Ben Bernanke

Allowing for the upward biases in inflation measurement and a zone of safety to avoid accidental deflation in prices, an inflation target in the range of 1-2% per annum for the core PCE deflator might be a good initial choice, although some might reasonably disagree about either the number or the choice of index.

My suggested framework for Fed policy regarding asset-market instability can be summarized by the adage, Use the right tool for the job.

As you know, the Fed has two broad sets of responsibilities. First, the Fed has a mandate from the Congress to promote a healthy economy--specifically, maximum sustainable employment, stable prices, and moderate long-term interest rates. Second, since its founding the Fed has been entrusted with the responsibility of helping to ensure the stability of the financial system. The Fed likewise has two broad sets of policy tools: It makes monetary policy, which today we think of primarily in terms of the setting of the overnight interest rate, the federal funds rate. And, second, the Fed has a range of powers with respect to financial institutions, including rule-making powers, supervisory oversight, and a lender-of-last resort function made operational by the Fed's ability to lend through its discount window. By using the right tool for the job, I mean that, as a general rule, the Fed will do best by focusing its monetary policy instruments on achieving its macro goals--price stability and maximum sustainable employment--while using its regulatory, supervisory, and lender-of-last resort powers to help ensure financial stability.

What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

The Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero. Most central banks seem to understand the need for a buffer zone.

To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities.

Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. The central bank's inability to use its traditional methods may complicate the policymaking process and introduce uncertainty in the size and timing of the economy's response to policy actions. Hence I agree that the situation is one to be avoided if possible.

As I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure...One approach...would be for the Fed to commit to holding the overnight rate at zero for some specified period...A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years)...Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt. (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951.¹⁰ Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding.¹¹ For example, the Fed held 7.0 percent of outstanding Treasury securities in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of outstanding Treasury debt.

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11. See Eichengreen and Garber (1991) and Toma (1992) for descriptions and analyses of the pre-Accord period. Both articles conclude that the Fed's commitment to low inflation helped convince investors to hold long-term bonds at low rates in the 1940s and 1950s. (A similar dynamic would work in the Fed's favor today.) The rate-pegging policy finally collapsed because the money creation associated with buying Treasury securities was generating inflationary pressures. Of course, in a deflationary situation, generating inflationary pressure is precisely what the policy is trying to accomplish.

An episode apparently less favorable to the view that the Fed can manipulate Treasury yields was the so-called Operation Twist of the 1960s, during which an attempt was made to raise short-term yields and lower long-term yields simultaneously by selling at the short end and buying at the long end. Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates were not close to zero.

When inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.  By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails.

I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself...The second bulwark...is the Federal Reserve System itself.

So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself...The second bulwark against deflation in the United States...is the Federal Reserve System itself...I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief...Having said that deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether.

A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.  [18]

[18] A tax cut financed by money creation is the equivalent of a bond-financed tax cut plus an open-market operation in bonds by the Fed, and so arguably no explicit coordination is needed. However, a pledge by the Fed to keep the Treasury's borrowing costs low, as would be the case under my preferred alternative of fixing portions of the Treasury yield curve, might increase the willingness of the fiscal authorities to cut taxes.

U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Is there then no middle ground for policymakers between the inflexibility of ironclad rules and the instability of unfettered discretion? My thesis today is that there is such a middle ground--an approach that I will refer to as constrained discretion--and that it is fast becoming the standard approach to monetary policy around the world, including in the United States. As I will explain, constrained discretion is an approach that allows monetary policymakers considerable leeway in responding to economic shocks, financial disturbances, and other unforeseen developments. Importantly, however, this discretion of policymakers is constrained by a strong commitment to keeping inflation low and stable.

What then about the rise in bankruptcy rates and similar indicators?  Bankruptcy rates are hard to forecast, as they vary over time with changes in law and financial practice; moreover, they themselves do not tend to forecast broad economic conditions very well. One partial explanation for their recent increase, as I intimated earlier, may be the expansion earlier in the decade of the so-called subprime lending market, in which lenders sought to make loans to households whose credit histories excluded them from the mainstream market.  Although some legitimate concerns have been raised about lending abuses in this market, overall the expansion of the subprime market is a positive development, opening up as it does new opportunities for borrowers previously excluded from credit markets.  Not unexpectedly, however, lenders, borrowers, and regulators have faced a significant learning curve as this market has developed, and perhaps we should not be surprised that some of the loans made in this market in a period of strong economic growth have become distressed in a period of recession and rising unemployment.

The publication of medium-term forecasts does not raise nearly the same difficult political and communication issues that quantification of price stability may, in my view, and so I propose it here as a more feasible short-term step. The FOMC already releases (and has released since 1979) a range and a "central tendency" of its projections for nominal GDP growth, real GDP growth, PCE inflation, and the civilian unemployment rate twice each year, publishing them as part of the semiannual Monetary Policy Report to the Congress.  These projections are actually quite interesting, as they represent the views of Fed policymakers of the future evolution of the economy, conditional on what each policymaker views as the best path for future policy. Two drawbacks of these projections as they now stand are that (1) they are sometimes not released for a number of weeks (the time between the FOMC meeting at which they are assembled and the Chairman's testimony to the Congress), and (2) the January projections cover only the remainder of the current year (the July projections cover the remainder of the current year and all of the subsequent year).

I think it would be very useful to detach these projections from the Monetary Policy Report and instead release them shortly after the meetings (in January and July) at which they are compiled. I would also suggest adding a second year of forecast to the January projection, to make it more parallel to the July projection as well as to the forecasts in the staff-prepared Greenbook. By releasing the projections in a more timely manner, and by adding a year to the January projection, the FOMC could provide quite useful information to the public. In particular, the FOMC projections would convey the policymakers' sense of the medium-term evolution of the economy, providing insight into both the Fed's diagnosis of economic conditions and its policy objectives.   Ideally, the release of these projections also would provide occasions for Governors and regional Bank Presidents, drawing on the expertise of their respective staffs, to convey their individual views on the prospects for the economy and the objectives of monetary policy.

To move substantially further in the direction of inflation targeting, should it choose to do so, the Fed would have to take two principal steps: first, to quantify (numerically, and in terms of a specific price index) what the Federal Open Market Committee means by "price stability", and second, to publish regular medium-term projections or forecasts of the economic outlook, analogous to the Inflation Reports published by both inflation-targeting central banks.

Monetary policy contributed to the oil price increases in the first place by creating an inflationary environment in which excess nominal demand existed for a wide range of goods and services. For example, in an important paper, Barsky and Kilian (2001) noted that the prices of many industrial commodities and raw materials rose in the 1970s about the same time as oil prices, reflecting broad-based inflationary pressures. Without these general inflationary pressures, it is unlikely that the oil producers would have been able to make the large increases in oil prices "stick" for any length of time.

In an earlier speech, I referred to the policy framework that describes what I consider to be best-practice inflation targeting as constrained discretion.  Constrained discretion attempts to strike a balance between the inflexibility of strict policy rules and the potential lack of discipline and structure inherent in unfettered policymaker discretion. Under constrained discretion, the central bank is free to do its best to stabilize output and employment in the face of short-run disturbances, with the appropriate caution born of our imperfect knowledge of the economy and of the effects of policy (this is the "discretion" part of constrained discretion). However, a crucial proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation--and, hence, public expectations of inflation--firmly under control (the "constrained" part of constrained discretion). Because monetary policy influences inflation with a lag, keeping inflation under control may require the central bank to anticipate future movements in inflation and move preemptively. Hence constrained discretion is an inherently forward-looking policy approach.

We don’t mean to suggest seriously that machine will replace human in monetary policy-making. But having such a system would have several advantages. First, like the automatic pilot in an airplane or an AI diagnostic system in medicine, an expert system for monetary policy would provide a useful information aggregator and benchmark for human decision-making. Second, because private forecasters or research institutes could replicate expert system results, such systems might enhance transparency and credibility of the central bank by providing objective information about forecasts and the implied policy settings.

What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred.

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Reflation--that is, a period of inflation above the long-run preferred rate in order to restore the earlier price level--proved highly beneficial following the deflations of the 1930s in both Japan and the United States. Finance Minister Korekiyo Takahashi brilliantly rescued Japan from the Great Depression through reflationary policies in the early 1930s, while President Franklin D. Roosevelt's reflationary monetary and banking policies did the same for the United States in 1933 and subsequent years.

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Eggertsson and Woodford (2003) have advanced a second argument for a price-level target for Japan in an important recent paper on monetary policy at the zero bound. These authors point out (as have many others) that, when nominal interest rates are at or near zero, the central bank can lower the real rate of interest only by creating expectations of inflation on the part of the public. Eggertsson and Woodford argue that a publicly announced price-level target of the type just described is more conducive to raising near-term inflation expectations than is an inflation target.

[T]he BOJ's most recent financial statement showed that of the 68 percent of its assets held in the form of government securities, about two-thirds are long-term Japanese government bonds (JGBs)... If the Bank of Japan were to succeed in replacing deflation with a low but positive rate of inflation, its reward would likely be substantial capital losses in the value of its government bond holdings arising from the resulting increase in long-term nominal interest rates.

With such concerns in mind, BOJ officials have said that a strengthening of the Bank's capital base is needed to allow it to pursue more aggressive monetary policy easing. In fact, the BOJ recently requested that it be allowed to retain 15 percent (rather than 5 percent) of the surplus for the 2002 fiscal year that just ended to increase its capital, and the Ministry of Finance has indicated that it will approve the request. Even with this additional cushion, however, concerns on the part of the BOJ about its balance sheet are likely to remain.

The public debate over the BOJ's capital should not distract us from the underlying economics of the situation... Indeed, putting aside psychological and symbolic reasons, important as these may be in some circumstances, there appear to be only two conceivable effects of the BOJ's balance sheet position on its ability to conduct normal operations. First, if the BOJ's income were too low to support its current expenditure budget, the Bank might be forced to ask the MOF for supplemental funds, which the BOJ might fear would put its independence at risk... Second, an imaginable, though quite unlikely, possibility is that the Bank could suffer sufficient capital losses on its assets to make it unable to conduct open-market sales of securities on a scale large enough to meet its monetary policy objectives.

In short, one could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy. Rather than engage in what would probably be a heated and unproductive debate over the issue, however, I would propose instead that the Japanese government just fix the problem... I am intrigued by a simple proposal that I understand has been suggested by the Japanese Business Federation, the Nippon Keidanren. Under this proposal the Ministry of Finance would convert the fixed interest rates of the Japanese government bonds held by the Bank of Japan into floating interest rates. This "bond conversion"--actually, a fixed-floating interest rate swap--would protect the capital position of the Bank of Japan from increases in long-term interest rates and remove much of the balance sheet risk associated with open-market operations in government securities.

Ambiguity has its uses but mostly in noncooperative games like poker. Monetary policy is a cooperative game. The whole point is to get financial markets on our side and for them to do some of our work for us. In an environment of low inflation and low interest rates, we need to seek ever greater clarity of communication to the markets and to the public.

Where is inflation likely to go over the foreseeable future? Medium-term inflation forecasting is highly contentious--not least because the underlying theory of the determination of inflation continues to divide macroeconomic schools of thought--and I cannot begin to do justice to the topic in a short talk. The Board staff, for example, uses an eclectic approach that includes a number of components, including data analysis, statistical techniques, a suite of econometric models, and judgment.

Today I would like to share my own thoughts on the prospect of an "unwelcome substantial fall in inflation"--in particular, why a substantial fall in inflation going forward would indeed be unwelcome; why some risk of further disinflation, though "minor," should not be ignored; and what such a fall would imply for the conduct of monetary policy...

Let's first be clear what we are talking about. Some in the media apparently interpreted the May 6 statement as saying that the Federal Reserve anticipated imminent deflation in the United States and informed the public accordingly. In my view, such an interpretation substantially overstates the concerns that the FOMC intended to communicate with its statement. First, we have no reason to think that a drastic change in the inflation rate is imminent...

This distinction between inflation that is positive yet too low and deflation is worth exploring for a moment. Although the Federal Reserve does not have an explicit numerical target range for measured inflation, FOMC behavior and rhetoric have suggested to many observers that the Committee does have an implicit preferred range for inflation. Most relevant here, the bottom of that preferred range clearly seems to be a value greater than zero measured inflation, at least 1 percent per year or so.

Part of the reason that core PCE inflation fell less than CPI inflation is that the PCE index includes so-called nonmarket prices--prices that are imputed by the Bureau of Economic Analysis because reliable market data are not available--and nonmarket prices have been trending upward lately. Indeed, the market-based portion of core PCE inflation for the year ending in May was only 0.7 percent.

Because of differences in the construction of this index and the CPI, an upward adjustment of 0.2 to 0.4 percentage point is probably necessary to make PCE inflation comparable to CPI inflation.

As a preliminary, I need to introduce the idea of the optimal long-run inflation rate, or OLIR for short. (Suggestions for a catchier name are welcome.) The OLIR is the long-run (or steady-state) inflation rate that achieves the best average economic performance over time with respect to both the inflation and output objectives.

Note that the OLIR is the relevant concept for dual-mandate central banks, like the Federal Reserve. Thus it is not necessarily equivalent to literal price stability, or zero inflation adjusted for the usual measurement error bias. Rather, under a dual mandate, a strong case can be made that, below a certain inflation rate, the benefits of reduced microeconomic distortions gained from price stability are outweighed by the costs of toofrequent encounters of the funds rate with the zero-lower-bound on nominal interest rates. (This argument underlies the common view that there should be a “buffer zone” against deflation.)  Hence, in general, the OLIR will be greater than zero inflation, correctly measured. Note also that the OLIR is an average long-run rate; variation of actual inflation around the OLIR over the business cycle would be expected and acceptable (Meyer, 2003).

To reassure those worried about possible loss of short-run flexibility, my proposal is that the FOMC announce its value for the OLIR {Optimal Long-run Inflation Rate} to the public with the following provisos (not necessarily in these exact words):

(i) The FOMC believes that the stated inflation rate is the one that best promotes its output, employment, and price stability goals in the long run. Hence, in the long run, the FOMC will try to guide the inflation rate toward the stated value and maintain it near that value on average over the business cycle.

(ii) However, the FOMC regards this inflation rate as a long-run objective only and sets no fixed time frame for reaching it. In particular, in deciding how quickly to move toward the long-run inflation objective, the FOMC will always take into account the implications for near-term economic and financial stability.

As you can see, stating the OLIR with these provisos places no unwanted constraints on short-run monetary policy, leaving the Committee free to deal with current financial and cyclical conditions as the Committee sees fit. In this respect, the proposal is very similar to one recently advanced by Governor Gramlich (2003).

In my view, the most fundamental policy recommendation put forth by Milton Friedman is the injunction to policymakers to provide a stable monetary background for the economy. I take this to be a stronger statement than the Hippocratic injunction to avoid major disasters; rather, there is a positive argument here that monetary stability actively promotes efficiency and growth. (Hence Friedman's suggestion that the long-run Phillips curve, rather than vertical, might be positively sloped.) Also implicit in Friedman's focus on nominal stability is the view that central banks should avoid excessively ambitious attempts to manage the real economy, which in practice may exacerbate both nominal and real volatility. In Friedman's classic 1960 work, A Program for Monetary Stability, he suggested that monetary stability might be attained by literally keeping money stable: that is, by fixing the rate of growth of a specific monetary aggregate and forswearing the use of monetary policy to "fine-tune" the economy.

The use of "fan charts" to indicate the range of uncertainty would be helpful in this regard[forecasting future Fed policy]; and indeed, providing more information about uncertainty for all FOMC forecasts would be a useful innovation.

[T]he direct effects of commodity price inflation on consumer inflation are empirically minuscule, both because raw materials costs are a small portion of total cost and because part of any increase in the cost of materials tends to be absorbed in the margins of final goods producers and distributors. Accelerations in commodity prices comparable to or larger than the most recent one occurred following the 1981-82 and 1990-91 recessions, as well as in 1986-87 and 1999, with no noticeable impact on inflation at the consumer level. A reasonable rule of thumb is that a permanent 10 percent increase in raw materials prices will lead to perhaps a 0.7 percent increase in the price of intermediate goods and to less than a 0.1 percent increase in consumer prices. Thus the recent acceleration in commodity prices, even if it were to persist (and futures prices suggest that it will not), would likely add only a tenth or two to the core inflation rate. In short, rising commodity prices are a better signal of strengthening economic activity than of inflation at the consumer level.

More controversially, the FOMC might consider forecasting future values of the short-term interest rate, as is currently done by the Reserve Bank of New Zealand. The difficulty would be to make clear that an interest-rate forecast is not the same as a policy commitment. The use of "fan charts" to indicate the range of uncertainty would be helpful in this regard; and indeed, providing more information about the range of uncertainty for all FOMC forecasts would be a useful innovation.

Can central bank talk--Fedspeak, in the vernacular of the U.S. media and financial markets--make monetary policy more effective and improve economic outcomes? To see why communication may be an integral part of good monetary policymaking, recall that the Federal Reserve directly controls only a single short-term interest rate, the overnight federal funds rate. Relative to the enormous size of global financial markets, the market for federal funds--the market in which commercial banks borrow and lend reserves on a short-term basis--is insignificant. Control of the federal funds rate is therefore useful only to the extent that it can be used as a lever to influence more important asset prices and yields--stock prices, government and corporate bond yields, mortgage rates--which in turn allow the Fed to affect the overall course of the economy.

In the United States, the August 2003 statement of the Federal Open Market Committee that "policy accommodation can be maintained for a considerable period" is another example of commitment. The close association of this statement with the Committee's expressed concerns about "unwelcome disinflation" implied that this commitment was conditioned on the assessment of the economy. The conditional nature of the commitment was sharpened in the Committee's December statement, which explicitly linked continuing policy accommodation to the low level of inflation and the slack in resource use.

Certainly, stability-enhancing changes in the economic environment have occurred in the past two decades. However, an intriguing possibility is that some of these changes, rather than being truly exogenous, may have been induced by improved monetary policies. That is, better monetary policies may have resulted in what appear to be (but only appear to be) favorable shifts in the economy's Taylor curve.

Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks.

Finally, perhaps the most important lesson of all is that price stability should be a key objective of monetary policy. By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and, through the workings of the gold standard, the economies of many other nations as well.

Unfortunately, as a measure of market participants' expected inflation, breakeven inflation has a number of problems (Sack, 2000; Shen and Corning, 2001). First, and probably the most important, breakeven inflation includes a return to investors for bearing inflation risk, implying that the breakeven rate likely overstates the market's expected rate of inflation. Estimates of the inflation risk premium for bonds maturing during the next five to ten years are surprisingly large, generally in a range between 35 and 100 basis points, depending on the time period studied (Ang and Bekaert, 2003; Goto and Torous, 2003; Buraschi and Jiltsov, 2004). If the inflation risk premium averages 50 basis points, for example, then breakeven inflation will overstate the market's true expectation of inflation by half a percentage point, a substantial amount. A further complication is that inflation risk premiums are not constant but instead appear to vary over time as economic circumstances change.

Second, although the issuance of inflation-protected securities has risen significantly, the outstanding quantities of these securities remain much smaller than those of conventional Treasury securities. Moreover, TIPS are attractive to buy-and-hold investors, in contrast to nominal Treasury securities, which are extensively used for trading and hedging (Sack and Elsasser, 2004). For both reasons, the market for TIPS remains significantly less liquid than those for most Treasury securities. All else equal, the likely presence of a liquidity premium in the TIPS return tends to make breakeven inflation an underestimate of expected inflation, thus offsetting to some degree the effect of the inflation risk premium. Like inflation risk premiums, liquidity premiums on TIPS appear to vary over time, further complicating the interpretation of breakeven inflation.

A third issue is that the real values of the coupon payments on an indexed security are fixed by construction, while the real coupons of a nominal bond usually decline over its life. Hence, an indexed security typically has a longer duration with respect to real interest rate changes than does the nominal security, a difference that affects the relative riskiness of real and nominal securities.4 More generally, because TIPS returns are imperfectly correlated with the yields on both nominal Treasuries and stocks, some investors demand TIPS for general diversification purposes--a demand that appears to have increased significantly as investors have become more familiar with this new type of asset. As the supply of TIPS has been fairly limited, the rise in demand by institutional investors and others may push down the equilibrium real return on TIPS and thus raise measures of breakeven inflation.5

A separate issue that bears on the relevance of breakeven inflation for policymaking is that TIPS returns depend on the overall consumer price index (CPI), whereas for many purposes policymakers are more interested in the behavior of core inflation, a measure of inflation that strips out volatile food and energy prices. In fact, TIPS returns appear sensitive to fluctuations in oil prices.

Specifically, Brainard showed that when policymakers are unsure of the impact that their policy actions will have on the economy, it may be appropriate for them to adjust policy more cautiously and in smaller steps than they would if they had precise knowledge of the effects of their actions. An analogy may help to clarify the logic behind Brainard's argument. Imagine that you are playing in a miniature golf tournament and are leading on the final hole. You expect to win the tournament so long as you can finish the hole in a moderate number of strokes. However, for reasons I won't try to explain, you find yourself playing with an unfamiliar putter and hence are uncertain about how far a stroke of given force will send the ball. How should you play to maximize your chances of winning the tournament?

How can the FOMC ensure that its policy actions feed into longer-term rates and thus influence the economy? An interesting result, noted in an early paper by Marvin Goodfriend (1991) of the Federal Reserve Bank of Richmond and developed more formally by my Princeton colleague Michael Woodford (2000, 2003), is that gradualist policies may allow the Fed to gain greater influence over long-term interest rates.3 The reason is the effect of past episodes of gradualist behavior on market expectations. In a gradualist regime, an increase in the federal funds rate not only raises current short-term rates but also signals to the market that rates are likely to continue to rise for some time. Because they reflect the whole path of expected future short-term rates, under a gradualist regime long-term rates such as mortgage rates tend to be relatively sensitive to changes in the federal funds rate. Thus, gradualism helps to ensure that the FOMC will have an effective lever over economic activity and inflation.

The phrase "international role of the euro" covers a number of disparate possible functions of the currency. These functions include the use of euro-denominated assets as official reserves, the use of the euro as a vehicle currency in foreign-exchange transactions, the denomination in euros of financing instruments issued by borrowers not resident in the euro zone, the acceptance of euro-denominated or euro-linked assets in international investment portfolios, and the invoicing in euros of internationally traded goods and services. Of course, during the post-World War II period the U.S. dollar has been the dominant international currency with respect to each of these functions. It seems plausible that the euro, a low-inflation currency used by an economy comparable to that of the United States in size and sophistication, will, over time, increase its "market share" in each of these areas.

Although economists and financial market participants will observe the developing role of the euro in international transactions with interest, the direct benefits to euro-zone economies of having the euro play an international medium-of-exchange role are relatively modest. Arguably, the more significant aspects of the euro's international role arise from the strengthening and expansion of euro-denominated financial markets as these markets take on a greater international character.

My own view is that we are approaching the limits of purely qualitative communication and should consider the inclusion of quantitative information presented in a clearly specified framework. For example, like policymakers at many other central banks, the FOMC could specify its long-term inflation objective and include explicit economic forecasts, conditioned on alternative assumptions, in its statements or in regular reports. That being said, one must recognize that the FOMC is not a "unitary actor," as the political scientists term it, but a committee of nineteen highly independent people. With the best will in the world, achieving a Committee consensus on a detailed forecast (for example) will always be difficult in the short time available. Some ambiguity in the FOMC's communications may therefore be unavoidable.

This increase in transparency is highly welcome, for many reasons. Perhaps most important, as public servants whose decisions affect the lives of every citizen, central bankers have a responsibility to provide the public as much explanation of those decisions as possible, so long as doing so does not compromise the decisionmaking process itself. A more open policymaking process is also likely to lead to better policy decisions, because engagement with an informed public provides central bankers with useful feedback in the form of outside views and analyses.

[O]pen and clear communication by the policy committee--which in practice includes speeches and congressional testimony by FOMC members, as well as official statements--makes monetary policy more effective in at least three distinct ways.

First, in the very short run, clear communication helps to increase the near-term predictability of FOMC rate decisions, which reduces risk and volatility in financial markets and allows for smoother adjustment of the economy to rate changes...

Second, in the long run, communicating the central bank's objectives and policy strategies can help to anchor the public's long-term expectations--most importantly, its expectations of inflation...

The third way in which clear and open communication enhances the effectiveness of monetary policy--the channel that will be the focus of my remarks today--is by helping to align financial-market participants' expectations about the future course of monetary policy more closely with the policy committee's own plans and projections. As I will discuss, to the extent that central bank talk provides useful guidance to markets about the likely future path of short-term interest rates, policymakers will exert greater influence over the longer-term interest rates that most matter for spending decisions. At the same time, expanding the information available to financial-market participants improves the efficiency and accuracy of asset pricing. Both of these factors enhance the effectiveness and precision of monetary policy.

Most recently, the Committee has introduced additional commentary on the outlook for policy into its statement. For example, the August 2003 statement of the FOMC indicated that "policy accommodation can be maintained for a considerable period," a formulation replaced a few meetings later with the comment that the Committee could be "patient" in removing policy accommodation. These statements conveyed information to markets about the Committee's economic outlook as well as its policy approach. .. The language of the statement in August 2003 and subsequent meetings persuaded the markets that an autumn tightening was not in the cards, and market expectations adjusted accordingly. Crucially, this change in expectations resulted in lower interest rates at all maturities, a development that helped support the expansion in the latter part of last year.

When the policy tightening cycle finally began earlier this year, the FOMC indicated that, with underlying inflation still relatively low, it would proceed "at a pace that is likely to be measured." As I discussed in a speech in May, the gradualist approach implied by this statement is often appropriate during a period of economic and financial uncertainty (Bernanke, 2004). At the same time that it provided information on its outlook and its expected policy path, however, the Committee properly insisted that its policies would be conditional on the arriving economic data. In particular, the Committee noted that it would respond as necessary to maintain price stability.

To be absolutely clear, in pointing out the benefits of clear communication I am not asserting that central bank talk represents an independent tool of policy. Indeed, if the central bank's statements are not informative about the likely future course of the short-term interest rate, they will soon lose their ability to influence market expectations. Rather, the value of more-open communication is that it clarifies the central bank's views and intentions, thereby increasing the likelihood that financial-market participants' rate expectations will be similar to those of the policymakers themselves--or, if views differ, ensuring at least that the difference can not be attributed to the policymakers' failure to communicate their outlook, objectives, and strategy to the public and the markets.

I should acknowledge that oil futures prices have a less-than-stellar record in forecasting oil price developments, but they are probably the best guide that we have. Chinn, LeBlanc, and Coibion (2001) find that futures quotes are unbiased predictors of future spot prices, though not very accurate ones.  

[Chinn, Menzie, Michael LeBlanc, and Olivier Coibion (2001). "The Predictive Characteristics of Energy Futures: Recent Evidence for Crude Oil, Natural Gas, Gasoline, and Heating Oil,"  (99KB PDF) unpublished paper, University of California, Santa Cruz.]

Since the beginning of the year, the cost of oil imported into the United States has increased by about $75 billion (at an annual rate), or about 3/4 percent of the gross domestic product (GDP). Add to this the effects of the rise in natural gas prices, and the total increase in imported energy costs over a full year--the increase in the "tax" being paid to foreign energy producers--comes to almost $85 billion. The impact of this decline in net income on the U.S. GDP depends in large part on how the increase in the energy "tax" affects the spending of households and firms...A reasonable estimate is that the increased cost of imported energy has reduced the growth in U.S. aggregate spending and real output this year by something between half and three-quarters of a percentage point.

Although traders expect the price of oil to decline somewhat from recent highs, they also believe that a significant part of the recent increase in prices will be long lived.

[T]he term "rule" suggests a rigid and mechanistic policy prescription that leaves no room for discretion or judgment. However, the argument that monetary policy should adhere mechanically to a strict rule, made by some economists in the past, has fallen out of favor in recent years. Today most monetary economists use the term "rule" more loosely to describe a general policy strategy, one that may include substantial scope for policymaker discretion and judgment. Here I will use the term "policy" instead of "rule" to avoid the connotations of the latter.

[U]nder a forecast-based policy regime, policymakers must predict how the economy is likely to respond in the medium term--say, over the next six to eight quarters--to alternative plans for monetary policy.

