[Senate Hearing 110-182]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 110-182
 
        FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 2007

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


                                HEARING

                               before the

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

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                                   ON

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

                               __________

                           FEBRUARY 14, 2007

                               __________

  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

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         WAYNE ALLARD, Colorado
EVAN BAYH, Indiana                   MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware           CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey          JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii              MIKE CRAPO, Idaho
SHERROD BROWN, Ohio                  JOHN E. SUNUNU, New Hampshire
ROBERT P. CASEY, Pennsylvania        ELIZABETH DOLE, North Carolina
JON TESTER, Montana                  MEL MARTINEZ, Florida

                      Shawn Maher, Staff Director

        William D. Duhnke, Republican Staff Director and Counsel

                      Aaron Klein, Chief Economist

          Peggy R. Kuhn, Republican Senior Financial Economist

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                          Jim Crowell, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                      WEDNESDAY, FEBRUARY 14, 2007

                                                                   Page

Opening statement of Chairman Dodd...............................     1

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     4
    Senator Casey................................................     5
    Senator Bunning..............................................     5
    Senator Bayh.................................................     6
    Senator Martinez.............................................     6
    Senator Menendez.............................................     6
    Senator Hagel................................................     7
    Senator Tester...............................................     8
    Senator Bennett..............................................     8
    Senator Brown................................................     9
    Senator Allard...............................................    10
    Senator Reed.................................................    10
    Senator Sununu...............................................    11

                                WITNESS

Ben S. Bernanke, Chairman, Board of Governors of the Federal 
  Reserve System, Washington, DC.................................    12
    Prepared statement...........................................    60
    Response to written questions of:
        Senator Shelby...........................................    64
        Senator Sununu...........................................    66

              Additional Material Supplied for the Record

Monetary Policy Report to the Congress dated February 14, 2007...    68
Letter to Senator Christopher J. Dodd from Ben S. Bernanke, 
  Chairman, Board of Governors of the Federal Reserve System 
  dated February 26, 2007........................................    98
Letter to Senator John E. Sununu from Ben S. Bernanke, Chairman, 
  Board of Governors of the Federal Reserve System dated February 
  26, 2007.......................................................   101

                                 (iii)


  FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT TO CONGRESS FOR 2007

                              ----------                              


                      WEDNESDAY, FEBRUARY 14, 2007

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

    The Committee met at 10:07 a.m., in room SD-106, Dirksen 
Senate Office Building, Senator Christopher J. Dodd (Chairman 
of the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN CHRISTOPER J. DODD

    Chairman Dodd. The hearing will come to order.
    Let me thank all of our colleagues and others who have made 
it in this morning to participate in this hearing on our first 
true winter morning this year. Mr. Chairman, we thank you for 
being with us as well, and we appreciate your testimony before 
the Committee.
    What I will do is open up with a brief opening statement. I 
will turn to my colleague, Senator Shelby, and then any of our 
other colleagues who would like to make some brief opening 
remarks. Your full statements, I will guarantee you, will be 
included in the record, as will yours and any supporting 
documentation, Mr. Chairman, you would like to be a part of 
this record this morning. We will try and move along so we can 
get to the question and answer period with you as quickly as 
possible.
    This morning, the Committee is pleased to welcome Federal 
Reserve Chairman Bernanke to deliver the Fed's Semi-Annual 
Monetary Policy Report. I want to congratulate you, Mr. 
Chairman, for completing your first year as Chairman. Following 
in the footsteps of a very successful Chairman can be 
difficult, and it is something that I can certainly relate to, 
sitting in this chair and sitting next to my friend from 
Alabama. But I believe that you have done a very good job in 
gaining the respect and confidence of the markets and your 
colleagues on the Federal Reserve Board.
    The Fed's monetary policy--most notably, its decision to 
stop rising interest rates in June--has played a very important 
role in some recent positive economic developments. During 
2006, the economy grew at a sustainable rate and unemployment 
was kept to under 5 percent. While this is not quite as strong 
as it was in the late 1990's--when growth was higher and 
unemployment fell below 4 percent, with much higher labor force 
participation--this economic news is welcome. Long-term 
interest rates have remained at modest levels, despite a large 
Federal budget deficit, a historic current account deficit, and 
the cumulative effect of the Fed's 2-year cycle raising the 
interest rates that ended in June.
    While these developments are, as I said, positive, there 
are other facts that, in my view, raise some very important 
questions about our Nation's long-term ability to provide 
economic security, opportunity, and prosperity to the people of 
this country.
    As I travel around these days and talk to many people from 
all walks of life, I am confronted by people who are concerned 
about the future, whether or not we will have the kind of 
stability and long-term growth necessary for our success. What 
I am hearing from people is that they are concerned about many 
of the same things.
    Health care costs are rising at a rate that is 
unsustainable for businesses and employees. Over the past 6 
years, health care costs have increased by 30 percent. More 
than 46 million Americans have no health insurance at all 
today, as we all know. That is an increase of 6 million people 
over the past 6 years. The price of gasoline, home heating oil, 
and other forms of energy has skyrocketed over the past years. 
This past summer, gasoline cost over $3 per gallon in many 
parts of the country. And while it is much lower today, it is 
still twice as high as it was 5 years ago. Families are 
concerned as well that they cannot afford to send their kids to 
college. My colleague from New York, Senator Schumer, has spent 
a lot of time on this issue. College tuition has risen by more 
than twice the rate of inflation over the past 20 years. Room, 
board, and tuition at many private universities now cost well 
over $50,000 a year.
    As these costs rise, working Americans are experiencing 
more and more uncertainty about their future. People are 
wondering whether their home is losing value as they see houses 
in their neighborhood sell for less today than they did a year 
ago. And millions of Americans are in exotic and subprime 
mortgages while the potential for sharp increases in monthly 
payments is right around the corner. Several credible reports 
say that we are facing a tidal wave of defaults and 
foreclosures, which could strip these families of their major, 
if not their only, source of wealth and long-term economic 
security.
    Despite some recent gains in household incomes, the real 
median family income, what a family right in the middle of the 
middle class earns in a year, is lower today than it was 6 
years ago. People are working longer and harder, and many are 
not bringing home enough money to keep pace with what they 
need. And for those who lose their jobs, the prospect of 
falling out of the middle class is far greater today. Americans 
are more than twice as likely to experience a precipitous drop 
in income as Americans of a generation ago, according to a 
recent research study by Jacob Hacker at Yale University.
    As we worry about some Americans falling out of the middle 
class, we must also be concerned about those working hard to 
climb into the middle class. Over 10 million Americans today do 
not have access to mainstream financial institutions, such as a 
bank, a credit union, or a thrift. For these entrepreneurs and 
workers, affordable credit and capital services are scarce, if 
not impossible to find. And as a result, millions of our fellow 
citizens lack the financial tools that they need to build more 
secure and prosperous futures for themselves and their 
families.
    Finally, Mr. Chairman, our Nation finds itself with trade 
policies that are unsustainable, as well, in my view. We have 
learned this week that last year, we ran a record trade deficit 
of $763 billion. Our Nation's current account deficit will 
approach 7 percent of our GDP. We are relying on over $2.4 
billion a day from foreign investors, who are increasingly 
foreign governments, to finance our economic growth because of 
the lack of savings here at home.
    The Administration has an official trade policy that is, in 
key respects, out of touch with reality. For instance, it is 
widely believed that China manipulates its currency. We had a 
very good hearing, as you may know, with Hank Paulson before 
this Committee a week or so ago on the exchange rate issue. 
Yet, the Administration refuses to officially recognize that 
fact. When Chairman Bernanke was in China, as part of the 
Strategic Economic Dialogue, he gave a speech that pointed out, 
``effective subsidy that an undervalued currency provides for 
Chinese firms that focused on exporting.''
    While this subsidy is not the sole cause of either our 
record international trade deficit or our loss of over 3 
million manufacturing jobs, including about 1 million of those 
jobs in critical national defense-related industries, the 
distortion of Chinese currency manipulation is having a very 
significant negative impact on American manufacturing jobs.
    As policymakers, I think we need to ask ourselves a very 
fundamental question: Are we satisfied with America's place in 
the world at the beginning of this new century? I do not think 
that any one of us can look at all the facts and reach any 
conclusion other than that we can do a lot better than I think 
we are. And for the sake of the people we serve and generations 
coming after them, I think all of us would agree we have to do 
better.
    There are steps we can and should take, in my view, to 
build a stronger foundation for a more secure and prosperous 
future. Today's hearing provides the Committee with an 
opportunity to discuss some of these steps. We can start by 
keeping interest rates at modest levels, and, again, I 
congratulate the Fed on doing that since last June. Certainly, 
monetary policy is obviously an important component of our 
economic future. The Fed's dual mandate is to promote full 
employment and price stability. This is a vital and difficult 
mission, and we look forward to hearing from the Chairman about 
the steps the Fed has taken since its last report to fulfill 
that statutory mandate.
    In addition, we need our Federal financial regulatory 
agencies to be vigilant in assuring not only the safety and 
soundness of our financial institutions, but also that those 
institutions are serving, not thwarting, the aspirations of 
Americans to build a more secure and prosperous life for 
themselves and those families.
    I look forward to discussing the aspects of the Fed's 
mission as well as with you today, Mr. Chairman, and I will 
turn to my colleague from Alabama for any opening comments he 
may have and then to my colleagues here as well for any brief 
statements they want to make as we start this hearing.
    Senator Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Chairman Dodd.
    Chairman Bernanke, we are pleased to have you before the 
Committee again to deliver the Federal Reserve's Semi-Annual 
Monetary Policy Report. This hearing provides an important 
mechanism for assuring accountability over the Fed's policies 
and operations.
    Chairman Bernanke, you have recently completed one year at 
the helm of the Federal Reserve System. When President Bush 
nominated you for this position, I noted at the hearing that 
you would have big shoes to fill, following in the footsteps of 
the distinguished Chairman Greenspan. I also noted my belief 
that the President made a superb choice in asking you to take 
on this responsibility. The Federal Reserve's conduct of 
monetary policy thus far under your leadership has given me 
further reason to applaud your service.
    Chairman Bernanke, as 2006 began, there was much debate as 
to whether the Federal Reserve would prove successful in 
engineering a ``soft landing,'' after many successive increases 
in the Fed funds target rate. Certainly the economic data in 
recent weeks tells us that the debate maybe all but over. 
Analysts and other Fed watchers are now giving you high praise 
for the manner in which you have handled your responsibilities, 
and I join them.
    Real gross domestic product, GDP, increased at an annual 
rate of 3.5 in the fourth quarter of 2006. For all of 2006, GDP 
grew 3.4 percent compared with the 3.2-percent increase in 
2005. Both numbers topped the 20-year average of 3.1 percent.
    Along with this strong growth, we have seen positive news 
on the job front. The Labor Department reported that the 
economy created, Mr. Chairman, more than 2.2 million jobs last 
year, 400,000 more than previously estimated. We continue to 
enjoy a low unemployment rate, both historically and relative 
to other industrialized nations.
    At its most recent meeting on January 31, Federal Open 
Market Committee kept the Federal funds target rate at 5.25 
percent, the fifth consecutive meeting with no change. Fed 
watchers noted that the latest FOMC statement seemed more 
upbeat on growth prospects and keeping inflation in check. My 
colleagues and I, Mr. Chairman, will no doubt spend time this 
morning trying to figure out how long the FOMC intends to leave 
short-term rates unchanged.
    I am certain that today's hearing will also include some 
discussions of the potential risks in the economy, such as the 
housing market slowdown, among others.
    Mr. Chairman, while it is our responsibility to continue to 
examine the horizon for such risks, we must also note the 
strong performance of this economy. I hope that we will also 
take time today to discuss the very strengths and how to 
maintain and build upon them.
    Chairman Bernanke, again, we welcome you back to the 
Committee, and we like the job you are doing.
    Chairman Dodd. He is not here, but Senator Schumer was next 
on our list, but, Senator Casey, this early bird rule applies 
here.
    Senator Casey.

              STATEMENT OF SENATOR ROBERT P. CASEY

    Senator Casey. Mr. Chairman, thank you very much for 
gathering us here. Chairman Bernanke, thank you for your time 
here today and for your service.
    I do not have a long statement, but I just wanted to 
highlight a couple of things I know that you have touched on 
before and that I am sure we will speak to today, some of the 
long-term fiscal challenges that you outlined here in your 
previous testimony, I guess a week or so ago, with regard to 
Medicare, Social Security, and other demands that are being 
placed on the Federal budget into the future. I appreciate the 
fact that you are thinking about and focusing on that and 
building that into the planning that you do.
    I think also the people that I represent in Pennsylvania 
are concerned about those costs. They are concerned about the 
deficit, which I guess last year was $248 billion. This year, 
the projection is for something less than that. But they are 
also concerned about the impact, as Chairman Dodd outlined, of 
the costs in their own lives, in their real lives, and you know 
the cost of health care and college tuition and housing and so 
many other areas. I hope that one of the things we have a 
chance to discuss today is the impact that those costs have, 
the impact not just on that family, the horrific impact it can 
sometimes have on their budgets, but also the impact that that 
has on overall long-term economic growth and stability.
    So, I look forward to discussing that today with you, and 
we appreciate the time you are spending with us, and we 
appreciate the report.
    Chairman Dodd. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman.
    Chairman Bernanke, thank you for being here today. To 
repeat what I told you at the Budget Committee hearing a few 
weeks ago, the Federal Open Market Committee did the right 
thing by stopping the increases in the Fed fund rates after the 
June 2006 Fed meeting. By holding rates constant, you have done 
the right thing ever since. After the latest increase, the 
stock markets took off and the cost of credit leveled off. If 
the Fed had chosen to continue hiking rates, mortgages and 
other forms of credit would have become less and less 
affordable to the average American.
    Over the last 2 years, the costs of credit, such as 
mortgages, student loans, and credit cards, have all increased. 
I am not sure how much more tightening consumers could have 
handled before serious harm was done to the economy. Higher 
interest rates accelerated the housing decline. We will not 
know the full extent of the damage for months, if not longer. 
If the Fed had not stopped when it did, we would have been in 
even more danger.
    You have been at the helm of the Fed for a year now. My 
initial fears were that you would be a carbon copy of your 
predecessor, yet you have done some things I have never seen 
your predecessor do: Embrace open and full debate. There is an 
old saying that there is a reason we have two ears and one 
mouth: It is often more important to listen than to talk.
    During your brief tenure at the Fed, you have made a 
serious effort to improve on how the Fed listens, but you know 
I am not going to let you off that easy, even though today is 
Valentine's Day. The people of my State and I have real 
concerns about the dangers that lie ahead for our economy. As 
this Committee discussed with Secretary Paulson last month, our 
constituents are nervous when they see more and more 
manufacturing jobs going to the Chinese. They are concerned 
about the future of the housing market. They are particularly 
concerned about the effects that the potential repeal of the 
Bush tax cuts will have on our economic recovery. You inherited 
an economy that was approaching a tipping point, and so far you 
have managed not to push it over. I urge you to act with 
caution and deliberation in the coming year.
    Finally, soon there will be two vacancies on the Board of 
Governors. I hope the President moves quickly to fill these 
positions with people who have real experience in financial 
services and commercial banking, not just ivory tower 
academics. I look forward to your remarks.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator Bunning.
    Senator Bayh.

                 COMMENTS OF SENATOR EVAN BAYH

    Senator Bayh. Thank you, Mr. Chairman.
    Chairman Bernanke, I suspect that most of the people here 
today have gathered to listen to you, not me, and I will, 
therefore, reserve my comments for the question period.
    Chairman Dodd. Very good.
    Senator Martinez.

               STATEMENT OF SENATOR MEL MARTINEZ

    Senator Martinez. I will almost resist the temptation.
    Chairman Dodd. That was a standard Senator Bayh set there.
    Senator Martinez. But I will be very brief, Mr. Chairman. 
Thank you very much.
    Chairman Bernanke, welcome, and I again join in the high 
praise that you have been receiving for your first year on the 
job. I will simply look forward to hearing your comments as it 
relates to the housing market, a great concern to me, housing 
affordability; also, the issue that we dealt with last week in 
this Committee, which is subprime lending and the rate of 
defaults in that area; and just in general the effect of the 
hurricanes in the Gulf Coast, which continue to be an impact on 
the economies of the Gulf States.
    So, I look forward to your comments, and thank you for 
being with us today.
    Chairman Dodd. Thank you very much.
    Senator Menendez.

              STATEMENT OF SENATOR ROBERT MENENDEZ

    Senator Menendez. Thank you, Mr. Chairman.
    Chairman Bernanke, welcome. It is great to welcome a fellow 
New Jerseyan back again to the Committee.
    Today, some people say the economy is solid due to some of 
the leading economic indicators appearing generally healthy, 
with unemployment below 5 percent, with moderate economic 
growth, with inflation stabilized, and I certainly want to 
commend you for the stewardship you have shown at the Fed in 
working on this economy. But at the same I also worry about who 
is benefitting from this economy and who is being left behind.
    Indeed, there are serious limitations, I think, in judging 
a situation solely through looking at the big-picture numbers, 
as this view often hides the details of a situation, and 
specifically I am talking about the burden being placed on our 
middle class. So while some in this country might believe that 
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. And the disparity that continues to 
grow, in my mind, is widening at an alarming rate.
    When I am back in New Jersey, I hear more and more from New 
Jerseyans that our current economic policies are not working 
for them. The middle class continues to shrink, poverty is 
increasing, the gap between the rich and the poor is growing 
wider. We have a record-breaking national debt and a record-
breaking trade deficit. The personal savings rate is now below 
zero, which has not happened since the Great Depression. 
Millions of Americans are seeing their wages stagnant and their 
pension and health care benefits slashed, while the wealthiest 
people in the country are doing better than ever.
    So ultimately my concern is that our economy is not working 
for the broadest scope of Americans that we would hope. The 
middle class is shrinking instead of growing, and we seem far 
more concerned about boosting the incomes of the wealthiest 
Americans while denying our responsibility to those struggling 
to make ends meet. I do not think we can sustain that position 
over the long-term. We are borrowing to pay for tax cuts and 
the war effort. It is an unfair burden we are placing on our 
children and grandchildren.
    So, I look forward to your testimony today and hearing your 
thoughts on some of these things I have mentioned, some of the 
other things I hope you will address, like the cooling off of 
the housing market, what that may mean; energy prices; the 
consequences of deficit and debt, from large budget deficits to 
record personal debt. And I understand that in your capacity as 
Chairman of the Federal Reserve, you are responsible for 
keeping inflation low and stable while maintaining economic 
growth, not economic equality. But I do hope either in your 
opening statement or subsequently in the questions that we will 
have an opportunity to ask to hear your views about how we get 
this economy working in a direction that it really helps 
middle-class families in this country.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Senator Hagel.

                STATEMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you.
    Mr. Chairman, welcome. We are glad you are here. I want to 
personally thank you for you taking time to address the Greater 
Omaha Chamber of Commerce at their annual meeting 2 weeks ago. 
It was a rather significant event, as it always is, and your 
speech matched the expectations that many had, and I appreciate 
you very much taking a day of your time to come to my State and 
deliver that speech and spend some time with our leaders in 
Nebraska. And I look forward to your testimony.
    Thank you.
    Chairman Dodd. Thank you very much.
    Senator Tester.

                 COMMENTS OF SENATOR JON TESTER

    Senator Tester. Thank you, Chairman Dodd.
    Chairman Bernanke, I want to also welcome you here. This is 
one of those odd occasions where I do not have another 
committee. Thank God for snow. So, I look forward to your 
comments, and I will have questions when you are done.
    Thank you.
    Chairman Dodd. Thank you very much.
    Senator Bennett.

             STATEMENT OF SENATOR ROBERT F. BENNETT

    Senator Bennett. Thank you, Mr. Chairman. I had planned to 
follow Senator Bayh's standard, but I have heard so many things 
being said here that I think at least one voice should rise in 
defense, if you will, of where certain things have been going.
    Mr. Chairman, you know my personal affection for you, but 
it will not be a surprise that I disagree with your opening 
statement.
    Chairman Dodd. I am shocked to hear that.
    [Laughter.]
    Senator Bennett. And, by coincidence, I suppose the best 
rebuttal is in a piece that appeared in this morning's paper by 
Brian Wesbury, who is the Chief Economist at First Trust 
Advisors, LP, in Illinois, ``A Portrait of the Economy.'' I 
would ask unanimous consent that the entire piece appear in the 
record.*
---------------------------------------------------------------------------
    * Held in Committee files.
---------------------------------------------------------------------------
    Chairman Dodd. Without objection.
    He starts out, ``It is the best of times. It is the 
scariest of times. Last year, U.S. exports, industrial 
production, real hourly compensation, corporate profits, 
Federal tax revenues, retail sales, GDP, productivity, the 
number of people with jobs, the number of students in college, 
airline passenger traffic, and the Dow Jones Industrial Average 
all hit record levels. For the third consecutive year, global 
growth was strong, continuing to lift and hold millions of 
people out of poverty. From 30,000 feet--heck, from 1,000 feet, 
it sure looks like the best of times. In relative terms, the 
first 5 years of the current recovery have been much better 
than the first 5 years of the 1990's recovery. But this has not 
softened the pessimism of many pundits and politicians who are 
either unimpressed or expect the whole thing to come crashing 
down any minute, unless the Government firmly grabs the rein of 
the global economy and steers it clear of disaster.''
    And then he goes on to outline the history of how badly 
things have gone every time the Government has tried to step in 
and steer it clear, starting with the 1930's and then the 
1970's. He makes this comment about the 1970's, which I 
responded to, and it says, ``Forgotten in the rush to pass 
judgment on capitalism is the fact that the last two times the 
Government seriously tried to control the economies in the 
1930's and 1970's and made a terrible mess of it''--well, I 
will leave the rest of it for people to read, but the one thing 
I would say to you, Mr. Chairman, if he is right--and I think 
he is--in the year of your stewardship, the last year, exports, 
industrial production, real hourly compensation, profits, tax 
revenues, retail sales, all are at record levels, you must have 
been doing a pretty good job. And if you were running for 
office, you would take full credit for absolutely all of it.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator Bennett.
    Senator Brown.

