower-income levels and at the upper-income 
levels. It is in that middle range, that middle-income earner 
that Senator Menendez talked about, and Senator Reed addressed, 
where we see not just a skill gap. But it seems to be hollowing 
out of job opportunities in that area. And that troubles me 
very deeply, with that sense of being a low-income earner and 
the sense of upper mobility, moving into those middle-income 
jobs. And they just seem to be disappearing at an incredible 
rate.
    I heard you say you had not really examined the outsourcing 
issue of jobs. I wish you would. It would be interesting to 
come back and give us some report on how you look at that issue 
of that. If I am correct, is there a hollowing out occurring 
here? And if so, how troubling is that to the Federal Reserve?
    Chairman Bernanke. Let me give you an example, which would 
be manufacturing, that certainly Senator Stabenow, for example, 
would be interested in.
    Whether you think U.S. manufacturing is strong or not 
depends on how you look at it. In terms of output and 
production, U.S. manufacturing output is up 50 percent in the 
last 10 years. It is growing faster than in any other major 
industrialized country.
    And moreover, we have moved toward higher tech, higher 
value-added, types of manufacturing. So from that perspective, 
manufacturing in the United States is alive and well.
    On the other side, you look at the labor inputs, you look 
at the number of workers. Because manufacturing has also been 
extraordinarily productive, we have about a 6 percent a year 
increase in manufacturing productivity over the last 10 years, 
we can produce that extra output with many fewer workers. And 
so the number of manufacturing jobs, and I think these are the 
kind of jobs that you are possibly referring to, has been 
declining.
    One thing to say about that, which is actually I think very 
interesting, is that even though the overall number of 
manufacturing jobs has declined quite significantly, the number 
of high skilled manufacturing jobs has actually been rising.
    And so again, and I know this sounds repetitive, but again 
there is a solution, which is to help workers get the skills 
that will give them those opportunities.
    But I agree that manufacturing is an example where the 
overall number of jobs has declined as the productivity of that 
sector has increased.
    Senator Dodd. Could you just add, by the way, you said to 
Senator Reed that the number of jobs that needed to be created 
on a monthly basis is dropping. I know the number today is 
roughly about 150,000 jobs per month. At least that is the 
number I have always used. What is the number you have in mind 
that we will be looking at?
    Chairman Bernanke. I think it is dropping. I would say now 
it is more like 130,000. And within the next few years we might 
be down to 100,000. This is all based on research at the 
Federal Reserve on labor force participation rates, which 
suggests that we will be seeing, over the next 10 years, some 
significant decline from the current rate. About 66 percent of 
the adult population is in the labor force. We expect to see 
that coming down, and therefore the number of jobs a month we 
need to keep the unemployment rate constant is likely to fall, 
as well.
    Senator Dodd. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    Obviously, we are going through a period of time where 
there has been a huge relative change in the price of energy. 
And the most recent period of time when we experienced this 
great a change would be in the late 1970's.
    At that particular point in time in our Nation's history, 
we had double-digit inflation, we had double-digit 
unemployment, we had double-digit interest rates. In fact, all 
of this was put together and frequently referred to as the 
misery index.
    We have a similar situation today. But when you look at 
these same figures that we looked at today, our unemployment is 
4.6 percent. Our inflation rate is 4.3 percent. Our interest 
rate is 5 to 6 percent.
    What is the difference between the late 1970's, when we had 
this huge increase in energy costs, yet the economy did not 
respond, and today when we have a huge increase--the economy is 
still staying very strong.
    I wondered if you could shed some light on your view on 
that?
    Chairman Bernanke. Thank you, Senator.
    There are a lot of reasons including, for example, the fact 
that we are less energy intensive as an economy now than we 
were 30 years ago.
    But the one I would like to somewhat self-servingly 
emphasize, and it relates to my answer to Senator Sununu, is 
the fact that the Fed has a lot more credibility for keeping 
inflation low and stable.
    In the 1970's, when the energy crisis arose, it generated 
expectations of further increases in wages and prices, and you 
got into a wage price spiral. The Fed was caught between a rock 
and a hard place, having to raise rates very significantly in 
order to try to arrest that inflation, at the same time leading 
to deep recessions.
    Over the last 20 years or so, the U.S. economy has become 
much more stable. And one of the very important reasons for 
that is the fact that the Fed has gained strong credibility for 
keeping inflation low.
    The Michigan Survey just came out, and the front page was 
describing inflation expectations of the American public. And 
they have a lot of confidence that the Fed will keep inflation 
low, despite the fact that gas prices are up at the pump.
    To the extent that the Fed's credibility is strong and 
people think that inflation will be low in the long-term, when 
energy price increases hit, it causes a temporary burst of 
inflation. But if nobody expects it to continue, then it will 
just moderate away. And we do not get into this pattern of 
having to raise rates a lot and getting into a stagnant, 
inflationary situation.
    So, I think monetary policy is not the only factor. There 
are other factors. But I think it does have a lot to do with 
the better performance we have seen the last 4 or 5 years.
    Senator Allard. Has the tax stimulus package had an impact 
on this?
    Chairman Bernanke. I think the tax stimulus package did 
help the economy recover from the 2003 period. And monetary 
policy helped, as well.
    Senator Allard. Now the United States has been enjoying a 
period of economic expansion. What do you see as a single 
biggest threat to the continuation of that expansion?
    Chairman Bernanke. I think I had a similar question earlier 
and I mentioned two things. One would be that we would have an 
inflationary problem which is greater than we now expect. And 
the other would be energy prices coming from geopolitical 
concerns or other sources. I think those are two.
    Obviously you can think of others. Senator Sarbanes has 
pointed to the housing market and other things. But I think 
those would be the ones I would point to.
    Senator Allard. My colleague from Connecticut talked about 
the debt. We have the public debt and then we have the total 
debt, which includes transfer funds for Social Security into 
the debt.
    If we did not have a deficit today and even, in fact, had a 
surplus, wouldn't our total debt figures increase because of 
the transfer from Social Security surpluses into the general 
fund? Would that not reflect on the total debt figure?
    And if we are ever really going to accomplish total debt 
reduction, how are we going to do that without mandatory 
spending reform?
