[Senate Hearing 112-230]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 112-230

 
           THE SEMIANNUAL MONETARY POLICY REPORT TO CONGRESS

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

                                HEARING

                               before the

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

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION

                                   ON

        THE FEDERAL RESERVE'S SEMIANNUAL MONETARY POLICY REPORT
                              TO CONGRESS

                               __________

                             JULY 14, 2011

                               __________

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


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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                       Charles Yi, Chief Counsel

                     Marc Jarsulic, Chief Economist

                     Laura Swanson, Policy Director

                 Andrew Olmem, Republican Chief Counsel

               Mike Piwowar, Republican Senior Economist

                  Dana Wade, Professional Staff Member

                       Dawn Ratliff, Chief Clerk

                      Brett Hewitt, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                        THURSDAY, JULY 14, 2011

                                                                   Page

Opening statement of Chairman Johnson............................     1

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     2
    Senator Moran:
        Prepared statement.......................................    41

                                WITNESS

Ben S. Bernanke, Chairman, Board of Governors of the Federal 
  Reserve System.................................................     3
    Prepared statement...........................................    41
    Response to written questions of:
        Senator Shelby...........................................   105
        Senator Reed.............................................   107


           THE SEMIANNUAL MONETARY POLICY REPORT TO CONGRESS

                              ----------                              


                        THURSDAY, JULY 14, 2011

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10:03 a.m. in room SD-538, Dirksen 
Senate Office Building, Hon. Tim Johnson, Chairman of the 
Committee, presiding.

           OPENING STATEMENT OF CHAIRMAN TIM JOHNSON

    Chairman Johnson. I call this hearing to order.
    We are pleased to welcome Chairman Bernanke, who today will 
deliver the Federal Reserve's semiannual Monetary Policy Report 
to the Congress. His testimony comes at an important moment.
    While our economy is recovering from the disaster created 
by the financial crisis, the recovery is far from complete. 
Employment is unacceptably low. The civilian unemployment rate 
remains at 9.2 percent. The high levels of unemployment are 
matched by output that is significantly lower than it ought to 
be. CBO estimates of potential GDP show that the economy is 5.6 
percent below what it could be producing. And, of course, the 
housing market, which is an important source of wealth for many 
families and our economy, has yet to recover from the collapse 
of the house price bubble. Although prices are down 
significantly from the 2006 peak level, inventories of vacant 
houses remain high, and residential investment is below pre-
bubble levels.
    In addition to these domestic economic problems, there are 
concerns about how the European sovereign debt crisis will 
develop and what affect it may have on our financial markets 
and institutions.
    Determining the best policy responses to such a complicated 
set of economic circumstances is no easy matter, but one thing 
is certain. We need to put the financial market safeguards of 
the Dodd-Frank Act into place as soon as reasonably possible. 
We must prevent a repetition of the events of 2007 and 2008.
    Chairman Bernanke, I look forward to your insights on these 
issues and to discussing the policy course the Federal Reserve 
has taken.
    To preserve time for questions, opening statements will be 
limited to the Chair and Ranking Member. I now turn to Ranking 
Member Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman. Welcome again, 
Chairman Bernanke.
    Last month the Federal Open Market Committee announced the 
end of its second round of so-called quantitative easing, 
commonly referred to as QE2. Chairman Bernanke had claimed that 
because of QE2 we no longer have the deflation risk. The data 
seems to support his claim here.
    For example, the 12-month change in the Consumer Price 
Index, which was 1.1 percent as recently as November, reached 
3.6 percent in May. The rise in inflation, however, reveals 
that the Fed's most challenging task still lies ahead, I 
believe.
    The Federal Reserve's balance sheet presently stands at 
about $2.9 trillion while the Federal funds rate has been 
effectively zero for more than 2 \1/2\ years. As a result, I 
believe the stage is set for a resurgence of inflation if the 
Fed is not real careful.
    The task confronting the Fed is how to unwind its massive 
balance sheet without sparking more inflation or damaging the 
economy--a real task in itself. Unfortunately, the dismal 
performance of our economy and our record Federal deficit will 
make this exceedingly difficult in the years ahead.
    Chairman Bernanke I believe must also contend with the 
consequences of the Administration's economic policies. The 
failure to adopt a pro-growth economic plan or to restrain 
Federal spending has effectively boxed the Fed into a corner. 
If the Fed is to curb inflation, it ultimately has to raise 
interest rates, but the absence of economic growth will likely 
make such a move more painful for the economy.
    If the Fed does not raise interest rates, higher inflation 
is almost assured. Federal borrowing costs could soar, 
worsening the already severe Federal budget crisis that we 
have.
    The last thing our weak economy needs right now is an 
inflation scare. The economic history of the 1970s should have 
taught us that it is more painful to get inflation under 
control than it is to keep inflation in check in the first 
place.
    History also demonstrates that the Fed's monetary policy 
usually remains too loose for too long. Accordingly, our 
markets are watching to see if Chairman Bernanke has not only a 
credible plan but also the will to take the difficult actions 
necessary to prevent inflation.
    Today's hearing gives Chairman Bernanke an opportunity to 
reassure our markets by explaining to the American people how 
the Fed intends to navigate through this difficult period.
    During Chairman Bernanke's last Humphrey-Hawkins testimony, 
I was pleased that he explicitly stated the Fed's price 
stability target is about 2 percent. Today I would like to know 
more about how the Fed plans to achieve this target. For 
example, what is the acceptable range around a 2-percent 
inflation target? Does the Fed think that the recent inflation 
data, which shows inflation above 3 percent, violates this 
target? If inflation is above target, how does the Fed plan to 
reduce it?
    In addition, I would like to know how the ongoing turmoil 
in the European Union could impact monetary policy here. In 
particular, will the euro crisis further constrain the Fed's 
ability to maintain price stability? More transparency we all 
believe is needed with regard to how the Fed plans to unwind 
its record balance sheet. And although the Federal Open Market 
Committee has terminated QE2, it has said that it will maintain 
the policy of reinvesting principal payments from its existing 
securities holdings.
    Chairman Bernanke's testimony here further indicates that 
the Federal Open Market Committee may consider another round of 
quantitative easing if the weak economy continues, and as a 
result, the Fed's balance sheet could easily balloon way beyond 
$3 trillion.
    It appears that the Fed may be going in the wrong 
direction. Recent Federal Open Market Committee minutes, 
however, indicate that the Fed is developing plans for 
addressing its balance sheet. I hope that Chairman Bernanke can 
shed here this morning more light on the options that the Fed 
is considering and when the Fed will begin its difficult task.
    Finally, I would like to commend Chairman Bernanke on his 
recent decision to hold press conferences after Federal Open 
Market Committee meetings. This is an important step that 
recognizes that the Fed can no longer make policy behind closed 
doors. This is a positive development because the Fed's 
policies will be more effective if they are understood and 
supported by the public.
    This step also recognizes that the Fed's secretive history 
is an antiquated practice that simply is incompatible with a 
free society. The Fed is a public institution, and the public 
has the right to expect both transparency and accountability. 
The Fed still has far to go in opening up, but I hope Chairman 
Bernanke will continue his efforts to modernize the Fed's 
transparency. I believe the American people deserve nothing 
less.
    Thank you, Mr. Chairman.
    Chairman Johnson. Chairman Bernanke, before you begin your 
testimony, I wanted to let you know that I may have to excuse 
myself during today's hearing. In another role as Chairman of 
the Military Construction VA's Appropriations Subcommittee, I 
may need to be on the floor this morning as we begin debate on 
that bill. Senator Reed will be taking over the gavel.
    Senator Reed, thank you.
    Chairman Bernanke, please begin.