               STATEMENT OF SENATOR SHERROD BROWN

    Senator Brown. Thank you, Mr. Chairman.
    Chairman Bernanke, I appreciate your joining us today to 
share your thoughts on the direction of monetary policy in the 
months ahead. I also appreciate the comments you have made in 
Nebraska and other places before other groups and the steps you 
have taken toward greater transparency.
    I am sure that you can appreciate for most of the families 
in my State of Ohio and elsewhere, many of the issues we 
discuss today are far removed from their day-to-day lives. As 
Senator Menendez said, the uncertainties that middle-class 
families face are not the uncertainties that the columnist that 
Senator Bennett mentioned and others and economists worry about 
as often perhaps as they should.
    I know and appreciate your acknowledging the widening gap 
of income in our society. I commend you for adding your voice 
to that discussion. I agree with you that we should look at 
ways to improve education and training of our citizens, but I 
do not think that is nearly enough. Globalization has had a 
tremendous impact on workers in this country, on communities, 
on teachers, on firefighters, on cities' ability to deliver 
services to their constituents. There is no question that good-
paying manufacturing jobs have gone offshore. Fourteen years 
ago, the trade deficit in this country was $38 billion. Today, 
announced just this week, it exceeds $760 billion. George Bush 
the First said that a $1 billion trade deficit translates into 
13,000 lost jobs. You do the math.
    Of course, we must trade with the world. The question is 
not if we will trade with other countries; rather, it is how we 
will trade with them and who will benefit. If the beneficiaries 
are limited to those with investment capital and the losers too 
often are workers and their communities across the country, we 
simply will not have a very sustainable trade policy. We devote 
substantial time and effort to protecting intellectual property 
in our trade negotiations and enforcement. We need to do this, 
but we exert almost no effort in protecting the rights of our 
workers and their counterparts overseas. That simply has to 
change.
    Many in the media and some in Government label those of us 
who advocate for labor and environmental standards as 
``protectionist.'' Yet when our trade agreements protect the 
drug industry or Hollywood films, we call that simply ``free 
trade.'' If we can protect an Ohio inventor, if we can protect 
pharmaceuticals, if we can protect copyrights, as we should, we 
can do a much better job protecting workers and the 
environment.
    I thank you for your time.
    Chairman Dodd. Thank you very much, Senator.
    Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Thank you, Mr. Chairman. I would like to 
thank you and Senator Shelby for holding this important 
hearing. I always look forward to hearing from Chairman 
Bernanke. I think that you have started off very well in your 
tenure as Chairman of the Federal Reserve, and I want to 
congratulate you on that initial effort. I think you have 
gained the confidence of the markets, and I think you have 
gained the confidence of many Members of the Congress, although 
there are a few skeptics still among us.
    I would like to emphasize that the economy is doing well. 
If we look at economic growth, this last year it is 3.4 
percent; the previous year it was 3.2 percent. The average over 
20 years is 3.1 percent. So we are above the average in 
economic growth. I think a lot of that is attributable to the 
economic growth package that we put in place in 2003 and the 
tax cuts that we had in 2001. We have heard a lot of comments 
here in this Committee about how it is going to impact the 
family. In my view, the hardest-working American is the small 
businessman, and those economic growth packages were targeted 
to the small businessman. That is where economic growth occurs. 
There are Members in Congress that are pushing hard to do away 
with those temporary tax reductions that we put in place to 
stimulate the economy.
    My question to you is: I hope you will address this. If we 
let those temporary tax cuts go away, what kind of impact is it 
going to have on the average family? I think it is going to 
have a dramatic impact, particularly on the hard-working men 
and women of this country who are in business for themselves. 
And I hope that you can address that in your comments.
    Thank you very much.
    Chairman Dodd. Thank you, Senator Allard.
    Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Thank you, Mr. Chairman, and thank you, 
Chairman Bernanke, for joining us today. Your task in setting 
the right course of monetary policy is complicated by fiscal 
policy and international imbalances. We no longer have the 
fiscal discipline that we had in the 1990's which allowed for a 
monetary policy that was more encouraging of robust investment 
and long-term growth.
    The present large and persistent budget deficits have led 
to an ever-widening trade deficit that forces us to borrow vast 
amounts from abroad and puts us at risk of a major financial 
collapse if foreign lenders suddenly stop accepting our IOU's. 
Continued budget and trade deficits will be a drag on the 
growth of our standard of living and leave us ill prepared to 
deal with the effects of the retirement of the baby-boom 
generation. Strong investment, financed by our own national 
saving, not foreign borrowing, is the foundation of a strong 
and sustained economic growth and rising standards of living.
    One final issue that I would like to raise is the growing 
inequality of income earnings and wealth in the U.S. economy. 
Between 2003 and 2005, GDP grew at a rate of 3.5 percent per 
year. However, after adjusting for inflation, the typical 
weekly earnings of full-time wage and salary workers at the 
median of the earnings distribution went up only 0.6 percent 
between the end of 2000 and the end of 2006. Obviously, these 
median workers are not sharing in that robust GDP.
    Data from the Federal Reserve Board Survey of Consumer 
Finances show that household wealth is very unevenly 
distributed. The wealthiest 1 percent of families held more of 
the country's wealth than the bottom 90 percent of families 
combined. Even more disturbing is the large number of families, 
particularly African-American and Hispanic communities, that 
have little or no net wealth.
    Chairman Bernanke, I was heartened to read you comments in 
Omaha last week emphasizing the importance of education and 
training in reducing this economic inequality. And I know you 
share the concern that widening inequality is not good for our 
democracy and the fabric of the country. So, I hope you will 
agree there is an inconsistency at best in the Administration's 
pursuit of tax breaks for those who are already well off, 
including the permanent elimination of the estate tax, while 
continuing to propose cuts to elementary and secondary 
education, student aid and loan assistance for higher 
education, and job training for displaced workers. The 
challenges facing our economy are compounded by the disarray 
that characterizes our fiscal policy. We have been running 
unsustainable fiscal deficits, and in order to make the 
necessary investments in training and education, we must 
reverse this course. And I would be remiss if I did not note 
that the lead story today in most of the wire services is that 
Chrysler is cutting 13,000 jobs. I suspect that will probably 
raise the stock of Chrysler, make the investors happy, and 
investment bankers who are structuring the transformation of 
the company; it is necessary perhaps to do. But for 13,000 
Americans who used to have good jobs with good health benefits, 
they are in a quandary, and our obligation is to them as well 
as it is to the shareholders of that company.
    So, I think we have to do a lot more, and I think you do 
sense that, and I think together, hopefully, we can make some 
progress.
    Chairman Dodd. Thank you, Senator Reed.
    Senator Sununu.

              STATEMENT OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Thank you very much, Mr. Chairman.
    Senator Bennett, I thought, was somewhat eloquent in 
talking about the very positive trends we have seen in the 
economy: Record job creation and above average recovery period, 
record homeownership, rising income levels. It is fair to say, 
though, for any Member who has spent a little time back home, 
there is a sense of insecurity that can be felt even in what 
are relatively strong economic times. And I think that is an 
issue or a set of issues dealing with their insecurity or 
uncertainty that we should deal with as policymakers and 
perhaps that at some level can even be addressed by the Fed. 
But I think it is important to understand that the role of the 
Fed is not to redistribute wealth, not to raise taxes, not to 
establish protectionist trade measures. And I think that is a 
good thing. I suspect maybe Chairman Bernanke thinks that is a 
good thing, because he has a tall enough order as it is.
    The areas where the Fed can have a very positive impact 
within their mission are to deal with the uncertainties of 
inflation, the uncertainties of establishing a sustainable and 
steady record of economic growth, the security that comes from 
the establishment of safe and sound financial markets. And 
those are all responsibilities of the Fed, I think 
responsibilities that Chairman Bernanke takes very seriously. 
You have spoken very well to those issues in the past, and I 
look forward to hearing your comments on those and other issues 
this morning.
    Thank you Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator Sununu.
    Mr. Chairman, we welcome you again to the Committee. We are 
anxious to hear your comments, and your full statement and 
supporting documents will, of course, be a part of the record.