    Chairman Bernanke. You are correct that because we have a 
consolidated budget the money we are essentially borrowing from 
Social Security, which shows up as paper in the trust fund, 
does not count in the deficit. So in that sense, a broader 
sense, if you want to think about the U.S. deficit as being the 
current flow deficit plus the accrued liabilities to future 
Medicare and Social Security recipients, it is actually a lot 
larger than the official deficit.
    And all that is just another way of saying that as we look 
forward to the next 10 or 15 years, we are going to be seeing a 
lot more pressure coming from these transfer programs and we do 
need to be thinking about how we are going to address those 
problems.
    Senator Allard. I see, Mr. Chairman, my time has expired.
    Chairman Shelby. We have concluded our first round.
    I have two questions I am going to submit to you, Mr. 
Chairman, for the record. One has to do with the Basel II 
capital standards. Senator Sarbanes raised Basel II earlier. We 
have some concern there. We have talked with you about this 
privately before.
    The other one has to do with the Chinese economy. And I 
know you will respond to these.
    Chairman Bernanke. Yes, sir.
    Chairman Shelby. Senator Sarbanes, do you have any other 
comments or questions?
    Senator Sarbanes. A few questions, Mr. Chairman.
    Chairman Bernanke, first of all, just to be clear, you make 
constant reference to the cost of energy going up and you 
relate that to a potential inflation problem. But it is my 
understanding it also has a relationship to a slowing down the 
economy problem, as well.
    So once again you are caught betwixt and between. It works 
in one direction to create more of an inflationary concern, but 
it also works in a direction to create more of a concern about 
the possibility of an economic downturn. Would you agree with 
that statement?
    Chairman Bernanke. Yes, I would.
    Senator Sarbanes. Now let me ask you this question. In view 
of the energy situation, the fact that household savings rate 
is now down at minus 1.7 percent, which is I think 
unprecedented certainly over a very long period of time. This 
chart I showed about new single-family housing home permits, 
which is way down, almost 25 percent since a year ago. And what 
we are hearing from the people in the housing field is that 
there is a real slow down.
    The inequality in income which we referred to earlier, 
which I think erodes purchasing power on behalf of the people 
not at just the lower end but the median portion of the income 
scale. The people that are getting these benefits, their 
consumption is not going to go up significantly because they 
are getting these benefits. But the people who are falling 
behind, it is going to impact consumer purchasing.
    This raise in interest rates, of course, carries with it 
making much more expensive servicing the national debt. We have 
run up the debt, the interest rates are going up. Now we have 
to have a bigger item in the budget to handle the interest 
charges.
    When you put all of this together, how worried are you 
about the possibility that we could have a substantial economic 
downturn?
    Chairman Bernanke. Senator, you raised a lot of issues.
    I would just say that I take very seriously the dual 
mandate, which is to keep the inflation low and to keep the 
economy growing at its potential. And we are setting our 
policies in a way that we think will do that. Our forecast is 
for the economy to grow near potential, and for inflation to 
moderate, and so that is consistent with what Congress has 
charged us to do.
    I do not see a recession as being very likely. We can never 
rule out anything. My expectation is that the economy will 
continue to grow going forward.
    Consumption, in particular, can still be strong enough to 
support growth even as the savings rate moves northward. I 
believe the savings rate will be improving somewhat over the 
next couple of years.
    Senator Sarbanes. I think the Members of the FOMC have some 
very tough decisions to make here in this particular--I think 
you yourself said we were in a transition period. I think you 
said that at the outset of your statement.
    And of course, only some of the Federal Reserve regional 
presidents are on the Open Market Committee. A lot of them seem 
to be running around making statements nowadays about the 
situation. I am not sure where that exactly takes us. I just 
make that observation.
    I want to just ask one final question, and the Chairman 
referenced the Basel II. I actually want to get that out here 
on the table.
    The Fed has taken the lead on this issue amongst our 
regulatory agencies. I am concerned that the Fed--and this is 
really before your watch--that the Fed has gotten us down a 
path that is now very difficult for us.
    In fact, I note that four of the largest U.S. banks have 
recently written the Federal bank regulatory agencies, saying 
that they want the option of adopting alternative 
methodologies, including the standardized approach, which are 
permissible under the Basel II framework.
    Other countries are allowing this. We are the only country, 
apparently, proposing to limit its banks to the advance 
approach option only.
    I do not know how we got so far down the path that when we 
ran the quantitative impact analysis, we had these tremendous 
drops in the capital the banks would be required, which have 
set off alarm bells all over the place. I mean virtually 
everyone has looked at that and said well, this is not a good 
model.
    How seized of this issue is the Federal Reserve? We 
expressed repeated concern here from the Congress. The Chairman 
has held a number of hearings on this issue to try to maintain 
oversight. But it seems to have almost a life of its own. It 
seems to me the Fed really needs to grab hold of this issue and 
start thinking it through because everyone who is looking at 
this thing thinks this is not going to work.
    And yet I get reports that the Fed continues to press ahead 
on this path, I guess in part because the Fed is being pushed 
by its international partners to do so. But I, for one, think 
you need to really take a hard look at this and reconsider 
exactly where we are.
    You do not have to answer that. I just leave that with you, 
unless you have some comment.
    Chairman Bernanke. I would like to comment briefly, 
Senator. I think you and I or a group need to talk about this 
in much more detail. I would just make a few comments.
    One is that the notice for proposed rulemaking which is 
going out is a joint product of all four Federal banking 
agencies. So it is an agreed upon notice. And it is one where, 
of course, we are going to invite all kinds of comments from 
all parties who are interested.
    I discussed the QIS-4 in previous testimony. I will not 
take time to do that. But we certainly agree that we would not 
tolerate, would not want to see capital levels decline anywhere 
like what was seen in the QIS-4.
    We do think that safety and soundness of the banking 
system, given how complex and sophisticated it is becoming, 
does require some significant updates of the Basel II approach. 
And the banking agencies have essentially agreed that this is 
the right framework. But we are very open both to suggestions 
about details and also about methods of making sure the capital 
does not fall unduly.
    If I may finally say, on the three methods, I believe it is 
the case that other countries will be asking their largest and 