The economic stimulus provided by monetary policy depends mostly on longer-term interest rates, which in turn are largely determined by the expectations of financial market participants about the future course of monetary policy. As a general matter, the more guidance the central bank can provide the public about how policy is likely to evolve (or about the principles on which policy decisions will be based), the greater the chance that market participants will make appropriate inferences--and thus the greater the probability that long-term interest rates will move in a manner consistent with the outlook and objectives of the monetary policy committee.

Under the forecast-based approach, in contrast, the public will generally find inferring the likely course of policy to be a great deal more difficult. In that regime, policy plans depend in a complex way on policymakers' outlooks, risk assessments, and objectives, which the public is unlikely to deduce accurately without guidance. Clear communication thus appears to be especially important for central banks that employ a forecast-based approach to policy--a category that includes most contemporary central banks, including the Federal Reserve.

Operationally, the risk-management approach differs from the forecast-based policies described in much of the monetary economics literature in only one important respect. For simplicity, researchers have generally analyzed forecast-based policies under the assumption that policymakers care only about average economic outcomes. However, in practice, policymakers are often concerned not only with the average or most likely outcomes but also with the risks to their objectives posed by relatively low-probability events.

I think having a long-run inflation objective that is defined first of all not as price stability per se, but rather as the long-run inflation rate that best achieves our dual mandate, would be a major step forward.  And if we were to take that step—that is, if we were to establish a true north on the compass, so to speak, for long-run monetary policy—I would not push for any further steps in the direction of a short-term inflation targeting regime.

One caveat for the future is that the recent rapid escalation in house prices--11 percent in 2004, according to the repeat-transactions index constructed by the Office of Federal Housing Enterprise Oversight--is unlikely to continue. A plausible scenario is that house prices will either move sideways or rise more slowly during the next few years, eventually bringing the rate of return on housing in line with the relatively low prospective rates of return that we currently observe on virtually all assets, both real and financial. If the increases in house prices begin to moderate as expected, the resulting slowdown in household wealth accumulation should lead ultimately to somewhat slower growth in consumer spending.

The pace of hiring also strengthened toward the end of last year, following a summertime lull, and I expect healthy employment gains in the coming quarters, albeit with possibly large month-to-month variations. Despite the growth in employment, however, the unemployment rate should decline relatively slowly, as a strengthening job market attracts people back into the labor force...

Evidence that the labor market is not yet at its potential includes subdued wage growth, the failure thus far of labor participation rates to increase from cyclical lows, the relatively large number of people who say they are working part-time for economic reasons, and the impression gleaned from surveys and anecdotes that the supply of potential employees in most occupations remains plentiful.

My own guess is that core PCE inflation in 2005 will be slightly higher than its 2004 rate of 1.6 percent, though likely remaining within what I think of as the "comfort zone" of 1 to 2 percent.

The potential volatility of energy prices, commodity prices, and (to a lesser extent) import prices has been dramatically demonstrated in recent years and so unexpectedly rapid increases--or decreases, for that matter--in producers' nonwage costs can by no means be ruled out. Cost increases that are both large and sustained would, of course, create inflationary pressure. Lagged effects on inflation of the nonwage cost increases that occurred in 2004 are also possible, particularly if the firming of demand increases pricing power and the ability of producers to pass on their higher costs. I can assure you that the Federal Reserve will monitor closely any developments affecting producers' costs.

The natural rate of unemployment is probably better thought of as a zone rather than as a single number, however. In particular, inflation does not appear to rise sharply or discontinuously when the economy reaches a specific rate of unemployment or capacity utilization but instead responds more gradually to variations in the degree of resource utilization (in economics lingo, the Phillips curve is fairly flat).

One may reasonably ask when this process of removing policy accommodation will stop. This question is not straightforward to answer. In particular, it is not helpful, in my view, to imagine the existence of some fixed target for the funds rate toward which policy should inexorably march. Instead, the correct procedure for setting policy requires the FOMC to continually update its forecast for the economy, conditional on all relevant information and on a provisional future path for monetary policy. The funds rate will have reached an appropriate and sustainable level when, first, the outlook is consistent with the Committee's economic goals and, second, the slope of the term structure of interest rates is approximately normal, as best as can be determined. With this definition in mind, one can search for indications of where the "neutral" funds rate is likely to be at a given point in time. For example, the fact that far future short-term interest rates have recently declined fairly significantly suggests that, in the view of the markets at least, the neutral funds rate may be somewhat lower today than it was in the past.  The most important lesson, however, is that the neutral policy rate depends on both current and prospective economic conditions. Accordingly, the neutral rate is not a constant or a fixed objective but will change as the economy and economic forecasts evolve.

The growth in export-oriented sectors such as manufacturing has been restrained by the U.S. trade imbalance (although the recent decline in the dollar has alleviated that pressure somewhat), while sectors producing nontraded goods and services, such as home construction, have grown rapidly. To repay foreign creditors, as it must someday, the United States will need large and healthy export industries. The relative shrinkage in those industries in the presence of current account deficits--a shrinkage that may well have to be reversed in the future--imposes real costs of adjustment on firms and workers in those industries.

Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things. However, in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines.

As U.S. business investment has recently begun a cyclical recovery while residential investment has remained strong, the domestic saving shortfall has continued to widen, implying a rise in the current account deficit and increasing dependence of the United States on capital inflows.

I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today...The global saving glut has been a remarkable reversal in the flows of credit to developing and emerging-market economies, a shift that has transformed those economies from borrowers on international capital markets to large net lenders.

The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.

The FOMC controls very short-term interest rates fairly directly. However...the Committee's control over longer-term yields and over the prices of long-lived financial assets depends crucially on its ability to influence market expectations about the likely future course of policy.

The Fed has only very indirect control over long-term yields and asset prices...To affect long-term rates, the FOMC must somehow signal to the financial markets its plans for setting future short-term rates. The most direct method is through talk...FOMC talk probably has the greatest influence on expectations of short-term rates a year or so into the future, as beyond that point the FOMC has very little, if any, advantage over market participants in forecasting the economy or even its own policy actions.

In the past decade or so, the Federal Reserve has become substantially more transparent and open in its communication with the public. Growing appreciation of the fact that greater openness makes monetary policy more effective is, I believe, an important reason for this welcome trend.

The large current account deficit of the United States, in particular, requires substantial flows of foreign financing...The underlying sources of the U.S. current account deficit appear to be medium-term or even long-term in nature, suggesting that the situation will eventually begin to improve, although a return to approximate balance may take some time. Fundamentally, I see no reason why the whole process should not proceed smoothly.

CNBC INTERVIEWER: Tell me, what is the worst-case scenario? We have so many economists coming on our air saying ‘Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.’ Some say it could even cause a recession at some point. What is the worst-case scenario if in fact we were to see prices come down substantially across the country?

BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.

In the shorter term, the devastation wrought by hurricane Katrina, and to a lesser extent by Rita, will have a palpable effect on the national economy. In particular, the virtual shutting-down of the Gulf Coast economy will leave its imprint on the national rates of job creation and output growth, especially in the third quarter, while recovery and rebuilding should ultimately increase growth rates and rates of job creation, perhaps by the fourth quarter and certainly in the first half of next year.

The President remains committed to halving the federal budget deficit by 2009, and I believe that that goal remains feasible despite these added costs [from Hurricanes Rita and Katrina].

Thus far at least, the growth effects of energy price increases appear relatively modest. The economy is much more energy-efficient today than it was in the 1970s, when energy shocks contributed to sharp slowdowns, and real energy prices remain below the peaks attained in the 1970s and early 1980s. Well-controlled inflation and inflation expectations have also moderated the effects of energy price increases, since those increases no longer set off an inflation spiral and the associated increases in interest rates, as they did three decades ago.

In this prospective new role, I would bear the critical responsibility of preserving the independent and nonpartisan status of the Federal Reserve--a status that, in my view, is essential to that institution's ability to function effectively and achieve its mandated objectives. I assure this Committee that, if I am confirmed, I will be strictly independent of all political influences and will be guided solely by the Federal Reserve's mandate from Congress and by the public interest.  With respect to monetary policy, I will make continuity with the policies and policy strategies of the Greenspan Fed a top priority.

Monetary policy is most effective when it is as coherent, consistent, and predictable as possible, while at all times leaving full scope for flexibility and the use of judgment as conditions may require.

Under Chairman Greenspan, monetary policy has become increasingly transparent to the public and the financial markets, a trend that I strongly support...One possible step toward greater transparency would be for the FOMC to state explicitly the numerical inflation rate or range of inflation rates it considers to be consistent with the goal of long-term price stability...I view the explicit statement of a long-run inflation objective as fully consistent with the Federal Reserve's current policy approach, including its appropriate emphasis on the role of judgment and flexibility in policymaking.  Most important, this step would in no way reduce the importance of maximum employment as a policy goal. Indeed, a key justification for this action is its potential to contribute to stronger and more stable employment growth by further stabilizing inflation and inflation expectations. In any case...if I am confirmed, I will take no precipitate steps in the direction of quantifying the definition of long-run price stability. This matter requires further study at the Federal Reserve as well as extensive discussion and consultation.

It's important for the Federal Reserve to be aware of what's going on in the market, particularly working through the banks, which are the counter-parties of a lot of hedge funds to understand their strategies and their positions. Nevertheless, broadly speaking, my understanding is that the hedge fund industry has become more sophisticated, more diverse, less leveraged and more flexible in the years since LTCM. So, again, while it's very important to understand that industry and particularly to make sure that the banks are dealing in appropriate ways with hedge funds, my sense is that on net they are a positive force in the American financial system.

The Federal Reserve has important responsibilities for maintaining financial stability. That involves ensuring ex ante, that banks, for example, are managing their portfolios safely, that the clearing and settlement systems are well-designed and secure, that there are good arrangements in place for dealing with some kind of financial crisis, no matter what its source might be, and that, ex post, should there be a problem, that there be plenty of liquidity provided to the banking system and that the Fed would make sure that whatever problems arise be brought to some venue where they can be unwound and discussed and assistance be given.

Basel II or something like it appears necessary. The banking system has become financially extraordinarily sophisticated. Basel I is no longer sufficient as a means of determining adequate regulatory capital for the banking system.

The Federal Reserve, the other banking regulators, international counter-parties have worked for a number of years trying to determine an appropriate system that would appropriately account for the complexity of the banking system. Basel II tries to embody the notion that the amount of regulatory capital should be based on modern risk- management techniques, which try to evaluate the risks associated with different kinds of investments.

With respect to choosing a inflation objective in the medium term, there are many considerations one would want to take into account, familiarity by the public, for example. So that I think would be something that would need to be discussed by the Federal Open Market Committee and in our general consultations. To the extent that, say the CPI overstates inflation by an approximately known amount, one could simply adjust the range of inflation rates that define price stability to allow for that bias.

In 2003, there was an episode where there was clearly a miscommunication between the Federal Reserve and the bond markets, and it caused a significant fluctuation in the bond markets. This was over the issue of whether or not there was some risk of deflation coming forward. And clearly there was a misunderstanding about that risk. It impressed on me the importance of speaking clearly and communicating clearly and making sure that there's understanding on both sides about what the Fed is saying and what the Fed is intending to do.

The global savings glut idea attempts to point out that the current account deficit of the United States is not simply or entirely a product of U.S. economic policies. It is a global phenomenon created by global forces. Over the last 10 years or so the amount of savings being done around the world has exceeded desired investment in those same countries for various reasons, including the aging of some industrial economies, the oil revenues of crude producers, and most importantly, the fact that emerging market economies over the last 10 years have gone from being significant borrowers in international capital markets to large lenders, to having large current account surpluses. As a result, there's been enormous amounts of capital dumped into international capital markets, which helps to account for the fact that global interest rates are at record lows or at least at very low levels. The inflows of that capital into the United States, which is an attractive destination for this capital, and the resulting impact on asset price in the United States is, in my view, part of the reason why Americans have increased their consumption and reduced their savings, which has resulted in this current account deficit. Now...I don't view the current account deficit as desirable. I think there's a number of reasons to try and end it. But in order to end it or at least to wind it down over a period of time, it's going to require action both within the United States and also within our trading partners. On the part of the United States, we need to increase our own savings relative to investment. With respect to our trading partners, there needs to be, first, increased reliance on flexible exchange rates, as we've already discussed, and also more willingness on the part of our trading partners to rely on domestic spending, domestic government purchases or consumption, to drive their economies, as opposed purely to an export-led strategy.

Normally, you would expect to see capital flowing to emerging market economies, rather than out of emerging market economies. The proximate cause of the switch, I would argue, was the financial crises of the late 1990s which occurred in a variety of emerging market economies in East Asia and Latin America and elsewhere, and led them to be much more cautious about accepting capital inflows and to focus more on building up their reserves, building up their current accounts, and looking more to an export- oriented strategy. So I think it's the effects of the financial crises which over a period of time I expect will wane. But that was the main impetus, I believe, for this shift in strategy on the part of the emerging market countries.

I think it's very important to look at [option ARMs and other nontraditional mortgages]. And I believe that doing so would have on the margin some beneficial effects in reducing speculative activity in some local markets. However, overall, I think the main reason to look at these instruments is to make sure that banks are protected and that the consumers are protected against the potential risks of these instruments.

There's no perfect forecaster, no perfect indicator of inflation...Exchange rates reflect inflation pressures. They may also reflect the balance of trade and other factors. So there's no single optimal indicator of inflation. My personal strategy, therefore, is to be very eclectic and to look at a wide range of indicators. And among those is commodities, gold, exchange rates, the whole list. I think interest rates, real- side indicators, surveys, expectations, there's a whole list of variables which can be useful in forecasting inflation. And I think one has to be very open minded about using whatever information one has.

I draw two lessons from that late '90s experience [the changing view of productivity growth]. The first is that you don't just look at the conventional measures, you look at the data quite deeply and try to understand how the data are constructed and how they relate to each other, because there may be anomalies that'll be instructive. And that was the case in the late '90s. The other is that published government data is not the only source of information. It's also important to talk to people in the marketplace, to talk to business people.

And, with respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve's responsibility is to make sure that the institutions which it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well-managed and don't create excessive risk in their institutions.

SEN. SARBANES: Warren Buffet has warned us that derivatives are time bombs, both for the parties that deal in them and the economic system. The Financial Times has said so far, there has been no explosion, but the risks of this fast growing market remain real. How do you respond to these concerns?

BERNANKE: I'm more sanguine about derivatives than the position you just suggested. I think, generally speaking, they are very valuable. They provide methods by which risks can be shared, sliced and diced and given to those most willing to bear it. They add, I believe, to the flexibility of the financial system in many different ways. And, with respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve's responsibility is to make sure that the institutions which it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well-managed and don't create excessive risk in their institutions.

I do believe the current account deficit needs to come down over a period of time. I think there are a number of elements needed to do that. Part of it would be to increase United States national savings through both private savings and public savings.

I would also be useful for our trading partners to do a number of things, including allowing their exchange rates to float more freely and be determined by the market and to rely less on exports as a source of demand for their economies.

So we need to rebalance the global international system. I believe that can be done over a period of time. But it won't happen overnight.

Of course, this is ultimately Congress's decision. But from a purely technical perspective, I believe there are better measures of inflation than the CPIU. In that respect, one might want to consider alternatives.

Natural gas prices have been rising for some time. And it's proved a very heavy burden to chemical manufacturers, alumina, other manufacturers in the United States. That's a real problem. I don't want to understate that problem at all. But...monetary policy...can only try to avoid having those price increases spread into general inflation. Monetary policy can't create more energy. It can't really solve the energy problem.

Under Chairman Greenspan, talk and action were combined to ensure the markets that over a period of time -- not necessarily within a quarter or two-quarters, but over a period of time, perhaps lasting several years, the Fed would ensure that inflation was stabilized in a region that was consistent with the objective of price stability.
So that is the approach I would take. I would certainly not try to return inflation to a target within a short period of time. I would simply try to assure the markets that over a long period of time that the Federal Reserve was committed to price stability as a central part of its monetary strategy.

During the 1970s, inflation expectations were very poorly anchored. There was very little confidence that the Fed would keep inflation low and stable. When oil prices rose, those price increases fed through quickly into other prices and began to raise the general rate of inflation quite quickly.

The Fed responded somewhat in a panicked way by raising interest rates enormously, which then contributed to the deep recessions of 1975 and 1981-'82.

In a more recent episode, we've had extensive increases in energy prices, but outside of the energy sector, if you look at core inflation, core inflation remains very well controlled. And as a result, the Fed Reserve has been able to raise interest rates from its low accommodative level, but to only 4 percent at this point. And the economy is growing strongly.

So I think this is an enormously good illustration of why keeping inflation low, stable and keeping expectations well-anchored is of tremendous benefit, not just on the inflation side, but also on the employment and growth side.

From the Q&A session

Transparency has an important role in helping the public understand policy intentions and policy goals. However, transparency should not be allowed to interfere with the decision-making process itself...One extreme form of transparency would be simply to televise the meeting at which the discussion takes place. My concern about that suggestion is that it would inhibit discussion, that it would affect the decision process, that it would create volatility in financial markets. 

My views on inflation targeting now are that it represents a continuity with the existing approach of the Federal Reserve System.  The existing approach of the Federal Reserve System focuses on maintaining medium- and long-term inflation stability as the primary contribution that the Fed can make to maintaining stability of the general economy.  We've seen, for example, in the last 20 years, that the economy's become more stable, that employment growth and output growth have been stronger and more stable, that recessions have been less frequent. I attribute that to the maintenance of stable inflation and inflation expectations.  So in that respect, the inflation targeting ideas that I've espoused simply are an attempt to perhaps codify or strengthen this important commitment of the Federal Reserve to maintaining low inflation.  I also think of [inflation targeting] as a continuation of the Fed's recent progress toward greater transparency in policymaking.  Over the past 10 years, the Fed has become incredibly more open about its processes, about its decision-making.  And I believe this is just a single step, and indeed just an incremental step, that would add to that transparency.  But in particular, I'd like to emphasize to those who may be concerned that I do in no way intend to make any significant change in the overall approach to monetary policy that was developed under Chairman Greenspan.

Since this is not a change in objectives or a change in fundamental operating procedure, in my view, the kinds of suggestions I am making would not require a change in the law. If I thought they did, I think I believe I would not follow them through, because I'm not interested in changing the mandate of the Federal Reserve.

In the past, when the inverted yield curve presaged a slowdown in the economy, it was usually in a situation where both long-term and short-term interest rates were actually quite high in real terms, suggesting a good bit of drag on the economy.  Currently, the short-term real interest rate is close to its average level and the long-term real interest rate is actually relatively low compared to historical norms.  And so with real interest rate not creating a drag on economic activity, I don't anticipate that the term structure is signal of oncoming slowing of the economy.

Today, we see oil prices going up, but we see very little response in wages and prices. We see overall inflation relatively stable. We don't have to have the same aggressive monetary policy response we had in the '70s. And that's a direct benefit of the improvement in inflation expectations that we've gotten in the last 30, 35 years.

Our expectation is that if and when the housing market slows, that savings rates will tend to rise. So we have built into the forecast, so to speak, some increase in personal saving.  As home values grow more slowly, then consumers can rely less on the increase in equity as a source of wealth-building and therefore must save more out of their current income. And, again, that's to be expected.  As I've indicated, our current expectation is that process will be gradual and is consistent with continued strong growth in the economy.  However, as I also indicated, the housing market and the consumer response to any changes in the housing market is one of the risks to the forecast and one that we'll be monitoring closely as we try to assess the state of the economy in the coming year.

The issue is not so much the change in China's portfolio; the issue really is the fact that we are consuming more than we are producing domestically. That means that foreign debt is increasing. And there may come a period or a time when foreigners are not willing to continue to add to their holdings of U.S. dollar assets. And that will, in turn, lead to perhaps an uncomfortable adjustment in the current account.

The question is, why are we allowing the portfolios to exist when they have as much inherent risk as they do. The question is, how much of the portfolio is necessary to fulfill the mission.  That is something that may require some judgment and analysis, but it seems clear that at the much smaller number than currently being held by the large GSEs.

I think that the financial markets are really very deep and liquid for U.S. dollar assets. If you include not only U.S. government debt, GSE debt, but also highly rated corporate debt, for example, the size of the market for high-rated U.S. dollar credit instruments is perhaps $40 trillion or something along those lines - would mean that China is only holding a few percentage points of that debt...I think that realistic changes in China's portfolio are not going to have major impacts on U.S. asset prices or interest rates. 

Savings glut - perhaps the terminology was unfortunate. In fact, the issue is the amount of global savings relative to the amount of global investment opportunities.  The most striking change in the past 10 or 12 years has been in emerging markets, particularly East Asia, which 10 to 12 years ago were large net borrowers on international capita markets and now are even much larger net lenders. And if you try to take apart the reasons for that change it's partly their very high rate of saving, but the change itself is due more to declines in investment, outside of China.  So part of the cause of this so-called global savings glut, I believe, is the financial crises of the late '90s, which reduced inflows of investment capital expenditure in some of these emerging market economies.  The oil producers also are playing a role here, because they are receiving all this oil money. They don't have sufficient opportunities at home for investment and therefore they too are recycling funds into the global capita markets.

It seems to be the case - there are some straws in the wind that housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate; that house prices will probably continue to rise but not at the pace that they had been rising.  So we expect the housing market to cool but not to change very sharply.  If the housing market does cool, more or less as expected, that would still be consistent with a strong economy. In 2006 and 2007, in particular, capital investment and other forms of demand would take up the slack left by residential investment.

But over a long period of time, a combination of higher national savings in the United States, increased demand by our trading partners and greater exchange rate flexibility - those three factors taken together will allow the current account deficit to come down in a way that I hope would not be disruptive to our economy.

On the minimum wage, it's actually a very controversial issue among economists. Clearly, if you raise the minimum wage, then those workers who retain their jobs will get higher income and therefore it helps them.  The concerns that some economists have raised about the minimum wage are first, is it as well targeted as it could be?  That is, how much of the increase is going to the teenage children of suburban families, for example?

And secondly, does it have any employment effects? That is, do higher wages lower employment of low-wage workers?

...The minimum wage affects a very small number of workers, actually, so I don't think it would affect a great majority of people that you're concerned about.

Inflation pressures increased in 2005. Steeply rising energy prices pushed up overall inflation, raised business costs, and squeezed household budgets. Nevertheless, the increase in prices for personal consumption expenditures excluding food and energy, at just below 2 percent, remained moderate, and longer-term inflation expectations appear to have been contained.

Rather, the Federal Reserve, together with all modern central banks, has found that the successful conduct of monetary policy requires painstaking examination of a broad range of economic and financial data, careful consideration of the implications of those data for the likely path of the economy and inflation, and prudent judgment regarding the effects of alternative courses of policy action on prospects for achieving our macroeconomic objectives. In that process, economic models can provide valuable guidance to policymakers, and over the years substantial progress has been made in developing formal models and forecasting techniques. But any model is by necessity a simplification of the real world, and sufficient data are seldom available to measure even the basic relationships with precision. Monetary policymakers must therefore strike a difficult balance--conducting rigorous analysis informed by sound economic theory and empirical methods while keeping an open mind about the many factors, including myriad global influences, at play in a dynamic modern economy like that of the United States.  Amid significant uncertainty, we must formulate a view of the most likely course of the economy under a given policy approach while giving due weight to the potential risks and associated costs to the economy should those judgments turn out to be wrong.

Similarly, the attainment of the statutory goal of moderate long-term interest rates requires price stability, because only then are the inflation premiums that investors demand for holding long-term instruments kept to a minimum.  In sum, achieving price stability is not only important in itself; it is also central to attaining the Federal Reserve's other mandated objectives of maximum sustainable employment and moderate long-term interest rates.

Another key factor in keeping core inflation low has been confidence on the part of the public and investors in the prospects for price stability. Maintaining expectations of low and stable inflation is an essential element in the Federal Reserve's effort to promote price stability. And, thus far, the news has been good: Survey measures of longer-term inflation expectations have responded only a little to the larger fluctuations in energy prices that we have experienced, and for the most part, they were low and stable last year. Inflation compensation for the period five to ten years ahead, derived from spreads between nominal and inflation-indexed Treasury securities, has remained well anchored.

Saving last year was probably further depressed by the rise in households' energy bills. Over the next few years, saving relative to income is likely to rise somewhat from its recent low level.

Nevertheless, the risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately--in the absence of countervailing monetary policy action--to further upward pressure on inflation. In these circumstances, the FOMC judged that some further firming of monetary policy may be necessary, an assessment with which I concur.

The hurricanes left an imprint on aggregate economic activity as well, seen, in part, in the marked deceleration of real GDP in the fourth quarter. However, the most recent evidence--including indicators of production, the flow of new orders to businesses, weekly data on initial claims for unemployment insurance, and the payroll employment and retail sales figures for January--suggests that the economic expansion remains on track.

Well, we are trying, and we have been for some time, to be transparent and as clear as we can about our strategy, our objectives and our approach. And one of the implications of that has been that interest rate moves have been highly predicted by the markets.  And I think as a general matter that that's good. It reduces volatility in financial markets and makes policy actually more effective.

Now, as I said, I think that we ought to work to reduce the current account deficit over time. I think that would reduce the possibility of an uncomfortable adjustment process. But again, as I said earlier...I don't think that the Chinese ownership of U.S. assets is so large as to put our country at risk economically.

From Q & A session

We think Basel II is very important because it will allow banks' capital holdings to be sensitive to the risks that they take, and that will be consistent with modern risk management techniques, so we think it's important to move forward with Basel II. But we don't see this as - we certainly don't want this to be the source of a significant reduction in aggregate capital in the U.S. banking system.

The general concern is that, if a commercial firm owns a bank, would there not be a possibility that the safety net would be inadvertently extended to the commercial firm? Would we be able to segregate the financial condition of the commercial firm from the bank? And would it be possible for not just the FDIC, but for any bank supervisor to adequately supervise not only the bank, but also the owning firm, to ensure that the safety and soundness rules were being met?

The widening deficits over a period of years will reduce national savings, will probably exacerbate the current account deficit, may raise interest rates and will probably inhibit the dynamism of the economy.

And the ability of the U.S. economy to generate ongoing productivity gains through use of technology, through the flexibility of our labor and capital markets has been most impressive. And we expect good productivity gains to continue for the next few years.

Lower inflation has been accompanied by inflation expectations that are not only lower but better anchored, so far as we can tell. Most striking, Greenspan's tenure aligns closely with the Great Moderation, the reduction in economic volatility I mentioned earlier, as well as with a strong revival in U.S. productivity growth--developments that had many sources, no doubt, but that were supported, in my view, by monetary stability. Like Volcker, Greenspan was ahead of academic thinking in recognizing the potential benefits of increased price stability.

Over a short period, then, higher inflation might bring lower unemployment, consistent with the empirical results found by Phillips. However, this logic applies only during the period in which wages and workers' expectations of inflation are fixed. If inflation were to rise persistently, Friedman and Phelps argued, workers' expectations of inflation would not remain unchanged but would adjust to match the actual rate of inflation...This work was both brilliant and prescient. In particular, among the seminal contributions of the Friedman and Phelps analyses was the identification of the key role of inflation expectations in determining the behavior of the economy, a point that remains central to our thinking today.

More recently, the evidence has mounted not only that low and stable inflation is beneficial for growth and employment in the long-term but also that it contributes importantly to greater stability of output and employment in the short to medium term. Specifically, during the past twenty years or so, in the United States and other industrial countries the volatility of both inflation and output have significantly decreased--a phenomenon known to economists as the Great Moderation (Bernanke, 2004). This finding challenges some conventional economic views, according to which greater stability of inflation can be achieved only by allowing greater fluctuations in output and employment. The key to explaining why price stability promotes stability in both output and employment is the realization that, when inflation itself is well-controlled, then the public's expectations of inflation will also be low and stable. In a virtuous circle, stable inflation expectations help the central bank to keep inflation low even as it retains substantial freedom to respond to disturbances to the broader economy.

The mandate of the Federal Reserve System has changed since the institution opened its doors in 1914. When the System was founded, its principal legal purpose was to provide "an elastic currency," by which was meant a supply of credit that could fluctuate as needed to meet seasonal and other changes in credit demand...  The Federal Reserve today retains important responsibilities for banking and financial stability, but its formal policy objectives have become much broader. Its current mandate, set formally in law in 1977 and reaffirmed in 2000, requires the Federal Reserve to pursue three objectives through its conduct of monetary policy: maximum employment, stable prices, and moderate long-term interest rates.

Price stability plays a dual role in modern central banking: It is both an end and a means of monetary policy.