            STATEMENT OF BEN S. BERNANKE, CHAIRMAN,

           BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM

    Chairman Bernanke. Thank you. Chairman Dodd, Senator 
Shelby, and other Members of the Committee, I am pleased to 
present the Federal Reserve's Monetary Policy Report to the 
Congress. Real activity in the United States expanded at a 
solid pace in 2006, although the pattern of growth was uneven. 
After a first-quarter rebound from weakness associated with the 
effects of the hurricanes that ravaged the Gulf Coast the 
previous summer, output growth moderated somewhat on average 
over the remainder of 2006. Real gross domestic product is 
currently estimated to have increased at an annual rate of 
about 2.75 percent in the second half of the year.
    As we anticipated in our July report, the U.S. economy 
appears to be making a transition from the rapid rate of 
expansion experienced over the preceding several years to a 
more sustainable average pace of growth. The principal source 
of the ongoing moderation has been a substantial cooling of the 
housing market, which has led to a marked slowdown in the pace 
of residential construction. However, the weakness in housing 
market activity and the slower appreciation of house prices do 
not seem to have spilled over to any significant extent to 
other sectors of the economy.
    Consumer spending has continued to expand at a solid rate, 
and the demand for labor has remained strong. On average, about 
165,000 jobs per month have been added to nonfarm payrolls over 
the past 6 months, and the unemployment rate, at 4.6 percent in 
January, remains low.
    Inflation pressures appear to have abated somewhat 
following a run-up during the first half of 2006. Overall 
inflation has fallen in large part as a result of declines in 
the price of crude oil. Readings on core inflation--that is, 
inflation excluding the prices of food and energy--have 
improved modestly in recent months. Nevertheless, the core 
inflation rate remains somewhat elevated.
    In the five policy meetings since the July report, the 
Federal Open Market Committee, or FOMC, has maintained the 
Federal funds rate at 5.25 percent. So far the incoming data 
have supported the view that the current stance of policy is 
likely to foster sustainable economic growth and the gradual 
ebbing of core inflation. However, in the statement 
accompanying last month's policy decision, the FOMC again 
indicated that its predominant policy concern is the risk that 
inflation will fail to ease as expected and that it is prepared 
to take action to address inflation risks if developments 
warrant.
    Let me now discuss the economic outlook in a little more 
detail, beginning with developments in the real economy and 
then turning to inflation. I will conclude with some brief 
comments on monetary policy.
    Consumer spending continues to be the mainstay of the 
current economic expansion. Personal consumption expenditures, 
which account of more than two-thirds of aggregate demand, 
increased at an annual rate of about 3.5 percent in real terms 
during the second half of last year, broadly matching the brisk 
pace of the previous 3 years. Consumer outlays were supported 
by strong gains in personal income, reflecting both the ongoing 
increases in payrolled employment and a pick-up in the growth 
of real wages. Real hourly compensation, as measured by 
compensation per hour in the nonfarm business sector deflated 
by the personal consumption expenditures price index, rose at 
an annual rate of around 3 percent in the latter half of 2006.
    The resilience of consumer spending is all the more 
striking given the backdrop of the substantial correction in 
the housing market that became increasingly evident during the 
spring and summer of last year. By the middle of 2006, monthly 
sales of new and existing homes were about 15 percent lower 
than a year earlier, and the previously rapid rate of house 
price appreciation had slowed markedly.
    The fall in housing demand in turn prompted a sharp slowing 
in the pace of construction of new homes. Even so, the backlog 
of unsold homes rose from about 4\1/2\ months' supply in 2005 
to nearly 7 months' supply by the third quarter of last year. 
Single-family housing starts have dropped more than 30 percent 
since the beginning of last year, and employment growth in the 
construction sector has slowed substantially.
    Some tentative signs of stabilization have recently 
appeared in the housing market. New and existing home sales 
have flattened out in recent months. Mortgage applications have 
picked up, and some surveys find that homebuyers' sentiment has 
improved. However, even if housing demand falls no further, 
weakness in residential investment is likely to continue to 
weigh on economic growth over the next few quarters as 
homebuilders seek to reduce their inventories of unsold homes 
to more comfortable levels.
    Despite the ongoing adjustments in the housing sector, 
overall economic prospects for households remain good. 
Household finances appear generally solid, and delinquency 
rates on most types of consumer loans and residential mortgages 
remain low. The exception is subprime mortgages with variable 
interest rates, for which delinquency rates have increased 
appreciably.
    The labor market is expected to stay healthy, and real 
incomes should continue to rise, although the pace of 
employment gains may be slower than that to which we have 
become accustomed in recent years. In part, slower average job 
growth may simply reflect the moderation of economic activity. 
Also, the impending retirement of the leading edge of the baby-
boom generation and an apparent leveling out from women's 
participation in the workforce, which had risen for several 
decades, will likely restrain the growth of the labor force in 
coming years. With fewer job seekers entering the labor force, 
the rate of job creation associated with the maintenance of 
stable conditions in the labor market will decline.
    All told, consumer expenditures appear likely to expand 
solidly in coming quarters, albeit a little less rapidly than 
the growth in personal incomes, if, as we expect, households 
respond to the slow pace of home equity appreciation by saving 
more out of current income.
    The business sector remains in excellent financial 
condition with strong growth and profits, liquid balance 
sheets, and corporate leverage near historical lows. Last year, 
those factors helped to support continued advances in business 
capital expenditures. Notably, investment in high-tech 
equipment rose 9 percent in 2006, and spending on 
nonresidential structures, such as office buildings, factories, 
and retail space, increased rapidly through much of the year, 
after several years of weakness.
    Growth in business spending slowed toward the end of last 
year, reflecting mainly a deceleration of spending on business 
structures, a drop in outlays in the transportation sector 
where spending is notably volatile, and some weakness in 
purchases of equipment related to construction and motor 
vehicle manufacturing.
    Over the coming year, capital spending is poised to expand 
at a moderate pace, supported by steady gains in business 
output and favorable financial conditions. Inventory levels in 
some sectors, most notably at motor vehicle dealers and in some 
construction-related manufacturing industries, rose over the 
course of last year, leaving some firms to cut production to 
better align inventories with sales. Remaining imbalances may 
continue to impose modest restraint on industrial production 
during the early part of this year.
    Outside the United States, economic activity in our major 
trading partners has continued to grow briskly. The strength of 
demand abroad helped stir a robust expansion in U.S. real 
exports, which grew about 9 percent last year. The pattern of 
real U.S. imports was somewhat uneven, partly because of 
fluctuations in oil imports over the course of the year. On 
balance, import growth slowed in 2006 to 3 percent.
    Economic growth abroad should further support steady growth 
in U.S. exports this year. Despite the improvements in trade 
performance, the U.S. current account deficit remains large, 
averaging about 6.5 percent of nominal GDP during the first 
three quarters of 2006.
    Overall, the U.S. economy seems likely to expand at a 
moderate pace this year and next, with growth strengthening 
somewhat as the drag from housing diminishes. Such an outlook 
is reflected in the projections that the members of the Board 
of Governors and presidents of the Federal Reserve Banks made 
around the time of the FOMC meeting late last month. The 
central tendency of those forecasts, which are based on the 
information available at that time and on the assumption of 
appropriate monetary policy, is for real GDP to increase about 
2.5 to 3 percent in 2007 and about 2.75 to 3 percent in 2008. 
The projection for GDP growth in 2007 is slightly lower than 
our projection last July. The difference partly reflects an 
expectation of somewhat greater weakness in residential 
construction during the first part of this year than we 
anticipated last summer. The civilian unemployment rate is 
expected to finish both 2007 and 2008 around 4.5 to 4.75 
percent.
    The risks to this outlook are significant. To the downside, 
the ultimate extent of the housing market correction is 
difficult to forecast and may prove greater than we anticipate. 
Similarly, spillover effects from developments in the housing 
market onto consumer spending and employment in housing-related 
industries may be more pronounced than expected. To the upside, 
output may expand more quickly than expected if consumer 
spending continues to increase at the brisk pace seen in the 
second half of 2006.
    I turn now to the inflation situation. As I noted earlier, 
there are some indications that inflation pressures are 
beginning to diminish. The monthly data are noisy, however, and 
it will consequently be some time before we can be confident 
that underlying inflation is moderating as anticipated.
    Recent declines in overall inflation have primarily 
reflected lower prices for crude oil, which have fed through to 
the prices of gasoline, heating oil, and other energy products 
used by consumers. After moving higher in the first half of 
2006, core consumer price inflation has also edged lower 
recently, reflecting a relatively broad-based deceleration in 
the prices of core goods. That deceleration is probably also 
due to some extent to lower energy prices, which have reduced 
costs of production and thereby lessened one source of pressure 
on the prices of final goods and services. The ebbing of core 
inflation has likely been promoted as well by the stability of 
inflation expectations.
    A waning of the temporary factors that boosted inflation in 
recent years will probably help to foster a continued edging 
down of core inflation. In particular, futures quotes imply 
that oil prices are expected to remain well below last year's 
peak. If actual prices follow the path currently indicated by 
futures prices, inflation pressures would be reduced further as 
the benefits of the decline in oil prices from last year's high 
levels are passed through to a broader range of core goods and 
services.
    Non-fuel import prices may also put less pressure on core 
inflation, particularly if price increases for some other 
commodities, such as metals, slow from last year's rapid rates. 
But as we have been reminded only too well in recent years, the 
prices of oil and other commodities are notoriously difficult 
to predict, and they remain a key source of uncertainty to the 
inflation outlook.
    The contribution from rents and shelter costs should also 
fall back following a step-up last year. The faster pace of 
rent increases last year may have been attributable in part to 
reduced affordability of owner-occupied housing, which led to a 
greater demand for rental housing. Rents should rise somewhat 
less quickly this year and next, reflecting recovering demand 
for owner-occupied housing as well as increases in the supply 
of rental units, but the extent and pace of that adjustment are 
not yet clear.
    Upward pressure on inflation could materialize if final 
demand were to exceed the underlying productive capacity of the 
economy for a sustained period. The rate of resource 
utilization is high, as can be seen in rates of capacity 
utilization above their long-term average, and most evidently 
in the tightness of the labor market. Indeed, anecdotal reports 
suggest that businesses are having difficulty recruiting well-
qualified workers in certain occupations. Measures of labor 
compensation, though still growing at a moderate pace, have 
shown some signs of acceleration over the past year, likely in 
part the result of tight labor market conditions.
    The implications for inflation of faster growth in nominal 
labor compensation depend on several factors. Increases in 
compensation might be offset by higher labor productivity or 
absorbed by a narrowing of firms' profit margins rather than 
passed on to consumers in the form of higher prices. In these 
circumstances, gains in nominal compensation would translate 
into gains in real compensation as well.
    Underlying productivity trends appear favorable, and the 
mark-up of prices over unit labor cost is high by historical 
standards, so such an outcome is certainly possible. Moreover, 
as activity expands over the next year or so at the moderate 
pace anticipated by the FOMC, pressures in both labor and 
product markets should ease modestly. That said, the 
possibility remains that tightness in product markets could 
allow firms to pass higher labor costs through their prices, 
adding to inflation and effectively nullifying the purchasing 
power of at least some portion of the increase in labor 
compensation. Thus, the high level of resource utilization 
remains an important upside risk to continued progress on 
inflation.
    Another significant factor influencing medium-term trends 
in inflation is the public's expectations of inflation. These 
expectations have an important bearing on whether transitory 
influences on prices, such as those created by changes in 
energy costs, become embedded in wage and price decisions and 
so leave a lasting imprint on the rate of inflation. It is 
encouraging that inflation expectations appear to have remain 
contained.
    The projections of the members of the Board of Governors 
and the presidents of the Federal Reserve Banks are for 
inflation to continue to ebb over this year and next. In 
particular, the central tendency of those forecasts is for core 
inflation, as measured by the price index for personal 
consumption expenditures, excluding food and energy, to be 2 to 
2.25 percent this year and to edge lower to 1.75 to 2 percent 
next year. But as I noted earlier, the FOMC has continued to 
view the risk that inflation will not moderate as expected as 
the predominant policy concern.
    Monetary policy affects spending and inflation with long 
and variable lags. Consequently, policy decisions must be based 
on an assessment of medium-term economic prospects. At the same 
time, because economic forecasting is an uncertain enterprise, 
policymakers must be prepared to respond flexibly to 
developments in the economy when those developments lead to a 
reassessment of the outlook. The dependence of monetary policy 
actions on a broad range of incoming information complicates 
the public's attempts to understand and anticipate policy 
decisions.
    Clear communication by the central bank about the economic 
outlook, the risks to that outlook, and its monetary policy 
strategy can help the public to understand the rationale that 
is behind policy decisions and to anticipate better the central 
bank's reaction to new information. This understanding should 
in turn enhance the effectiveness of policy and lead to 
improved economic outcomes. By reducing uncertainty, central 
bank transparency may also help anchor the public's longer-term 
expectations of inflation.
    Much experience has shown that while anchored inflation 
expectations tend to help stabilize inflation and promote 
maximum sustainable economic growth, good communication by the 
central bank is also vital for ensuring appropriate 
accountability for its policy actions, the full effects of 
which can be observed only after a lengthy period. A 
transparent policy process improves accountability by 
clarifying how a central bank expects to attain its policy 
objectives and by ensuring that policy is conducted in a manner 
that can be seen to be consistent with achieving those 
objectives.
    Over the past decade or so, the Federal Reserve has 
significantly improved its methods of communication, but 
further progress is possible. As you know, the FOMC last year, 
established a subcommittee to help the full committee evaluate 
the next steps in this continuing process. Our discussions are 
directed at examining all aspects of our communications and 
have been deliberate and thorough. These discussions are 
continuing, and no decisions have been reached.
    My colleagues and I remain firmly committed to an open and 
transparent monetary policy process that enhances our ability 
to achieve our dual objectives of stable prices and maximum 
sustainable employment. I will keep Committee Members apprised 
of the developments as our deliberations move forward. I look 
forward to continuing to work closely with the Members of the 
Committee and your colleagues in the Senate and the House on 
the important issues pertaining to monetary policy and the 
other responsibilities with which the Congress has charged the 
Federal Reserve.
    Thank you. I would be happy to take questions.
    Chairman Dodd. Thank you very much, Mr. Chairman, for a 
very comprehensive statement. What I am going to do is we will 
have 7 minutes per Member. I will not hold to that so tightly. 
I would just ask Members to be conscious of the time, and you 
have the clocks in front of you here so we can make sure 
everybody has adequate time to ask questions and give you an 
adequate time to respond to them as well.
    Let me pick up, if I can, a number of my colleagues 
referred to your speech in Omaha. Senator Hagel talked about 
your reception there and the comments you made about income 
inequality, and I want to pick up on those comments, if I can 
as well.
    I think all of us recognize here, I would say to my friend 
from Utah, we are all very conscious the tremendous wealth that 
has been created in certain sectors of our economy, that there 
are good things that are happening. None of us is suggesting 
all is bad.
    There is a sense, as Senator Sununu has said, and others, 
of uncertainty that people are feeling across the country about 
the long-term economic growth and stability of the Nation. And 
I think those of us who are expressing those views to you here, 
Mr. Chairman, probably reflect your comments as well as I read 
them. Your quote in Omaha, ``By many measures, inequality in 
economic outcomes has increased over time.''
    Your predecessor, Chairman Greenspan, was very concerned 
about the growth in income inequality as well. He testified, 
``I think the income distribution issue is very critical 
because we cannot have a significant inequality of income and 
expect to have support for the type of institutions that have 
been made this country great.''
    Do you share Chairman Greenspan's concern, Mr. Chairman, 
that continued economic growth of inequality is a significant 
threat to our Nation's fundamental promise of economic 
opportunity? Do you suggest by your comments here that we 
should have a balanced view? I just left a markup a few minutes 
ago before coming here, marking up a new Head Start bill that 
will hopefully deal with greater accountability, but serving 
about 900,000 to 1 million young people in this country in the 
past 41 or 42 years that has tried to give those children an 
opportunity to become active and successful members of our 
economy in the future.
    I am concerned as we look at this that the decisions we 
make here will lack that kind of balance, and your comments 
seem to suggest a similar train of thought. And I wonder if you 
might just take a few more minutes this morning to expound on 
those comments in Omaha, and just a general observation. I am 
not asking if you endorse a specific spending program here and 
there, but just your general observation about this inequality 
issue and your concern that you obviously expressed in Omaha.
    Chairman Bernanke. Thank you, Mr. Chairman. The very 
important drivers of economic growth and prosperity in this 
country include free and open trade and technological progress. 
It is very important to allow those forces to continue to 
operate in our economy. However, we do have to recognize, as I 
discussed in Omaha, that the effects of these forces can be 
differential across the population. They may create greater 
income possibilities for some than others. They may create 
painful dislocations, for example, if the composition of 
industries changes or job skill requirements change.
    I agree with Chairman Greenspan's general point that in 
order to support and retain support for policies of free trade, 
open borders, technological change, flexible labor markets, we 
need to make sure that the gains and benefits from these 
powerful, growth-producing forces are broadly shared and that 
people understand that these things are good for the American 
economy and good for people generally in the economy.
    How to do that is very difficult. It is easy enough to say 
let us promote economic opportunity. I certainly support that 
idea. Doing it is not necessarily easy. I discussed in my 
speech some general issues and approaches, including education, 
not only K-12 education but also training throughout the life 
span, from early childhood through adult retraining. We need to 
help people who are dislocated by these powerful dynamic forces 
to find new jobs, to find new opportunities. I think that is 
very important.
    I would just say, though, that I am glad you did not ask me 
to endorse specific policies, because making that work in 
practice is difficult. We have to find ways to achieve these 
objectives. For example, retraining workers in ways that are 
effective, and are effective in terms of the spending that we 
put into it.
    So it is a great challenge for us going forward to look 
among all the possible approaches and decide which types of 
programs, which types of initiatives will be most effective at 
achieving this objective.
    That being said, again, I do agree that we need to spread 
the benefits widely and make people understand that open trade 
and technological change are beneficial for not only the 
economy in the aggregate, but also for the great majority of 
people in the economy.
    Chairman Dodd. Well, I do not know if you had the chance to 
read a report called ``The Gathering Storm.'' It was prepared 
by a number of senior retired corporate executives along with 
some of our leading academicians in the country about a year 
and a half ago who took a month off and examined where we were 
in K-12 in science and math--again, without getting into the 
specifics of individual programs, but they were very cautious. 
In fact, they warned us, all of us, those of us who sit on this 
side of the dais, as well as others across the country, that if 
we did not make some investments in the quality of education, 
particularly in math and science, we could find abrupt changes 
occurring in our country very quickly in this century.
    I do not know if you have had an opportunity to look at 
that report or not, whether or not you agree with their 
conclusions about your concerns over whether or not this 
inequality could be exacerbated by the failure of us to have a 
level of education, investments in education from that earliest 
early childhood area through the higher educational 
opportunity.
    Chairman Bernanke. Mr. Chairman, I did read that report. It 
had a lot of interesting things to say. I think if you look at 
it carefully, it suggests that the issues are different in 
different parts of the educational system. For example, our 
universities remain very strong. Our research universities lead 
the world. So in terms of research, development, innovation, 
and so on, the United States retains substantial leadership in 
the world. But in other parts of the educational system, 
perhaps in elementary school, for example, we are probably not 
doing what we should in terms of ensuring that all children 
have opportunities to learn math and science and the 
applications of those areas.
    Again, my wife is a teacher, and I have been in education 
for a long time. I was on the school board for many years, so I 
am very sensitive to these issues. But I also appreciate from 
those particular positions that we have been worrying about 
educational quality for a long time, and it is a difficult 
thing to achieve. I encourage continued thought and continued 
efforts to improve these vital components of our economy 
without having any delusions about how difficult that really is 
to accomplish effectively.
    Chairman Dodd. I thank you for that.
    I am going to turn to my colleague from Alabama, but I will 
probably send this as a written question, unless one of my 
colleagues raises it with you here.
    Back in December, Senator Sarbanes, Senator Allard, Senator 
Reed, Senator Bunning, Senator Schumer, and myself sent you and 
other regulators a letter regarding these exotic mortgages. We 
had a hearing here the other day, and I have talked about this. 
I am a strong advocate of subprime lending. It has made a huge 
difference in accessibility to homeownership. I am also 
simultaneously very concerned about the predatory lending 
practices that go on. That concern about providing those 
subprime borrowers with the same kind of protections we do to 
the prime borrowers is a matter of concern to many of us here 
on this Committee.
    The letter we got back, frankly, Mr. Chairman, was a little 
inadequate. The notion, ``We are thinking about it,'' was nice 
to know, but I think many of us would like to know they are 
taking some additional steps. And, again, I will make this a 
written question to you, but I am very concerned about this 
issue, and some of the data we are receiving were as many as 2 
million of our fellow citizens may be foreclosed out of their 
homes because of predatory practices.
    Again, I will not ask you here. I want to turn to Senator 
Shelby, but I want to raise that issue with you and ask you to 
be thinking about it because it is an important concern for 
many of us.
    Senator Shelby.
    Senator Shelby. Thank you, Chairman Dodd.
    Chairman Bernanke, the Federal Open Market Committee has 
held the Federal funds rate target at 5.25 percent since June 
2006. In the FOMC statement following your most recent meeting 
in January, the FOMC noted, ``the high level of resource 
utilization has the potential to sustain inflation pressures. 
The Committee judges that some inflation risks remain.''
    Mr. Chairman, what data related to resource utilization 
will you be paying the closest attention to between now and the 
next FOMC meeting in March?
    Chairman Bernanke. Senator, a flip answer is, 
``Everything.'' I should be clear: Our concern is not about the 
labor market per se. Our concern is about the overall balance 
of spending and productive capacity.
    Senator Shelby. The whole picture.
    Chairman Bernanke. The whole picture. The Federal Reserve 
contributes to setting overall financial conditions, which in 
turn stimulates spending by consumers and businesses on the 
product of our companies.
    If spending is growing more quickly than the underlying 
productive capacity for a sustained period, we risk creating 
inflation which will then make it more difficult to sustain a 
healthy expansion over a longer period of time.
    So we are looking for evidence that consumption spending 
and other components of spending growth are exceeding the 
underlying capacity. In doing so, we look at a wide variety of 
indicators, including the strength of various spending 
components, measures of resource utilization, which include not 
only capacity utilization and unemployment, but also many 
indicators in labor markets and capital markets.
    We also look very much at prices because they are the 
canary in the coal mine. If prices begin to rise, that is 
indicative that there is too much demand given the amount of 
supply.
    We do not have any fixed speed limit in mind when we think 
about the economy going forward. We do not have any fixed 
number for the unemployment rate. But rather, we are looking at 
the overall balance of supply and demand, looking at the 
evolution of inflation, and trying to ensure that there is a 
reasonable balance between demand and supply so that our 
economy can continue to grow at a sustainable, moderate pace 
going forward.
    Senator Shelby. Is your economic goal here basically price 
stability?
    Chairman Bernanke. Price stability consistent with strong 
employment as well.
    Senator Shelby. Productivity. The President's economic 
report noted that between 2000 and 2005, productivity growth in 
the United States accelerated to about 3 percent, Mr. Chairman, 
the fastest growth of any G-7 country, which includes Canada, 
France, Germany, Italy, Japan, and the United Kingdom. Most 
other major industrialized countries suffered a slowdown in 
productivity growth.
    What factors do you believe explain the difference in 
productivity growth given that the other G-7 countries also 
have access to the same technological improvements and broad 
capital markets the United States has? And could you expand on 
these differences in productivity, what productivity implies 
for our standard of living and our long-term growth?
    Chairman Bernanke. Senator, you are quite correct that 
productivity began to grow more quickly in the United States 
about a decade ago, and that has been a very important factor 
in the strength of our economy.
    In 1995, we saw a step-up in productivity growth from 1.5 
to 2.5 percent, which seems to have been driven primarily by 
improved and more efficient methods of producing high-tech 
equipment--faster computers, stronger, better communications 
equipment, and the like.
    Over the succeeding few years--and, in fact, we saw 
productivity growth step up further around 2000--those 
technological innovations had been diffused through the economy 
and helping industries across the economy manage their 
production and distribute their output more efficiently, and 
reduce costs and increase productivity. So in some sense, the 
underlying factor is the technological change, the investment 
in information and communications technologies, and the 
diffusion of those technologies throughout the economy.
    Now, you ask, quite properly, why we have seen better 
results here in the United States than in some other countries, 
and I have given some speeches on that subject. I do believe 
that it is the interaction of the new technologies and our 
flexible dynamic economic system. That includes flexible labor 
markets that can adjust to changes in the market associated 
with technological change. That includes deep and liquid 
capital markets that can allocate capital toward new ventures, 
toward new technologies. And I believe that flexibility has 
been essential in helping us take technological advances and 
create from them economic benefits. This relates to my answer 
to Chairman Dodd that we need to maintain that flexibility in 
our economy and that providing broad opportunity and education 
is one way to support that going forward.
    Senator Shelby. Mr. Chairman, I want to get to another part 
of your responsibilities, and that is, bank regulation. 
Regulation Z, Senator Dodd has already referred to this. The 
Banking Committee held a hearing on the credit card industry 
that was widely followed. Witnesses at the hearing highlighted 
a number of troubling industry practices, many of which are 
subject to Federal Reserve oversight. I understand that the 
Federal Reserve Board is currently reviewing its Regulation Z, 
which implements the Truth in Lending Act.
    What is the status of the Board's Regulation Z review? And 
does the Board intend to use this review to address any of the 
questionable industry practices raised in the Committee's 
hearing?
    Chairman Bernanke. Senator, we have been putting a great 
deal of effort into our review of Regulation Z, with a 
particular focus on short-term revolving credit, like credit 
cards. One of the real challenges in improving disclosures for 
credit cards and other types of lending is to make the 
disclosures both compliant with legal requirements, but also 
sufficiently clear and understandable that people can 
understand what it is that they are getting into.
    In order to improve the understandability and the clarity 
of disclosures, the Federal Reserve has conducted extensive 
consumer testing. We have not just done it in the ivory tower, 
as somebody mentioned. We have gone out into the public and 
conducted focus groups. We have done psychological testing to 
try to figure out how to structure disclosures in a way that 
people will notice them, pay attention to them, and understand 
them. So that has been a big part of our effort.
    We are very close to the end of that effort. We expect to 
have a proposed rule out within a few months, by the middle of 
this year, and I believe and hope that it will address many of 
the appropriate concerns that people have had about disclosures 
and practices in the credit card industry and other short-term 
debt.
    Senator Shelby. Chairman Dodd, I know my time is up, but 
could I just ask the Chairman a question for the record? I 
think it would take some time.
    We have been concerned for some time about the 
implementation of the Basel II Capital Accord and the impact 
that Basel II may have on safety and soundness of the U.S. 
banking system. I am worried that Basel II may lead to a sharp 
reduction in the amount of capital banks are required to hold, 
which would put U.S. taxpayers ultimately at risk of having to 
pay for expensive bank failures, if there are some. I believe 
that it is critical that Basel II be implemented with the 
utmost care and diligence.
    Mr. Chairman, would you for the record update the Committee 
on the status of Basel II Capital Accords, the current time 
frame for implementing Basel II, and also comment on whether 
there is another time for banking regulators, including 
yourself, to finalize the rules in implementing Basel II so 
that banks adopting Basel II can start the test run for Basel 
II presently scheduled to begin next year? If you care to, you 
can do it for the record.
    Chairman Bernanke. Should I answer, Mr. Chairman?
    Chairman Dodd. We will make that for the record, and let me 
add to that quickly before turning to Senator Schumer. Some of 
my bankers have raised the issue, too, about foreign 
acquisition of domestic banks and whether or not they are 
really meeting the capital requirements today. We have some 
real concerns raised by my bankers in Connecticut about this 
issue. They follow it very closely. And I would add that to the 
question that Senator Shelby has raised with you, whether or 
not that is something we should be looking more closely at. Are 
they actually meeting those criteria before those acquisitions 
occur?
    Senator Schumer.
    Senator Schumer. Thank you, Mr. Chairman, and it is your 
first year. You have completed a year. You are getting good 
grades everywhere, and I would concur. I think you are doing a 
fine job and have vindicated the support that you received 
almost unanimously from this Committee.
    My first question deals with the issues of income 