most sophisticated banks to use the advanced method because 
that is really the only one of the three that is appropriate 
for the kind of international banks that we are talking about.
    Senator Sarbanes. We understand that the Conference of 
State Bank Supervisors has recently written, encouraging 
consideration of the standardized approach in the 
implementation of Basel II. And this also apparently is the 
request that these major U.S. banks have now made to the 
regulatory agencies. It is an approach apparently being allowed 
by other countries.
    What is the problem in considering the standardized 
approach?
    Chairman Bernanke. It is being allowed for other countries 
for the appropriate banks, for small banks. The standardized 
approach is very similar to what we have now. What we are doing 
is proposing a Basel I-A, that is a modification of the 
existing system that would be appropriate for the smaller and 
medium-sized banks in our system. And that is analogous to what 
foreign countries will be doing when they put smaller banks on 
the standardized approach.
    But I do not think you are going to see any large 
international, sophisticated, complex banks with all these 
different kinds of derivatives and off-balance sheet activities 
and operational risks, you are not going to see any of those on 
the standardized approach because they just do not accommodate 
the risks that those banks are taking.
    Senator Sarbanes. So you would not allow that as an option? 
You would not be prepared to even consider it is an option?
    Chairman Bernanke. We are prepared to consider anything, 
but I think that my judgment is that the standardized approach 
is essentially the same as the existing approach and would not 
be adequate for complex internationally active banks.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bunning.
    Senator Bunning. I apologize, but since we only get to see 
you twice a year, I am going to ask some more questions.
    Does it concern you that so many on the Federal Reserve 
Board come from an academic background? Do you think it would 
be beneficial to have some of the remaining vacancies filled 
with someone with experience in the business or finance world?
    Chairman Bernanke. Well Senator, we have an opening right 
now. As you know, Mark Olson, who is a banker, former President 
of the American Bankers Association, has moved over to the 
accounting board. I would very much like to see his replacement 
be somebody with a similar set of banking and financial 
business skills, yes.
    Senator Bunning. That is a yes answer.
    Chairman Bernanke. Yes.
    Senator Bunning. I do not get many of them from you. That 
is okay.
    The Fed minutes say that there is a discussion of a range 
of options. But it turns out that the vote is almost always 
unanimous. I had to go back, I cannot remember when the last 
dissenting vote in the FOMC occurred. Leading up to the June 
meeting, public statements by some of the Fed Members indicated 
there might be a pause. But once again the vote was unanimous 
to raise rates.
    How much serious debate is there really if the Fed keeps 
coming up with unanimous decisions?
    Chairman Bernanke. Senator, different committees have 
different approaches to decisionmaking. The Monetary Policy 
Committee in the United Kingdom, for example, like the Senate, 
is where everybody votes directly. And on a recent occasion, 
the Governor of the Bank of England was voted down in his 
recommendation.
    Senator Bunning. Gee, that would be a very pleasant 
surprise at times.
    Chairman Bernanke. In the Federal Reserve, we are more of a 
consensus-based organization. We do try to come to an agreement 
among ourselves, the same way other organizations like the 
European Central Bank do. But I assure you that we have lengthy 
and spirited discussions within the meetings, and outside the 
meetings with staff. And each person is contributing a 
perspective and a point of view to the policy.
    Senator Bunning. Mr. Chairman, they never show up in the 
minutes of the FOMC meetings. All this discussion, all this 
debate never shows up in the minutes when we get them.
    Chairman Bernanke. Perhaps the minutes could be more 
detailed.
    Senator Bunning. Transparent?
    Chairman Bernanke. Possibly. Another possibility, sir, is 
to look at some of the transcripts, which are of course only 
available with 5-year legs. But they give a full verbatim 
description of the meeting. You will see there, if you look, 
quite a bit of debate and discussion. That is the tradition we 
continue today.
    Senator Bunning. It took me years of practice, but before 
Chairman Greenspan left, I was actually able to understand what 
he was talking about. There is still a problem with 
understanding what the Fed is thinking though totally. You have 
thought about bringing back the balance of risk statements or 
doing something else so people can understand what is going 
through all of your heads.
    Is that a fact? Is that going to happen?
    Chairman Bernanke. In the short-run, Senator, we are trying 
to maintain some continuity with previous practice so as not to 
confuse people who are paying attention to the Fed too much. 
But what we are doing, as was revealed in the minutes, we have 
set up a small committee which is going to help the entire FOMC 
think through our entire range of communications, all aspects, 
including the minutes, including the statements, and try to 
develop a better, more explicit, and more useful form of 
communication.
    And I will certainly keep Congressional leaders apprised of 
this. And if anything happens that is a departure from past 
practice, I will certainly let you know about it and get your 
input.
    Senator Bunning. Last but not least, one thing different in 
your time as Fed Chairman than when Chairman Greenspan, is the 
amount of attention the public is paying to statements from 
other Fed Members. There was even a Bloomberg article yesterday 
about that.
    Do you have any problem with other Fed Members speaking out 
with different points of view? Do you think that is good for 
the markets and the economy?
    Chairman Bernanke. Senator, you were asking about 
differences of opinion and getting around group think, and this 
is one way in which Members of the FOMC can express different 
shades of their views.
    We do not restrict, we do not coordinate, the speeches of 
FOMC Members. They are going out on their own in their own 
districts and talking about whatever issues are important to 
them. And sometimes they make comments on monetary policy.
    Senator Bunning. Most of those people that are speaking out 
are members of the four banks that happen to be also Members of 
the FOMC, the different banks that are also members, four 
different ones.
    Chairman Bernanke. Not necessarily, Senator. All 12 bank 
presidents do come to the meeting and offer their views. Of 
course only four----
    Senator Bunning. Vote.
    Chairman Bernanke. Actually five, including the Bank of New 
York, vote.
    Senator Bunning. Thank you very much, Mr. Chairman.
    Chairman Shelby. Thank you.
    Chairman Bernanke, we appreciate your appearance here. We 
wish you well in your job. We know it is difficult, but we 
think you are up for the job.
    Chairman Bernanke. Thank you very much, Senator.
    Chairman Shelby. The hearing is adjourned.
    [Whereupon, at 12:39 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
                             July 19, 2006