Like Volcker, Greenspan was ahead of academic thinking in recognizing the potential benefits of increased price stability. Indeed, in recent years, academic research on monetary policy has caught up with the policymakers, providing new support for what I have termed the modern consensus, that price stability supports both strong growth and stability in output and employment.

Specifically, during the past twenty years or so, in the United States and other industrial countries the volatility of both inflation and output have significantly decreased--a phenomenon known to economists as the Great Moderation (Bernanke, 2004). This finding challenges some conventional economic views, according to which greater stability of inflation can be achieved only by allowing greater fluctuations in output and employment. The key to explaining why price stability promotes stability in both output and employment is the realization that, when inflation itself is well-controlled, then the public's expectations of inflation will also be low and stable. In a virtuous circle, stable inflation expectations help the central bank to keep inflation low even as it retains substantial freedom to respond to disturbances to the broader economy.

In principle, the problem of inflation could be reduced by the practice of indexing dollar payments such as interest and wages to the price level, but people seem to find indexing costly and avoid it when they can. It is interesting and instructive, for example, that the indexation of wages to prices in labor contracts has always been quite limited in the United States; some indexation was used during the high-inflation 1970s but the practice has been substantially reduced since then. Moreover, some countries that adopted indexing during high-inflation periods, such as Brazil and Israel, largely abandoned the practice when inflation receded.

With little confidence that the Fed would keep inflation low and stable, the public at that time reacted to the oil price increases by anticipating that inflation would rise still further. A destabilizing wage-price spiral ensued as firms and workers competed to "keep up" with inflation...

By contrast, the oil price increases of recent years appear to have had only a limited effect on core inflation (that is, inflation in the prices of goods other than energy and food), nor do they appear to have generated significant macroeconomic volatility. Several factors account for the better performance of the economy in the recent episode, including improvements in energy efficiency and in the overall flexibility and resiliency of the economy. But, the crucial difference from the 1970s, in my view, is that today inflation expectations are low and stable (as shown, for example, by many surveys and a variety of financial indicators). Oil price increases in the past few years, unlike in the 1970s, have not fed through to any great extent into longer-term inflation expectations and core inflation, as the public has shown confidence that any increases in inflation will be temporary and that, in the long run, inflation will remain low. As a result, the Fed has not had to raise interest rates sharply as it did in the 1970s but instead has been able to pursue a policy that is more gradual and predictable.

In financial terms, community banks remain quite strong, and there is considerable entry into the business. New technologies and management methods have eroded some of the traditional informational benefits of relationship finance, however, and community banks have lost market share to larger banks and to nondepository institutions. But the data also show that many customers want to be served locally; they value proximity and convenience. In my view, the strong relationships and personalized services provided by community banks remain an important reason for their continuing success.

The federal banking agencies have recently proposed guidance that would focus examiners' attention on those loans that are particularly vulnerable to adverse market conditions--that is, loans dependent primarily on the sale, lease, or refinancing of commercial property as the source of repayment.  I emphasize that, in proposing this guidance, supervisors are not aiming to discourage banks from making sound loans in commercial real estate or in any other loan category. Rather, we are affirming the need for each bank to recognize the risks arising from concentration and to have in place appropriate risk-management practices and capital levels.

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

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

I attribute the relatively low level of long-term rates generally to several factors, including a tendency in recent years for global saving to exceed the amount of potential capital investments, yielding historically normal rates of return as well as relatively low term premiums to interest rates to compensate investors for interest rate risk.  In the unlikely event that any of these factors tended to push real long-term yields to levels that appeared to be incompatible with our macroeconomic objectives, the Federal Reserve would respond by adjusting the stance of monetary policy appropriately.

I do support the Treasury's decision to resume issuance of thirty-year bonds.  Given the large current and prospective federal financing needs, it is prudent to distribute the Treasury's borrowing across the yield curve.  Moreover, long-term interest rates are currently quite low, apparently reflecting in part strong demand among investors for long-term issues.  In these circumstances, it is sensible for the Treasury to accommodate this demand in part by issuing thirty-year securities.

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

I am quite concerned about the intermediate to long-term federal budget outlook.  In particular, the budget is expected to come under severe pressure as impending demographic changes fuel rapid increases in entitlement spending.  By holding down the growth of national saving and real capital accumulation, the prospective increase in the budget deficit will place at risk future living standards of our country.  As a result, I think it would be very desirable to take concrete steps to lower the prospective path of the deficit.  Such actions would boost national saving and ultimately the future, prosperity of our country...Although the stock of debt held by the public would decline in absolute magnitude only if budget surpluses are run, fiscal actions that result in smaller deficits can slo the growth in the stock of debt held by the public and reduce the federal debt relative to the size of the economy.  The key is not so much the absolute level of federal debt, but rather that we take deficit-reducing steps to increase national saving and, hence, future living standars.

Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.

Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.

Finally, the yield curve is only one of the financial indicators that researchers have found useful in predicting swings in economic activity. Other indicators that have had empirical success in the past, including corporate risk spreads, would seem to be consistent with continuing solid economic growth. In that regard, the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook.

Given the global nature of the decline in yields, an explanation less centered on the United States might be required. About a year ago, I offered the thesis that a "global saving glut"--an excess, at historically normal real interest rates, of desired global saving over desired global investment--was contributing to the decline in interest rates. In brief, I argued that this shift reflects the confluence of several forces. On the saving side, the factors include rapid growth in high-saving countries on the Pacific Rim, export-focused economic development strategies that directly or indirectly hold back the growth of domestic demand, and the surge in revenues enjoyed by oil producers. On the investment side, notable factors restraining the global demand for capital include the legacy of the Asian financial crisis of the late 1990s, which led to continuing sluggishness in investment in some of those economies, and the slower growth of the workforce in many industrial countries. So long as these factors persist, global equilibrium interest rates (and, consequently, the neutral policy rate) will be lower than they otherwise would be.

Given this reality, policymakers are well advised to follow two principles familiar to navigators throughout the ages:  First, determine your position frequently. Second, use as many guides or landmarks as are available In the context of monetary policy, these principles suggest that policymakers should monitor bond yields carefully in judging the current state of the economy--but only in tandem with the signals from other important financial variables; direct readings on spending, production, and prices; and a goodly helping of qualitative information. Ultimately, a robust approach to policymaking requires the use of multiple sources of information and multiple methods of analysis, combined with frequent reality checks. By not tying policy to a small set of forecast indicators, we may sacrifice some degree of simplicity, but we are less likely to be misled when a favored variable behaves in an unusual manner.

Fourth and finally, as investors' demands for long-duration securities may have increased over the past few years, the supply of such securities seems not to have kept pace. The average maturity of outstanding Treasury debt, for example, has dropped by 1‑1/2 years since its peak in 2001, a trend just now beginning to turn with the Treasury's reissuance of the thirty-year bond. Corporations and households, however, have taken advantage of low long-term rates to lengthen the duration of their debt in recent years, which has compensated to some extent for the reduced duration of available Treasury debt.

I will conclude that the implications for monetary policy of the recent behavior of long-term yields are not at all clear-cut.

At least four possible explanations have been put forth for why the net demand for long-term issues may have increased, lowering the term premium. First, longer-maturity obligations may be more attractive because of more stable inflation, better-anchored inflation expectations, and a reduction in economic volatility more generally. With the benefit of hindsight, we now recognize that an important change occurred in the U.S. economy (and, indeed, in other major industrial economies as well) sometime in the mid-1980s. Since that time, the volatilities of both real GDP growth and inflation have declined significantly, a phenomenon that economists have dubbed the "Great Moderation"...  In that regard, it is interesting to observe that long-term forward rates were also low in the 1950s and 1960s. With long-term inflation expectations apparently anchored at low levels and with the prospect of continued economic stability, market participants may believe that it is appropriate to price bonds for an environment like that which prevailed four or five decades ago.

[P]olicy moved gradually, tightening in one-quarter point increments over fourteen successive meetings. Together with expanded communication, this gradual approach served to stabilize policy expectations and damp market volatility.

Providing information about the expected path of policy helped to ensure that long-term interest rates and other asset prices did not build in a projected pace of tightening that was more rapid than the Committee itself anticipated, and the statement's focus on the conditionality of future policy actions emphasized the ongoing need for both policymakers and financial market participants to respond to economic news. In retrospect, the clear communication of policy provided notable benefits, in my view, by increasing the effectiveness of monetary policy while minimizing unnecessary volatility in financial markets.

Changes in the management of and accounting for pension funds are a third possible source of a declining term premium. Reforms proposed in the United States, Europe, and elsewhere are widely expected to encourage pension funds to be more fully funded and to take steps to better match the duration of their assets and liabilities. Together with the increased need of aging populations in the industrial countries to prepare for retirement, these changes may have increased the demand for longer-maturity securities. We have seen little direct evidence to date of sizable pension-fund portfolio shifts toward long-duration bonds, at least in the United States. But judging from anecdotal reports, bond investors might be attaching significant odds to scenarios in which pension funds tilt the composition of their portfolios toward such assets substantially over time.

A second possible explanation of the evident decline in the term premium is linked to the increased intervention in currency markets by a number of governments, particularly in Asia. According to this explanation, foreign official institutions, primarily central banks, have invested the bulk of their greatly expanded dollar holdings in U.S. Treasuries and closely substitutable securities, and these demands by the official sector have put downward pressure on yields. This interpretation has some support, including research that I did with two coauthors that found that longer-term yields came under significant downward pressure during episodes of heavy official purchases of dollars in 2004...

However, these observations speak more to the existence of a short-term impact of large purchases and sales--the result of limits to liquidity in the very short run--than to the perhaps more important question of whether those transactions have a lasting effect on yields.

A reasonable conclusion is that the accumulation of dollar reserves abroad has influenced U.S. yields, but reserve accumulation abroad is not the only, or even the dominant, explanation for their recent behavior.

In the case of the crude oil market, some observers have attempted to attribute at least part of the increase in oil prices over the past few years to the activities of hedge funds and other speculative traders.  The apparent increased participation of these traders in the market, however, does not mean that their actions are actually responsible for the price run-up.  In fact, increases in oil prices probably encouraged the entry of speculative investors in the market. It may also be the case that these market participants have added liquidity to the market and have faciliated the price discovery process at a time when the balance of supply and demand in the physical oil market has undergone significant change.

The surge in energy prices since late 2003 has significantly reduced the purchasing power of households and decreased the profits of non-energy firms, thereby restraining both consumer spending and business investment. By rough estimate, these increases in energy prices have probably reduced real GDP growth between 1/2% and 1% per year over this period. Although some of this loss in output will be made up in the longer run as the U.S. economy adjusts to higher energy prices, the level of productivity is likely to remain lower than it otherwise would have been, as firms use less energy per worker.

Financially literate consumers make the financial marketplace work better, and they are better-informed citizens as well...I am personally convinced that improving education is vital to the future of our economy and that promoting financial literacy in particular must be a high priority.

As for inflation, the rise in energy costs has had a significant impact on overall or "headline" inflation and has likely also affected core inflation (which excludes the direct effect of energy price increases), although thus far the impact on core inflation appears to have been relatively modest. In the longer run, these inflation effects should fade even if energy prices remain elevated, so long as monetary policy keeps inflation expectations well-anchored by responding appropriately to future price and output developments.

The development of more and better data on economically distressed communities, together with sophisticated tools for analyzing those data, is essential for continued progress in community economic development.

The movement toward quantifying the performance, risk, and community impact of CDFIs [community development financial institutions] is essential to the growth and sustainability of the field, in my view. By demonstrating both financial viability and social impact through hard data, CDFIs are better positioned to obtain the funding necessary to maintain their operations and to respond to emerging needs and opportunities.

To reduce its dependence on foreign capital, the United States should take action to increase its national saving rate. The most direct way to accomplish this objective would be by putting federal government finances on a more sustainable path.

As foreign holdings of U.S. assets increase, at some point foreigners may become less willing to add these assets to their portfolios. While it is likely that current account imbalances will be resolved gradually over time, there is a small risk of a sudden shift in sentiment that could lead to disruptive changes in the value of the dollar and in other asset prices.

Even if in the Committee's judgment the risks to its objectives are not entirely balanced, at some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings, and the Committee will not hesitate to act when it determines that doing so is needed to foster the achievement of the Federal Reserve's mandated objectives.

Although pass-through from energy and commodity price increases to core inflation has thus far been limited, the risk exists that strengthening demand for final products could allow firms to pass on a greater portion of their cost increases in the future.

At this point, the available data on the housing market, together with ongoing support for housing demand from factors such as strong job creation and still-low mortgage rates, suggest that this sector will most likely experience a gradual cooling rather than a sharp slowdown. However, significant uncertainty attends the outlook for housing, and the risk exists that a slowdown more pronounced than we currently expect could prove a drag on growth this year and next.

Rising energy prices pose risks to both economic activity and inflation. If energy prices stabilize this year, even at a high level, their adverse effects on both growth and inflation should diminish somewhat over time. However, as the world has little spare oil production capacity, periodic spikes in oil prices remain a possibility.

The Federal Reserve has a three-part mandate: price stability, low/moderate long-term interest rates and maximum employment.  Clearly, keeping inflation low and stable addresses directly the first two of those, in particular, since long-term interest rates can only be low if investors expect inflation to remain low.  I would argue that there's very strong evidence that low and stable inflation and well-anchored inflation expectations also contributes mightily to the third objective which is strong and stable employment growth.

Based on the information in hand, it seems reasonable to expect that economic growth will moderate toward a more sustainable pace as the year progresses. In particular, one sector that is showing signs of softening is the residential housing market.

Our focus on core is mostly a technical thing because, generally speaking, energy and food prices are more volatile and tend to respond, tend to stabilize more quickly than other parts of the inflation basket.  That hasn't been true lately, as you know.  And we really need to pay attention, I think, to the overall inflation rate as well as the core inflation rate.

If we're going to address wages and in particular inequality in wages, we've got to do that, I would say on the supply side; that is, by addressing the skills gaps that exist among different groups of people in our society.

The US really can't solve the current account deficit problem by itself.  It is a global issue.  We need the cooperation of our trading partners.  And altogether, by taking actions which are in our own individual interests, we can also help create a better balance in terms of trade flows as well.

In particular, we do expect to see a slight slowing in growth, perhaps a couple tenths, this year and next, associated with the higher oil prices and their effects on consumer spending.  And we are very aware of that and are paying attention to those developments.

Federal Reserve Chairman Ben S. Bernanke said investors and the media misread his congressional testimony last week as meaning the Fed is done raising interest rates, CNBC reported.

Bernanke said economic data will determine the Fed's rate moves, CNBC anchor Maria Bartiromo said, citing a discussion she had with Bernanke at the White House Correspondents' Association dinner in Washington on April 29.

"I asked him whether the markets got it right after his Congressional testimony and he said, flatly, no,'' Bartiromo said. "He said he and his Federal Open Market Committee members were basically trying to create some flexibility for the Federal Reserve, saying the Fed may pause but the data will really dictate whether more rate hikes will occur.''

First of all, with respect to growth, I think we are following the path laid out by the Greenbook toward greater moderation in the second half. The main difference is that, since our last meeting, the uncertainty around that prospective path has increased. Obviously, the key to this moderation is the housing market, and fundamental analysis would suggest that the combination of high prices and rising interest rates would make affordability a problem and would bring housing starts and housing prices down. So far we are seeing, at worst, an orderly decline in the housing market; but there is still, I think, a lot to be seen as to whether the housing market will decline slowly or more quickly. As I noted last time, some correction in this market is a healthy thing, and our goal should not be to try to prevent that correction but rather to ensure that the correction does not overly influence growth in the rest of the economy.

Authorities cannot entirely eliminate systemic risk. To try to do so would likely stifle innovation without achieving the intended goal. However, authorities should (and will) try to ensure that the lapses in risk management of 1998 do not happen again.

Experienced investors know, or should know, that in any given year some hedge funds lose money for their investors and some funds go out of business. Those occurrences are only normal and to be expected in a competitive market economy. The Working Group's recommendations were aimed, instead, at ensuring that when hedge funds fail, as some inevitably will, the effects will be manageable and the potential for adverse consequences to the broader financial system or to real economic activity will be limited.

A key mechanism in Basel II for balancing the inevitable tensions that arise when attempting to achieve sometimes competing objectives is the so-called use test. Under the use test, the systems and processes that a bank uses for regulatory capital purposes must be consistent with those used internally. Note that I use the word "consistent," not "identical."

Financial education is a critical component of a robust and effective financial marketplace, but it is not a panacea. Clear disclosures, wise regulation, and vigorous enforcement are also essential to ensuring that financial service providers do not engage in unfair or deceptive practices. Even the most financially savvy consumer may fall victim to fraud or deception.

Bernanke said in response to questions about the Bartiromo affair, that what had happened was "a lapse in judgment on my part." He added, "in the future, my communications with the public and with the markets will be entirely through regular and formal channels.

It is reasonably clear that the US economy is entering a period of transition. For the past three years or so, economic growth in the United States has been robust, reflecting both the ongoing re-employment of underutilized resources as well as the expansion of the economy's underlying productive potential, as determined by factors such as productivity trends and the growth of the labor force...Real gross domestic product grew rapidly in the first quarter of this year, but the anticipated moderation of economic growth seems now to be under way.

Futures markets imply that oil prices are not expected to continue rising.  The realization of that outcome would reduce one source of upward pressure on inflation.  However the volatility of these and other commodity prices is such that possible future increases in these prices remain a risk to the inflation outlook.

The best way to prevent increases in energy and commodity prices from leading to persistently higher rates of inflation is by anchoring the public's long-term inflation expectations.  Achieving this requires, first, a strong commitment of policymakers to maintaining price stability, which my colleagues and I share, and second, a consistent pattern of policy responses to emerging development needed to accomplish that objective.

With the economy now evidently in a period of transition, monetary policy must be conducted with great care and with close attention to the evolution of the economic outlook as implied by incoming information. Given recent developments, the medium-term outlook for inflation will receive particular scrutiny.  There is a strong consensus among the members of the Federal Open Market Committee that maintaining low and stable inflation is essential for achieving both parts of the dual mandate assigned to the Federal Reserve by Congress...Therefore the Committee will be vigilant to ensure that the recent pattern of elevated monthly core inflation readings is not sustained. Toward this end, and taking full account of the lags with which monetary policy affects the economy, the Committee will seek a trajectory for the economy that aligns economic activity with underlying productive capacity.  Achieving this balance will foster sustainable growth and help to forestall one potential source of inflation pressure.  In addition, the Committee must continue to resist any tendency for increases in energy and commodity prices to become permanently embedded in core inflation.

Anecdotal reports suggest, however, that the labor market is tight in some industries and occupations and that employers are having difficulty attracting certain types of skilled workers.

While monthly inflation data are volatile, core inflation measured over the past three to six months has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth.

Globally, output growth appears poised to exceed 4 percent for the fourth consecutive year--a strong performance that will support the US economy by continuing to stimulate our exports of goods and services.

Longstanding concerns about global imbalances remain with us as well.  Along with greater national saving in the United States, increased domestic demand in countries with current account surpluses and a greater flexibility of exchange rates more broadly would help to reduce those imbalances over time.  Should US economic growth moderate as expected, sustaining the global expansion will require a greater reliance by our trading partners on their own domestic spending as a source of growth.

As had been expected, recent readings also indicate that the housing market is cooling, partly in response to increases in mortgage rates...A slowing real estate market will likely have the effect of restraining other forms of household spending as well, as homeowners no longer experience increases in the equity value of their homes at the rapid pace seen in recent years.

It bears emphasizing that productivity growth seems likely to remain strong, supported by the diffusion of new technologies. Capital investment, and the creative energies of businesses and workers.  Thus, productive capacity should continue to expand over the next few years at a rate consistent with solid growth of real output.

Both robust risk management and strong capital positions are critical to ensure that individual banking organizations operate in a safe and sound manner that enhances the stability of the financial system. More generally, strong capital helps banks absorb unexpected shocks and reduces the moral hazard associated with the federal safety net.

Despite the increased complexity of financial products and the wider availability of credit in many forms, U.S. households overall have been managing their personal finances well. On average, debt burdens appear to be at manageable levels, and delinquency rates on consumer loans and home mortgages have been low. Measured relative to disposable income, household net worth is at a fairly high level, although still below the peak reached earlier this decade.

But beginning around 2003, futures prices began moving up roughly in line with the rise in spot prices. Thus, unlike in earlier episodes, the significantly higher relative price of energy that we are now experiencing is expected to be relatively long lasting and thus will likely prompt more-significant adjustments by households and businesses over time.

In all likelihood, growth in the demand for energy will be tempered to some extent by continued improvements in energy efficiency which, in turn, will be stimulated by higher prices and ongoing concerns about the security of oil supplies. Such improvements are possible even without technological breakthroughs.

Today's proved reserve figures ignore not only the potential for new discoveries but also the likelihood that improved technologies and higher oil prices will increase the amount of oil that can be economically recovered.

In the short run, [energy] prices are likely to remain high in an environment of strong world economic growth and a limited ability to increase energy supplies. Moreover, prices are likely to be volatile in the near term, given the small margins of excess capacity to produce crude oil or natural gas that traditionally have buffered short-run shifts in supply and demand.

Natural gas prices are likely to remain elevated for at least the coming few years. It is possible, however, that within a decade new supplies from previously untapped areas of North America could boost available output here, while imports of LNG will increase to more substantial levels as countries seek to bring their isolated natural gas reserves to market. Given time, these developments could serve to lower natural gas prices in the United States significantly.

Energy prices have moved up considerably since the end of 2002, reflecting supply and demand factors. In the short run, prices are likely to remain high in an environment of strong world economic growth and a limited ability to increase energy supplies. Moreover, prices are likely to be volatile in the near term, given the small margins of excess capacity to produce crude oil or natural gas that traditionally have buffered short-run shifts in supply and demand. However, in the long run, market forces will respond. The higher relative prices of energy will create incentives for businesses to create new, energy-saving technologies and for energy consumers to adopt them.

The supply-demand fundamentals seem consistent with the view now taken by market participants that the days of persistently cheap oil and natural gas are likely behind us.

As yet, these [inflation] expectations measures have remained within the ranges in which they have fluctuated in recent years and inflation compensation implied by yields on government debt has fallen back somewhat in the past month. Nevertheless, these developments bear watching.

In the long run, higher energy prices are likely to reduce somewhat the productive capacity of the U.S. economy. That outcome would occur, for example, if high energy costs make businesses less willing to invest in new capital or cause some existing capital to become economically obsolete. All else being equal, these effects tend to restrain the growth of labor productivity, which in turn implies that real wages and profits will be lower than they otherwise would have been. Also, the higher cost of imported oil is likely to adversely affect our terms of trade; that is, Americans will have to sell more goods and services abroad to pay for a given quantity of oil and other imports. For the medium term at least, the higher bill for oil imports will increase the U.S. current account deficit, implying a greater need for foreign financing.

Although the rate of pass-through of higher energy and other commodity prices to core consumer price inflation appears to have remained relatively low in the current episode--reflecting the inflation-fighting credibility built by the Fed in recent decades the cumulative increases in energy and commodity prices have been large enough that they could account for some of the recent pickup in core inflation.

It is a tribute to the underlying strength and resiliency of the U.S. economy that it has been able to perform well despite the drag from increased energy prices.

Under the assumption that energy prices do not move sharply higher from their already high levels, these long-run effects, though clearly negative, appear to be manageable.

The US economy appears to be in a period of transition.  For the past three years or so, economic growth in the United States has been robust.  This growth has reflected both the ongoing re-employment of underutilized resources, as the economy recovered from the weakness of earlier in the decade, and the expansion of the economy's underlying productive potential, as determined by such factors as productivity trends and growth of the labor force.  Although the rates of resource utilization that the economy can sustain cannot be known with any precision, it is clear that, after several years of above-trend growth, slack in resource utilization has been substantially reduced.  As a consequence, a sustainable, non-inflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past three years to a pace more consistent with the rate of increase in the nation's underlying productive capacity.

As I have noted, the anticipated moderation in economic growth now seems to be under way, although the recent erratic growth pattern complicates this assessment.

Home prices, which have climbed at double-digit rates in recent years, still appear to be rising for the nation as a whole, though significantly less rapidly than before.

With a few exceptions, business inventories appear to be well aligned with sales, which reduces the risk that a buildup of unwanted inventories might act to reduce production in the future.

Growth of the global economy will help support US economic activity by continuing to stimulate demand for our exports of goods and services.

Anecdotal reports suggest that the labor market is tight in some industries and occupations and that employers are having difficulty attracting certain types of skilled workers.  To date, however, moderate growth in most broad measures of nominal labor compensation and the ongoing increases in labor productivity have held down the rise in unit labor costs, reducing pressure on inflation from the cost side.

The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth.  In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still "in the pipeline."

Futures quotes imply that market participants expect petroleum prices to roughly stabilize in coming quarters; such an outcome would, over time, reduce one source of upward pressure on inflation.  However, expectations of a leveling out of oil prices have been consistently disappointed in recent years, and as the experience of the past week suggests, possible decreases in these and other commodity prices remain a risk to the inflation outlook.

I would agree that we have essentially removed that extraordinary degree of monetary policy accommodation, and we're much more in the more normal range of interest rates at this point.

The increase in inflation we have seen is a much broader phenomenon than that single component [owner-occupied equivalent rent in the CPI].  If that single component was the only issue, I would think twice. But I do see movements in inflation in a broad range of goods and services.

And so, one of the benefits, I think, of a more open trading system, a more open economy, where we compete with and trade with countries around the world, despite the fact that it does create stress and sometimes changes and dislocations, is that competition forces productivity gains and has been, I think, a source of growth for us as well as for our trading partners.

Well, I think that the risk that we are considering -- and again, it's just a risk, that inflation might move up and might force us to be more aggressive, which we don't want to do, because we hope that inflation will stay under control and come down as we expect it to -- I think that is a risk.

And so this increase in energy prices and commodity prices certainly has been a significant contributor [to inflation]. And I think that we wouldn't really be talking about this now if energy prices were still $30 or $40 a barrel.

However, from a current account perspective, if we look forward five or 10 years, at the rate we're going, there will be increasing reluctance of foreigners to hold USD -- that will have effects on our economy. We need to address that.

I think [the number of jobs that must be created monthly to maintain constant employment] is dropping. I would say now it's more like 130,000. And within the next few years, it might be down to 100,000...This is all based on research at the Federal Reserve on labor participation rates, which suggest that  we'll be seeing, over the next 10 years, some significant decline from the current about 66 percent of the adult population is in the labor force.  We expect to see that coming down and, therefore, the number of jobs a month we need to keep the unemployment rate is constant is likely to fall as well.

To the extent that the Fed's credibility is strong and people think that inflation will be low in the long term, when energy price increases hit, it causes a temporary burst of inflation. But if nobody expects it to continue, then it will just moderate away and we don't get into this pattern of having to raise rates a lot and getting into an inflationary situation.

[In response to the question, What do you see as the single biggest threat to the continuation of that expansion?]
One would be that we would have an inflationary problem which is greater than we now expect.  And the other would be energy prices coming from geopolitical  concerns or other sources.

FOMC participants project that the growth in economic activity should moderate to a pace close to that of the growth of potential both this year and next.  Should that moderation occur as anticipated, it should help to limit inflation pressures over time.

As you know, the Federal Reserve has argued for a substantial time that the portfolios are larger than is needed to serve the fundamental housing mission of the GSEs.  And my advice would be not to set a hard cap or a number -- you know, restrict the portfolio in that way -- but to give strong guidance to the regulator about how to relate the portfolio to the mission of the GSEs...By grounding the size of the portfolio in the mission of the agency, you would bring down, over time, the portfolio, to a safer level and not hurt the underlying mission of the GSE.

The U.S. economy appears to be in a period of transition... [I]t is clear that, after several years of above-trend growth, slack in resource utilization has been substantially reduced.  As a consequence, a sustainable, non-inflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past three years to a pace more consistent with the rate of increase in the nation's underlying productive capacity.

The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still "in the pipeline." ...

...[P]olicy must be flexible and ready to adjust to changes in economic projections. In particular, as the Committee noted in the statement issued after its June meeting, the extent and timing of any additional firming that may be needed to address inflation risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by our analysis of the incoming information.

If you look even today at the futures markets, the futures markets predict energy prices will be relatively flat over the next couple of years. If you take that forecast as correct, then today's core inflation rate is actually a reasonable forecast of tomorrow's total inflation rate if energy prices do, in fact, flatten out as the markets seem to expect.