inequality in the speech you gave yesterday where you pointed 
out that this has just been an ideas, almost instantaneous, 
economy and wealth agglomerates to the top. You talked about 
Manny Ramirez. I would like to talk about Henry Ford, his great 
idea. He deserved to become rich from it, but he needed a 
million people to carry it out, and each of them made $10,000 a 
year to make the cars, distribute the cars.
    Bill Gates, maybe the Henry Ford of our generation, had 
another. He mass produced in a certain sense computer 
platforms, but he needed 10,000 people to carry it out, and 
they each made a couple million dollars.
    Given that this is happening--and it is not the 
Government's doing. This is just the nature of our economy, as 
you pointed out in the speech. Doesn't it make sense, if this 
goes too far, to have a more progressive tax code, even though 
Government did not cause it, to keep a middle-class base, to 
keep too much wealth from agglomerating at the top? I am not 
asking you any specific policy, but just a general view that 
wouldn't progressivity, further progressivity in the tax code 
help be an antidote to the natural flow of money to the very 
top, to the few who create those new ideas and deserve to make 
money from that and not get in the way of doing that?
    Chairman Bernanke. Senator, your comparison of Henry Ford 
and Bill Gates was very telling, actually. Henry Ford developed 
the assembly line, and it allowed relatively low-skilled 
workers to be very productive in that context and generated 
high wages for those workers.
    Bill Gates created a new model of operating systems in the 
high-tech industry. The kinds of workers he needed were much 
more skilled workers.
    Senator Schumer. Exactly, and many fewer of them as well.
    Chairman Bernanke. And fewer of them, certainly. So, I 
think that one very important lesson from that comparison is 
that those who are going to benefit the most from globalization 
and technology are those who have the skills, who have the 
capabilities to benefit and to be productive in that context.
    So, I would say whatever we do with tax policy and transfer 
policy, I hope that we will try to address the issues of skills 
and individual productivity.
    Senator Schumer. I agree with you completely. But that is 
going to take a while.
    Chairman Bernanke. Senator, on the issue of progressivity, 
you will be unsatisfied. As the head of the nonpartisan central 
bank, I think it is very important for me not to take sides on 
issues where values are very important.
    Senator Schumer. Talking about more money or more help for 
education is as much a policy decision as talking about the 
progressivity of the code. I am not asking you about a specific 
policy, and I think you should address it.
    Chairman Bernanke. Senator, I am sorry, I decline, because 
there really is a value judgment involved in trading off--I 
talked about this in my inequality speech. I said, on the one 
hand, you have the importance of promoting incentives. Senator 
Bennett mentioned entrepreneurs, people who take risks. We have 
to give them incentives to take risks. On the other hand, as 
you point out, correctly the tax code has an important role to 
play in generating more equality. But I am not an elected 
official, so I cannot comment.
    Senator Schumer. Okay. I think you are ducking it, in all 
due respect, because you do talk about other policy issues, but 
let me move on.
    Trade deficit. Are you happy with the size of the trade 
deficit, at the rate of its growth? And do you think stronger 
policies, particularly against those who we have huge balance 
of trade deficits with to open their markets, not particularly 
to close ours, would be helpful in reducing the trade deficit? 
Obviously, my focus is on China, but I would ask a more general 
question.
    So, the first question, are you happy with the size of the 
deficit and its rate of growth?
    Chairman Bernanke. No, I am not happy with it.
    Senator Schumer. Do you think policies that would not 
require, but importune other countries whose markets are not as 
open as ours to open theirs would be a salutary change and that 
we should emphasize that as a, if you will, pro-free trade way 
to deal with the trade deficit?
    Chairman Bernanke. Senator, I am entirely in favor of 
trying to open markets. We have the World Trade Organization, 
and China is a signatory. We should aggressively pursue 
attempts to open markets to foreign investment and----
    Senator Schumer. Do you think the Chinese have done enough 
on their currency?
    Chairman Bernanke. They have moved in the right direction, 
but, no, I do not think they have done enough.
    With respect to trade, though, I would like to add that 
trade policies alone are not going to resolve the trade 
deficit. There is also the issue of saving and investment, 
which we do need to address as well.
    Senator Schumer. I think I agree with you on that.
    Senators Graham, Baucus, Grassley, and myself are going to 
try to do a WTO-friendly way or compliant way of getting the 
Chinese to do more on currency, and I hope you will look at 
that carefully and be supportive.
    A final question is on competitiveness of our financial 
institutions and industries. Coming from New York, I am 
obviously concerned, but so should my colleagues from many 
other States be. The Carolinas, South Dakota, New Jersey, so 
many other States have a stake here. And the problem we seem to 
be facing is this: That other regulatory and legal schemes--you 
know, regimens in other countries are looser than ours. And now 
that capital can flow quite freely, companies who are 
international and their loyalty to their stockholders means 
they are not going to be loyal to the United States or it will 
precede their loyalty to the United States may seek the lowest 
common denominator or a lower common denominator. And the 
pretty exquisite balance between regulation and 
entrepreneurialness that we have had over the last quarter of 
the last century seems to be in some trouble, that people are 
fleeing to go to less regulated places for their short-term 
gain, even if it creates problems in the system as a whole.
    Could you comment on that problem? Do you think it is a 
real one? Do you think it is only caused by simply knowledge 
spreading and the Internet or is caused by some of these 
regulatory differences? And do you think we should look at that 
in a policy way to do something about it?
    Chairman Bernanke. Senator, to some extent, it is caused by 
the diffusion of knowledge and the growth of other markets, and 
to the extent that we are having a more competitive, deeper, 
broader capital market around the world, that is probably good 
for world growth. It is probably good for even our companies 
because they have more options for raising funds.
    There is, though, I think, an issue of regulation, as has 
been pointed out in the two reports that you are quite familiar 
with. There is a subtle distinction to make. If you take 
Sarbanes-Oxley as an example, to the extent that Sarbanes-Oxley 
appropriately balances disclosures and governance against the 
cost of achieving those disclosures and governance, I think it 
is worthwhile to keep. Even if there is some short-run tendency 
for firms to run away from that, because the investor wants 
that protection, ultimately the investor will reward firms that 
list on exchanges that have appropriate, adequate protections 
such as a well-designed Sarbanes-Oxley.
    That being said, there are always concerns about Sarbanes-
Oxley, about Basel II, about the regulatory structure, about 
securities litigation, about CIFIUS, where legitimate questions 
can be raised whether the costs of those regulatory schemes 
exceed the actual benefits to investors and to others of 
implementing them. As a general matter, not just in the context 
of competitiveness of our exchanges, we should always be 
looking to restore that balance and make sure that the costs we 
are imposing from a regulatory side are justified in terms of 
the social benefits.
    So, for example, it is a good step that the Public Company 
Accounting Oversight Board and the SEC have taken some steps in 
revising the audit standard to reduce the burden of SOX 404 
while maintaining, I believe, many of the benefits in terms of 
disclosure and controls that that law was intended to achieve.
    Senator Schumer. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator Schumer.
    Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Two of your predecessors, Paul Volcker and Alan Greenspan, 
always expressed great concern. I happen to have served on the 
House Banking Committee when Mr. Volcker was the head of the 
Federal Reserve and then Chairman Greenspan, both House Banking 
and now Senate Banking. And yesterday in the Washington Post, 
there was an article about the inversion of the yield curve for 
8 straight months and how local banks and banking in general--
and since that is the Fed's charge, to make sure that our banks 
are sound and secure--were having difficulty with the inverted 
yield curve.
    I have questioned you about this before, and you have 
always said it is not very important in this day and time. I am 
going to ask you again: How long can we stand to have--we have 
had it 8 straight months now--an inverted yield curve, where 
short-term rates are higher than our 30-year bond rate?
    Chairman Bernanke. Senator, the usual context of this 
question is: Does an inverted yield curve presage a recession 
or a slowdown in the economy?
    Senator Bunning. Well, it also hurts our banks very badly.
    Chairman Bernanke. I will address that, sir. Just very 
quickly, though, on the forecasting power of the yield curve: 
There has been a good bit of evidence that declines in the term 
premium and perhaps a great deal of saving chasing a relatively 
limited number of investment opportunities around the world 
have led to a somewhat permanent flattening--or even 
inversion--of the yield curve, and that pattern does not 
necessarily predict slowing in the economy or a recession. 
Indeed, if you look at other measures of financial markets such 
as corporate bond spreads, you do not see anything that 
suggests anticipations of future stress.
    The question you raise is a different one, of course, which 
is the effect on the banking system. Specifically, banks that 
do their traditional business of taking deposits and making 
loans are going to be put under pressure because the short-term 
deposit rates tend to be higher than the loan rates they can 
get. I recognize that is a problem for some banks. Other banks 
have been able to deal with it by hedging interest rate risk, 
by getting fees, and finding other ways of doing their 
business.
    So, overall, I do not see the banking sector as being under 
tremendous pressure in terms of its profits and asset quality 
at the moment. But I recognize--particularly for smaller banks, 
which have fewer options in terms of raising funds and earning 
fees and income--that the inverted yield curve does produce 
some pressure.
    From the Federal Reserve's point of view, we are entirely 
cognizant of that and hear about it from bankers. We have to 
set monetary policy, of course, to achieve overall price 
stability and maximum sustainable employment growth. So we 
sometimes find that in the context of various industries policy 
creates some pressure in individual industries. But we only 
have this one tool, and we try to use it to achieve overall 
macroeconomic stability, while fully recognizing that it does 
create some problems for some sectors.
    Senator Bunning. You are telling us today that an inverted 
yield curve down the road will not affect the economy. Did I 
misunderstand that, or is that accurate?
    Chairman Bernanke. I think the yield curve could be 
inverted for a considerable period without significant 
implications for the economy as a whole, yes--possibly for some 
banks, but not for the economy as a whole.
    Senator Bunning. How does this economic cycle that we are 
in, and recovery and expansion, compare to previous recoveries 
and expansions? In other words, when we hit the wall in 1992 
and then also in 2002, how does this recovery that we are 
involved in now compare to those recoveries?
    Chairman Bernanke. I would say that qualitatively it is 
fairly similar to the recovery that followed the 1991 
recession, with many of the same features. There was weakness 
for some time after the recession ended, including a period of 
so-called ``jobless growth.''
    Senator Bunning. But we did not have a housing market 
that----
    Chairman Bernanke. Well, the housing market was actually 
quite weak during the recession itself. The decline in 
residential starts during 1991 was not quite as large, but in 
the same neighborhood, as what we have seen recently. During 
the recovery period, we did not have that particular pattern, 
but in many ways, it was a fairly similar expansion.
    Senator Bunning. Could you estimate how close we are to a 
full employment in the United States?
    Chairman Bernanke. It is very hard to say specifically, and 
I do not pretend to know an exact number or an exact estimate. 
But the economy has certainly been growing faster than 
potential for a number of years, and that can be seen in the 
tightening of labor markets and capacity utilization. So, 
clearly, we are much closer today, I think it is safe to say, 
to full employment, to the sustainable level of growth than we 
were a few years ago.
    Senator Bunning. And in your opening statement, you made 
the remarks to the effect that you have not seen any new 
evidence of inflation since your last Fed meeting in January or 
February?
    Chairman Bernanke. We have not had much information on 
inflation since just 2 weeks ago, but the recent readings on 
inflation have been encouraging.
    Senator Bunning. Encouraging?
    Chairman Bernanke. Yes.
    Senator Bunning. Okay.
    Chairman Bernanke. But as I indicated in my remarks, they 
are somewhat noisy, the data, and we do not want to draw a 
complete conclusion----
    Senator Bunning. Well, that is why we have Fed meetings, 
you know, every month or two.
    Chairman Bernanke. That is correct, Senator.
    Senator Bunning. Thank you very much, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator Bunning.
    Senator Casey.
    Senator Casey. Thank you, Mr. Chairman, and the other 
Chairman in the room, thank you for your time and for your 
service. I have two general questions, one on debt and one on 
children.
    With regard to debt, I was looking at the report that the 
Federal Reserve Board is submitting in connection with your 
appearance here today and your testimony. And, in particular, I 
wanted to direct your attention and the attention of others to 
the report.
    I note here that in the section which deals with the 
Federal Government and expenditures and outlays by the Federal 
Government, it says, ``Net interest payments increased 23 
percent in fiscal year 2006 as interest rates rose and Federal 
debt continued to grow.''
    Then it goes on from there and talks about the outlays for 
Medicare Part D, Medicare itself up 10.5 percent. It talks 
about disaster relief, Medicaid spending, and then it gets to 
the next part of the paragraph. ``Outlays for defense in fiscal 
year 2006 slowed to their lowest rate of increase since fiscal 
year 2001, although the rise was still about 6 percent.'' That 
is the first predicate of my question.
    It goes on to talk about debt, the Federal debt subject to 
the statutory limit has increased, now we are at the $8.6 
trillion level.
    I guess with that as a predicate, let me tell you what I 
think about this. I think that that is unsustainable, and as 
much as we have talked, as important as it is to talk about the 
good sound bite, reducing our dependence on foreign oil, I 
think we need a lot more effort in this Congress and in this 
town on reducing our dependence on foreign debt. I think it is 
making us less safe in the fight against terrorism. I think it 
is making us less safe in terms of our ability to spend money 
on defense, not to mention our inability to spend money on good 
investments in the economy, as you talked about, education, 
training, and the rest.
    So, I guess my basic question is: In light of that data, 
and any other data you want to factor into this question, are 
these numbers sustainable, an $8.6 trillion debt and a 23-
percent increase in net interest payments? Is that sustainable 
over time?
    Chairman Bernanke. I recently testified before the Senate 
Budget Committee, and I pointed out--and it is not exactly a 
secret--that the long-term prospects for the U.S. fiscal 
situation are quite serious. In particular, we are going to 
start seeing--as the population ages--expanded costs of 
entitlements, Social Security and Medicare; those grow very 
quickly. And we will generate, if no action is taken, an 
increasing spiral of higher interest payments and debt.
    I quoted in that testimony several interesting, useful 
simulations by the Congressional Budget Office. The 
intermediate simulation suggests that by the year 2030 the 
deficit will be 9 percent of GDP, and the debt-to-GDP ratio, 
which is currently about 37 percent, will be closer to 100 
percent of GDP--a number which we have not seen since World War 
II.
    So, obviously, there are a lot of issues that Congress will 
debate about short-term spending and tax proposals. But if you 
think about fiscal sustainability in a longer time frame, 
dealing with the fiscal implications of the aging population 
and rising health care costs are going to be dominant, and 
essentially there will not be any way to address fiscal 
sustainability without addressing that issue in some way.
    Senator Casey. I wanted to pick up, in the remaining time I 
have, on the issue of how we invest in children, pick up on 
what Chairman Dodd spoke of earlier.
    There is a great organization out there that has as its 
moniker, as its message, ``Fight crime, invest in kids.'' It is 
a great sound bite. Sometimes we need sound bites to make the 
point. I would also assert--and I would ask for your sense of 
this and your reflections on this--that you could use the same 
construct for the impact on how we invest in children and how 
we grow our economy. Instead of saying, ``Fight crime, invest 
in kids,'' you could say, ``Grow the gross national product'' 
or ``Grow GDP'' or ``Grow the economy, invest in kids.''
    Now, I ask you that because we are going to be making some 
critically important decisions in the next couple of months and 
certainly in this 110th Congress. Chairman Dodd talked about 
the issue of the Head Start program. There have been votes cast 
in the U.S. Senate in the last couple of years where the choice 
was clearly and unambiguously a choice between investing in 
Head Start or investing in education or investing in any other 
support for children and their economic future, not to mention 
our future, and tax cuts. Sometimes the votes have been that 
stark, and there are people here who voted for the tax cuts 
over Head Start and over some other priorities.
    So, I would ask you about your opinion--and this is a 
policy question, but I think you can answer this--your opinion 
on the level of investment in children, whether it is with 
regard to education or Head Start, early learning, all of these 
initiatives to give kids a healthy and smart start in life, how 
you see that in the context of economic growth and GDP growth, 
and whether or not you think the investment currently is 
adequate.
    Chairman Bernanke. I think that investing in children is 
extremely important and has significant economic and social 
benefits. I hope that Congress will continue to look very 
carefully at that.
    What I do not know is precisely how best to do that, and I 
think you are going to have to bring real experts here to talk 
about different approaches--what works and what does not. But I 
urge you to continue to do that.
    In terms of priorities, to go back to Senator Schumer's 
question, clearly, there are always priorities. But you can 
weigh these things against tax cuts, you can weigh them against 
other kinds of spending. Clearly, you have to have an overall 
picture of what is important.
    Again, I cannot speak to the overall combination of taxes 
and spending other than to say that they should be in balance. 
But I will go so far as to say that I think that there is a 
significant return to investing in young kids.
    In my remarks in Omaha, I even cited some Federal Reserve 
research from the Federal Reserve Bank of Minneapolis, which 
showed the very substantial economic returns associated with 
early childhood education, and I do think that that is 
certainly worth investigating.
    Senator Casey. Thank you.
    Chairman Dodd. Thank you, Senator Casey. Very good 
questions. I appreciate your focusing attention on that.
    I want to just mention, before turning to Senator Martinez, 
your response, Mr. Chairman, to Senator Schumer's questions 
about Sarbanes-Oxley and competitiveness. I appreciated your 
answer very much to that question. There are some things 
clearly that could be done to try and show some balance and 
making sure we are not overburdening smaller public companies, 
but your thrust was that this is working pretty well. And, 
frankly, anecdotally, I suspect most of us here ask the 
question of every business we talk to: How is this working? And 
I must tell you, overall the response I get is a good one.
    I had one company the other day say to me that, ``Even if 
Congress decided tomorrow to repeal Sarbanes-Oxley, we would 
decide to stay with all the things that have been required of 
us. We have found that it has been very worthwhile for our 
company.'' So, I appreciate your comments about that.
    Senator Martinez.
    Senator Martinez. Mr. Chairman, thank you very much.
    I hate to differ with the Chairman, but I must say that the 
experience that I hear on the competitiveness and Sarbanes-
Oxley issue is far different from that. I hear a great deal of 
concern about the incredible cost and the burden of 
competitiveness that it has created. And, in fact, I will begin 
with this area because I intended to get into it, but our 
colleague from New York, Senator Schumer, and Mayor Bloomberg 
recently released a report that I found quite interesting 
detailing an analysis of market conditions in the United States 
and abroad and about the concern that there is about whether 
New York will continue to be the financial capital of the world 
or whether, in fact, there seems to be others competing for 
that title, which might include London. And there were some 
rather dramatic statistics of declines and increases in New 
York vis-a-vis London.
    One of the things that was mentioned in the report was the 
U.S. regulatory framework being too complicated and the 
implementation of Sarbanes-Oxley having produced heavier costs 
than were expected at the beginning or when you initiated that 
effort. Also it was mentioned immigration policies which create 
problems for those abroad who might wish to come here to do 
business, to invest in America, and the difficulties that 
current immigration problems raise for that, and some of them 
coming to be educated, others coming just as business people 
and investors.
    In any event, I wondered if you had an opportunity to see 
that report and whether its finding cause the same concerns to 
you that they raised to me.
    Chairman Bernanke. Senator, as I indicated, I do think that 
we should be trying to reduce regulatory burden, and in 
particular ensuring that the costs of the burden are 
commensurate with the benefits.
    With respect to Sarbanes-Oxley, my intent was to say that I 
do believe that there are benefits from that legislation, 
including improved controls, improved disclosures, improved 
governance of corporations. So there are certainly some 
benefits.
    It is important to decide whether we can reduce the costs 
and retain the benefits, and in that respect, I think that the 
proposed change in one audit standard being put forth by the 
SEC and the PCAOB is a step in the right direction because it 
attempts to focus on the most materially important issues, and 
it also makes allowance for the size and complexity of a firm 
in setting up the audit standard.
    So to try to summarize, Sarbanes-Oxley accomplishes some 
important objectives, but I do believe those objectives can be 
accomplished at lower cost, and I think the new audit standard 
moves in that direction. And in all other regulatory areas, 
including those the Federal Reserve is involved, we should 
continually be looking to find ways to accomplish the social or 
economic objectives of the regulation at a lower cost.
    Senator Martinez. Well, I agree that there are many good 
features to Sarbanes-Oxley. What I was speaking of is some of 
the excesses, particularly in the auditing arena and some of 
the areas that have caused such an overburden of costs. So, I 
appreciate your comment on that.
    Shifting to the issue of home sales, I used to sit in that 
very chair when I was Housing Secretary before this Committee, 
and at times, I would be asked a question about a housing 
bubble and in the overheated housing market whether, in fact, 
we were headed for a collapse and a bubble that would burst. In 
fact, we have seen as significant decrease in housing starts. 
We have seen the market cool down significantly, but we have 
not seen a bursting bubble. I always said at the time that the 
fears of a bubble were misplaced and that the housing market is 
more regional than it is national, and there were many 
different features between that and a localized market.
    But do you feel that the fear of a bubble has receded given 
the fact that the market cooled off, that it has done so in a 
fairly modest way without any cataclysmic consequences?
    Chairman Bernanke. Senator, as I indicated in my opening 
testimony, we think we see some tentative signs of 
stabilization in demand in the housing market, that 
nevertheless takes some time yet to work its way out because of 
the inventories of unsold homes that still exist on the market. 
I would emphasize that the signs of stabilization are 
tentative, and we do not want to jump to conclusions. It will 
be helpful to see what happens when the spring selling season 
begins and strong demand is at that time.
    But it is interesting that so far the economy has done a 
good job of withstanding the slowdown in construction, which, 
although substantial relative to the last couple of years, is 
still similar to the late 1990's, for example. It is not that 
we have had a complete collapse in construction by any means. 
So the decline in construction, while it has slowed the 
economy, has obviously not thrown us into a much slower growth 
situation. And we have not seen substantial spillovers from the 
housing slowdown to consumer spending or to other parts of the 
economy.
    So it is early to say that this problem is over. I think we 
are going to have to continue to watch it very carefully, and 
as I indicated, I think it is a downside risk to the economy 
going forward. But so far, the economy has reasonably adapted 
to this adjustment in the housing market.
    Senator Martinez. You mentioned in your remarks also that 
household finance appears solid and that delinquency rates on 
most consumer loans, including residential mortgages, were low, 
but you did note the subprime mortgages with variable interest 
rates where delinquency rates have increases appreciably. And 
it is an issue that is of great concern to several of us on 
this Committee, the issue of predatory lending, the abuse of 
some of our most vulnerable consumers.
    Any comments on that or any issues that you see there which 
could impact the overall economy?
    Chairman Bernanke. I think, first of all, that this 
distress in the subprime area is a significant concern. I am 
obviously following it very carefully, both in terms of the 
impact it has on the borrowers and lenders as well.
    I do not think that it has at this point implications for 
the aggregate economy in terms of the ongoing expansion, but as 
I said, it is an important issue for those sectors.
    I could certainly list a wide variety of things that we do 
to try to address predatory lending, which I do think is an 
important issue, and I think the subprime market, which is 
distinct from predatory lending, it is a legitimate market.
    Senator Martinez. Right. That is a good distinction to 
make.
    Chairman Bernanke. It also has some issues.
    Just to note one action we have taken recently, along with 
the other Federal banking agencies, we have issued guidance on 
nontraditional mortgages, mortgages that involve interest-only 
or option ARM's that may not be amortizing mortgages. We have 
emphasized to the lenders that they should be, first, very 
careful in their underwriting--that is, they should ensure that 
the borrower is equipped to deal with payment shock if interest 
rates go up, that they have sufficient income to meet higher 
payments; and, second, that disclosures are adequate so that 
the borrowers are fully informed about the nature of the 
contract that they are getting involved in.
    There are some loans that have been made that are not 
turning out well, and to the detriment of both the lenders and 
the borrowers. We will certainly be watching that carefully and 
trying to provide guidance and oversight to minimize that risk 
going forward.
    Senator Martinez. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator Martinez.
    Senator Bayh.
    Senator Bayh. Mr. Chairman, I would like to ask you some 
questions about our national security interests and the role of 
the Fed in our financial system in protecting those interests.
    As you probably have read, there are the tentative outlines 
of an agreement with North Korea to begin to get them to change 
their behavior with regard to their nuclear program. And one of 
the reasons that we were able to at least achieve a tentative 
understanding was because of pressure that we brought to bear 
on a bank in Macau that the North Koreans used to interact with 
the global banking system.
    Iran, as you know, is pursuing nuclear ambitions as well. 
Several Iranian banks do business in Western Europe. We are 
currently attempting to do something similar with regard to a 
couple of Iranian banks.
    My question to you is: What can the Fed do, what can the 
United States banking system do, to cut off Iranian access to 
the global banking system to exert some pressure on them to 
behave in a more responsible way with regard to their nuclear 
ambitions?
    Chairman Bernanke. Senator, the primary responsibility for 
initiating such measures and enforcing them is with the 
Treasury, the Financial Crimes Enforcement Network, for 
example, and OFAC. They have take the leadership in trying to 
ensure that American banks and, through negotiation, banks from 
other countries do not deal with the banks you are referring to 
in Iran and North Korea.
    So we are not the leaders in that effort. However, we as 
bank regulators and overseers have an important responsibility 
to try to ensure that it is carried out as the rules dictate, 
and as a very extensive part of our oversight responsibility, 
we evaluate banks' compliance with the Bank Secrecy Act and 
other such rules.
    Senator Bayh. I hope you will make this a priority and 
bring some sense of urgency to it. Iran is a tremendous 
problem. You know, the military option is obviously something 
that no one wants to have to resort to, and so we are looking 
for other levers that we can utilize to try and get them to do 
the right thing here. And this seems to have been effective in 
the North Korean context.
    My investigations in this area tell me that it has, you 
know, increased the cost of doing business to the Iranians. It 
has made things more inconvenient for them, and perhaps if we 
continue to pursue this, we might encourage a change in 
behavior on their part as well. So, I would encourage you to be 
vigorous in this effort because it does affect our national 
security interests in a very important area.
    Staying on the subject of Iran for a moment--and you are 
busy with many other things; you may not have noticed. But they 
have indicated publicly that their response, if we did get to 
the point of having to take some action against them because of 
their nuclear program, would be to try and cut off the flow of 
oil from the Persian Gulf by closing the Straits of Hormuz, so 
that not only they would suffer but also the Saudis and others, 
trying to maximize the pain on the global economy.
    I hope that there is some contingency planning being 
undertaken, so my question to you is: If such an event were to 
occur, what would the impact be on the global economy, on the 
U.S. economy, obviously the price of oil? You mentioned the 
role that the cost of energy plays in our inflation 
expectations and that thing. So what would the effect of such 
an act be on the economy? And, second, are you aware of any 
steps that we can take to mitigate those consequences? The 
President in his State of the Union address has suggested 
doubling the Strategic Petroleum Reserve, for example. Are 
there other things that we could do to prepare for such an 
eventuality so that we would mitigate the consequences?
    Chairman Bernanke. Senator, you are pointing to an 
important problem. I am not really equipped to say what the 
impact of these actions would be on aggregate supply of oil and 
on the oil price. I assume it would be dramatic, but I do not 
know exactly how big the effect would be.
    It would certainly have an impact on the world economy. 
There is no question about that. And I doubt that there is 
anything we can do in advance that would completely offset that 
impact.
    In the short-run, one of the tools we have you already 
mentioned--the Strategic Petroleum Reserve--which does provide 
some protection for a certain number of months, anyway, against 
those kinds of disruptions. I think that would be helpful.
    In the longer-term, as many people have noted, reducing our 
dependence on oil would be beneficial. If we could find ways to 
diversify our energy portfolio and, therefore, rely less on 
this particular source, that would be helpful from a national 
security perspective.
    Senator Bayh. Well, I know your people are probably 
stretched to their limits, dealing with a variety of things, 
but I do think that some part of the Government--whether it is 
your shop or Treasury or working in concert with some of the 
national security agencies--we need to at least begin to some 
thinking about this. God willing, we have a number of years 
before we get to such an event, and God willing, it will never 
happen. But I am always a big believer in you start with the 
worst case, protect yourself from that, and you kind of work 
back from there.
    When Secretary Paulson was before us a couple weeks ago, he 
reiterated the comments that had become routine by his 
predecessors, and that is the Treasury's belief that a strong 
dollar is in the interest of the United States of America. Do 
you agree with that point of view?
    Chairman Bernanke. Senator, I do agree with it, and I would 
add that I defer to the Secretary of the Treasury in all 
matters related to currency policy.
    I would only add that the Federal Reserve, to the extent 
that we can keep our economy strong and attractive to foreign 
investment, will help keep a strong dollar.
    Senator Bayh. Well, I agree with that, and this relates in 
some regard to what Senator Casey was asking about. You may 
recall that previously there had been--oh, there was a rumor in 
Seoul at one point that they were going to diversify in dollar-
denominated assets, and that caused a run on their currency. A 