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

    Mr. Bernanke. Thank you, Mr. Chairman, Ranking Member 
Shelby, and other Members of the Committee. I am pleased to 
present the Federal Reserve's semiannual Monetary Policy Report 
to the Congress. I will start with a discussion of current 
economic conditions and the outlook and then turn to monetary 
policy.
    The U.S. economy has continued to recover, but the pace of 
the expansion so far this year has been modest. After 
increasing at an annual rate of 2 \3/4\ percent in the second 
half of 2010, real GDP rose at about a 2-percent rate in the 
first quarter of this year, and incoming data suggest that the 
pace of recovery remained soft in the spring. At the same time, 
the unemployment rate, which had appeared to be on a downward 
trajectory at the turn of the year, has moved back above 9 
percent.
    In part, the recent weaker-than-expected economic 
performance appears to have been the result of several factors 
that are likely to be temporary. Notably, the run-up in prices 
of energy, especially gasoline, and food has reduced consumer 
purchasing power. In addition, the supply chain disruptions 
that occurred following the earthquake in Japan caused U.S. 
motor vehicle producers to sharply curtail assemblies and 
limited the availability of some models. Looking forward, 
however, the apparent stabilization in the prices of oil and 
other commodities should ease the pressure on household 
budgets, and vehicle manufacturers report that they are making 
significant progress in overcoming the parts shortages and 
expect to increase production substantially this summer.
    In light of these developments, the most recent projections 
by members of the Federal Reserve Board and presidents of the 
Federal Reserve Banks, prepared in conjunction with the FOMC 
meeting in late June, reflected their assessment that the pace 
of the economic recovery will pick up in coming quarters. 
Specifically, participants' projections for the increase in 
real GDP have a central tendency of 2.7 to 2.9 percent in 2011, 
inclusive of the weak first half, and 3.3 to 3.7 percent in 
2012--projections that, if realized, would constitute a notably 
better performance than we have seen so far this year.
    FOMC participants continued to see the economic recovery 
strengthening over the medium term, with the central tendency 
of their projections for the increase in real GDP picking up to 
3.5 to 4.2 percent in 2013. At the same time, the central 
tendencies of the projections of real GDP growth in 2011 and 
2012 were marked down nearly one-half percentage point compared 
with those reported in April, suggesting that FOMC participants 
saw at least some part of the first-half slowdown as persisting 
for a while. Among the headwinds facing the economy are the 
slow growth in consumer spending, even after accounting for the 
effects of higher food and energy prices; the continuing 
depressed condition of the housing sector; still-limited access 
to credit for some households and small businesses; and fiscal 
tightening at all levels of Government. Consistent with 
projected growth in real output modestly above its trend rate, 
FOMC participants expected that, over time, the jobless rate 
will decline--albeit only slowly--toward its longer-term normal 
level. The central tendencies of participants' forecasts for 
the unemployment rate were 8.6 to 8.9 percent for the fourth 
quarter of this year, 7.8 to 8.2 percent at the end of 2012, 
and 7 to 7.5 percent at the end of 2013.
    The most recent data attest to the continuing weakness of 
the labor market: The unemployment rate increased to 9.2 
percent in June, and gains in non-farm payroll employment were 
below expectations for a second month. To date, of the more 
than 8.5 million jobs lost in the recession, 1.75 million have 
been regained. Of those employed, about 6 percent--8.6 million 
workers--report that they would like to be working full time 
but can only obtain part-time work. Importantly, nearly half of 
those currently unemployed have been out of work for more than 
6 months, by far the highest ratio in the post-World War II 
period. Long-term unemployment imposes severe economic 
hardships on the unemployed and their families, and by leading 
to an erosion of skills of those without work, it both impairs 
their lifetime employment prospects and reduces the productive 
potential of our economy as a whole.
    Much of the slowdown in aggregate demand this year has been 
centered in the household sector, and the ability and 
willingness of consumers to spend will be an important 
determinant of the pace of the recovery in coming quarters. 
Real disposable personal income over the first 5 months of 2011 
was boosted by the reduction in payroll taxes, but those gains 
were largely offset by higher prices for gasoline and other 
commodities. Households report that they have little confidence 
in the durability of the recovery and about their own income 
prospects. Moreover, the ongoing weakness in home values is 
holding down household wealth and weighing on consumer 
sentiment. On the positive side, household debt burdens are 
declining, delinquency rates on credit cards and auto loans are 
down significantly, and the number of homeowners missing a 
mortgage payment for the first time is decreasing. The 
anticipated pickups in economic activity and job creation, 
together with the expected easing of price pressures, should 
bolster real household income, confidence, and spending in the 
medium run.
    Residential construction activity remains at an extremely 
low level. The demand for homes has been depressed by many of 
the same factors that have held down consumer spending more 
generally, including the slowness of the recovery in jobs and 
income as well as poor consumer sentiment. Mortgage interest 
rates are near record lows, but access to mortgage credit 
continues to be constrained. Also, many potential homebuyers 
remain concerned about buying into a falling market, as weak 
demand for homes, the substantial backlog of vacant properties 
for sale, and the high proportion of distressed sales are 
keeping downward pressure on house prices.
    Two bright spots in the recovery have been exports and 
business investment in equipment and software. Demand for U.S.-
made capital goods from both domestic and foreign firms has 
supported manufacturing production throughout the recovery thus 
far. Both equipment and software outlays and exports increased 
solidly in the first quarter, and the data on new orders 
received by U.S. producers suggest that the trend continued in 
recent months. Corporate profits have been strong, and larger 
nonfinancial corporations with access to capital markets have 
been able to refinance existing debt and lock in funding at 
lower yields. Borrowing conditions for businesses generally 
have continued to ease, although, as mentioned, the 
availability of credit appears to remain relatively limited for 
some small firms.
    Inflation has picked up so far this year. The price index 
for personal consumption expenditures rose at an annual rate of 
more than 4 percent over the first 5 months of 2011 and 2.5 
percent on a 12-month basis. Much of the acceleration was the 
result of higher prices for oil and other commodities and for 
imported goods. In addition, prices of motor vehicles increased 
sharply when supplies of new models were curtailed by parts 
shortages associated with the earthquake in Japan. Most of the 
recent rise in inflation appears likely to be transitory, and 
FOMC participants expected inflation to subside in coming 
quarters to rates at or below the level of 2 percent or a bit 
less that participants view as consistent with our dual mandate 
of maximum employment and price stability. The central tendency 
of participants' forecasts for the rate of increase in the PCE 
price index was 2.3 to 2.5 percent for 2011 as a whole, which 
implies a significant slowing of inflation in the second half 
of the year. In 2012 and 2013, the central tendency of the 
inflation forecasts was 1.5 to 2.0 percent. Reasons to expect 
inflation to moderate include the apparent stabilization in the 
prices of oil and other commodities, which is already showing 
through to retail gasoline and food prices; the still-
substantial slack in U.S. labor and product markets, which has 
made it difficult for workers to obtain wage gains and for 
firms to pass through their higher costs; and the stability of 
longer-term inflation expectations, as measured by surveys of 
households, the forecasts of professional private sector 
economists, and financial market indicators.
    Turning to monetary policy, FOMC members' judgments that 
the pace of the economic recovery over coming quarters will 
likely remain moderate, that the unemployment rate will 
consequently decline only gradually, and that inflation will 
subside are the basis for the Committee's decision to maintain 
a highly accommodative monetary policy. As you know, that 
policy currently consists of two parts.
    First, the target range for the Federal funds rate remains 
at 0 to one-fourth percent and, as indicated in the statement 
released after the June meeting, the Committee expects that 
economic conditions are likely to warrant exceptionally low 
levels of the Federal funds rate for an extended period.
    The second component of monetary policy has been to 
increase the Federal Reserve's holdings of longer-term 
securities, an approach undertaken because the target for the 
Federal funds rate could not be lowered meaningfully further. 
The Federal Reserve's acquisition of longer-term Treasury 
securities boosted the prices of such securities and caused 
longer-term Treasury yields to be lower than they would have 
been otherwise. In addition, by removing substantial quantities 
of longer-term Treasury securities from the market, the Fed's 
purchases induced private investors to acquire other assets 
that serve as substitutes for Treasury securities in the 
financial marketplace, such as corporate bonds and mortgage-
backed securities. By this means, the Fed's asset purchase 
program--like more conventional monetary policy--has served to 
reduce the yields and increase the prices of those other assets 
as well. The net result of these actions is lower borrowing 
costs and easier financial conditions throughout the economy.
    We know from many decades of experience with monetary 
policy that, when the economy is operating below its potential, 
easier financial conditions tend to promote more rapid economic 
growth. Estimates based on a number of recent studies as well 
as Federal Reserve analyses suggest that, all else being equal, 
the second round of asset purchases probably lowered longer-
term interest rates approximately 10 to 30 basis points.
    Our analysis further indicates that a reduction in longer-
term interest rates of this magnitude would be roughly 
equivalent in terms of its effects on the economy to a 40- to 
120-basis-point reduction in the Federal funds rate.
    In June, we completed the planned purchases of $600 billion 
in longer-term Treasury securities that the Committee initiated 
in November, while continuing to reinvest the proceeds of 
maturing or redeemed longer-term securities in Treasuries. 
Although we are no longer expanding our securities holdings, 
the evidence suggests that the degree of accommodation 
delivered by the Federal Reserve's securities purchase program 
is determined primarily by the quantity and mix of securities 
that the Federal Reserve holds rather than by the current pace 
of new purchases. Thus, even with the end of net new purchases, 
maintaining our holdings of these securities should continue to 
put downward pressure on market interest rates and foster more 
accommodative financial conditions than would otherwise be the 
case. It is worth emphasizing that our program involved 
purchases of securities, not Government spending, and as I will 
discuss later, when the macroeconomic circumstances call for 
it, we will unwind those purchases. In the meantime, interest 
on those securities is being remitted to the U.S. Treasury.
    When we began this program, we certainly did not expect it 
to be a panacea for the country's economic problems. However, 
as the expansion weakened last summer, developments with 
respect to both components of our dual mandate implied that 
additional monetary policy accommodation was needed. In that 
context, we believed that the program would both help reduce 
the risk of deflation that had emerged and provide a needed 
boost to faltering economic activity and job creation. The 
experience to date with the round of securities purchases that 
just ended suggests that the program had the intended effects 
of reducing the risk of deflation and shoring up economic 
activity. In the months following the August announcement of 
our policy of reinvesting maturing and redeemed securities and 
our signal that we were considering more purchases, inflation 
compensation as measured in the market for inflation-indexed 
securities rose from low to more normal levels, suggesting that 
the perceived risks of deflation had receded markedly. This was 
a significant achievement, as we know from the Japanese 
experience that protracted deflation can be quite costly in 
terms of weaker economic growth.
    With respect to employment, our expectations were 
relatively modest; estimates made in the autumn suggested that 
the additional purchases could boost employment by about 
700,000 jobs over 2 years, or about 30,000 extra jobs per 
month. Even including the disappointing readings for May and 
June, which reflected in part the temporary factors I discussed 
earlier, private payroll gains have averaged 160,000 per month 
in the first half of 2011, compared with average increases of 
only about 80,000 private jobs per month from May to August 
2010. Not all of the step-up in hiring was necessarily the 
result of the asset purchase program, but the comparison is 
consistent with our expectations for employment gains. Of 
course, we will be monitoring developments in the labor market 
closely.
    Once the temporary shocks that have been holding down 
economic activity pass, we expect to again see the effects of 
policy accommodation reflected in stronger economic activity 
and job creation. However, given the range of uncertainties 
about the strength of the recovery and prospects for inflation 
over the medium term, the Federal Reserve remains prepared to 
respond should economic developments indicate that an 
adjustment in the stance of monetary policy would be 
appropriate.
    On the one hand, the possibility remains that the recent 
economic weakness may prove more persistent than expected and 
that deflationary risks might re-emerge, implying a need for 
additional policy support. Even with the Federal funds rate 
close to zero, we have a number of ways in which we could act 
to ease financial conditions further. One option would be to 
provide more explicit guidance about the period over which the 
Federal funds rate and the balance sheet would remain at their 
current levels. Another approach would be to initiate more 
securities purchases or to increase the average maturity of our 
holdings. The Federal Reserve could also reduce the 25-basis-
point rate of interest it pays to banks on their reserves, 
thereby putting downward pressure on short-term rates more 
generally. Of course, our experience with these policies 
remains relatively limited, and employing them would entail 
potential risks and costs. However, prudent planning requires 
that we evaluate the efficacy of these and other potential 
alternatives for deploying additional stimulus if conditions 
warrant.
    On the other hand, the economy could evolve in a way that 
would warrant a move toward less accommodative policy. 
Accordingly, the Committee has been giving careful 
consideration to the elements of its exit strategy, and as 
reported in the minutes of the June FOMC meeting, it has 
reached a broad consensus about the sequence of steps that it 
expects to follow when the normalization of policy becomes 
appropriate. In brief, when economic conditions warrant, the 
Committee would begin the normalization process by ceasing the 
reinvestment of principal payments on its securities, thereby 
allowing the Federal Reserve's balance sheet to begin 
shrinking. At the same time or sometime thereafter, the 
Committee would modify the forward guidance in its statement. 
Subsequent steps would include the initiation of temporary 
reserve-draining operations and, when conditions warrant, 
increases in the Federal funds rate target. From that point on, 
changing the level or range of the Federal funds rate target 
would be our primary means of adjusting the stance of monetary 
policy in response to economic developments.
    Sometime after the first increase in the Federal funds rate 
target, the Committee expects to initiate sales of agency 
securities from its portfolio, with the timing and pace of 
sales clearly communicated to the public in advance. Once sales 
begin, the pace of sales is anticipated to be relatively 
gradual and steady, but it could be adjusted up or down in 
response to material changes in the economic outlook or 
financial conditions. Over time, the securities portfolio and 
the associated quantity of bank reserves are expected to be 
reduced to the minimum levels consistent with the efficient 
implementation of monetary policy. Of course, conditions can 
change, and in choosing the time to begin policy normalization 
as well as the pace of that process, should that be the next 
direction for policy, we would carefully consider both parts of 
our dual mandate.
    Thank you, and I would be pleased to take your questions.
    Chairman Johnson. Thank you for your testimony. We will now 
begin the questioning of our witness. Will the Clerk please put 
5 minutes on the clock for each Member for their questions.
    The Fed, to its great credit, has pursued policies to 
stimulate the economy. However, although the Fed continues to 
hold short-term interest rates near zero, it has ended efforts 
to reduce longer-term rates through quantitative easing. Given 
the high rate of unemployment and relatively slow growth in 
output, why not start a new round of easing, a QE3?
    Mr. Bernanke. Well, Mr. Chairman, first, as you point out, 
our policies are already very highly accommodative. We have 
almost zero interest rates. And the stock of assets that we 
have acquired, which Mr. Shelby talked about, continue to put 
downward pressure on interest rates in the markets, even if we 
are not buying new assets going forward.
    I think the important point to make is that the situation 
today is somewhat different than it was in August of 2010, when 
we began to initiate discussion of further purchases of 
securities. At that time, inflation was dropping. Inflation 
expectations were dropping. It looked like deflation was 
becoming a potential risk to the economy, and a serious risk. 
At the same time, over the summer, the recovery looked like it 
was stalling. We were down to 80,000 jobs a month, private 
sector jobs a month. Growth was not sufficient to prevent what 
looked like a potentially significant increase in the 
unemployment rate, and so we felt that with both unemployment 
and inflation being missed in the same direction, so to speak, 
that monetary policy accommodation was surely needed and so we 
undertook that step.
    Today, the situation is more complex. Inflation is higher. 
Inflation expectations are close to our target. We are 
uncertain about the near-term developments in the economy. We 
would like to see if the economy does pick up as we are 
projecting. And so we are not prepared at this point to take 
further action.
    Chairman Johnson. In your testimony, you note that fiscal 
tightening at all levels of Government is one of the headwinds 
facing the economic recovery. Can you explain whether this 
means that additional short-term fiscal expansion could help us 
return to full employment and increase overall confidence in 
the economy.
    Mr. Bernanke. Mr. Chairman, I think our fiscal planning and 
policy needs to be integrated in the sense that we have to be 
looking at both the short run and the long run at the same 
time. The Congress and the Administration are currently looking 
to make major changes in our spending, deficit projections over 
the next decade or so. I think that is extremely important, 
that we bring down our deficit so we will have a sustainable 
fiscal policy going forward, and I want to emphasize that that 
is very important.
    At the same time, that process is a long-term process. It 
is something that needs to take place over a number of years. 
And I only ask or suggest that as Congress looks at the timing 
and composition of its changes to the budget that it does take 
into account that in the very near term that the recovery is 
still rather fragile and that sharp and excessive cuts in the 
very short term would be potentially damaging to that recovery.
    It is up to Congress what further actions to take. I guess 
I could suggest that there is intermediate steps between fiscal 
stimulus and cuts, and that would be some focused programs 
addressing some of the areas in the economy which are 
particularly stressed, like unemployment or housing.
    Chairman Johnson. As you acknowledge in your testimony, the 
U.S. housing market is stubbornly depressed. Residential 
investment is more than a third below its 1997 level. The 
inventory of homes that are vacant and for sale remains 
elevated. Do you see policy solutions that would help resolve 
the problems in the housing market?
    Mr. Bernanke. Well, Mr. Chairman, you are absolutely right 
that the weakness in the housing market is one of the major 
sources of the slow recovery. Normally, in an expansion, you 
would see the housing market strengthening and adding jobs and 
creating new opportunities. We are not seeing that, in part 
because, as you mentioned, the big overhang of distress sales, 
open, vacant homes, foreclosed homes which are weighing on 
prices and creating a vicious circle, where people do not want 
to buy because prices are falling, and prices are falling 
because people do not want to buy.
    There are a number of things that we are doing. The Fed is 
keeping mortgage rates low. There is work to try to modify 
mortgages. I think it is worth looking at that area, though. 
One area where clearly more work needs to be done is in housing 
finance. You know, we have not yet begun to really clarify for 
the market and the public how housing finance will be conducted 
in the future.
    Another area where I just suggest that you might think 
about is the overhang of distressed houses. For example, 
Fannie, Freddie, and the banks own about half-a-million homes 
right now which are basically sitting there on the market and 
which are pressing down prices and reducing appraisals and 
making the housing market just much weaker than it otherwise 
would be. So that is another area to look at. I mean, there are 
various things that one could do to approach that, but I agree 
with you that the housing market is really, in some sense, the 
epicenter of the problem we have at the moment.
    Chairman Johnson. As yet, there has been no agreement on 
raising the Federal debt limit. What would be the effects on 
financial markets and the real economy if the Treasury were 
forced to default on these obligations?
    Mr. Bernanke. Well, Mr. Chairman, as I have said on a 
number of occasions, I think it would be a calamitous outcome. 
It would create a very severe financial shock that would have 
effects not only to the U.S. economy, but on the global 
economy. Treasury securities are critical to the entire 
financial system. They are used in many different ways as 
collateral or as margin. Default on those securities would 
throw the financial system into chaos, and what would certainly 
be the case is that we would destroy the trust and confidence 
that global investors have in U.S. Treasury securities as being 
the safest and most liquid assets in the world. We are already 
seeing threats of downgrades from rating agencies.
    This is a tremendous asset of the United States, the 
quality and reputation of our Treasury securities, and we 
benefit from it with low interest rates. So I would urge 
Congress to take every step possible to avoid defaulting on the 
debt or creating even any significant probability of defaulting 
on the debt.
    Chairman Johnson. Senator Shelby.
    Senator Shelby. Thank you.
    Mr. Chairman, tell us here today, and, of course, you are 
speaking to the American people, why our economy is not moving, 
our jobs are not growing, unemployment is going in the wrong 
direction, what, 9.2 official unemployment right now. If you 
bring in, according to the Labor Department, if you bring in 
people who have quit looking for a job, it is about 16 percent. 
That is very, very high. I think it does not bode well for the 
future for all of us. But why, why is all of this? Is it just 
the housing bubble, which is severe? Is it the housing bubble 
and reckless lending that put a lot of our banks in jeopardy? 
Tell us what it all is and how do we get out of it? Is it 
reckless spending? All of this.
    Mr. Bernanke. Well, Senator, you have almost answered your 
question.
    Senator Shelby. Mm-hmm. Not as well as you could, probably.
    Mr. Bernanke. Well, first, let me say that, as I mentioned 
in my testimony, we do think that the weakness of the first 
half of this year is, in part, due to temporary factors, and I 
talked about the disaster in Japan and the developments in the 
Middle East and so on, and we do think we will see somewhat 
better growth, although forecasting is very difficult, going 
forward.
    But that being said, it has been a very slow recovery and 
there are a number of reasons for that. One is the aftermath of 
the housing bubble. With so many houses empty and prices having 
fallen so much, that has created almost new construction in 
housing. It means that people have lost wealth because they no 
longer have any equity in their home. So that has been a major 
factor.
    Second is that we know from a lot of research that 
recoveries after financial crises can be slow because it takes 
time for the credit system to become operative again. And while 
I think there has been a lot of improvement in the banking 
system, there are still some areas, like consumer and small 
business lending, which are constrained to some extent.
    The consumer has been very cautious, trying to build back 
up their wealth, concerned about the durability of the 
recovery, worried about their own financial prospects. So even 
though the high price of gasoline and food has taken away some 
purchasing power, as I mentioned, confidence is pretty low and 
consumers are not showing the confidence in terms of spending.
    And then I did mention that there is, in the near term, 
withdrawal of fiscal stimulus, tightening. For example, the job 
numbers last Friday, the private numbers were certainly better 
than the headline numbers because part of this report was the 
loss of 40,000 State and local jobs as those governments are 
being forced to contract. Now, of course, over time it is 
perfectly possible to want to change the composition of public 
and private employment. That is perfectly understandable. But 
in the short run, as jobs are lost and they are not replaced 
elsewhere, it creates pressure on the economy.
    Senator Shelby. Are you basically telling us we are not 
going to have a robust recovery, not in the next 6 months, 8 
months, 10 months, are we?
    Mr. Bernanke. We are expecting improvement, but we are not 
expecting----
    Senator Shelby. Nothing----
    Mr. Bernanke.----something like would normally follow a 
deep recession in previous episodes.
    Senator Shelby. Let us talk about the European crisis for a 
minute. We are all familiar with this to some extent, Greece, 
Portugal, Ireland, perhaps Italy and others. It seems to me 
that they are sitting on a financial-related time bomb over 
there. Do you believe that the European Union, Monetary Union, 
will stay together? Can it stay together with some smaller 
countries' fragile economies that will basically never pay 
their debt back, cannot pay it back, or what will happen?
    Mr. Bernanke. Well----
    Senator Shelby. And how will it impact us, because we will 
be----
    Mr. Bernanke.----let me just say that the European 
leadership places a great value on maintaining the Euro area 
and in maintaining the European political integration which has 
taken place in the post-war period, and I know they are making 
extraordinary efforts to address these problems.
    The problems are not entirely economic because the three 
countries that you mentioned are really a very small part of 
the European continent and the European economy. So the 
questions are at least as much political, and they involve how 
are you going to address these problems in these countries.
    One approach is to try to do it completely through 
austerity, to have the countries just cut and cut and see if 
they can make it with a little bit of temporary assistance. 
Another strategy would be to get more direct assistance from 
other countries, but that is a very unpopular strategy in some 
of the countries that would be expected to pay----
    Senator Shelby. But that is not a solution to their 
problem, though----
    Mr. Bernanke. Well, if the better-off countries were to 
basically help solve the problems of the small countries, it 
would solve their immediate issue and then there would need to 
be austerity, fiscal reforms, structural reforms, and so on to 
make sure the countries stay on a healthier path in the future. 
So there are different ways to approach it, and again, I think 
it is really a political issue as much as an economic issue.
    It is causing a good bit of anxiety in markets, and that 
has been affecting our economy both last summer and now 
recently, as well. We are spending a lot of time evaluating the 
exposures of U.S. financial institutions to these countries, 
including money market mutual funds and so on. The direct 
exposures to the three countries you mentioned are quite small 
and manageable. So we would not expect those direct impacts to 
be the critical channel if there were problems; a default, for 
example.
    But I think that, nevertheless, the U.S. economy is at risk 
from those developments because were there to be a significant 
deterioration in conditions in Europe, we would see a general 
increase in risk aversion, declining asset prices, a lot of 
volatility in markets, and we would suffer from that more 
general financial situation than we would from the direct 
exposures to those sovereign countries.
    Senator Shelby. Thank you, Mr. Chairman.
    Chairman Johnson. Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman.
    Mr. Chairman, following up on Senator Johnson's question, 
which was about a default on our outstanding obligations of the 
Federal Government, some have suggested that if we cannot 
resolve the debt ceiling limit, we simply prioritize payments. 
We presumably pay on some Treasuries as long as we can, pay 
some principal, some interest. That, of course, requires us to 
not pay on things like military pay and Social Security.
    But just in the context of the financial sector, would that 
fix the problem, simply not having the debt limit extended and 
trying to pay as long as we can on our securities?
    Mr. Bernanke. Well, Senator Reed, first of all, it is the 
Treasury's area to determine how they are going to manage this. 
They have been very clear that they do not think it is either 
appropriate or feasible to prioritize. And as the fiscal agent, 
the Federal Reserve simply does what they tell us to do, and I 
think there are some operational issues that arise if you were 
to try to do it. But again, the Treasury is the determinant of 
this and they are pretty clear that they do not think that is a 
workable solution.
    That being said, whether the default is on securities or it 
is on payments we owe to Medicare recipients, it is going to 