With respect to wages, there are alternative measures of wages that give somewhat different answers, but I agree that, for example, that average hourly earnings for production workers as measured by the payroll survey has not shown real gains.  And one of the key problems there, it's important to note, is, in fact, the increase in energy prices. So what people get at the pay stub, they lose at the gas pump.

The increase in energy prices is clearly making the economy worse off, both in terms of real activity and in terms of inflation. There's no question about it.

I expect wages to rise, and I do think that higher real wages are completely compatible with low inflation.

It's possible to overtighten and to have the growth be slower than potential. It's also possible to not sufficiently address inflation problems and inflation rises. That both cuts into buying power, and it also creates the risks that the Fed would have to raise interest rates more later.

The purchase of a bank by a commercial firm violates the separate of banking and commerce, and so I wouldn't advise allowing that. But if you do allow it, then it would be better to have consolidated supervision, which includes an overview of the financial condition of the parent - that is, the commercial firm - as well as of the ILC subsidiary.

I’m concerned with alternative D because, besides raising the rate to 5.50, it signals further increases. After seventeen consecutive moves, we would be tightening into a housing decline. We don’t have that much confidence that we need to be so strong at this point. Signaling a strong concern about inflation but being more cautious in groping for the optimal level of the interest rate is probably a wiser course. I remind you that the Fed has not been terribly successful with soft landings. We have a chance to get one. All else being equal, I think it would be good if we could achieve that.

Therefore, the rapid pace of house price appreciation in recent years likely contributed to the decline in the saving rate.  Similarly, the cooling of the housing market and associated reduction in capital gains on housing will probably provide some upward impetus to the saving rate.  Even so, as I said in my testimony, rising disposable incomes should enable household spending to expand at a moderate pace and provide continued support for the overall economic expansion.

Rising disposable incomes should enable household spending to expand at a moderate pace and provide continued support for the overall economic expansion.

Further progress in global economic integration should not be taken for granted, however. Geopolitical concerns, including international tensions and the risks of terrorism, already constrain the pace of worldwide economic integration and may do so even more in the future. And, as in the past, the social and political opposition to openness can be strong. Although this opposition has many sources, I have suggested that much of it arises because changes in the patterns of production are likely to threaten the livelihoods of some workers and the profits of some firms, even when these changes lead to greater productivity and output overall. The natural reaction of those so affected is to resist change, for example, by seeking the passage of protectionist measures. The challenge for policymakers is to ensure that the benefits of global economic integration are sufficiently widely shared--for example, by helping displaced workers get the necessary training to take advantage of new opportunities--that a consensus for welfare-enhancing change can be obtained.

The Fed, in the short run, tolerates the pressure rising energy prices exert on headline price measures, Mr. Bernanke said. "Our objective is to make sure it doesn't pass through into other wages and prices, in other words, that there are not second-round effects," he said.

"In the long run, what we would like to control is headline inflation," Mr. Bernanke said, "After all, that's what is determining the value of money, and it's what people need for their planning," along with being the force that "affects real wages and real incomes," he said.

"It is very difficult to eliminate the inflationary impact of the immediate effects of an increase in energy prices," he said. "Doing so would require forcing down wages and other prices quite dramatically to keep the overall price level from rising."

From Q&A session reported by the Wall Street Journal

One leading explanation for the strong U.S. productivity growth is that labor markets in the United States tend to be more flexible and competitive, market characteristics that have allowed the United States to realize greater economic benefits from new technologies.  For example, taking full advantage of new information and communication technologies may require extensive reorganization of work practices, the reassignment and retraining of workers, and ultimately some reallocation of labor among firms and industries.  Regulations that raise the costs of hiring and firing workers and that reduce employers’ ability to change work assignments--like those that exist in a number of European countries--may make such changes more difficult to achieve. 

To make effective use of such a technology within a specific firm or industry, however, managers must supplement their purchases of new equipment with investments in firm- or industry-specific research and development, worker training, and organizational redesign--all examples of what economists call intangible capital.  Although investments in intangible capital are, for the most part, not counted as capital investment in the national income and product accounts, they appear to be quantitatively important.  One recent study estimated that, by the late 1990s, investments in intangible capital by U.S. businesses were as large as investments in traditional tangible capital such as buildings and machines (Corrado, Hulten, and Sichel, 2006).

Recognizing the importance of intangible capital has several interesting implications.  First, because investment in intangible capital is typically treated as a current expense rather than as an investment, aggregate saving and investment may be significantly understated in the U.S. official statistics.  Second, firms’ need to invest in intangible capital--and thus to divert resources from the production of market goods or services--helps to explain why measured output and productivity may decline or grow slowly during the period after firms adopt new technologies.  Finally, the concept of intangible capital may shed light on the puzzle of why productivity growth has remained strong despite the deceleration in IT investment.  Because investments in high-tech capital typically require complementary investments in intangible capital for productivity gains to be realized, the benefits of high-tech investment may become visible only after an extended period during which firms are making the necessary investments in intangibles.

On net, the recent experience does not appear to require a significant rethinking of long-term productivity trends.  Indeed, recent estimates by leading economists continue to peg the expected longer-term rate of productivity growth at roughly 2-1/2 percent per year.

If current trends continue, the typical U.S. worker will be considerably more productive several decades from now.  Thus, one might argue that letting future generations bear the burden of population aging is appropriate, as they will likely be richer than we are even taking that burden into account.  On the other hand, I suspect that many people would agree that a fair outcome should involve the current generation shouldering at least some of that burden, especially in light of the sacrifices that previous generations made to give us the prosperity we enjoy today.

Perhaps the most straightforward way to raise national saving--although not a politically easy one--is to reduce the government’s current and projected budget deficits.  To the extent that reduced government borrowing allows more private saving to be used for capital formation or to acquire foreign assets, future U.S. output and income will be enhanced and the future burdens associated with demographic change will be smaller.

Mr. Bernanke, answering questions after a speech in Washington, said the housing sector is undergoing a "substantial correction" that will likely shave about "a percentage point off growth in the second half of the year" from what it would otherwise have been "and probably something going into next year as well," estimates close to private forecasters' views. Mr. Bernanke also said there is "limited evidence" the falloff in housing activity had spilled over to other parts of the economy. "To this point, other parts of the economy are remaining relatively strong."

As reported by the Wall Street Journal

We do believe that inflation is going to be coming down gradually over time, but it is something that we have to watch very carefully to make sure that it doesn't rise or even remain where it is.

From the Q&A session, as reported by Bloomberg News

[D]evoting resources to improving our K-12 education system, expanding access to community colleges, increasing on-the-job training, and stimulating basic research could augment the nation’s capital in the broadest sense of the term and might have desirable distributional effects as well.

Although demographic change will affect many aspects of the government’s budget, the most dramatic effects will be seen in the Social Security and Medicare programs, which provide income support and medical care for retirees and which have until now been funded largely on a pay-as-you-go basis.  Under current law, spending on these two programs alone will increase from about 7 percent of the U.S. gross domestic product (GDP) today to almost 13 percent of GDP by 2030 and to more than 15 percent of the nation’s output by 2050.  The outlook for Medicare is particularly sobering because it reflects not only an increasing number of retirees but also the expectation that Medicare expenditures per beneficiary will continue to rise faster than per capita GDP.  For example, the Medicare trustees’ intermediate projections have Medicare spending growing from about 3 percent of GDP today to about 9 percent in 2050--a larger share of national output than is currently devoted to Social Security and Medicare together. 

[T]he aging of the population is likely to lead to lower average living standards than those that would have been experienced without this demographic change.

Good regulatory and supervisory policies should implement congressional intent in ways that maximize social benefits and minimize social costs. The regulatory burden on banks is not the only element of social cost, but it is an important component. Accordingly, in developing regulatory and supervisory policies, the Federal Reserve and the other banking agencies will continue to pay close attention to the implications of those policies for regulatory burden, competitiveness, and efficiency in banking.

We have also been working to promote a level playing field internationally for U.S. banking organizations that adopt Basel II. Indeed, maintaining competitive equity was one of our key motivations for developing Basel II jointly with foreign supervisors through the Basel Committee. More recently, we have been working through the Basel Committee's Accord Implementation Group to mitigate home-host conflicts while promoting consistent implementation of Basel II internationally.

Despite these efforts, some significant differences do exist between the United States and other countries in the proposed implementation of Basel II's advanced approaches, beyond the transitional safeguards. Early comments on the Basel II NPR suggest that, whatever the merits of these international differences in rules, they are likely to add to implementation costs and home-host issues, particularly for globally active banks operating in multiple jurisdictions. Before we issue a final rule, we intend to review all international differences to assess whether the benefits of rules specific to the United States outweigh the costs. In particular, we will look carefully at differences in the implementation of Basel II that may adversely affect the international competitiveness of U.S. banks.

The growth of subprime mortgage lending is one indication of the extent to which access to credit has increased for all households, including those with lower incomes...

Although the emergence of risk-based pricing has increased access to credit for all households, it has also raised some concerns and questions, which are magnified in the case of lower-income borrowers.

Monetary policy is a blunt tool that cannot target industries, population groups, or regions. In contrast, as you know, CDFIs operate primarily at the microeconomic level, community by community. Using techniques such as financial counseling, local market research, and specialized lending, CDFIs work with partners in both the public and the private sectors to help unlock the economic potential of lower-income and underserved communities.

If you condition monetary policy strictly on expectations you're going to get a hall of mirrors problem, and it's not a good idea, to put it mildly...

We do look at expectations.  We think it's informative in a number of ways.  But we certainly don't substitute expectations data for more fundamental analysis of inflation. 

From the Q&A session.

The closest the Federal Reserve came to a "monetarist experiment" began in October 1979, when the FOMC under Chairman Paul Volcker adopted an operating procedure based on the management of non-borrowed reserves.11 The intent was to focus policy on controlling the growth of M1 and M2 and thereby to reduce inflation, which had been running at double-digit rates.  As you know, the disinflation effort was successful and ushered in the low-inflation regime that the United States has enjoyed since.  However, the Federal Reserve discontinued the procedure based on non-borrowed reserves in 1982. 

Why have monetary aggregates not been more influential in U.S. monetary policymaking, despite the strong theoretical presumption that money growth should be linked to growth in nominal aggregates and to inflation?  In practice, the difficulty has been that, in the United States, deregulation, financial innovation, and other factors have led to recurrent instability in the relationships between various monetary aggregates and other nominal variables. 

...Board staff developed the so-called P* (P-star) model, based on M2, which used the quantity theory of money and estimates of long-run potential output and velocity (the ratio of nominal income to money) to predict long-run inflation trends.  The P* model received considerable attention both within and outside the System; indeed, a description of the model was featured in a front-page article in the New York Times. ¹³

Unfortunately, over the years the stability of the economic relationships based on the M2 monetary aggregate has also come into question.  One such episode occurred in the early 1990s, when M2 grew much more slowly than the models predicted. Indeed, the discrepancy between actual and predicted money growth was sufficiently large that the P* model, if not subjected to judgmental adjustments, would have predicted deflation for 1991 and 1992.  Experiences like this one led the FOMC to discontinue setting target ranges for M2 and other aggregates after the statutory requirement for reporting such ranges lapsed in 2000.

Despite these difficulties, the Federal Reserve will continue to monitor and analyze the behavior of money.  Although a heavy reliance on monetary aggregates as a guide to policy would seem to be unwise in the U.S. context, money growth may still contain important information about future economic developments.  Attention to money growth is thus sensible as part of the eclectic modeling and forecasting framework used by the U.S. central bank.

Over the next year or so, the economy appears likely to expand at a moderate rate, close to or modestly below the economy's long-run sustainable pace. Core inflation is expected to slow gradually from its recent level, reflecting the reduced impetus from high prices of energy and other commodities, contained inflation expectations, and perhaps further reductions in the rate of increase of shelter costs and some easing in the pressures on capital and labor resources. However, substantial uncertainties surround this baseline forecast.

In the medium term, because the factors that affect potential output and thus aggregate supply also tend to affect aggregate demand, slower growth of potential output does not necessarily mean that inflation will be higher or that monetary policy will have to be tighter.  Rather, the implications for monetary policy of a possible slowing in the growth of potential output depend on the extent to which such a slowing alters the balance of supply and demand in the economy. For example, as we saw in the second half of the 1990s, changes in expected productivity growth and potential output can significantly affect aggregate demand through their influences on income expectations and asset prices. The problem for policymakers is to identify, in real time, any changes in the prospective growth rate of potential output and to anticipate the accompanying effects on the balance of supply and demand.

With regard to the labor force, research by the Board's staff highlights the role of demographic factors in determining the number of people available to work in the years just ahead. Most notably, the impending retirement of the baby boomers and the fact that women are no longer increasing their participation in the labor force at the rate they were in the past will tend to restrain the future growth rate of the U.S. labor force. All else being equal, these developments translate into a slower rate of growth of potential output.

Although residential construction continues to sag, some indications suggest that the rate of home purchase may be stabilizing, perhaps in response to modest declines in mortgage interest rates over the past few months and lower prices in some markets. Sales of new homes ticked up in August and increased a bit further in September. The University of Michigan's survey of consumers shows an increase in the share of respondents who believe that now is a good time to buy a home, from 57 percent in September to 67 percent in November.

[T]he level of the core inflation rate remains uncomfortably high.

As slack in the economy is reduced, however, economic growth tends to moderate. Indeed, at that stage, some slowing of growth to a pace consistent with the rate of increase in the nation's underlying productive capacity is necessary if the expansion is to be sustained without a buildup in inflationary pressures. In my testimony to the Congress in July, as part of the Federal Reserve's semiannual monetary policy report, I noted that the U.S. economy had entered this transition phase, and that some moderation of economic growth over the remainder of the year seemed likely.

The deceleration in economic activity currently under way appears to be taking place roughly along the lines envisioned in the Federal Reserve's July report. As anticipated, the slowdown primarily reflects a cooling of the housing market. Most other sectors of the economy appear still to be expanding at a solid rate, and the labor market has tightened further.

How can China direct a greater share of its output to domestic consumption? Again, increased flexibility in the exchange rate could help. As the Chinese trade surplus has continued to widen, many analysts have concluded that the RMB is undervalued. Indeed, the situation has likely worsened recently; because of the RMB's link to the dollar, its trade-weighted effective real exchange rate has fallen about 10 percent over the past five years. Allowing the RMB to strengthen would make imports of consumer goods (as well as capital goods) into China less expensive. Greater scope for market forces to determine the value of the RMB would also reduce an important distortion in the Chinese economy, namely, the effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market.

Further appreciation of the RMB, combined with a wider trading band and with the ultimate goal of a market-determined exchange rate, would allow an effective and independent monetary policy and thereby help to enhance China's future growth and stability.

The information, expertise, and powers that the Fed derives from its supervisory authority enhance its ability to contribute to efforts to prevent financial crises; and, when financial stresses emerge and public action is warranted, the Fed is able to respond more quickly, more effectively, and in a more informed way than would otherwise be possible.

In the remainder of my remarks, I will discuss some economies of scope arising from the combination of bank supervision and other central bank responsibilities...

My point today is a narrower one:  that the supervisory authority of the Fed has significant collateral benefits in helping it carry out its responsibilities for financial stability.  In particular, the information, expertise, and powers that the Fed derives from its supervisory authority enhance its ability to contribute to efforts to prevent financial crises; and, when financial stresses emerge and public action is warranted, the Fed is able to respond more quickly, more effectively, and in a more informed way than would otherwise be possible. 

[T]he Fed has unique powers to provide liquidity to the financial system, through means that include open-market purchases, discount-window loans, and intra-day overdrafts. 

The Fed undertook similar discussions with other supervisors and with financial firms in response to the failure of Drexel Burnham Lambert in 1990 and the collapse of Long Term Capital Management (LTCM) in 1998.  As the condition of Drexel deteriorated, other firms became less willing to trade with it, making it difficult to wind down its positions in an orderly manner (Breeden, 1990).  Because of the Federal Reserve’s ongoing supervisory relationships with the main clearing banks and its detailed knowledge of the payments system, the Fed was able to address the banks’ concerns and facilitate the liquidation of Drexel’s positions (Greenspan, 1994).  In the case of LTCM, the Federal Reserve had the credibility with large financial firms to facilitate a discussion, from which emerged a private-sector solution that helped to avoid potential market disruptions (Greenspan, 1998).

Official projections suggest that the unified budget deficit may stabilize or moderate further over the next few years. Unfortunately, we are experiencing what seems likely to be the calm before the storm. In particular, spending on entitlement programs will begin to climb quickly during the next decade. In fiscal 2006, federal spending for Social Security, Medicare, and Medicaid together totaled about 40 percent of federal expenditures, or roughly 8-1/2 percent of GDP.² In the most recent long-term projections prepared by the Congressional Budget Office (CBO), these outlays are projected to increase to 10-1/2 percent of GDP by 2015, an increase of about 2 percentage points of GDP in less than a decade. By 2030, according to the CBO, they will reach about 15 percent of GDP.

To some extent, strong economic growth can help to mitigate budgetary pressures, and all else being equal, fiscal policies that are supportive of growth would be beneficial. Unfortunately, economic growth alone is unlikely to solve the nation's impending fiscal problems.

[T]he unified budget deficit does not fully capture the fiscal situation and its effect on the economy, for at least two reasons.

First, the budget deficit by itself does not measure the quantity of resources that the government is taking from the private sector. An economy in which the government budget is balanced but in which government spending equals 20 percent of GDP is very different from one in which the government's budget is balanced but its spending is 40 percent of GDP, as the latter economy has both higher tax rates and a greater role for the government. Monitoring current and prospective levels of total government outlays relative to GDP or a similar indicator would help the Congress ensure that the overall size of the government relative to the economy is consistent with members' views and preferences.

Second, the annual budget deficit reflects only near-term financing needs and does not capture long-term fiscal imbalances. As the most difficult long-term budgetary issues are associated with the growth of entitlement spending, a comprehensive approach to budgeting would include close attention to measures of the long-term solvency of entitlement programs, such as long-horizon present values of unfunded liabilities for Social Security and Medicare.

Although average economic well-being has increased considerably over time, the degree of inequality in economic outcomes has increased as well. Importantly, rising inequality is not a recent development but has been evident for at least three decades, if not longer.

The challenge for policy is not to eliminate inequality per se but rather to spread economic opportunity as widely as possible.  Policies that focus on education, job training, and skills and that facilitate job search and job mobility seem to me to be a promising means for moving toward that goal.

I agree that derivatives are an incredibly important part of our expanding financial market, part of financial innovation, and I would like to see the United States remain competitive in those areas...

From Senate Q&A session.

Readings on core inflation--that is, inflation excluding the prices of food and energy--have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated...

A waning of the temporary factors that boosted inflation in recent years will probably help foster a continued edging down of core inflation...  The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated. 

In the statement accompanying last month's policy decision, the FOMC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected and that it is prepared to take action to address inflation risks if developments warrant.

Monetary policy affects spending and inflation with long and variable lags. Consequently, policy decisions must be based on an assessment of medium-term economic prospects. At the same time, because economic forecasting is an uncertain enterprise, policymakers must be prepared to respond flexibly to developments in the economy when those developments lead to a re-assessment of the outlook. The dependence of monetary policy actions on a broad range of incoming information complicates the public's attempts to understand and anticipate policy decisions.

Clear communication by the central bank about the economic outlook, the risks to that outlook, and its monetary policy strategy can help the public to understand the rationale behind policy decisions and to anticipate better the central bank's reaction to new information.

We do not have any fixed speed limit in mind when we think about the economy going forward. We do not have any fixed number for the unemployment rate.

Rather, we are looking at the overall balance of supply and demand, looking at the evolution of inflation, and trying to ensure that there's a reasonable balance between demand and supply so that our economy can continue to grow at a sustainable, moderate pace going forward.

From the Senate Q&A session

So we believe {counterparty risk management} is a very important and, so far, successful method of overseeing hedge funds. I would be very reluctant to get involved in heavy-handed, direct regulation of hedge funds.

They are a very diverse group of institutions. They have a wide variety of strategies, and one of their key characteristics is that they're very nimble. They change very quickly, and that's good for the economy, because they help to create more liquidity in markets. They help to spread risks around more broadly.

From Senate Q&A session

The approach that regulators have taken since the report of the president's working group after the LTCM crisis has been a market-based approach, an indirect regulation approach, whereby we put a lot of weight on good risk management by the counter-parties to the hedge funds, such as the prime dealers, the lenders, as well as the good oversight of the investors, the institutions and so on that invest in hedge funds.

 And we found that that's a very useful way to control leverage and to provide market discipline on those funds.

The original report of the president's working group also suggested disclosures, and that never went anywhere in Congress. And I think part of the problem was it was difficult to agree upon what should be disclosed and what would be useful.

The hedge funds are naturally reluctant to disclose proprietary information about their trading strategies and approaches, and their positions change very quickly, and so therefore position information can be overwhelming and perhaps not very useful. I think it's important to continue to think about hedge funds.

     They certainly play an important role in our financial system. Exactly what a disclosure regime would look like, though, is not yet clear to me how that best would be organized.

Well, in the short term, the demand for oil is inelastic, that is, it doesn't respond much to price changes. And so, when there are fluctuations in availability of oil, you get these big spikes and movements in oil prices. And we've seen quite an increase in oil prices over the last few years, as you know.

Over the longer term, higher oil prices actually have a benefit, which is they encourage conservation and they encourage alternative supply sources.

Coal, of course, is actually a very promising source. It's, of course, a traditional source of energy, but assuming we can find ways to address the environmental implications, and there are many promising directions there, coal could be a very big part of our energy diversification in the future.

So my expectation is that as long as the markets are allowed to work, together with some support for research and development from the government, together with clear and effective regulation, that we will solve our energy problems and that that solution is going to come not just from one single magic bullet, it's going to come from a wide variety of different alternative sources, including, I think, coal.

On the minimum wage, economists generally agree that a higher minimum wage will have an adverse effect on employment of low- skilled members, but they disagree extremely on how big that effect would be, some saying it would be very small, others saying it would be more significant.

So I can only say that, probably, there would be some employment effect, but it's very difficult to know how big it would be.

There has been a surge in delinquencies and foreclosures, particularly, as I mentioned in my testimony, in sub-prime lending with variable rates, rates that adjust with short-term interest rates.

 And that is a concern to us. We certainly have been following it carefully. It's obviously very bad for those who borrowed on those circumstances, and it's not good for the lenders either, who are taking losses. We have tried, together with the other banking agencies, to address some of these concerns. We recently issued a guidance on nontraditional mortgages, which had three major themes.

The first was that lenders should underwrite properly, that is they should make sure that borrowers had the financial capacity to pay even when rates go up, and not simply underwrite based on the initial rate - deal with the possible payment shock.

Secondly, that lenders should give a full disclosure and make sure that people understand the terms of the mortgages they're getting into. And I would add that the Federal Reserve provides a number of documents, booklets and descriptions that are required to be included along with mortgage applications for adjustable rate mortgages.

 And thirdly - and this is more on the issue of the lenders rather than the borrowers - that lenders should make sure that they appropriately risk manage these exotic mortgages, which we don't have much experience with and so some caution is needed, as we're now seeing, in managing them.

[F]irst, China is a very large country and it should, at some point, have an independent monetary policy of its own, rather than being tied to the United States. In order to do that, they have to have a flexible currency.

Secondly, the flexibility in the yuan is needed to accomplish to accomplish this rebalancing from export orientation to domestic demand that I was referring to earlier.

And thirdly, yuan appreciation and flexibility would make some contribution to helping us to rebalance the current account deficit we currently have, although I think the larger force, quantitatively, would be the rebalancing of demand from exports toward domestic demand in China.

In House Q&A session.

To some extent, the declining relative position of the American exchanges reflects the natural growth and development of exchanges abroad, in London, in Asia and so on. And as those economies, those exchanges become larger, more efficient, deeper, that's actually not a bad thing, because it gives, for example, American companies more alternatives for raising money.

 On the other hand, to the extent that business is being drive off shore by high regulatory costs, as was the conclusion of these two recent studies on capital market competitiveness, then that's a problem, and we need to begin to address those costs.

The Sarbanes-Oxley issue that you raised earlier has been cited by a number of these studies, and the SEC and the Public Company Accounting Oversight Board have recently issued a new audit standard which will attempt to reduce the costs of implementing Sarbanes-Oxley's Section 404 on internal controls, and in particular to make it more focused on the most important matters, rather than on trivial matters, and also more appropriate for smaller and less complex firms.

 So I think that's going to be an important step in reducing that particular set of costs.

Because of demographic changes and rising medical costs, federal expenditures for entitlement programs are projected to rise sharply over the next few decades. Dealing with the resulting fiscal strains will pose difficult choices for the Congress, the Administration, and the American people. However, if early and meaningful action is not taken, the U.S. economy could be seriously weakened, with future generations bearing much of the cost. The decisions the Congress will face will not be easy or simple, but the benefits of placing the budget on a path that is both sustainable and meets the nation's long-run needs would be substantial.

[S]cenarios that project large deficits also project rapid growth in the outstanding government debt.  The higher levels of debt in turn imply increased expenditures on interest payments to bondholders, which exacerbate the deficit problem still further.  Thus, a vicious cycle may develop in which large deficits lead to rapid growth in debt and interest payments, which in turn adds to subsequent deficits.  According to the CBO projection that I have been discussing, interest payments on the government's debt will reach 4-1/2 percent of GDP in 2030, nearly three times their current size relative to national output.  Under this scenario, the ratio of federal debt held by the public to GDP would climb from 37 percent currently to roughly 100 percent in 2030 and would continue to grow exponentially after that.  The only time in U.S. history that the debt-to-GDP ratio has been in the neighborhood of 100 percent was during World War II.  People at that time understood the situation to be temporary and expected deficits and the debt-to-GDP ratio to fall rapidly after the war, as in fact they did.  In contrast, under the scenario I have been discussing, the debt-to-GDP ratio would rise far into the future at an accelerating rate.  Ultimately, this expansion of debt would spark a fiscal crisis, which could be addressed only by very sharp spending cuts or tax increases, or both. 

It's true that the empirical evidence suggests that the link is looser, that there's less responsiveness of inflation to employment conditions than there perhaps may have been in past decades.

My own view is that we should take a very eclectic approach in thinking about inflation.

I look at the state of the economy. I try to assess whether demand is exceeding supply in some sense; whether the financial conditions are promoting growth in demand which is greater than the productive capacity of the economy.  But I also look at a wide variety of indicators, including commodity prices, including financial indicators like bond rates and inflation compensation.

I don't think we can rely on any single indicator, particularly one like the natural rate of unemployment concept. It's very difficult to know. Even if there is such a relationship, it's very difficult to assess in real time where that number might be.

And so we really have no alternative but to look at, you know, many indicators -- including {commodity prices} -- to try to assess where inflation's going.

From the Q&A session

I should say that I view inflation objectives and the like as being part of the communication tool kit that a central bank may have to try to explain to the markets and to the public what its approach is, what its plans are and how it sees the economy.

We are currently, in the Federal Open Market Committee, conducting a zero-based review of our communications policies, looking at, among them, numerical objectives for inflation, but many other approaches as well, to try to provide more information to the public about our plans and our approach.

So in terms of specifics, I think I would leave that open because our committee has not yet decided what approaches we want to take.

From the Q and A session

I should first point out that it's not in the interest of China or Japan to dump treasuries on the market. They, themselves, would suffer capital losses from doing that.

I do think if there were -- and I should be very clear, I have not information or expectation this is going to happen. But if there were significant sales by foreign central banks, for example, that there would be some short-run effect on the market, in terms of the currency and interest rates probably.

I think the longer-term effect would be somewhat less because the market would adjust. It is a liquid market. And the holdings of, say, China of U.S. debt securities, including both public and nonpublic, is only about 5 percent of the total credit market outstanding.

BERNANKE: I think it would be extraordinarily difficult to move that far to on-budget surplus in a few years, within five years.

ANDREWS: But if it were, would it be a positive development?

BERNANKE: Well, we would have to -- the Federal Reserve would have to offset the short-term spending effects of that with lower interest rates. But that would be...

ANDREWS: Do you promise us lower interest rates if we do that?  Is that what I just heard?

     (LAUGHTER)

BERNANKE: If you do that, we will do our best.  But what we would do is we would respond in such a way as to try and keep the economy at full employment.