similar rumor went through Japan not long thereafter.
    What would be the impact on the value of the dollar in our 
economy if the Chinese were to, for example, announce that they 
were going to either diversify out of dollar-denominated assets 
or were to, in fact, begin a precipitous sale of such assets?
    Chairman Bernanke. Well, Senator, first, I think it is 
important to understand that that is not a very likely 
scenario, and China own interests would not be well-served by 
such actions. They would take portfolio losses themselves and--
--
    Senator Bayh. Forgive me for interrupting. That is 
something similar to what the Treasury Secretary said, and the 
reason for my question, Chairman, is this: You are right, it 
might not be in their pecuniary best interests, but nation 
states do have interests other than their financial concerns. 
Let's just say hypothetically, you know, bringing pressure to 
bear on Taiwan and Taiwan's allies might be worth the loss of 
some money to the Chinese at some point in time.
    So my concern is simply this: Global interdependence is one 
thing, but the dependency is another. And it puts us in the 
position of being somewhat vulnerable to another country's view 
of their own best interests. And I have real concerns about 
whether that is in our best interest.
    Chairman Bernanke. I will answer your question, but I just 
wanted to reiterate that I think the costs to them of doing 
this would be greater than the costs to us.
    That being said, I think a substantial move on their part 
would be disruptive in the market in the short-term. In the 
longer-term the dollar, the Treasury yield and so on, would 
largely recover. Part of the reason is that Chinese holdings of 
United States fixed-income securities--which, of course, 
include not only Treasury but also GSE's and corporate debt and 
other instruments as well--amount to something less than 5 
percent of the outstanding dollar fixed-income securities in 
the global market--which is a very significant amount, but is 
not by itself enough to be a monopoly of some sort in this 
market.
    So if they were to do that--which, again, I do not 
anticipate--it would have short-term disruptive effects. I 
think that most of those effects would be short term as the 
market, which is very deep and liquid, began to adjust to that 
shock.
    Senator Bayh. Thank you, Chairman. My time has expired. 
Again, the reason for my question is simply, as a great power, 
I am reluctant to see us, even for a short duration, to be in a 
position of vulnerability to the actions of another government.
    Thank you.
    Chairman Dodd. Senator Bayh, thank you. Those are excellent 
questions, and I appreciate your raising them.
    Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    We are currently working on our budget, and it is a 5-year 
budget, I assume, you have looked at 5-year projections as far 
as how our economy is going to be doing. If I remember 
correctly, you pretty much feel that we are going to have a 
pretty good economy for the next 5 years, certainly within the 
average. Is that correct?
    Chairman Bernanke. We have not released any forecasts of 
the economy beyond a couple of years. The projections I gave 
today suggest reasonable growth and inflation over the next 2 
years. The underlying fundamentals of the economy in terms of 
productivity and so on look good to me, and so my expectation 
is that the economy will continue to be strong after that 
period. But we have not released any specific forecasts.
    Senator Allard. Now, in 2009, our Social Security surplus 
begins to decline, and that is the projection that we are 
looking at now, where we have had the surpluses but now they 
begin to reduce. How does that get factored in? That is within 
the next 2 years. We will be working on the 2009 budget in a 
year from now. How does that factor into your economic growth 
projections? Or is it too early to begin to have much validity 
to that?
    Chairman Bernanke. It is a bit early to be thinking about 
that. From a macroeconomic point of view, if we focus on the 
cashflows of the deficits, current in, current out, it looks 
like the deficit will not be rising significantly and may even 
be declining for the next few years for various reasons. So, I 
do not anticipate that fiscal policy will be a major force 
shaping the near-term growth pattern of the economy.
    The concerns that I emphasized in my Senate Budget 
testimony were really the longer-term issues of solvency and 
fiscal responsibility in the context of the aging of the 
population and the large increase in entitlement spending.
    Senator Allard. The deficit is going down. In my view, it 
is more attributable to revenues. It is not that we have done 
anything particular to hold down on spending. If we do 
something--and I do not know how you factor in the expiration 
of these temporary taxes that have been put in place. It looks 
to me like they have had a positive impact on the economy and 
the revenues that are coming in. When those expire, what kind 
of adjustments do you think we will have to make in our budget 
projections from that point on?
    Chairman Bernanke. Well, again, I am not going to take a 
position on whether they should be allowed to expire. I think 
if they do expire, it would probably increase revenues 
somewhat. It would have other effects on the economy in terms 
of incentives and growth potential as well.
    From the Federal Reserve's point of view, we are simply 
going to look at the fiscal situation as it evolves and make 
our adjustments to try to maintain full employment as the 
economy goes forward. I think the considerations the Congress 
should have with respect to near-term tax policy should be less 
to do with maintaining short-term full employment--we will be 
able to address that--but, rather, think about the long-term 
trade-offs between the benefits of lower taxes and the costs of 
lower taxes, essentially.
    Senator Allard. I am going to move over to the small 
business question. When you look at the economy, it seems as 
though--most of the figures I look at on the small business 
sector, they contribute about 50 percent, 52, 53 percent of the 
growth in the economy. Is that about what you look at?
    Chairman Bernanke. It is similar--small and large 
businesses are similar in magnitude, and so in that respect, 
you are correct, yes.
    Senator Allard. You are saying that the small business 
sector would grow--you think it is 50-50, then, between 
economic growth from large business and economic growth from 
small business?
    Chairman Bernanke. I do not recall the exact data, but I 
believe I have heard that number for job creation as opposed to 
growth. But it would be similar, yes.
    Senator Allard. Okay. Thank you for that. That was just a 
point of information. I wanted to see how you were looking at 
that.
    Chairman Bernanke. We can provide you with more detailed 
information.
    Senator Allard. I would appreciate that, if you could.
    The other question is Sarbanes-Oxley. Apparently, there is 
a rise in private equity firms, and they are increasingly 
acquiring some public companies and apparently taking them 
private. Does that phenomenon concern you?
    Chairman Bernanke. Not necessarily. It can be a good method 
of enforcing discipline on corporations and management. By 
taking the firms private, they essentially create a situation 
where the private equity investors have a short period of time 
in which to create a more productive, more effective, and more 
profitable firm. They then usually try to bring the firm back 
into the public markets, so it is not in some sense an attempt 
to permanently escape Sarbanes-Oxley, because they do 
eventually want to come back into the public markets.
    So, generally, it is a policy development in that it 
creates more competition for corporate control and should 
increase discipline among management. There may be some 
circumstances where the leverages are excessive or that there 
are other problems associated with it.
    Senator Allard. When I was taking economics in college, I 
think full employment was considered 5 percent. Is there a 
figure like that that most people generally agree is a full 
employment figure? Or are there other variables you have to 
bring in, you cannot use a static number like that?
    Chairman Bernanke. The Congressional Budget Office uses, I 
think, 5.2 percent.
    Senator Allard. Yes.
    Chairman Bernanke. But the Federal Reserve does not have a 
fixed number that we use. Again, as I indicated earlier, we try 
to look at a wide variety of indicators, both of the labor 
market and of the general economy in terms of prices, for 
example. In the past, we have found that the amount of 
employment the economy can sustain on a long-term basis changes 
over time. It changes within demographics, with the structure 
of the labor market, and with the structure of industry. It is 
not, I think, good policy to have a fixed number in mind. It is 
important to be flexible, look at all the information that is 
coming in, and try to make an ongoing judgment about how the 
capacity of the economy is adjusting.
    Senator Allard. And do you think the unemployment is at a 
desirable place in the economy right now?
    Chairman Bernanke. Well, as I indicated earlier to Senator 
Bunning, we are certainly much closer to the capacity of the 
economy now than we were a few years ago, as we have seen 
unemployment come down and capacity utilization go up. Whether 
we are at that level or not, again, I cannot say. We will be 
looking at a wide variety of indicators and trying to make a 
judgment about where the economy should go.
    Senator Allard. In addition to that, wages have gone up, 
haven't they?
    Chairman Bernanke. Nominal wages have gone up, and we have 
seen some increase in real wages as well, and that is a good 
development.
    Senator Allard. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator.
    Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman.
    Chairman Bernanke, I want to start where I started off in 
my opening comments to you. I am very concerned about the 
economic squeeze that has been put on the middle class, 
particularly since the turn of the 21st century. Since the 
beginning of 2001, middle-class families have experienced 
increased levels of debt, anemic growth in real wages, all the 
while essential costs for food, housing, and medical services 
have increased at levels drastically higher than inflation.
    As a result, the financial security of middle-class 
households has suffered, and more and more American families 
are unable to afford life emergencies such as an unexpected 
health problem or unemployment.
    Employment opportunities are at their lowest level since 
the Great Depression. Since the recession ended in November 
2001, job growth has averaged a mere eight-tenths of a percent 
per month, less than a third of the 2.7 percent average growth 
we experienced in previous recovery periods since World War II. 
For the first time since the 1950's, job opportunities have 
actually decreased from a 16-percent growth rate in the 1990's 
to a 14-percent decrease since March 2001.
    I look at that and I add to that factor that families seems 
to me to be living on thin ice. I hear these stories of 
families in New Jersey that they are only one unexpected 
illness or lay-off away from sinking into perpetual debt. I 
think one measure of this economic insecurity is the percentage 
of middle-class families who have at least 3 months of their 
salary in savings. The percentage of middle-class families who 
had 3 or more months salary in savings rose 72 percent from 
16.7 percent in 1992 to 28.8 percent in 2001. So middle-class 
families are becoming more secure year by year. But, 
unfortunately, in the span of less than 4 years, that 
percentage dropped by over 36 percent, down to 18.3 percent in 
2004.
    Finally, I noted with interest in your written statement, 
you said, ``Consumer spending continues to be the mainstay of 
the current economic expansion.'' That is true, but when you 
add that reality to anemic growth in wages and sharp increases 
in the cost of necessities, household debt in America has risen 
to record levels over the past 5 years. By the third quarter of 
2006, outstanding household debt was 130 percent relative to 
disposable income. That means that the average family is in 
debt of over $130 for every $100 it has to spend. And, 
additionally, the average household savings rate has actually 
been negative for the past seven quarters, averaging about a 
negative 1 percent rate for 2006.
    So, I look at all of this, and I say to myself, you know, I 
have my friends and colleagues who are heralding this great 
economy. I do not get the sense that people back at home and in 
other parts of the country feel that good about it. You see it 
in every poll of the barometer of their feelings. They feel 
really squeezed and really put upon.
    And so my question to you is: Aren't these indicators a 
real cause for concern as it relates to the struggle that the 
middle-class families in this country are facing? And how do we 
create an economy that is more inclusive and which the macro 
benefits end up being achieved by those who are the great 
center of those who keep this country afloat?
    Chairman Bernanke. Senator, in my remarks in Omaha, I did 
the usual economist's ``on the one hand, on the other hand'' 
approach. On the one hand, average living standards in the 
United States have risen very substantially since World War 
II--very substantially--and that is true for the majority of 
the population. Even in the last 10, 15 years, we have seen on 
average, or even at the median, middle parts of the income 
distribution, pretty good overall growth, not year-to-year but 
over a period of time. So there has been a general improvement 
in living standards, which has affected a very large part of 
the population.
    That being said, on the other hand, there are various 
issues, as I talked about in my remarks, that inequality has 
increased. We have seen more concerns about job security 
related to trade and technology. Health care remains a concern. 
People are concerned if they lose their job they will not be 
able to afford new health care or move their health care 
between their existing employer and a potential new employer.
    You mentioned wealth. Wealth is very unequally distributed 
in the United States. A big challenge is to help people in the 
lower part of the wealth distribution begin to save and 
accumulate assets so they can have some reserve against the 
kinds of problems you referred to, like a health emergency or 
unemployment or some other problem that may arise.
    So my broad answer is that I do think the economy has 
strengthened over time and the benefits have been felt by a 
large part of the population. But there are persistent issues 
that relate to people's sense of security or insecurity, and 
there is no single answer because each of these issues--wealth 
creation, health care, inequality--are all large issues, and 
they each require individual attention.
    Senator Menendez. I appreciate that. It seems to me that 
the policies both in the taxing side as well as in the 
incentive side and in the programmatic side that would go to 
narrow these divisions--you have mentioned education; I 
certainly agree with you on that. But we have seen educational 
outcomes rise, and yet we have still seen inequality rise.
    We have challenges, as it relates to how families achieve 
health care. We have challenges maybe in policies that 
incentivize savings and find ways to help that segment of 
society save. It seems to me that this consumer-driven 
expansion of the economy at some point at the cost of debt has 
a consequence to it. And so it is a real concern.
    One last question. In the written version of your remarks 
to the Chinese Academy of Social Sciences in December, you 
referred to China's currency policies as ``an effective 
subsidy'' for the country's exporting industries. I am just 
wondering why you omitted that reference in your presentation 
on December 15?
    Chairman Bernanke. I omitted it because I thought at the 
time that it would be more clear to my audience there in 
Beijing if I explained it a little bit differently. But I stand 
by my written comment. I think it is accurate.
    Senator Menendez. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator.
    Senator Sununu.
    Senator Sununu. Thank you, Mr. Chairman.
    I want to first begin by going back to a subject that was 
brought up, and I think inappropriately so, in a discussion 
about whether you, Chairman Bernanke, should be willing to talk 
about ``policy'' before this Committee. As most everyone has 
noted, you talked about education in your opening statement. 
And the suggestion was made, by, I think, more than one 
Senator, that while education is policy and if you talked about 
education, therefore, you should be willing to talk about 
policy prescriptions on the tax side, and in particular talk 
about raising tax rates. And I think a lot of this discussion 
about income inequality, quite frankly, is a prelude to a 
policy recommendation from some on the other side of the aisle 
to raise tax rates on entrepreneurs and individuals in certain 
income brackets.
    Well, I think that that sequence of conclusions is just 
flat wrong because it is entirely appropriate for the Fed 
Chairman to talk about education as an input, like productivity 
or technology. Education and technology affect productivity, 
productivity affects growth rates, and perhaps inflation. That 
is entirely appropriate.
    But it is, of course, not appropriate for Chairman Bernanke 
to talk about or recommend specific policy prescriptions in the 
area of education at the State, the Federal, or the local 
level, spending on a particular program, school vouchers or 
issues that people on various sides of the aisle might support.
    So, I think we need to make this distinction. I think it is 
unfair to the Chairman to suggest that because he talks about 
the value of education, generally speaking, to the workforce in 
terms of its flexibility that he should be willing to weigh in 
on education legislation or tax legislation that Members might 
be writing.
    I guess that is the opinion piece, and now I will go on to 
my questions.
    You noted that growth in the second half of 2006 was 2.75 
percent. Was that higher or lower than you originally expected, 
or expected, say, a year prior, a year out? And why was it 
higher or lower than your expectations?
    Chairman Bernanke. It was close to our expectation. Our 
assessment was that the economy was making a transition to a 
more moderate and sustainable pace, which would be something in 
that general vicinity.
    It does look that the fourth quarter GDP growth number is 
going to be revised down somewhat, and so the actual number 
will be a bit lower. But probably the implications will be 
slightly stronger first quarter, so it does not really change 
the overall picture, which is that we see the economy growing 
at a healthy pace, but it is one that is sustainable and not 
overheated.
    Senator Sununu. Thank you, and I want to apologize for not 
presenting the option that you might have been correct in your 
projection. I suppose that should have been one of the choices.
    You noted in your testimony that real incomes should 
continue to rise. At what rate do you project real incomes to 
rise over the next four to six quarters?
    Chairman Bernanke. Well, it depends on what your definition 
of ``income'' is. We have seen real wages growing the last half 
of 2006 by about 3 percent in real terms. I hope to see 
continued strong growth in real wages. I am not quite sure 
whether it will be quite that strong, but I think as long as 
energy prices do not rise quickly again, we should continue to 
see good growth in real wages.
    Broader measures of income should grow broadly at the same 
pace as GDP, and our forecasts are for something between 2.5 
and 3 percent.
    Senator Sununu. And when you talk about broader measures of 
income----
    Chairman Bernanke. Including capital income and so on.
    Senator Sununu. You talked about the fact that there was a 
7-month supply in unsold homes in the third quarter of 2006. 
Where do you expect that inventory to go in the next 6 to 12 
months? Has it peaked or do you expect the inventories to 
increase further?
    Chairman Bernanke. The predicate is that we have seen what 
we call ``tentative signs of stabilization in demand for 
housing.'' If, in fact, the demand for housing is stabilizing--
and, again, we will not know that for sure, I think, until we 
see sales figures in the spring--then we should see from here a 
gradual decline in the months for sale inventory. The normal, 
at least for the last 8 to 10 years, is 4\1/2\ months of homes 
for sale, and my anticipation would be that we would get back 
toward that general level by the end of next year, assuming 
that demand stabilizes.
    Senator Sununu. By the end of 2008, not the end of 2007.
    Chairman Bernanke. Yes, 2008.
    Senator Sununu. The last question. I guess the question is: 
Please explain this to me. It is one of the charts, and the 
monetary policy booklet is, I think, very well written and very 
informative, no surprise there because, as you know, you have 
very good staff. But there is the graph of the savings rate 
from 1983 to 2006.
    From 1983 to 2006, we had two recessions, three bull 
markets, two market crashes. We had rising and falling 
deficits. We did have a relatively steady trend in improving 
employment numbers and a lowering of the rate of unemployment 
and a fairly strong record of dealing with and containing 
inflation. And yet the personal savings rate, you know, that 
chart is a steady downward trend through all of these things. 
And I am curious to know what the factors are that go into that 
steady decline in savings rate. We know it means that people 
are consuming more than they are earning or a greater 
proportion of what they are earning. But what is contributing 
to that trend? And is this something that the Fed is worried 
about?
    Chairman Bernanke. Well, you raise a question that a lot of 
people have weighed in on. It is a complicated question. I 
think several factors have been pointed to. One is 
demographics. Different cohorts or different generations have 
different propensities to save. The baby boomers have not been 
particularly impressive in that respect, and as they have 
become the biggest recipients of income their savings rates 
have shown through.
    Senator Sununu. I apologize for interrupting, but has there 
been an evaluation of the propensities of different cohorts 
currently?
    Chairman Bernanke. Yes.
    Senator Sununu. And how much of this declining savings rate 
can be attributed to that one cohort?
    Chairman Bernanke. Well, there have been a number of 
papers, and we would be happy to send you a few surveys or 
summaries of some of the research that has been done. A number 
of papers have looked at this demographic issue and viewed it 
as being important, although not necessarily the whole story.
    The other important part of the story is that personal 
savings rates are out of current income, and they do not 
include capital gains of any kind. So the general strength of 
the stock market and then more recently of the housing market 
has meant that people could increase their wealth without 
saving, and that has been, I think, an important factor in 
leading to a lower savings rate more recently.
    The other technical point to make is that private saving 
actually consists of the sum of the household or personal 
savings together with the savings done by corporations. Savings 
by corporations has become a larger share of the private saving 
than overall, and in a sense, the corporations ultimately 
belong to the households, whether you are a small business 
owner who is keeping profits in your business or an investor 
who is enjoying capital gains in stocks. Some of that saving is 
not appearing in households because it is taking place in 
corporations. It is a measurement issue.
    But I think it is an issue because the national savings 
rate has come down, and it contributes to issues like the 
current account deficit we have talked about. Our anticipation, 
as I mentioned in the testimony, is that the household saving 
rate should rise a bit in the next couple of years partly 
because housing prices are not rising as fast and people will 
turn back to saving from their current income. But we do not 
anticipate anything like the 12 percent in 1985 anytime soon. 
It is going to be a slow process.
    Senator Sununu. Thank you very much. Thank you, Mr. 
Chairman, and I would note, since I am not a member of the 
baby-boom generation and you are, I look at every possible 
opportunity to blame something bad on your generation.
    Thank you.
    Chairman Dodd. Well, you have not proven you are part of 
the Greatest Generation either yet.
    [Laughter.]
    Senator Sununu. And I would never make such a claim.
    Chairman Dodd. I was just going to note, I have been on 
this Committee some 25 years, and I recall with great fondness 
your predecessor appearing here on numerous occasions, and I 
cannot recall specifically the Members who may have raised, but 
the number of times Chairman Greenspan was asked to support 
specific tax cut policies was rather frequent on the Committee. 
So this is not a first-time occurrence that a policy question 
was raised to a Chairman of the Federal Reserve.
    Senator Sununu. But my point is that he would never answer 
the question, and that was the right thing to do.
    Chairman Dodd. And I suspect my colleague from New 
Hampshire may have been one of the people to ask those 
questions.
    I would just note as well on the savings rate issue here, I 
am told--and maybe you can correct me on this if I am wrong, 
Mr. Chairman--that the last time we had a negative savings rate 
of this magnitude, it was the Great Depression. Is that correct 
historically?
    Chairman Bernanke. I think that is correct.
    Chairman Dodd. Someone mentioned to me the other day as 
well that, of course, the consumer debt issues are staggering, 
and at least the revolving debt, a good part of which is 
probably credit card debt, on the average is around $9,300 per 
individual. Does that number ring true with you?
    Chairman Bernanke. I do not know the number for revolving 
debt specifically. The incidence of debt issues varies quite a 
bit across the population. For a good bit of the population, 
particularly those of higher incomes, there has been asset 
accumulation which offsets the debt.
    Chairman Dodd. Right.
    Chairman Bernanke. So, in particular, over the economy as a 
whole, the average loan-to-value ratio for homes is about 50 
percent. That is, the mortgage companies own half the housing 
stock and the public owns half the housing stock. But there are 
certainly segments of the population who are facing very high 
debt loads, either through their mortgage borrowing or through 
credit card revolving debt, and for them it is obviously a 
hardship.
    Chairman Dodd. Thanks very much.
    Senator Tester.
    Senator Tester. Yes, Mr. Chairman, I do have questions, and 
I do hope to ask them, but my comrade Senator Brown has a 
commitment, and I will defer to him for now.
    Chairman Dodd. Thank you.
    Senator Brown. I thank my friend from Montana. Thank you, 
Senator Tester.
    Chairman Bernanke, in your remarks last week in Omaha, you 
noted that our policy responses to economic inequality must be 
informed by our ethics and our values and are ultimately 
political questions. You said a moment ago that inflation was 
the canary in the mine. I have for 5 or 6 years worn a 
depiction of a canary in a cage on my lapel to signify the 
Government's role in everything from mine safety to the 
environment to minimum wage to Medicare.
    You also expressed--and I think that the ethics and values 
in our domestic economy, I think those ethics and values are 
reflected in what we do in our domestic economy, like the 
canary in the cage. It is minimum wage and it is Medicare and 
it is Social Security, and it is helping the middle class 
thrive, as it has done in the last 100 years. And there has 
been clearly a consensus in this country, differences on the 
edges perhaps, but a consensus that those ethics and values 
drive what we do in our domestic economy.
    It seems to me those values and ethics do not stop at the 
water's edge, that as a Nation we should continue to propagate 
and promote those same ethics and values as we have done in our 
country in our domestic policies and our domestic economic 
issues. We should look at those internationally.
    I know you expressed concern that inhibiting trade flows 
would do more harm than good, but I would argue that if our 
country is, in fact, going to live its values and going to live 
the ethics that we discuss and that we sometimes pat ourselves 
on the back about, we would look internationally in some of 
those cases.
    I would just start by asking if--we have as a Nation our 
values say that we should not buy products manufactured by 
slave labor in China. Do you agree with that?
    Chairman Bernanke. Absolutely.
    Senator Brown. Okay. And would you say then that we should 
not import products made by child labor.
    Chairman Bernanke. Yes. I agree that we should not.
    Senator Brown. Okay. Then I guess that would be--the next 
step would be we should not import products produced in 
sweatshops, if we, in fact, can agree on a workable definition 
of ``sweatshops.''
    Chairman Bernanke. Well, that is a very difficult 
qualification you just added at the end. Just to get where you 
are going, I think it is probably not a good idea to try to 
enforce Western-level standards of worker benefits in emerging 
market countries. Since those workers have such low 
productivity, if we were to insist on the same standards we 
have in the United States in terms of benefits and the like, 
the workers would either have very low wages or no job at all. 
I think the way to get to the kinds of living standards we have 
in America is to allow people to participate in the market and 
to produce.
    We in the United States, of course, have come a long way, 
starting from situations where workers did not have very good 
protections to a situation now where we have much better 
protections.
    Senator Brown. But, Mr. Chairman, if I could, we also did 
not have a foreign government implanting on us an economic 
structure with foreign investment and that international 
economic structure.
    Let me take this in a little bit different direction. I 
agree we should not impose--we should not have imposed under 
NAFTA or CAFTA minimum wage--the minimum wage that we have in 
the United States, of course, we should not have imposed it in 
Guatemala. But these are not Western--when you talk about 
International Labor Organization standards, that is an arm of 
the United Nations, I believe, and that is not Western economic 
standards.
    Does that mean then you would support, if you were looking 
more internationally, would you support International Labor 
Organization standards in these trade agreements that we 
negotiate?
    Chairman Bernanke. I believe those standards come in many 
different levels, and there are literally hundreds of them.
    Senator Brown. There are five central International Labor 
Organization provisions and standards, there are questions 
within those, but the right to organize and bargain 
collectively, the prohibition on forced labor, the prohibition 
on child labor, those kinds of general standards that we have 
not--we did in the Jordan Trade Agreement, but we have not in 
the last 6 or 7 years. Is that a policy question reflecting our 
ethics and values that we should pursue?
    Chairman Bernanke. I think it is. I think it would be 
reasonable to look to basic human rights, such as slave labor 
and forced labor. I think those are not something we want to 
countenance. When it becomes a question of whether we should 
require minimum wage, for example, it is a much difficult 
issue, and----
    Senator Brown. That is not one of the ILO standards.
    Chairman Bernanke. Okay.
    Senator Brown. Okay. Fair enough.
    Let me shift for a moment to industrial loan companies 
briefly. As you know, the FDIC has extended for 1 year a 
moratorium on commercial firms like Wal-Mart owning a bank 
through and ILC charter. This Committee and this Congress have 
just a short time--a year--to address the important issues 
involved before the moratorium expires. Do you have any 
concerns on the uneven regulatory structure between banks and 
what perhaps would be an unlimited number of commercial firms 
owning ILC's?
    Chairman Bernanke. The Federal Reserve is concerned about 
an unlimited expansion of the industrial loan company 
exception. We have two particular concerns, which we have 
talked about on a number of occasions. First is the mixing of 
banking and commerce. The Congress in Gramm-Leach-Bliley and 
other contexts has expressed its desire to keep banking and 
commerce separated. I agree with that, and I think that is an 
issue for the Wal-Mart acquisition, for example.
    The other concern is about consolidated supervision. If 
there is an acquisition of an ILC by either a commercial or 
noncommercial firm, I think it is important that the oversight 
of that combined entity be done at the higher level to ensure 
that there is sufficient financial strength in the holding 
company to ensure the safety of the deposit insurance funds for 
the ILC itself.
    So those two principles are important to keep in mind as we 
debate this question.
    Senator Brown. Thank you.
    And, Chairman Dodd, Senator Johnson as you know has been 
very involved in the ILC issue.
    Chairman Dodd. Right.
    Senator Brown. And we clearly in this Committee need to 
pursue that.
    Thank you, Senator Tester, very much.
    Chairman Dodd. Thank you very much, and I am sorry Senator 
Bennett was not here to engage. I know he has some strong 
interest in this subject matter. I was going to give you the 
opportunity--and I thank Senator Brown for raising the 
question--there has been some issue about whether or not this 
is--tough issues have been raised, and I want to give you a 
chance to respond to this. Some have suggested that the reason 
the Fed has taken the position it has is because it is an area 
of jurisdiction that they like to have.
    I think I know the answer to this question, but what is 
your response to that particular concern?
    Chairman Bernanke. If the ILC exemption is limited and not 
allowed to expand indefinitely, we are perfectly comfortable 
with the FDIC doing the consolidated supervision, and we think 
they do a very good job.
    Chairman Dodd. Thank you, Mr. Chairman, very much.
    Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman. And 
Chairman Bernanke, we appreciate you being here with us.
    I want to return to the global competitiveness issue for a 
minute. I know that others have spoken to you about this 
already. First and foremost, I want to commend Senator Schumer 
for working with Mayor Bloomberg for the McKenzie report. There 
is also, as you know, the new interim report of the Committee 
on Capital Markets Regulation, and both of those reports I 
think add significantly to this debate and to the issue. I am 
working on a resolution, and talking with Senator Schumer about 
it as well, and hope to be working with him on a resolution to 
help highlight this and to express the sense of the Senate 
about what steps we need to take in terms of better dealing 
with our global competitiveness.
    Now what I want to focus my questioning on with you is 
derivatives and hedge funds. I will start by noting that in the 
McKenzie report this following quote occurs.