    Mr. Chairman and Members of the Committee, I am pleased to be here 
again to present the Federal Reserve's Monetary Policy Report to the 
Congress.
    Over the period since our February report, the U.S. economy has 
continued to expand. Real gross domestic product (GDP) is estimated to 
have risen at an annual rate of 5.6 percent in the first quarter of 
2006. The available indicators suggest that economic growth has more 
recently moderated from that quite strong pace, reflecting a gradual 
cooling of the housing market and other factors that I will discuss. 
With respect to the labor market, more than 850,000 jobs were added, on 
net, to nonfarm payrolls over the first 6 months of the year, though 
these gains came at a slower pace in the second quarter than in the 
first. Last month, the unemployment rate stood at 4.6 percent.
    Inflation has been higher than we had anticipated in February, 
partly as a result of further sharp increases in the prices of energy 
and other commodities. During the first 5 months of the year, overall 
inflation as measured by the price index for personal consumption 
expenditures averaged 4.3 percent at an annual rate. Over the same 
period, core inflation--that is, inflation excluding food and energy 
prices--averaged 2.6 percent at an annual rate. To address the risk 
that inflation pressures might remain elevated, the Federal Open Market 
Committee (FOMC) continued to firm the stance of monetary policy, 
raising the Federal funds rate another \3/4\ percentage point, to 5\1/
4\ percent, in the period since our last report.
    Let me now review the current economic situation and the outlook in 
a bit more detail, beginning with developments in the real economy and 
then turning to the inflation situation. I will conclude with some 
comments on monetary policy.
    The U.S. economy appears to be in a period of transition. For the 
past 3 years or so, economic growth in the United States has been 
robust. This growth has reflected both the ongoing reemployment of 
underutilized resources, as the economy recovered from the weakness of 
earlier in the decade, and the expansion of the economy's underlying 
productive potential, as determined by such factors as productivity 
trends and growth of the labor force. Although the rates of resource 
utilization that the economy can sustain cannot be known with any 
precision, it is clear that, after several years of above-trend growth, 
slack in resource utilization has been substantially reduced. As a 
consequence, a sustainable, noninflationary expansion is likely to 
involve a modest reduction in the growth of economic activity from the 
rapid pace of the past 3 years to a pace more consistent with the rate 
of increase in the Nation's underlying productive capacity. It bears 
emphasizing that, because productivity growth seems likely to remain 
strong, the productive capacity of our economy should expand over the 
next few years at a rate sufficient to support solid growth in real 
output.
    As I have noted, the anticipated moderation in economic growth now 
seems to be under way, although the recent erratic growth pattern 
complicates this assessment. That moderation appears most evident in 
the household sector. In particular, consumer spending, which makes up 
more than two-thirds of aggregate spending, grew rapidly during the 
first quarter but decelerated during the spring. One likely source of 
this deceleration was higher energy prices, which have adversely 
affected the purchasing power of households and weighed on consumer 
attitudes.
    Outlays for residential construction, which have been at very high 
levels in recent years, rose further in the first quarter. More 
recently, however, the market for residential real estate has been 
cooling, as can be seen in the slowing of new and existing home sales 
and housing starts. Some of the recent softening in housing starts may 
have resulted from the unusually favorable weather during the first 
quarter of the year, which pulled forward construction activity, but 
the slowing of the housing market appears to be more broad-based than 
can be explained by that factor alone. Home prices, which have climbed 
at double-digit rates in recent years, still appear to be rising for 
the Nation as a whole, though significantly less rapidly than before. 
These developments in the housing market are not particularly 
surprising, as the sustained run-up in housing prices, together with 
some increase in mortgage rates, has reduced affordability and thus the 
demand for new homes.
    The slowing of the housing market may restrain other forms of 
household spending as well. With homeowners no longer experiencing 
increases in the equity value of their homes at the rapid pace seen in 
the past few years, and with the recent declines in stock prices, 
increases in household net worth are likely to provide less of a boost 
to consumer expenditures than they have in the recent past. That said, 
favorable fundamentals, including relatively low unemployment and 
rising disposable incomes, should provide support for consumer 
spending. Overall, household expenditures appear likely to expand at a 
moderate pace, providing continued impetus to the overall economic 
expansion.
    Although growth in household spending has slowed, other sectors of 
the economy retain considerable momentum. Business investment in new 
capital goods appears to have risen briskly, on net, so far this year. 
In particular, investment in non-
residential structures, which had been weak since 2001, seems to have 
picked up appreciably, providing some offset to the slower growth in 
residential construction. Spending on equipment and software has also 
been strong. With a few exceptions, business inventories appear to be 
well-aligned with sales, which reduces the risk that a buildup of 
unwanted inventories might act to reduce production in the future. 
Business investment seems likely to continue to grow at a solid pace, 
supported by growth in final sales, rising backlogs of orders for 
capital goods, and high rates of profitability. To be sure, businesses 
in certain sectors have experienced financial difficulties. In the 
aggregate, however, firms remain in excellent financial condition, and 
credit conditions for businesses are favorable.
    Globally, output growth appears strong. Growth of the global 
economy will help support U.S. economic activity by continuing to 
stimulate demand for our exports of goods and services. One downside of 
the strength of the global economy, however, is that it has led to 
significant increases in the demand for crude oil and other primary 
commodities over the past few years. Together with heightened 
geopolitical uncertainties and the limited ability of suppliers to 
expand capacity in the short run, these rising demands have resulted in 
sharp rises in the prices at which those goods are traded 
internationally, which in turn has put upward pressure on costs and 
prices in the United States.
    Overall, the U.S. economy seems poised to grow in coming quarters 
at a pace roughly in line with the expansion of its underlying 
productive capacity. Such an outlook is embodied in the projections of 
members of the Board of Governors and the Presidents of Federal Reserve 
Banks that were made around the time of the FOMC meeting late last 
month, based on the assumption of appropriate monetary policy. In 
particular, the central tendency of those forecasts is for real GDP to 
increase about 3\1/4\ percent to 3\1/2\ percent in 2006 and 3 percent 
to 3\1/4\ percent in 2007. With output expanding at a pace near that of 
the economy's potential, the civilian unemployment rate is expected to 