constitute a default of some type on obligations incurred by 
the U.S. Government. It will certainly have an impact on both 
the economy, but also on confidence. You know, what inference 
should investors take from the fact that the United States is 
not paying its bills and that it cannot resolve this issue?
    So I think that there is not really any solution other than 
to find a way to solve these problems, to address the fiscal 
issues, and to----
    Senator Reed. Pass the debt limit.
    Mr. Bernanke.----raise the debt limit at the appropriate 
time.
    Senator Reed. Let me just explore a little bit. Moody's 
today and Standard and Poor's have suggested that they are 
putting us on a watch, downgrading, and what clearly is behind 
them is that if we do not pass the debt limit ceiling raise, 
then they will downgrade us, not only U.S. Treasuries, but 
Moody's has indicated Fannie Mae paper, Freddie Mac paper, 
Federal Credit Bureau paper. We have also placed for possible 
downgrade securities either guaranteed by, backed by, 
collateral securities issued by, or otherwise directly linked 
to the U.S. Government. So, essentially, they are going to 
downgrade things we do not even know yet--maybe you know.
    What does this do in terms of interest rates across the 
board, likely raise them, even in a, quote, ``technical'' 
default?
    Mr. Bernanke. Well, the combination of downgrades and loss 
of investor confidence could potentially raise interest rates 
quite significantly. And the ironic aspect of that is what we 
are all interested in doing is reducing the deficit. If you 
raise interest rates, that means your interest costs go up 
substantially and you are actually making--you are regressing 
rather than progressing in terms of----
    Senator Reed. So a failure to raise the debt ceiling would 
be probably the most significant and immediate increase in the 
deficit that we are likely to see, the one act that would 
dramatically increase the deficit?
    Mr. Bernanke. It would be a self-inflicted wound, I would 
say.
    Senator Reed. Let me ask about something else, too, and 
that is--because you have talked about the fiscal crisis, but 
also a jobs crisis. What is your presumption into this scenario 
about jobs? Are we likely to see people eagerly going out and 
hiring under this situation of technical or real default?
    Mr. Bernanke. Well, we have a recent example. In 2008, when 
the financial system froze up and we saw an immediate, very 
sharp contraction of the global economy. Even if things did not 
get that bad, and one of the key issues here is it is very hard 
to predict exactly what is going to happen, but if interest 
rates rise, that is clearly going to reduce investment. 
Uncertainty will arise. That will reduce the willingness of 
firms to hire and invest. So if the Government is reducing its 
payments by 40 percent, that is going to have an impact, as 
well.
    Senator Reed. Right.
    Mr. Bernanke. So I can only conclude that this would be 
very bad for jobs.
    Senator Reed. Let me ask you another area which we 
discovered much to our chagrin was a huge and explosive 
problem. That is the situation of derivatives. I would presume 
that there area a lot of credit default swaps written on many 
of these securities, et cetera, and that if they are 
downgraded, that could be a condition of default. That could 
require additional collateral. Do you have any idea on the 
institutions that you regulate the potential exposure they 
would have as credit ratings fall or as there is a default in 
the market? Is it in the trillions?
    Mr. Bernanke. Well, there are many knock-on effects from a 
default, ranging throughout the entire system. But CDS directly 
on Treasuries as opposed to on other securities are actually 
not that big, and it would take an action of the ISDA to invoke 
the credit event. So that could be a problem for some 
institutions, but it would not be the biggest problem among all 
the things that we have been discussing.
    Senator Reed. But your point, which I want to reiterate, is 
that this could be a self-inflicted wound doing more damage to 
the deficit than has been done to date.
    Mr. Bernanke. It is really not an option that we want--we 
should be considering.
    Senator Reed. Thank you.
    Chairman Johnson. Senator Toomey.
    Senator Toomey. Thank you, Mr. Chairman, and I am going to 
follow up on this for just a moment, but then I want to move on 
to some other issues, and that is to make the observation that 
the market proceeds, and, in fact, the consequences are starkly 
different between, on the one hand, the U.S. Government failing 
to make an interest payment on a bond, or on the other hand, 
furloughing some Government workers or delaying a reimbursement 
to a vendor or failing to cut the grass at the monument. These 
are very, very different events.
    The month of August has scheduled about $30 billion of 
interest payments. The Treasury is sitting on a $94 billion 
portfolio of mortgage-backed securities and we expect a minimum 
of $125 billion in tax revenue. Now, I do not know of anybody 
that suggests that we can or should go indefinitely without 
raising the debt ceiling, and I have argued that we certainly 
would be much better off reaching an agreement and raising the 
debt ceiling prior to August 2. But there is a big, big 
difference between a payment default on our debt and the other 
kinds of payment disruptions.
    I think this Administration would be wise to send an 
unambiguous message to the market that under no circumstances 
would they tolerate a default on our debt which is entirely 
under their control to prevent. But I acknowledge that that is 
the realm of the Treasury and that is not your responsibility.
    What I would like to address is what is under your realm, 
and I have said, Mr. Chairman, and I fully acknowledge that the 
things that you have done under very difficult circumstances 
have only had the best motivation, but I am concerned about the 
expansion in power of the central bank that we have, the 
unusual steps that we have taken, the enormous discretion that 
the Fed now has and exercises. My concern is that this distorts 
markets, intentionally, actually. It also introduces enormous 
uncertainty as to how the Fed will behave. The Fed becomes the 
biggest player in driving the bond market, the equity markets, 
and that this is a dangerous place that we have come to, and I 
hope that we revert as soon as possible to the more normal role 
that the Fed has played.
    One of the unintended, I suspect, if not unforseen 
consequences of this unusual policy, it seems to me, if we take 
the very, very low interest rates, the zero, or roughly zero 
percent Fed funds rate, the negative real interest rates the 
Fed has maintained for an extended period now, it seems to me 
that this contributes to enabling Congress to run excessive 
deficits. You know, our debt is cheap to finance, especially 
when compounded by the fact that the Treasury has chosen to 
shorten up the maturity--I think unwisely. The net effect is we 
are not yet paying the price, the real market price that we 
will certainly eventually have to pay for these massive 
deficits and this huge debt. I do not think for a minute that 
that is your intention, to facilitate this fiscal 
irresponsibility, but I think it is the unintended consequence 
of these extremely low interest rates, as just one example.
    But to your testimony, you have raised the possibility now 
that if economic circumstances warranted, you would consider--
you have opened the door to an additional round of securities 
purchases, so what will no doubt be dubbed QE3. And I guess my 
concern is that what is wrong with this economy is not 
fundamentally monetary policy. It is other things.
    And so I would just ask you to comment on what you see that 
is wrong with our economy that QE3 would fix. What is the 
theory that another round of security purchases will somehow 
generate the economic growth that we lack?
    Mr. Bernanke. Well, first, to go back to the facilitation 
issue, our goal is to try to meet our mandate of maximum 
employment and price stability, which is why we run monetary 
policy as we do. I do not think that our policy would prevent a 
loss of confidence if creditors lost confidence in the 
Treasury, which would drive up interest rates. It has not 
happened yet, and I do not think it is because of us. I think 
it is because people still think that they have confidence in 
our Government's ability to make its payments.
    These asset purchases, in terms of their effects on the 
economy, they work more or less in the same way that ordinary 
monetary policy works, by easing financial conditions, lowering 
interest rates, and providing stimulus through that mechanism.
    Now, you may be entirely correct, A, that it might not be 
needed, and B, that it might not be particularly effective 
given the configuration of problems that we have, if credit is 
not being extended, or if the problems really arise from other 
sectors that are not responsive to interest rates. So those are 
certainly things we will take into account, Senator. We are not 
proposing anything today.
    The main message I want to leave is that this is a serious 
situation. It involves a significant loss of human and economic 
potential. The Federal Reserve has a mandate and we want to 
meet that mandate, and to do that, we just want to make sure 
that we have the options when they become necessary. But at 
this point, we are not proposing to undertake that option.
    Senator Toomey. Thank you, Mr. Chairman.
    Chairman Johnson. Senator Akaka.
    Senator Akaka. Thank you very much, Mr. Chairman.
    Good morning, Chairman Bernanke.
    Mr. Bernanke. Good morning, Senator.
    Senator Akaka. I appreciate your joining us today again. 
Before I begin, I want to thank you very much for your strong 
leadership. You continue to do an excellent job under very 
difficult circumstances.
    Chairman Bernanke, we all understand the importance of 
preventing a Government default. Many Americans, however, seem 
not to share this urgency. A Gallup poll in May found that only 
19 percent of Americans would want their Member of Congress to 
vote for a debt ceiling increase, and 34 percent did not even 
know enough about the issue to answer the question. Another 
poll in July by Pew and Washington Post showed that Americans 
are more concerned about controlling spending than they are 
about a Government default.
    Chairman Bernanke, will you please explain specifically how 
a Government default would affect the everyday lives of 
working-class Americans.
    Mr. Bernanke. Yes, Senator, I would be glad to. First, an 
analogy I made yesterday, some people make the analogy that 
this is all about sitting down at the kitchen table, making 
sure that your income and your spending are equal. That is true 
for the long run, but the debt ceiling is really about paying 
for bills that we have already incurred. So it is more like 
saying we are going to solve our problems by defaulting on our 
credit card, which is not something that most people would 
consider would be the right way to behave.
    But putting that aside, not increasing the debt ceiling and 
certainly allowing default on the debt would have very real 
consequences for average Americans. First, interest rates would 
jump. Treasury rates are the benchmark interest rates, so 
mortgage rates and all other interest rates that consumers pay 
would rise. Of course, that would also increase the Federal 
deficit because we have to pay the interest on the debt as part 
of our spending.
    If the Treasury cut back as it would be required to do 
because it could not borrow, it would mean that there would be 
a significant reduction in both the payments, the benefits, 
payments for services paid to the Armed Forces and so on, so 
people would see that in terms of their Medicare check or 
whatever other benefits they are getting.
    And then without much delay, I think this would also slow 
the economy, and so the job situation would get worse. So in 
almost every area where people have pocketbook concerns--jobs, 
interest rates, credit, availability of Government payments, 
benefits, all those things would be affected in relatively 
short order.
    Senator Akaka. Well, thank you for briefly explaining all 
of that.
    Chairman Bernanke, even though home prices, and it has been 
mentioned, have only slightly declined, high-cost housing areas 
like Hawaii are still feeling the full effects of a weak 
housing market. Mortgage credit is still limited. Concern for 
the future is that bank retained mortgages are performing worse 
than those sold to or backed by the Government and yet the loan 
limits are scheduled to step down later this year.
    Do you think it is a good idea to allow the loan limits to 
decrease? How might loan limits affect the housing market and 
homeownership opportunities?
    Mr. Bernanke. Well, there is a tradeoff, as always, 
Senator. The increase in the loan limits was made on an 
emergency basis, obviously, to try to address the housing 
crisis. The GSEs are making the determination that it is time 
to begin to wean a little bit the mortgage market from those 
higher conforming limits.
    I think the question in terms of the effect on the housing 
market is to what extent are non-conforming jumbo mortgages 
available and how are they priced in Hawaii, and I do not know 
specific facts for Hawaii. But, nationally, there has been some 
improvement in the willingness of banks to make jumbo loans, 
and the differential, which at one point was more than 100 
basis points, I think is much closer to 25 to 35 basis points 
at this point.
    So that will impose some extra costs on borrowers in very 
large mortgages, but I do not think in most cases that they 
will be squeezed out of the market. So they are some of the 
tradeoffs that the GSEs and the Congress are looking at.
    Senator Akaka. Thank you, Mr. Chairman.
    Chairman Johnson. Senator Kirk.
    Senator Kirk. Thank you, Mr. Chairman.
    Mr. Chairman, I have three quick issues I want to raise 
with you, and I will put them all on the table.
    First, my understanding is that, according to Terry Zivney 
and Richard Marcus in Federal Review, August 1989, we had a 
technical default of the United States April 26, May 3, and May 
10, 1979, when the United States could not pay individual bond 
holders holding Treasuries on time, and my understanding is it 
was about a 60-basis-point rise in borrowing costs to the 
Federal Government. If you could talk about when we defaulted 
last time, 1979.
    Second, I understand that Italy just tried to borrow money 
twice today. Their 5-year benchmark had a 21-percent increase 
in the cost of borrowing over last year, just went out at 4.9 
percent, up from 3.9 percent a year ago. And they set a record 
on their 15-year borrowing. They paid the highest interest rate 
ever at 5.9 percent. And we are seeing a real M1 decline in 
Italy, and my question is: Should we have a kind of Greek-style 
bailout for Spain and Italy? The Congressional Research Service 
estimates that the IMF is $50 billion short.
    And, last, I am worried about the long-term finances of 
especially my home State of Illinois and California, and given 
their pension liabilities, Illinois being the lowest-paid 
pensions in the United States, do you see a systemic risk posed 
by these two States to the municipal finance and bond sector 
for the United States?
    I lay all three of those issues out for your comment.
    Mr. Bernanke. Sure. Thank you. It is true that in 1979, 
mostly because of mechanical problems, operational problems, 
there were a few Treasury bills that did not receive interest 
payments on time. Interest rates did go up there, but it is not 
entirely clear whether it was entirely due to the default or 
whether it was due to some other factors, like changes in 
expectations of monetary policy, for example.
    I do not think it is really comparable to the current 
situation because this was just a couple of isolated issues, 
and, in fact, the Wall Street Journal did not even report that 
this had happened. People did not generally know that this had 
happened. So it was not viewed as something that was a broad-
based risk to the financial markets.
    On Italy, it is true there has been a bit of market jitters 
there, and the kind of concern you worry about is exactly this 
kind of vicious circle that we are worried about in the case of 
the United States, where loss of confidence raises interest 
rates, that makes the deficit worse, and it makes it just even 
more difficult to get fiscal stability.
    My sense of Italy is that certainly the first line of 
defense is for Italy to take the necessary steps. It is true 
that Italy has a very high debt-to-GDP ratio, but it has some 
strengths. Notably, it currently has a primary surplus, that 
is, excluding interest, it actually has a small surplus, so its 
fiscal position in terms of the current deficit is much better 
than Greece, for example. Its banks are in decent shape. They 
have taken some extra capital in recently. It has got a well-
diversified, manufacturing-based economy. So there are a lot of 
strengths that it has, so I think the first line of defense, 
perhaps with some assistance or commitments from the Europeans, 
would be for Italy to try to address the concerns that the 
markets have.
    In terms of explicit debt, States do not generally have the 
same kinds of levels of debt that our U.S. Federal Government 
or European governments have, and they rely on Federal money 
for Social Security, for medical care, and other things. So 
there are some States--Illinois, California, as you mentioned--
that are having more difficulty. We watch those very carefully. 
We also look at the exposures of banks and other institutions 
to those States. We do not see any immediate risk there, but it 
is true that a number of States do need to be thinking about 
their longer-term sustainability given the unfunded liabilities 
they may have for State pensions and for in some cases the 
health care programs as well. But we are monitoring that 
situation, but we do not think it is really analogous to the 
European situation.
    Senator Kirk. I have got 13 seconds to go. What about the 
adequacy of the IMF should we face a Spanish and Italian 
contingency? Are you concerned that at Greek bailout levels we 
would run about $50 billion short?
    Mr. Bernanke. Spain and Italy are much bigger economies 
than the three that have already been addressed, and if it came 
to that point, I want to be very clear that I do not anticipate 
that happening. But if it came to that point, I think the 
Europeans would have to make a very substantial contribution to 
stabilize those countries.
    Senator Kirk. Thank you, Mr. Chairman.
    Chairman Johnson. Senator Kohl.
    Senator Kohl. Thank you very much, Mr. Chairman.
    Nice to have you with us this morning, Mr. Bernanke. I 
would like to ask you about our job situation and our recovery 
and their interrelationship. We have a jobless recovery by many 
people's estimate. Even as the economy seems to be getting 
better and profits in corporations are stronger, hiring has not 
been what we want it to be, and, of course, wages are not what 
we want them to be. The wage picture in particular is 
disturbing because average wages in this country, family income 
has not moved in many years. And as companies continue to 
progress and not hire, what we are finding is that they are 
able to do business at a higher level with the same number of 
employees, in some cases even fewer employees.
    So I am asking myself, How do we turn this around? And when 
is this going to get turned around? Back in other times, there 
was a much more direct correlation between economic activity, 
rising profits and growth, and hiring and wages. We do not seem 
to have that connection today.
    I would like you to comment on that and what that portends 
for us even as business gets better.
    Mr. Bernanke. Well, I can only agree with your diagnosis. 
We have high unemployment. It is improving very, very slowly in 
terms of jobs regained. We have the potential for very long run 
consequences because of the long-term unemployed. Those folks 
are going to find it much harder to find new work or find work 
that was comparable to the work they had before. Wages are very 
stagnant, and that is affecting consumer spending and consumer 
confidence. So I agree absolutely this is a major problem.
    There has been a tendency in the last 20 years or so for 
recoveries to be more jobless in the early post-war period. We 
saw the same thing in the 1990s and the beginning of the last 
decade. There is a little bit of an irony here, which is that, 
generally speaking, productivity gains are a really good thing 
and that helps make the country rich over time. But over very 
short periods in this crisis, a lot of firms got very scared. 
They reduced their labor forces, and they tried to find ways to 
produce the same output without as many workers, and in doing 
so they increased productivity remarkably. But given the low 
level of demand, that means that their demand for workers is 
not as strong as we would like.
    There is also ongoing uncertainty about the durability of 
the recovery and about the economic environment, including 
fiscal issues, as we have been talking about. So if I had the 
answer, I would give it to you. The Federal Reserve has been 
providing as much accommodative support as we can to meet our 
dual mandate. I do think it would be worth Congress looking at 
some specific issues related to the unemployed. I am concerned 
about the long-run implications of the long-term unemployment. 
Are there things that the Congress could do to help people 
improve their skills or to find new opportunities? I think 
those are questions that should be asked.
    Senator Kohl. And it is also very troubling, isn't it, that 
family wages have just stagnated, not just for the last year or 
two but for the last decade or longer. And unless we can find a 
way to turn that around, we are looking at a troubling future, 
to say the least. After all, the economy is driven by consumer 
demand, and if wages are not increasing in spite of a stronger 
economy, let alone employment, if wages are not increasing, we 
are facing a very troubling future. Wouldn't you say that?
    Mr. Bernanke. Yes, and it is a long-run trend. It is a 30-
year trend.
    Senator Kohl. Right.
    Mr. Bernanke. And one part of it is skills and preparation. 
We have a globalized, highly technological society, and those 
people who are prepared for it can do very well, but it used to 
be if you had a high school education, you were prepared to get 
a decent job, but now that is not nearly the case.
    Senator Kohl. Right.
    Mr. Bernanke. So we are going to have to address those 
education deficits and help people get the skills.
    Senator Kohl. Can I ask just one more question?
    Mr. Bernanke. Sure.
    Senator Kohl. Consolidation of the banking industry is not 
new, but it is certainly something that I am thinking about at 
this time because last week, after 164 years in Wisconsin, the 
M&I Bank was bought out by Harris Bank, a subsidiary of the 
Bank of Montreal. M&I was Wisconsin's largest and oldest banks, 
and now it has been purchased, as I said, by a national bank.
    One concern I have with larger national banks moving into 
Wisconsin is what impact that will have on local customers, 
small businesses, and farmers. We have seen evidence that 
mergers of smaller banks can be good for small business, but 
when a large national bank buys smaller banks, small business 
loans tend to decrease. That is the statistic.
    As more national banks acquire regional and community 
banks, what can we do to see to it that they keep lending to 
small businesses? Is the Federal Reserve looking at the impacts 
of consolidation on lending to small business and farmers?
    Mr. Bernanke. Yes, Senator, we are. We and the Department 
of Justice are typically involved in approving mergers and 
acquisitions, and when we do that, one of the key exercises we 
do is we look at the resulting concentration of banking 
services within the local area, within a city, within a county. 
And we want to be sure, when taking into account all the 
banking services, thrifts, and others that are in that area, 
that any merger or acquisition does not create a situation 
where one firm dominates that market. And so we do pay a lot of 
attention to making sure that there is competition, that 
consumers and businesses have alternatives to go to within 
their local market when we approve those mergers.
    It is true that larger banks, particularly recently, have 
been not as forthcoming with small business as some local 
banks, community banks have been. And we see a lot of advantage 
in community banks, and we are very supportive of community 
banks. We have a subcommittee in our supervisory function which 
looks entirely at the implications of new rules and regulations 
for smaller banks and tries to do whatever we can to minimize 
the burden on those banks. We would like to see a healthy 
community banking system, and we are going to do our best to 
support that goal.
    Senator Kohl. Thank you very much.
    Chairman Johnson. Senator Johanns.
    Senator Johanns. Mr. Chairman, good to see you again.
    Mr. Chairman, as we have been working through the 
challenges of the debt ceiling and August 2nd--and maybe August 
2nd is actually August 3rd or August 4th--I have been trying to 
do as deep a dive as I can to understand the cash-flow and the 
financial requirements of the U.S. Government. And so I am 
hoping I can use my 5 minutes to offer hopefully some insight 
on that, but I would like your reaction to a couple of things 
that I think I have identified here that are enormously 
important.
    The first thing, I looked at the indebtedness of the United 
States, the Treasuries, the Treasuries we issue, and on August 
4th, we need to roll over $90.8 billion; August 11th, $93.3 
billion; August 15th, $26.6 billion; August 18th, $87 billion; 
August 25th, $112 billion; and August 31st, $60.8 billion.
    Let us say that, for whatever reason, there is no solution 
to this raising the debt ceiling issue through August and we 
are constantly in the market, as you know, trying to deal with 
the Treasury situation. We have got these that we have to roll 
over. What is the market reaction going to be just in terms of 
this? It just seems to me that if I were a big trader in 
Treasuries, I would want a better deal. I would want more 
interest. I would want something from the U.S. Government, 
because all of a sudden there is an element of political risk 
that has been injected that maybe there will not be enough 
consensus to deal with this.
    What is your reaction to that?
    Mr. Bernanke. Senator, you are absolutely right. We know 
what our interest payments are going to be, but we have to roll 
over large amounts of Treasuries, and it could be that if 
investors demand higher interest rates, that means basically 
that we will be short, that the price that will be paid will be 
less than we need to borrow, so that is another source of 
uncertainty in terms of what we are going to owe from the 
coffers of the Treasury.
    So, yes, I think that it is very uncertain, and we are 
seeing already the downgrade threats and so on. But it is 
entirely possible that a loss of confidence or political risk 
could raise interest rates and would effectively make it more 
difficult or at least more expensive to roll over the debt 
going forward.
    Senator Johanns. Now, in terms of that rollover, my 
understanding is we cannot avoid that without really severe 
consequences. In other words, as these dates come up, we have 
got to deal with it. Is that a correct assumption, or are there 
alternatives I do not know about?
    Mr. Bernanke. When the principal comes up, we have to roll 
it over or sell other bonds to meet that amount.
    Senator Johanns. OK. Now, the next piece of this--and, 
gosh, there was so much discussion out there about whether 
Treasury could do this and Social Security recipients will, in 
fact, get paid or whatever the latest point is. But I was 
looking at an analysis that was done, again, for August, and it 
anticipates revenues of $172.4 billion. I admit there could be 
some give and take on that. Outflows--in other words, 
requirements for money--of $306,713,000,000. So obviously we 
know we are borrowing 40 cents on every dollar. Less is coming 
in than we have got obligations for August.
    But I looked at the requirements in August: interest on 
Treasuries, $29 billion; Social Security, $49 billion; 
Medicare, $50 billion; defense vendor payments, $31 billion; 
unemployment benefits, $12 billion. So if you just paid those 
items, you would spend $172 billion; in other words, you have 
spent the money that came in. And since we have not raised the 
debt ceiling, that is it.
    Now, there is a whole list of items under that that are not 
getting paid, and you might move some of those up. But it is 
pretty awful: Veterans Affairs programs; we have not made 
payroll for the Federal Government; that does not include 
military pay, although many would argue it should be above the 
line.
    How will the market regard us--let us say we can deal with 
this Treasury issue. How will the market regard us not paying 
this long list of other financial obligations? They are not 
securities, but they are truly financial obligations.
    Mr. Bernanke. Well, Senator, nobody knows with certainty, 
which is part of the reason why we should not be taking this 
risk in the first place. But it seems to me very reasonable to 
expect that a government that shows it is unwilling to pay its 
bills, pay its obligations, would engender some distrust in the 
markets and that we would still see response of interest rates 
and increased financial volatility.
    I should say once again that this is a hypothetical 
discussion because Treasury takes the view that it is not 
appropriate or feasible to prioritize in that strict way that 
you described.
    Senator Johanns. I will just wrap up with one last comment 
because my time has expired. For me, this is mathematics. So 
much money comes in, so much money goes out. It is mathematics. 
It is not magic. My hope is that between now and whatever date 
Treasury, you, others will descend upon the Hill to do what I 
have done, to avoid some of the discussion that, quite 
honestly, maybe is not just fully accurate--and I do not want 
to accuse anybody of anything, but I think this would be very 
helpful to understand the math.
    Thank you, Mr. Chairman.
    Chairman Johnson. Senator Bennet.
    Senator Bennet. Thank you, Mr. Chairman.
    Just to follow up on Senator Johanns' line of questioning, 
first, Mr. Chairman, and I do not mean this in a technical 
sense, but isn't there a huge risk if we announce to the world 
that we cannot raise the debt ceiling, that we are so 
politically dysfunctional that there is no plan, that the 
market would treat our lack of payment on any of these 
obligations as a cross-default, in effect, with the debt, and 
then we would see interest rate rates rise very quickly as a 
result of that.
    Mr. Bernanke. Again, nobody knows for sure, but that is a 
possibility. And I would just add that nobody thinks the United 
States cannot pay its debts. It is really a political risk, not 
a----
    Senator Bennet. It is a political risk.
    Mr. Bernanke. It is not an economic risk.
    Senator Bennet. Exactly. It is a political risk. No mayor 
in my State of Colorado would ever threaten to jeopardize the 
credit rating of his city. He would be run out on a rail for 
doing it. And we find ourselves in this position.
    I wanted to ask a question that--and, by the way, we are 
not focused on the things that Senator Kohl was talking about, 
which is what the people in my State want to know: how we are 
going to create an economy where median family income is 
actually rising instead of falling and what we are doing to 
create jobs. I appreciate that line of questioning.
    Moody's said yesterday:

        An actual default, regardless of duration, would fundamentally 
        alter Moody's assessment of the timeliness of future payments, 
        and a AAA rating would likely no longer be appropriate.

    Can you remember the last time a credit rating agency 
threatened a downgrade of U.S. debt?
    Mr. Bernanke. It has happened recently.
    Senator Bennet. Before this.
    Mr. Bernanke. But before this?
    Senator Bennet. It happened recently in the same context 
that we are in today.
    Mr. Bernanke. The current context, yes.
    Senator Bennet. Right. When was the last time before this 
debate about raising the debt ceiling arose?
    Mr. Bernanke. I do not think that has happened in the 20th 
century, but I am not certain.
    Senator Bennet. We are now in the 21st century, so it has 
not happened in the 21st century, it has not happened in the 
20th century.
    Mr. Bernanke. I do not believe so.
    Senator Bennet. This Congress has put ourselves in this 
position where credit ratings are actually threatening our 
credit rating.
    Mr. Bernanke. That is right.
    Senator Bennet. Can you think of an asset that is more 
important to us than our credit rating? When you think about 
the----
    Mr. Bernanke. Well, there are many assets, but clearly 
the----
    Senator Bennet. That gives us more competitive advantage 
than our credit rating?
    Mr. Bernanke. It is tremendously important that we have the 
confidence of the world in terms of willingness to hold 
Treasuries, to trade in Treasuries, to maintain a liquid market 
in Treasuries for the stability of the dollar. It is a very 
important asset, and losing that credit rating is a self-
inflicted wound.
    Senator Bennet. Mr. Chairman, am I over time? I am confused 
about the clock? Did we reset it?
    Chairman Johnson. Yes, it has been reset.
    Senator Bennet. Thank you. I still have time left.
    I want to come back to the question of what the effect of 
losing that credit rating would be--not on our interests cost 
in the Government because we know they would--the effect would 
obviously be devastating, but the effect on people living in 
the State of Colorado. You generally talked about how interest 
rates--but if you could specifically say to people in my State, 
what does it mean to me when I go to buy a car or to get a bank 
loan or to buy my house or to go to the grocery store? What is 
the effect on me if people wake up in August of 2011 and our 
debt has been downgraded by these rating agencies and we do not 
have a political path forward to address the problem?
    Mr. Bernanke. Well, Treasuries are the benchmark security. 
Most other interest rates are priced off of Treasuries. So if 
5-, 10-year Treasury yields were to go up by 2 percentage 
points, then you would expect to see mortgage rates go up 
immediately by 2 percentage points, and likewise with other 
borrowing costs that firms and households face.
    There would also very likely be an impact on the economy, 
which would then affect jobs and consumer income as well.
    Senator Bennet. What do you mean by ``affect jobs''?
    Mr. Bernanke. Higher interest rates, uncertainty, fiscal 
contraction--all those----
    Senator Bennet. Higher unemployment.
    Mr. Bernanke. It would lead to higher unemployment.
    Senator Bennet. It would lead to higher unemployment. The 
unemployment rate today is 9 percent.
    Mr. Bernanke. Correct.
    Senator Bennet. Can you think of a greater self-inflicted 
wound that we could manage to accomplish through our 
dysfunctionality than drive our unemployment rate higher when 
it is at 9 percent?
    Mr. Bernanke. We certainly do not want to take an action to 
threaten our credit rating or to drive up our interest rates, 
which is counterproductive to the goal of reducing the deficit.
    Senator Bennet. Well, that was where I was going next.
    Mr. Bernanke. Right, right.
    Senator Bennet. Which is, if all you cared about, if the 
only thing--the sun rose in the morning and it set at night and 
the only thing you were thinking about was our deficit--which 
is of huge concern to me. I have spent a lot of time on the 
floor talking about it. I have got kids that I am worried 
about, and we have got to get a hold of it--we really do--in a 
bipartisan way. Can you think of anything that would be more 
destructive to my desire to pay down our deficit than to fail 
to raise the debt ceiling--raise the interest rate?
    Mr. Bernanke. You tax my imagination.
    Senator Bennet. I tax your imagination.
    Mr. Bernanke. Yes.
    Senator Bennet. Even economists have imaginations.
    Mr. Bernanke. Even some.
    [Laughter.]
    Senator Bennet. But, you know, in all seriousness--in all 
seriousness--we are sitting across the table from you saying:

        I am deeply concerned about the fiscal condition of this 
        country, I am deeply concerned about the size of the deficit. 
        Can you think of anything I could do that would be more 
        problematic than jeopardize our credit rating?