    London already enjoys clear leadership in the fast-growing 
and innovative over-the-counter derivatives market. This is 
significant because of the trading flow that surrounds 
derivative markets and because of the innovation these markets 
drive, both of which are key competitive factors for financial 
centers. Dealers and investors increasingly see derivatives and 
cash markets as interchangeable, and are therefore combining 
trading operations for both products. Indeed, the derivatives 
markets can be more liquid than the underlying cash markets. 
Therefore, as London takes the global lead in derivatives, 
America's competitiveness in both cash and derivatives flow 
trading is at risk, as is its position as a center for 
financial innovation.

    Would you agree with that portion of the McKenzie report?
    Chairman Bernanke. I agree that derivatives are an 
incredibly important part of our expanding financial market, 
part of financial innovation, and I would like to see the 
United States remain competitive in those areas.
    Senator Crapo. So you think it would be appropriate for us 
to focus in this Congress on things that we can do or not do to 
assure that we remain competitive or that we become more 
competitive in those arenas?
    Chairman Bernanke. Again, I think the best way to be 
competitive is to make sure that the regulatory structure has a 
minimal costs as needed to justify the benefits that are seen 
to be obtained from those regulations.
    Senator Crapo. One of the common themes that we are seeing 
in terms of the movement of business away from the United 
States to London and other capital markets is just that, the 
regulatory burdens and the regulatory regime that we impose 
here in the United States. I do not think anybody would say 
that we should simply take down our regulatory position, 
because we do have one of the strongest markets in the world. 
But the question is, are we over-regulating.
    I want to go specifically to an issue that you and I have 
talked about many times before, and that is the regulation of 
energy derivatives. As you know, we have faced proposals in 
Congress and the Senate now for the last 4 or 5 years to 
increase the regulatory climate around the handling of energy 
derivatives. There has yet been another bill introduced just 
yesterday or day I think, to do the same thing, so we are back 
into the same issue.
    You have expressed a position on this in the past. I have 
in front of me the last letter that was put out by the 
President's Working Group, of which you are a member. The last 
paragraph of that letter says, ``several times in recent years 
the PWG has been asked for its views on various legislative 
proposals to expand regulation of energy derivatives. Most 
recently, in testimony before the Senate Banking Committee on 
September 8, 2005 representatives of the PWG agencies 
reaffirmed the position of the PWG that additional regulation 
of energy derivatives is not warranted.''
    Is that still the position of the PWG, and is it still your 
position that we do not need to further increase the regulatory 
regime surrounding energy derivatives?
    Chairman Bernanke. The PWG has not discussed it recently 
but I have no reason to think the position has changed. I 
believe it is a reasonable position, that we should be very 
careful about adding additional regulatory costs in this 
market. There are two reasons to regulate. Potentially one is 
investor protection. But in this market, of course, we have 
very large institutions, very sophisticated institutions who 
are, I think, able to take care of themselves.
    The other would be a concern about price manipulation. 
There the CFTC does have, of course, ex post powers to 
investigate potential frauds or manipulation. But it seems 
unlikely that manipulation in most cases would come from the 
OTC markets since the exchanges provide a good venue for 
determining prices.
    So, I have not changed the position I expressed before.
    Senator Crapo. Thank you. I appreciate you sharing that 
with us. I suspect that we will be asking the entire PWG to 
reevaluate this issue since we now have legislation yet again 
introduced on the issue. So, I would just give you that advance 
warning that we will be coming to you for some guidance as we 
once more enter into this debate.
    Just one last question; moving a little bit to hedge funds. 
Can you explain what is involved in fostering market discipline 
in the hedge fund context? It is my understanding that you 
believe that that is a superior approach to direct regulation.
    Chairman Bernanke. That is correct, Senator.
    The proposal of the President's Working Group, once again, 
in their report following the LTCM crisis focused on the so-
called ``indirect'' or market-based regulation of hedge funds. 
That has essentially two components. The first is through the 
counterparties, that is, the investment banks or the banks, who 
lend money to the hedge funds or serve as their prime brokers. 
The supervision process requires that these large 
counterparties manage their counterparty risk effectively, that 
is, that they have good information about the risks being taken 
by the hedge funds, their financial positions, and so on. And 
it is both in the interest of those counterparties, obviously, 
since they do not want to lose money, that they pay close 
attention to what their counterparties are doing, and the 
supervisors give additional encouragement, incentive, for the 
counterparties to manage those risks effectively.
    The other type of counterparty is the investor itself, 
particularly large institutions like endowments or insurance 
companies and the like, which also provide a good bit of market 
discipline on the hedge funds by gathering information as they 
make their investment decisions.
    So we believe that is a very important, and so far, 
successful method of overseeing hedge funds. I would be very 
reluctant to get involved in heavy-handed direct regulation of 
hedge funds. They are a very diverse group of institutions. 
They have a wide variety of strategies, and one of their key 
characteristics is that they are very nimble. They change very 
quickly. And that is good for the economy because they help to 
create more liquidity in markets, they help to spread risks 
around more broadly. A regulatory regime that inhibited that 
flexibility and nimbleness would eliminate a lot of the 
economic benefits of the hedge funds and the other types of 
private pools of capital that use sophisticated instruments to 
share risk.
    That being said, it is always useful for regulators and 
supervisors to keep abreast of what is happening in the hedge 
fund market, to speak to hedge fund managers, to understand 
recent developments.
    The G-7 meeting which I attended over the weekend, in the 
spirit of information gathering, proposed that the Financial 
Stability Forum, which is an international group consisting of 
central bankers and supervisors, update a report they did in 
2000 about the status of this market. I think that is 
consistent with us simply trying to keep up our information 
base that we know enough so that we are keeping up with 
developments in that industry.
    Senator Crapo. Thank you very much, Mr. Chairman. I want to 
just say, personally, I appreciate your candor and the candor 
that we get from the President's Working Group as we face these 
kinds of issues. The expertise that you and the other members 
of the working group can bring to the issue to help us evaluate 
them is invaluable, so thank you for providing that.
    Chairman Dodd. Those are great questions, Senator. I 
appreciate you raising them as well. Very well done.
    Senator Tester.
    Senator Tester. Thank you, Mr. Chairman.
    I also want to thank Chairman Bernanke for being here today 
and being forthright in your answers. It is very nice.
    The reason I want to stick around and ask these questions, 
quite frankly, is because I value your opinion. It is not for 
political reasons. It is not for anything other than I want to 
know your perspective. Because quite frankly, from my 
perspective of being a farmer in North Central Montana, there 
is a lot of things that are just flat backward in this country 
right now.
    So the first question I wanted to ask is what is the number 
one factor that concerns you as a potential impediment for our 
economic growth here in this country?
    Chairman Bernanke. Well, over the medium-term, it is the 
demographic transition that we are going through. We are 
getting older, our society is aging. We are going to have a 
much larger share of the population in retirement age, or even 
in the oldest of the old, 80 and 90 years old. And we have not 
really made good preparation for that, either in terms of 
broader savings in the society, or in terms of fiscal policy, 
which I have discussed in previous context.
    Senator Tester. Does the $8.6 trillion debt fall into that 
issue then? Or is that somewhere else?
    Chairman Bernanke. Well, it is closely related because if 
we do not take some measures to address how we are going to 
deal with the fiscal implications of an aging society, the debt 
and deficits are going to grow, interest payments on those debt 
and deficits are going to grow, and we will be in an 
unsustainable fiscal situation.
    So the fiscal picture is closely linked to the underlying 
demographic changes that are going on.
    Senator Tester. I have had a tough time struggling with, 
because quite frankly tax load is something I am very concerned 
about, too, as I think everybody on this Committee is. But the 
debt load concerns me, too, very much.
    Could you rank them as what could be the most severe 
impediment? Is it the debt load or is it tax policy that is 
flawed?
    Chairman Bernanke. I do not think I can rank those. The 
main concern would be that Congress has to decide how big the 
Government is going to be and what share of national resources 
are going to flow through the Government, either for Government 
spending or through entitlement programs.
    The tax collections need to be commensurate with that, and 
that is the main decision. I am not qualified or in a position 
to tell you how big that share should be.
    Senator Tester. Foreign investment. I hear occasionally on 
TV, I hear from some of my constituents in Montana, that those 
people that are able to save some dough are being encouraged to 
put a certain percentage--I think 20, 25 percent is what I am 
hearing--into foreign markets. Is that a concern?
    Chairman Bernanke. No, not necessarily. Foreign markets 
have strengthened considerably in terms of their quality. 
Clearly, the world is experiencing a lot of growth and so there 
are a lot of opportunities out there. By investing broadly, an 
investor diversifies his or her portfolio and reduces the 
overall risk that they face.
    Senator Tester. How about from an economic growth 
standpoint here in this country? I think from an investor 
standpoint, I hear you. But what about an economic growth 
standpoint here? Is it a negative factor, positive factor, or 
no impact?
    Chairman Bernanke. I think it is probably slightly positive 
in the sense that it gives American investors greater 
diversification. And implicit in your question is where do we 
get the funds for domestic investment? Well, they flow in from 
abroad.
    And so by swapping essentially between foreign and domestic 
investors, you get better diversification for everybody.
    Senator Tester. Sounds good.
    Last question, and this deals with employment versus 
inflation. It has been talked about here a lot today, but when 
we get near full employment, does that necessarily drive 
inflation up?
    Chairman Bernanke. There is no specific level of employment 
or unemployment that is a trigger, in some sense, for 
inflation. The main concern is to make sure that the overall 
spending in the economy, which is driven in turn by financial 
conditions, does not exceed the underlying productive capacity 
for a sustained period. That seems to generate inflation.
    But as I have mentioned a couple of times, it is not easy 
to determine exactly where that balance should be struck. And 
simply looking at the unemployment rate, for example, is not 
going to tell you. You need to look at a wide variety of 
indicators, including price indicators, to get a sense of when 
the economy is overheating and when it is more or less in 
balance.
    Senator Tester. That is great. And that is actually what I 
was hoping to hear.
    So we should be continuing to strive to make employment 
complete, full to the best of our ability?
    Chairman Bernanke. Certainly. The Federal Reserve has a 
mandate for maximum sustainable employment, and we want to 
achieve that. We do not want to achieve employment which is 
high for a short moment but then crashes.
    Senator Tester. No.
    Chairman Bernanke. We want something that is sustainable.
    Senator Tester. Exactly.
    Once again I just want to go back, thank you, Mr. Chairman. 
I think this has been a great hearing. And I want to thank you, 
Chairman, for your honest forthright answers.
    Thank you very much.
    Chairman Dodd. Thank you, Senator Tester. Very good.
    Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman.
    Again, thank you, Chairman Bernanke, for your testimony.
    I was very impressed, as so many of my colleagues were, 
with your speech in Omaha. I thought it was thoughtful, 
comprehensive, and balanced, which is typical of your 
leadership at the Fed.
    At least one phrase or section struck me as interesting and 
that is you talked not only about technological change and 
international trade as causing this divergence between equality 
of incomes. But you also talked about institutional 
arrangements. The principal one you alluded to was labor 
unions.
    You say in your speech whatever the precise mechanism 
through which lower rates of unionization affected the wage 
structure, the available research suggests that it can explain 
between 10 percent and 20 percent of the rise in wage 
inequality among men during the 1970's and 1980's. I would 
suspect if it is 10 percent and 20 percent in the 1970's and 
1980's, it is at least that now, perhaps more, since unions 
have declined since that period of time.
    And it begs the question is one of the responses to wage 
inequality a more robust representation in the labor unions in 
the United States.
    Chairman Bernanke. It is difficult to know the answer 
because, as I indicated in my remarks, there have also been 
structural changes--like changes in the share of manufacturing 
employment in the economy as a whole--which have affected the 
rate of unionization. It is a little hard to tell whether it is 
the decline of unionization itself or the structural reasons 
for that that are the causes of the inequality.
    I do think that if workers want to be represented by a 
union, of course, they should be allowed to do that.
    Senator Reed. One of the issues here is that this is not 
just the hidden hand of the marketplace and technological 
change. There is Government policies. Policies which, until 
recently, one might say favored more, encouraged more 
participation in unions. Policies pursued by this 
Administration seem to go against it. The National Labor 
Relations Board, court decisions, Congressional activities.
    So this is an area, too, I think, that should be on the 
table, I presume, in terms of at least consideration by the 
Congress, if we are really concerned about narrowing this gap 
in terms of the economic equality. Is that a fair statement?
    Chairman Bernanke. Well, again, there is the problem of 
deciding how much of the effect comes from the structural 
changes that underlie the changes in unionization patterns and 
how much comes from changes in unionization propensity itself. 
So, I do not really know how much effect that would have.
    Senator Reed. Well, I think you have opened up a very 
serious line of inquiry, and I applaud you for doing that. 
Because once again, I think this is an issue that is there.
    And maybe anecdotally, I grew up in a State where everyone 
seemed to be in a union and they seemed to make pretty good 
wages and had health benefits. And now that is declining 
dramatically. And that, I think, contributes to this anxiety we 
have all referred to.
    Today, of course, I alluded in my opening statement, 13,000 
workers from Chrysler presumably--I would guess with some sense 
of probability that they are union workers--are losing their 
jobs and probably will not find union employment again. So, I 
think this is something we should consider.
    Again, I think mentioning it in your speech opens up a line 
of inquiry that is important.
    There is another issue, too, that you talked about and we 
all talk about the average income being stagnant for many 
working Americans. There is something else that I am hearing, 
is that the volatility of incomes for individual Americans 
fluctuates so wildly and causes huge problems. You could be a 
vice president for sales in a jewelry manufacturing company in 
Rhode Island making a handsome salary of $100,000. The next 
year you are making $35,000 because you are working at a lumber 
yard.
    That seems to be more common these days. And again, it gets 
lost in the aggregate, but for individuals we have to do 
something. Do you have any first thoughts about this 
phenomenon?
    Chairman Bernanke. Well, it is an issue that has been 
raised by Mr. Hacker and others, and I have a footnote in my 
speech about some of the impact it might have on measures of 
inequality. It is a little bit mysterious exactly what the 
source of this is. It could be more or less benign things, like 
job changes and so on. It could be less benign things like 
periods of unemployment or health problems.
    There does not seem to be an increase in this pattern. The 
1990's, if anything, seemed a little bit less volatile in that 
respect. There is no data that I know of for the most recent 
years. So it is a little bit of a black box, a little bit not 
clear what policy implications of that volatility should be.
    Senator Reed. By the way, anyone who has footnotes to his 
speeches should be commended, so you are commended on that.
    Is this an area of inquiry, though, that you intend to 
pursue at the Federal Reserve, in terms of this volatility as 
well as the aggregate income levels?
    Chairman Bernanke. We looked at that in preparing the 
speech and we did discuss it. And we were not, again, able to 
come to a strong conclusion about what the policy implications 
might be, and so we did not highlight it in the remarks.
    Senator Reed. I know that you are--and I think you do this 
very well--wary of making endorsements of particularly 
policies. But in your speech you did allude to some policies 
that should be considered.
    So in the spirit of what we should be considering, you talk 
about portability of health and pension benefits as one area. 
There are other areas, for example wage insurance proposals 
that have been made. Again, rather than taking a position, is 
that something that we should be considering?
    Chairman Bernanke. The general principle I was trying to 
address was the insecurity the people feel about job loss and 
job change. And I think it would be beneficial if we could 
reduce that insecurity.
    One way to do that would be to increase portability of 
benefits across jobs. There are many ways to do that, so I am 
not taking a specific means. Wage insurance is an interesting 
idea that has been advocated by a number of economists. Again, 
I am not sure I can take a specific position on it.
    One of the things I said, and I should reiterate, is that 
it is easy enough for me to say we should address these issues. 
The actual implementation is quite difficult. These are very 
complex problems. I just urge Congress to look at them and try 
to get as much good input and advice as they can in thinking 
about how to best address these issues.
    Senator Reed. A final issue, which is the Earned Income Tax 
Credit, which seems to me to be a very efficient way to deal 
with this issue that has been the constant source of our 
discussions this morning, inequality of wages, inequality of 
opportunity. Is that something that we should be looking at 
seriously, to expand it?
    Chairman Bernanke. Well, I was asked in the past about the 
minimum wage and, at that time, I said the Earned Income Tax 
Credit had some advantages compared to the minimum wage and 
that it was better targeted to the poor, to lower income 
people. And I still believe that to be the case.
    Of course, it does not come without cost. But I think it 
does have some advantages.
    Senator Reed. Thank you very much, Mr. Chairman.
    Thank you.
    Chairman Dodd. Thank you.
    Senator Carper.
    Senator Carper. Chairman Bernanke, I would like to say that 
we saved the best to the last. That is probably not true, but I 
might be the last. And for you, that is probably blessed 
relief.
    Thanks for coming today. Thanks for sharing your thoughts 
with all of us, and responding to our questions.
    Senator Reed mentioned an announcement earlier today by 
DaimlerChrysler, that they are taking steps to cut their work 
force, it sounds like, by as much as 13,000 across the country. 
Sometimes we listen to those announcements and they do not 
strike very close to home. In our case, in Delaware, they do. 
We have a DaimlerChrysler assembly plant we have had for over 
50 years in Newark, Delaware, close to the university. And so 
this one is one that is troubling to us.
    Having said that, I want to ask you a question. I 
telegraphed my pitch. And then I want to say a couple of other 
things.
    I am going to come back and talk to and raise an issue that 
the leaders of the big three--GM, Ford, and Chrysler--raised 
with President Bush 2 months ago when they came to Washington. 
Among the concerns that they raised was concerns about whether 
or not the Japanese are manipulating their currency in order to 
make their products more competitive in this country. So that 
is where I am going with this.
    But with respect to our own State, we build all of the 
Dodge Durangos and Chrysler Aspens in our plant. We have a 
reputation for doing a good job, and have had for a long time. 
About 14 years ago, literally the month I was elected Governor 
of Delaware in November 1992, our friends at General Motors 
announced that they were going to close their assembly plant in 
Wilmington, Delaware, along with a bunch of other plants, 
assembly plants and parts plants, across the country.
    They ended up closing, I think, just about all of them 
except this one in Wilmington, Delaware. It is one of two auto 
assembly plants that is still operating on the East Coast. I 
think the Ford Taurus plant down in Norfolk is going to close 
fairly soon. Then there will just be two plants, and one is the 
GM plant in our State. The other is the DaimlerChrysler plant.
    Our friends at DaimlerChrysler have announced today that 
they were going to go back to one shift at our plant in Newark. 
They are going to prepare to idle the plant at the end of 2009 
if they do not have a new product for the plant then, then the 
plant might close, which is worrisome to us all.
    But we have seen this movie before and we did not just wait 
for the inevitable to happen. We fought very hard to make sure 
that it did not happen. The workers at GM, the labor and the 
management people, did a great job. I hope the State did, as 
well. And we averted what could have been a bad situation, not 
there is a very successful operation there.
    There are a number of things, I think, that can be done. 
This question relates to how do we revitalize manufacturing in 
our country, particularly auto manufacturing, which I hope we 
can do and think we ought to. But there are a number of things, 
in my own view, that can be done and should be done. I will 
just start with Chrysler, and then I am leading up to monetary 
policy.
    The people at Chrysler, they have to make vehicles that 
people want to buy. They have to make vehicles that are energy 
efficient, environmentally friendly, have good quality. The 
people at Chrysler, they have to go to what Toyota has done 
very well, flexible manufacturing where the people at Toyota 
make maybe three or four vehicles at a plant. And if the demand 
for product A is stronger than B, they make more A. If product 
C gets hot, they make more C. They usually have a fourth 
vehicle that is a pilot vehicle that they are getting ready to 
develop and to sell when it is time to launch it on the market. 
So there is a lot of things that DaimlerChrysler can do. Those 
are some.
    There are things that we can do at the local level, in 
Delaware or any other State that is affected by announcements 
by this. You could take a page from what happened at our GM 
plant. It is being more committed to quality, more committed to 
productivity, more committed to good labor management 
relations, more committed to innovation, and willing to work 
and think outside the box. We did that 14 years ago and we need 
to do that again here, at our Newark plant.
    The State can work even harder to provide a nurturing 
environment for manufacturing jobs. There is a lot that we have 
done and there is more than can still be done.
    And at the Federal level, and I am finally coming to my 
question to you, but at the Federal level we do a fair amount 
with R&D. The President has proposed, in his budget, 
significant investments in research and development with 
respect to new battery technology, these lithium ion batteries 
that can be used to plug in hybrid vehicles, flex fuel/plug-in 
hybrid vehicles, which I think is a very promising technology.
    We have an opportunity to use the Government's purchasing 
power on the civilian side and on the defense side, to help 
commercialize technologies that have a great deal of promise, 
whether they are variable fuel, flex fuel, plug-in hybrids, or 
next generation hybrids or low emission diesel.
    We have tax credits in our law. We have a tax credit for 
people who buy highly energy efficient hybrids and it caps out 
at 60,000. After 60,000 units have been sold by a manufacturer, 
I think that tax credit begins to go away. But until it does, 
there is a tax credit that can incentivize people to buy high 
energy efficient hybrids.
    We have a mirror tax credit that not many people know about 
but they are going to be learning about, that works on the 
diesel side, highly energy efficient low-emission diesel, which 
DaimlerChrysler is beginning to bring onto the roads here, also 
qualifies for a similar tax credit.
    We can do better work on the health care costs, harnessing 
information technology, and all kinds of things to work on the 
health care side. Those are things for the people at 
DaimlerChrysler to do, State and local, at the plants 
themselves that are put here in harm's way. And there are 
opportunities for us at the Federal level.
    Now to you. The people who run these three companies--GM, 
Ford, and Chrysler--suggested to the President that the 
Japanese were manipulating the currency. Secretary Paulson was 
there, he pushed back and said no, in fact, we talked about 
this here in the last month. And he said no, I do not think 
they are. Maybe they were at one time, but we do not think they 
are today.
    There was a time not long ago when the Japanese economy was 
in such a fund, they were going through deflation. And we 
wanted them to take strong actions to change that.
    But fast-forwarding to the present, what is going on? Are 
these concerns or allegations, are they baseless? Is there some 
basis to them? Is this something that we should be mindful of, 
concerned about, do something about?
    Chairman Bernanke. The Treasury and the Federal Reserve 
have expressed the view that exchange rates should be 
determined in free and open markets. As best as we can tell, 
the yen's value is being determined in a free, open, and 
competitive market. There is no evidence of any intervention 
going on. The last time the Japanese purchased dollars was in 
March 2004.
    The behavior of the yen appears to be consistent with the 
monetary policies they are conducting which, in turn, are 
closely related to the state of their domestic economy. So we 
do not see any manipulation or intervention in the value of the 
yen.
    Senator Carper. How would we know if they were doing it?
    Chairman Bernanke. We can see it, for example, in the case 
of China where there is a very closely managed exchange rate. 
It moves very slowly and there are large capital inflows. In 
order to maintain the yuan within the range that they are 
trying to achieve, they have to acquire huge amounts of 
reserves and they have to sterilize the effects of those 
reserves on the domestic money supply. And so there is a very 
clear type of behavior that we can see.
    Now it is true that there are many factors that affect the 
value of a currency. But to my knowledge there are no overt 
interventions or any such factors affecting the yen at this 
time.
    Senator Carper. My last, if I could, just in closing. If 
you are giving advice to domestic auto manufacturers on what to 
do to regain market share to return to profitability, what are 
some of the steps that you would suggest that they and we take?
    Chairman Bernanke. You made a number of good points. One of 
them, I think, is R&D. It is not really true that U.S. 
manufacturing is disappearing. That is not the case. The output 
of U.S. manufacturing has grown more quickly than almost any 
other industrial country in the last 10 years and it has been 
supported by enormous increases in productivity, which is one 
of the reasons why we need fewer and fewer workers. But the 
output continues to rise.
    The other feature of U.S. manufacturing is that it has 
shifted very much from lower tech type production to the most 
high tech type production. We see that in airplane exports and 
sophisticated capital equipment, medical equipment, silicon 
chips and so on, things that we currently export.
    And indeed, one more point, one effect of that has been 
that the demand for labor and manufacturing has shifted very 
dramatically from low-skilled workers to the highest skilled 
workers.
    One of the things that has really supported those 
successful areas of manufacturing has been our leadership in 
R&D and technology. The Government can support that in various 
ways. Among them, helping to support basic research, which may 
not be in the interest of any specific company to undertake on 
its own, but with Government assistance or Government 