It's true that the empirical evidence suggests that the link is looser, that there's less responsiveness of inflation to employment conditions than there perhaps may have been in past decades.

My own view is that we should take a very eclectic approach in thinking about inflation.

From the Q&A session

Our assessment, though -- while this is a very important problem and an issue, obviously, for many people who are facing foreclosure, our assessment is that there's not much indication at this point that subprime mortgage issues have spread into the broader mortgage market, which still seems to be healthy and the lending side of that still seems to be healthy.

From the Q&A session

I will say that the Federal Reserve, in collaboration with the president's working group, has been closely monitoring the markets. They seem to be working well, normally.

We've also, of course, been closely monitoring the economy, looking at new data and trying to evaluate their implications for the forecast.

And my view is that taking all the new data into account that there is really no material change in our expectations for the U.S. economy since I last reported to Congress a couple of weeks ago in the Humphrey-Hawkins hearings.

 ...We are looking for moderate growth in the U.S. economy going forward.  And I would add, parenthetically, that the downward revision of the fourth quarter GDP numbers we got this morning is actually more consistent with our overall view of the economy than were the original numbers.

...So we expect moderate growth going forward. We believe that if the housing sector begins to stabilize and if some of the inventory corrections that are still going on in manufacturing begin to be completed, that there's a reasonable possibility that we'll see some strengthening of the economy sometime during the middle of the year.

During Q&A session.

"To the extent that there is a relationship between economic slack more broadly, and I mean not just labor market conditions, but capital and product market conditions as well, it's become a much weaker relationship. That is, the relationship between slack and slower inflation is clearly lower than it used to be. So that connection is much weaker and there are other factors that seem to play an important role.''

     ``The other problem with using this natural rate concept actively is that a lot of research, some of it at the Federal Reserve Board, has shown that in real time we have a really hard time determining what the natural rate is, if such a thing exists.

     ``And in particular, with demographic changes, changes in the labor market, all kinds of other things, you wouldn't expect a measure of slack to be constant. So what we do at the Federal Reserve is, we really have to be very eclectic.''

     ``We don't rely on any single indicator, on any single measure. We look at a wide variety of indicators.''

     ``The economy is just too complicated now to rely on any single indicator.''

From the audience Q and A session, as reported by Bloomberg News

The empirical literature supports the view that U.S. monetary policy retains its ability to influence longer-term rates and other asset prices. Indeed, research on U.S. bond yields across the whole spectrum of maturities finds that all yields respond significantly to unanticipated changes in the Fed’s short-term interest-rate target and that the size and pattern of these responses has not changed much over time. Empirical studies also find that U.S. monetary policy actions retain a powerful effect on domestic stock prices.

"There's still some overstatement'' {in the CPI} by about half to a full percentage point, Bernanke said."

"Clearly, when the Fed looks at inflation measures, we do have to look at more than one measure to get a sense of what inflation is doing."

From the audience Q and A, as reported by Bloomberg News

The competition fostered by trade should also promote productivity growth, reducing growth in costs and making the attainment of low inflation easier. That productivity growth is linked to the intensity of competition is plausible, and more-rapid productivity growth seems to help to explain the slowing of inflation in the United States in the mid-1990s. However, the fact that most other industrial countries did not experience the same increase in productivity growth as the United States during that period, even as they became more open to trade, suggests that the relationship between productivity and trade may be complex.

Recently, however, several researchers affiliated with the Bank for International Settlements (BIS) have reported results favorable to the global output gap hypothesis (Borio and Filardo, 2006). Using data for sixteen industrialized countries (plus the euro area) for 1985-2005, they found significant effects of the global output gap on domestic inflation rates--indeed, effects that were generally larger than those of domestic output gaps and that were rising over time. This provocative result has in turn been challenged by Federal Reserve Board researchers, who find that the empirical support for a role for the global output gap does not survive modest changes in the way the data are analyzed. As domestic output gaps are difficult to measure, even with the benefit of hindsight, it is perhaps not surprising that measuring and assessing the effects of a global output gap have proved contentious.

[I]mported goods make up only part of what people consume, and so the effect on overall inflation is less than the deceleration in the prices of imports alone. Typical estimates of the short-term effect on the overall inflation rate of less-rapid increases in the prices of imports stemming from trade with China are in the neighborhood of 0.1 percent or less per year--a discernable but certainly not a large effect.

Rogoff (2003) provides an alternative theory of how globalization may affect the central bank’s inflation objective. He argues that deregulation and international integration have led to more flexible prices, so that any attempt by a central bank to stimulate the real economy by allowing inflation to rise unexpectedly will be less effective than it would have been in the past. Because central banks have less incentive to create unexpected inflation, their promises to keep inflation low are more credible, which in turn reduces the cost of keeping inflation low. Accordingly, in Rogoff’s analysis, globalization has led monetary authorities to maintain lower long-term inflation rates. A criticism of this story is that it implies that the Phillips curve is steeper today than in the past (that is, that inflation is more sensitive to slack in the economy), a prediction that does not accord with most empirical studies.

More subtly, a central bank following a strategy of “opportunistic disinflation” might react to a favorable shock to supply or prices by lowering its medium-term objective for inflation (Orphanides and Wilcox, 2002). In the case of a central bank pursuing such a strategy, foreign factors that depress domestic inflation may have a persistent effect so long as inflation exceeds the central bank’s long-term objective.

Recent research suggests another possibility, which is that U.S. monetary policy actions may have significant effects on foreign yields and asset prices as well as on domestic financial prices. For example, changes in U.S. short-term interest rates seem to exert a substantial influence on euro area bond yields and appear to have a strong effect on foreign equity indexes as well.  In contrast, the effects of foreign short-term rates on U.S. asset prices appear to be relatively weaker. These cross-border effects of policy, and their asymmetric nature, are somewhat puzzling. One would expect a more symmetric relationship between the United States and the euro area, for example, as the two regions are of comparable economic size. It will be interesting to see if these relationships persist.

However, the conclusion that inflation is determined only by monetary policy choices need not hold in the short-to-medium run. In the shorter term, central banks do not usually offset completely the effects of shocks to supply or prices--of which a change in the relative price of imports is an example--in part because any monetary action made in response will take time to be effective.

The Fed’s ability to set the short-term interest rate independently of foreign financial conditions depends critically, of course, on the fact that the dollar is a freely floating currency whose value is continuously determined in open, competitive markets. If the dollar’s value were fixed in terms of another currency or basket of currencies, the Fed would be constrained to set its policy rate at a level consistent with rates in global capital markets. Because the dollar is free to adjust, U.S. interest rates can differ from rates abroad, and, consequently, the Fed retains the autonomy to set its federal funds rate target as needed to respond to domestic economic conditions.

The establishment of a clear and credible GSE receivership process, the second element, is needed to create market discipline for these companies.  Reform legislation should establish (1) a well-defined and mandatory process for placing a GSE in receivership and (2) a method for resolving a GSE once it is placed in receivership.  Both parts are necessary for the receivership process to be meaningful and credible.  Market participants should clearly understand that, once certain conditions arise, regulatory forbearance will be impermissible and a GSE receivership will be established.  Importantly, the GSE receivership process should include a mechanism for ensuring that both the shareholders and creditors of a failed GSE will bear financial losses.  Only if GSE debt holders are persuaded that the failure of a GSE will subject them to losses will they have an incentive to exert market discipline.

A straightforward means of anchoring the GSE portfolios to a clear public mission would be to require Fannie and Freddie to focus their portfolios almost exclusively on holdings of mortgages or mortgage-backed securities that support affordable housing.  The evolution of mortgage markets since the GSEs were created strongly suggests that a concentration on affordable-housing products would provide the greatest public benefit.  

Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.

{The President's Working Group on Financial Markets} did not have a meeting on February 27. It's a usual practice, whenever there is some stress in financial markets, for the staff, the senior staff or deputies to be in touch with each other just to see what are you seeing, what are you seeing, just trying to gather information to see if anything is going on.

I'd say it would be more accurate to say we are looking for a bit more flexibility, given the uncertainties that we are facing and the risks that are occurring on both sides of our outlook.

An additional point. We, in general, this is more technical, but we, in general, prefer not to give advance rate guidance, that is, not to tell the market we're going to do this, that and the other. Rather, it's better for the FOMC to describe our outlook and the risks that we see for the outlook and let the markets make their own determination about how to price assets. One aspect of this change has been to move away from forward rate guidance, which we view as being something that should be undertaken mostly under unusual circumstances.

...

Our statement included a description both of the situation on the real side of the economy and on the inflation side and our sense was both, that the risks had increased on both sides, that the outlook for output was a bit weaker, as we indicated in our statement, but that, also, the inflation situation had become slightly riskier, as well. And so both sides of the mandate have -- are facing somewhat greater risks.

From the Q&A session

Even if the demand for housing falls no further, weakness in residential construction is likely to remain a drag on economic growth for a time as homebuilders try to reduce their inventories of unsold homes to more normal levels.

Neutral policy would be one where there is a sense that the risks are weighted equally on both sides of the dual mandate and, therefore, policy is essentially unpredictable. It depends on events as they come forward.

Our general outlook, the contour of how we expect the economy to evolve, is very much unchanged, at least it's not materially changed. In particular we expect the economy to continue to grow at a moderate pace. We expect to see some strengthening later on as the housing market returns to something closer to equilibrium. And we expect inflation to moderate gradually. But as I discussed this morning, we do see risks to all of those forecasts.

From the Q&A session

Because core inflation is above the levels most conducive to the achievement of sustainable growth and price stability, the Committee indicated in the statement following its recent meeting that its predominant policy concern remains the risk that inflation will fail to moderate as expected. However, the uncertainties around the outlook have increased somewhat in recent weeks. Consequently, the Committee also indicated that future policy decisions will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

Our statement included a description both of the situation on the real side of the economy and on the inflation side and our sense was both, that the risks had increased on both sides, that the outlook for output was a bit weaker, as we indicated in our statement, but that, also, the inflation situation had become slightly riskier, as well.

From Q&A session

Whether, and if so, how to try to differentiate "good" from "bad" lending in the CRA context is an issue that is likely to challenge us for some time.    

Credible receivership provisions for insolvent banks are another method of enhancing market discipline. Effective market discipline requires that uninsured investors believe they could lose some, or all, of their stake. This belief is especially important in the case of very large banks, which investors may otherwise perceive to be too big to fail. Receivership rules that make clear that investors will take losses when a bank becomes insolvent should increase the perceived risk of loss and thus also increase market discipline.

In the United States, the banking authorities have ensured that, in virtually all cases, shareholders bear losses when a bank fails. Historically, however, bondholders and uninsured depositors have at times doubted that regulators would impose significant losses on them in the event of a bank’s failure. To address this issue, the Congress has reduced regulators’ discretion when dealing with troubled banks. For example, the requirement for prompt corrective action prohibits regulatory forbearance when a bank’s capital falls to a predetermined level; and the least-cost-resolution requirement compels regulators to resolve a troubled bank at the lowest cost to the deposit insurance fund.²

Regulatory oversight of hedge funds is relatively light. Because hedge funds deal with highly sophisticated counterparties and investors, and because they have no claims on the federal safety net, the light regulatory touch seems largely justified.

Thus far, the market-based approach to the regulation of hedge funds seems to have worked well, although many improvements can still be made (Bernanke, 2006). In particular, risk-management techniques have become considerably more sophisticated and comprehensive over the past decade. To be clear, market discipline does not prevent hedge funds from taking risks, suffering losses, or even failing--nor should it. If hedge funds did not take risks, their social benefits--the provision of market liquidity, improved risk-sharing, and support for financial and economic innovation, among others--would largely disappear.

In response to this series of financial panics, the Congress in 1913 founded the Federal Reserve to provide the nation with a safer, more flexible, and more stable monetary and financial system. Specifically, the Fed was established "to furnish an elastic currency, to afford means of rediscounting commercial paper, [and] to establish a more effective supervision of banking in the United States."

I have argued today that, in many situations, regulation that relies on the invisible hand of market-based incentives can complement direct government regulation.  For market-based regulation to work, the incentives of investors and other private actors must align with the objectives of the government regulator.  In particular, private investors must be sophisticated enough to understand and monitor the financial condition of the firm and be persuaded that they will experience significant losses in the event of a failure.  When these conditions are met, market discipline is a powerful and proven tool for constraining excessive risk-taking.  

Bernanke said "there is no indication (the Chinese) are thinking of radically changing their composition of assets" and to back away quickly from their U.S. holdings would "not be in their interest." He added the threat of China moving away from U.S. assets is not "a significant risk."

As reported by Dow Jones News

...I believe that helping young people become financially literate is critical for their future economic well-being and should be a high priority for educators. 

Although expansion of trade makes the U.S. economy stronger...the broad benefits of trade and the associated economic change may come at a cost to some individuals, firms, and communities.  We need to continue to find ways to minimize the pain of dislocation without standing in the way of economic growth and change.

Of course, current trading arrangements are far from perfect. Some features of the world trading regime, such as excessive restrictions on trade in services and the uneven protection of intellectual property rights, are both unfair and economically counterproductive.    

I will argue that one possible response to the dislocations that may result from trade--a retreat into protectionism and isolationism--would be self-defeating and, in the long run, probably not even feasible. Instead, our continued prosperity depends on our embracing the many opportunities provided by trade, even as we provide a helping hand to individuals and communities that may have suffered adverse consequences.

The effects of trade on employment must also be put in the context of the remarkable dynamism of the U.S. labor market. The amount of "churn" in the labor market--the number of jobs created and destroyed--is enormous and reflects the continuous entry, exit, and resizing of firms in our ever-changing economy. Excluding job layoffs and losses reversed within the year, over the past decade an average of nearly 16 million private-sector jobs have been eliminated each year in the United States, an annual loss equal to nearly 15 percent of the current level of nonfarm private employment.⁶ The vast majority of these job losses occur for a principal reason other than international trade (Kletzer, 2001; Bernanke, 2004).  Moreover, during the past ten years, the 16 million annual job losses have been more than offset by the creation of about 17 million jobs per year--some of which, of course, are attributable to the direct and indirect effects of trade. Truly, the U.S. labor market exhibits a phenomenal capacity for creative destruction.

Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or institution. Rather, we should strive to develop common, principles-based policy responses that can be applied consistently across the financial sector to meet clearly defined objectives.

In thinking about how, or whether, to regulate innovative financial institutions (such as hedge funds) or instruments (such as credit derivatives), we should be wary of drawing artificial distinctions. Are the characteristics of hedge funds or credit derivatives that arouse concern peculiar to these institutions and instruments, or are they associated with others as well? If the characteristics in question are in fact a feature of the broader financial landscape, then a narrowly focused approach to regulation will be undermined by the incentives such an approach creates for regulatory arbitrage.

For example, while the complexity of new financial instruments and trading strategies is potentially a concern for policy, as I will discuss, not all credit derivatives are complex and--to state the obvious--not all complex financial instruments are linked to credit risk. Single-name credit default swaps and credit default swap indexes are relatively simple instruments, whereas derivatives based on other asset classes--such as exotic interest-rate and foreign-exchange options--can, by contrast, be quite complex. Moreover, derivatives in general are not necessarily more complex than some types of structured securities. In short, if complexity per se is the concern, we cannot address that concern by focusing on a single class of financial instruments. Similarly, hedge funds are hardly a homogeneous group of institutions, nor can their trading strategies be unambiguously distinguished from those of large global banks or of some traditional asset managers. A consistent regulatory strategy needs to be tailored to the essential characteristics of institutions or instruments that pose risks for policy objectives, not to arbitrary categories.

The goal of regulation should be to preserve those [economic] benefits while achieving important public policy objectives, including financial stability, investor protection, and market integrity. Although financial innovation promotes those objectives in some ways, for example by allowing better sharing of risks, certain aspects of financial innovation--including the complexity of financial instruments and trading strategies, the illiquidity or potential illiquidity of certain instruments, and explicit or embedded leverage--may pose significant risks. These risks should not be taken lightly.

Market liquidity depends not only on the presence of willing buyers and sellers but also on the underlying infrastructure, including market-making capacity and the system for clearing and settling financial transactions. Twenty years ago this fall, the 1987 stock market crash was significantly worsened by the inability of trade-processing systems to keep up with order flows, including orders resulting from program trading.

Some commentators have sought to draw a sharp distinction between the approach to financial regulation in the United States and that in the United Kingdom. These observers have characterized the British approach as being principles-based and as using a "light touch"--the implication being that these two features somehow go together. In a speech in February of this year, Sir Callum McCarthy, the head of the United Kingdom's Financial Services Authority (FSA), took issue with this interpretation.¹ Sir Callum confirmed that the FSA's approach is built on a framework of principles, although he noted that the FSA also has an 8,500-page rulebook to accompany the eleven principles it has laid out. But the FSA head rejected the view that their approach is "light touch." Rather, he said, it is risk-based, which means that regulatory resources and attention are devoted to firms, markets, or instruments in proportion to the perceived risks to the FSA's regulatory objectives.

...I have argued today that we should strive to implement a regulatory regime that is principles-based, risk-focused, and consistently applied. Enhancing market discipline can complement and strengthen such an approach. As in the United Kingdom, a principles-based approach is not inconsistent with the use of rules, which can provide needed clarity or a safe haven from legal and regulatory risks. However, rules should implement principles rather than develop in an ad hoc manner.

Of course, in some respects financial innovation makes risk management easier. Risk can now be sliced and diced, moved off the balance sheet, and hedged by derivative instruments. Indeed, the need for better risk sharing and risk management has been a primary driving force behind the recent wave of innovation. But in some respects, new instruments and trading strategies make risk measurement and management more difficult. Notably, risk-management challenges are associated with the complexity of contemporary instruments and trading strategies; the potential for market illiquidity to magnify the riskiness of those instruments and strategies; and the greater leverage that their use can entail.

At last year's conference, I discussed a policy proposal focused narrowly on hedge funds--namely, the development of a database of hedge fund positions and portfolios. As I noted last year, given the complexity of trading strategies and the rapidity with which positions change, creating a database that would be sufficiently timely and detailed to be of practical use to hedge funds' creditors and investors or to regulators would be extremely difficult. Collecting such information also risks moral hazard, if some traders conclude that, in gathering the data, the regulators have somehow reduced financial risk.

[W]e believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well.

Real gross domestic product has expanded a little more than 2 percent over the past year, compared with an average annual growth rate of 3-3/4 percent over the preceding three years.  The cooling of the housing market is an important source of this slowdown.  Sales of both new and existing homes have dropped sharply from their peak in the summer of 2005, the inventory of unsold homes has risen substantially, and single-family housing starts have fallen by roughly one-third since the beginning of 2006.  Although a leveling-off of sales late last year suggested some stabilization of housing demand, the latest readings indicate a further stepdown in the first quarter.  Sales of new homes moved down to an appreciably lower level in February and March, and sales of existing homes have also come down on net since the beginning of this year.

...given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.  The vast majority of mortgages, including even subprime mortgages, continue to perform well.  Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable.

What about borrowers already in distress?  The Board and other federal supervisory agencies have taken actions to encourage the banks and thrift institutions we supervise to work with borrowers who may be having trouble meeting their mortgage obligations.  Often, loan workouts are in the interest of both parties.  With effective loan restructuring, borrowers facing temporary economic setbacks may be able to work through their problems while staying in their homes, and lenders may be able to avoid the costs of foreclosure and the losses usually associated with selling a repossessed home.

Credit market innovations have expanded opportunities for many households. Markets can overshoot, but, ultimately, market forces also work to rein in excesses. For some, the self-correcting pullback may seem too late and too severe. But I believe that, in the long run, markets are better than regulators at allocating credit. We at the Federal Reserve will do all that we can to prevent fraud and abusive lending and to ensure that lenders employ sound underwriting practices and make effective disclosures to consumers. At the same time, we must be careful not to inadvertently suppress responsible lending or eliminate refinancing opportunities for subprime borrowers.

The Federal Reserve is also authorized to write rules; notably, the Home Ownership Equity Protection Act (HOEPA) gives the Board the power to prohibit acts and practices in mortgage lending deemed "unfair" or "deceptive."

Then as now, the principal path to opportunity is through education. As an economist, I am persuaded that a strong educational system--one that promotes lifetime learning and skill development--is a critical factor in our nation's prosperity. The economic importance of education will only increase as technology advances and as the global economy becomes increasingly integrated and complex.

The Board believes the rise in subprime foreclosures needs to be addressed in a way that preserves incentives for responsible subprime lenders so that borrowers with non-prime credit can become homeowners, access the equity in their homes, or have flexibility in financing their mortgages when necessary.

Tighter lending standards in the subprime mortgage market--together with the possibility that the well-publicized problems in this market may dissuade potentially eligible borrowers from applying--will serve to restrain housing demand, although the magnitude of these effects is difficult to quantify.  Subprime and near-prime mortgage originations rose sharply in 2004 and 2005 and likely accounted for a large share of the increase in the number of home sales over that period.  However, originations of nonprime mortgages to purchase homes appear to have peaked in late 2005 and declined substantially since then, and by more (even in absolute terms) than prime mortgage originations.  Thus, some part of the effect on housing demand of the retrenchment in the subprime market has likely already been felt.  Moreover, indicators such as the gross issuance of new subprime and near-prime MBS suggest that the supply of nonprime mortgage credit, though reduced, has by no means evaporated.  That said, the tightening of terms and standards now in train may well lead to some further contraction in nonprime originations in the period ahead.  We are also likely to see further increases in delinquencies and foreclosures this year and next as many subprime adjustable-rate loans face interest-rate resets.

Under the Home Ownership Equity Protection Act (HOEPA), the Board has the responsibility to prohibit mortgage lending practices that it finds to be unfair and deceptive.

We will follow developments in the subprime market closely. However, fundamental factors--including solid growth in incomes and relatively low mortgage rates--should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.

[A]lthough core inflation seems likely to moderate gradually over time, the risks to this forecast remain to the upside.  In particular, the continuing high rate of resource utilization suggests that the level of final demand may still be high relative to the underlying productive capacity of the economy.

Growth during the first quarter of this year was held down by some factors--notably, significant declines in inventory accumulation, net exports, and federal defense spending--that seem likely to be at least partially reversed in the near term. Of course, the adjustment in the housing sector is still ongoing, and the slowdown in residential construction now appears likely to remain a drag on economic growth for somewhat longer than previously expected. Thus far, however, we have not seen major spillovers from housing onto other sectors of the economy. On average, over coming quarters, we expect the economy to advance at a moderate pace, close to or slightly below the economy’s trend rate of expansion.

Just as a healthy financial system promotes growth, adverse financial conditions may prevent an economy from reaching its potential.  A weak banking system grappling with nonperforming loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth.  Japan faced just this kind of challenge when the financial problems of banks and corporations contributed substantially to sub-par growth during the so-called "lost decade." 

Similar logic explains the finding that inflation is less responsive than it used to be to changes in oil prices and other supply shocks. Certainly, increases in energy prices affect overall inflation in the short run because energy products such as gasoline are part of the consumer's basket and because energy costs loom large in the production of some goods and services. However, a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent "wage-price spiral." With inflation expectations well anchored, a one-time increase in energy prices should not lead to a permanent increase in inflation but only to a change in relative prices. A related implication is that, if inflation expectations are well anchored, changes in energy (and food) prices should have relatively little influence on "core" inflation, that is, inflation excluding the prices of food and energy.

I pose three questions to researchers, the answer to any of which would be quite useful for practical policymaking.

First, how should the central bank best monitor the public's inflation expectations?  ... Do we need new measures of expectations or new surveys? Information on the price expectations of businesses--who are, after all, the price setters in the first instance--as well as information on nominal wage expectations is particularly scarce.

Second, how do changes in various measures of inflation expectations feed through to actual pricing behavior?...

Third, what factors affect the level of inflation expectations and the degree to which they are anchored?...

 Interestingly, however, the system approach does not seem to forecast price inflation as well as single-equation Phillips curve models do. This weaker performance appears to reflect, at least in part, the shortcomings of the available data on labor compensation. The two principal quarterly indicators of aggregate hourly compensation are the employment cost index (ECI) and nonfarm compensation per hour (CPH). Both are imperfect measures of the labor costs relevant to pricing decisions. For example, the ECI's fixed employment and occupation weights may not reflect changes in the labor market, and the ECI excludes stock options and similar forms of payment. CPH is volatile, perhaps in part because it measures stock options at exercise rather than when granted, and it is subject to substantial revisions. Moreover, these two hourly compensation measures often give contradictory signals.

Indeed, considerable progress has been made in recent years, at the Board and elsewhere, in developing dynamic stochastic general equilibrium (DSGE) models detailed enough for policy application. These models have become increasingly useful for policy analysis and for the simulation of alternative scenarios. They are likely to play a more significant role in the forecasting process over time as well, though, like other formal methods, they are unlikely to displace expert judgment.

I don’t think there has been a strong tendency to follow periods of high inflation with periods of abnormally low inflation, which is what a price level targeting regime would do. Rather, I would say, although there is kind of a mixture, I’m sure, I think the weight is probably greater on stabilizing inflation per se, and as you know arithmetically what that implies is that if you have an accidental inflation rate above your expectation, then you try to get inflation back down to your normal rate and that would tend to raise prices in the longer term. I’m quite aware that there’s a big debate about what the best way to go is… The advantage of price level targeting obviously is that people know what the value of money is going to be ten years from now whereas with inflation stabilization they may not know that. There are disadvantages though, including the fact that you may have to have periods of deflation or very sharp disinflation that may be destabilizing. So there are arguments on both sides of that, but I think if you looked at the data I think you’d find that most of that surprise would persist in later price levels. Not even later inflation rates, let me be clear, but in later price levels.

The Board staff employs a variety of formal models, both structural and purely statistical, in its forecasting efforts. However, the forecasts of inflation (and of other key macroeconomic variables) that are provided to the Federal Open Market Committee are developed through an eclectic process that combines model-based projections, anecdotal and other "extra-model" information, and professional judgment. In short, for all the advances that have been made in modeling and statistical analysis, practical forecasting continues to involve art as well as science.

An indirect but elegant way to make the point that inflation expectations remain imperfectly anchored comes from a statistical analysis of inflation by Stock and Watson (2007). Stock and Watson model inflation as having two components, which may be interpreted as the trend and the cycle. Changes in the trend component are highly persistent whereas shocks to the cyclical component are temporary.²  The key finding of this research is that the variability of the trend component of inflation (and thus the share of the overall variability of inflation that it can explain) appears to have fallen significantly after about 1983. That is, unexpected changes in inflation are today much more likely to be transitory than they were before the early 1980s. Because it seems quite unlikely that changes in inflation could persist indefinitely unless long-run expectations of inflation also changed, I interpret the Stock-Watson finding as consistent with the view that inflation expectations have become much more anchored since the early 1980s.

Monetary policy, or the short-term interest rate, is not a good tool for leaning against or trying to pop asset price bubbles for a variety of reasons, including the fact that it is very difficult for us to know when an asset price is in a bubble; it’s very hard to know how the asset price would react to increases in interest rates; it’s hard to know what to do when some asset prices might be in bubbles and others not; it’s a concern what would happen to the real economy if you raise interest rates a lot to pop a bubble and the higher interest rates have adverse effects on the real economy. So there a lot of unknowns and uncertainties that make me very cautious and conservative about thinking about using monetary policy to address asset prices.

 Likewise, a lower sensitivity of long-run inflation to supply shocks would imply that such shocks are much less likely to generate economic instability today than they would have been several decades ago. Notably, the sharp increases in energy prices over the past few years have not led either to persistent inflation or to a recession, in contrast (for example) to the U.S. experience of the 1970s.

The fact that there are some very wealthy people doesn't necessarily make me or you worse off if they're creating value. You know, I'm a baseball fan. I like to watch Alex Rodriguez. And I don't particularly care that he earns a lot more money than I do.

But we do need to make sure that people throughout the income scale have opportunities to raise their own standards of living and make progress in our society.

And that's why I've advocated the principle of trying to give people opportunity through education, through skills, through support during periods of transition between jobs to make them more productive and more able to deal with the disruptions that come with a globalized economy.

As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first five months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability. ¹  Because monetary policy works with a lag, however, policymakers must focus on the economic outlook.  Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends. 

However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans.  In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments.  Credit spreads on lower-quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened.  Even after their recent rise, however, credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk. 

In coordination with the other federal supervisory agencies, we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve Banks around the country are cooperating with community and industry groups that work directly with borrowers having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage products to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market developments.