    Mr. Bernanke. That would certainly be a very negative 
thing, and this is happening at the same time that Europe is 
dealing with fiscal issues, so there is just a lot of 
uncertainty piling on each other globally.
    Senator Bennet. Right. Exactly. So here is the last thing. 
We are just emerging from the worst recession since the Great 
Depression, and we went into this recession--we sort of went 
straight off the cliff. A lot of people did not predict it. A 
lot of people could not see that it was coming. How do you 
assess the risk that if we end up driving this car over the 
cliff with our eyes wide open, which they are, we could see a 
downturn in our economy at a point when our deficit is already 
at $1.5 trillion, which it was not before the last recession, 
when your balance sheet is now $3 trillion, which it was not 
before the last downturn, that this economic crisis could be at 
least as bad as the one that we just came out of, and that the 
policy responses that are available to you and to the Treasury 
and to the Congress are actually more limited at this point 
because we are still recovering from the last crisis we went 
through? Could you talk that through a little bit? What would 
it look like on the other side if we actually do get to a place 
where we find ourselves in this utterly predictable----
    Mr. Bernanke. Well, it certainly could slow the economy 
through higher interest rates and through financial volatility, 
but you actually make an additional point which I think is 
worth emphasizing. The higher interest rates would add to the 
deficit, but also a slowdown in economic activity by reducing 
revenues would also further add to the deficit. So it really is 
going in the wrong direction in terms of fiscal stability.
    Senator Bennet. Thank you, Mr. Chairman. I apologize for 
going over.
    Chairman Johnson. Senator Corker.
    Senator Corker. Mr. Chairman, thank you for being here, and 
I will continue, as has been the tradition this morning, to use 
you as a prop to make our own points.
    [Laughter.]
    Senator Corker. But thank you for your willingness to 
participate in that manner.
    The fact is that all this talk about the debt ceiling is 
farcical at this moment. I think we all know that our 
leadership has concocted a scheme where folks on the other side 
of the aisle can allow the debt ceiling to increase and 
continue to appeal to their constituencies for the 2012 
election, and on our side, we can continue to cause spending to 
be an issue for us in the election, and basically by virtue of 
concocting this scheme, we are not going to make any tough 
decisions. We all know that. And maybe the debt ceiling was the 
wrong place for us to be making that argument.
    But let me move to the other side of this. It is evident 
the debt ceiling is going to be increased. It is probable that 
not much is going to occur as it relates to spending. And I 
would say that the flip side of this is people have to be 
waking up at some point when we go through this whole short-
term hurdle and say, you know, on the other hand, if the U.S. 
Government does not do something as it relates to spending, 
then the credit rating agencies--as a matter of fact, some of 
them have already referred to that, not this debt ceiling 
issue, as being a major problem. Would you agree?
    Mr. Bernanke. Yes, Senator. I want to be clear. Whenever I 
have talked about this, I have had a two-handed economist 
approach, which is the debt ceiling needs to be addressed, but 
we also do need to address the stability and sustainability of 
our fiscal position.
    Senator Corker. Yes. So let me, since you are a prop and 
you are answering the way we all want you to answer, I guess 
the debt ceiling is probably not the best place for us to deal 
with this issue. What is the best place for Congress to 
actually deal with the issues of spending?
    Mr. Bernanke. Well, through the legislative and 
consultative process that the Founders----
    Senator Corker. Is it called a budget?
    Mr. Bernanke. Well, except for one thing----
    Senator Corker. The answer is supposed to be yes----
    Mr. Bernanke. Sorry.
    [Laughter.]
    Senator Corker.----if you are an appropriate prop for us.
    Mr. Bernanke. I will. My only point was just to say, the 
answer is yes, but we need to think about this both in the 
current year and also on a longer-term basis.
    Senator Corker. Future years, I agree.
    Mr. Bernanke. Yes.
    Senator Corker. So let me just--you know, we basically--I 
do not know what the most common joke is around the Fed about 
most of us around here. I would love to hear it maybe sometime 
if you will not do it with a microphone today, but we basically 
have been sort of feckless Members.
    The U.S. Senate has basically caused this great Nation to 
be in decline because we are not willing to deal with the tough 
issues we need to deal with. So some people resorted to the 
debt ceiling, and that is obviously--we figured out a political 
solution to that that works well for both sides to be able to 
campaign through 2012. But the fact is, we have not dealt with 
a budget now for some time.
    The majority party could actually be mostly criticized for 
that, but I do not want to do that. I think both sides are 
critical, because now we are moving to a spending bill today 
without a budget. And so all these--this has been a lot of fun, 
for everybody to use you as their prop about the debt ceiling, 
but the fact is that we are all sort of two-bit pawns in all of 
this by allowing our country to continue to spend money.
    What has happened is our leadership has wanted to protect 
us. You see, we have to make tough decisions when we budget and 
prioritize. And so in order to protect majorities, we do not go 
through that process. How do you think--being the good prop 
that you are--how do you think the financial analysts view our 
inability to make those tough decisions?
    Mr. Bernanke. Well, as I indicated, I think they view this 
whole situation, both the debt ceiling situation and the long-
term fiscal stability situation, as being a political issue and 
not an economic issue. The question is whether or not we can 
come together and find real solutions. I think some of the 
discussions that have been had suggest that some very large-
scale fixes could be undertaken. I am not prescribing one or 
the other. But we need to do something very significant just to 
keep our debt-to-GDP ratio from rising over the next decade, 
and then after that, we have entitlement issues, as well. So we 
need to do something big, strong----
    Senator Corker. I had dinner Monday night with a number of 
my colleagues on both sides of the aisle, and I will not 
mention who they were to impugn them, but all complaining about 
how dysfunctional this place is, and yet today, I am going to 
use this opportunity to point out that we are moving to a 
spending bill without a budget. So any of us who complain about 
how dysfunctional--and my friend used the word 
``dysfunctional;'' I use it often, unfortunately--any of us who 
complain about how dysfunctional the U.S. Government is today 
and the fact that the Senate is moving our country into decline 
who would then vote for a spending bill without a budget are 
basically accomplices in allowing us to move toward that place 
that you are talking about where the credit rating agencies are 
going to be downgrading us because we do not make tough 
decisions.
    My time is up and I appreciate you--basically, when you are 
the second day of Humphrey-Hawkins, there is really not much to 
talk about other than what we want to put forth. I do want to 
close with this.
    I thank you for your service and I respect you and I 
appreciate the way the Fed has been with me very open, very 
transparent. You shared confidences with me that I have keep 
confidential and I have appreciated that. I will tell you that 
I find the activism at the Fed right now a major turn-off and I 
am very concerned. As one person who I think we have had a good 
relationship, I want to tell you that I am quickly moving to a 
camp that wants to clip the wings of the Fed, because I do 
believe that the activism there is distortive of the market, 
and I believe that the dual mandate that we have set up is 
causing you--something is causing you to do a lot of things 
that I think are going to create some long-term damage.
    So just know that while I respect you and I respect 
certainly the people who work with you and I appreciate the 
kindness, I am extremely turned off by your activism.
    Chairman Johnson. Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman.
    Chairman Bernanke, thank you again for your service to our 
country. You know, you and I at different times here have 
spoken about the 2008 crisis and the reality that, but for the 
Congress acting, we would have maybe not been in the deep 
recession we are in but on the verge of a near depression. And 
as that as a backdrop, I look at past recoveries which were 
first led by a surge in the home market, home building, and 
then by the easing of credit, and with the high number of 
distressed homes on the market creating a crippled housing 
construction sector and with financial firms still cautious as 
they rebuild their capital base, is this the best recovery we 
could have expected? And, second, given those persisting 
problems, do you really think, or are there policies that can 
create a stronger recovery with many more jobs?
    Mr. Bernanke. I do not see any easy solutions, obviously. I 
certainly would have recommended them if I saw them. Senator 
Corker alluded to activism. I think what we are trying to do is 
to fulfill our mandate, which is to provide as much support as 
we can for the recovery.
    On the fiscal side, I recognize there are some real 
tensions because there would be scope for targeted programs to 
help some of the issues that we have in housing and otherwise. 
But I understand the concerns on both sides of the aisle about 
the long-term fiscal stability of the country and the need to 
address those issues. So it is a difficult situation. We do not 
have any substantial unused capacity to increase the speed of 
the recovery.
    Senator Menendez. And so it is a difficult situation 
stemming from where we started, because there is always a 
starting point here.
    Mr. Bernanke. That is right.
    Senator Menendez. And so I look at, you know, a combination 
of tax cuts that went unpaid for and deprive the Treasury of 
enormous amounts of money at a time that we had two wars raging 
abroad in Iraq and Afghanistan, also unpaid for, a new 
entitlement program passed in the past Congress that is unpaid 
for, and a Wall Street that instead of being a free market was 
a free-for-all market. And you put that all together and that 
is what we are coming out of.
    So I am wondering--your answer to me suggests that there is 
not any more monetary policy that is going to come forward that 
could, in essence, seek a more faster, more robust recovery 
with a greater job growth.
    Mr. Bernanke. Well, as I said in my testimony, given that 
there is a lot of uncertainty about how the economy will 
evolve, we have to keep all options, both for tightening and 
for easing, on the table, and we are doing that. But again, we 
are already providing an exceptional amount of accommodation. 
As you know, recovery is still pretty slow.
    Senator Menendez. Now, I want to turn to the question of 
the debt ceiling. I know you have discussed that quite a bit. 
You know, I find it interesting. Under President Bush's years, 
he raised the debt ceiling to the tune of about $5.4 trillion 
during his period of time. I did not hear the same comments 
then that raising the debt ceiling was something that was not 
necessary to do, that, in essence, having the Nation be a 
deadbeat is OK. And I find it alarming that there are people 
running for high office in this country and others already in 
significant positions who suggest that there is no great 
concern to allowing the Nation to be a deadbeat, to default, 
and no real consequences.
    And so in pursuit of a solution, we have had these efforts 
to have severe cuts, to consider entitlement changes, as well. 
But I wonder whether entitlement changes should not also be the 
question of entitlements. Somehow, it seems that revenues are 
now an entitlement, as well. It seems that those who are the 
wealthiest in the country, that major entities like the oil and 
gas industry that is getting $21 billion in tax breaks when 
they are going to make $144 billion in profits this year alone, 
no, we cannot touch them. So it seems to me we have a new class 
of entitlements.
    Is not, in order to solve this problem, it really going to 
require real shared sacrifice, because I look at GDP in this 
country and about 70 percent of it is driven by domestic 
consumer demand. Well, there are no jobs, there is no demand. 
And if we are going to put this on the backs of middle-class 
working families who spend more of their disposable income, 
then I do not know how we are going to drive this economy based 
upon your previous answer that there is not too much more 
monetary policy we can have. Do you not think that it is fair 
to consider a shared sacrifice that is spread across the board 
to try to solve this debt ceiling question and the debt 
questions that confront the Nation?
    Mr. Bernanke. Well, Senator, I think you can appreciate I 
do not inject myself into these negotiations, which are very 
difficult and delicate, but I do hope that everything will be 
on the table and that there will be frank and open discussion 
about the tradeoffs and----
    Senator Menendez. Well, as fiscal policy, do you believe 
that only one section of the American society should bear the 
burden? For example, is it overwhelmingly going to be the 
middle class in cuts that affect their lives and may have to 
reach into their pockets more at the end of the day that is the 
way in which we achieve the right fiscal policy for the 
country?
    Mr. Bernanke. Well, I think that we want to have shared 
sacrifice. We also want to make sure we maintain a strong 
economy. There are a whole bunch of issues there. These are not 
issues that a pure economic analysis can answer. These are 
values issues and this is what elected officials are supposed 
to be determining. I really cannot make those decisions for 
you.
    Senator Menendez. No, I am not looking for you to do that, 
Mr. Chairman. I just think that we have come to a point in 
which it seems that the tax code for those who benefit by it, 
whether it be large corporations like the oil and gas 
companies, whether it be the wealthiest millionaires and 
billionaires in the country, they are entitled to keep those 
tax breaks, but middle-class working families seem to be called 
upon for the burden of the resolution of this problem, and to 
me, that is both a moral issue, but it also is a fiscal issue. 
It is the wrong process by which we achieve the balance we 
need.
    Thank you, Mr. Chairman.
    Chairman Johnson. Senator Vitter.
    Senator Vitter. Thank you, Mr. Chairman, and thank you, Mr. 
Chairman, for being here.
    Moody's, in their recent outlooks, said that a credible 
agreement on substantial deficit reduction would support a 
continued stable outlook. Lack of such an agreement could 
prompt Moody's to change its outlook to negative on the AAA 
rating. Do you think that sort of statement about a plan for 
deficit reduction is indicative of the entire market?
    Mr. Bernanke. Yes, I do. As I have said, there are two 
prongs here. One is to navigate this debt ceiling issue without 
any kind of disruption, but the other, which would not be 
successful, that we just kick the can down the road in terms of 
our fiscal, long-term fiscal situation. So I very much support 
a strong fiscal deal.
    Senator Vitter. Right, and I have asked you previously how 
quickly this lack of a sustainable fiscal path could bite us 
and could have serious consequence, and I believe--I do not 
want to put words in your mouth--I believe you said you do not 
know, but it certainly could be sooner rather than later and it 
is not necessarily years off. Could you make a comment on that 
now?
    Mr. Bernanke. No, that is correct. Markets are forward 
looking. They are trying to assess the likelihood that they 
will get paid years down the road. And we are seeing it in 
other countries around the world, that there is a loss of 
confidence by investors in a country's fiscal stability and its 
political resolve to address those fiscal issues, that interest 
rates can start to rise and then you get a vicious circle.
    Senator Vitter. Right. So if the resolution of this present 
showdown and negotiation is increasing the debt ceiling with no 
significant change in terms of our fiscal path, how do you 
think the markets will digest that?
    Mr. Bernanke. Well, I am sorry the two things got linked 
together the way they did, but I would very much like to see 
both parts of this work, both addressing the debt ceiling and 
addressing longer-term fiscal issues. I do not know how quickly 
or in what degree the markets would respond, but I think they 
are looking to Washington to show that they can manage their 
spending and control deficits over a long period of time.
    Senator Vitter. What you said a minute ago is part of my 
point. We have been talking about this event for months and it 
has been built up, smartly or dumbly, rightly or wrongly, as an 
opportunity to do something. So particularly with that buildup 
and that context, I guess my gut is that if we extend the debt 
limit and essentially do nothing for fiscal sustainability, the 
markets will have some sort of meaningful negative reaction as 
reflected in the Moody's statement. Would you agree with that 
or not?
    Mr. Bernanke. It is possible.
    Senator Vitter. Turning to other policy and talk of, 
essentially, a QE3, I certainly agree with Senator Corker's 
comments. I am sure that does not surprise you. What would you 
point to in terms of success with QE1 or QE2 in terms of 
suggesting and convincing us that a third round is advisable?
    Mr. Bernanke. Well, QE1 came in, basically in March of 
2009, which was at a very, very weak point in the recovery. It 
was the absolute trough of the economy. The stock market was 
about half where it is now. The first round seemed to restore 
confidence and seemed to strengthen financial markets. It 
helped the economy grow quickly in the latter part of that 
year. And it was not the only contributor to the recovery and 
improvement in financial conditions, but I think it was a 
significant contributor.
    QE2, as it is called, was first signaled in August of last 
year, and as I mentioned in my testimony, at that time, we were 
missing our mandate in the same direction on both parts of the 
mandate. That is, employment was very weak. It looked like the 
growth was so weak that unemployment might start to rise again. 
And inflation, rather than not being inflation, was actually 
falling down toward a very low level, and we know that we have 
not experienced it here since the 1930s that deflation can be a 
very pernicious situation.
    So our policies, which are admittedly different from the 
normal ones, they lower interest rates, they strengthen asset 
prices, and they provide more incentive for people to borrow, 
spend, invest. I think it obviously has addressed the inflation 
issue, and we think that by the second half of the year, we are 
going to be more or less on target in terms of where we want to 
be in inflation. And although job creation has not been all we 
would like it to be, it has been consistent with our 
expectations of about 700,000 jobs over 2 years.
    So we think it has moved in the right direction and it has 
not had, if our forecasts are right and inflation stabilizes 
around 2 percent in the second half of the year, then some of 
these fears about hyperinflation and so on will have been shown 
not to have been accurate. So we think it has been 
constructive.
    That being said, we are trying to maintain flexibility in 
both directions, both in terms of easing and tightening. But we 
recognize that monetary policy is not a panacea and we hope 
that Congress will be addressing issues related to the economy, 
as well.
    Senator Vitter. Mr. Chairman, if I can just have one more 
question to finish out----
    Senator Reed. [Presiding.] Very quickly, sir.
    Senator Vitter. Thank you. In that framework of promoting 
growth, promoting recovery, what do you think the impact would 
be if we announced today letting the Bush tax cuts expire at 
the end of 2012 for the top brackets, so essentially a tax 
increase for those brackets. What do you think the impact on 
growth and the economy would be?
    Mr. Bernanke. I cannot really assess that. It would have 
some effects on higher marginal rates. It would have some 
effects on incentives. Higher rates would also take some 
consumer spending out of the economy. On the other hand, we 
have all been talking about the importance of addressing the 
overall deficit situation, so that would work in the other 
direction. So it would have multiple, different effects on the 
economy, and those kinds of specific policy decisions are going 
to have to be worked out by the folks who were elected to do 
that.
    Senator Reed. Senator Hagan.
    Senator Hagan. Thank you, Mr. Chairman, and Mr. Bernanke, 
thank you for your testimony and thank you for your hard work 
and all that you are doing right now.
    Mr. Bernanke. Thank you.
    Senator Hagan. I served for 10 years in the State Senate in 
North Carolina, co-chaired our budget, and we did everything 
possible to keep a AAA credit rating in the State because we 
knew the consequences if we did not, the increase of our 
interest rates on our debt, and I just think the American 
people deserve better than what they are seeing right now from 
the lack of inaction--of the inability for Democrats and 
Republicans to come together right now and help solve this 
issue. So I am extremely concerned about it, as I know the 
American people are, and I think we agree that failing to raise 
the debt ceiling could create, obviously, tremendous problems 
for our financial system and our economy that you have been 
discussing today and problems that might require accommodative 
monetary policy from the Fed.
    I understand that the Federal funds rates, they cannot be 
lowered in any other meaningful way, and that one of the Fed's 
responses to an economic weakness would be to initiate more 
securities purchases. I was just wondering, can you help me 
understand what the Fed would do, how you would respond if we 
went into default, and could the Fed purchase Treasury 
securities that had defaulted?
    Mr. Bernanke. Well, on that last question, that is really 
an FOMC decision and I would have to leave that to that broader 
group.
    We would do what we could to preserve the operationality of 
the system. We participate in securities transfers and so on. 
But I want to eliminate any expectation that the Fed through 
any mechanism could offset the impact of a default on the 
Government debt. I think that it would be a very destructive 
event, and while the Fed would do what it could, again, I do 
not think it is fair to have any expectations that we could 
offset the impact of that.
    Senator Hagan. How would this impact the Fed's ability to 
conduct monetary policy?
    Mr. Bernanke. Well, it would immediately offset a lot of 
the benefits from our policy by causing interest rates to rise 
and that would effect the state of the economy. It would also 
likely create disorderly conditions in money markets and so on 
where we do actually move interest rates around. So it would be 
counterproductive, certainly, to the goal of restoring a 
healthier economy.
    Senator Hagan. What happens to the Fed's income and its 
distributions to the Treasury if the Treasury stops making 
timely payments?
    Mr. Bernanke. Well, that part is kind of a wash with 
respect to the Fed's payments because we receive interest from 
the Treasury and then we remit most of it back to the Treasury. 
So I think our greater concerns would be the impacts on the 
financial markets.
    I think it is important to understand that Treasuries are 
not just a buy-and-hold asset. They are used for margin, for 
collateral, for liquidity, for hedging, for a whole variety of 
different functions. They are the fundamental element that 
keeps the financial system moving. And so there would be a 
great deal of disruption in the private sector in the financial 
markets, and that is where I think the main problems would 
occur.
    Senator Hagan. Chairman Bernanke, I cannot tell you how 
alarmed I was on Friday of this past week when the Bureau of 
Labor Statistics released the employment report and there are 
over 430,000 people unemployed in my State now that are looking 
for work. And the bottom line of the creation of 18,000 new 
jobs nationwide is obviously very disappointing to everybody.
    I am very concerned, too, about the persistently high 
unemployment rate among veterans. We have quite a few veterans 
in North Carolina, and over 13 percent of these veterans are 
currently unemployed right now. And it seems that we have got a 
serious problem in the short run when it comes to unemployment, 
and we have all been talking about that today, too. I believe 
it is a problem that we do need to separate from the longer-
term fiscal imbalance that we are attempting to address.
    What can be done in the short term to boost demand, help 
get our citizens back to work? And I would be interested to 
hear what you think of different policies that maybe have 
worked in the past or any policies and thoughts that you might 
have going forward.
    Mr. Bernanke. Well, we were very disappointed, as well, and 
as I said, we think it is partly temporary. We hope it is going 
to be a little better going forward.
    We have to think of fiscal policy as a whole. It is a 
complicated problem because we are trying to maintain several 
objectives at the same time, and one is we want to achieve a 
long-term credible stabilization of our fiscal policy and 
reduce deficits. We want to do that in a way that is going to 
promote growth. We want to have a better tax system. We want to 
have good investments made by the Government and so on.
    But I also think we need to be a little bit careful about 
the very short term because the recovery is still fragile and, 
you know, very sharp cuts in the very short term could pose 
some risk to that recovery. So I hope that all those different 
goals can be combined in trying to solve this overall problem.
    Again, the Fed is doing what it can to support the 
recovery. Congress might want to look at some targeted 
programs. For example, one of the issues that we have been 
talking about is the effects on skills of long-term 
unemployment. Veterans have perhaps been out of the labor force 
while coming back. So one thing to look at, and again, there 
are many different ways to do this, using the private sector 
and so on, but one thing to look at would be what can we do to 
help unemployed workers refresh their skills so that they will 
be available and eligible for employment when job opportunities 
arise.
    Senator Hagan. I actually have a bill on that, and I was 
not using you as a prop, either.
    Mr. Bernanke. As a prop. OK. Thank you.
    [Laughter.]
    Senator Hagan. Thank you, Mr. Chairman.
    Senator Reed. Senator Wicker.
    Senator Wicker. Thank you, and thank you, Chairman, for 
your testimony this morning and also yesterday, which I watched 
part of.
    I think a number of us on both sides of the table are 
asking the question that is on the minds of Americans, and that 
is, where is the recovery and why is the economy not doing any 
better?
    In your testimony on page 2, you say that Open Market 
Committee participants see the first-half slowdown as 
persisting for a while, and you mention at least four 
headwinds: number one, slow growth in consumer spending; number 
two, continued depressed housing sector; number three still-
limited access to credit for some households and small 
businesses; and, number four, fiscal tightening at all levels 
of Government.
    Let me ask you, isn't it a fact that another headwind 
affecting our economy and helping to cause this slowdown to 
persist is the daunting slew of regulatory requirements, 
particularly on financial institutions, in the past few years? 
We have got the Basel capital requirements, enhanced 
examinations of institutions, multiple new regulations under 
Dodd-Frank. Has any attempt been made by the Fed or some other 
entity, by FSOC, to add up the cumulative cost of these 
regulatory burdens?
    Mr. Bernanke. Well, what the Federal Reserve does is that 
for each rule that we promulgate, we do a cost/benefit 
analysis, which is part of our practice and required by law, 
and we do our very best to make sure that we interpret the 
statutes in a way that will be effective but will also minimize 
the costs on the financial system. So we are doing what we can 
to assess the costs and benefits.
    It is a very difficult balance, I agree. On the one hand, 
we certainly want to have credit flowing, and we want to have a 
strong financial sector, and I think we will have a strong 
financial sector. But we cannot forget where we were 3 years 
ago when the financial system almost collapsed. And we are 
still seeing the damage from that.
    So we are trying to apply rules in a way that will minimize 
the risk of another crisis and still permit good loans to be 
made to creditworthy borrowers.
    Senator Wicker. But you concede that credit is not flowing 
as it should be.
    Mr. Bernanke. In some areas it is, but in small business 
and some household areas, not like we would like. Part of it is 
the financial condition of the borrowers because they have 
suffered through the recession or the value of their house or 
collateral has fallen that they are not qualified. But 
certainly there is still some tightness in some areas, that is 
correct.
    Senator Wicker. And small business is where jobs are 
created.
    Mr. Bernanke. Small businesses are an important part of job 
creation, yes.
    Senator Wicker. I appreciate that you said you do a cost/
benefit analysis on each individual regulation. How about 
looking at doing a cost/benefit analysis of the cumulative 
effect of all the regulations taken together? I think it is 
possible that you might find that at some point these expected 
benefits of addressing the problems of 2008 become such a 
burden that actually the cost is too great and credit shuts 
down.
    Mr. Bernanke. Well, to do that, we would have to understand 
the interactions, and we do try to understand those 
interactions between different rules. But that is difficult. I 
understand your point and am sympathetic with your point. But 
once again, we do know that a financial crisis can be 
extraordinarily costly, and so we want to take that into 
account as well.
    Senator Wicker. And one final question. Do you see any 
particularly negative effect of a short-term increase in the 
debt ceiling given the negotiating impasse that has occurred so 
far? Would it be particularly disadvantageous to our credit 
rating if we agreed to a ceiling last until early next year, 
for example?
    Mr. Bernanke. Well, it would be certainly advantageous not 
to put us in a situation where we are threatening to default or 
not make other payments. That would be----
    Senator Wicker. It would be far better than no agreement at 
all, would it not?
    Mr. Bernanke. I think it would, but as Senator Corker 
pointed out, or Senator Vitter, the other part of this is we 
also want to make substantial progress on the long-term fiscal 
situation. And if the rating agencies felt we were just 
abandoning that effort, that would not be so good either. So we 
want to make a convincing case that we are continuing to try to 
find solutions to our fiscal issues.
    Senator Wicker. And I would share that. I think speaking 
for this side of the aisle, we would continue that, but clearly 
rather than have the situation blow up, a short-term is not 
something you would walk out of the room about, is it?
    Mr. Bernanke. Well, my first best is that the debt limit 
gets increased promptly and that we have a real solution for 
our longer-term fiscal problems.
    Senator Wicker. Thank you.
    Thank you, Mr. Chairman.
    Senator Reed. Senator Tester?
    Senator Tester. Well, thank you, Senator Reed, and you for 
being here, Chairman Bernanke.
    Real quickly, I think we all understand we have a fiscal 
problem in this country. We can keep kicking the can down the 
road forever. The problem is if we want stability, 
predictability, dependability, if we want the markets to react 
like they can, we need a long-term plan. Correct?
    Mr. Bernanke. Correct.
    Senator Tester. Thank you. I want to talk about housing. 
One of the areas of particular concern to me continues to be 
the housing market. I know it is of concern to you. It is 
weighing heavily on our ability to recover. In fact, earlier I 
think you told Chairman Johnson it is the epicenter of the 
problem.
    The loan servicers, some of them are square in the middle 
of this, and I think they have taken a role in creating it. 
They did not seem very interested in solving the problem until 
they were associated with the problem, to a large extent. We 
learned about robo-signing, which you know about, not double-
checking the facts; in fact, in some cases even selling 
mortgages they did not even own.
    The result has been in my State, and I think probably 
throughout the country--you would know this better than I--that 
we have got some folks that are being foreclosed on without 
good reason. In fact, that kind of attitude is not healthy for 
our recovery, and it is not going to cut it.
    We have got a number of reports about different settlements 
that address the liabilities associated with toxic mortgages. 
One bank recently announced $20 billion. There is another 
report as large as $30 billion between State and Federal 
prosecutors.
    It is apparent to me--and I would like to get your opinion 
on this--that some of the same guys that we bailed out in the 
interest of stabilizing the markets are the ones who have made 
the housing market far worse than it has to be. The market is 
tied in a massive knot, and banks have made little progress in 
untying it.
    You have performed a second round of stress tests earlier 
this year--correct--to determine the ability of many of these 
servicers to withstand tough conditions? Can you give me a 
sense of the scope and the magnitude of this problem and the 
challenge it poses for the housing market and if, in fact, this 
second round of stress tests have indicated whether these 
servicers really have the ability to get their act together and 
move forward in a way that can do positive things for the 
housing industry?
    Mr. Bernanke. Well, Senator, the stress tests actually bore 
on the broader capital levels of these institutions, not 
specifically on the servicing part. We had an investigation of 
the servicing concerns jointly with the other banking agencies, 
and as you know, we found many bad practices. I agree with your 
characterization. It is just very poor business, very poor 
practices in terms of making sure that consumers were 
contacted, that they were appropriately treated, that all the 
legalities were observed, et cetera.
    The Federal Reserve together with other agencies has 
imposed an order on the servicers to fix up their act and to go 
back and look at every foreclosure going back for some number 
of years and to compensate anybody who was injured by their 
practices. And we will be imposing civil money penalties at 
some point.
    Senator Tester. That is good. I will tell you that some of 
the folks that dealt in my office--and, by the way, there are a 
lot of folks who did not call my office, and they should not 
have to call a U.S. Senator's office to get results. But I can 
give you an example of a man who was widowed and was about to 
be kicked out of his house, and within weeks of doing it by one 
of these servicers. Absolutely ridiculous. So I think you need 
to help hold the people accountable, and if we can be helpful 
in that, we will.
    The housing market, it is in a knot. What can you do to 
help unwind it?
    Mr. Bernanke. Well, from the Fed's perspective we are 
trying first obviously to keep mortgage rates low. We are 
trying to encourage lending, an appropriate balance of lending 
between making sure that loans are safe and sound but making 
sure creditworthy borrowers have access to credit.
    I think one area where I think Congress might want to take 
a look, one of the basic problems is that we have such a large 
overhang of empty, distressed-sale, foreclosed-upon houses. 
That is pulling down prices. That is pulling down appraisals. 
As I mentioned earlier, there are about half a million of these 
houses in the REO books of the banks and Fannie and Freddie, 
plenty more with other types of ownership. And it is hurting 
neighborhoods, it is hurting cities. I think that is an area 
that is worth looking at. Can we find a way to try and reduce 
that overhang or to try to provide incentives for investors to 
convert them or something like that? I think that is one of the 
main problems that the Fed cannot directly address, but it 
could be addressed perhaps by some focused program.
    Senator Tester. OK. Do you have any idea of how many--we 
talked about excess housing for a while, and that is the 
overhang you are talking about, right?
    Mr. Bernanke. Well, that is just the REO. There are a 
couple million houses that are vacant.
    Senator Tester. And typically what do we have normally in a 
robust housing market?
    Mr. Bernanke. Probably a third of that. I do not know the 
exact number.
    Senator Tester. OK. Do you have any idea of what percentage 
of homes are underwater at this point in time?
    Mr. Bernanke. About a quarter or more, 25 to 30 percent.
    Senator Tester. A quarter or more?
    Mr. Bernanke. Of mortgages. Not homes but of mortgaged 
homes.
    Senator Tester. OK. All right. Well, thank you very much, 
Mr. Chairman. I appreciate it.
    Thank you, Senator Reed.
    Senator Reed. Senator Schumer, please.
    Senator Schumer. Thank you, Mr. Chairman--Mr. Chairman and 
Mr. Chairman, for being here, and my colleague Jon Tester.
    First, I would like to talk a little bit about deficit 
reduction, and Senator Wicker touched on this, but I want to 
clarify. Leader McConnell, as you know, has proposed a plan 
that would allow for the debt ceiling to be lifted but without 
accomplishing any debt reduction. Many of us have conflicted 
feelings about this approach because, on the one hand, it would 
ensure we do not default, but on the other, it does not make 
any headway in reducing our debt, which sooner or later will 
cause problems. I like to say we are blindfolded man heading 
toward a cliff. If we keep walking in that direction, we will 
fall off. Some people think the cliff is 5 yards away, and some 
people think it is 50 or 100 yards away. But we are headed that 
way.
    Anyway, we have to make--the McConnell plan says, OK, renew 
the ceiling, no progress on debt.
    Which do you think would be more reassuring to investors 
and the markets: just raising the debt ceiling or raising the 
debt ceiling and achieving some debt reduction at the same 
time?
    Mr. Bernanke. Well, as I said to Senator Wicker, there are 
two prongs to this: one is to avoid the problems associated 
with not raising the debt ceiling, but the other is to make 
meaningful reductions in the long-term deficit.
    Senator Schumer. It would be better to do both than just 
one.
    Mr. Bernanke. We certainly should. That is certainly the 
best outcome.
    Senator Schumer. OK, and that is the outcome some of us are 
working toward right now, so I appreciate that, because to do 
one without the other does not make much sense.
    This is about prioritizing interest payments. Many of our 
Republican colleagues here in the Senate today, Mr. Toomey on 
the Committee, they seem to feel that we can avoid default by 
prioritizing interest payments on the debt, pay back just the 
debt we owe but not all the other obligations, whether it is 
paying our troops or paying the FAA, the guys in the towers so 
our airplanes can go, our food inspectors, our Border Patrol, 
our FBI.
    But if we do not raise the debt ceiling after August 2nd, 
that would require us to stop paying almost half of our other 
bills, even if you paid back the debt. Isn't that just default 
by another name? And, in fact, wouldn't the credit rating 
agencies likely downgrade our credit rating anyway if we miss 
payments on our other obligations?
    Mr. Bernanke. I think the downgrade is possible. I do not 
know for sure. I do not think they have stated that precisely. 
But, yes, I do think this is a direction we do not want to go. 
I think that not paying our obligations, whether they be 
financial obligations or payments to Social Security recipients 
or others, any of those things would involve essentially a 
default.
    Senator Schumer. So you do not agree with those that--that 
in a sense is default, right?
    Mr. Bernanke. I want to add that the Treasury has been 
pretty clear that they do not think that is either appropriate 
and they are concerned about----
    Senator Schumer. And, by the way, to boot, wouldn't that 
hurt the economy? If we stop----
    Mr. Bernanke. Yes, of course.
    Senator Schumer.----paying $160, $170 billion worth of 
obligations--maybe it is $110 billion, but it is over $100 
billion of obligations. Some estimate that it could reduce the 
GDP by a significant percent. Is that right?
    Mr. Bernanke. Sure. Of course.
    Senator Schumer. So it seems to me you are saying--and I am 
not going to put words in your mouth--that Senator Toomey is 
just way off base here. For a smart guy, I mean, to say we can 
pay the obligations and not pay the rest and that is just fine, 
wow, I am sort of surprised at it. And I do think, by the way, 
in today's Wall Street Journal I think, it stated that Standard 
& Poor's said it would likely downgrade U.S. debt if we missed 
payments on other obligations, so they agree with you. OK.
    Next, short-term extension. Some around here--Leader Cantor 
has been pushing this--have advocated shorter-term extensions 
of the debt ceiling so we would have to do this every few 
months. Now, of course, markets would be relieved that default 
is off the table--in other words, better than not doing 
anything. But do you agree that eventually the markets would 
start to get nervous that we cannot find the political will to 
get a meaningful deal together and might start to view us a 
little more like Europe? Wouldn't it send a troubling signal to 
the markets if Congress attempted to only extend the debt 
ceiling a month or two at a time?
    Mr. Bernanke. It is important both to raise the debt 
ceiling to avoid these kinds of problems we discussed; it is 
also important to show that we can make progress on the long-
term deficit.
    Senator Schumer. But I am not talking about the long-term 
deficit. I am talking about renewal of the debt ceiling by such 
a little amount that month after month we would have to come 
back and renew it. Isn't it preferable to do it in as large an 
amount as possible just from the debt ceiling point of view?
    Mr. Bernanke. Well, there are political and tactical issues 
here which I do not want to get into, but clearly----
    Senator Schumer. I am not asking you that. I am asking 
economically.
    Mr. Bernanke.----what we want to do is to get as big a deal 
as we can to show that we are serious and that we are going to 
address the long-term stability----
    Senator Schumer. How would you characterize a 1-month 
extension of the debt ceiling compared to, say, doing it until 
2012?
    Mr. Bernanke. Well----
    Senator Schumer. Two thousand thirteen, early 2013?
    Mr. Bernanke. The risk is that you would lose credibility 
in the markets about your willingness to carry through, and so 
if you did that, it would be important to send signals somehow 
that you have a plan and----
    Senator Schumer. Better to do it through 2013 than do it a 
month at a time?
    Mr. Bernanke. Well, better to do a strong, credible plan, 
and the sooner the better.
    Senator Schumer. OK. Thank you, Mr. Chairman.
    Thank you, Mr. Chairman.
    Mr. Bernanke. Thank you.
    Senator Reed. Thank you, Senator Schumer.
    I just have one question. Who is the largest holder of our 
Treasury debt and our agency debt? Is it the Chinese Government 
or Chinese institutions?
    Mr. Bernanke. Well, the Fed has a lot----
    Senator Reed. You have a lot of it.
    Mr. Bernanke. The Chinese, I think probably right.
    Senator Reed. Right after the Fed would be the Chinese.
    Mr. Bernanke. As an individual institution, the central 
bank that holds the reserves.
    Senator Reed. Of China.
    Mr. Bernanke. Of China, yes.
    Senator Reed. So, effectively, if we were to be paying our 
debt and not paying our Social Security payments, we would be 
principally paying the Chinese central bank in lieu of paying 
Americans?
    Mr. Bernanke. That is right. But if we did not do that we 
would suffer financial consequences.
    Senator Reed. I completely concur, and I think the solution 
is to appropriately raise the debt ceiling, deal with the 
fiscal issues of the deficit that we face, and we are trying to 
do that. But just ironically, you know, when you do this sort 
of prioritization, the irony is the priority is to the Chinese 
central bank, and lower on the pecking order would practically 
be seniors and Social Security recipients and maybe even 
American military personnel. I think that is the reality, isn't 
it?
    Mr. Bernanke. Well, again, if prioritization were even 
feasible----
    Senator Reed. Were even feasible. Your point is you do not 
believe it is even feasible.
    Well, Mr. Chairman, thank you again not only for your 
testimony today but your service to the Nation in very, very 
difficult and challenging times.
    The hearing record will remain open for 7 days for 
additional statements and questions. With that, the hearing is 
adjourned. Thank you, Mr. Chairman.
    Mr. Bernanke. Thank you, Senator.
    [Whereupon, at 12:15 p.m., the hearing was adjourned.]
    [Prepared statements and response to written questions 
supplied for the record follow:]