finish both 2006 and 2007 between 4\3/4\ percent and 5 percent, close 
to its recent level.
    I turn now to the inflation situation. As I noted, inflation has 
been higher than we expected at the time of our last report. Much of 
the upward pressure on overall inflation this year has been due to 
increases in the prices of energy and other commodities and, in 
particular, to the higher prices of products derived from crude oil. 
Gasoline prices have increased notably as a result of the rise in 
petroleum prices as well as factors specific to the market for ethanol. 
The pickup in inflation so far this year has also been reflected in the 
prices of a range of nonenergy goods and services, as strengthening 
demand may have given firms more ability to pass energy and other costs 
through to consumers. In addition, increases in residential rents, as 
well as in the imputed rent on owner-occupied homes, have recently 
contributed to higher core inflation.
    The recent rise in inflation is of concern to the FOMC. The 
achievement of price stability is one of the objectives that make up 
the Congress's mandate to the Federal Reserve. Moreover, in the long 
run, price stability is critical to achieving maximum employment and 
moderate long-term interest rates, the other parts of the Congressional 
mandate.
    The outlook for inflation is shaped by a number of factors, not the 
least of which is the course of energy prices. The spot price of oil 
has moved up significantly further in recent weeks. Futures quotes 
imply that market participants expect petroleum prices to roughly 
stabilize in coming quarters; such an outcome would, over time, reduce 
one source of upward pressure on inflation. However, expectations of a 
leveling out of oil prices have been consistently disappointed in 
recent years, and as the experience of the past week suggests, possible 
increases in these and other commodity prices remain a risk to the 
inflation outlook.
    Although the costs of energy and other raw materials are important, 
labor costs are by far the largest component of business costs. 
Anecdotal reports suggest that the labor market is tight in some 
industries and occupations and that employers are having difficulty 
attracting certain types of skilled workers. To date, however, moderate 
growth in most broad measures of nominal labor compensation and the 
ongoing increases in labor productivity have held down the rise in unit 
labor costs, 
reducing pressure on inflation from the cost side. Employee 
compensation per hour is likely to rise more quickly over the next 
couple of years in response to the strength of the labor market. 
Whether faster increases in nominal compensation create additional cost 
pressures for firms depends in part on the extent to which they are 
offset by continuing productivity gains. Profit margins are currently 
relatively wide, and the effect of a possible acceleration in 
compensation on price inflation would thus also depend on the extent to 
which competitive pressures force firms to reduce margins rather than 
pass on higher costs.
    The public's inflation expectations are another important 
determinant of inflation. The Federal Reserve must guard against the 
emergence of an inflationary psychology that could impart greater 
persistence to what would otherwise be a transitory increase in 
inflation. After rising earlier this year, measures of longer-term 
inflation expectations, based on surveys and on a comparison of yields 
on nominal and inflation-indexed government debt, have edged down and 
remain contained. These developments bear watching, however.
    Finally, the extent to which aggregate demand is aligned with the 
economy's underlying productive potential also influences inflation. As 
I noted earlier, FOMC participants project that the growth in economic 
activity should moderate to a pace close to that of the growth of 
potential both this year and next. Should that moderation occur as 
anticipated, it should help to limit inflation pressures over time.
    The projections of the Members of the Board of Governors and the 
Presidents of the Federal Reserve Banks, which are based on information 
available at the time of the last FOMC meeting, are for a gradual 
decline in inflation in coming quarters. As measured by the price index 
for personal consumption expenditures excluding food and energy, 
inflation is projected to be 2\1/4\ percent to 2\1/2\ percent this year 
and then to edge lower, to 2 percent to 2\1/4\ percent next year.
    The FOMC projections, which now anticipate slightly lower growth in 
real output and higher core inflation than expected in our February 
report, mirror the somewhat more adverse circumstances facing our 
economy, which have resulted from the recent steep run-up in energy 
costs and higher-than-expected inflation more generally. But they also 
reflect our assessment that, with appropriate monetary policy and in 
the absence of significant unforeseen developments, the economy should 
continue to expand at a solid and sustainable pace and core inflation 
should decline from its recent level over the medium term.
    Although our baseline forecast is for moderating inflation, the 
Committee judges that some inflation risks remain. In particular, the 
high prices of energy and other commodities, in conjunction with high 
levels of resource utilization that may increase the pricing power of 
suppliers of goods and services, have the potential to sustain 
inflation pressures. More generally, if the pattern of elevated 
readings on inflation is more protracted or more intense than is 
currently expected, this higher level of inflation could become 
embedded in the public's inflation expectations and in price-setting 
behavior. Persistently higher inflation would erode the performance of 
the real economy and would be costly to reverse. The Federal Reserve 
must take account of these risks in making its policy decisions.
    In our pursuit of maximum employment and price stability, monetary 
policy makers operate in an environment of uncertainty. In particular, 
we have imperfect knowledge about the effects of our own policy actions 
as well as of the many other factors that will shape economic 
developments during the forecast period. These uncertainties bear 
importantly on our policy decisions because the full influence of 
policy actions on the economy is felt only after a considerable period 
of time. The lags between policy actions and their effects imply that 
we must be forward-looking, basing our policy choices on the longer-
term outlook for both inflation and economic growth. In formulating 
that outlook, we must take account of the possible future effects of 
previous policy actions--that is, of policy effects still ``in the 
pipeline.'' Finally, as I have noted, we must consider not only what 
appears to be the most likely outcome but also the risks to that 
outlook and the costs that would be incurred should any of those risks 
be realized.
    At the same time, because economic forecasting is far from a 
precise science, we have no choice but to regard all our forecasts as 
provisional and subject to revision as the facts demand. Thus, policy 
must be flexible and ready to adjust to changes in economic 
projections. In particular, as the Committee noted in the statement 
issued after its June meeting, the extent and timing of any additional 
firming that may be needed to address inflation risks will depend on 
the evolution of the outlook for both inflation and economic growth, as 
implied by our analysis of the incoming information.
    Thank you. I would be happy to take questions.