coordination the industry as a whole can undertake and find, in 
the case of automobiles, new fuel efficient technologies, for 
example, or other changes that make the cars more attractive.
    Senator Carper. Mr. Chairman, you have been good with your 
time.
    Thank you, Chairman Bernanke. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you.
    Senator Carper. That is probably good advice, not just for 
auto manufacturers, but for people running for President.
    Chairman Dodd. Or any office, for that matter.
    Senator Carper. There you go. Thank you.
    Chairman Dodd. The basic research point is an excellent 
one. I do not have the numbers on the top of my head here, but 
the decline of the U.S. Government's commitment to basic 
research has dropped precipitously. I think over the last 
number of years, it is not something that has occurred in the 
last couple of years. I am pleased to hear you say that. That 
is something we do not pay enough attention to, and how much we 
have benefitted over the years for applied research to live off 
the basic research commitments we have made in the past, so it 
is worthwhile.
    If I can, Mr. Chairman, just a couple of points I wanted to 
raise with you, and I thank my colleague from Delaware for his 
comments. Just a couple of cleanup things.
    I mentioned earlier, the issue we had in the hearings on 
the predatory lending issue. We did not bring up GSE's today. 
My colleague from Delaware has a strong interest, as I do. And 
we are going to move fairly quickly here on a Senate bill. It 
is an important issue.
    Although I think things are in pretty good control. It is 
not as if there is some immediate threat out there. There are a 
number of things we need to be doing and we intend to move in 
that direction.
    One of the things I wanted to raise with you, because with 
Fannie Mae and Freddie Mac, is the purchasing of some of these 
ARM's that are pretty abusive. Understand in these things, the 
broker and the bank is out of it pretty quickly, 10 to 12 
weeks. These things are bundled and then go off and are 
securitized.
    And the fact that Fannie and Freddie are purchasing these 
at a pretty high standard, AA or AAA, whatever the standard is 
they are applying to them, concerns me in a sense. One good way 
to begin to try and reverse some of these practices, in 
addition to what regulators may be able to do, is to have some 
different requirements here in terms of the securitization of 
these products.
    I wonder if you have any comment on that at all you care to 
share.
    Chairman Bernanke. I am not quite sure about how one 
distinguishes so-called ``legitimate ARM products'' from those 
which may be less legitimate. If you could do so, then that 
would be a direction to go.
    I think more broadly that it would be a good thing for the 
GSE portfolios to be more consistent with their housing 
mission. According to OFHEO, the GSE portfolios are only 30 
percent related to affordable housing. The rest is all 
different other kinds of things. So to match their mission with 
their portfolios would be, I think, very desirable.
    The specific suggestion you make might be feasible, but it 
would require some way of determining which types of loans are 
to be acceptable or not.
    Chairman Dodd. I just wanted to raise that point with you.
    Let me come back, if I can, to the points that Senator 
Carper was raising about trade and foreign governments. It was 
reported yesterday, you have heard this again from some other 
colleagues this morning, that our trade deficit has now reached 
a record $763 billion last year. That is the fifth straight 
year that we have had a record trade deficit.
    The Wall Street Journal reported, ``Following yesterday's 
report, economists on Wall Street said the Government, later 
this month, would likely lower its final growth estimate 
sharply for the fourth quarter.''
    In order to finance our trade budget and current account 
deficits, we are required to have an influx of something in the 
neighborhood of a little less than $2.5 billion of foreign 
capital on a daily basis, as I am told. Now some have argued 
that this is all right and it is no great threat because it is 
coming from the private investors offshore.
    But in your report the Fed states, ``On net private 
foreigners purchased few U.S. treasuries.''
    The obvious question is then it is governments who appear 
to be buying them. I put that in the form of a question. I 
should not make the statement. Is it your conclusion that the 
decline in private investors here, it is governments then that 
are purchasing this?
    Chairman Bernanke. Are you referring to private foreign 
investors or private domestic?
    Chairman Dodd. Yes, private foreign investors.
    Chairman Bernanke. Private foreign investors are still 
holding significant U.S. assets, but it is true that 
acquisition of treasuries and other fixed income instruments 
for the purposes of foreign reserves are an important component 
of the in-flow.
    Chairman Dodd. The end of the line was, in fact, that 
foreign direct investment flows in the United States remains 
robust. So again, it is that public commitment that we are 
relying on at this particular junction. So it is not so much 
the private foreign investor, it is the governmental investor 
that we are----
    Chairman Bernanke. We can send you some numbers. It depends 
on the instrument. Foreign private investors are more likely to 
buy equities, for example, than central banks.
    Chairman Dodd. Going back to the issues raised earlier 
about China, and again the question is a good question Senator 
Carper was raising. He talks about the yen and I think you 
had--and I agree with your answer on the yen, based on what I 
have known. It is troubling, to some degree. We have the cost 
like a health care cost, I think at a GM automobile, is $1,500. 
I think someone has made that conclusion. At Toyota, it is 
$150.
    So in addition to what other factors may exist out there, 
we have some built-in costs that I think have contributed to 
the lack of competitiveness, in some cases, in our American-
produced automobiles.
    But there is an issue of China's manipulation of their 
currency. What would recommend, if anything at all? I accept 
the fact that they are getting better. And I heard you say that 
is the case. But we get this all the time. When Senator Carper 
and I go back to our constituencies, one of the first questions 
that come up, if we get into any discussion of economics at 
all, is this issue. I am just wondering if we are not doing 
enough or there is something else we could be doing to take 
what you have said here and call it what it is. I agree with 
you, it is manipulation of their currency. There is no question 
about it.
    Then what do we do about that? How do we respond to this?
    Chairman Bernanke. Senator, I did not use the word 
manipulation.
    Chairman Dodd. I thought I heard you say that?
    Chairman Bernanke. No, sir. If I did, it was a mistake.
    Chairman Dodd. I tried.
    Chairman Bernanke. I think a point to make, and this is, to 
some extent, recognized in Secretary Paulson's Strategic 
Economic dialogue, is that while the exchange rate is a very 
important issue and one that we are continuing to press China 
on, we have many, many other issues of mutual concern in 
economics.
    Just to talk specifically about the trade balance, another 
dimension besides the exchange rate is whether China can become 
more reliant on its own domestic demand, its own consumption 
spending as a source of growth, rather than relying on exports 
to the United States.
    I think it is somewhat encouraging that the Chinese have 
officially recognized the problem of a growing trade surplus 
and both the economic and political risks that that poses. They 
have proposed a plan for trying to increase domestic 
consumption which, over time, should reduce the reliance of 
China on exports. It should reduce their trade surplus. So 
there are some other measures that they are taking, albeit ones 
that will take some time to work.
    But again, rather than putting everything on that 
particular issue of the exchange rate, we should also note that 
we have common interests with the Chinese on matters of the 
environment, for example, on matters of energy, trade and 
investment, and immigration and visas.
    So, I would hope that while we continue to press China to 
make progress on this very important issue of the exchange 
rate, it is not exclusive of all the other very important 
issues that we have in common and that we could collectively 
benefit from if we were to work with the Chinese to come to 
better arrangements than we have.
    Chairman Dodd. I appreciate that. Again, I know you 
appreciate the concerns we hear about and using your language 
in China, the subsidy notion here. And clearly, when you have 
lost your job because the company you work for can no longer 
compete because your competitor is able to adjust that currency 
to such an extent that it causes your job to disappear, that 
level of frustration is beyond just an intellectual exercise. 
If you are walking home that night to face your family because 
there is no longer the job there, and what it means.
    I want to return last, if I can, to one point. Again, your 
candor has been terrific and your comments. The quote that Jack 
Reed raised in your Omaha speech, where too often this 
discussion about unionization falls on an ideological fault 
line. And I appreciate immensely here that you talked about it 
based on just data here, rather than drawing conclusions about 
whether you like or dislike unions.
    But the important role they played, in terms historically 
of closing income gaps. This is not the first time we are 
talking about income gaps. In fact, income gaps were far more 
pronounced during the early part of the 20th century.
    And what I read from your quote here is that, and I will 
ask the question here in a sense. You talk about these numbers 
back in the 1970's and 1980's, and I presume even earlier, some 
of those income gaps that closed up, you attribute to the fact 
that there was the ability of people to organize and to 
negotiate for better wages and working conditions for 
themselves.
    I wonder if you might just expound on that a little bit, 
without getting involved in the ideological discussion. I am 
not asking you to do that. But it is a very important point, I 
think, as those of us try to assist in this effort of closing 
that gap, to realize how important that particular element can 
play in making it possible for people to move up that economic 
ladder.
    Chairman Bernanke. I was reporting some research, which I 
think is good research.
    Chairman Dodd. I know you were.
    Chairman Bernanke. Again, I think that workers who wish to 
be represented by unions have every right to do, and we should 
not block that in any way. We should give them the 
opportunities to do that.
    The implications of unionization for income equality or 
inequality, as I indicated before, are a bit difficult to tease 
out because there have been changes in union rates. But there 
have also been changes in the structure in the economy, the 
most notable one being the decline of manufacturing jobs and 
manufacturing employment, and the increase in international 
competition. There certainly was a time when GM, for example, 
had a certain amount of monopoly power and was able to charge 
probably a higher price than it otherwise could. And now, of 
course, GM is in very intense competition with other companies 
around the world.
    So it is an open question, a very interesting question, to 
what extent that association between wage changes and 
unionization is causal--that the changes in unionization have 
changed the wage pattern--or to what extent they are both the 
product of a third force such as the change in manufacturing 
employment or the change in the extent of international 
competition.
    The kinds of studies we have seen so far really cannot 
distinguish between those two hypotheses.
    Chairman Dodd. I appreciate your comments. This will be 
part of an ongoing conversation. But the comments here, based 
on just hard data I thought were very valuable to contribute to 
the debate and discussion as to what we need to be doing to 
move forward in closing that gap that you have spoken about so 
eloquently.
    Thank you immensely. I thank my colleagues, they have had 
to leave here. But there were great questions that came up this 
morning and your answers were very candid and very 
straightforward and forthright, and we appreciate it immensely.
    So we look forward to having an ongoing conversation with 
you and we thank you for your appearance here this morning.
    This hearing will stand adjourned.
    [Whereupon, at 1:18 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]
                 PREPARED STATEMENT OF BEN S. BERNANKE
       Chairman, Board of Governors of the Federal Reserve System
                           February 14, 2007
    Chairman Dodd, Senator Shelby, and other Members of the Committee, 
I am pleased to present the Federal Reserve's Monetary Policy Report to 
the Congress.
    Real activity in the United States expanded at a solid pace in 
2006, although the pattern of growth was uneven. After a first-quarter 
rebound from weakness associated with the effects of the hurricanes 
that ravaged the Gulf Coast the previous summer, output growth 
moderated somewhat on average over the remainder of 2006. Real gross 
domestic product (GDP) is currently estimated to have increased at an 
annual rate of about 2\3/4\ percent in the second half of the year.
    As we anticipated in our July report, the U.S. economy appears to 
be making a transition from the rapid rate of expansion experienced 
over the preceding several years to a more sustainable average pace of 
growth. The principal source of the ongoing moderation has been a 
substantial cooling in the housing market, which has led to a marked 
slowdown in the pace of residential construction. However, the weakness 
in housing market activity and the slower appreciation of house prices 
do not seem to have spilled over to any significant extent to other 
sectors of the economy. Consumer spending has continued to expand at a 
solid rate, and the demand for labor has remained strong. On average, 
about 165,000 jobs per month have been added to nonfarm payrolls over 
the past 6 months, and the unemployment rate, at 4.6 percent in 
January, remains low.
    Inflation pressures appear to have abated somewhat following a run-
up during the first half of 2006. Overall inflation has fallen, in 
large part as a result of declines in the price of crude oil. Readings 
on core inflation--that is, inflation excluding the prices of food and 
energy--have improved modestly in recent months. Nevertheless, the core 
inflation rate remains somewhat elevated.
    In the five policy meetings since the July report, the Federal Open 
Market Committee (FOMC) has maintained the Federal funds rate at 5\1/4\ 
percent. So far, the incoming data have supported the view that the 
current stance of policy is likely to foster sustainable economic 
growth and a gradual ebbing of core inflation. However, in the 
statement accompanying last month's policy decision, the FOMC again 
indicated that its predominant policy concern is the risk that 
inflation will fail to ease as expected and that it is prepared to take 
action to address inflation risks if developments warrant.
    Let me now discuss the economic outlook in a little more detail, 
beginning with developments in the real economy and then turning to 
inflation. I will conclude with some brief comments on monetary policy.
    Consumer spending continues to be the mainstay of the current 
economic expansion. Personal consumption expenditures, which account 
for more than two-thirds of aggregate demand, increased at an annual 
rate of around 3\1/2\ percent in real terms during the second half of 
last year, broadly matching the brisk pace of the previous 3 years. 
Consumer outlays were supported by strong gains in personal income, 
reflecting both the ongoing increases in payroll employment and a 
pickup in the growth of real wages. Real hourly compensation--as 
measured by compensation per hour in the nonfarm business sector 
deflated by the personal consumption expenditures price index--rose at 
an annual rate of around 3 percent in the latter half of 2006.
    The resilience of consumer spending is all the more striking given 
the backdrop of the substantial correction in the housing market that 
became increasingly evident during the spring and summer of last year. 
By the middle of 2006, monthly sales of new and existing homes were 
about 15 percent lower than a year earlier, and the previously rapid 
rate of house-price appreciation had slowed markedly. The fall in 
housing demand in turn prompted a sharp slowing in the pace of 
construction of new homes. Even so, the backlog of unsold homes rose 
from about 4\1/2\ months' supply in 2005 to nearly 7 months' supply by 
the third quarter of last year. Single-family housing starts have 
dropped more than 30 percent since the beginning of last year, and 
employment growth in the construction sector has slowed substantially.
    Some tentative signs of stabilization have recently appeared in the 
housing market: New and existing home sales have flattened out in 
recent months, mortgage applications have picked up, and some surveys 
find that homebuyers' sentiment has improved. However, even if housing 
demand falls no further, weakness in residential investment is likely 
to continue to weigh on economic growth over the next few quarters as 
homebuilders seek to reduce their inventories of unsold homes to 
morecomfortable levels.
    Despite the ongoing adjustments in the housing sector, overall 
economic prospects for households remain good. Household finances 
appear generally solid, and delinquency rates on most types of consumer 
loans and residential mortgages remain low. The exception is subprime 
mortgages with variable interest rates, for which delinquency rates 
have increased appreciably. The labor market is expected to stay 
healthy, and real incomes should continue to rise, although the pace of 
employment gains may be slower than that to which we have become 
accustomed in recent years. In part, slower average job growth may 
simply reflect the moderation of economic activity. Also, the impending 
retirement of the leading edge of the baby-boom generation, and an 
apparent leveling out of women's participation rate in the workforce, 
which had risen for several decades, will likely restrain the growth of 
the labor force in coming years. With fewer jobseekers entering the 
labor force, the rate of job creation associated with the maintenance 
of stable conditions in the labor market will decline. All told, 
consumer expenditures appear likely to expand solidly in coming 
quarters, albeit a little less rapidly than the growth in personal 
incomes if, as we expect, households respond to the slow pace of home-
equity appreciation by saving more out of current income.
    The business sector remains in excellent financial condition, with 
strong growth in profits, liquid balance sheets, and corporate leverage 
near historical lows. Last year, those factors helped to support 
continued advances in business capital expenditures. Notably, 
investment in high-tech equipment rose 9 percent in 2006, and spending 
on nonresidential structures (such as office buildings, factories, and 
retail space) increased rapidly through much of the year after several 
years of weakness. Growth in business spending slowed toward the end of 
last year, reflecting mainly a deceleration of spending on business 
structures; a drop in outlays in the transportation sector, where 
spending is notably volatile; and some weakness in purchases of 
equipment related to construction and motor vehicle manufacturing. Over 
the coming year, capital spending is poised to expand at a moderate 
pace, supported by steady gains in business output and favorable 
financial conditions. Inventory levels in some sectors--most notably at 
motor vehicle dealers and in some construction-related manufacturing 
industries--rose over the course of last year, leading some firms to 
cut production to better align inventories with sales. Remaining 
imbalances may continue to impose modest restraint on industrial 
production during the early part of this year.
    Outside the United States, economic activity in our major trading 
partners has continued to grow briskly. The strength of demand abroad 
helped spur a robust expansion in U.S. real exports, which grew about 9 
percent last year. The pattern of real U.S imports was somewhat uneven, 
partly because of fluctuations in oil imports over the course of the 
year. On balance, import growth slowed in 2006, to 3 percent. Economic 
growth abroad should support further steady growth in U.S. exports this 
year. Despite the improvements in trade performance, the U.S. current 
account deficit remains large, averaging about 6\1/2\ percent of 
nominal GDP during the first three quarters of 2006 (the latest 
available data).
    Overall, the U.S. economy seems likely to expand at a moderate pace 
this year and next, with growth strengthening somewhat as the drag from 
housing diminishes. Such an outlook is reflected in the projections 
that the Members of the Board of Governors and Presidents of the 
Federal Reserve Banks made around the time of the FOMC meeting late 
last month. The central tendency of those forecasts--which are based on 
the information available at that time and on the assumption of 
appropriate monetary policy--is for real GDP to increase about 2\1/2\ 
to 3 percent in 2007 and about 2\3/4\ to 3 percent in 2008. The 
projection for GDP growth in 2007 is slightly lower than our projection 
last July. This difference partly reflects an expectation of somewhat 
greater weakness in residential construction during the first part of 
this year than we anticipated last summer. The civilian unemployment 
rate is expected to finish both 2007 and 2008 around 4\1/2\ to 4\3/4\ 
percent.
    The risks to this outlook are significant. To the downside, the 
ultimate extent of the housing market correction is difficult to 
forecast and may prove greater than we anticipate. Similarly, spillover 
effects from developments in the housing market onto consumer spending 
and employment in housing-related industries may be more pronounced 
than expected. To the upside, output may expand more quickly than 
expected if consumer spending continues to increase at the brisk pace 
seen in the second half of 2006.
    I turn now to the inflation situation. As I noted earlier, there 
are some indications that inflation pressures are beginning to 
diminish. The monthly data are noisy, however, and it will consequently 
be some time before we can be confident that underlying inflation is 
moderating as anticipated. Recent declines in overall inflation have 
primarily reflected lower prices for crude oil, which have fed through 
to the prices of gasoline, heating oil, and other energy products used 
by consumers. After moving higher in the first half of 2006, core 
consumer price inflation has also edged lower recently, reflecting a 
relatively broad-based deceleration in the prices of core goods. That 
deceleration is probably also due to some extent to lower energy 
prices, which have reduced costs of production and thereby lessened one 
source of pressure on the prices of final goods and services. The 
ebbing of core inflation has likely been promoted as well by the 
stability of inflation expectations.
    A waning of the temporary factors that boosted inflation in recent 
years will probably help foster a continued edging down of core 
inflation. In particular, futures quotes imply that oil prices are 
expected to remain well below last year's peak. If actual prices follow 
the path currently indicated by futures prices, inflation pressures 
would be reduced further as the benefits of the decline in oil prices 
from last year's high levels are passed through to a broader range of 
core goods and services. Nonfuel import prices may also put less 
pressure on core inflation, particularly if price increases for some 
other commodities, such as metals, slow from last year's rapid rates. 
But as we have been reminded only too well in recent years, the prices 
of oil and other commodities are notoriously difficult to predict, and 
they remain a key source of uncertainty to the inflation outlook. The 
contribution from rents and shelter costs should also fall back, 
following a step-up last year. The faster pace of rent increases last 
year may have been attributable in part to the reduced affordability of 
owner-occupied housing, which led to a greater demand for rental 
housing. Rents should rise somewhat less quickly this year and next, 
reflecting recovering demand for owner-occupied housing as well as 
increases in the supply of rental units, but the extent and pace of 
that adjustment is not yet clear.
    Upward pressure on inflation could materialize if final demand were 
to exceed the underlying productive capacity of the economy for a 
sustained period. The rate of resource utilization is high, as can be 
seen in rates of capacity utilization above their long-term average 
and, most evidently, in the tightness of the labor market. Indeed, 
anecdotal reports suggest that businesses are having difficulty 
recruiting well-qualified workers in certain occupations. Measures of 
labor compensation, though still growing at a moderate pace, have shown 
some signs of acceleration over the past year, likely in part the 
result of tight labor market conditions.
    The implications for inflation of faster growth in nominal labor 
compensation depend on several factors. Increases in compensation might 
be offset by higher labor productivity or absorbed by a narrowing of 
firms' profit margins rather than passed on to consumers in the form of 
higher prices; in these circumstances, gains in nominal compensation 
would translate into gains in real compensation as well. Underlying 
productivity trends appear favorable, and the markup of prices over 
unit labor costs is high by historical standards, so such an outcome is 
certainly possible. Moreover, if activity expands over the next year or 
so at the moderate pace anticipated by the FOMC, pressures in both 
labor and product markets should ease modestly. That said, the 
possibility remains that tightness in product markets could allow firms 
to pass higher labor costs through to prices, adding to inflation and 
effectively nullifying the purchasing power of at least some portion of 
the increase in labor compensation. Thus, the high level of resource 
utilization remains an important upside risk to continued progress on 
inflation.
    Another significant factor influencing medium-term trends in 
inflation is the public's expectations of inflation. These expectations 
have an important bearing on whether transitory influences on prices, 
such as those created by changes in energy costs, become embedded in 
wage and price decisions and so leave a lasting imprint on the rate of 
inflation. It is encouraging that inflation expectations appear to have 
remained contained.
    The projections of the Members of the Board of Governors and the 
Presidents of the Federal Reserve Banks are for inflation to continue 
to ebb over this year and next. In particular, the central tendency of 
those forecasts is for core inflation--as measured by the price index 
for personal consumption expenditures excluding food and energy--to be 
2 to 2\1/4\ percent this year and to edge lower, to 1\3/4\ to 2 
percent, next year. But as I noted earlier, the FOMC has continued to 
view the risk that inflation will not moderate as expected as the 
predominant policy concern.
    Monetary policy affects spending and inflation with long and 
variable lags. Consequently, policy decisions must be based on an 
assessment of medium-term economic prospects. At the same time, because 
economic forecasting is an uncertain enterprise, policymakers must be 
prepared to respond flexibly to developments in the economy when those 
developments lead to a reassessment of the outlook. The dependence of 
monetary policy actions on a broad range of incoming information 
complicates the public's attempts to understand and anticipate policy 
decisions.
    Clear communication by the central bank about the economic outlook, 
the risks to that outlook, and its monetary policy strategy can help 
the public to understand the rationale behind policy decisions and to 
anticipate better the central bank's reaction to new information. This 
understanding should, in turn, enhance the effectiveness of policy and 
lead to improved economic outcomes. By reducing uncertainty, central 
bank transparency may also help anchor the public's longer-term 
expectations of inflation. Much experience has shown that well-anchored 
inflation expectations tend to help stabilize inflation and promote 
maximum sustainable economic growth. Good communication by the central 
bank is also vital for ensuring appropriate accountability for its 
policy actions, the full effects of which can be observed only after a 
lengthy period. A transparent policy process improves accountability by 
clarifying how a central bank expects to attain its policy objectives 
and by ensuring that policy is conducted in a manner that can be seen 
to be consistent with achieving those objectives.
    Over the past decade or so, the Federal Reserve has significantly 
improved its methods of communication, but further progress is 
possible. As you know, the FOMC last year established a subcommittee to 
help the full Committee evaluate the next steps in this continuing 
process. Our discussions are directed at examining all aspects of our 
communications and have been deliberate and thorough. These discussions 
are continuing, and no decisions have been reached. My colleagues and I 
remain firmly committed to an open and transparent monetary policy 
process that enhances our ability to achieve our dual objectives of 
stable prices and maximum sustainable employment. I will keep Members 
of this Committee apprised of developments as our deliberations move 
forward. I look forward to continuing to work closely with the Members 
of this Committee and your colleagues in the Senate and House on the 
important issues pertaining to monetary policy and the other 
responsibilities with which the Congress has charged the Federal 
Reserve.
    Thank you. I would be happy to take questions.
        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY 
                      FROM BEN S. BERNANKE