               PREPARED STATEMENT OF SENATOR JERRY MORAN

    Mr. Chairman, I thank you for calling this hearing today and I 
thank Chairman Bernanke for joining us to have an important discussion 
about the state of our economy.
    Mr. Chairman--as you well know, our country is facing a financial 
crisis. But in my view, the financial collapse around the corner is the 
most expected economic crisis in our lifetime, yet nothing is being 
done to stop it. The co-chairs of the President's own Fiscal Commission 
agree and have warned that if we fail to take swift and serious action, 
the United States faces ``the most predictable economic crisis in its 
history.'' They predict such an event could occur in 2 years or less.
    The President's solution is to raise revenues to balance the 
budget, but does anyone really believe that increased taxes will be 
used to pay down the debt or will it just be used for even more 
spending? History shows that money raised in Washington, DC, results in 
more spending in Washington, DC. If we increase taxes, we reduce the 
chance of economic growth and we reduce the chance of more and better 
paying jobs.
    In Kansas, for example, the President proposes we increase taxes on 
those who own a business plane. Airplanes are a pretty important 
component of our State's economy, and this proposal would have a 
devastating impact upon the Wichita economy, which has already suffered 
the loss of thousands of jobs under declining business in this country. 
Now is not the time to penalize a U.S. industry that produces the best 
quality airplanes in the world. The United States and North America 
ship a significant amount of business jets worldwide, more than any 
other region in the world. But because of the recession, nearly every 
aircraft manufacturer has had to cut jobs, some up to 50 percent of 
their workforce. We see this in Kansas day in and day out, and yet the 
proposal is to make it more expensive to own an aircraft. This does not 
punish the owners of aircraft. It punishes the people who work every 
day to make an airplane.
    To turn our economy around and put people back to work, Congress 
and the Obama administration should be implementing policies that 
encourage job creation, not diminish the chances; rein in burdensome 
Government regulations; replace our convoluted Tax Code with one that 
is fair, simple, and certain; open foreign markets for American 
manufactured goods and agricultural products; and develop a 
comprehensive energy policy. Yet none of these things are being done.
    The debate over Government spending is often seen as a 
philosophical or academic debate that always goes on in Washington, DC. 
And I am aware of the heated rhetoric that has been exchanged between 
both political parties the last few weeks, but the reality is this time 
it is different, and our failure to act will have dramatic consequences 
on the daily lives of Americans.
    Officials from the Obama administration warn that the failure of 
Congress to raise the legal debt limit would risk default. But at least 
an equal economic threat confronts our country: the consequences of 
allowing our country's pattern of spending and borrowing to continue 
without a serious plan to reduce that debt. We are not immune from the 
laws of economics that face every country, and if we fail to get our 
financial house in order, our creditors will decide we are no longer 
creditworthy, and we will face the same consequences that other 
countries are suffering that followed this path.
    Our Government is not on the verge of a financial meltdown because 
Republicans will not vote to raise the debt ceiling. We are at the 
point of financial catastrophe because Republicans and Democrats have 
spent money we do not have for way too long. We must now seize this 
opportunity to force elected officials to do something they otherwise 
would not do: curb spending, balance the budget, and put in place 
policies that allow business, industry, and agriculture to invest in 
plants and equipment and create jobs.
    If we fail to act responsibly, if we fail to act as we should, if 
we let this issue pass one more time for somebody else to solve because 
it is so difficult, we will reduce the opportunities the next 
generation of Americans have to pursue the American dream. I look 
forward to having a conversation with Chairman Bernanke about these 
topics and thank him for his appearance here today.
                                 ______
                                 
                 PREPARED STATEMENT OF BEN S. BERNANKE
       Chairman, Board of Governors of the Federal Reserve System
                             July 14, 2011

    Chairman Johnson, Ranking Member Shelby, and other Members of the 
Committee, I am pleased to present the Federal Reserve's semiannual 
Monetary Policy Report to the Congress. I will begin with a discussion 
of current economic conditions and the outlook and then turn to 
monetary policy.
The Economic Outlook
    The U.S. economy has continued to recover, but the pace of the 
expansion so far this year has been modest. After increasing at an 
annual rate of 2 \3/4\ percent in the second half of 2010, real gross 
domestic product (GDP) rose at about a 2 percent rate in the first 
quarter of this year, and incoming data suggest that the pace of 
recovery remained soft in the spring. At the same time, the 
unemployment rate, which had appeared to be on a downward trajectory at 
the turn of the year, has moved back above 9 percent.
    In part, the recent weaker-than-expected economic performance 
appears to have been the result of several factors that are likely to 
be temporary. Notably, the run-up in prices of energy, especially 
gasoline, and food has reduced consumer purchasing power. In addition, 
the supply chain disruptions that occurred following the earthquake in 
Japan caused U.S. motor vehicle producers to sharply curtail assemblies 
and limited the availability of some models. Looking forward, however, 
the apparent stabilization in the prices of oil and other commodities 
should ease the pressure on household budgets, and vehicle 
manufacturers report that they are making significant progress in 
overcoming the parts shortages and expect to increase production 
substantially this summer.
    In light of these developments, the most recent projections by 
members of the Federal Reserve Board and presidents of the Federal 
Reserve Banks, prepared in conjunction with the Federal Open Market 
Committee (FOMC) meeting in late June, reflected their assessment that 
the pace of the economic recovery will pick up in coming quarters. 
Specifically, participants' projections for the increase in real GDP 
have a central tendency of 2.7 to 2.9 percent for 2011, inclusive of 
the weak first half, and 3.3 to 3.7 percent in 2012--projections that, 
if realized, would constitute a notably better performance than we have 
seen so far this year.\1\
---------------------------------------------------------------------------
    \1\ Note that these projections do not incorporate the most recent 
economic news, including last Friday's labor market report.
---------------------------------------------------------------------------
    FOMC participants continued to see the economic recovery 
strengthening over the medium term, with the central tendency of their 
projections for the increase in real GDP picking up to 3.5 to 4.2 
percent in 2013. At the same time, the central tendencies of the 
projections of real GDP growth in 2011 and 2012 were marked down nearly 
\1/2\ percentage point compared with those reported in April, 
suggesting that FOMC participants saw at least some part of the first-
half slowdown as persisting for a while. Among the headwinds facing the 
economy are the slow growth in consumer spending, even after accounting 
for the effects of higher food and energy prices; the continuing 
depressed condition of the housing sector; still-limited access to 
credit for some households and small businesses; and fiscal tightening 
at all levels of Government. Consistent with projected growth in real 
output modestly above its trend rate, FOMC participants expected that, 
over time, the jobless rate will decline--albeit only slowly--toward 
its longer-term normal level. The central tendencies of participants' 
forecasts for the unemployment rate were 8.6 to 8.9 percent for the 
fourth quarter of this year, 7.8 to 8.2 percent at the end of 2012, and 
7.0 to 7.5 percent at the end of 2013.
    The most recent data attest to the continuing weakness of the labor 
market: The unemployment rate increased to 9.2 percent in June, and 
gains in nonfarm payroll employment were below expectations for a 
second month. To date, of the more than 8 \1/2\ million jobs lost in 
the recession, 1 \3/4\ million have been regained. Of those employed, 
about 6 percent--8.6 million workers--report that they would like to be 
working full time but can only obtain part-time work. Importantly, 
nearly half of those currently unemployed have been out of work for 
more than 6 months, by far the highest ratio in the post-World War II 
period. Long-term unemployment imposes severe economic hardships on the 
unemployed and their families, and, by leading to an erosion of skills 
of those without work, it both impairs their lifetime employment 
prospects and reduces the productive potential of our economy as a 
whole.
    Much of the slowdown in aggregate demand this year has been 
centered in the household sector, and the ability and willingness of 
consumers to spend will be an important determinant of the pace of the 
recovery in coming quarters. Real disposable personal income over the 
first 5 months of 2011 was boosted by the reduction in payroll taxes, 
but those gains were largely offset by higher prices for gasoline and 
other commodities. Households report that they have little confidence 
in the durability of the recovery and about their own income prospects. 
Moreover, the ongoing weakness in home values is holding down household 
wealth and weighing on consumer sentiment. On the positive side, 
household debt burdens are declining, delinquency rates on credit card 
and auto loans are down significantly, and the number of homeowners 
missing a mortgage payment for the first time is decreasing. The 
anticipated pickups in economic activity and job creation, together 
with the expected easing of price pressures, should bolster real 
household income, confidence, and spending in the medium run.
    Residential construction activity remains at an extremely low 
level. The demand for homes has been depressed by many of the same 
factors that have held down consumer spending more generally, including 
the slowness of the recovery in jobs and income as well as poor 
consumer sentiment. Mortgage interest rates are near record lows, but 
access to mortgage credit continues to be constrained. Also, many 
potential homebuyers remain concerned about buying into a falling 
market, as weak demand for homes, the substantial backlog of vacant 
properties for sale, and the high proportion of distressed sales are 
keeping downward pressure on house prices.
    Two bright spots in the recovery have been exports and business 
investment in equipment and software. Demand for U.S.-made capital 
goods from both domestic and foreign firms has supported manufacturing 
production throughout the recovery thus far. Both equipment and 
software outlays and exports increased solidly in the first quarter, 
and the data on new orders received by U.S. producers suggest that the 
trend continued in recent months. Corporate profits have been strong, 
and larger nonfinancial corporations with access to capital markets 
have been able to refinance existing debt and lock in funding at lower 
yields. Borrowing conditions for businesses generally have continued to 
ease, although, as mentioned, the availability of credit appears to 
remain relatively limited for some small firms.
    Inflation has picked up so far this year. The price index for 
personal consumption expenditures (PCE) rose at an annual rate of more 
than 4 percent over the first 5 months of 2011, and 2 \1/2\ percent on 
a 12-month basis. Much of the acceleration was the result of higher 
prices for oil and other commodities and for imported goods. In 
addition, prices of motor vehicles increased sharply when supplies of 
new models were curtailed by parts shortages associated with the 
earthquake in Japan. Most of the recent rise in inflation appears 
likely to be transitory, and FOMC participants expected inflation to 
subside in coming quarters to rates at or below the level of 2 percent 
or a bit less that participants view as consistent with our dual 
mandate of maximum employment and price stability. The central tendency 
of participants' forecasts for the rate of increase in the PCE price 
index was 2.3 to 2.5 percent for 2011 as a whole, which implies a 
significant slowing of inflation in the second half of the year. In 
2012 and 2013, the central tendency of the inflation forecasts was 1.5 
to 2.0 percent. Reasons to expect inflation to moderate include the 
apparent stabilization in the prices of oil and other commodities, 
which is already showing through to retail gasoline and food prices; 
the still-substantial slack in U.S. labor and product markets, which 
has made it difficult for workers to obtain wage gains and for firms to 
pass through their higher costs; and the stability of longer-term 
inflation expectations, as measured by surveys of households, the 
forecasts of professional private-sector economists, and financial 
market indicators.