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

Q.1. China's foreign exchange reserves stand at $941.1 billion, 
creating excess liquidity in their banking system. In addition, 
various estimates of China's first and second quarter growth 
rates suggest that the Chinese economy has grown by upward of 
10 percent this year.
    Do you see any danger that the Chinese economy is 
overheating? Are the Chinese now willing to take all necessary 
steps, like a revaluation of their currency, which could rein 
in problems before they pose systemic risk?

A.1. The ratio of investment to GDP was over 40 percent in 
2005, which is likely too high a rate for an economy to absorb 
efficiently. This is leading to overcapacity in some industries 
and is likely to add to the already large stock of bad loans in 
the future. However, there is less evidence of widespread 
overheating. Inflation is still quite low, at about 1\1/2\ 
percent for consumer prices on a 12-month basis, despite the 
fact that the money supply has been growing at a rate of almost 
19 percent.
    Chinese authorities have indicated that they would like 
investment to slow and that they would also like growth to be 
better balanced between external and domestic demand. They have 
taken some steps to try to encourage consumption. However, they 
still have not allowed a substantial appreciation of the 
reminbi, a step that many analysts argue would be the most 
effective way to address the imbalances in the economy.

Q.2. Has the Federal Reserve been asked or offered to provide 
guidance to the Chinese Central Bank and are you concerned 
about any spillover effects that a Chinese economic crisis 
could have in U.S. markets?

A.2. The Federal Reserve has provided technical assistance to 
the People's Bank of China for a number of years on various 
aspects of central banking. The Federal Reserve has also been 
supportive of the U.S. Treasury's initiative to provide 
technical assistance to China in the economic and financial 
areas.
    We believe that the chance of a Chinese economic crisis is 
very low for the foreseeable future. Although the banking 
sector is burdened with an enormous and probably growing stock 
of problematic loans, the government possesses sizable 
resources and is unlikely to allow the banking system to fail. 
The large stock of foreign exchange reserves also makes a 
potential currency crisis a very low probability event.
    However, we do not entirely discount the possibility of a 
``hard landing,'' in the form of significantly slower growth, 
as the authorities attempt to reduce investment growth from its 
current rapid pace. We do not think this is the most likely 
outcome, but it is a possibility. Such an outcome would have 
significant repercussions for other Asian economies, including 
Japan, and would also be detrimental for some of the other 
emerging market economies, notably in Latin America and the 
Middle East, that have been supplying the enormous Chinese 
demand for oil and other commodities. The impact on the United 
States would be less direct, given that China is not a major 
buyer of our exports, but the overall impact on world GDP would 
certainly have some negative effect on the United States.

Q.3. In recent weeks, several banks have suggested that the 
current Basel II framework should be revised to provide any 
bank the option to use either the advanced approach or the 
standardized approach set forth in the original Basel II 
framework. Apparently, there is concern that Basel II as set 
forth in the draft NPR released last March would not be cost 
effective for banks to implement. Does the Federal Reserve 
support allowing banks such an option? If not, please explain 
your rationale. Does the Federal Reserve believe that concerns 
about the cost effectiveness of Basel II as presently set forth 
in the draft NPR are valid? Would you please update the 
Committee on the Federal Reserve's timetable for the 
implementing Basel II and Basel IA? Please provide specific 
dates, if possible, by which the Federal Reserve expects to 
have completed each of steps for implementing Basel II and 
Basel IA.