Q.1. I have been concerned for some time about the 
implementation of the Basel II Capital Accord and the impact 
Basel II may have on the safety and soundness of the U.S. 
banking system. In particular, I am worried that Basel II may 
lead to a sharp reduction in the amount of capital banks are 
required to hold, which would put U.S. taxpayers at risk of 
having to pay for expensive bank failures. Accordingly, I 
believe that it is critical that Basel II be implemented with 
the utmost care and diligence. Would you please update the 
Committee on the status of the Basel II Capital Accords and the 
current timeframe for implementing Basel II? I would like you 
to comment on whether there is enough time for banking 
regulators to finalize the rules implementing Basel II, so that 
banks adopting Basel II can start the test run for Basel II 
presently scheduled to begin next year. What, if any, is the 
likelihood that the timeframe currently envisioned may need to 
be adjusted?

A.1. First, let me reiterate that the primary goal of the 
agencies in implementing Basel II in the United States is to 
enhance the safety and soundness of the U.S. banking system. 
Accordingly, we will not permit capital levels to decline under 
the Basel II framework so as to potentially jeopardize safety 
and soundness. We remain committed to ensuring that regulatory 
capital levels at all U.S. banking organizations remain robust. 
It is important to keep in mind that under Pillar II, banking 
supervisors will be reviewing total capital plans relative to 
risk at each Basel II bank, not just the minimum capital 
requirements calculated under Pillar I. We also continue to 
believe, subject to the receipt of comments on the outstanding 
Basel II notice of proposed rulemaking (NPR), that it is 
critical to move forward with Basel II implementation so that 
our largest and internationally active banking organizations 
have the most risk reflective regulatory capital framework and 
can remain competitive with other banking organizations that 
apply similar risk sensitive frameworks.
    The Basel II NPR issued in September 2006 remains open for 
comment through March 26, 2007. As outlined in the NPR, the 
first opportunity for a bank to be able to begin a parallel run 
(that is, apply the Basel II framework and report results to 
the appropriate supervisor, but continue to use Basel I ratios 
for regulatory purposes) would be January 2008. The first 
opportunity for a bank to begin applying the Basel II framework 
subject to the proposed transition floors would be January 
2009. We remain committed to this schedule; however, it will be 
challenging to meet the previously announced June 2007 date for 
a final rule. We are very interested in public comments 
submitted on the proposal. We will need to take sufficient time 
to fully consider comments and to make corresponding 
modifications to the proposed framework as the agencies deem to 
be appropriate. Because the comment period is still open, it is 
difficult to estimate how comprehensive the comments will be. 
While we already are aware of a number of issues raised by the 
industry, in complex rulemakings such as this one there are 
always unanticipated issues as well. The extent and complexity 
of the comments overall will have an impact on the ultimate 
timing for issuing a final rule. We continue to believe that it 
is important to meet the previously stated first live start 
date of January 2009 and at this time do not anticipate that 
that start date will need to be adjusted.

Q.2. Your testimony noted that the U.S. current account deficit 
remains large, averaging about 6\1/2\ percent of nominal GDP. 
You also note that economic growth abroad should support 
further steady growth in U.S. exports this year. Do you 
anticipate much improvement in the current account deficit over 
the next year as a result of export improvement? Do you see any 
other economic factors changing over the next year that might 
lead to an improved trade deficit?

A.2. In the past year, U.S. exports have grown strongly, 
reflecting a number of factors, including solid foreign 
economic growth, increases in investment spending abroad that 
have boosted sales of capital goods produced in the United 
States, and the booming market for agricultural goods and other 
commodities. These developments have played out against the 
backdrop of continued innovation and productivity growth in the 
U.S. economy that, along with the decline in the foreign 
exchange value of the dollar since earlier in this decade, have 
buoyed the attractiveness of American-made products. As a 
result of strong export growth, in combination with sharp 
declines in the price of imported oil, the trade deficit has 
narrowed from 6 percent of U.S. GDP in the third quarter of 
last year to about 5\1/4\ percent of GDP in the fourth, and the 
current account deficit has improved by a broadly similar 
extent. These movements, coming as they did toward the end of 
2006, may well cause the trade and current account deficits for 
2007 as a whole, measured as a share of GDP, to be smaller than 
those for 2006.
    Focusing on their evolution from the current quarter 
onwards, however, it is uncertain whether our Nation's external 
deficits will narrow further over the next few years. On the 
export side, the extraordinary growth in overseas sales of some 
U.S. products during 2006 may be difficult to sustain; for 
example, exports of aircraft grew more than 20 percent last 
year. On the import side, the price of imported oil has bounced 
back from recent lows, and futures markets suggest that further 
increases may be in the offing. Another important determinant 
of U.S. trade flows, the foreign exchange value of the dollar, 
is volatile and extremely difficult to predict. Finally, even 
if the trade balance were to continue to improve, it is not 
clear that the current account balance--which is equal to the 
trade balance plus the balance on international income flows 
and transfers--would follow suit. The need to finance continued 
trade deficits, even if these deficits are smaller than in the 
past, puts upward pressure on the Nation's external debt and 
thus investment income payments to foreigners, thereby tending 
to expand the current account deficit.

Q.3. This Committee continues to have a great degree of 
interest in the Chinese economy, particularly currency 
practices. China's foreign exchange reserves now stand at over 
$1 trillion, creating excess liquidity in their banking system. 
Some financial experts have stated that the United States 
should not view China's large stock of foreign currency 
reserves as a problem. What is your view of this level of 
reserves? Do you believe China's ratio of reserves to money 
supply is reasonable? To what extent do you believe that 
China's reserves are the result of speculation? Could this, in 
fact, result in an even lower value for the RMB should that 
currency become more flexible in the future?

A.3. For some time now, the monetary authorities in China have 
been resisting upward pressure on the value of the renminbi in 
foreign exchange markets by purchasing dollars and perhaps 
other foreign currencies. Even though these accumulated 
purchases have reached a value of more than $1 trillion, it is 
not certain that the accumulation has created excess liquidity 
in China's banking system. Reserves and liquidity do not move 
in lockstep in China, because Chinese authorities have policy 
tools available to drain liquidity, including issuance of 
official securities (so-called ``sterilization bonds'') and 
increasing banks' reserve requirements. At present, it does not 
appear that China has had any substantial difficulty using 
either of these tools to drain liquidity, although that may 
change in the future. Because the linkage between reserves and 
money need not be tight, it would be hard to determine a 
reasonable range for the ratio of reserves to the money stock 
appropriate for China's economy.
    I do not believe China's substantial accumulation of 
reserves in itself represents a problem for the United States 
or for United States monetary policy. Official demand in China 
and other countries for United States assets reflects the 
dollar's role as preeminent reserve currency, which results in 
great part from the strength of our economy and the safety and 
liquidity of the United States financial system. Because 
foreign holdings of U.S. Treasury securities represent only a 
small part of total U.S. credit market debt outstanding, U.S. 
credit markets should be able to absorb without great 
difficulty any shift in foreign allocations. And even if such a 
shift were to put undesired upward pressure on U.S. interest 
rates, the Federal Reserve has the capacity to operate in 
domestic money markets to maintain interest rates at a level 
consistent with our domestic economic goals.
    It is not easy to identify the portion of the upward 
pressure on the renminbi, and hence on the accumulation of 
reserves, that might be the result of speculation. It is also 
difficult to predict where the renminbi would settle were the 
currency to float freely. However, speculation in the renminbi 
would not occur if investors did not expect the Chinese 
currency to appreciate at some point. It seems reasonable to 
conclude that, at the present exchange rate with the dollar, 
the renminbi is undervalued.

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

Q.1. Does the arbitrary deposit cap, which bars any U.S. bank 
from an acquisition that would give it more than 10 percent of 
the Nation's total bank deposits, make American banks 
vulnerable to foreign acquisition?

A.1. Federal law currently prohibits a bank holding company or 
bank from acquiring an additional bank if, after the 
acquisition, the resulting banking organization would control 
more than 10 percent of all deposits held by insured banks and 
savings associations in the United States. At the present time, 
it appears unlikely that this restriction makes U.S. banks 
materially more vulnerable to acquisition by a foreign entity 
than they would be if this deposit cap were not in place. Of 
course, as the banking and financial systems evolve, the impact 
of the current deposit cap also may change, and thus the 
Congress may wish to review the benefits and costs of the 
current restriction at regular intervals.
    The deposit cap could potentially increase the likelihood 
of foreign acquisitions of U.S. banks if it prevented U.S. 
banks from reaching the size needed to achieve important 
economies of scale or scope. However, research overwhelmingly 
indicates that economies of scale in banking are achieved at 
sizes far below those of our largest banks. In addition, the 
landmark Gramm-Leach-Bliley Act significantly expanded the 
ability of U.S. banking organizations to achieve any important 
economies of scope that may exist within the broad financial 
services industry. Indeed, U.S. banks are among the most 
profitable, most efficient, and best capitalized in the world.






































































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