Monetary Policy
    FOMC members' judgments that the pace of the economic recovery over 
coming quarters will likely remain moderate, that the unemployment rate 
will consequently decline only gradually, and that inflation will 
subside are the basis for the Committee's decision to maintain a highly 
accommodative monetary policy. As you know, that policy currently 
consists of two parts. First, the target range for the Federal funds 
rate remains at 0 to \1/4\ percent and, as indicated in the statement 
released after the June meeting, the Committee expects that economic 
conditions are likely to warrant exceptionally low levels of the 
Federal funds rate for an extended period.
    The second component of monetary policy has been to increase the 
Federal Reserve's holdings of longer-term securities, an approach 
undertaken because the target for the Federal funds rate could not be 
lowered meaningfully further. The Federal Reserve's acquisition of 
longer-term Treasury securities boosted the prices of such securities 
and caused longer-term Treasury yields to be lower than they would have 
been otherwise. In addition, by removing substantial quantities of 
longer-term Treasury securities from the market, the Fed's purchases 
induced private investors to acquire other assets that serve as 
substitutes for Treasury securities in the financial marketplace, such 
as corporate bonds and mortgage-backed securities. By this means, the 
Fed's asset purchase program--like more conventional monetary policy--
has served to reduce the yields and increase the prices of those other 
assets as well. The net result of these actions is lower borrowing 
costs and easier financial conditions throughout the economy.\2\ We 
know from many decades of experience with monetary policy that, when 
the economy is operating below its potential, easier financial 
conditions tend to promote more rapid economic growth. Estimates based 
on a number of recent studies as well as Federal Reserve analyses 
suggest that, all else being equal, the second round of asset purchases 
probably lowered longer-term interest rates approximately 10 to 30 
basis points.\3\ Our analysis further indicates that a reduction in 
longer-term interest rates of this magnitude would be roughly 
equivalent in terms of its effect on the economy to a 40 to 120 basis 
point reduction in the Federal funds rate.
---------------------------------------------------------------------------
    \2\ The Federal Reserve's recently completed securities purchase 
program has changed the average maturity of Treasury securities held by 
the public only modestly, suggesting that such an effect likely did not 
contribute substantially to the reduction in Treasury yields. Rather, 
the more important channel of effect was the removal of Treasury 
securities from the market, which reduced Treasury yields generally 
while inducing private investors to hold alternative assets (the 
portfolio reallocation effect). The substitution into alternative 
assets raised their prices and lowered their yields, easing overall 
financial conditions.
    \3\ Studies that have provided estimates of the effects of large-
scale asset purchases, holding constant other factors, include James D. 
Hamilton and Jing (Cynthia) Wu (2011), ``The Effectiveness of 
Alternative Monetary Policy Tools in a Zero Lower Bound Environment,'' 
NBER Working Paper Series No. 16956 (Cambridge, Mass: National Bureau 
of Economic Research, April), and Journal of Money, Credit and Banking 
(forthcoming); Arvind Krishnamurthy and Annette Vissing-Jorgensen 
(2011), ``The Effects of Quantitative Easing on Interest Rates,'' 
working paper (Evanston, Ill.: Kellogg School of Management, 
Northwestern University, June); Stefania D'Amico and Thomas B. King 
(2010), ``Flow and Stock Effects of Large-Scale Treasury Purchases,'' 
Finance and Economics Discussion Series 2010-52 (Washington: Board of 
Governors of the Federal Reserve System, September); Joseph Gagnon, 
Matthew Raskin, Julie Remache, and Brian Sack (2011), ``Large-Scale 
Asset Purchases by the Federal Reserve: Did They Work?'' Federal 
Reserve Bank of New York, Economic Policy Review, vol 17 (May), pp. 41-
59; and Eric T. Swanson (2011), ``Let's Twist Again: A High-Frequency 
Event-Study Analysis of Operation Twist and Its Implications for QE2,'' 
Working Paper Series 2011-08 (San Francisco: Federal Reserve Bank of 
San Francisco, February), and Brookings Papers on Economic Activity 
(forthcoming).
---------------------------------------------------------------------------
    In June, we completed the planned purchases of $600 billion in 
longer-term Treasury securities that the Committee initiated in 
November, while continuing to reinvest the proceeds of maturing or 
redeemed longer-term securities in Treasuries. Although we are no 
longer expanding our securities holdings, the evidence suggests that 
the degree of accommodation delivered by the Federal Reserve's 
securities purchase program is determined primarily by the quantity and 
mix of securities that the Federal Reserve holds rather than by the 
current pace of new purchases. Thus, even with the end of net new 
purchases, maintaining our holdings of these securities should continue 
to put downward pressure on market interest rates and foster more 
accommodative financial conditions than would otherwise be the case. It 
is worth emphasizing that our program involved purchases of securities, 
not Government spending, and, as I will discuss later, when the 
macroeconomic circumstances call for it, we will unwind those 
purchases. In the meantime, interest on those securities is remitted to 
the U.S. Treasury.
    When we began this program, we certainly did not expect it to be a 
panacea for the country's economic problems. However, as the expansion 
weakened last summer, developments with respect to both components of 
our dual mandate implied that additional monetary accommodation was 
needed. In that context, we believed that the program would both help 
reduce the risk of deflation that had emerged and provide a needed 
boost to faltering economic activity and job creation. The experience 
to date with the round of securities purchases that just ended suggests 
that the program had the intended effects of reducing the risk of 
deflation and shoring up economic activity. In the months following the 
August announcement of our policy of reinvesting maturing and redeemed 
securities and our signal that we were considering more purchases, 
inflation compensation as measured in the market for inflation-indexed 
securities rose from low to more normal levels, suggesting that the 
perceived risks of deflation had receded markedly. This was a 
significant achievement, as we know from the Japanese experience that 
protracted deflation can be quite costly in terms of weaker economic 
growth.
    With respect to employment, our expectations were relatively 
modest; estimates made in the autumn suggested that the additional 
purchases could boost employment by about 700,000 jobs over 2 years, or 
about 30,000 extra jobs per month.\4\ Even including the disappointing 
readings for May and June, which reflected in part the temporary 
factors discussed earlier, private payroll gains have averaged 160,000 
per month in the first half of 2011, compared with average increases of 
only about 80,000 private jobs per month from May to August 2010. Not 
all of the step-up in hiring was necessarily the result of the asset 
purchase program, but the comparison is consistent with our 
expectations for employment gains. Of course, we will be monitoring 
developments in the labor market closely.
---------------------------------------------------------------------------
    \4\ See Hess Chung, Jean-Philippe Laforte, David Reifschneider, and 
John C. Williams (2011), ``Have We Underestimated the Likelihood and 
Severity of Zero Lower Bound Events?'' Working Paper Series 2011-01 
(San Francisco: Federal Reserve Bank of San Francisco, January).
---------------------------------------------------------------------------
    Once the temporary shocks that have been holding down economic 
activity pass, we expect to again see the effects of policy 
accommodation reflected in stronger economic activity and job creation. 
However, given the range of uncertainties about the strength of the 
recovery and prospects for inflation over the medium term, the Federal 
Reserve remains prepared to respond should economic developments 
indicate that an adjustment in the stance of monetary policy would be 
appropriate.
    On the one hand, the possibility remains that the recent economic 
weakness may prove more persistent than expected and that deflationary 
risks might reemerge, implying a need for additional policy support. 
Even with the Federal funds rate close to zero, we have a number of 
ways in which we could act to ease financial conditions further. One 
option would be to provide more explicit guidance about the period over 
which the Federal funds rate and the balance sheet would remain at 
their current levels. Another approach would be to initiate more 
securities purchases or to increase the average maturity of our 
holdings. The Federal Reserve could also reduce the 25 basis point rate 
of interest it pays to banks on their reserves, thereby putting 
downward pressure on short-term rates more generally. Of course, our 
experience with these policies remains relatively limited, and 
employing them would entail potential risks and costs. However, prudent 
planning requires that we evaluate the efficacy of these and other 
potential alternatives for deploying additional stimulus if conditions 
warrant.
    On the other hand, the economy could evolve in a way that would 
warrant a move toward less-accommodative policy. Accordingly, the 
Committee has been giving careful consideration to the elements of its 
exit strategy, and, as reported in the minutes of the June FOMC 
meeting, it has reached a broad consensus about the sequence of steps 
that it expects to follow when the normalization of policy becomes 
appropriate. In brief, when economic conditions warrant, the Committee 
would begin the normalization process by ceasing the reinvestment of 
principal payments on its securities, thereby allowing the Federal 
Reserve's balance sheet to begin shrinking. At the same time or 
sometime thereafter, the Committee would modify the forward guidance in 
its statement. Subsequent steps would include the initiation of 
temporary reserve-draining operations and, when conditions warrant, 
increases in the Federal funds rate target. From that point on, 
changing the level or range of the Federal funds rate target would be 
our primary means of adjusting the stance of monetary policy in 
response to economic developments.
    Sometime after the first increase in the Federal funds rate target, 
the Committee expects to initiate sales of agency securities from its 
portfolio, with the timing and pace of sales clearly communicated to 
the public in advance. Once sales begin, the pace of sales is 
anticipated to be relatively gradual and steady, but it could be 
adjusted up or down in response to material changes in the economic 
outlook or financial conditions. Over time, the securities portfolio 
and the associated quantity of bank reserves are expected to be reduced 
to the minimum levels consistent with the efficient implementation of 
monetary policy. Of course, conditions can change, and in choosing the 
time to begin policy normalization as well as the pace of that process, 
should that be the next direction for policy, we would carefully 
consider both parts of our dual mandate.
    Thank you. I would be pleased to take your questions.

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

Q.1. Chairman Bernanke, in prior testimony before this 
Committee, you stated that the Fed chose $600 billion as the 
appropriate amount for QE2 because that amount would roughly 
correspond to a 75 basis point cut in the policy rate in terms 
of its broad impact.

   Did QE2 work as intended? Did it have the broad 
        impact of a 75 basis point cut in the policy rate?

A.1. As the expansion weakened in 2010, developments with 
respect to both components of our dual mandate implied that 
additional monetary accommodation was needed. The Federal 
Reserve's second asset purchase program--like more conventional 
monetary policy--was intended to reduce interest rates and 
boost the prices of a broad range of financial assets, thereby 
supporting spending and economic activity. A wide range of 
market indicators supports the view that the program had the 
desired effects. For example, between August, 2010--when we 
announced our policy of reinvesting principal payments on 
agency debt and agency MBS and indicated that we were 
considering more securities purchases--and late 2010, equity 
prices increased significantly, volatility in the equity market 
declined, corporate bond spreads narrowed, and inflation 
compensation as measured in the market for inflation-indexed 
securities rose to historically more normal levels. These 
market responses were similar to those that occurred in the 
months following our March 2009 announcement of increased asset 
purchases.
    As I noted in my testimony, we did not expect so-called QE2 
to be a panacea for the country's economic problems. But, we 
believed that the program would both help reduce the risk of 
deflation that had emerged and provide a needed boost to 
faltering economic activity and job creation. In the event, the 
evidence suggests that the program had its intended effect in 
shoring up economic activity and particularly in reducing the 
risk of deflation, which as we know from the Japanese 
experience can be quite costly in terms of weaker economic 
growth.

Q.2. Chairman Bernanke, according to your testimony, the 
economic outlook remains uncertain.

   What specific metrics do you use to determine how 
        the economy is doing at any point in time?

A.2. In assessing current and prospective developments in the 
macroeconomy, the Federal Reserve monitors a wide variety of 
information. For example, we analyze closely data on 
production, spending, labor market conditions, prices and 
financial markets. We also look at survey-based indicators of 
household and business attitudes and spending intentions. In 
addition, the Federal Reserve Banks collect anecdotal 
information from business contacts in their Districts regarding 
current economic conditions, which we publish in the Beige Book 
eight times per year. Participants in the meetings of the 
Federal Open Market Committee incorporate all of this input 
into the formulation of the economic projections that they 
prepare four times per year.

Q.3.a. Chairman Bernanke, last month, the Obama administration 
announced that it would release 30 million barrels of oil from 
the Strategic Petroleum Reserve to ``offset the disruption in 
the oil supply caused by unrest in the Middle East.'' When you 
were an academic economist, you studied the recessionary 
effects of oil price shocks and the Fed's responses to those 
shocks.

   Has the recent turmoil in the Middle East and the 
        resulting increase in oil prices already affected our 
        economic recovery?

A.3.a. Oil prices jumped significantly as a result of the loss 
of oil production in a number of North African and Middle 
Eastern countries earlier this year, with the most substantial 
supply disruptions happening in Libya. The higher energy prices 
damped consumer purchasing power and spending during the first 
half of the year and likely contributed to some of the weakness 
in economic activity in economy that we have observed.

Q.3.b. How will it affect our economy in the coming months?

A.3.b. Since their peak in early April, oil prices have 
retraced some of their recent run up. If the lower prices are 
maintained, these negative influences on economic activity 
should prove to be transitory.

Q.3.c. Has the Obama administration's surprise announcement 
resulted in any meaningful positive effects in the oil markets? 
Has it had any detrimental effects?

A.3.c. On June 23, the International Energy Agency (IEA) 
announced a release of 60 million barrels of oil from strategic 
stocks in light of the significant disruption to Libyan crude 
supplies and the impending seasonal rise in oil demand. Oil 
from the United States' Strategic Petroleum Reserve (SPR) 
accounted for about half of the total release. Although the IEA 
announcement prompted an immediate decline in oil prices, 
parsing out the independent influence of the SPR release on oil 
prices is extremely difficult given the myriad factors that 
move oil prices. The IEA's announcement may have provided some 
certainty regarding near-term oil availability and, therefore, 
may have been helpful in reducing oil price volatility in the 
short run. In the longer run, however, only increased 
production or reduced demand will keep oil prices contained.

Q.3.d. What type of Fed response should we expect?

A.3.d. The Federal Reserve does not respond directly to 
movements in oil prices nor to the price of any other 
individual items. Rather, consistent with its statutory 
mandate, the Federal Reserve seeks to foster maximum employment 
and overall price stability. Accordingly, if movements in oil 
prices were to have sustained adverse effects on the 
macroeconomy--for example, reducing aggregate production and 
employment for a prolonged period or causing inflation 
expectations to become unanchored--those adverse macroeconomic 
developments would factor in the Federal Reserve's overall 
policy analysis. As of now, it does not appear that the 
increase in oil prices during the latter part of 2010 and the 
first part of 2011 has had sustained adverse macroeconomic 
effects.

Q.4. In an article earlier this year, Dr. Martin Feldstein, 
former President of the National Bureau of Economic Research, 
expressed his concern that QE2 could result in asset-price 
bubbles that may come to an end before the year is over. In 
recent speeches, you and Federal Reserve Bank of Kansas City 
President Thomas Hoenig both have mentioned potential bubbles 
in agricultural land prices.

   What data do you examine to evaluate the risk of 
        asset bubbles from QE2?

   In addition to agricultural land prices, do you see 
        any evidence of asset bubbles forming in other markets, 
        such as the stock market or the bond market?

A.4. The Federal Reserve, working in concert with the Financial 
Stability Oversight Council (FSOC), reviews a very wide range 
of data in assessing financial conditions and evidence of asset 
price imbalances. The FSOC annual report provides a very useful 
discussion of the types of data employed in financial stability 
analysis (see http:// www.treasury.gov/initiatives/fsoc/Pages/
annual-
report.aspx).
    As discussed in the FSOC annual report, there are no clear 
signs at present of the types of financial imbalances observed 
prior to the financial crisis. The management of credit and 
liquidity risk in most sectors appears conservative, and market 
prices do not provide clear indications of a departure of asset 
prices from fundamentals.

Q.5. Federal Reserve Bank of Philadelphia President Charles 
Plosser has proposed a plan to shrink the Fed balance sheet 
while raising interest rates, based on a simple exit rule 
proposed by Professor John Taylor. Under Taylor's plan, the Fed 
would reduce reserve balances by $100 billion for each 25 basis 
point increase in the Fed funds rate.

   Do you agree that this would be a good strategy?

A.5. As noted in the minutes of the June 2011 FOMC meeting, all 
but one of the FOMC participants agreed on key elements of an 
exit strategy that will adjust the level of short-term interest 
rates and normalize the size and composition of the balance 
sheet over time. (See the discussion on page 3 of the FOMC 
minutes at http://www.federalreserve.gov/monetarypolicy/files/
fomcminutes
20110622.pdf). This strategy would not involve the type of 
tight linkage between increases in the Federal funds rate and 
incremental declines in reserve balances described by President 
Plosser. However, it is quite likely that reserve balances 
would gradually decline over the same period in which short-
term interest rates are rising.

Q.6. Chairman Bernanke, I want to follow up on the FOMC's 
discussion, detailed in the minutes for the June meeting, of 
the principles that will ``guide the strategy'' of shrinking 
the Fed's balance sheet.

   Do you believe that the Fed's exit plan should be 
        transparent to the public?

   If so, when can we expect the Fed to announce its 
        formal plan for shrinking its balance sheet?

A.6. The Federal Reserve remains committed to transparency as a 
fundamental principle that supports both the effective 
implementation of monetary policy and appropriate 
accountability of the central bank to the Congress and the U.S. 
taxpayer. The FOMC provided a considerable level of detail 
regarding its plans for shrinking its balance sheet over time 
in the minutes of the June 2011 FOMC meeting; more details on 
the precise timing and operational implementation of these 
steps will be communicated well in advance of any policy 
actions. Based on current information, it appears that more 
detailed information on the exit strategy will not be necessary 
for some time. In its January 2012, FOMC statement, the FOMC 
noted that it currently anticipates that economic conditions--
including low rates of resource utilization and a subdued 
outlook for inflation over the medium run--are likely to 
warrant exceptionally low levels for the Federal funds rate at 
least through late 2014.

Q.7. Federal Reserve Bank of Philadelphia President Charles 
Plosser has said that the excess bank reserves parked at the 
Fed are ``fuel for inflation.''

   Are you concerned that excess reserves will flow 
        out too quickly and create inflationary pressures?

   What specific metrics are you using to determine 
        whether the Fed should start reining in excess reserves 
        by raising interest rates?

A.7. The FOMC has the tools it needs to remove policy 
accommodation at the appropriate time. As noted in the exit 
strategy discussion in the June 2011 FOMC minutes, even with an 
expanded balance sheet and elevated levels of excess reserves, 
the Federal Reserve can put upward pressure on interest rates 
by raising the interest rate paid on reserve balances. 
Moreover, the Federal Reserve has developed new reserve 
draining tools such as reverse RPs and term deposits that can 
be used to reduce the quantity of excess reserves. Finally, the 
Federal Reserve can sell securities to remove policy 
accommodation and lower the quantity of reserves.
    The Federal Reserve conducts monetary policy to foster its 
statutory mandate to promote maximum employment and price 
stability. The Federal Open Market Committee carefully monitors 
a very wide array of economic indicators in assessing the 
outlook for inflation including variables such as various 
measures of resource slack, cost pressures, and inflation 
expectations. In addition, the Committee regularly monitors the 
level of excess reserves, money growth, and bank lending as 
part of the policy process. In its January, 2012 statement, the 
Committee noted that it anticipates inflation will run at or 
below those consistent with the Committee's dual mandate over 
coming quarters.

Q.8. The Federal Reserve recently lost a case against Bloomberg 
in which it opposed disclosing to the public the names of banks 
that had borrowed from the discount window. This case is an 
important precedent in improving the Fed's transparency.

   Who made the initial decision to not release the 
        information? When Bloomberg decided to litigate, who 
        made the decision to fight the release in court?

   How will the Bloomberg case impact the Fed's 
        disclosure policies going forward with respect to its 
        bank regulation activities? In other words, will you 
        continue to oppose the release of this type of 
        information notwithstanding the ruling in Bloomberg?

A.8. It had been the Federal Reserve's longstanding practice 
since 1914 not to publicly release the names, loan amounts, 
dates or collateral pledged for individual discount window 
loans. This practice, consistent with the practices of major 
central banks around the world, resulted from concern about the 
stigma that can result from public knowledge that a financial 
institution has borrowed from the Federal Reserve, which acts 
as the lender of last resort to banks that are unable to access 
ordinary sources of liquidity on a short-term basis. Although a 
bank may borrow from the discount window for reasons other than 
financial difficulties, disclosure of just the fact that a bank 
has borrowed can lead to runs on the bank or other serious 
consequences that can harm individual banks or our Nation's 
economy.
    The decision to defend the Board's position in litigation 
initiated by Bloomberg was made after consultation between the 
Board and its Legal Division, and the Board's litigation 
position was developed by the Board's Legal Division. The 
decision to litigate was based on well-established FOIA 
precedent holding that privileged or confidential commercial or 
financial information obtained from a person, the disclosure of 
which would likely result in competitive injury--such as the 
discount window lending information at issue--is exempt from 
disclosure under FOIA Exemption 4. Following the Supreme 
Court's denial of the petition for certiorari filed in the 
Bloomberg case, the Board fully complied with the Second 
Circuit's decision in Bloomberg.
    Section 1103(b) of the Dodd-Frank Wall Street Reform and 
Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376, 
provides for the disclosure of the names, loan amounts, and 
certain other information about individual discount window 
loans made after the date of enactment. This information must 
be released 2 years after the loan was made, and is exempt from 
disclosure before that period. 124 Stat. 2118-19. Section 11 
03(b) also provides for disclosure of borrower information for 
lending under emergency facilities that may be authorized in 
the future under section 13(3) of the Federal Reserve Act no 
later than 1 year after the effective date of the termination 
of the credit facility. Id. Separately, as required under 
section 1109(c) of Dodd-Frank, on December 1, 2010, the Board 
disclosed on its public Web site borrower and related 
information concerning emergency credit decisions made prior to 
July 21, 2010, under section 13(3). 124 Stat. 2129. This and 
much more information can be found at the following link: 
http://www.federalreserve.gov/monetarypolicy/
bst_supportspecific.htm.
    The Board believes that the time lag provided for in 
section 1103(b) between the time a discount window loan is made 
and the date of publication of borrower-related information 
about that loan will substantially lessen the stigma and 
potential for harm to borrowing institutions that could result 
from the earlier publication of this information while at the 
same time fostering public accountability for the Federal 
Reserve's lending practices. The FOIA as written and 
interpreted prior to the enactment of Dodd-Frank would not have 
allowed this balancing of interests.

Q.9. In a recent editorial in the Wall Street Journal, 
University of Chicago Professor John Cochrane points out that 
the average maturity of Treasury debt is less than a year.

   Should we be concerned that the need to frequently 
        roll over our debt presents more opportunities for 
        Treasury investors to take flight over concerns about 
        the U.S. fiscal condition?

   What impact could that have on our debt service 
        costs?

   What impact could that have on the real economy?

A.9. As noted in the Treasury's quarterly refunding documents, 
the average maturity of marketable Treasury debt outstanding is 
about 5 years--about in the middle of the range observed over 
the last 25 years. (See http://www.treasury.gov/resource-
center/data-chart-center/quarterly-refunding/Documents/
TBAC%20Discussion%20
Charts%20Feb%202012.pdf.)
    The U.S. Treasury issues large volumes of debt on regular 
weekly, monthly and quarterly auction cycles. As was widely 
noted in the discussions over the debt ceiling, the inability 
to rollover maturing debt would have very serious consequences 
for debt servicing costs, the level of interest rates, 
financial market functioning, and the real economy. At present, 
investor demand for Treasury securities remains strong and 
Treasury yields are very low by historical standards. However, 
as I have noted on previous occasions, the current fiscal 
situation of the United States is not sustainable. The low 
level of Treasury yields reflects confidence that Congress and 
the Administration will implement in a timely manner changes 
necessary to bolster the long-run fiscal position of the United 
States.
                                ------                                


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

Q.1. Extended unemployment insurance benefits provided during 
the economic downturn have fostered economic stability by 
helping to maintain consumer spending and keeping people in 
their homes.
   Nationwide, Federal Government outlays for 
        unemployment assistance were $120 billion in 2009 and 
        $158 billion in 2010--a marked increase from 2008 
        levels of $43 billion.\1\
---------------------------------------------------------------------------
    \1\ Table 11.3 pgs. 247; FY l2 Historical Tables.

   Rhode Islanders have received a total of more than 
        $850 million in Federally funded UI benefits since the 
        outset of the temporary program.\2\
---------------------------------------------------------------------------
    \2\ Rhode Island Dept. of Labor & Training; Labor Market 
Information; http://www.dlt.ri.gov/lmi/uiadmin/2011.htm.