A.3. The Federal Reserve and the other banking agencies have 
received several comment letters asking that we provide 
optionality in the United States. Basel II framework similar to 
that provided in the Basel Mid-Year text. As with other 
comments we have received on the draft Basel II NPR, and 
consistent with out duties under the Administrative Procedure 
Act, we will seriously consider the merits of the suggestion.
    As I tried to indicate in my response to a similar question 
posed by Senator Sarbanes, I am concerned that the Basel II 
standardized approach would not accommodate the risks that the 
large, complex, internationally active banks take, both on and 
off their balance sheets. In my judgment, elements of the Basel 
II standardized approach, particularly those related to the 
measurement of credit risk, would be more appropriately applied 
to smaller, less complex, and primarily domestic U.S. banking 
organizations. That is how it was designed and that is how it 
appears it will be implemented in other countries. For example, 
there is no evidence that any of the largest 50 non-U.S. G-10 
banks plans to adopt the standardized approach, even though 
they have the option to do so.
    Evaluating the cost effectiveness of Basel II NPR requires 
measurement of both costs and benefits, both of which are 
difficult. With respect to the costs of compliance, it should 
be noted that many of the risk measurement and risk management 
policies and practices required by the draft Basel II NPR are 
policies and practices that banking organizations adopted or 
would have adopted even in the absence of Basel II in order to 
(i) improve their own understanding of their risk profile; (ii) 
meet supervisory expectations for good risk measurement and 
management; or (iii) satisfy Basel II regulatory capital 
requirements in other jurisdictions. On the benefits side, we 
expect that Basel II will improve the risk sensitivity of our 
bank regulatory capital framework, remove opportunities for 
regulatory capital arbitrage, improve our supervisory ability 
to evaluate a bank's capital adequacy, improve market 
discipline of banks, and, ultimately enhance the safety and 
soundness of our banking system. Given the inherent 
complexities in measuring costs and benefits, it is difficult 
to evaluate the question of cost effectiveness in any simple 
terms. We have sought, and will continue to seek, comment from 
banks and others to gain a better understanding of the costs of 
compliance with our Basel II proposals.
    The timetable for implementation of Basel II and Basel IA 
is set by the four Federal banking agencies acting in concert. 
That timetable currently contemplates adoption of final rules 
for Basel II and Basel IA by mid-2007 so that the parallel run 
for Basel II can begin in January 2008. Transitional capital 
floors and other safeguards will be in place at least through 
January 2012 and perhaps longer for some banks depending on 
when they complete their parallel run.

        RESPONSE TO A WRITTEN QUESTION OF SENATOR REED 
                      FROM BEN S. BERNANKE

Q.1. Chairman Bernanke, in your testimony you state that the 
standardized approach is ``essentially the same as the existing 
approach'' in Basel I. My understanding is that the 
standardized approach has some significant differences, 
including, for example, greater differentiation of assets by 
credit quality; an operational risk charge; more accurate 
measures of counterparty exposure; recognition of some credit 
risk mitigation measures; and risk-weighting of mortgages. 
Could you clarify for the record whether you really believe 
that the standardized approach is the same as Basel I?

A.1. I believe that the general broad-brush approach to risk-
weight categories and the expectations for risk management 
contained in the credit risk standardized approach in Basel II 
are not a large change from our existing Basel I-based capital 
rules. To be sure, there are a number of differences between 
Basel I and the credit risk standardized approach in Basel II, 
and your question highlights many of these differences. 
However, my remarks were made in the context of whether the 
Basel II credit risk standardized approach would be appropriate 
for large, internationally active banking organizations in the 
United States. In my opinion, the Basel II credit risk 
standardized approach is much less risk-sensitive than the 
Basel II advanced approach and does not make use of the most 
advanced risk management practices. For example, I note that 
the Basel II credit risk standardized approach generally 
provides the same risk weight for all first-lien mortgage loans 
(35 percent), nonmortgage retail loans (75 percent), and 
unrated corporate credits (100 percent), regardless of the 
creditworthiness of the borrower.
    As you are aware, the agencies intend to update the Basel 
I-based capital rules for most banks in the United States. In 
updating those rules, we expect to utilize some of the 
improvements in the Basel II standardized approach.

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

Q.1. On Wednesday, July 12, China's top planning agency 
forecasted that China would report a more than 10 percent 
growth for the first half of the year.
    In response, the National Development and Reform Commission 
reiterated their calls for stronger action to curb excessive 
investment. And, the Financial Times reported that credit 
tightening policies are imminent--a matter of weeks not months.
    Given that the United States-China trade deficit continues 
to surpass previous records every passing month, we need to be 
much more in tune with Chinese economic policies. Therefore, my 
question for you is--do you think China will begin to tighten 
their lending policies and if they do, how will it impact our 
trade deficit and the global economy at large?

A.1. China has taken a number of steps this year to try to 
restrain growth in lending, with limited success. Chinese 
authorities have imposed some administrative controls, raised 
interest rates, and increased banks' reserve requirements. Most 
recently, the Chinese central government has issued a circular 
requiring a review of all new investment projects undertaken 
this year in excess of RMB 100 million, with a cutoff of RMB 30 
million in sectors that are thought to have excess capacity 
(including steel, aluminum, and autos). If these measures are 
still not successful in slowing investment growth, they are 
likely to do more. In any case, slower growth is not likely to 
translate into any improvement in our trade deficit with China. 
In fact, if slower growth in China resulted in reduced growth 
in China's imports, the Chinese trade surplus would increase.

Q.2a. The next time we meet will be at the end of 2006. From 
now until then, China is gearing up for its first real push 
into the U.S. auto market.
    In your opinion, how will the entrance of China--who has a 
history of under pricing their products through currency 
manipulation--affect the manufacturing industry in the United 
States?

A.2a. I understand that three Chinese companies are aiming to 
introduce autos and light trucks into the U.S. market over the 
next several years. Overall, they are not likely to have a 
significant impact on the U.S. auto industry because they are 
small: The largest, Chery, sold fewer than 200,000 vehicles 
globally last year compared with GM's sales of more than 8 
million vehicles. More important over the longer-run, our 
experience with other foreign firms indicates that offering 
vehicles at a low price will by no means guarantee their 
success. The quality and reliability of these vehicles will be 
an important determinant of their effect on the domestic market 
for vehicles. Foreign firms also will need to adapt their 
designs to meet strict U.S. safety and emissions standards and 
to establish new dealerships.