I take this opportunity to reiterate the Federal Reserve’s strong support of the dual mandate; in pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. 

     As you know, this occasion marks the 30th year of semi-annual testimony on the economy and monetary policy for the Federal Reserve.  In establishing these hearings -- Mr. Hawkins and Humphrey were mentioned -- the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in making monetary policy. Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve's communication with the public about monetary policy, even as they have served to enhance the Federal Reserve's accountability for achieving the dual objectives of maximum employment and price stability set for it by the Congress.

     Well, we approach {energy price forecasting} at the Federal Reserve on essentially two levels.

     First, we try to do a fundamental supply-and-demand analysis, try to look at how we expect demand to grow both not only in the United States, of course, but in emerging markets and around the world and where we see supply emerging in OPEC and outside of OPEC, and try to make some sense of where that market is going.

     But another very important piece of information is futures markets. Investors in -- dealing in NYMEX and other futures markets put their money, essentially making bets where they think the price of oil is going to be at various horizons going out to six or more years.

     Those futures markets have been wrong in the past. They have underestimated the increase in oil prices that we've seen, which is one reason why we're very cautious about it. But over long periods of time they're probably about the best source of information we have about where the markets see energy prices going.

     And so the markets -- those energy markets currently see oil prices remaining high, but leveling off over the next couple of years, to the point where, if that actually happens, overall headline inflation would be about the same as core inflation.

From the Q&A session

     The dual mandate says price stability. It doesn't say price stability without energy and food. The Federal Reserve is concerned about the overall inflation rate. That is our long-term objective in the sense of maintaining price stability.

     But there are some technical issues involved in achieving that. In particular, when oil prices rise sharply, as they have in the last few months, there's really not much that the Federal Reserve can do in a short period of time to reverse that.

     Rather, what we have to do is look forward a year to two years, which is the horizon over which monetary policy has its effect. And so we really have to ask ourselves what's the underlying trend of inflation going forward, what's the best forecast of inflation going forward?

     Because energy and food prices have been so volatile, up and down, historically, the core portion, which excludes energy and food, is sometimes a better indicator of where sort of the trend of inflation is going to be a year or two from now.

     So it's not that we think core inflation is more important in itself, but rather we think it's an important indicator of the underlying inflation trend.

     So by paying attention to core inflation, we are in a way saying that this is how we hope to maintain stability in overall inflation over the horizon at which the monetary policy can be effective.

From the Q&A session

And in private equity in particular, [private pools of capital and hedge funds] play an important role in the market for corporate control. We need to have a mechanism whereby poorly run companies, weak managements are subject to being taken over, replaced and their companies improved. And when it's working right, at least, private equity -- as LBOs in the past -- helps to serve that function. So they do serve some positive functions.  

They raise many issues of financial stability and the like, you know, making sure that their counterparties are taking appropriate attention to their risks and the like. And we've discussed those some in the president's working groups' principles. But they certainly are a benefit to the economy.  

In the Q&A session

     The pension bill that was passed by Congress recently had a provision in it that allows employers to create savings plans with an opt-out provision. That is, an employee is put into the savings plan unless they explicitly request to be let off.

     There's a lot of research which suggests that that opt-out type approach, that most people will stay in the saving plan, and you get very significantly effects that way...

      One, one might consider, I suppose, using the existing Social Security system. There was a big debate here in Congress, of course, about so-called carve-out accounts, et cetera. Something that might be less controversial possibly would be an add-on account, whereby individuals had a chance through their payroll saving -- through their payroll taxes to contribute to an independent account that would be in their name.

In the Q&A session

Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. 

Our objective is to achieve enduring price stability. And in particular we want to make sure that inflation remains under good control in the medium run.

There are several elements of that. One is that I think it's important to recognize that the month-to-month inflation numbers are very noisy. And so, a couple of good numbers does not, by itself, meant that the problem is solved and gone away.  So part of it is just simply seeing more data and getting a greater sense of assurance that the trend is really in the direction we'd like to see it.  The other is that as long as there's some very important risks out there to inflation, there's the possibility that inflation, even if it's a bit -- if it's come down some, there's a possibility that it will go back up in the future.

And the risks that I talked about in my testimony include high resource utilization, the fact that the economy is working at a very tight use of resources; and secondly, the fact that energy and food prices have raised headline inflation. Those prices might feed through into core inflation. They might raise inflation expectations.  So what we need to see is enough confidence that the risks have subsided so that we can feel confident that, in the medium term, inflation will be well-controlled.

In response to a question from Senator Bunning in the Q&A session

Well, Mr. Chairman, the essence of making the market discipline approach work is that the counterparties, investors, and creditors be sophisticated and able to evaluate the investments that they're undertaking.  In the case of a pension fund, the pension fund manager has a fiduciary duty to make investments which are appropriate for the risk return needs of that fund.  So if that fiduciary manager has sufficient sophistication to use some of these things, that perhaps is OK.  But in most cases, I think that pension funds should probably not, you know, go heavily into these types of instruments {hedge funds}.

From Q&A session

[T]here's clearly less reliance on the FHA than in the past. My sense is that part of the problem is lack of flexibility, the costs of dealing with the FHA, lack of diversity of product, and so on.  So I think that modernizing the FHA, trying to make it more responsive, easier for ultimate lenders to work with and so on might reverse this trend and might give the FHA a larger share in the market, which could be a positive thing.

I guess I would point out that the FHA does have, I think, if I remember correctly, I think it still has a fairly high delinquency and default rate. It doesn't -- it hasn't solved the problem of delinquencies and so on.   And so, as those changes get made, I would suggest moving with some caution to make sure that we don't create yet another source of problems in terms of inappropriate loans for specific borrowers.

So I do see a case for trying to make the FHA more modern and to expand its role. But I would urge some caution and go slow on that.

From the Q&A session

And so the challenge for the Fed is always to balance supply and demand, to think about whether or not the level of demand that we're generating with our interest rate policies and with other policies -- government policies for example -- is consistent with the underlying supply. It's not so much that a given level of unemployment is, per se, inflationary, but if the economy is overheating, one might see a temporary dip in unemployment reflecting the extra resource utilization associated with it. So we don't have a magic unemployment rate that we look at and say, "Oh, that's too low or too high."   What we try to do is look at the whole economy, look for sources of price pressure. Are firms finding it easy to raise prices? Are there indications that markets are very tight, both at the labor level and the product level? And we try to make a judgment about the balance of supply and demand.  And that helps to govern our thinking about this.

The labor market -- you mentioned 6 percent -- the labor market changes a lot over time in terms of demographics, in terms of skills and education, in terms of job-finding through the Internet and so on. And so that number is not a fixed number. We always have to think about, you know, how it might be changing over time.

From the Q&A session

I agree with you that legitimate subprime lending is beneficial. It gives people access to homeownership and access to credit, and so the real trick for us is to write rules, to write regulations that will screen out the abusive practices and the improper practices while preserving this market. And I think that's a very challenging task.

From Q&A session

Again, from the Federal Reserve's perspective, our principal concern is the safety and soundness of the banking system. What we have done recently is worked with other regulators, such as the SEC and the OCC, and in some cases, also with foreign regulators -- the FSA in the U.K., for example, and German and Swiss regulators -- to do what we call horizontal reviews, which is that, collectively, we look at the practices of a large set of institutions -- both commercial banks and investment banks -- to see how they're managing certain types of activities, for example, the financing of leverage buyouts, equity -- bridge equity -- and the like, and trying to make an evaluation of what are best practices, trying to give back information back to the companies and trying to use that -- those reviews to inform our own supervision.

And so we are very aware of these issues from the perspective of the risk-taking by large financial institutions, and we are studying them, trying to provide information to the institutions themselves, and using them in our own supervisory guidance.

Some estimates are in the order of between $50 billion and $100 billion of losses associated with subprime credit products. The credit rating agencies have begun to try to make sure they account for those losses, and they have downgraded some of these products.  I should say that the investors, many of them recognize that even before the downgrades occurred that there were risks associated with these products, including not only credit risks, but also liquidity and interest rate, other types of risks.

DODD: Is it still your opinion that {China's exchange rate} is an effective subsidy on that issue?

BERNANKE: It is not a subsidy in the legal sense, that is a subsidy is a payment by the government directly to producers to support their production. Nothing like that is going on. That's not what I was referring to.

I was talking about the economic implication, which is that the undervalued exchange rate creates a distortion in the economy which artificially sends resources into the export sector, as opposed to in the demand domestic sector.

So it is a distortion in the economy. From a legal perspective, it's not the same thing as...

DODD: No, I noticed where you said "effective" subsidy.

BERNANKE: Yes, or implicit.

I agree with your premise that it's important that the Chinese begin to appreciate further. 

Let me just raise a couple of issues which I guess I would call tactical issues, without addressing any specific legislative proposal.

The first is that the currency, while an important issue, is probably in itself not going to solve the trade imbalance problem. There are fundamental saving/investment imbalances, both in the United States and abroad, which need to be changed in order to make real progress on the trade balance.

And in particular we have emphasized with the Chinese the importance of structural changes in their economy, such as increased safety net and improved financial system, that would increase the share of their output going to consumers and being consumed at home. And the combination of currency appreciation and this other set of measures is really what's needed to begin to move things in the right direction.

So I would urge you to broaden your focus just a bit, beyond the currency, to talk about the savings and investment balances that need to be adjusted in both the United States and in China.

The markets are indeed experiencing a significant information deficit. Market participants are struggling to discover 1) the true performance of subprime pools, 2) where exposure to these and other structured instruments ultimately rests, 3) the risk, therefore, associated with trading and borrowing counterparties, and 4) the linkages between asset classes, funding markets, and institution-to-institution exposures.

The opaque nature of our current financial world is the result of a long trend of replacing direct bank lending with less transparent investment vehicles in securities markets. In the coming weeks we will see more disclosure of gains and losses on exposure as well as performance trends of portfolios and securities, but I believe clarity will take some time to develop.

It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions.  But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.

...

Well-functioning financial markets are essential for a prosperous economy… The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets...

...

The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country.

Although this episode appears to have been triggered largely by heightened concerns about subprime mortgages, global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans. In part, these wider losses likely reflect concerns that weakness in U.S. housing will restrain overall economic growth. But other factors are also at work. Investor uncertainty has increased significantly, as the difficulty of evaluating the risks of structured products that can be opaque or have complex payoffs has become more evident. Also, as in many episodes of financial stress, uncertainty about possible forced sales by leveraged participants and a higher cost of risk capital seem to have made investors hesitant to take advantage of possible buying opportunities. More generally, investors may have become less willing to assume risk. Some increase in the premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time. However, in this episode, the shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks to create significant market stress.

The markets for asset-backed commercial paper and for lower-rated unsecured commercial paper market also have suffered from pronounced declines in investor demand, and the associated flight to quality has contributed to surges in the demand for short-dated Treasury bills, pushing T-bill rates down sharply on some days. Swings in stock prices have been sharp, with implied price volatilities rising to about twice the levels seen in the spring. Credit spreads for a range of financial instruments have widened, notably for lower-rated corporate credits. Diminished demand for loans and bonds to finance highly leveraged transactions has increased some banks' concerns that they may have to bring significant quantities of these instruments onto their balance sheets. These banks, as well as those that have committed to serve as back-up facilities to commercial paper programs, have become more protective of their liquidity and balance-sheet capacity.

As you know, the financial stress has not been confined to mortgage markets.

We will not return to the days in which all mortgage lending was portfolio lending, but clearly the originate-to-distribute model will be modified--is already being modified--to provide stronger protection for investors and better incentives for originators to underwrite prudently.

Economic theory suggests that the greater liquidity of home equity should allow households to better smooth consumption over time.  This smoothing in turn should reduce the dependence of their spending on current income, which, by limiting the power of conventional multiplier effects, should tend to increase macroeconomic stability and reduce the effects of a given change in the short-term interest rate.  These inferences are supported by some empirical evidence.¹⁰

Since I discussed these issues in March 2005, real interest rates have reversed some of their previous declines.  For example, in the United States, real yields on inflation-indexed government debt averaged 2.3 percent in 2006 as compared with 1.85 percent in 2004.  In the past few weeks, that yield has averaged about 2.4 percent.  Inflation-adjusted yields in other industrial countries have also started to move back up after falling in 2005.⁸      

How does this all fit together?  My reading of recent developments is that although some of the details have changed, the fundamental elements of the global saving glut remain in place. ..

Further increases in net capital flows from the developing economies, all else being equal, should have further depressed real interest rates around the world.  But as I have noted, in the past few years, real interest rates have moved up a bit.  This increase does not imply that the global saving glut has dissipated.  However, it does suggest that, at the margin, desired investment net of desired saving must have risen in the industrial countries enough to offset any increase in desired saving by emerging-market countries...

Once again, however, I do not want to rely exclusively on this line of explanation for the behavior of long-term real interest rates, as other factors have no doubt been relevant.  In particular, term premiums appear recently to have risen from what may have been unsustainably low levels, in part because of the greater recent volatility in financial markets and investors' demands for increased compensation for risk-taking.

This analysis of the sources of global imbalances does not address the critical normative question:  Are the current account imbalances that we see today a problem?  Not everyone would agree that they are, for several reasons. 

First, these external imbalances are to a significant extent a market phenomenon and, in the case of the U.S. deficit, reflect the attractiveness of both the U.S. economy overall and the depth, liquidity, and legal safeguards associated with its capital markets...

Second, current account imbalances can help reduce tendencies toward recession, on the one hand, or overheating and inflation, on the other...

Third, although the U.S. current account deficit is certainly not sustainable at its current level, U.S. liabilities to foreigners are not, at this point, putting an exceptionally large burden on the American economy...

All that said, the current pattern of external imbalances--the export of capital from the developing countries to the industrial economies, particularly the United States--may prove counterproductive over the longer term...

China has officially recognized the need to increase its domestic spending and scale back its reliance on exports.  Measures that could help achieve these goals include further reforms of the financial sector; increased government spending on infrastructure, environmental improvement, and the social safety net; and currency appreciation. 

I did not hear a great deal of opposition to the principle that the Federal Reserve at times should help markets function when they are in a state of panic or otherwise in serious dysfunction. So in that respect, I think that this is the kind of tool that under some circumstances might prove quite useful.

In discussing a staff proposal for a term auction credit facility and activation of foreign central bank swap lines in response to the liquidity crisis.

The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac are, to a limited extent, assisting in subprime refinancings and should be encouraged to provide products for subprime borrowers to the extent permitted by their charters.  However, the GSE charters are likely to limit the ability of the GSEs to serve any but the most creditworthy subprime borrowers.  Indeed, if GSE programs remove the strongest borrowers from the pool, the risks faced by other programs--such as a modernized FHA program--could be increased.

Some have suggested that the GSEs could help restore functioning in the secondary markets for non-conforming mortgages (specifically jumbo mortgages, those with principal value greater than $417,000) if the conforming-loan limits were raised.   However, in my view, the reason that GSE securitizations are well-accepted in the secondary market is because they come with GSE-provided guarantees of financial performance, which market participants appear to treat as backed by the full faith and credit of the U.S. government, even though this federal guarantee does not exist.  Evidently, market participants believe that, in the event of the failure of a GSE, the government would have no alternative but to come to the rescue.  The perception, however inaccurate, that the GSEs are fully government-backed implies that investors have few incentives in their role as counterparties or creditors to act to constrain GSE risk-taking.  Raising the conforming-loan limit would expand this implied guarantee to another portion of the mortgage market, reducing market discipline further. 

Nevertheless, many homeowners who took out mortgages in recent years are in financial distress.  To help those borrowers, the Federal Reserve, together with the other federal supervisory agencies, has issued two statements--in April, to mortgage lenders; and earlier this month, to mortgage servicers--to encourage the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures... Often, loan workouts are in the interest of all parties...  In addition, a member of the Federal Reserve Board serves as a director of NeighborWorks America, which encourages borrowers facing payment difficulties to seek help by contacting their lenders, services, or trusted counselors...

Additionally, the Federal Reserve is working closely with community and industry groups around the country to reduce homeowners' risks of foreclosure.  The community affairs offices in each of the Reserve Banks provide significant leadership and technical assistance...

In addition, the sharp deceleration in home prices since 2005, including outright declines in some markets, left many of these more-recent borrowers with little or no home equity.  In this situation, some borrowers (particularly owner-investors) may have found that simply walking away from their properties was their best option.  Moreover, low home equity has made refinancing--the typical way for many subprime borrowers to avoid large scheduled interest rate resets--difficult or impossible for many.  Thus, with house prices still soft and many borrowers of recent-vintage subprime ARMs still facing their first interest rate resets, delinquencies and foreclosure initiations in this class of mortgages are likely to rise further. 

[R]egulatory changes and the ongoing growth of the secondary mortgage market increased the ability of lenders, who once typically held mortgages on their books until the loans were repaid, to sell many mortgages to various intermediaries, or "securitizers."  The securitizers in turn pooled large numbers of mortgages and sold the rights to the resulting cash flows to investors, often as components of structured securities.  This "originate-to-distribute" model gave lenders (and, thus, mortgage borrowers) greater access to capital markets, lowered transaction costs, and allowed risk to be shared more widely.  The resulting increase in the supply of mortgage credit likely contributed to the rise in the homeownership rate from 64 percent in 1994 to about 68 percent now--with minority households and households from lower-income census tracts recording some of the largest gains in percentage terms.

Modernizing the programs administered by the Federal Housing Administration (FHA) is one promising direction.  The FHA has considerable experience in providing home financing for low- and moderate-income borrowers.  It insures mortgages made to borrowers who meet certain underwriting criteria and who pay premiums into a reserve fund that is designated to cover the costs in the event of default.  This insurance makes the loans less risky for lenders and investors, and it makes the loans eligible for securitization through the Government National Mortgage Association (Ginnie Mae).

Historically, the FHA has played an important role in the mortgage market, particularly for first-time home buyers.  However, the FHA's share of first-lien home purchase loans declined substantially, from about 16 percent in 2000 to about 5 percent in 2006, as borrowers who might have sought FHA backing instead were attracted to nontraditional products with more-flexible and quicker underwriting and processing.  In addition, maximum loan values that the FHA will insure have failed to keep pace with rising home values in many areas of the country.  

In modernizing FHA programs, Congress might wish to be guided by design principles that allow flexibility and risk-based pricing...

Earlier this week, [the] Federal Open Market Committee lowered its target for the federal funds rate by 50 basis points.  The action was intended to help forestall some of the adverse effects on the broader economy that might arise from the disruptions in financial markets and to promote moderate growth over time.  Recent developments in financial markets have increased the uncertainty surrounding the economic outlook.  The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

The risk of moral hazard must be considered in designing government-backed programs; such programs should not bail out failed investors, as doing so would only encourage excessive risk-taking. 

On August 17, the Federal Reserve Board announced a cut in the discount rate of 50 basis points and adjustments to the Reserve Banks' usual discount window practices to facilitate the provision of term financing for as long as thirty days, renewable by the borrower.  The purpose of the discount window actions was to assure depositories of the ready availability of a backstop source of liquidity.  

Markets do tend to self-correct.  In response to the serious financial losses incurred by investors, the market for subprime mortgages has adjusted sharply.  Investors are demanding that originators employ tighter underwriting standards, and some large lenders are pulling back from the use of brokers.  The reassessment and resulting increase in the attention to loan quality should help prevent a recurrence of the recent subprime problems. 

Education fundamentally supports advances in productivity, upon which our ability to generate continuing improvement in our standard of living depends.   

The Taylor rule also embeds a basic principle of sound monetary policy that has subsequently been referred to as the Taylor principle.² According to this principle, when a shock causes a shift in the inflation rate, the central bank must adjust the nominal interest rate by more than one-for-one. This ensures that the real interest rate moves in the right direction to restore price stability. The Taylor principle provides essential guidance for central banks on how to anchor long-run inflation expectations and foster stable growth and low inflation.

Ever since its inception, John has emphasized that the Taylor rule should not be applied mechanistically. The world is far too complicated for that. But he has argued that such rules can serve as useful benchmarks for the practical conduct of monetary policy. In fact, policymakers at the Federal Reserve and many other central banks do routinely consult various policy rules as they make judgments on the appropriate stance of monetary policy.

The Federal Reserve's actions to ease the liquidity strains in financial markets were similar to actions that central banks have taken many times in the past. Promoting financial stability and the orderly functioning of financial markets is a key function of central banks. Indeed, a principal motivation for the founding of the Federal Reserve nearly a century ago was the expectation that it would reduce the incidence of financial crises by providing liquidity as needed.

Loans through the discount window differ from open market operations in that they can be made directly to specific banks with strong demands for liquidity.  (In contrast, open market operations are arranged with a limited set of dealers of government securities.)  In addition, whereas open market operations typically involve lending against government securities, loans through the discount window can be made against a much wider range of collateral, including mortgages and mortgage-backed securities.  As with open market operations, however, Fed lending through the discount window provides banks with liquidity, not risk capital. In particular, the strong collateralization accompanying discount window credit eliminates essentially all risk for the Federal Reserve System and the taxpayer. Nonetheless, the availability of the discount window is potentially significant for banks, as it gives them greater confidence that they can obtain additional liquidity as necessary. Access to a backstop source of liquidity in turn reduces the incentives of banks to limit the credit they provide to their customers and counterparties.

The problems in the mortgage-related sector reverberated throughout the financial system and particularly in the market for asset-backed commercial paper (ABCP)... The problems intensified in the second week of August after the announcement by a large overseas bank that it could not value the ABCP held by some of its money funds and was, as a result, suspending redemptions from those funds. Some commercial paper issuers invoked their right to extend the maturity of their paper, and a few issuers defaulted. In response to the heightening of perceived risks, investors fled to the safety and liquidity of Treasury bills, sparking a plunge in bill rates and a sharp widening in spreads on ABCP.

The retreat by investors from structured investment products also affected business finance. In particular, issuance of collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs), which in turn had been major buyers of leveraged syndicated loans, fell off significantly during the summer. Demand for leveraged loans slowed sharply, reducing credit access for private equity firms and other borrowers seeking to finance leveraged buyouts (LBOs).

[T]he Committee chose to cut its target for the federal funds rate by 50 basis points at the September meeting. This action was intended to help offset the tightening of credit conditions resulting from the financial turmoil. Risk-management considerations also played a role in the decision, given the possibility that the housing correction and tighter credit could presage a broader weakening in economic conditions that would be difficult to arrest. By doing more sooner, policy might be able to forestall some part of the potential adverse effects of the disruptions in financial markets. As most of the meeting participants saw growth likely to run below trend for a while and with the incoming inflation data on the favorable side, the risks to inflation from this action seemed acceptable, especially as the Committee was prepared to reverse the policy easing if inflation pressures proved stronger than expected.

The Federal Reserve's efforts to provide liquidity appear to have been helpful on the whole. To be sure, the volume of loans to banks made through the discount window, though it increased for a time, has been modest. However, collateral placed by banks at the discount window in anticipation of possible borrowing rose sharply during August and September, suggesting that some banks viewed the discount window as a potentially valuable option.

In its supervisory role, the Federal Reserve--like other bank regulators--attempts to ensure that individual banks maintain adequate liquidity on hand and make provision to raise additional funds quickly when the need arises. We must be wary of a subtle fallacy of composition, however. Even if each market participant holds a significant reserve of what--in normal times, at least--would be considered highly liquid assets, for the system as a whole the only truly liquid assets are cash and its equivalents. The quantity of cash assets in the system at a point in time is, in turn, essentially fixed, being determined directly or indirectly by the central bank.

The U.S. subprime mortgage market is small relative to the enormous scale of global financial markets. So why was the impact of subprime developments on the markets apparently so large?  To some extent, the outsized effects of the subprime mortgage problems on financial markets may have reflected broader concerns that problems in the U.S. housing market might restrain overall economic growth. But the developments in subprime were perhaps more a trigger than a fundamental cause of the financial turmoil. The episode led investors to become more uncertain about valuations of a range of complex or opaque structured credit products, not just those backed by subprime mortgages. They also reacted to market developments by increasing their assessment of the risks associated with a number of assets and, to some degree, by reducing their willingness to take on risk more generally.

For example, Bill wrote a Federal Reserve staff paper titled "Rules-of-Thumb for Guiding Monetary Policy" (Poole, 1971).  Because his econometric analysis of the available data indicated that money demand was more stable than aggregate demand, Bill formulated a simple rule that adjusted the money growth rate in response to the observed unemployment rate.  Bill was also practical in noting the pitfalls of mechanical adherence to any particular policy rule; in this study, for example, he emphasized that the proposed rule was not intended "to be followed to the last decimal place or as one that is good for all time [but] . . . as a guide--or as a benchmark--against which current policy may be judged" (p. 152).

The fact that the public is uncertain about and must learn about the economy and policy provides a reason for the central bank to strive for predictability and transparency, avoid overreacting to current economic information, and recognize the challenges of making real-time assessments of the sustainable level of real economic activity and employment.  Most fundamentally, our discussions of the pervasive uncertainty that we face as policymakers is a powerful reminder of the need for humility about our ability to forecast and manage the future course of the economy.

The past decade has also witnessed significant progress in analyzing the policy implications of uncertainty regarding the structure of the economy...

Although Bayesian and robust-control methods provide insights into the nature of optimal policy, the corresponding policy recommendations can be complex and sensitive to the set of economic models being considered.  A promising alternative approach--reminiscent of the work that Bill Poole did in the 1960s--focuses on simple policy rules, such as the one proposed by John Taylor, and compares the performance of alternative rules across a range of possible models and sets of parameter values (Levin, Wieland, and Williams, 1999 and 2003).  That approach is motivated by the notion that the perfect should not be the enemy of the good; rather than trying to find policies that are optimal in the context of specific models, the central bank may be better served by adopting simple and predictable policies that produce reasonably good results in a variety of circumstances.

Successful microbusinesses provide jobs as well as valuable products and services to their communities. Not least important, they can provide economic independence and self-reliance for the owner-entrepreneurs. The full benefits of this movement are difficult to calculate. Indeed, one important challenge for the future is to find ways to better measure the impact and cost effectiveness of microfinance programs. What is clear is that the microfinance movement has grown and adapted considerably during its short history in the United States. I hope that microfinance organizations will sustain their energetic spirit of innovation and experimentation as they strive to become more self-sufficient and adapt to our ever-changing economy. 

BERNANKE: Well, Senator, it {the Super-SIV} all depends on the execution, as
I'm sure you would agree.

My understanding of the idea behind it is that a consortium of banks, together with investors, major investors, would oversee the process of purchasing high-quality assets from these unwinding sieves and then create a new vehicle which would then be financed by commercial paper, you know, purchased by, for example, large mutual funds, for example.

So my understating of the process is that, because investors, as well as a number of banks, would be involved essentially as gatekeepers in bringing assets into this new vehicle, that the valuations -- there would be an incentive, particularly on part of the investors, but also in terms of banks who didn't have direct exposures, there would be an incentive to create accurate market pricing.

If that is the way it works -- and, again, you know, it depends on the execution -- but if that's the way it works, it would remove some overhang from the market, it would create a stable financing source for those assets, and it ought not to be inconsistent with the price discovery process.

As I mentioned, delinquencies will probably rise further for borrowers who have a subprime mortgage with an adjustable interest rate, as many of these mortgages will soon see their rates reset at significantly higher levels.  Indeed, on average from now until the end of next year, nearly 450,000 subprime mortgages per quarter are scheduled to undergo their first interest rate reset.  Relative to past years, avoiding the payment shock of an interest rate reset by refinancing the mortgage will be much more difficult, as home prices have flattened out or declined, thereby reducing homeowners' equity, and lending terms have tightened.  Should the rate of foreclosure rise proportionately, communities as well as individual borrowers would be hurt because concentrations of foreclosures tend to reduce property values in surrounding areas. 

The Committee projected overall and core inflation to be in a range consistent with price stability next year.  Supporting this view were modest improvements in core inflation over the course of the year, inflation expectations that appeared reasonably well anchored, and futures quotes suggesting that investors saw food and energy prices coming off their recent peaks next year. 

The view of the G-7 -- and we asked, collectively -- we asked the IMF and other institutions to work with us on this -- is that sovereign wealth funds need to have a code of conduct that describes how they go about investing in other countries.

That code of conduct includes transparency, so we know what they're doing; governance, so we know they're controlled and to what purpose; and, importantly, to the issue that you're referring to, that their investments be economically oriented -- economically motivated that is in order to make a profit or a return, as opposed to gaining control of an important company or industry.