    These benefits are set to terminate at the end of this 
year.
    Considering the Federal Reserve projects the unemployment 
rate to be as high as 8.7 percent (with a low of 7.5 percent) 
next year, what do you believe will be the consequences to the 
economy and the impact felt by individual families if 
unemployment insurance benefits are allowed to lapse?

A.1. According to the latest estimates, about 3 \3/4\ million 
persons received extended or emergency unemployment 
compensation (EUC) in mid-July, of whom 2,000 were Rhode 
Islanders. Nationally, EUC benefit payments have averaged about 
$4 billion per month so far this year, of which about $20 
million per month was received by Rhode Islanders. Were those 
benefits to lapse, some current recipients would likely find 
jobs. However, given the weak economy and the associated 
scarcity of job opportunities, many others would have 
difficulty finding employment and would likely suffer a 
significant reduction in their incomes. All else equal, I would 
expect that the expiration of emergency unemployment 
compensation would lower total household income and consumption 
in 2012, reducing the rate of economic growth by a small 
amount.

Q.2. On Tuesday, July 12, 2011, Bruce Bartlett, a former senior 
policy advisor to both Presidents Reagan and H.W. Bush, warned 
about the possibility of repeating mistakes of the past. Mr. 
Bartlett compared the contraction in Government spending and 
investment during 1937-38, which spurred a recession, to our 
current situation. Then, as now, the economy was slowly 
recovering from a financial crisis. Mr. Bartlett wanted us to 
be ``very careful, because it may only take a small misstep on 
either the monetary or fiscal side to the balance.''
    In 1937, during the Great Depression, the Government made a 
significant economic policy error. Federal fiscal policy turned 
sharply contractionary, and the Federal deficit was reduced to 
about 2.5 percent of GDP. The Fed also tightened monetary 
policy. The result was a downturn that extended the Depression.
    Do you think that, under current circumstances, a 
significant fiscal contraction could recreate the ``Mistake of 
1937''? Why or why not?

A.2. The Federal budget swung from a deficit of 4 percent of 
GDP in 1936 to balance in 1937. To be sure, if Congress and the 
Administration were to balance the budget as rapidly as 
occurred in 1937 this would have significant negative 
consequences for economic growth and employment in the near 
term. In part, this reflects the fact that monetary policy has 
less capacity than usual to offset a contractionary fiscal 
policy of magnitude of 1937 because interest rates are already 
quite low. In this regard, both fiscal and monetary policy face 
the challenge of balancing the short run concerns of supporting 
the recovery with long run concerns of sustainable fiscal 
policy and low inflation. I have spoken about the challenges 
facing fiscal policymakers as they try to balance support for 
the economy in the near-term with the need to address long-run 
fiscal imbalances. Fiscal policy actions over the past 2 years 
have bolstered aggregate demand and given some impetus to 
economic activity. For example, the 2009 stimulus package and 
last year's fiscal policy actions have provided support to the 
economy during this period of weakness without significantly 
worsening the long-run outlook.\3\ Recent budget actions and 
most current proposals to reduce the large Federal deficits 
appear to be designed to phase-in the budget restraint over 
time, again trying to balance these two objectives.
---------------------------------------------------------------------------
    \3\ These actions included the extension of Medicaid and education 
grants, the extension of the 2001-3 tax cuts and EUC benefits, and the 
enactment of the payroll tax cut.

Q.3. As you know, the Federal Reserve's Flow of Funds report 
(first quarter 2011) indicates that nonfinancial businesses are 
sitting on $1.9 trillion in ``cash'' defined as total liquid 
assets [L. 102 Nonfarm Nonfinancial Corporate Business, Line 
41, Total liquid assets].
    Can you put this figure into historical perspective? What 
is the Federal Reserve doing--consistent with its statutory 
mandate to foster maximum employment--to get corporations to 
use their cash to make more investments that create jobs? Are 
there other good measures of how much cash on hand is held by 
corporations?

A.3. The share of cash in the total assets for nonfinancial 
corporations is estimated to have remained at about 11 percent 
as of 2011 Q1,\4\ a high level by historical standards. Part of 
the explanation for these high cash balances may reflect an 
upward shift in the precautionary demand for cash, following 
the liquidity and credit market disruptions seen during the 
past recession. High cash retention may also result from firms 
that earn significant profits overseas. These firms may choose 
to hold the resulting cash on balance sheets of their foreign 
subsidiaries to facilitate future investment overseas or to 
minimize corporate tax expenses.
---------------------------------------------------------------------------
    \4\ Source: Standard and Poors Compustat.

Q.4. Corporate profits reached an all-time high in the first 3 
months of 2011, with companies raking in an annualized $1.727 
trillion in pre-tax operating profits.\5\ \6\
---------------------------------------------------------------------------
    \5\ http://www.bea.gov/national/xls/technote_tax_acts.xls.
    \6\ http://www.bea.gov/newreleases/national/gdp/2011/pdf/
gdp1q11_3rd/pdf. [Table 11]
---------------------------------------------------------------------------
    Can you explain the disjunction between booming profits and 
the need for more robust job creation? How much of this profit 
is earned overseas? Why isn't more of it being invested in job-
creating activities?

A.4. In the most recently published National Income and Product 
Accounts (NIPAs), total corporate profits increased in the 
first quarter of 2011 to $1.876 trillion, an 8.8 percent gain 
relative to year-earlier levels. A large fraction of those 
profits, about one-third, were earned from operations outside 
of the United States.\7\ In fact, in the first quarter, 
receipts from foreign operations grew 12 percent from four 
quarters earlier, while profits generated from U.S. domestic 
operations grew 8 percent. As overseas operations have become a 
larger part of the business of U.S. parent companies, a higher 
fraction of the parent firms' profits are generated using 
foreign, as opposed to domestic, labor. Moreover, firms may be 
reluctant to invest in activities that create jobs in the 
United States if they are uncertain about the prospects for 
growth in U.S. demand, especially if they perceive that 
opportunities for sales and profit growth primarily lie in 
overseas markets.
---------------------------------------------------------------------------
    \7\ Receipts from the rest of the world totaled $612 billion in 
2011 Q1.

Q.5. Most States began the new fiscal year on July 1st. Even 
though revenues are rising, many States are not in a position 
to close their budget gaps. Consequently, States have been 
forced to make massive spending cuts, often impacting the most 
vulnerable populations.
    How has the lapse of Federal funding flowing from the 
temporary assistance provided by the Recovery Act affected 
States? Will cuts in State spending exacerbate the economic 
situation? If current expectations weaken, would further 
Federal stimulus in the short term help prevent protracted 
stagnation? Why or why not?

A.5. State and local government budgets have been under 
considerable stress owing to the combination of a deep 
recession and their balanced budget requirements. Some of this 
strain has been alleviated by the extraordinary Federal aid 
given through the 2009 Recovery Act and the subsequent aid 
package enacted last year. Nevertheless, the Bureau of Economic 
Analysis estimates the real State and local purchases have been 
contracting since early 2008. This decline in State and local 
government spending reduced real GDP growth by two-tenths 
percent in 2010 and by four-tenths percent so far in 2011.
    With the depth of the recession and slowness of the 
recovery it is likely that State and local governments are 
spending a large fraction of the extra Federal aid, but it is 
difficult to determine how much of the recent weakness in State 
and local spending reflects the decline this year in Federal 
aid from the Recovery Act and how much reflects their reaction 
to weak revenues.\8\ In particular, because the size and timing 
of the grants has been known from some time, State and local 
governments may have tried to smooth through the 2010 bulge in 
grants, saving some of the 2010 grants to support spending in 
2011. Moreover, in the aggregate data the pickup in State and 
local tax revenues over the past year has offset the downshift 
in Federal grants. State government revenues remain low 
relative to pre-recession trends, though, and layoffs in the 
sector have shown no signs of slowing. This suggests that 
budgets are still strained and that additional Federal aid 
would likely provide some support for State and local spending.
---------------------------------------------------------------------------
    \8\ Federal aid to State and local governments from the 2009 
Recovery Act totaled $79 billion in 2009, $124 billion in 2010, and $63 
billion (at an annual rate) so far in 2011. Some of this decline has 
been offset by last year's $25 billion extension of Medicaid and 
education stimulus grants.

Q.6. Consumer spending accounts for roughly 70 percent of 
overall economic activity. As a result of the recession and the 
impact on wealth, personal savings as a percentage of 
disposable personal income has increased from its recent low of 
0.8 percent in April 2005 to 5.0 percent in May (down from 
recent peak of 8.2 percent in May 2009).
    How can we spur the type of economic growth we need in 
order to create jobs in light of consumers appropriately 
decreasing spending and increasing savings in response to a 
weak economy?

A.6. You are correct to emphasize the importance of consumer 
spending for the economic outlook. The forces weighing on 
consumer spending, which include a need by many households to 
increase savings in a difficult economic environment, are an 
important part of the reason that the FOMC projects only 
moderate economic growth and a relatively slow decline in the 
unemployment rate during the next couple of years. 
Nevertheless, increasing personal saving, and the exercise of 
sound judgment in personal financial affairs more generally, 
are not inconsistent with a healthy growing economy, and sound 
household decisionmaking can lay the foundations for 
sustainable economic growth. Looking forward, I do expect 
consumer spending to play some role in contributing to an 
economic recovery that gradually picks up steam as households 
make further progress in strengthening their balance sheets, as 
credit availability improves further, and especially as job and 
income prospects gradually improve. The Federal Reserve is 
committed to doing its part to meet its statutory mandate to 
promote maximum employment in the context of price stability.

Q.7. On Wednesday, June 29th, the Federal Reserve announced the 
extension of temporary U.S. dollar liquidity swap lines with 
several foreign central banks until August 2012. What were the 
reasons for this action? What are the strengths and weaknesses 
of this policy?

A.7. These lines were extended because we believe they are 
helpful in relieving persistent strains in dollar funding 
markets abroad, which, as we saw beginning in 2007, can spill 
over into U.S. financial markets. Given the level of 
integration of global finance and the possibility that further 
turbulence in European financial markets would spill over into 
the United States, it seemed prudent, as a precautionary 
measure, to leave the lines in place for a while longer.
    The main policy benefit of the swap lines is to help 
contain the spread of pressures in global dollar funding 
markets into the United States. In addition, the swap lines 
carry minimal risk to the Federal Reserve. The lines convey no 
exchange rate risk and negligible counterparty risk because the 
Federal Reserve's transactions are only with other foreign 
central banks, whose credit standing is of the highest quality. 
The credit risks that result from lending the dollars acquired 
through the swap lines are borne solely by the foreign central 
banks.

Q.8. In April of this year, the Federal Reserve, the OCC, and 
the OTS released their Interagency Review of Foreclosure 
Policies and Practices, which resulted in the OCC's consent 
orders requiring banks to hire independent consultants to do a 
foreclosure review of past practices. As part of this review, 
these consultants will be reviewing the bank's loss mitigation 
activities. That is, whether the banks properly evaluated 
families for loan modifications in order to avoid foreclosures 
that could have been prevented.
    Do you believe that as part of this review, which requires 
the consultants to ``1) identify borrowers that have been 
financially harmed by deficiencies identified in the 
independent review and 2) provide remediation to those 
borrowers where appropriate,'' the consultant should review the 
file of every borrower who was denied a loan modification?

A.8. For the four mortgage servicers that have entered into 
Consent Orders with the Federal Reserve, we are requiring a 100 
percent review of all denied loan modifications for loans 
serviced by the servicer that were pending foreclosure at any 
time from 1/1/2009 until 12/31/2010, as well as where a 
foreclosure sale occurred during that time period.

Q.9. Please describe any recent trends in bank's converting 
from Federal to State charters, or from State to Federal 
charters. For example, a number of smaller financial 
institutions in Massachusetts recently became Federal Reserve 
members, including Canton Co-operative Bank, Reading Co-
operative Bank, Walpole Co-operative Bank, among others.

   Please provide a list of the banks converting their 
        charters to the Federal Reserve during the past the 
        last year.

   Please describe all factors that contribute to this 
        trend.

   Please describe any incentives or encouragement by 
        Federal Reserve staff relating to these conversions.

A.9. During the year ended June 30, 2011, 36 banks converted to 
State member banks supervised by the Federal Reserve. This 
includes eight national banks that were previously supervised 
by the Office of the Comptroller of the Currency and 28 State-
chartered banks that were previously supervised by the Federal 
Deposit Insurance Corporation. Over the last 5 calendar years 
(through December 31, 2010), the average number of banks 
converting to State member banks was 24 and the number of 
conversions in each year ranged from 19 to 35. This suggests 
that the trend has not changed significantly.
    A number of factors may affect a bank's decision to change 
charters. These include the perceived quality of supervision by 
a given agency, an agency's perceived level of knowledge about 
local market conditions, the accessibility and responsiveness 
of regulators, the amount of examination fees charged by State 
versus Federal regulatory agencies, or the perceived benefits 
of a national charter for operating a nationwide banking 
operation.
    The Federal Reserve typically accepts only banks rated 1 or 
2 under the interagency CAMELS rating system as State member 
banks. New State members also generally must have satisfactory 
or better consumer compliance or CRA ratings and present no 
major unresolved supervisory issues. In some cases, pre-
membership examinations may be required as described in the 
Federal Reserve's SR Letter 11-2/CA Letter 11-2. In addition, 
the Federal Reserve complies with the July 1, 2009 interagency 
Statement on Regulatory Conversions which, among other things, 
emphasizes that the agencies will not entertain regulatory 
conversion applications that undermine the supervisory process. 
Federal Reserve staff members do not provide incentives to 
converting banks, but the Federal Reserve Banks provide 
information on the process for applying for membership when 
asked and on their Web sites. Also, when approached by banks 
about potential membership they explain their approach to 
supervising State members, provide information on the support 
and guidance that they provide to current State members, and 
answer banks' inquiries related to membership.

Q.10. What is the counterparty exposure in the financial sector 
on the ``sell side'' to Government paper (U.S. Treasuries, 
Fannie Mae, Freddie Mac, etc.) Please include all financial 
firms for which you have data, including but not limited to 
bank holding companies, hedge funds, and money markets. In 
addition, please list the increase to cash collateral that may 
required if any of this Government paper defaults, as well the 
cash which may be necessary to pay off the contract.

A.10. The first attached table shows Treasury and Agency 
holdings of the top 50 bank holding companies as of March 31, 
2011. It is based on FRY9-C filings.
    The Federal Reserve does not directly regulate hedge funds 
or money market funds. The Securities and Exchange Commission 
(SEC) may be better positioned to respond to that part of the 
request.
    The procedures for addressing changes in collateral values, 
including due to default of the issuer of the debt serving as 
collateral, vary substantially across types of activities and 
by counterparties. In a worst case scenario, a USG default 
would require the party posting U.S. Treasury debt as 
collateral to replace the full amount with cash or other 
eligible assets, as specified in the underlying contract(s) 
governing each bilateral relationship. The second attached 
table shows the fair value of Treasury and Agency securities 
posted by OTC derivatives counterparties and held by the top 50 
bank holding companies.
    Separately, under a credit default swap contract where the 
USG is the reference entity, the party having sold default swap 
protection will need to pay to the buyer of protection the 
notional amount less the recovery rate, under cash settlement. 
In the worst case scenario, where there is zero recovery on a 
defaulted USG debt obligation, the amount necessary to payoff 
the contract would be the notional amount of protection sold. 
Data on CDS, including those contracts referencing the USG, is 
compiled by the Trade Information Warehouse (TIW) managed by 
DTCC. See http://www.dtcc.com/products/derivserv/
data_table_i.php.

Q.11. What is the size of the market for credit default swaps 
on United States Government paper? What are the consequences of 
low rates on these contracts if the Government defaults on its 
obligations? What other current market forces may affect this 
market?

A.11. According to the Depository Trust and Clearing 
Corporation (DTCC) $29.4 billion in gross notional CDS on U.S. 
Treasury debt were outstanding as of July 29, 2011. However, a 
significant proportion of this gross value reflects offsetting 
trades between counterparties in which, for example, a party's 
long position is effectively unwound by entering into an 
offsetting short position. Measured on a net notional basis, 
$5.6 billion in CDS referencing U.S. Government paper were 
outstanding. Whether measured on a gross or a net basis, the 
market for CDS on U.S. Government paper is miniscule relative 
to the $9.9 trillion in Federal Government debt held by the 
public. CDS on U.S. Government paper represents well under 1 
percent of the outstanding CDS on single-name reference 
entities (both corporates and sovereigns). DTCC reports that 
overall $15.8 trillion gross notional and $1.2 trillion net 
notional CDS on single name reference entities were outstanding 
as of July 29.
    CDS spreads reflect market participants' forward-looking 
expectations about the likelihood and severity of a reference 
entity default as well as participants' risk appetite. To the 
extent that market participants revise expectations about the 
likelihood or severity of a U.S. sovereign default upward, 
spreads on CDS referencing U.S. treasuries could be expected to 
rise. Were a default to actually occur, it is likely that no 
new contracts referencing U.S. treasuries would be negotiated 
until existing contracts were settled. Spreads on all CDS (not 
just those referencing U.S. Government paper) also depend on 
market participants' overall willingness to bear risk. Both CDS 
and bond spreads tend to fall during times when market 
participants are more willing to take on risk and rise when 
market participants become more risk averse.
    Spreads on short-duration CDS referencing U.S. treasuries 
increased substantially prior to the passage of the Federal 
debt-limit expansion on August 2. The spread on 1-year maturity 
CDS on U.S. treasuries reported by Markit Partners hovered 
around 10 basis points from January through April but grew to 
about 30 basis points in May and peaked at 57 basis points on 
July 27. By market close on August 3, the spread had fallen 
back to a still somewhat elevated level of 26 basis points.

Q.12. What analysis has been done to evaluate and quantify the 
gross credit default exposure of the top 10 banks in the United 
States to credit defaults swaps written on European sovereign? 
What source data does the Federal Reserve use in such analysis?

A.12. Banking supervisors and analysts at the Board and Reserve 
Banks have been monitoring the peripheral European sovereign 
CDS exposures of the largest U.S. bank holding companies (BHCs) 
for some time. Analyses have tended to focus on the market risk 
and counterparty profiles for each BHC. Special analyses--e.g., 
with regards to ``hedge (in)effectiveness'' and its impacts--
are done as events in the region and supervisory assessments 
warrant.
    With regards to CDS, a variety of data sources are utilized 
and cross-checked against each other to ensure that risk 
assessments are not reliant on any single source:

  1. CDS trade data from DTCC's Trade Information Warehouse 
        provides useful perspectives on trends, in particular 
        with gross and net notional positions referencing 
        different sovereigns and the identities of 
        counterparties. (Note, counterparty credit risk 
        exposures cannot be inferred from DTCC CDS data. See #3 
        below.)

  2. Targeted supervisory data requests provide opportunities 
        to gather additional information (e.g., mark-to-market 
        information, which the DTCC CDS data lacks) from 
        different perspectives (e.g., risk systems). Given that 
        over-the-counter derivatives trading is bilateral, data 
        provided by one firm can be cross-checked against the 
        same data provided by a counterparty firm to gauge data 
        robustness and to flag areas for supervisory followup.

  3. Continuous monitoring of firms' top European bank 
        counterparty credit risk exposures, internal scenario 
        loss estimates, liquidity/funding conditions and ad hoc 
        internal risk management analyses provide insight into 
        BHCs' evolving risk profiles. Although these are not 
        CDS-specific, the risks from CDS positioning are 
        reflected, and as such can be cross-checked against 
        information gleaned from the sources above.

  4. LRegulatory reporting data provides another perspective.
Attachment for Question 9



Attachments for Question 10





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