Q.2b. I have one broader question about manufacturing in the 
United States. Every quarter I review the manufacturing numbers 
produced by the Bureau of Labor Statistics. As you can see from 
this graph--manufacturing continues to decline, ever since 
2000. When do you see this slowing down? And in Michigan, the 
graph looks like this. Again, how do you analyze these trends 
and what do you expect in the future?



A.2b. Although manufacturing employment fell substantially 
during the last economic downturn, declines in the sector 
slowed markedly beginning in late 2003 and from April through 
July of this year, manufacturing jobs and the average factory 
workweek were up from the lows reached last fall. Over the 
longer-run, even as manufacturing employment has been 
declining, manufacturing production has risen solidly. This is 
because the reduction in labor input has been more than offset 
by rapid increases in productivity. Indeed, we estimate that 
overall manufacturing capacity in the United States in 2005 
stood about 50 percent higher than in 1995.
    Of course, underlying those positive overall trends are 
structural changes that affect the composition and location of 
manufacturing jobs. For example, many of the expanding 
manufacturing industries in recent years, such as computers and 
electronic components, have located outside of the Midwest. The 
Federal Reserve Bank of Chicago, which studies trends in the 
Midwest, notes that structural developments in the motor 
vehicle industry have had an important effect in the region and 
in Michigan.\1\ With the introduction of new assembly by 
transplants, the geographic distribution of motor vehicle 
production has spread to the mid-South. And, the loss of market 
share of sales by the Big Three producers to the transplant 
firms has exacerbated the loss. Suppliers have followed the 
shift in assemblies.
---------------------------------------------------------------------------
    \1\ William A. Testa, Thomas H. Klier, and Richard H. Mattoon, 
``Challenges and Prospects for Midwest Manufacturing,'' Chicago Fed 
Letter (March 2005).
---------------------------------------------------------------------------

         RESONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 
                      FROM BEN S. BERNANKE

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. As you know, the President's Working Group on 
Financial Markets has explained why proposals we have faced in 
the last couple of years for additional regulation of energy 
derivatives were not warranted, and has urged Congress to be 
aware of the potential for unintended consequences. Do you 
share this view? Do you agree with the view of Alan Greenspan 
and others that derivatives have helped create a far more 
flexible, efficient, and resilient financial system? Are you 
aware of any evidence that additional reporting requirements or 
other regulatory actions would reduce energy prices and price 
volatility or are energy prices and price volatility determined 
by the market?

A.1. I share the view that additional regulation of energy 
derivatives is not warranted. More generally, I agree that 
derivatives have created a more flexible, efficient, and 
resilient financial system. To be sure, as Chairman Greenspan 
recognized, derivatives pose a variety of risk management 
challenges that users must address. In particular, they must 
effectively manage the counterparty risks associated with 
derivatives. Thus far, with a few notable exceptions they have 
done so and, as a result, derivatives have produced the 
benefits that you have mentioned.
    I am unaware of any evidence that supports a view that 
additional reporting requirements or other new regulations 
would reduce energy prices or energy price volatility. Prices 
and volatility are indeed determined by the market, and as far 
as I am aware, energy prices and volatility recently have moved 
in ways that seem sensibly related to fundamentals.

Q.2. Mr. Chairman, in your Sea Island speech in May on the 
subject of ``Hedge Funds and Systemic Risk,'' you noted that 
``[t]he primary mechanism for regulating excessive leverage and 
other 
aspects of risk-taking in a market economy is the discipline 
provided by creditors, counterparties, and investors.''
    You further observed that, in light of 1998's LTCM episode, 
the President's Working Group's ``central policy recommendation 
was that regulators and supervisors should foster an 
environment in which market discipline--in particular, 
counterparty risk management--constrains excessive leverage and 
risk-taking.''
    You also noted that the PWG rejected so-called ``direct 
regulation'' of hedge funds, observing that ``[d]irect 
regulation may be 
justified when market discipline is ineffective at constraining 
excessive leverage and risk-taking but, in the case of hedge 
funds, the reasonable presumption is that market discipline can 
work. Investors, creditors, and counterparties have significant 
incentives to rein in hedge funds' risktaking. Moreover, direct 
regulation would impose costs in the form of moral hazard, the 
likely loss of private market discipline, and possible limits 
on funds' ability to provide market liquidity.''
    Can you tell us a little more about what is involved in 
fostering market discipline in the hedge fund context and why 
you believe that is a superior approach to ``direct 
regulation?''

A.2. The creditors and counterparties of hedge funds are 
regulated banks and securities firms. Banking and securities 
supervisors have been fostering market discipline by issuing 
supervisory guidance on counterparty risk management, by 
encouraging private 
sector initiatives to identify and promote best practices for 
risk management, and by undertaking supervisory reviews that 
assess whether banks and securities firms' practices are 
consistent with supervisory guidance and emerging best 
practices.
    As I indicated in my Sea Island speech, I believe that it 
is a reasonable presumption that market discipline can 
effectively constrain hedge funds' leverage. The banks and 
securities firms that provide hedge funds with leverage have 
strong incentives and capabilities to constrain their leverage 
so as to avoid counterparty losses. Supervisors of those banks 
and securities firms can and should take action if competition 
appears to be dulling those incentives in ways that threaten 
the counterparties and the financial system. Direct regulation 
of hedge funds could weaken market discipline if hedge funds' 
creditors and counterparties came to view direct regulation as 
an effective substitute for their own due diligence and 
monitoring of risks. Furthermore, development of an effective 
regulatory regime for hedge funds would be challenging in light 
of the diversity of hedge fund investment strategies and the 
speed with which their risk profiles tend to change. A 
regulatory regime that was insufficiently risk sensitive could 
impair hedge funds' ability to bear risks and provide liquidity 
to financial markets, which would make our financial system 
less efficient and less resilient.



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