BERNANKE: Well, Congressman, first, just a small technical point. On the growth in money, money growth has been pretty moderate over the last few years. The increase in MZM is probably related to the financial turmoil. People have been taking their savings out of, you know, risky assets, putting them into the bank, and that makes the money data show faster growth.

So I'm not sure that's indicative of policy, necessarily.

From the Q&A session

So, one possibility would be, if the federal government were willing to act as guarantor. For example, suppose that the GSEs were to pay their usual mortgage insurance credit fee to the federal government, which enacted is guarantor -- so, to take away the credit risk from the GSEs, then they could process these jumbo loans and sell them into the secondary market and that would be, I think, of some assistance to the mortgage market.

From the federal government's point of view, they would be taking on some credit risk, which you may or may not be willing to do. I think that if you did that, it would be a good idea to make the GSEs ultimately responsible for some -- any excess losses or some part of excess losses, relative to the premiums that are paid, and leave it to the regulator to determine when the safety and soundness was adequate that the GSEs could make that repayment.

So, I think there might be some mechanisms that would involve federal interaction. But I think it's extremely important, as we look at these options, that we don't take actions that will endanger the safety and soundness of the underlying institutions.

From the Q&A session

Well, first, Congresswoman, we're not bailing out anybody. We haven't put a penny of our money or federal money into these -- into the banks or into the CDOs.

What we are doing is exercising our responsibility to make sure that the banks disclose the information and that they value these things properly.

It's not our practice, in the broad financial world, to protect investors, particularly sophisticated investors, who should be able to make their own evaluations, from buying individual instruments.

What our responsibility is, is to make sure that the banks are safe and sound and that they are appropriately valuing their balance sheets and that their exposures to these off-balance sheet instruments are appropriately measured and accounted for, particularly with respect to capitals.

From the Q&A session

We do not take an alarmist view on this {housing wealth effects}. However, there are some who feel that consumers react extremely strongly to changes, for example, in home equity line availability.

Our sense is that the relationship between home wealth and consumer spending is governed primarily by what's called the wealth effect, which suggests that, for each dollar that a house value falls, there's a net effect on consumer spending of somewhere between 4 cents and 9 cents, something like that.

So there is -- and that effect may be spread over a period of  time. So there would be an effect. But we see it as relatively moderate.

From the Q&A session.

... I'm not particularly concerned about any major change in the holdings of China or any other country.

There is, on the margin, sovereign wealth funds and portions of reserve accumulations that are being devoted to higher return, which means spreading across instruments, as well as across currencies.

But again, I don't see any significant change in the broad holdings of dollars around the country -- around the world.  Dollars remains the dominant reserve asset and I expect that to continue to be the case.

I would like to add, though, that the strength of the dollar, in the medium term, will ultimately depend not on those portfolio choices, so much as on the strength of the U.S. economy, our trade situation and on the openness of our financial markets to foreign capital.

And I'm optimistic on those fronts. And I do believe that that will lead to a sound dollar in the medium term.

BERNANKE: Mr. Chairman, as you noted, our forecast is for moderate, but positive growth going forward for the next few quarters. Economists are extremely bad at predicting turning points, and we don't pretend to be any better. We have not calculated the probability of recession, and I wouldn't want to offer that today.

During the Q&A session

Home losses through foreclosure can be reduced if financial institutions work with borrowers who are having difficulty meeting their mortgage payment obligations.  In recent months, the Federal Reserve and other banking agencies have issued statements calling on mortgage lenders and mortgage servicers to pursue prudent loan workouts...  Comprehensive data on the success of these efforts to avert foreclosures are not available, but my sense is that there is scope for servicers to further increase their loss-mitigation efforts.  The development of standardized approaches to workouts and the sharing of best practices can help increase the scale of the effort, even if, ultimately, workouts must be undertaken loan by loan.  Although workouts are to be encouraged, regulators must be alert to ensure that they are done in ways that protect consumers' interests and do not disguise lenders' losses or impair safety and soundness.

 Montagu Norman, the Governor of the Bank of England from 1921 to 1944, reputedly took as his personal motto, "Never explain, never excuse."  Norman's aphorism exemplified how he and many of his contemporaries viewed the making of monetary policy--as an arcane and esoteric art, best practiced out of public view.  Many central bankers of Norman's time (and, indeed, well into the postwar period) believed that a certain mystique attached to their activities and that allowing the public a glimpse of the inner workings would only usurp the prerogatives of insiders and reduce, if not grievously damage, the effectiveness of policy.

In sum, as I have indicated, we will be receiving a good deal of relevant information in the coming days. In making its policy decision, the Committee will have to judge whether the outlook for the economy or the balance of risks has shifted materially. In doing so, we will take full account of the implications for the outlook of both the incoming economic data and the ongoing developments in the financial markets.

Economic forecasting is always difficult, but the current stresses in financial markets make the uncertainty surrounding the outlook even greater than usual. We at the Federal Reserve will have to remain exceptionally alert and flexible as we continue to assess how best to promote sustainable economic growth and price stability in the United States.

The changes to the discount window were designed to assure banks of the availability of a backstop source of liquidity. Although banks borrowed only moderate amounts at the discount window, they substantially increased the amount of collateral they placed with Reserve Banks. This and other factors suggest that these changes to the discount window facility, together with the statements and actions of the FOMC, had some positive influence on market conditions.

Based on our initial experience, it appears that the TAF may have overcome the two drawbacks of the discount window, in that there appears to have been little if any stigma associated with participation in the auction, and--because the Fed was able to set the amounts to be auctioned in advance--the open market desk faced minimal uncertainty about the effects of the operation on bank reserves. The TAF may thus become a useful permanent addition to the Fed’s toolbox.   TAF auctions will continue as long as necessary to address elevated pressures in short-term funding markets, and we will continue to work closely and cooperatively with other central banks to address market strains that could hamper the achievement of our broader economic objectives.

However, as a tool for easing the strains in money markets, the discount window has two drawbacks. First, banks may be reluctant to use the window, fearing that markets will draw adverse inferences about their financial condition and access to private sources of funding--the so-called stigma problem. Second, to maintain the federal funds rate near its target, the Federal Reserve System’s open market desk must take into account the fact that loans through the discount window add reserves to the banking system... [T]he amounts that banks choose to borrow at the discount window can be difficult to predict, complicating the management of the federal funds rate, especially when borrowings are large.

Even as the outlook for real activity has weakened, there have been some important developments on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices and probably putting some upward pressure on core inflation measures as well. Last year, food prices also increased exceptionally rapidly by recent standards, further boosting overall consumer price inflation. Thus far, inflation expectations appear to have remained reasonably well anchored, and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability.

To be useful, a fiscal stimulus package should be implemented quickly and structured so that its effects on aggregate spending are felt as much as possible within the next twelve months or so.  Stimulus that comes too late will not help support economic activity in the near term, and it could be actively destabilizing if it comes at a time when growth is already improving.  Thus, fiscal measures that involve long lead times or result in additional economic activity only over a protracted period, whatever their intrinsic merits might be, will not provide stimulus when it is most needed...  A fiscal program that increased the structural budget deficit would only make confronting those challenges more difficult.

Banks have exposure the financial guarantors through banks' holdings of insured municipal securit1es and structured securities, through derivative transactions for which the guarantors are a counterparty, and through loans and lines of credit they have extended to the guarantors. Banks also have significant exposures to the financial guarantors through the liquidity support that banks provide for certain types of municipal securities and structures, including variable-rate demand obligations (VRDOs) and tender-option bonds (TOBs), as wen as some asset-backed commercial paper conduits. Reduced confidence in the financial guarantors could lead some investors to exercise options to put these securities back to the liquidity providers. Moreover, money market funds, who are major investors in these securities, can be required to put the securities back to the liquidity providers if the financial guarantor is downgraded significantly. Thus, banks could be required to bring a sizable volume of assets, especially municipal securities, onto their books.

In about a week we'll have a new set of {quarterly FOMC} projections. And it will show lower projections of growth, and they'll be reasonably consistent with what we're seeing with private forecasters and so on. They do show, as I suggested in my testimony, that growth looks to be weak but still positive during the first half of the year, and with some expectation of strengthening later in the year.

We'll be looking over the next few quarters -- obviously the general performance of the economy, but as I mentioned in my testimony, there are a few areas of particular sensitivity that we could watch.

First is the housing market.  We need to begin to see some stabilization in starts and sales, it would be very productive in terms of both the economy and the credit markets.

Secondly is the labor market.  We don't expect a riproaring labor market by any means, but it would be nice if the labor market would begin to stabilize close to current levels.

Third, credit markets.  Senator Schumer was correct that there is a lot of concern among participants of the financial markets about the state of the credit markets. Much of that is connected with uncertainty about the broader economy. A significant worsening in financial conditions or credit availability would certainly be a warning bell that we need to take further action.

From Q&A, when asked how the Fed would decide if January's policy actions were sufficient. As reported by Market News International.

The softer labor market, together with factors including higher energy prices, lower equity prices, and declining home values, seem likely to weigh on consumer spending in the near term. On the other hand, growth in U.S. exports should continue to provide some offset to the softening in domestic demand, and the recently approved fiscal package should help to support household and business spending during the second half of this year and into the first part of next year.
 

To date, inflation expectations appear to have remained reasonably well anchored, but any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank's policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring inflation expectations and the inflation situation more generally.

At present, my baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt. At the same time, overall consumer price inflation should moderate from its recent rates, and the public's longer-term inflation expectations should remain reasonably well anchored.

A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability and, in particular, whether the policy actions taken thus far are having their intended effects. Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation, as well as the risks to that forecast.

Although the baseline outlook envisions an improving picture, it is important to recognize that downside risks to growth remain, including the possibilities that the housing market or the labor market may deteriorate to an extent beyond that currently anticipated, or that credit conditions may tighten substantially further. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks.

We are very sensitive, both in the credit card rules and also in the mortgage rules, that these markets are important, we don't want to create a chilling effect, we don't want to shut down these markets; we just want them to work better.

 And in particular we think it's important for consumers to have a better understanding of what it is that they're buying when they purchase products in these markets.

there is not much evidence that investors or holders of foreign reserves have shifted in any serious way out of the dollar to this point. And, indeed, we've seen a lot of flows into U.S. treasuries, which is one of the reasons why the rates of short-term U.S. treasuries are so low, reflecting their safety, liquidity and general attractiveness to international investors.

From the Q&A session

We, obviously, watch the dollar very carefully. It's a very important economic variable.

From the Q&A session

I think the originate-distribute model and the securitization has a lot of value. It allows borrowers to have, essentially, direct access to capital markets.  But the recent experience shows we need to do some work on it, both the private sector and in collaboration with supervisors and regulators. We need to have more responsibility and accountability at the point of origination. We need to have better information and clarity about what securitized products contain.

If we do those things, I think we can restore this market. But at the moment, as you know, it's very dysfunctional.

From the Q&A session

A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risks to growth, stressed financial conditions, and inflation pressures. 

[A]fter growing robustly through much of 2007, nonresidential construction is likely to decelerate sharply in coming quarters as business activity slows and funding becomes harder to obtain, especially for more speculative projects.    

On the fiscal situation, I agree we're in a less advantageous situation than we were. The deficit is certainly higher. And perhaps even more seriously, we are now seven years further on toward the retirement of the baby boomers and the entitlements and those costs that are certainly bearing down on us as we speak.

 So it is a difficult situation, and there are multiple factors. I think there are some similarities, but, I guess as a Russian novelist once said, unhappy families are all unhappy in their own way, and every period of financial and economic stress has unique characteristics.

     SEN. DODD:  Am I hearing you correctly that we're in actually -- we're in a worse position today to respond to this than we were eight years ago? Is that my -- is that how I hear what you're saying?

      BERNANKE: I think that's fair, in that both fiscal and monetary policy face some additional constraints, and that the broad effects on the consumer -- I mean, many people own stocks, too, of course, and so that affected their wealth and their willingness to spend.

      But, in fact, the effects of the stock market declines in 2001 were primarily on investment and on firms more than on consumers. In this case, the consumers are taking the brunt of the effects.

With respect to the sovereign wealth funds, I think that's just another indication of the fact that foreigners have not lost confidence in the U.S. economy in that there's been a good bit of inflow. In particular, about something close to half of the capital that the financial institutions have raised in the last few months has come from sovereign wealth funds from other countries.

I think that, in general, that's quite constructive. If we are confident, as I think we are in this case, that the investments are made for economic reasons and not for political reasons or other non- economic reasons, and there's no issue of national defense, which the CFIUS process takes care of, then that inflow of investment is good for our economy and certainly is helping, in this case, the financial system.  At the same time, allowing inflows of foreign capital through reciprocity gives us more opportunities to invest abroad.

 I know that Congress is very interested in sovereign wealth funds, and you should certainly take a close look at it. International agencies, like the International Monetary Fund and the OECD, are developing codes of conduct. The basic idea there is that sovereign wealth funds should be as transparent as possible. We should understand their governance and their motivations. And, in particular, we should be confident that they are investing, again, for economic, rather than political or other purposes.

If we are confident in that, then we ourselves, it's in our interest to keep our borders open and to allow that capital to flow in. And I think it will continue to flow in.

 From the Q&A session

With respect to monetary policy per se, although we keep each other apprised, each economy is in a different place, in a different situation, and there's no necessity that each country has to have the same policy. I think the policy that's chosen depends on the particular circumstances of that country or that region.

     And so, that's one of the benefits of having flexible exchange rates: It provides some insulation, some ability for countries to run independent monetary policies.

     And so, it's been our practice, as you know, for each major central bank to run an independent monetary policy. And while we keep each other apprised, I don't expect to see any extensive coordination in the near future.

From the Q&A session

On your second concern, I think we're better off now than we were in the '70s, in that there's a much broader recognition of the important of price stability and greater confidence that central banks will deliver price stability.

     The indicia of inflation expectations, where some of them have moved a bit, are basically stable. We have not seen any major shift in views about inflation and where inflation's likely to go.

     The Federal Reserve has emphasized the importance of maintaining price stability and has indicated that we will watch very carefully to make sure that we don't see any deterioration in either broad measures of inflation expectations or increased pass-through of food and energy prices into other prices. We will watch those carefully and we will respond.

Around the turn of the year, early in January, the data took a significant turn for the worse. And it seemed clear that the economy was slowing and slowing more than anticipated and that the credit market condition -- situation was continuing.

     On January 9th, I called a meeting of the Federal Open Market Committee by video conference to discuss the situation. It was agreed by the committee that some substantial additional cuts in the federal funds rate were likely to be necessary.

     The thought at the time of that meeting was that it might be worth waiting until the regular meeting at the end of the month where we could have a fuller discussion and see the revised forecast and so on, taking into account the possibility that we could also move inter-meeting if necessary.

     On January 10th, I gave a speech where I informed the public that I thought that substantive additional action might well be necessary, thereby signaling that the conditions had changed and that further rate cuts were likely to happen.

     In the days that followed that speech, the tone of the data deteriorated considerably further, which made me think that the outlook was, in fact, much weaker and the risks were greater.

     That was showing up both in the data and in the financial markets. We were seeing sharp declines in equity prices, we were seeing widening of spreads and we were also seeing, again, adverse data.

     On January 21st, I became concerned that the continued deterioration of financial markets was signaling a loss of confidence in the economy. And I felt the Fed really, instead of waiting until the meeting, we really needed to get ahead of that and needed to take action. So I called a FOMC conference call and we agreed at that point to cut the federal funds rate target by 75 basis points.

     There was an understanding at that meeting that further additional action was very likely to be needed, but we felt that we could wait another 10 days to the regular meeting to determine exactly how much additional action.

     At the meeting at the end of January, we had a full review, discussion, forecast round and so on, and determined that an additional 50 points was justified.

One of the concerns that I have is that there is some interaction between the credit market situation and the growth situation. That is, if the economy slows considerably, which reduces credit quality, that worsens, potentially, the condition of credit markets, which then may tighten credit further in a somewhat adverse feedback loop, if you will.

 From the Q&A session

There probably will be some bank failures. There are, for example, some small, or, in many cases, de novo banks that are heavily invested in real estate in locales where prices have fallen and therefore they would be under some pressure.  So I expect there will be some failures.  Among the largest banks,  the capital ratios remain good. And I don't anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system.

From the Q&A session

 The FHASecure plan, which the Federal Housing Administration (FHA) announced late last summer, offers qualified borrowers who are delinquent because of an interest rate reset the opportunity to refinance into an FHA-insured mortgage.  Recently, the Congress and Administration temporarily increased the maximum loan value eligible for FHA insurance, which should allow more borrowers, particularly those in communities with higher-priced homes, to qualify for this program and to be eligible for refinancing into FHA-insured loans more generally.  These efforts represent a step in the right direction.  Not all borrowers are eligible for this program, of course; in particular, some equity is needed to qualify.  In addition, second-lien holders must settle or be willing to re-subordinate their claims for an FHA loan, which has sometimes proved difficult to negotiate. 

Although I am aware, as you are, that community banks originated few subprime mortgages, community bankers are keenly interested in these issues; foreclosures not only create personal and financial distress for individual homeowners but also can significantly hurt neighborhoods where foreclosures cluster.  Efforts by both government and private-sector entities to reduce unnecessary foreclosures are helping, but more can, and should, be done.  Community bankers are well positioned to contribute to these efforts, given the strong relationships you have built with your customers and your communities.

Mortgage delinquencies began to rise in mid-2005 after several years at remarkably low levels.  The worst payment problems have been among subprime adjustable-rate mortgages (subprime ARMs); more than one-fifth of the 3.6 million loans outstanding were seriously delinquent at the end of 2007.¹  Delinquency rates have also risen for other types of mortgages, reaching 8 percent for subprime fixed-rate loans and 6 percent on adjustable-rate loans securitized in alt-A pools.  Lenders were on pace to have initiated roughly 1-1/2 million foreclosure proceedings last year, up from an average of fewer than 1 million foreclosure starts in the preceding two years.  More than one-half of the foreclosure starts in 2007 were on subprime mortgages.

In cases where refinancing is not possible, the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower.  Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent.  For the lender or servicer, working out a loan makes economic sense if the net present value (NPV) of the payments under a loss-mitigation strategy exceeds the NPV of payments that would be received in foreclosure... The magnitude of, and uncertainty about, expected losses in a foreclosure suggest considerable scope for negotiating a mutually beneficial outcome if the borrower wants to stay in the home. 

Unfortunately, even though workouts may often be the best economic alternative, mortgage securitization and the constraints faced by servicers may make such workouts less likely.  For example, trusts vary in the type and scope of modifications that are explicitly permitted, and these differences raise operational compliance costs and litigation risks.  Thus, servicers may not pursue workout options that are in the collective interests of investors and borrowers.  Some progress has been made (for example, through clarification of accounting rules) in reducing the disincentive for servicers to undertake economically sensible workouts.  However, the barriers to, and disincentives for, workouts by servicers remain serious problems that need to be part of current discussions about how to reduce preventable foreclosures.

...

Lenders tell us that they are reluctant to write down principal.  They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again.  Moreover, were house prices instead to rise subsequently, the lender would not share in the gains.  In an environment of falling house prices, however, whether a reduction in the interest rate is preferable to a principal writedown is not immediately clear.  Both types of modification involve a concession of payments, are susceptible to additional pressures to write down again, and result in the same payments to the lender if the mortgage pays to maturity.  The fact that most mortgages terminate before maturity either by prepayment or default may favor an interest rate reduction.  However, as I have noted, when the mortgage is "under water," a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure.  

The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, likewise could do a great deal to address the current problems in housing and the mortgage market. New capital-raising by the GSEs, together with congressional action to strengthen the supervision of these companies, would allow Fannie and Freddie to expand significantly the number of new mortgages that they securitize. With few alternative mortgage channels available today, such action would be highly beneficial to the economy. I urge the Congress and the GSEs to take the steps necessary to allow more potential homebuyers access to mortgage credit at reasonable terms.

In addition to regulations, strong uniform oversight of different types of mortgage lenders is critical to avoiding future problems. Regulatory oversight of mortgage lending has become more challenging as the breadth and depth of this market has grown over the past decade. Other changes, such as the increased role of nonbank mortgage lenders, have added complexity.

Among the practices addressed by our proposal is the use of yield spread premiums (YSPs).⁶ Many consumers use mortgage brokers to guide them through a complex process and shop for the best deal. Unfortunately, consumers may believe that the broker has a responsibility to get them that best deal, which is not necessarily the case. In fact, the design of YSPs may provide the broker a financial incentive to offer a loan with a higher rate. Consumers who do not understand this point may not shop to their best advantage. Therefore, we would prohibit a lender, for both prime and subprime loans, from paying a broker an amount greater than the consumer agrees to in advance. Brokers would also have to disclose their potential conflict of interest. The combination of stricter regulation and better disclosure will not solve all the problems. We do believe, however, that this proposal will give consumers much better information and raise their awareness of brokers' potential conflict of interest while reducing a broker's incentive to steer a consumer to a higher rate.

6.  A YSP is the present dollar value of the difference between the lowest interest rate the wholesale lenders would have accepted on a particular transaction and the interest rate the broker actually obtained for the lender.  This dollar amount is usually paid to the mortgage broker.  It may also be applied to other loan-related costs, but the Board's proposal concerns only the amount paid to the broker. 

KENNEDY:  Let me ask you, just finally, toys and drugs are regulated, a great many other kinds of factors are regulated. Shouldn't we make sure that financial products are safe for consumers? Should we consider having a new agency that's going to review unsafe financial products on the market?

BERNANKE: Senator, that's extremely important. The Treasury blueprint, for what it's worth, has an agency in it that would do that.  In the current situation, the Federal Reserve has responsibilities along those lines. 

Well, I would just make one comment, which is that one of the ideas in the blueprint is to give the Federal Reserve, sort of, broad authority to be a financial market stability regulator.  The Federal Reserve has a long tradition of trying to maintain financial stability and is very interested and concerned with those issues. But we would want to be sure that if we were given that very important responsibility that we had adequate powers, authorities, expertise and so on to make sure that we could do it effectively. And so that would be an issue for us to think about as we go forward.

From the Q&A session

Clearly, the U.S. economy is going through a very difficult period. But among the great strengths of our economy is its ability to adapt and to respond to diverse challenges. Much necessary economic and financial adjustment has already taken place, and monetary and fiscal policies are in train that should support a return to growth in the second half of this year and next year. I remain confident in our economy’s long-term prospects.  

They {Bear Stearns} may have had adequate regulatory capital, but their problem was more liquidity than capital. What happened was that there were certainly market concerns about their positions, and confidence began to erode and they began to lose their funding.

     We were not informed of the imminence of the situation until about 24 hours before the event -- probably on Thursday with the announcement of their information that they were going to be likely in default on Friday morning. And it was at that time that we began our emergency response.

     More normally, we would have had more warning and we have had more time to develop a more effective response.

     Going forward, we continue to monitor financial institutions. We hope to improve the liquidity situation by extending liquidity to investment banks, dealers, as well as to depository institutions.

From the Q&A session.

We did not bail out Bear Stearns. Bear Stearns' shareholders took a very significant loss. An 85-year-old company lost its independence and became acquired by another firm. Many Bear Stearns employees, as you know, are concerned about their jobs. I don't think any company is interested in repeating the experience of Bear Stearns.

     SCHUMER: But don't you feel there is a dichotomy between federal intervention, taxpayer money, to prevent systemic risk -- it's appropriate to do for a large investment bank; isn't it just as appropriate to do it in the housing market? Because that also prevent, as a whole, presents systemic risk issues.

     That's the dichotomy many of us are troubled about. Not saying one is a bailout and one is not a bailout or anything like that.

     BERNANKE: Well, the Federal Reserve was acting in its sphere of influence to address financial issues. As I've said, I think housing is very important and we need to address it. But of course that's the Congress' sphere of influence, not the Fed's.

From the Q&A session

MALONEY: Given recent news reports about hedge funds having made huge bets against the stock price of Bear Stearns during the week leading up to its collapse and now reports that Iceland is investigating whether certain hedge funds may have played a role in beating down its currency, do you believe there is a need for any new regulatory oversight of hedge funds? And, if so, what type of oversight?      

BERNANKE: Congresswoman, the concerns that you raise and similar ones are examples, if they were true, of course, of market manipulation, which is already the province of the Securities and Exchange Commission and which I am sure will look into these contentions. So I certainly don't have any objection or any problem with enforcement of securities laws and of investor protection in the context of hedge funds.

     It's been remarkable, the hedge funds have been less of a problem than we anticipated in some sense, and we've seen more problem in some other sectors.   So far, one of our main concerns had been that hedge funds that failed would create losses for their counterparties, the major financial institutions.  Thus far, we have not seen any significant losses taken by a major financial institution because of a hedge fund loss or failure. So in that respect, their behavior has not, so far, created risks for our major financial institutions.

From the Q&A session

With respect to small business, I've heard mixed anecdotes about small business. Not all small community banks have had problems. Many of them were not involved in any way in the subprime lending, for example, and they haven't taken any losses, and so many of them are still making loans to local businesses.

But as a general matter, the loss of capital in the banking system, which has only been partially replenished; the increase in the size of the balance sheets as they brought off-balance-sheet assets onto their balance sheets; and their concerns about liquidity all are creating a situation where our financial institutions are hunkered down. They're not making loans at the normal rate.  And it's having real effects on small businesses, on mortgages, on all aspects of our economy.

From the Q&A session

The valuation -- the primary valuation was done by Bear Stearns on March 14th, so currently, using the best available market information and including adjustments for the fact that those markets are quite liquid, which is important.

We have had our investment adviser, BlackRock, go through those assets, and they are confident, or at least reasonably confident, that we will be able to recover the full amount if we dispose of these assets on a measured basis, rather than to sell them all at once.

From the Q&A session

CASEY: Now, in terms of your investment adviser, can you tell us something about how they were chosen, number one, and what they'll be paid?

BERNANKE: Again, this is the details. I will speak only from my indirect knowledge, because this happened in New York.

We were operating, obviously, under extreme time constraints. This negotiation was going on over the weekend with the need to have it completed by the time that the Asian markets opened on Sunday.

The Federal Reserve Bank of New York engaged BlackRock on a fee- to-be-determined-later basis that is to be negotiated later, and brought them in to take a look at the assets.  They're a highly respected firm. I think that, you know, opportunity to do a full requisition for services and, you know, that competition for bids and those sorts of things was simply not practical given the short time period.      

 CASEY: Just generically, how would they be paid? Is it straight fee or is there any other arrangement just generally in a situation like that in terms of what the Fed would do?

BERNANKE: I just -- I don't know the answer for sure, and therefore I'd prefer to leave it to President Geithner, who could answer that question for you.

From the Q&A session

Well, Congressman, first a word on the President's Working Group. That's an informal group of the heads of various agencies. It has no separate statutory authorities, but it's a chance to get together and talk about issues.  And on a number of occasions, as you've noted, we've put out reports that have no statutory authority but represent our thinking and our staff's thinking on some various issues.

A recession is possible. But a recession is a technical term defined by the National Bureau of Economic Research depending on data which will be available quite a while from now, so I'm not yet ready to say whether or not the U.S. economy will face such a situation.   

However, it's clearly a period of very slow growth, extending back to the fourth quarter of last year, and we are trying to set our policies appropriately for that situation.

From the Q&A session

{On the question of a second stimulus package}

Well, again, if we go into next year and the economy continues weak and monetary policy is not being effective, and financial markets, for whatever reason, are not improving, then that would be a time to look at alternative options.

I think, for the near term -- and again, I'm not addressing issues like homeownership and many other things that Congress may want to deal with.

But simply, in terms of the fiscal stimulus package that was put in place, it's a fairly significant package which should add something like a percentage point, or even a little more, to growth in the second half of the year.  And I think we ought to -- on that particular issue, I think we ought to give that some time to work before we take additional steps.

The financial crisis, I think, is the unwinding of what was an excessive credit boom in the years up through middle of last year.  For a variety of reasons global interest rates were quite low, and that generated strong efforts to reach for yield, as it was said, and so there was a lot of risk taking. There was a lot of financial innovation. And the result I think was some unsustainable investment, some unsustainable asset creation.

We've seen the unwinding of that. That is in some ways positive. But on the other hand, the contraction of credit and the restriction of financing that we've seen associated with that has slowed the economy and has had adverse effects on families, as you indicate.    We are trying to find a financial stability. The Fed is working as best we can to stabilize the economy and to stabilize the financial system.

From the Q&A session

The Japanese case is interesting because it does demonstrate that financial factors do matter for Main Street, so to speak.  But in that case, there were some important differences, notably the Japanese banks hid their losses for many years. And even though they were functionally insolvent, it was not evident in terms of their bookkeeping that they were.  Eventually it became necessary for the government to bail out those banks.

Our banking system is much more open, in terms of describing its financial condition. And while many banks certainly have taken losses and there have been problems, it is, on the whole, very solvent and has a high level of capital.  And so we're nowhere near the situation that government bailouts are needed for our financial system.

From the Q&A session

We have a very high bar for unusual and exigent, so this is twice in 75 years that we've used this -- that we've applied this power.

During the Q&A session.

I believe more states should consider making personal finance a requirement for all students who seek a high school diploma. I am personally convinced that improving education is vital to the future of our economy and all its citizens, and I strongly believe that promoting financial literacy, in particular, must be a high priority.   

The U.S. banking system remains well capitalized. The quality of capital and capital ratios are still quite good.

From Q&A as reported by Market News International

Improving the performance of the credit rating agencies is another key priority. As I mentioned, analytical weaknesses and inadequate data underlay many of the problems in the ratings of structured finance products. Beyond improving their methods, however, the credit rating agencies would serve investors better by providing greater transparency. Credit rating agencies should, for example, publish sufficient information about the assumptions underlying their rating methodologies and models so that users can understand how a particular rating was determined. It is also important for the credit rating agencies to clarify that a given rating applied to a structured credit product may have a different meaning than the same rating applied to a corporate bond or a municipal security. Indeed, some have suggested that the agencies use different rating nomenclatures for different types of products. Transparency about methods should also help to reduce concerns about conflicts of interest that might arise from the fact that issuers of securities pay the rating agencies for their work in rating those securities.

The credit rating agencies themselves clearly appreciate that concerns about the quality of ratings and potential conflicts of interest represent a fundamental challenge to their business model, and they have begun to address these issues. The SEC, which has regulatory responsibility for the credit rating agencies, is conducting a broad review of issues regarding potential conflicts of interest at the rating agencies and is likely to identify further measures that should be implemented.

We will not experience anything remotely like that in the United States today ... We are certainly going to make sure that the financial system remains in good functioning order.

From Q&A as reported by Market News International and Reuters, on comparisons to the Great Depression

In recent months, the Federal Reserve has been intensely focused on the continuing strains in financial markets. Healthy, well-functioning financial markets are essential to sustainable growth. In particular, much experience shows that economies cannot perform at their full potential when financial conditions are such as to restrict the supply of credit to sound borrowers. We are addressing these financial strains and their potential economic consequences with a number of tools, including the provision of extra liquidity to the system and reductions in our target for the federal funds rate.

The process of implementing the PWG's [President's Working Group's] implementations will be challenging, in no small measure because of the continuing pressures of short-term crisis management. However, we do not have the luxury of waiting for markets to stabilize before we think about the future. Indeed, many of the necessary changes that have been identified, including increasing transparency, improving risk management, and attaining better coordination among regulators, could provide important support to the process of normalizing our financial markets.

Given its focus on fundamental reform, the recommendations of the Treasury blueprint are mostly intended to be undertaken in the longer term. In that respect, it is an important first step, and we look forward to working with the Congress and others in developing a framework that modernizes our financial and regulatory architecture. The analysis of the PWG [President's Working Group] that I will be discussing today is more sharply focused on recent events, and its recommendations are intended to be part of the near-term and medium-term effort to restore more normal functioning of financial markets and to improve the operation of the current system.

The supervisors concluded that the firms that suffered the most significant losses tended to exhibit common problems, including insufficiently close monitoring of off-balance-sheet exposures, inadequate attention to the implications for the firm as a whole of risks taken in individual business lines, dependence on a narrow range of risk measures, deficiencies in liquidity planning, and inadequate attention to valuation issues. To be sure, firms varied in the degree to which they were subject to these weaknesses, with better performance on these dimensions generally being reflected in better financial performance.

Correcting these weaknesses is, first and foremost, the responsibility of the firms' managements and they have powerful incentives to do so. But prudential supervisors, including the Federal Reserve, must also review their existing policies and guidance to identify areas where changes could help firms strengthen their risk management--a process that is already under way.

More transparency about the risks and other characteristics of securitized credits on the part of their sponsors would obviously help. But more generally, investors must take responsibility for developing independent views of the risks of these instruments and not rely solely on credit ratings.

In the mortgage area, the PWG [President's Working Group] recommended action at both the federal and state levels, including, for example, stronger nationwide licensing standards for mortgage brokers and more consistent government oversight for all originators. In particular, the PWG recommended that the Federal Reserve use its authority to strengthen consumer protection rules and enhance required disclosures for mortgage originations.

I strongly support this recommendation, and its implementation is well under way.

[The originate-to-distribute system] broke down at a number of key points, including at the stages of underwriting, credit rating and investor due diligence ... These problems notwithstanding, the originate-to-distribute model has proven effective in the past and with adequate repairs could be so again in the future.

From Q&A as reported by Reuters

The interests of the financial system, the individual firms, are in some sense opposed to the interests of the broader economy.

From Q&A as reported by Reuters

Many foreclosures are not preventable.  Investors, for example, are unlikely to want to hold onto a property whose value has depreciated significantly, and some borrowers--perhaps because they were put into an inappropriate loan or because personal circumstances have changed--cannot realistically sustain homeownership.  However, if a foreclosure is preventable, and the borrower wants to stay in the home, the economic case for trying to avoid foreclosure is strong. 

As my listeners know, conditions in mortgage markets remain quite difficult, and mortgage delinquencies have climbed steeply.  The sharpest increases have been among subprime mortgages, particularly those with adjustable interest rates:  About one quarter of subprime adjustable-rate mortgages are currently 90 days or more delinquent or in foreclosure.¹  Delinquency rates also have increased in the prime and near-prime segments of the mortgage market, although not nearly so much as in the subprime sector. 

Clear disclosures of loan modifications will not only make it easier for regulators, the mortgage industry, and homeowners to assess the effectiveness of foreclosure-prevention efforts, but they will also foster greater transparency, and hence greater confidence, in the securitization market.

Most Americans are paying their mortgages on time and are not at risk of foreclosure.  But high rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets, and the broader economy.  Therefore, doing what we can to avoid preventable foreclosures is not just in the interest of lenders and borrowers.

 To be effective, such programs must be tightly targeted to borrowers at the highest risk of foreclosure, as measured, for example, by debt-to-income ratio or by the extent to which the mortgage is "underwater."  Finding the right balance--particularly the need to avoid programs that give borrowers who can make their payments an incentive to default--is difficult.  But realistic public- and private-sector policies must take into account the fact that traditional foreclosure avoidance strategies may not always work well in the current environment.

Nationally, as of the fourth quarter of 2007, the rate of serious delinquency, as measured by credit records, stood at 2 percent of all mortgage borrowers, up nearly 50 percent from the end of 2004.²  The fourth quarter of 2004 is a useful benchmark, because general economic conditions were fairly normal and the lax underwriting that emerged later was not yet evident.

And what are the terms at which the central bank should lend freely? Bagehot argues that "these loans should only be made at a very high rate of interest" (p. 99). Some modern commentators have rationalized Bagehot's dictum to lend at a high or "penalty" rate as a way to mitigate moral hazard--that is, to help maintain incentives for private-sector banks to provide for adequate liquidity in advance of any crisis. I will return to the issue of moral hazard later. But it is worth pointing out briefly that, in fact, the risk of moral hazard did not appear to be Bagehot's principal motivation for recommending a high rate; rather, he saw it as a tool to dissuade unnecessary borrowing and thus to help protect the Bank of England's own finite store of liquid assets.³ Today, potential limitations on the central bank's lending capacity are not nearly so pressing an issue as in Bagehot's time, when the central bank's ability to provide liquidity was far more tenuous.

Recent research by Allen and Gale (2007) confirms that, in principle at least, "fire sales" forced by sharp increases in investors' liquidity preference can drive asset prices below their fundamental value, at significant cost to the financial system and the economy. Their work underscores the basic logic in Bagehot's prescription for crisis management: A central bank may be able to eliminate, or at least attenuate, adverse outcomes by making cash loans secured by borrowers' illiquid but sound assets. Thus, borrowers can avoid selling securities into an illiquid market, and the potential for economic damage--arising, for example, from the unavailability of credit for productive purposes or the inefficient liquidation of long-term investments--is substantially reduced.

The financial distress since August has also underscored the importance of international cooperation among central banks. For some time, central banks have recognized that managing crises involving large financial institutions operating across national borders and in multiple currencies can present difficult challenges. Funding pressures can easily arise in more than one currency and in more than one jurisdiction. In such cases, central banks may find it essential to work closely together. For just this reason, the Federal Reserve, the ECB, and the Swiss National Bank have established currency swap arrangements and have coordinated their provision of dollar liquidity to international financial institutions over recent months.

By mid-March, however, the pressures in short-term financing markets intensified, and market participants were speculating about the financial condition of Bear Stearns, a prominent investment bank. On March 13, Bear advised the Federal Reserve and other government agencies that its liquidity position had significantly deteriorated, and that it would be forced to file for bankruptcy the next day unless alternative sources of funds became available. A bankruptcy filing would have forced Bear's secured creditors and counterparties to liquidate the underlying collateral and, given the illiquidity of markets, those creditors and counterparties might well have sustained losses. If they responded to losses or the unexpected illiquidity of their holdings by pulling back from providing secured financing to other firms, a much broader liquidity crisis would have ensued. In such circumstances, the Federal Reserve Board judged that it was appropriate to use its emergency lending authorities under the Federal Reserve Act to avoid a disorderly closure of Bear. Accordingly, the Federal Reserve, in close consultation with the Treasury Department, agreed to provide short-term funding to Bear Stearns through JPMorgan Chase. Over the following weekend, JPMorgan Chase agreed to purchase Bear Stearns and assumed the company's financial obligations. The Federal Reserve, again in close consultation with the Treasury Department, agreed to supply term funding, secured by $30 billion in Bear Stearns assets, to facilitate the purchase.

The provision of liquidity by a central bank can help mitigate a financial crisis. However, central banks face a tradeoff when deciding to provide extraordinary liquidity support. A central bank that is too quick to act as liquidity provider of last resort risks inducing moral hazard; specifically, if market participants come to believe that the Federal Reserve or other central banks will take such measures whenever financial stress develops, financial institutions and their creditors would have less incentive to pursue suitable strategies for managing liquidity risk and more incentive to take such risks.

Although central banks should give careful consideration to their criteria for invoking extraordinary liquidity measures, the problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis. Recall Bagehot's advice: "The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times" (p. 24). Indeed, under the international Basel II capital accord, supervisors are expected to require that institutions have adequate processes in place to measure and manage risk, importantly including liquidity risk. In light of the recent experience, and following the recommendations of the President's Working Group on Financial Markets (2008), the Federal Reserve and other supervisors are reviewing their policies and guidance regarding liquidity risk management to determine what improvements can be made. In particular, future liquidity planning will have to take into account the possibility of a sudden loss of substantial amounts of secured financing. Of course, even the most carefully crafted regulations cannot ensure that liquidity crises will not happen again. But, if moral hazard is effectively mitigated, and if financial institutions and investors draw appropriate lessons from the recent experience about the need for strong liquidity risk management practices, the frequency and severity of future crises should be significantly reduced.

These are welcome signs, of course, but at this stage conditions in financial markets are still far from normal. A number of securitization markets remain moribund, risk spreads--although off their recent peaks--generally remain quite elevated, and pressures in short-term funding markets persist. Spreads of term dollar Libor over comparable-maturity overnight index swap rates have receded some from their recent peaks but remain abnormally high.

I will concentrate on four categories of risk-management practices:  risk identification and measurement, valuation practices, liquidity risk management, and senior management oversight.

For risks to be successfully managed, they must first be identified and measured. Recent events have revealed significant deficiencies in these areas. Notable examples are the underestimation by many firms of the credit risk of subprime mortgages and certain tranches of structured products. Other firms did not fully consider the linkages between credit risk and market risk, leading to mismeasurement of their overall exposure...

Valuation practices are a second area that supervisors' comparative reviews identified as critical. The SSG report indicates that those firms that paid close attention to the problems associated with the valuation of financial instruments, particularly those for which markets were not deep, fared better. These more-successful institutions developed in-house expertise to conduct independent valuations and refrained from relying solely on third-party assessments...

Weak liquidity risk controls were a common source of the problems many firms have faced.  For example, some firms' treasury functions were not given information from all business lines about either expected liquidity needs or contingency funding plans, in part because managers of individual business lines had little incentive to compile and provide this information...

Effective oversight of an organization as a whole is one of the most fundamental requirements of prudent risk management. The SSG report highlighted solid senior management oversight and engagement as a key factor that differentiated firms' performance during the recent events. Senior managers at successful firms are actively involved in risk management, which includes determining the firm's overall risk preferences and creating the incentives and controls to induce employees to abide by those preferences...

Recent events have also demonstrated the importance of generous capital cushions for protecting against adverse conditions in financial and credit markets. I have been encouraged by the recently demonstrated ability of many financial institutions, large and small, to raise capital from diverse sources.  Importantly, capital raising and balance sheet repair allow for the extension of new credit, which supports economic expansion. I strongly urge financial institutions to remain proactive in their capital-raising efforts. Doing so not only helps the broader economy but positions firms to take advantage of new profit opportunities as conditions in the financial markets and the economy improve.

Last December, the Federal Reserve introduced the Term Auction Facility, or TAF, through which predetermined amounts of discount window credit are auctioned every two weeks to eligible borrowers for terms of 28 days. In effect, TAF auctions are very similar to open market operations, but conducted with depository institutions rather than primary dealers and against a much broader range of collateral than is accepted in standard open market operations...  The size of individual TAF auctions has been raised over time from $20 billion at the inception of the program to $75 billion in the auctions this month. We stand ready to increase the size of the auctions further if warranted by financial developments.

In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets.  The challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation.  We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations.  Over time, the Federal Reserve's commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy--including flexible markets and robust innovation and productivity--will be key factors ensuring that the dollar remains a strong and stable currency.

 From the U.S. perspective, this growth has been a double-edged sword.  On the one hand, low-cost imports from emerging markets for many years increased U.S. living standards and made the Fed's job of managing inflation easier.  Moreover, currently, the demand for U.S. exports arising from strong global growth has been an important offset to the factors restraining domestic demand, including housing and tight credit.  On the other hand, the rapid growth in the emerging markets and the associated sharp rise in their demand for raw materials have been--together with a variety of constraints on supply--a major cause of the escalation in the relative prices of oil and other commodities, which has placed intense economic pressure on many U.S. households and businesses.

The housing boom came to an end because rising prices made housing increasingly unaffordable.  The end of rapid house price increases in turn undermined a basic premise of many adjustable-rate subprime loans--that home price appreciation alone would always generate enough equity to permit the borrower to refinance and thereby avoid ever having to pay the fully-indexed interest rate.  When that premise was shown to be false and defaults on subprime mortgages rose sharply, investors quickly backpedaled from mortgage-related securities.  The reduced availability of mortgage credit caused housing to weaken further.

Thus far, the pass-through of high raw materials costs to domestic labor costs and the prices of most other products has been limited, in part because of softening domestic demand.  However, the continuation of this pattern is not guaranteed and will bear close attention...  Unfortunately, the prices of a number of commodities, most notably oil, have continued upward recently, even as expectations of future policy rates and the foreign exchange value of the dollar have remained generally stable in the past few months.  The possibility that commodity prices will continue to rise is an important risk to the inflation forecast.  Another significant upside risk to inflation is that high headline inflation, if sustained, might lead the public to expect higher long-term inflation rates, an expectation that could ultimately become self-confirming.

Our decisive policy actions were premised on the view that a more gradual reduction in short-term rates could well have failed to contain the financial and economic problems confronting us.  For now, policy seems well positioned to promote moderate growth and price stability over time.  We will, of course, be watching the evolving situation closely and are prepared to act as needed to meet our dual mandate. 

Our goal is to emerge from this difficult period with a financial system that will be more stable without being less innovative, with a more effective balance between market discipline and regulation. 

The oil price shock of the 1970s began in October 1973 when, in response to the Yom Kippur War, Arab oil producers imposed an embargo on exports. Before the embargo, in 1972, the price of imported oil was about $3.20 per barrel; by 1975, the average price was nearly $14 per barrel, more than four times greater. President Nixon had imposed economy-wide controls on wages and prices in 1971, including prices of petroleum products; in November 1973, in the wake of the embargo, the President placed additional controls on petroleum prices.²

As basic economics predicts, when a scarce resource cannot be allocated by market-determined prices, it will be allocated some other way--in this case, in what was to become an iconic symbol of the times, by long lines at gasoline stations. In 1974, in an attempt to overcome the unintended consequences of price controls, drivers in many places were permitted to buy gasoline only on odd or even days of the month, depending on the last digit of their license plate number. Moreover, with the controlled price of U.S. crude oil well below world prices, growth in domestic exploration slowed and production was curtailed--which, of course, only made things worse.

...

Fast-forward now to 2003. In that year, crude oil cost a little more than $30 per barrel.³ Since then, crude oil prices have increased more than fourfold, proportionally about as much as in the 1970s.  Now, as in 1975, adjusting to such high prices for crude oil has been painful. Gas prices around $4 a gallon are a huge burden for many households, as well as for truckers, manufacturers, farmers, and others. But, in many other ways, the economic consequences have been quite different from those of the 1970s. One obvious difference is what you don't see: drivers lining up on odd or even days to buy gasoline because of price controls or signs at gas stations that say "No gas." And until the recent slowdown--which is more the result of conditions in the residential housing market and in financial markets than of higher oil prices--economic growth was solid and unemployment remained low, unlike what we saw following oil price increases in the '70s.

I am pleased and honored to be invited back by the students of Harvard. Our speaker in 1975 was Dick Gregory, the social critic and comedian, who was inclined toward the sharp-edged and satiric. Central bankers don't do satire as a rule, so I am going to have to strive for "kind of interesting."

From the perspective of monetary policy, just as important as the behavior of actual inflation is what households and businesses expect to happen to inflation in the future, particularly over the longer term.  If people expect an increase in inflation to be temporary and do not build it into their longer-term plans for setting wages and prices, then the inflation created by a shock to oil prices will tend to fade relatively quickly. Some indicators of longer-term inflation expectations have risen in recent months, which is a significant concern for the Federal Reserve.  We will need to monitor that situation closely. However, changes in long-term inflation expectations have been measured in tenths of a percentage point this time around rather than in whole percentage points, as appeared to be the case in the mid-1970s. Importantly, we see little indication today of the beginnings of a 1970s-style wage-price spiral, in which wages and prices chased each other ever upward.

Economists generally agree that monetary policy performed poorly during {the 1970s}.  In part, this was because policymakers, in choosing what they believed to be the appropriate setting for monetary policy, overestimated the productive capacity of the economy. I'll have more to say about this shortly. Federal Reserve policymakers also underestimated both their own contributions to the inflationary problems of the time and their ability to curb that inflation. For example, on occasion they blamed inflation on so-called cost-push factors such as union wage pressures and price increases by large, market-dominating firms; however, the abilities of unions and firms to push through inflationary wage and price increases were symptoms of the problem, not the underlying cause.  Several years passed before the Federal Reserve gained a new leadership that better understood the central bank's role in the inflation process and that sustained anti-inflationary monetary policies would actually work. Beginning in 1979, such policies were implemented successfully--although not without significant cost in terms of lost output and employment--under Fed Chairman Paul Volcker.  For the Federal Reserve, two crucial lessons from this experience were, first, that high inflation can seriously destabilize the economy and, second, that the central bank must take responsibility for achieving price stability over the medium term.

Even though average economic well-being has increased considerably over time, the degree of inequality in economic outcomes over the past three decades has increased as well.  Economists continue to grapple with the reasons for this trend...

What should we do about rising economic inequality? Answering this question inevitably involves difficult value judgments and tradeoffs. But approaches that inhibit the dynamism of our economy would clearly be a step in the wrong direction. To be sure, new technologies and increased international trade can lead to painful dislocations as some workers lose their jobs or see the demand for their particular skills decline. However, hindering the adoption of new technologies or inhibiting trade flows would do far more harm than good over the longer haul. In the short term, the better approach is to adopt policies that help those who are displaced by economic change. By doing so, we not only provide assistance to those who need it but help to secure public support for the economic flexibility that is essential for prosperity.

In the long term, however, the best way by far to improve economic opportunity and to reduce inequality is to increase the educational attainment and skills of American workers...

Significant scope exists to improve the quality of price data as well--for example, by using the wealth of information available from checkout scanners or finding better ways to adjust for quality change.  I encourage researchers to become more familiar with the strengths and shortcomings of the data that they routinely use.  Besides leading to better analysis, attention to data quality issues by researchers often leads to better data in the longer term, both because of the insights generated by research and because researchers are important and influential clients of data collection agencies.

The second category of questions involves the channels through which inflation expectations affect actual inflation.  Is the primary linkage from inflation expectations to wage bargains, or are other channels important?  One somewhat puzzling finding comes from a survey of business pricing decisions conducted by Blinder, Canetti, Lebow, and Rudd, in which only a small share of respondents claimed that expected aggregate inflation affected their pricing at all.¹¹  How do we reconcile this result with our strong presumption that expectations are of central importance for explaining inflation?  Perhaps expectations affect actual inflation through some channel that is relatively indirect.  The growing literature on disaggregated price setting may be able to shed some light on this question.¹²

An inability to measure the output gap in real time obviously limits the usefulness of the concept in practical policymaking.  On the other hand, to argue that output gaps are very difficult to measure in real time is not the same as arguing that economic slack does not influence inflation; indeed, the bulk of the evidence suggests that there is a relationship, albeit one that may be less pronounced than in the past.⁷ 

Over the past decade, formal work in the modeling of inflation has treated marginal cost, particularly the marginal cost of labor, as central to the determination of inflation.²  However, the empirical evidence for this linkage is less definitive than we would like.³  This mixed evidence is one reason that much Phillips curve analysis has centered on price-price equations with no explicit role for wages.⁴

Problems in the measurement of labor costs may help explain the absence of a clearer empirical relationship between labor costs and prices.  Compensation per hour in the nonfarm business sector, a commonly used measure of labor cost, displays substantial volatility from quarter to quarter and year to year, is often revised significantly, and includes compensation that is largely unrelated to marginal costs--for example, exercises (as opposed to grants) of stock options.  These and other problems carry through to the published estimates of labor's share in the nonfarm business sector--the proxy for real marginal cost that is typically used in empirical work.  A second commonly used measure of aggregate hourly labor compensation, the employment cost index, has its own set of drawbacks as a measure of marginal cost.  Indeed, these two compensation measures not infrequently generate conflicting signals of trends in labor costs and thus differing implications for inflation.

Problems in the measurement of labor costs may help explain the absence of a clearer empirical relationship between labor costs and prices.  Compensation per hour in the nonfarm business sector, a commonly used measure of labor cost, displays substantial volatility from quarter to quarter and year to year, is often revised significantly, and includes compensation that is largely unrelated to marginal costs--for example, exercises (as opposed to grants) of stock options.  These and other problems carry through to the published estimates of labor's share in the nonfarm business sector--the proxy for real marginal cost that is typically used in empirical work.  A second commonly used measure of aggregate hourly labor compensation, the employment cost index, has its own set of drawbacks as a measure of marginal cost.  Indeed, these two compensation measures not infrequently generate conflicting signals of trends in labor costs and thus differing implications for inflation.

Empirical work on inflation, including much of the classic work on Phillips curves, has generally treated changes in commodity prices as an exogenous influence on the inflation process, driven by market-specific factors such as weather conditions or geopolitical developments.  By contrast, some analysts emphasize the endogeneity of commodity prices to broad macroeconomic and monetary developments such as expected growth, expected inflation, interest rates, and currency movements.  Of course, in reality, commodity prices are influenced by both market-specific and aggregate factors...

I have only mentioned a few of the issues raised by commodity price behavior for inflation and monetary policy.  Here are a few other questions that researchers could usefully address:  First, how should monetary policy deal with increases in commodity prices that are not only large but potentially persistent?  Second, does the link between global growth and commodity prices imply a role for global slack, along with domestic slack, in the Phillips curve?  Finally, what information about the broader economy is contained in commodity prices?  For example, what signal should we take from recent changes in commodity prices about the strength of global demand or about expectations of future growth and inflation?

Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly.  Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.  Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy.  However, the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside. 

...

Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities.  Thus far, the pass-through of high raw materials costs to the prices of most other products and to domestic labor costs has been limited, in part because of softening domestic demand.  However, the continuation of this pattern is not guaranteed and future developments in this regard will bear close attention.  Moreover, the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations.  The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.

Policymakers and other analysts have often relied on quotes from commodity futures markets to derive forecasts of the prices of key commodities.  However, as you know, futures markets quotes have underpredicted commodity price increases in recent years, leading to corresponding underpredictions of overall inflation.  The poor recent record of commodity futures markets in forecasting the course of prices raises the question of whether policymakers should continue to use this source of information and, if so, how.

Despite this recent record, I do not think it is reasonable, when forecasting commodity prices, to ignore the substantial amounts of information about supply and demand conditions that are aggregated by futures markets...

Nationally, 278 private citizens--including business people, bankers, nonprofit executives, and community, agricultural and labor leaders--serve on the boards of our 12 Banks and their Branches. These individuals provide us with extensive and current information about economic conditions from a unique local perspective. Often, they provide an early warning of shifting economic conditions before they show up in official government statistics. I commend them for their service to both the central bank and our nation.

Our health-care system is, de facto, a private-public partnership; as a result, governments should not view health-care costs narrowly as a budgetary issue. Rather, they should consider how the totality of government intervention in the health-care market--including tax policies, insurance regulation, and the structure of Medicare and Medicaid--affect the sector as a whole. The best way to reduce the fiscal burdens of health care is to deliver cost-effective health care throughout the entire system.

From the economist's perspective, the question of whether we are spending too much on health care cannot ultimately be answered by looking at total expenditures relative to GDP or the federal budget. Rather, the question, whatever we spend, is whether we are getting our money's worth. In general, good information and appropriate incentives are necessary to allocate resources efficiently.

As I have noted, I believe that the Federal Reserve's actions to facilitate the acquisition of Bear Stearns, thereby preventing its bankruptcy and the disorderly liquidation of positions by its counterparties and creditors, were necessary and warranted to head off serious damage to the U.S. financial system and our economy. That said, the intended purpose of Federal Reserve lending is to provide liquidity to sound institutions. We used our lending powers to facilitate an acquisition of a failing institution only because no other tools were available to the Federal Reserve or any other government body for ensuring an orderly liquidation in a fragile market environment. As part of its review of how best to increase financial stability, and as has been suggested by Secretary Paulson, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools. Because the resolution of a failing securities firm might have fiscal implications, it would be appropriate for the Treasury to take a leading role in any such process, in consultation with the firm's regulator and other authorities.

As part of its review of how best to increase financial stability, and as has been suggested by Secretary Paulson, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools. Because the resolution of a failing securities firm might have fiscal implications, it would be appropriate for the Treasury to take a leading role in any such process, in consultation with the firm's regulator and other authorities.

The details of any such tools and of the associated decisionmaking process require more study. As Chairman Bair recently pointed out, one possible model is the process currently in place under the Federal Deposit Insurance Corporation Improvement Act (FDICIA) for dealing with insolvent commercial banks...

Designing analogous rules for the prompt and orderly resolution of securities firms is not straightforward, as these firms differ significantly from most commercial banks in their financing, business models, and in other ways.  Despite the complexities of designing a resolution regime for securities firms, I believe it is worth the effort.  In particular, by setting a high bar for such actions, the adverse effects on market discipline could be minimized.

More generally, both the operational performance under stress of key payment and settlements systems and their ability to manage counterparty and market risks are critical to the stability of the broader financial system. Currently, the Federal Reserve relies on a patchwork of authorities, largely derived from our role as a banking supervisor, as well as on moral suasion to help ensure that the various payments and settlements systems have the necessary procedures and controls in place to manage their risks. By contrast, most major central banks around the world have an explicit statutory basis for their oversight of payment systems, and in recent years a growing number of central banks have been given statutory authority to oversee securities settlement systems as well. Given how important robust payment and settlement systems are to financial stability, a strong case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems.